European mortgage markets.

Mortgage lending is a growth industry in Europe. The volume of mortgage loans outstanding in the EU and Norway has increased at a remarkable rate, more than doubling (in nominal terms) over the period 1988-1998, and amounting to around EUR 3 tn at the end of 1998, representing 33% of European GDR The external source of funding of mortgage credit is split between retail markets and the wholesale capital markets. In other words, the funding vehicles can either be classified as "specialized" referring to mortgage bonds and MBS, or as "general" referring to deposits (saving deposits and accounts) and other general funding (bank bonds, loans from other MFIs and insurance premiums).

I. THE ASSET SIDE

A. Overview

1. Mortgage market growth

Mortgage lending is a growth industry in Europe. The volume of mortgage loans outstanding in the EU and Norway has increased at a remarkable rate, more than doubling (in nominal terms) over the period 1988-1998, and amounting to around EUR 3 tn at the end of 1998, representing 33% of European GDP.

This important growth in the mortgage lending industry has been the result of a certain number of factors. Among them stand the technological advances (Internet as a growing distribution channel), the financial sector deregulation and a low interest rate level. The latter resulting from the countries preparing their economy for the introduction of the single currency. The consequent highly competitive environment led to a decrease in house prices and therefore stimulated the demand for new mortgage loans.

2. Structural diversity

Although this growth is globally very important, mortgage markets are structurally very different from each others; they retain strong national characteristics and their economic importance varies from one country to another.

The largest markets in terms of volume outstanding are Germany, the United Kingdom, France and the Netherlands. The markets that have grown most during the period 1988-1998 are Portugal, Spain, Ireland and the Netherlands. In Denmark, the Netherlands, the United Kingdom and Germany, the volume of residential mortgage loans outstanding is equivalent to 50% of GDP or more, in contrast to other countries such as Italy, Greece and Austria, where it is equivalent to less than 10%.

The large differences in size of the mortgage markets as a proportion of the national economy is mainly due to structural differences between countries: different types of lenders and consequently different types of product granted (e.g. duration of mortgage loans, type of mortgage interest rate and loan-to-value ratios). These structural differences are themselves the consequence of different political, historical and legal frameworks in which mortgage lenders operate. The differences across mortgage markets are also the result of differences in the property markets and in the construction industry. Furthermore, the general economic situation has also an important role to play. Despite economic convergence in Europe, there are still significant differences in the fundamental macroeconomic variables which in turn impact the development of the national mortgage markets.

3. Residential vs. Non-Residential mortgage loans

We can distinguish between residential mortgage loans and non-residential mortgage loans. Overall residential mortgage lending is significantly more important than non-residential mortgage lending. However this second type of activity still represents a relatively important segment of the EU mortgage markets and its share is steadily increasing. The volume of non-residential mortgage loans outstanding amounted to more than EUR 430 bn at the end of 1998 which represents 15% of the total volume of mortgage loans outstanding. Here again, this proportion only represents an average. Indeed, the significance of non-residential mortgage loans in comparison to their residential counterpart varies from one country to another. In Norway, Italy and Spain, nonresidential mortgage lending represents 30% or more of total mortgage credit activity. The largest non-residential mortgage lending market is Germany.

4. Lenders

Mortgage loans are granted by a large variety of different types of mortgage lenders. They range from specialized credit institutions (mortgage banks, building societies, Bausparkassen and other specialist mortgage lenders) to savings banks, mutual banks, co-operative banks and universal banks. Theses types of lenders are Monetary Financial Institutions (MFIs) and grant more than 90% of the mortgage loans in the EU (1).

The current composition of the mortgage market share by type of lender has been shaped by the progressive deregulation of financial industries in Europe. Until the 1980s, mortgage activity was dominated by specialist lenders such as mortgage banks and building societies. Deregulation has enabled non-specialized lenders to enter the mortgage market and put pressure on specialized lenders to change their legal statute. As a result, commercial banks have been increasing their market share in the mortgage market industry. Nonetheless 60% of mortgage credit is still granted by specialized institutions and more particularly mortgage banks. These banks dominate in Denmark and Sweden with 90% and 80% of market share respectively and are active in Germany, France, Austria and the Netherlands.

5. Governmental intervention

European governments support the development of home ownership through a system of tax benefits (indirect intervention) or subsidies (direct intervention). The results of a survey of 1998 made by the European Mortgage Federation confirm the tact that tax relief represents the most common form of facilitating ownership of fiats and family houses. In the majority of member countries it is possible to deduct interest charges from the taxable income base, either in full of in part.

6. Trend towards integration

The current situation of" fragmented mortgage and property markets is increasingly subject to external factors of change which should, in the long run, lead to a greater degree of integration. The factors usually cited are: deregulation, the internal market, the single currency, the Internet and last but not least, the revision of bank capital requirements.

B. Main structural differences with respect to its American counterpart

There is a great diversity of mortgage lenders in Europe as housing finance systems have evolved within national boundaries. This contrasts with the US mortgage market which is dominated by mortgage banks.

European mortgage loans remain, most of the time, on the balance sheets of banks and are capital intensive (50% or 100% weighting). US institution, on the other hand, remove these loans from their balance sheet through the securitisation process.

As a consequence, European mortgage lenders need to hold funds of between 4% and 8% for mortgages on balance sheet. Thus, credit risk and prepayment risk remain on the European banks' balance-sheet.

II. EUROPEAN MORTGAGE FUNDING--"THE LIABILITY SIDE"

A. Overview

1. Analysis in terms of sources of funds

The use of an internal source of" funding-namely the equity capital--does only help to fund a minor part of the mortgage loans.

Indeed, the external source of funding of mortgage credit is split between retail markets and the wholesale capital markets. In other words, the funding vehicles can either be classified as "specialized" referring to mortgage bonds and MBS, or as "general" referring to deposits (saving deposits and accounts) and other general funding (bank bonds, loans from other MFIs and insurance premiums).

* Nowadays, saving deposits still account for a large part in this funding, although there is an increasing recourse to the capital markets, in particular through the issue of mortgage bonds. The use of saving deposits to finance mortgage loans is the most widespread method in Europe. Savings deposits are used by universal banks, savings banks and mutual and co-operative banks. However, this vehicle is not used by mortgage banks, building societies and insurance companies. Given the desire of most depositors to have ready access to their capital, the use of savings for mortgage funding offers the lender no long term guarantees. Consequently this form of funding tends to favor mortgage products with variable rates of interest. In the majority of countries, credit institutions are increasingly combining short-term deposit retail funding with special derivative products to fund longer term fixed mortgage loans for the purpose of market risk reduction. The exceptions are Denmark and France.

* The mortgage bond is, a long term fixed interest rate product. The issuance of mortgage bonds is the second most important type of funding method after retail deposits. The volume of mortgage bonds outstanding in the EU is estimated at EUR 530 bn (end 1999). Mortgage bonds provide almost 20% of the funding of all mortgage credit in Europe. At present, three countries (Germany, Denmark, Sweden) share 88% of the overall mortgage bond market. However, the relative sizes of the national mortgage bond markets in Europe is expected to change in the near future as several countries try to promote this funding instrument, largely inspired by the success of the Pfandbrief in Germany.

* The issuance of MBS is the alternative method to fund mortgage loans through the capital markets. MBS has however developed to a far lesser extent in Europe than in the United States. The value of MBS outstanding in the EU and Norway is estimated at EUR 16 bn which represents less than 1% of total residential mortgage loans outstanding (end 1998). However, MBS has become a significant funding vehicle in United Kingdom, Ireland, Spain and France and its importance is increasing.

These last two instruments represent the secondary mortgage market. First, it is important to underline the fact that secondary mortgage markets have been slow to develop in Europe (and globally outside the US). The major reasons for their slow growth have been the need to introduce the legal and regulatory infrastructure for securitisation, the lack of need to sell assets by major lenders (2), the access to favorably priced retail funds by depository institutions, and the lack of a government-sponsored secondary market entity. This is slowly changing.

Second, it should be emphasized that the situation varies widely across country and by type of mortgage lenders. Heterogeneity has always been an European characteristic. The development of secondary mortgage market instruments, namely mortgage bonds and mortgage-backed securities has not spread evenly throughout Europe. The reasons for this disparity in the market developments lie mainly at the national level: mortgage market structure, credit culture, legal and regulatory framework are the most important factors contributing to the development of this securitisation process.

2. Analysis in terms of financing model

The traditional model of housing finance is one in which specialized institutions are created or provide incentives to concentrate their lending activities in housing. These institutions are portfolio lenders that perform all of the functions of mortgage lending: origination, servicing, risk management and funding. The major distinction between the different types of specialized institutions lie in their primary funding source: deposits, mortgage bonds or direct government funding.

* Depository system. The specialized institutions can be commercial banks, savings banks, savings and loans, building societies, and credit unions. They are characterized by a predominance of short-term deposits as their primary funding source. For Asset/Liability management purposes, this funding source leads most institutions in these systems to offer mainly variable rate mortgages.

* Mortgage bank systems. These are systems in which the lenders have primary if not exclusive dependence on mortgage bonds as a funding source. Although they are also portfolio lenders they obtain funds from the capital markets rather than deposits.

The modern model of housing finance is one in which the various functions (origination, servicing, risk management, funding) are unbundled and performed by specialized entities. This model is based on a secondary mortgage market wherein mortgage loans are sold and securitised. Loan sales may come from traditional mortgage lenders or mortgage companies that specialize in the origination and servicing of the mortgage assets. Mortgage companies may operate on a retail basis (dealing directly with the borrowers or brokers) or a wholesale basis (buying loans from other lenders, packaging them and re-selling or securitising them. There are two primary secondary market models:

* Direct Sale: In a direct sale system the originating lender pools the loans and issues the securities, typically through a trust or special purpose vehicle. Credit enhancement is done by a third party, pool insurer, bond insurance company or by structuring the securities (e.g. senior-subordination, reserve funds). Most MBS issued in Europe have been direct sales by originating lenders.

* Conduits. Conduits are specialized institutions that purchase mortgages from a number of different lenders, contract with these lenders or other institutions to service the mortgages and issue MBS. Credit enhancement may be done, as in the "direct sale" case, by the conduit itself: Conduits may be government supported or private.

3. Impact of model housing finance development on the securitisation process

Increased cross-border competition will reduce retail funding advantages and increase the use of securitisation for balance sheet attractiveness and reduce relative funding costs. As these market develop, entry by origination/servicing specialists as in the US will develop.

B. Main structural differences with respect to its American counterpart

1. Agency vs Non-Agency backing

European mortgage banks are portfolio lenders, tightly regulated, funding their mortgage loans to a large extent through the issue of mortgage bonds whereas their American counterpart sell their loans into the secondary market to the federal agencies who benefit from lower capital-to-assets ratios than banks. These US central government sponsored enterprises indeed play a central role in the mortgage lending industry. The EU law, by contrast, considers state aid in the form of guarantees as an element of competitive distortion. There is thus no such national or central government agency to help lenders fund their loans in Europe. Mortgage loans have to be funded on the basis of the financial strength of banks or the intrinsic quality of the securities.

The implicit guarantee of the US government agencies has thus important implications on the structure and development of the mortgage market in the United States. This element of state aid in the American mortgage funding reduces funding costs by about 50 bp. Besides the implicit guarantee, the government agencies have an emergency credit line from the Treasure of $8.5 billion. Moreover, Fannie and Freddie have roughly $32 of debt for each dollar of capital (compared to $ 11.5 of debt per dollar at private banks). Furthermore, the sheer size of the enterprises allows economies of scale. All these elements reduce fundamentally the mortgage funding costs, increasing the attractiveness of the capital market to raise the needed funds and, as a consequence, leading to a far more developed secondary, market were mortgage securitisation plays a central role.

2. Funding costs

As a consequence of this disparity in terms of" government backing, funding instruments are inexpensive in US but relatively costly and capital intensive in Europe. On the old continent, MBS are 50% weighted in contrast with MBS issued by US government sponsored agencies and other AAA institutions who enjoy a 20% weighting. Mortgage bonds (only issued in Europe) are 10% weighted following the compliance of criteria set by the EU. Mortgage bonds trade 20 to 30 bp over government bonds and MBS trade with an average spread of 75 bp 150 bp over government bonds.

END NOTES

(1) In 1997, the European Mortgage Federation classified the different types of mortgage lenders according to the ESA95 framework. Mortgage lenders are classified as follows: a) Monetary Financial Institutions (MFI) include universal/commercial banks, mortgage banks/mortgage credit institutions, savings banks, mutual and co-operative banks, building societies, Bausparkassen, other specialized mortgage lenders; b) other financial intermediaries refer to umbrella companies (SPVs) established to hold securitised mortgage assets through MBS; c) insurance companies and pension funds, d) other sectors.

(2.) Some countries in which lending institutions are sufficiently capitalized prefer to hold the loans on their books.

MATHILDE FRANSCINI Graduated from HEC Lausanne, Switzerland in 2001. She is a titular of a Licence en Sciences Economiques, a Master in Banking and Finance (MBF) and a Certificate FAME (Financial Asset Management and Engineering). She currently works at ABB Financial Services.

TAMARA SCHILLINGER obtained a Licence en Sciences Economiques from University of Lausanne, Switzerland in 2000; a Master of Science in Banking and Finance from University of Lausanne, Switzerland in 2001-2002. Tamara is currently working for ABB Financial Services.