Mortgage bond and MBS market development in the UK and France.

The UK mortgage market has been dominated by variable-rate mortgages. It is therefore not appropriate to the development of mortgage bonds as a source of funding these mortgages and banks have turned towards securitisation instead. France has modernized its financial markets to enable the development of both mortgage bonds and mortgage-backed securities.

I. UNITED KINGDOM

A. Mortgage Market

The typical UK mortgage market looks nothing like the US market. The UK has one of the most varied mortgage markets around. This market is driven by variable rate and flexible mortgages.

A relatively recent product is the flexible mortgage which is proving popular with borrowers. Flexible mortgages have developed largely in response to changes in the demographics of the UK, with less job stability, more temporary workers and increased mobility meaning income and circumstances can be changeable. The key feature of this type of loan is flexibility of payments: borrowers can pay more or less than their regular monthly payment and even take payment holidays for a few months. To the extent that the borrower has paid more than his scheduled amortization, he is often permitted to redraw (or borrow back) overpayments up to scheduled outstanding, or original advanced, amount, subject to certain conditions.

B. Motivations for RMBS 

Compared to the rest of Europe, UK has a large and established market for mortgage-backed securities-but no market for mortgage bonds. Even so, only a small proportion of UK mortgages are securitised. The main reason is that UK banks have long been able to raise cheaper funding from customer deposits than asset-backed bonds would give them. This has left smaller financial institutions that specialize in non-conforming mortgages as the main source of mortgage-backed issuance. But as customers become more selective in the "destination" of their deposits, UK banks are losing fast their source of cheap money and now start looking at securitisation. High housing prices and low rates are driving RMBS growth. The securitisation process is now well understood by UK banks that are looking to diversify their funding sources. Moreover, innovative mortgage products, such as the country's new flexible mortgages, continue to foster and create a favorable borrowing climate. (1) UK MBS issuance to date has been almost exclusively at floating rates, but this trend could change.

C. Tax Treatment

Mortgage Interest Relief" Act Source (MIRAS) has been one of the most powerful tax incentive in UK. Indeed, home ownership increased tremendously throughout the UK in the 80s. In April 2000, this tax break has been abolished. The reason is that, since it was deducted at the source, it made it impossible for eligible mortgage to be securitised.

D. Legal Framework

By now, different types of securitisation structures have been able to evolve relatively free of legal restrictions, as long as they are not expressly prohibited by existing statutes.

The UK mortgage industry is facing the prospect of government regulation. In January 2001, the government announced that mortgage sales would be brought under the jurisdiction of the Financial Services Authority (FSA). It also would set benchmark CAT (Cost, Access and Terms) standards for mortgages.

This is part of the legal framework provided by the Financial Services and Markets Act, under which the FSA is the unique regulator. This Act is not implemented yet.

In June 2001, the FSA issued its draft Interim Prudential Sourcebooks (IPSBs) for building societies (CP51) and banks (CP52). These set out the prudential framework until the end of 2002 when the new Final Prudential Sourcebook will be introduced. One of the consequences of the FSA's securitisation rules will be the establishment of new obligations for any building society involved in securitisation.

E. Risk Assessment

1. Credit risk

In the case of MBS, the credit risk depends only on the quality of the collateral (asset cover) and on the transaction structure.

FitchIBCA believes that the primary indicators of potential for future delinquency and default are a combination of the following factors: the affordability of a loan for a borrower (ability to pay) and the LTV ratio (incentive to pay).

2. Prepayment risk 

With the growing popularity of flexible mortgage products and a review by the Office of Fair Trading, prepayment penalties are increasingly being dropped from mortgage products. However, many mortgage lenders, having dropped penalties, offer teaser rates encouraging the borrower not to prepay. In effect, the borrower will still be penalized for early redemption. In addition, prepayment penalties remain applicable to many of the fixed and capped-rate mortgages currently available during the fixed or capped period. Levels of prepayment are therefore difficult to predict and will not necessarily follow a historical trend.

In the case of flexible mortgages, assessing this risk depends upon the specific features of the mortgage product. FitchIBCA has found that there is little uniformity to flexible mortgage products with regard to such factors as restrictions on redrawing (e.g. some lenders may impose fees above a certain redraw amount, others may not) and the extent to which a borrower may redraw. Note that there are no redemption penalties in the case of flexible mortgages.

The "master trust" technique (2) is a structure to eliminate prepayment risk. An example is the "Holmes Financing" issue. The vehicle-Holmes Financing-issued the equivalent of USD 3.4 bn of securities backed by a pool of GBP 7.2 bn-worth of mortgages. Because of the size of the pool of mortgages, and the fact that new loans can be added into the structure to replace those that repay early, Holmes Financing is able to issue securities that look more like conventional bonds.

F. Concluding Remarks

The UK mortgage market has been dominated by variable-rate mortgages (flexible mortgages know an increasing success). It is therefore not appropriate to the development of mortgage bonds as a source of funding these mortgages. Given the increasing selectivity customers operate in the destination choice of their funds, banks have turned towards securitisation as an alternative to decreasing customer deposits.

II. FRANCE

A. Mortgage Market

Traditional mortgage lenders are not looking to securitise. Thus, most activity will be generated by specialized mortgage lenders that have clearly targeted securitisation as a strategic refinancing source.

There is significant state support of housing financing. This is not only reflected in a wide offer of mortgage loans of a strongly social nature, but also in the total share of the so-called social ownership of fiats or houses. Two products-the Epargne-logement and the 0% loan--are examples of this policy.

B. Specialized Funding Vehicles

1. Mortgage Bonds-Obligations Foncieres

General mechanism in its legal framework:

As part of the modernization and strengthening of the French financial markets, a new mortgage banking act came into force on June 25, 1999. This reform has been motivated by the 1995 crisis of Credit Foncier de France, the introduction of the Euro and the desire to stimulate the bond markets.

In line with the new regulations, which are similar to the German model in a number of areas, financial institutions are allowed to found special subsidiaries--"Societes de Credit Foncier" (SCF)-which are entitled to issue the French version of mortgage bonds--"Obligations Foncieres" (OF)--to refinance property and public sector loans activities.

OF meet the requirements dictated by the UCITS Directive. In addition, French mortgage bonds are admitted to the Tier 1 register of the European Central Bank.

A specialist bank principle applies in France. SCF's activities are restricted to the issue of mortgage loans and loans to the public sector in Euroland countries, and to the issue of OF and unsecured bonds. Therefore, foreign assets are limited to Euroland countries. Thus, as opposed to Germany, lending to Central and Eastern Europe is prohibited. Unlike in Germany, the law in France does not impose a ceiling on the total issue volume of OF. However, the absolute volume of OF is limited by the value of the assets available as cover.

OF can basically be secured by all available assets eligible as cover. Eligible assets are loans secured by a real estate lien, credit to the public sector, shares in loan pools and substitute cover assets. For property loans, there is a loan to value ceiling of 60% of the value of the property (unless specific guarantees are available). The French version of MBS ("Parts de Fonds Communs de Creances") can be also be included in the pool of assets of the SCF provided that at least 90% of the underlying loans are assets eligible for a SCF.

SCF must stick to the principle of surplus cover prescribed under the French law, according to which the value of assets must at all times be higher than any liabilities with priority in the event of bankruptcy.

Holders of OF are given priority in the event of bankruptcy, which applies to all interest and repayment amounts. Even the French State comes second to the claims of OF holders. In addition, if required, the ex-cover business is also at the disposal of the creditors, although the parent company's assets cannot be used. Moreover, in the event of bankruptcy proceedings involving the parent company, the assets of the SCF may not be included, so that the default risk of the OF is at least kept separate from a legal point of view from that of the party providing the business.

Consumer protection laws allow borrowers to repay their loans early. The mortgage banks protect themselves against prepayment risk through overcollateralization and by keeping more liquid assets in the pool.

As a summary, the new mortgage banks exhibit the following characteristics:

* specialized credit institutions with limited scope of their activities (to mortgage business)

* fund mortgage loans and loans to local authorities, which remain on banks' balance sheet

* loans are originated and managed by another bank (SCF)

* loan-to-value ratio is fixed at 60%

* valuation of assets regulated by law

Issuers:

In France, OF were traditionally issued by two institutions: Credit Foncier de France and Caisse de Refinancement de l'Habitat (CRH). Since June 25, 1999, the issuers are "societe de credit foncier" (SCF). Currently, there are two SCF in operation (see "Development").

Market structure--liquidity and transparency:

To ensure a certain level of liquidity, market makers and issuers of OF have agreed on minimum standards, which closely mirror the rules governing the German jumbo Pfandbrief. The issue volume of a jumbo OF must be at least EUR 500 ran, and three market makers must simultaneously quote offer and bid prices for deals of up to EUR 15 mn during the respective trading period. OF must be listed on at least two European stock markets and have two ratings. Hence, exceptionally high legal requirements have been set up in terms of security and transparency.

Development:

Since the law came into force, the market for French OF has experienced strong growth. Credit Foncier de France and Credit Local de France have each set up a mortgage banking subsidiary--the Compagnie de Financement Foncier (CoFF) and Dexia Municipal Agency (DexiaMA)--and have issued Euro jumbos with a volume of EUR 10.7 bn.

Further credit institutions are likely to follow the successful primary market debut of CoFF and DexiaMA, leading to a rise in the number of issuers, increased market depth and liquidity.

2. Mortgage-Backed Securities--Parts de Fonds Communs de Creances

In many respects, the SCFs are a form of securitisation, sharing some of the characteristics of France's FCC. Some of these characteristics are the sale of receivables process, limited purpose entity, limited risk of default, credit enhancement to achieve target rating and subcontracting of operational functions. Notable differences exists however, which have to do mainly with the scope of operations of the SCF, which does not have the same closed-end nature associated with other form of securitisation. Moreover, in theory, a SCF may exist for an unlimited period.

C. Tax Treatment

These are the possible deductions:

* 25% of interest on a new property up to the amount of FRF 20,000 for a single person

* 25% of interest on a new property up to the amount of FRF 40,000 for a married couple

* 25% of interest on an existing property up to the amount of FRF 15,000

These amounts will vary depending on the number of dependants.

D. Legal Framework

1. Mortgage Bonds

* French mortgage bonds follow the characteristics prescribed under Article 22(4) of the UCITS Directive.

* The Law of June 25, 1999, together with the implementing decree of August 3 and the regulation of July 21 issued by Comite de la Reglementation Bancaire et Financiere (CRBF), market the official creation of the special status of the Societes de Credit Foncier (SCF). This new legal framework is largely inspired by the status accorded previously to Credit Foncier de France as well as by the German Pfandbriefe.

2. Mortgage-Backed Securities

* The "1988 Act", complemented by the "1989 Decree" which have been amended and supplemented several times since then, most recently by a new Act, the "1998 Act" and two new Decrees, the "1997 Decree" and to "1998 Decree".

In the case of FCC (securitisation), companies can decide to go offshore when they do not want to or simply cannot meet the legal constraints imposed by the 1988 Act.

E. Risk Assessment

1. Credit risk

a. Mortgage bonds

In the case of mortgage bonds, the credit risk depends on the quality of the originator and of the collateral.

The treatment of holders of Obligations Foncieres in the event of default by the issuer differs from the provisions of common French bankruptcy law in at least three major aspects:

* Priority claim

* Even in the event the SCF files for bankruptcy, Obligations Foncieres must be honored on the due date.

* The bankruptcy of the parent company may, under no circumstances, apply by extension to its subsidiary if it is an SCF.

With respect to this last point, it is important to analyze the legal relationship between the parent company and the SCF and the resulting risks.

Legal relationship between parent company and SCF:

The bankruptcy of the parent company cannot apply by extension to the SCF. This does not mean that the SCF is a bankruptcy-remote vehicle. The SCF is a financial institution, provided with a legal status and is exposed to the risk of bankruptcy like any other corporation. However, while an SCF bankruptcy may arise from insufficiency of assets or liquidity, it cannot be brought about legally by the bankruptcy of the parent company. However, sensitivity to the parent company's credit raring and outlook is far from negligible mainly on the operational level (management of the SCF by the parent entity). Hence, eligible assets ,are transferred out of the balance-sheet but are consolidated by parent(s). To limit this transfer risk, a back-up servicer could be designated in theory but it might turn out to be problematic to replace the parent company.

However, this extension risk is limited to the extent that the SCF will be able to unilaterally terminate the servicing agreement if the servicer is placed in receivership or in bankruptcy proceedings. Moreover, the provision in the Act of June 25, 1999 forbids the SCF from holding equity interests in the parent company, which eliminates the threat of a subsidiary's bankruptcy being extended to the SCF. Therefore, the OF instrument lies in a quasi-bankruptcy remoteness structure. Furthermore, in case of insolvency, mortgage bond holders have priority claim over all collateral assets of the SCF.

Given that the SCF lacks total independence from the issuer, it could be subject to administrative delays in the event of issuer default (lower rating than similar German Pfandbriefe).

Collateral:

Assets serving as collateral for the Obligations Foncieres present an inherent credit risk. This credit risk is a function of the probability of default, the severity of the loss in the event of default, the time to recovery and foreclosure costs. These factors vary considerably according to the type of asset. The counterparty risk is an additional credit risk.

However, maximum LTV thresholds have been set: 60% for commercial real estate, 60% to 80% for residential housing--up to 80% provided that the portion of the loan that is larger than 60% is financed by non-privileged debt. Although the LTV varies according to the type of collateral, there is no such differentiation at the instrument level. Indeed, as opposed to Germany, there is only one single type of OF.

A minimum overcollateralization is legal and mandatory requirement. It specifies that the amount of assets must be at all times higher than the nominal value of total liabilities. This overcollateralization is lost in case of bankruptcy.

Protection against mismatching is not compulsory although the law requires the special supervisor to inform both the SCF's management and the Commission Bancaire in SCF's mismatching risk appears to be too high.

In terms of external support mechanisms, there is no formal recourse to assets outside the SCF.

In view of the high requirements in terms of cover funds and extensive priority in the event of bankruptcy, the bonds have been rated with a triple A by all three big rating agencies.

b. Mortgage-backed securities

In the case of MBS, the credit risk depends on the collateral and on the transaction structure. It is thus possible to separate the rating of the issue from the originator's financial strength.

Link between parent entity and FCC:

In compliance with the 1988 Act, the transfer of assets give rise to a "true sale", and therefore permits an off-balance sheet treatment for the seller, without the risk that a court may recharacterize the transfer as a loan granted to the seller that is secured by a pledge on its receivables. However, it is important to verify the solvency of the seller at the time of each purchase. Pursuant to French bankruptcy law, a sale of assets such as receivables may be challenged by the bankruptcy receiver during a claw-back period if the receiver can prove that the sale was made at a price substantially below the market value of the assets, or that the purchaser was aware of the seller's insolvency at the time of the purchase.

Subordinated structures:

FCC may issue subordinated units ("Parts Specifiques"), which will first support the risk of default of the debtors; payment of interest and principal amounts due under the subordinated units will be subject to the prior payment in full of interest and principal due under the senior units ("Parts Ordinaires").

In order to protect investors against the risk of default of the assigned debtors, the 1989 Decree as amended by the 1998 Decree sets forth five different types of protection, one or more of which may be used:

* A guarantee from an independent third-party

* The issuance of subordinated units

* Overcollateralization

* Security interests attached to the assigned receivables

* Subordinated loans 

In practice, the credit enhancement of most French securitisation transactions results from a combination of different elements. The first layer of protection, which is not mentioned as such in the 1989 Decree, is provided by the excess spread, i.e., the difference between the interest generated by the receivables and the sum of the interest paid on the units and the fees paid to the FCC participants. To be considered as credit enhancement, the excess spread must be put aside in a reserve account when not used to cover losses under the assigned receivables. If the excess spread is not sufficient, another frequently used credit enhancement devise consists of issuing subordinated units that will first absorb the default risk of the assigned debtors. The last credit enhancement devise often used is the irrevocable and unconditional guarantee issued by an independent third-party.

Moreover, in order to avoid any risk of insolvency or mismanagement of assets, FCCs are prevented from engaging in certain transactions.

2. Prepayment risk

Prepayment risk in France exists. However, prepayment penalties are capped by law: 3% legal ceiling. Moreover, there is currently a tendency to limit these penalties as much as possible. Indeed, Article 97 of the Law of 06/25/99 states that:

"Lenders are not permitted to charge early prepayment penalties on residential mortgage loans in case the prepayment is necessitated by forced disposal of residence for professional reasons, in case of death, redundancy, or invalidity (this clause is not exclusively applicable to SCFs)".

F. Concluding Remarks

France has set up a legal and regulatory framework with the objective to modernize and strengthen its financial markets. This process was stimulated by the success of the German Pfandbriefe. It is thus no surprise that the French legal framework is similar in many aspects to its German counterpart.

Contrary to Germany, France had no history in mortgage bonds. Therefore, the mortgage bond dominance observed in Germany is much more balanced in France. Indeed, the country has modernized its financial markets to enable the development of both mortgage bonds and mortgage-backed securities.

The legal structure of SCF and FCC and their relationship with their parent entity is highly regulated. This enables to enhance the level of credit risk, which in turn strongly affects the development of mortgage funding vehicles.

END NOTES

(1) Most flexible mortgages allow the borrower to make overpayments and pay interest only on that portion of the unpaid principal balance.

(2) This structure has been put together by Schroder Salomon Smith Barney for Abbey National in year 2000.

MATHILDE FRANSCINI Graduated from HEC Lausanne, Switzerland in 2001. She is a titular of a Licence en Science 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.

Exhibit 1. FCC Notes vs. Obligations Foncires

                         FCC Notes           Obligations foncieres

Legal nature of the  FCC, mutual funds   Credit institutions certified
      vehicle          without legal     as financial institutions by
                        personality         the CECEI "societes de
                                              credit foncier-SCF"

Kind of securities   Co-ownership units       Preferential bonds
      issued                                "obligations foncieres"
                                         and/or other nonpreferential
                                                   resources

 Exclusive object        To acquire         To grant or to acquire
                        receivables         secured loans, loans to
                     and to issue units   public sector entities, and
                     representing these    other securities, and to
                        receivables       finance these assets either
                                         with privileged "obligations
                                           foncieres" or with other
                                           nonpreferential resources

    Supervision         Mgt company        Commission bancaire--CB--
                        approved by       and specific controller in
                          the COB             accordance with CB

  Eligible loans        Any kind in         Law on 06/25/99 on SCF
                      accordance with
                     the provisions of
                          the FCC
                         Reglement

 Transfer of loans   Yes, by means of a       Yes, by means of a
                         bordereau                 bordereau

LTV for real estate          No             Depends of the kind of
       loans                                         loans
   Imposed over-             No             Yes, with specific risk
collateral isation                                 weighting

Debtor notification  No, except in case               Eq.
                        of servicer
                       substitution:
                      ordinary letter

  Enforceability     As of the date of                Eq.
   against third       the bordereau
      parties

 Mgt and recovery    Indirect: seller/   Direct or indirect by credit
     of loans        originator, credit          institutions
                      institutions or
                       the Caisse des
                         Depots et
                       Consignations

  Utilization of      Yes, in order to      The instruments used in
 hedging financial       cover only         order to hedge eligible
    instruments                              assets and privileged
                                          resources will benefit also
                                              from the privileged
                                                   resources

  Fungibility of       Possibility to                 Yes
       risks         divide an FCC into
                       compartiments

 Off balance sheet          Yes                       No
     treatment

  Bankruptcy risk       No, no legal      Yes, but the liquidation of
                        personality       its parent company does not
                                         trigger the liquidation of an
                                                      SCF

 Early redemption           N.A.                      No
in case of issuer's
    bankruptcy

Source: Fitch IBCA, "Obligations Foncieres: Fitch IBCA's
Approach", 1999