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Mortgage bond and MBS market development in Germany.

Funding mortgage loans through Pfandbriefe is constrained by a conservative loan-to-value limit of 60%. Therefore, there is an increasing need for MBS, particularly synthetic transaction. However, MBS are still subject to 100% risk weighting.

The international reforms, through the Basel Accord among other things, will affect German banks more than in any other European country because they will force them to change their less-stringent capital reserve requirements, which now give them a competitive advantage in pricing loans and holding them on their books. Furthermore, Landesbanks, the state-owned German banks required to lend on property law, enjoy "AAA" ratings because they are state supported. This gives them a funding advantage that has been recently challenged by the European Banking Federation to the European Union.

I. RESIDENTIAL PROPERTY MARKET STRUCTURE

The German property market has historically been stable and conservative:

* A relatively stable interest rate environment has led to a large proportion of fixed-interest mortgages with long maturities. The interest is mainly fixed for between five and ten years. However, high penalties make an early conversion of the loans in time of falling interest rates economically unattractive.

* Lenders are generally conservative in their lending policy. As a rule, borrowers are expected to have a minimum equity cushion of about 20% of the value of the property. Down payment is typically 35 to 40%.

The main mortgage lenders are the savings banks and private mortgage banks with a share of around 25% each. With a market share of about 15% cooperative banks are the third largest group of lenders. Universal banks have less than 10% of the property lending market.

The mortgage banks are strongly specialized as a consequence of legal restrictions and mainly integrated within the scope of the major universal banks where they act as subsidiaries.

These mortgage banks can only refinance a maximum of 60% of the mortgageable value through Pfandbriefe. The amount over and above this 60% cannot be included in the collateral for Pfandbriefe and must be refinanced elsewhere, creating an opportunity for MBS.

Some characteristics of the German housing market can be highlighted. First, the level of home ownership has always been very low in Germany--40%, with 42% in Western Germany and 31% in Eastern Germany. This is due primarily to historical reasons (state housing policy), to the high land and property prices and to an unfavorable tax regime. However, home ownership is expected to rise in the long term. Second, there seems to be a certain geographical attachment in Germany, which means that there is little geographical mobility. Third, there are huge social and cultural barriers against defaulting on mortgage payments.

In the traditional model category, there is a mix of the depository system (savings banks, cooperative banks) and of the mortgage bank system (mortgage banks). In the modern model category, the direct sale system is predominant.

II. SPECIALIZED FUNDING VEHICLES

A. Mortgage Bonds--Pfandbriefe

The German Pfandbrief market is the largest non-state segment in the European bond market with a volume outstanding of over EUR 1 tn at the end of 1999. Public Pfandbriefe account for around 80% of the volume outstanding, the rest being Mortgage Pfandbriefe.

1. Types of mortgage bonds

Traditional Pfandbriefe

The bonds are usually with fixed interest rates and with maturities of 1 to 10 years (although the medium term maturities of 5 to 7 years predominate). On average the size of a classical Pfandbrief is some EUR 150 mn. Traditional Pfandbriefe are offered for sale in the open market in the form of tap issues. Within one issue, individual series are set up, the issuing price of which varies depending on the capital market rate applicable at the time of issue. This type of mortgage bond is flexible and can thus be tailored to investors' specific needs.

Jumbo Pfandbriefe

In order to be considered as a Jumbo, the issue volume has to be at least of EUR 500 mn. Other conditions need to be met: a) only fixed-interest, bullet instruments with annual interest payable in arrears (so-called straight-bond format); b) at least three market makers, two rates with a spread of a maximum of 5 to 10 pfennigs; c) standardization (which makes for transparency) of the Pfandbrief global certificate, the Pfandbrief terms and conditions and other documentation.

The jumbo Pfandbrief market currently consists of over 280 Pfandbriefe with a maturity of up to 14 years and a combined volume of over EUR 325 bn. Here the Public Pfandbrief, which is covered by state loans is dominant. Recently however, Jumbo Mortgage Pfandbriefe have increasingly been issued too. For example, in 1999 a Global Mortgage Pfandbriefe in the amount of EUR 2 bn was launched. The successful placing of new issues with international investors, the listing of jumbo Pfandbriefe in various international bond market indices and the issue of Globals, which are offered in the leading financial centers, underline the attraction and outstanding role of the jumbo Pfandbrief among European spread products. The inclusion of large-volume Pfandbriefe in the electronic trading system EuroCreditMTS, which brings the jumbos involved closer to the liquid government bonds, reflects the success of this new instrument.

Jumbo Pfandbriefe are placed through issuing syndicates consisting of national, and to an everincreasing extent, international banks. To guarantee the liquidity of Jumbo Pfandbriefe at all times, at least three syndicate banks must act as market-makers for each issue.

There is apparently a trend towards larger issue volumes (EUR 2 bn or more). As a result of the EMU convergence process, the remaining yield difference between government bonds of the EMU countries have settled on a low level and jumbo Pfandbriefe might benefit from an increase in the demand for spread product. In this new environment, this new security is becoming a European benchmark in view of its high rating, liquidity, homogeneity, and rising international investors' market acceptance. One can thus assess Jumbo Pfandbriefe as liquid and transparent, but not very flexible, instruments.

Structured Pfandbriefe

These bonds range from simple step-up bonds or callable bonds to highly complex structures. They can be tailored to specific risk-yield profiles. Although these instruments are flexible, they are illiquid and are therefore of interest to buy-and-hold investors. International investors show great interest in such structured products.

2. Issuers

45 credit institutions are allowed to issue Pfandbriefe. 23 are private mortgage banks whose lending operations are limited essentially to mortgage loans and public-sector loans. In addition to these "pure" mortgage banks, there are also two "mixed" mortgage banks. The latter are also licensed to engage in universal banking operations. The remaining are 19 credit institutions from the public sector (among others, 12 Landesbanken) and two private ship mortgage banks.

33 amid the authorized institutions are present in the jumbo market. The five most active issuing banks account for a combined market share of around 50%. Those are Depfa, AHB, Hypo Essen, Dt. Hypo H/F and Rheinhyp.

3. Investors

Credit institutions (banks) represent the largest investor (26% in 1998), followed by insurance companies (23%). Foreign investors represent about 20% of the market share. This large proportion is due to their primary interest in the Jumbo Pfandbriefe. In 1999, around 40% of newly issued Jumbos were placed abroad.

4. Market structure-liquidity and transparency

There is a high level of liquidity due to large market volumes and high issue volumes, the market making, a relatively well developed secondary market and a broad investor base. Furthermore, additional liquidity is expected in the future due primarily to electronic trading (EuroCreditMTS).

There is also a high level of transparency due to standardization procedures, introduction of Pfandbrief indices and introduction of the German mortgage bond in the cross-segment and cross-border bond indices of international investment banks.

One important addition has come in the shape of Medium Term Note (MTN) and Commercial Paper (CP) programs, which are being launched by a growing number of mortgage banks and under which Pfandbriefe can be issued with different maturities and in different currencies. Programs of this kind offer issuers a number of advantages; in particular: a high degree of flexibility in refinancing, an access to new circles of investors and a reduction in the workload and consequently in the costs.

5. German Pfandbrief--a European benchmark

German Pfandbriefe together with the other newer European mortgage bonds are an essential component of the financial intermediation bringing together the demand for funds by households in order to finance real-estate property at an efficient cost of capital and the supply of funds by portfolio investors who wish to obtain an attractive return on safe and liquid fixed-income debt securities. The safety of the mortgage bond allows lenders to obtain funds in capital markets at a reduced borrowing cost. The possibility to issue mortgage bonds therefore encourages lenders to provide medium or long term finance for housing, non-residential property or urban development at the lowest and most stable rate of interest for the borrower.

The German Pfandbrief is the only non-government bond in Europe that satisfies all the main criteria for a benchmark function, that is:

* a first-class, internationally recognised credit standing

* modern issuing and trading practices used internationally

* sufficient liquidity in all important maturities

* a wide range of derivatives

The German Pfandbrief is included in the Tier 1 category with the ECB. As such it automatically retains its eligibility for Lombard credit, repo and settlement transactions within EMU, can be used by commercial banks across borders and without restrictions for open-market transactions with the ECB and the national central banks. This makes the Pfandbrief the only private sector debt instrument so far to be placed on a par with government bonds.

The success story of the Pfandbrief on the international capital markets in recent years is reflected in the increasing interest shown by foreign investors in Pfandbrief market investments. Today, about a quarter of all Pfandbriefe are held in foreign portfolios.

The growing international demand for Pfandbriefe is just one indication of the esteem in which the Pfandbrief is held beyond Germany's borders. Another indication are the numerous Pfandbrief-like systems that have emerged in other European countries of late and which are often very closely modeled on the strict regulations laid down in the German system.

As far as the investors are concerned, the growing variety of Pfandbrief-style products makes a differentiated credit assessment of the individual products all the more important. Above all, the collective term "Pfandbrief" which is frequently used internationally for this paper must not be allowed to disguise the significant differences that exist in terms of credit quality and market liquidity. The German Pfandbrief must continue to be seen as the undisputed benchmark.

B. Residential Mortgage-Backed Securities

1. MBS market development

So far in Germany, there have only been isolated examples of Residential Mortgage Backed Securities (RMBS). Nonetheless, at around EUR 900 bn, the German residential property market is by fare the largest in Europe. However, at the moment, German RMBS still only play a secondary role in the European capital market. The GEMS 1995 and HAUS 1998 are the only MBS transactions in Germany, which were mainly secured by residential properties.

Due to the low liquidity level, MBS in Germany are often "buy-and-hold" investments.

2. MBS relative attractiveness

For issuers, RMBS offer much greater flexibility than Pfandbriefe for the purpose of securitising mortgage loans. For universal banks especially, which are not allowed by law to issue Pfandbriefe, RMBS are an attractive opportunity for refinancing their loan books and to improve their balance sheet equity. Mortgage banks can securitise subordinated loans and the residual loan amount exceeding the 60% LTV ratio.

From the investor's point of view, RMBS offer a much broader spectrum of risk/return combinations and they therefore lend themselves to diversification along the credit curve. For this reason, however, RMBS require a more detailed risk analysis than the largely standardized Pfandbriefe.

3. True sale vs. synthetic MBS transactions

"Pfandbriefe technology" allows for the large volume issuance of a mix of commercial and residential properties, whereas RMBS can only be issued backed by residential properties loans. Synthetic unfunded structures have been the most common, allowing issuers to transfer risk without transferring the assets.

A major new development is the use of residential mortgages for credit default swaps, which entitle banks that use them to receive regulatory and monetary relief: These structures combine funding and capital relief objectives.

Numerous problems of true sale transaction structures in Germany: restrictions imposed by bank supervisory authorities as for example the transfer of personal or corporate loans is often subject to special sales clauses. The sale of loans out of the bank's balance sheet to a SPV can be rendered more difficult as a result. However it should be noted that these clauses have been amended in more recent contracts. Another problem facing banks when they come to sell loan assets is that of complying with bank secrecy regulations.

Apart from these problems set by the true sale, cost considerations and the time needed to bring a transaction to market have been the main factors explaining the growing importance of synthetic transactions.

Few German RMBS transactions to date are structured as traditional true sale transactions. Indeed, most German RMBS transactions have been structured in a synthetic form. And particularly, a certain number of unfunded structures have been executed. CLN are going to play an important role alongside the refinancing methods just mentioned.

4. Rating

A central problem in the valuation of RMBS in Germany is the limited availability of data. The rating agencies are therefore dependent on assumption and on statistics that are hardly representative for the whole market. In their attempt to limit the resulting risk, those agencies make very conservative assumptions.

III. TAX TREATMENT

Mortgage interest does not qualify as an item deductible from the taxable income base. The tenant-friendly legislation and tax incentives for investment properties lead to relatively low rent levels when compared with the cost of owner-occupied housing. Therefore, most individuals buying property for their own use do so more as a result of personal preferences rather than pure economic considerations.

IV. LEGAL FRAMEWORK

A. Mortgage Bonds

German Pfandbriefe follow the characteristics prescribed under Article 22(4) of the UCITS Directive. Mortgage banks are the major issuer group and are subject to the Mortgage Bank Act, which has the following major implications:

* Specialist bank principle

* Risk offset in separate collateral pools

* Pfandbrief creditors' preferential claim in case of insolvency

* Independent trustee

* Volume of Pfandbriefe outstanding limited by own capital

* Limited activities abroad

* Risk management

Some special safety features for the mortgage Pfandbriefe include the following:

* Prudential calculation of the mortgage lending value

* A 60% LTV shields against price fluctuations

* Financing only for multi-function properties

* Tight rein on development finance

* The Pfandbrief enjoys a privileged position

The German legal framework is completed by the Act on mortgage bonds and related bonds from public credit institutions and by the new insolvency law (January 1, 1999). One of the new features of this law is the possibility of a private bankruptcy.

B. Mortgage-Backed Securities

In Germany, unlike in Spain or in France, for example, there is no specific legal framework for the issue of MBS. However, since 1997 the supervisory authority of the German banking sector (BaKred) has circulated answers to a number of key questions relating to supervisory rules in connection with MBS. MBS are thus issued in Germany since 1997 after appropriate clarification from BaKred. The issuers are mortgage banks and all-purpose banks with large mortgage credit portfolios.

V. RISK ASSESSMENT

A. Credit Risk

1. Mortgage bonds

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

Germany has set up a strong legal framework and effective supervision in order to ensure the quality of the mortgage bonds.

Elements determining the quality of the originator

The largest group of originators is composed by mortgage banks. Therefore, we will assess the quality of mortgage banks as originators of mortgage bonds.

First, mortgage banks follow a specialist principle in the sense that their activities are legally constrained, mainly to public sector, residential and commercial mortgage lending in Germany. The restrictions on the lending operations of mortgage banks are aimed at obtaining the highest possible quality of covering assets. However, the Mortgage Bank Act, the Public Pfandbrief Act and the Shipping Bank Act are about to be amended. The amendment will expand the scope of activities of the mortgage banks: apart from covering transactions, mortgage credit will be possible in the US, Canada and Japan.

Second, mortgage banks are under special supervision, namely a regulatory body and an independent trustee.

Third, in terms of credit quality of the assets being securitised, mortgage banks must adhere to cautious mortgageable values as laid down by law and only first ranked mortgage loans may be used as cover. The Mortgage Banking Act stipulates that the mortgageable value may not exceed the carefully calculated sale value. In addition, the basis for the calculation of the value must be documented and authorized.

From the above paragraph, it is clear that the quality of mortgage bonds will be strongly determined by the quality requirements of the underlying collateral.

Elements determining the quality of the collateral

Given that mortgage bonds are collateral-secured instruments, the credit risk is strongly determined by the quality of the collateral, which is influence by the followings:

First, not only is a prudential calculation of the mortgage lending value required, but maximum Loan-To-Value thresholds are also set. The maximum is generally 60%, but it can increase up to 80%. In the case of social housing loans, it can even go up to 93%.

Second, only public-sector loans and first-ranked mortgages loans are eligible collateral assets given the high safety embedded (government guarantee or underlying property).

Third, mandatory overcollateralization has been set up. Indeed, the law requires the amount of assets to be at all times higher than the nominal value of total liabilities. This feature is lost in case of bankruptcy.

Fourth, since the third law for the promotion of the financial market came into force, the collateral pools for Pfandbriefe have taken on the status of special assets (bankruptcy remoteness). Therefore, in case of bankruptcy, cover assets may not count as part of the insolvency funds and the Pfandbriefe may not be called in. As a result, the issuer's ability to meet its financial commitments is now only a marginal factor in mortgage bonds' credit rating, which now hinges mainly on the quality of the loan portfolio. Furthermore, in case of bankruptcy, mortgage bonds holders have priority claim over the collateral assets, i.e. all mortgages in the asset pool. Indeed, Pfandbriefe are fully covered by all the mortgage loans included in the issuer's cover pools. This loans portfolio is characterized by constant inflows and outflows during the period of the issue and theoretically therefore, the portfolio has a perpetual maturity. This remark is valid for all mortgage bonds, not only for those issued in Germany.

Fifth, some interest and maturity matching required under the mortgage Banking Act. But this applies only to the Pfandbriefe and their respective asset pools. Mortgage banks are not restricted in terms of overall mismatching.

Sixth, external support mechanisms have been organized. For instance, in the event of insufficient proceeds from the pool assets to cover their claim, Pfandbriefe investors rank pari passu with senior debt holders. In addition, the parent bank may extend some other form of support.

Finally, since clear "rules of the game" are in place in Germany, i.e. parties to the relationship between a mortgagor, a mortgage bank and holders of mortgage bonds are familiarized with their statutory and contractual rights and obligations, exercising a mortgage (reimbursement of old mortgage and replacement by new loan) does not pose any insurmountable problem. The violation of obligations arising from mortgage transactions may rather be seen as something exceptional, which is for instance reflected in the low proportion of amounts enforced via auctions to the mortgage loan portfolio--approximately 1%.

Therefore, it is no surprise that today, virtually all issuers of(Jumbo) Pfandbriefe carry a seal of quality from at least one of the three large rating agencies. Every Public Pfandbrief rated thus far has received at least one Triple-A by one rating agency. Mortgage Pfandbriefe has also been awarded the highest possible rating in the majority of cases.

2. 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.

There are no restrictions in terms of the quality of assets and no limit on the maximum possible lending level on a property. This offers more flexible opportunities for an investor in terms of risk/return profiles.

The loan pool to be securitised is usually determined at the beginning of the maturity based on set eligibility criteria. If; during the term of the MBS, there are any defaults or prepayments in the loans portfolio, then they will be passed on to the investor in the MBS. The loan are not replaced. As a consequence, the cash flows generated by an MBS transaction are not truly known at the date of issuance. This remark is valid for all MBS, not only for the ones issued in Germany.

B. Prepayment Risk

The Pfandbrief investor bears virtually no prepayment risk since early repayment is precluded in the first 10 years by contract. Furthermore, German banks often prohibit renegotiation of the terms of a mortgage in the early years of the loan, but since German interest rates have been consistently low, few consumers have complained.

In case the bank agrees to a prepayment, it will do so only against reimbursement of the economic loss sustained as a result (early prepayment penalty). Therefore, a borrower is permitted to prepay a loan subject to certain prepayment penalties for fixed-rate loans. There are generally no prepayment penalties for variable-rate loans or fixed-rate loans at their reset date. Prepayment penalties for fixed-rate loans before the reset date are calculated based on the interest rate differential to current interest rates until the reset date.

VI. CONCLUDING REMARKS

The high quality of the Pfandbriefe, both in terms of credit risk and prepayment risk, explains the development of the current market. However, other factors are also responsible for this growth. Hence, standardization and thus flexibility have been crucial to the development of the Pfandbrief market. Finally--and most importantly--the cost advantage of mortgage bonds relative to MBS (Basel Accord risk weighting) has given Pfandbriefe the opportunity to become a major fixed-income instrument.

However, given the 60% LTV limit, mortgage banks will find it necessary in the future to fund their mortgages through off-balance securitisation instruments such as MBS. Therefore, the use of MBS will come into play primarily in lending beyond the cover limit. Cost and flexibility factors, as well as legal considerations (the lender's duty to inform the borrower when loans are transferred) provide clear indications that synthetic transactions will constitute the bulk of the MBS transactions done.

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.
Exhibit 1. Basic Features of True Sale and Synthetic RMBS Vs
Pfandbriefe Transactions

 RMBS

 True Sale Synthetic

Assets Assets transfered to Defined pool of
 an SPV reference assets and a
 defined notion of losses

Nature of the Residential mortgage Residential mortgage
assets loans loans

Issuer SPV SPV or a sufficiently
 rated bank or any bank
 with certain collateral
 arrangements

Funding Fully funded to match Unfunded, partially
 the pool of assets funded, or fully funded
 based on the obligation
 of the rated bank or
 collateral arrangements

BS treatment Generally designed for Generally designed for
 off-BS treatment off-BS treatment

Principal and From the pool of From the issuing bank or
interest segregated assets the collateral securing
payments the funded elements

CF analysis Detailed CF analysis to Rated collateral usually
 ensure the payments from tailored to provide CF
 pool of assets are as required. Interest
 sufficient to payments subparticipation might
 of interest and principal require separate CF
 on the rated debt in a modeling
 recessionary environment

Maturity of the Dependent on the Potentially part of the
transaction maturity of the transaction definitions
 underlying assets

 Hypotheken Pfandbriefe

Assets Assets with a cover register

Nature of the Principally residential and
assets commercial mortgage loans
 up to 60% lendable value as
 defined by the Mortgage
 Banking Act and associated
 rulings

Issuer Mortgage bank or
 Landesbank

Funding Fully funded and supported
 by assets in the cover
 register

BS treatment On-BS design

Principal and Assets of the cover register
interest
payments

CF analysis Detailed CF analysis
 addressing the dynamic
 nature of the asset pool

Maturity of the Usually shorter than the
transaction underlying assets, but still
 dependent on the asset
 characteristics
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Title Annotation:mortgage backed securities
Author:Schillinger, Tamara
Publication:The Securitization Conduit
Geographic Code:4EUGE
Date:Mar 22, 2001
Words:4180
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