Asia Pacific Union for Housing Finance International Conference on Housing April 10-13, 2013 New Delhi, India M

1. Asia Pacific Union for Housing Finance International Conference on Housing April 10-13, 2013 New Delhi, India MORTGAGE COVERED BONDS: ECONOMICS, BENEFITS, CHALLENGES Olivier Hassler ohhfinance@gmail.com

2. A fast growing marketOutstanding amounts- Chile, Korea not included (millions Euros– Source: ECBC)

3. A clear geographic expansion, but still a mostly European market - Only 4 countries in Asia currently: Japan, Korea, Russia, TurkeyIndia, Brazil, Mexico, Morocco: frameworks under waySource: Euromoney:

4. The Benefits of Covered Bonds • For lenders • Long term funding, fixed rates available But ALM mismatches generally (bullet repayment vs amortizable loans) • Rating enhancement can be significant (several notches possible) • Cost effective, cheaper than securitization • For investors • High level of security , with yield pick up • Market liquidity: no valuation problem, large volumes, market making achievable under certain conditions, repos • From a macro perspective: financial stability factor • Long term investments stimulated by security conditions

5. The 7 Pillars of a CB system Types of assets Quality standards Additional components of the cover pool Segregation of assets Coverage mechanism Supervision Management of insolvency situations

6. Assets • Main types • Traditional: well secured , low risk profile loans • Residential mortgage loans • Secured Commercial real estate loans • Public sector loans • Ship loans, used only Germany and Denmark • Trend towards diversification : consistent with the concept? • Special Commercial real estate CBs (Ireland) • SME loans (Korea, Turkey – Asset Backed Bonds distinct from Mortgage CBs-, draft US legislation, Germany – recent transactions, but with a public sector guarantee ) • Aircraft finance (Germany) • Export finance CBs (Spain) • Consumer loans (draft US legislation) • Quality standards Basic standards (legal, contractual ) to eliminate risk factors- LTV, valuation: key elements • Other components of the cover pool • Substitute assets, to allow flexibility in the management of the pool : e.g. prepayments, large issues preceding the extension of new loans • Hedging instruments

7. Coverage • Segregation of assets • Objective: avoid mingling the cover pool with the general bankruptcy estate • Methods: depend on the national legal system • Ring-fencing on balance sheet loans (typically recorded in a public register) • Specialized subsidiaries set out by dedicated legislation - ex.: France • Separation issuer /guarantor holding the cover pool: structured CB model, transposed in legal frameworks of countries where it was prevailing (Austr., NZ, Netherland, UK) • Mechanics • Coverage in terms of • principal balance outstanding (repayment perspective) • Net Present Value (liquidation perspective) • interest cash flows (continuity of servicing the bonds) • Overcollateralization • “structural”: to face temporary mismatches(delinquencies, cash flows gaps)- legal miinimum • “dynamic” : to face changes of situations (e.g. issuer’s downgrade, periodic asset coverage tests, fall of real estate prices ) • Asset coverage tests to check the coverage on an on-going basis

8. 6 - Supervision • Cover pool monitor • Compliance with requirements, legal checks • Checks of withdrawals from / entries in the cover pool • Verification of calculations (e.g. valuations, tests) • Independently organized function • Supervision by the banking Authority • Licensing • Registration of programs • Special on-going oversight • Market information on cover pool • Initial disclosure • On-going disclosure Transparency: a new emphasis of statutory & market practices (ECBC label, CBIC template, some national regulatory frameworks - ex. Norway)

9. 7 - Management of Insolvency Situations • Ring fencing legally binding • No automatic acceleration of maturity: central feature • Specific insolvency administrator • CP becomes static. Risks to address for continuation: • Lower recovery  Back-up loan servicer • Liquidity gaps possibility to borrow, soft bullet arrangement (maturity extension, typically 1 year), conversion into a pass trough structure • If portfolio liquidation unavoidable: • Legal validity of voluntary OC: critical • In case of shortfall: recourse to the general insolvency estate (paripassu typically)

10. Challenges Depositors’ subordination and asset encumbrance Withstanding financial crises Fitting in national contexts

11. Depositors’ subordination / Asset Encumbrance • CBs by commercial banks • the protection of depositors, primary goal of prudential frameworks, implies a priority over other creditors, competing with secured claim holders • Some banking laws had to be changed to accommodate CB frameworks : Australia, New Zealand • CB Overcollateralization (OC): the critical aspect • A wider issue: • CBs not the only driver of unsecured creditors’ subordination • “The real question: the ratio unencumbered assets /unsecured debt”* and its capital adequacy implication • A strong need: measuring the degree of encumbrance • Protection of depositors • Ability for the issuer to manage funding crisis by offering collateral • Assessment of assets available in a resolution situation • Another frequent claim ranking issue: salaries and tax privileges *Ralf Grossman, EMF Mortgage Info February 2013

12. Asset Encumbrance – Selected Regulatory answers • Link CBs issuance to soundness criteria • Licensing criteria • Minimum solvency ratios Italy : limits for cover pool size: • None if Capital ratio > 11% • 60% if Capital ratio = 10%-11% & tier 1 capital > 6.5% • 25% if Capital ratio = 9%-10% & tier 1 capital > 6% • Hard limits - from 4% to 20% in various jurisdictions • Regulation • Cases by case approach (UK, Netherlands) • Capital requirement to OC Denmark (capital center), Netherlands • Contribution to Deposit Insurance Schemes Not a tested solution

13. The robustness of Covered Bonds Has it been tested in the recent financial turmoil?

14. A Global Resilience to the Financial Crisis2008-2009 New issues in Europe remained strong Source: ECBC

15. … but with shorter maturitiesSource: Euromoney:

16. CB spreads parallel sovereign bonds Why?

17. Governments step in before the CB mechanism is enforced in stress situations • Spain: CedulasHipotecarias • Most CH downgraded to [A-, BBB] –fall of the housing market, risk of lower OC, insufficient transparency (i.e.no indexation of LTVs),high commercial RE components. • Strong government measures (MOU) for financial system restructuring / orderly resolution –bad bank, resolution entity- : up-stream strengthening, before reliance on cover pools • Bankia’s partial nationalization (SIFI), 2012 • Other State bail-outs : • Hypo Real Estate / Depfa Group(Ger), 2008 : nationalized • Anglo Irish Bank 2008-2010: nationalization, creation of a new bank, winding down entity with CBs - downgraded to BB-, then redeemed • Dexia (Fr/Belgium), SNS Reaal (NL): nationalized + senior unsecured bondholders bail-in (SNS) • 3CIF (Fr), 2012,: Government guarantee • Cyprus (Bank of Cyprus, Cyprus Popular (Laiki) Bank) • Before the crisis: rating uplift (1 notch) limited by the marketability of assets , inefficient foreclosure process. Covered bonds = BBB- • February-March 2013 crisis: • Severe downgrade of the country rating (B) • BC& CPB in default, but BC to be bail-out by the government and CPB merged into it • Cov Bonds excluded from the bail-in measures, contrarily to large depositors • CPB Cov Bonds downgraded to Caa • But all the Cypriot CBs were retained by the 2 issuers (to access ECB liquidity support), several were cancelled, hence not a significant test

18. Efficiency of Covered bonds in insolvency situation- Lessons for recent experiences Despite the lack of full security enforcement, recent experiences show some key conditions for the actual efficiency of CB mechanisms in insolvency scenarios: • No or remote bail-in risk, a major status in the recent bank failures, to be confirmed by regulation • Dynamic overcollateralization capacity • Market maturity and size (potential buyers / alternative servicers for the cover pool) • Sovereign rating –even for domestic investors (government's capacity to provide support if other solutions fail)

19. Conclusion:Introducing CBs- Some Key Conditions • Lenders: • Standing • Critical mass • Shortage of stable liquidity (Loan-to-Deposit Ratios, ALM constraints) • Investors: • Critical mass • Need of long term investment instruments • Adjusted investment rules • Market structure: • Strong supervision capacities • Availability of credible alternate servicers / mortgage business buyers – pass through option: a way around the lack thereof • Legal framework: • Exemption to basic bankruptcy law, • Bail-in of CB holders excluded from bank resolution/restructuring • Legal validity of OC above statutory minimum