EU-Monitor 86
Financial Market Special
August 12, 2011
Bank funding of residential
mortgages in the EU
The funding and financing of residential mortgages may affect
financial stability, because mortgages are both an important asset
and liability for MFIs and households. The question is: which funding mix
contributes most to financial stability?
Mortgage funding markets in Europe are diverse. Covered bonds and
RMBS accounted for the funding of more than 50% of outstanding residential
mortgages in 8 out of 27 EU countries at the end of 2010. In 8 countries neither of
the two funding instruments was used.
MBS and covered bonds: different risk monitoring incentives, lengths
of intermediation chains and resilience in times of stress have effects
on financial stability. A crucial factor seems to be the ―on-balance-sheet―
nature of covered bonds, standardisation and quality requirements regarding
collateral.
Covered bond funding proved resilient in the crisis. However, it is exactly
those features that have a stabilising effect which limit the use of covered bonds
as a funding instrument. MBS are a necessary complementary funding instrument
that will benefit from regulatory changes.
Unattractive pricing vis-à-vis other fixed income assets prevents the
MBS market from re-launching. One factor is the lack of important
information, for instance on prepayment rates. The prepayment option has a value
of 40-50 bp. More and better data on prepayment rates would contribute to
transparent risk-adjusted pricing and enable deeper analysis.
Measures that will target problems identified with bank funding
during the crisis. More and better transparency, a closer matching of maturities,
the management of misaligned incentives, less leverage, risk-adjusted pricing and
adequate internal transfer pricing.
Author
Sophie Ahlswede
+49 69 910-31832
sophie.ahlswede@db.com
Editor
Bernhard Speyer
Securitisation: Different importance as a funding instrument
for banks
RMBS outstanding (Q4/2010) and outstanding mortgage covered bonds (end-2010) as a %
of residential mortgages outstanding (end-2010)
140%
120%
Technical Assistant
Sabine Kaiser
Managing Director
Thomas Mayer
60%
40%
20%
0%
MT
BG
SI
EE
LT
RO
CY
LU
PL
LV
AT
FI
FR
DE
CZ
SK
GR
HU
IT
UK
PT
BE
ES
SE
NL
IE
DK
Deutsche Bank Research
Frankfurt am Main
Germany
Internet: www.dbresearch.com
E-mail: marketing.dbr@db.com
Fax: +49 69 910-31877
100%
80%
RMBS
Mortgage covered bonds
Sources: ECB, ECBC, EMF, ESF, DB Research
EU-Monitor 86
Bank funding structures are
important for financial stability
The development of bank funding before and during the crisis has
highlighted its importance for financial intermediation and credit
1
provision in an economy. One main lesson is that maturity
mismatches not only within individual institutions but in the financial
system as a whole, created risk that was neither adequately priced
2
nor prepared for. This led, among other factors, to financial market
instability. Residential mortgages are an important asset in most
economies, accounting for a large part of banks’ assets and
households’ liabilities. Their financing and funding may affect
financial stability.
This paper provides an overview of banks’ funding of residential
mortgages in Europe, taking a close look at the structure of funding
instruments and potential effects on financial stability.
Differences in mortgage funding
Some funding instruments of banks can be clearly attributed to
residential mortgages: securitised debt in the form of covered bonds
or residential mortgage backed securities (RMBS). Others such as
equity, unsecured debt or hybrid forms of the two, and deposits are
general sources of funding, which are not clearly linked to a
particular line of business. Nevertheless, they may also be used to
fund mortgage lending. In the case of equity, retail deposits or longterm senior unsecured debt this is generally not worrying from the
maturity perspective because these funding instruments are
associated with a medium- to long-term permanence even in times
Banks' issuance
Euro-area-17, in EUR bn, securities
excluding shares and derivatives
6,000
5,000
4,000
3,000
Residential mortgages: Importance varies
2,000
Outstanding lending for house purchase in % of total assets, 12/2010
35%
1,000
1993
1999
2005
30%
0
2011
25%
20%
Short-term securities
Long-term securities
… of which fixed rate issues
… of which floating rate issues
10%
5%
1
0%
LU
MT
IE
BE
RO
AT
SI
CY
IT
FR
BG
Euro area
DE
HU
UK
GR
FI
NL
CZ
SK
ES
PT
SE
LV
PL
LT
DK
EE
Source: ECB
15%
Sources: ECB, DB Research
Certificates of deposit
of stress. The permanence in times of stress can be further
increased for retail deposits by having credible and sustainable
deposit guarantee schemes in place. Short-term unsecured debt
instruments, interbank lending and wholesale deposits, however,
tend to be more volatile funding instruments. Since the beginning of
the crisis short-term and floating-rate issues have remained
constant or declined while long-term and fixed-rate issues have
increased (see chart 1).
Short-term bonds
Funding risks
Repurchase agreements
Funding risk is the ―potential for unanticipated costs or losses due to
3
a mismatch between asset yields and liability funding costs.―
MFIs' funding layers
1 Equity
Subordinated debt
Medium and long-term senior debt
2 Customer deposits
3 Commercial paper
Swapped foreign exchange liabilities
Wholesale deposits
Source: ECB
3
1
2
3
2
2
In UK, NL, RO, HU and BE, 4-12% of mortgage loans were provided by non-banks
in 2007. However, funding of non-banks will not be a topic in this paper. For details
see London Economics. Study on the role and regulation of non-credit institutions
in EU mortgage markets. September 2008.
ECB. EU banks’ funding structures and policies. May 2009, p. 28.
IFCI Risk Institute: www. Riskinstitute.ch
August 12, 2011
Bank funding of residential mortgages in the EU
Funding risk may result from maturity mismatches, currency
mismatches and liquidity risk.
Funding in foreign currency
Euro-area-17 financial and non-financial
issuers, outstanding securities in non-euro
currencies as % of total outstanding
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
99
01
03
05
07
09
11
Short-term securities other than
shares
Long-term floating-rate issues
Long-term fixed-rate issues
Source: ECB
4
Housing loans in foreign currency as % of
total housing loans to households*
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
AT BG PL HU LT EE LV RO
End 2007
End 2010
* LV, LT: all loans, not only mortgages
5
European mortgage market
Outstanding amounts at the end of the
period, in EUR bn
6,000
5,000
4,000
3,000
2,000
1,000
RMBS
Mortage covered bonds
Residential mortgages
August 12, 2011
Funding liquidity risk is the risk that liabilities can only be met at
prices that result in the obligor incurring a loss, or not at all. If this
risk increases suddenly, as seen recently in the financial crisis, this
can pose a threat to financial stability as well.
Securitised debt
The bank funding landscape of residential mortgages in Europe is
diverse: in 8 out of 27 countries covered bonds and RMBS
accounted for the funding of more than 50% of outstanding
residential mortgages at the end of 2010. However, in another 8 EU
countries banks did not use covered bonds or mortgage backed
securities at all.
Covered bonds
Covered bonds are a part of the banks’ funding mix in 18 EU
member states. All in all, the value of European mortgage covered
bonds outstanding at the end of 2010 was around EUR 1.8 tr – a
third of the EU´s residential mortgage market (see chart 6). The
volume of the EU mortgage covered bond market grew by almost
18% p.a. between 2003 and 2010. However, the relevance of
covered bonds for the residential mortgage market differs
significantly from country to country. In Poland or Latvia covered
bonds hardly exist, while in 12 member states they accounted for a
minimum of 17% and up to 100% of residential mortgage funding in
2010. The different take-up of covered bonds as a funding
instrument has several reasons: 1) While some markets have a long
history of covered bond legislation (e.g. DE, DK, FR), others only
introduced a legal basis a few years ago (e.g. NL, SE, UK, IT, EL,
PT, FI, IE); 2) legal frameworks differ, making covered bonds more
or less attractive as a funding tool and for investors; or 3) alternative
funding like deposits, unsecured bonds and securitisation are
available and more attractive.
In addition to the mainly national legal framework for covered bonds
some EU legislation affecting and loosely defining covered bonds
2010
2009
2008
2007
2006
2005
2004
2003
0
Sources: AFME, ECBC, ECB, DB Research
Foreign currency risk results from assets and liabilities in different
currencies. Some euro-area banks depend to a substantial part on
non-euro currency funding (see chart 4) and in some other EUcountries, private households have increasingly taken on debt in
5
currencies not equalling the currency of their income (see chart 5).
Hence, when the ―debt currency‖ appreciates vis-à-vis the ―income
currency‖, borrowers can face higher debt service. Depending on
whether default risk resulting from currency volatility was adequately
priced or hedged by issuers, this could contribute to financial
instability.
Considering the importance of residential mortgages for banks and
households in many economies, the question is: which funding mix
for residential mortgages contributes most to financial stability?
FX mortgages
Source: National central banks
A maturity mismatch occurs when short-term funding is used to
issue long-term assets, e.g. mortgages. When risk resulting from
this maturity transformation is not adequately priced, this may
4
contribute to financial instability in times of stress.
4
6
5
Gambacorta, Leonardo and David Marques-Ibanez (2011). The bank lending
channel: Lessons from the crisis. BIS working paper No. 345. May 2011.
ECB (2010). EU Banking Sector Stability Report. September 2010 and ECB
(2011). Financial Stability Review. June 2011.
3
EU-Monitor 86
exists. Covered bonds receive a preferential treatment in EU
legislation (UCITS, CRD and Solvency directives) if they fulfil certain
basic criteria. The UCITS directive sets limits for investments in
securities by mutual funds and allows a higher concentration in
6
covered bonds (25% as opposed to 5% for other securities). In the
CRD covered bonds receive a preferential risk weighting for the
7
calculation of capital requirements.
Residential mortgage backed securities (RMBS)
Residential mortgage backed securities (RMBS) are being used as
a funding tool by banks in 12 out of 27 EU countries. They
accounted on average for 23% of outstanding mortgage funding in
the EU at the end of 2010. In 2006, this was estimated to be around
Securitisation of residential mortgages in Europe
RMBS outstanding in % of residential mortgages outstanding
Q1/2008
Q3/2008
UK
IT
Q1/2009
Q3/2009
Q1/2010
ES
IE
PT
BE
Q3/2010
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Q1/2011
NL
Sources: AFME, ECB, DB Research
7
8
10%. However, they only play a major role in seven countries: BE,
NL, IT, IE, UK, PT, ES. In those countries, RMBS accounted on
average for 52% of residential mortgage funding at the end of 2010.
While Belgium, Ireland and Italy had the highest growth rates of
9
RMBS outstanding between 2008 and 2010 (see chart 7) , the
highest amounts outstanding of total European RMBS are in UK, NL
and ES.
MBS are based on individual contracts which are partly
standardised but there is no law regulating collateral or supervision
of securitisations in most countries. As for covered bonds, the same
EU legislation affects securitisation.
Other sources of funding
Deposits are more important for
banks in new member states
10
Competition for deposits has increased which is further fuelled by
regulatory initiatives such as Basel III and bank levies introduced
recently in many markets. For example, in the calculation of the
bank levy in Germany, a larger share of deposits in total liabilities
will lead to lower contributions. However, deposits are finite
depending on a variety of factors (e.g. income, savings, interest
11
rates). They grew by 7% p.a. in Europe during the last 10 years.
6
7
8
9
10
11
4
Art. 52 (4) of Directive 2009/65/EC.
Art. 113, 3. (l) and Annex VI, Part 1, point 71 of Directive 2006/48/EC.
Report of the Mortgage Funding Expert Group 2006.
Including retained issuance. Retained issuance for all securitisations in Europe
(not only MBS) was around 23% in 2007. In 2008 and 2009 94% and 96% were
retained and only very selected transactions were placed. In 2010 retained
issuance declined slightly to 81%, see ESF Securitisation 2011 datafile.
ECB (2010).
Calculated on the basis of the 14 countries for which ECB data on deposits by
non-MFIs is available for February 2001-February 2011. Deposits by non-MFIs
August 12, 2011
Bank funding of residential mortgages in the EU
Mortgage lending increases where it
is not restrained by deposit growth
In general, deposits play a more prominent role in the funding of
banks in the new Member States. Where no form of securitisation is
used, deposits are more important or mortgages are not that
important as assets for banks. In countries where the mortgage
market is relatively large compared with the size of the economy,
deposits are relatively unimportant and covered bonds and/or RMBS
account for a high share of residential mortgage funding. This points
to increased mortgage lending where funding is not restrained by
deposit availability and growth. The ability to refinance assets via
on-balance (covered bonds) or off-balance (MBS) securitisation
relieves banks of funding constraints.
Funding structures and importance of mortgage credit 2009
How important
are mortgages
as assets for
MFIs?
How important How important
are mortgages are mortgages in
for the economy? households loan
portfolios?
How important
are mortgages
relative to
households
income?
How important
are RMBS as a
funding tool?
How important
How important
are mortgage
are deposits as
covered bonds as a funding tool?
a funding tool?
Mortgages as % Mortgages as % Mortgages as % Mortgages as % RMBS as % of
of total MFIs
of GDP
of total loans to of net disposable mortgages
assets
households
income of
outstanding
households
Mortgage
Total deposits
covered bonds as from non-MFIs
% of mortgages in % of MFIs
outstanding
total assets
LU
1.8%
42.0%
56.6%
-
0.0%
0.0%
34.6%
MT
5.4%
43.0%
70.3%
-
0.0%
0.0%
38.9%
IE
6.5%
90.3%
77.1%
123.0%
48.9%
26.9%
23.4%
BE
7.5%
43.3%
75.8%
39.1%
61.2%
0.0%
46.9%
RO
7.5%
4.9%
24.2%
0.0%
0.0%
53.3%
AT
8.2%
26.2%
54.9%
44.1%
3.0%
7.2%
42.0%
SI
9.1%
11.4%
46.7%
18.2%
0.0%
0.0%
46.5%
CY
9.1%
61.3%
50.3%
88.0%
0.0%
0.0%
50.9%
IT
9.3%
21.7%
56.5%
28.7%
49.6%
5.0%
41.9%
FR
9.9%
38.0%
75.1%
56.3%
1.6%
18.8%
36.8%
BG
11.2%
12.6%
43.8%
28.6%
0.0%
0.0%
61.3%
DE
11.7%
47.6%
68.0%
61.9%
1.8%
23.4%
31.4%
HU
12.5%
16.7%
50.5%
29.1%
0.0%
48.4%
49.5%
UK
12.8%
87.6%
83.0%
98.8%
46.4%
20.3%
36.0%
GR
15.5%
33.9%
69.3%
40.5%
13.7%
9.6%
56.4%
FI
16.0%
58.0%
73.0%
73.7%
7.9%
10.6%
31.7%
NL
16.0%
105.6%
89.1%
143.8%
52.2%
7.5%
44.9%
CZ
16.8%
19.4%
70.2%
36.1%
0.0%
31.4%
70.6%
SK
18.6%
14.6%
67.9%
24.4%
0.0%
38.0%
69.2%
ES
19.2%
64.6%
75.0%
97.3%
25.5%
51.2%
49.8%
PT
20.4%
67.5%
79.7%
96.5%
32.3%
18.3%
42.7%
SE
21.0%
82.0%
66.6%
98.2%
0.2%
88.3%
28.0%
LV
21.4%
36.6%
79.3%
58.6%
0.0%
1.2%
46.1%
PL
21.7%
18.2%
50.8%
26.7%
0.0%
1.1%
60.7%
LT
23.3%
22.6%
72.1%
32.0%
0.0%
0.0%
45.5%
DK
24.1%
103.8%
85.8%
271.7%
0.0%
120.5%
25.8%
EE
29.4%
44.5%
82.1%
79.7%
0.0%
0.0%
46.5%
-
Sources: ECB, ECBC, EMF, Eurostat, DB Research
8
So, which specific features of the two funding instruments make a
difference with regard to their impact on financial stability?
grew 8.3% p.a. in the last 5 years (26 Member States). Most of the new Member
States had double-digit CAGRs in the last 5 years.
August 12, 2011
5
EU-Monitor 86
How covered bonds and MBS affect financial stability
Three aspects play a role when looking at differences in the way
covered bonds and MBS affect financial stability: 1. risk monitoring
incentives; 2. the length of the credit intermediation chain; and 3.
resilience in times of stress.
Risk monitoring
Covered bonds: issuer monitors and
hedges risks
The cover pool of covered bonds is generally dynamic. This means
that in case a loan in the cover pool defaults or prepays, the issuer
substitutes it with a performing loan. The cover pool is essentially a
credit enhancement rather than an exposure to the asset class from
the point of view of the investor because first of all he has a claim
vis-à-vis the issuer. In case the issuer fails, he also has a claim on
the cover pool. From the perspective of the issuer this order of
claims carries risks that he has to monitor and hedge. The bank that
originated the loan therefore retains a strong incentive to monitor its
performance.
MBS: risks are completely passed on
to investors
By contrast, MBS generally have a static cover pool and pass
ondefaults and prepayments directly to investors or allocate them
according to tranches reflecting different maturities and default risk.
For example, there could be three different tranches A, B and C,
where tranche A receives the first prepayments and/or defaults, B
the later ones and C the last. Investors with a long desired maturity
and high risk aversion will opt for tranche C while short-term
investors may choose tranches A or B.
Default rates in Europe
Countries missing: DE, NL, AT, SE, SI, LU
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
2008
No RMBS*
2009
RMBS
Hence, interest rate risk, prepayment risk and default risk is passed
on to investors in the case of MBS. The pass-through of risks
translates, inter alia, into higher risk premia for MBS compared with
12
covered bonds. A result of this risk transfer together with the
derecognition of the securitised loans from the balance sheet, is that
the incentive for the issuer to monitor those risks decreases. This
has resulted in higher default rates in the case of loans securitised
13
in US subprime RMBS. Data on the European market is patchy but
points into the same direction (see chart 9). Default rates for
residential mortgages tend to be higher in countries were banks
securitised and sold loans off their balance sheet.
The length of the intermediation chain
* Countries where RMBS are not or hardly used as a
funding instrument by banks
Sources: AFME, European Commission,
DB Research
Another feature that distinguishes covered bonds from MBS is that
they generally pay fixed rates while MBS generally have floating
rates.
9
Another difference between the two instruments is the length of the
intermediation chain:
Covered bonds: short intermediation
chain
Assets backing the cover pool of a covered bond are not
derecognised from the balance sheet of the issuer. The bank issuing
the covered bond is the direct intermediary between the borrower
and the investor. Hence, the initial risk taker (bank) and the one
bearing the risk (investor) have a close relationship.
MBS: longer intermediation chain
In a simple securitisation the intermediation chain has at least one
more layer: the bank advancing the loan to a borrower sells the loan
to a special purpose vehicle (SPV). The SPV funds its purchase of
12
13
6
Schaefer, Stefan (2006). Integration of EU mortgage markets: Its the funding,
commissioner! DB Research. EU Monitor 38. 19. October 2006.
Keys, Benjamin et al. (2008). Did securitization lead to lax screening? Evidence
from subprime loans. December 2008 and Mian, Atif and Amir Sufi (2008). The
consequences of mortgage credit expansion: Evidence from the U.S. mortgage
default crisis. December 2008.
August 12, 2011
Bank funding of residential mortgages in the EU
the loans with the issuance of bonds which it sells to investors and
which are backed by claims on the loans purchased. Some
investors in turn fund the purchase of those bonds by issuing shortterm papers.
The lengthening of the intermediation chain of funding carries risks
14
to financial stability. This is due to risk being transferred several
times which increases the distance between the originator and the
ultimate risk bearer.
Who holds what?
The investor base in European RMBS and covered bonds is not
transparent. According to the CML, investors in UK RMBS before
the crisis were increasingly (around 75%) so-called leveraged
15
investors, including banks. Long-term unleveraged investors such
as pension funds, insurers or other asset managers chose to invest
in more long-term fixed-rate bonds such as covered bonds. A survey
among covered bond dealers in 2009 showed that only 34% of
covered bond investors can be counted towards the ―intermediary
16
sector‖, i.e. the so-called leveraged investors.
Resilience in times of stress
Looking at the performance in terms of spread widening and actual
issuance during the financial crisis, covered bonds proved to be a
17
more resilient funding instrument than MBS. Apart from the
structural differences already mentioned (risk monitoring, short
intermediation chain), quality requirements for covered bond
collateral are strict. The standardised quality requirements and credit
enhancement via ―dual recourse‖ contributed to the (relative)
liquidity of the market. Investors knew what they were buying and
pricing was less distorted by doubts about the value of the
underlying assets. Yields of covered bonds have started to show a
stronger differentiation since the beginning of the crisis (see chart
10) which reflects different levels of resilience. This is, among other
18
things , a result of different legal requirements.
Funding via Pfandbriefe is very attractive
Covered bond yields
Yield to maturity in %, all maturities,
collateral includes mortgages and/or public
loans
8.0
7.5
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
04 05 06 07 08 09 10 11
FR
DE
IE
ES
Asset swap spreads of iBoxx covered bond indices, in bp
09
10
11
Italy
Spain Pooled Cedulas
UK
Sources: Markit, Deutsche Bank
11
UK
Source: EuroMTS
10
14
15
16
17
18
August 12, 2011
French Legal
Mortgage Pfandbriefe
Ireland
500
450
400
350
300
250
200
150
100
50
0
Shin, Hyun Song (2010). Financial intermediation in the post crisis financial
system. BIS working paper No. 304. March 2010.
CML (2010). The outlook for mortgage funding markets in the UK 2010-2015. 28.
January 2010.
Shin (2010) and SIFMA (2009). 1st Annual European Covered Bond Investors
Survey. May 2009.
See also Fitch (2011). Trends in bank funding profiles. June 2011.
Other things include, for example, requirements for over-collateralisation by rating
agencies which differ depending on national or even regional mortgage market
characteristics.
7
EU-Monitor 86
Covered bonds: better for financial stability?
LTV limits for calculation of
collateralization rates of
cover pools for residential
mortgage covered bonds
DE
60% of MLV*
HU
70% of MLV
SK
70% of MLV
ES
80% of MLV
FR - Obligations
Foncières
80% of MLV
IE
75% of MV**
SE
75% of MV
DK-SDO
75% or 80% of MV
DK-SDRO
75% or 80% of MV
In contrast to covered bonds, funding via MBS has an expansionary
effect on the credit market. By derecognising loans from the balance
sheet banks do not have to hold own capital against those loans and
19
can use the freed up capital for generating other assets. This is not
necessarily bad for financial stability and covered bonds are not per
se better for financial stability than MBS. MBS do not necessarily
have negative effects on the economy as long as higher risk
resulting from structural characteristics of the instrument is
transparent, understood by investors and adequately priced.
FR general law based 80% of MV
FR - Obligations á l'
Habitat
80% of MV
DK-RO
80% of MV
IT
80% of MV
NL
80% of MV
PT
80% of MV
UK
80% of MV
In fact, several reasons call for caution with respect to an
unconditional increase in covered bond funding:
* MLV= Mortgage Lending Value, ** MV= Market Value
Source: ECBC
12
Overcollateralisation
Overcollateralisation means that the value of
underlying assets backing a securities issue is
higher than the value of securities issued. For
example, a cover pool contains mortgages
worth EUR 120 bn but the bonds issued
backed by this cover pool only amount to EUR
100 bn. This lowers the creditors’ exposure to
default risk and is done in order to obtain a
higher credit rating.
Since the start of the crisis, normal
overcollateralisation levels have roughly
doubled.
The fact that assets are not derecognised in the case of covered
bonds is an advantage from a stability perspective. It leads to higher
incentives for risk monitoring and keeps the intermediation chain
short, which together with quality requirements resulted in better
resilience in times of crisis. However, keeping loans on the balance
sheet requires banks to hold certain regulatory own capital which
limits the ability to issue covered bonds and other assets.
Consequently, the use of covered bonds and the concomitant
increase in mortgage lending is limited by available own capital in
addition to the quality restrictions.
1. Too much covered bond funding may lead to a greater
subordination of other creditors of the issuer. Increasing overcollateralisation (see box) contributes to greater subordination.
Since the cover pool is reserved for covered bond investors in
case the issuer defaults, other creditors have access to fewer
20
and potentially less valuable assets to cover their claims. Other
creditors will therefore ask for higher risk premia. Shareholders,
too, are likely to react with lower equity valuations as their
residual claim will be reduced. Consequently, the amount of
covered bond funding that is economically sensible for an issuer
is limited.
2. Secondly, not all mortgages are eligible for covered bond funding
based on national and EU legislation (UCITS, CRD) requiring
certain quality standards. MBS are not subject to such
restrictions and are therefore a complementary funding
instrument.
3. As spread developments in the crisis have shown, the quality
and resilience of covered bonds differs substantially depending
on national legislation covering quality requirements and
supervision of covered bonds, the country of the collateral and
21
the issuer (see chart 11). Different LTV limits are just one
example (see table 12) showing the differences in the national
legal frameworks (and considering that property valuation
standards vary significantly, this shows only part of the
differences).
4. There is also a risk that (an overly) preferential treatment for
covered bonds will distort incentives and lead to excessive
19
20
21
8
Loutskina, Elena (2010). The role of securitization in bank liquidity and funding
management. August 2010.
Spain is an extreme case in this respect, because there the cover pool consists of
all of the issuer`s outstanding mortgages.
ECBC (2011). Covered Bond Fact Book 2010. P. 51 and BayernLB Research
(2011). Covered Bond Report. 21. April 2011. P. 3 and Volk, Bernd. EUR Liquid
Credit Weekly. 23.5.2011, P. 2.
August 12, 2011
Bank funding of residential mortgages in the EU
22
demand from investors. The risk that this might happen could
increase as a result of planned regulation (see below) that will
likely boost demand for covered bonds.
5. Covered bond funding does not automatically mean that
maturities are better matched. Covered bonds may have a
significantly shorter maturity than the assets in the cover pool.
How to increase monitoring
incentives?
As discussed, MBS have characteristics that let them appear, prima
facie, as a greater risk to financial stability than covered bonds.
What could help mitigate the risks resulting from structural
differences between MBS and covered bonds? Requiring the issuer
to hold the equity tranche as well as transparency in the market
(loan-level data, ―who holds what‖) will contribute to correct some of
the market failures detected. However, regarding the US market it
has been argued that data was available and transparent but not
adequately used. This points to a need for better data consolidation
and analysis, not only for more data. Independent, unbiased and
forward-looking ratings could also benefit the MBS market.
Standardisation could make risk monitoring easier for investors.
Most of these aspects feature the current public regulatory
discussion but are also being taken up by the private sector.
Regulatory answers
More and better transparency
Several work streams of public authorities and industry associations
aim to address the shortcomings of securitisations that became
23
evident in the crisis. Among those, one that is pursued by public
and private agents alike are transparency and standardisation
initiatives:
— Regarding covered bond funding, the ICMA´s Covered Bond
Investor Council (CBIC) has reacted to calls for greater
transparency and launched an initiative to set transparency
24
standards for covered bonds.
— In Germany, the True Sale Initiative has established standards
leading to a certification (―seal of quality‖) for securitisations. The
standards define certain criteria regarding reporting, disclosure,
the credit process and the relationship between lenders and
borrowers.
— The European Financial Services Roundtable (EFR) has
launched an initiative for a ―Prime Collateralised Standard‖ (PCS)
for securitisations.
— Regarding ABS/MBS the ECB has announced its intention to
25
introduce loan-level-data information requirements and is
working together with the BIS and the IMF on the design of the
statistics on securities holdings.
— Provisions introduced in the CRD following the crisis included
additional disclosure and capital requirements for complex
securitisations.
— CRD IV will introduce reporting requirements regarding default
rates of mortgages.
Better data on prepayment rates
More and better transparency of relevant information should make
risk-based pricing of MBS and covered bonds easier. The Joint
Forum highlights that not all potentially important information will be
22
23
24
25
August 12, 2011
Joint Forum. Report on asset securitization incentives. July 2011.
Joint Forum (2011) shows a more detailed overview.
http://www.icmagroup.org/ICMAGroup/files/5f/5fb7d2ce-e9b6-4286-9222e4d63906f4dd.pdf
https://www.ecb.int/press/pr/date/2011/html/pr110429.en.html
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EU-Monitor 86
readily available, for example on prepayment rates. However,
information on prepayment rates is crucial for risk-based pricing.
The introduction of a reporting requirement on prepayment rates
would allow more transparent pricing of the option. More
transparency with regard to prepayment rates could also benefit EU
mortgage market integration and inform policy makers’ decision
making.
Matching maturities
Another work stream pursued by legislators and regulators strives to
achieve a better matching of maturities through different measures:
— The liquidity coverage ratio (LCR) and the net stable funding ratio
(NSFR) are part of “Basel III” that is currently in the process of
being transposed into EU legislation (CRD IV). The LCR is a
short-term (30 days) and the NSFR a longer-term liquidity
measure. Covered bonds receive preferential treatment in the
26
LCR. However, detailed definitions on what will count as
extremely high liquidity and high liquidity for the LCR in Europe
27
will only be proposed by EBA by the end of 2013.
In the NSFR, mortgages that are in a cover pool have an
advantage vis-à-vis residential mortgages not backing a cover
pool. They receive a lower weighting in the denominator requiring
less available stable funding. In the current Commission proposal
the NSFR figures as a reporting requirement only.
— Solvency II makes a similar difference between residential
mortgages and mortgage covered bonds as the NSFR. Apart
from that, considering the importance of insurers and pension
funds in the financial system and investors in corporate and bank
bonds in particular, Solvency II rules will have an impact on
28
funding structures in the economy.
Risk-adjusted pricing and aligned
incentives
Other measures to be pursued partly on the issuers’ own initiative
and partly by regulators include:
— Adequate internal transfer pricing which takes account of funding
liquidity risk in times of stress
— Management of misalignment of incentives regarding rating
agencies.
What’s the issue with covered bonds, MBS and
prepayment?
As mentioned above, one structural factor distinguishing MBS from
covered bonds is the pass-through of prepayments. Prepayment
affects pricing: the prepayment option is worth 40-50 bp, according
29
to estimates. Since unattractive pricing vis-à-vis other fixed income
assets is mentioned as a factor that keeps the MBS market from re30
launching , the following will shed some light on the differences
between covered bonds and MBS when it comes to prepayment.
26
27
28
29
30
10
Within the LCR, covered bonds (rated AA- and above) fall under the definition of
high-quality liquid assets (Level 2). This means a haircut of 15% has to be applied
and, all in all, Level 2 assets may not comprise more than 40% (after haircut) of
total high-quality liquid assets. Furthermore, an issuer’s own covered bonds do not
count towards high-quality liquid assets.
European Commission (2011). Proposal for a Regulation on prudential
requirements for credit institutions and investment firms Part III. 20 July 2011.
BIS (2011). Fixed income strategies of insurance companies and pension funds.
CGFS Papers No. 44. July 2011; Zaehres, Meta. Solvency II. DB Research
Current Issues. Forthcoming.
LaCour-Little, Michael (2005). Call protection in mortgage contracts.
Joint Forum (2011).
August 12, 2011
Bank funding of residential mortgages in the EU
As described earlier, with covered bonds the issuer bears the
prepayment risk while MBS pass prepayments through to investors.
Covered bond: issuer bears
prepayment risk
In case the replacing loan in the cover pool is issued at a lower
interest rate, the covered bond issuer will incur a loss if two things
apply: 1) the covered bond pays investors a fixed rate above the
one that the issuer contracted with the borrower for the new loan
(reinvestment loss) and 2) this loss and the margin loss is not
covered by prepayment compensation.
There are several options to reduce losses from early repayment
and hence increase the attractiveness of long-term funding through
covered bonds for banks and investors:
1. Covering reinvestment loss and margin loss by early repayment
compensation. This reduces prepayment speed and decreases
prepayment risk for issuers. In many European countries
currently only parts of early repayment losses are covered by
31
compensation.
2. Increasing issuance of variable-rate mortgages and floating-rate
covered bonds to fund them. Variable-rate mortgages enjoy the
advantage that interest rate risk is passed on to the consumer.
This prevents reinvestment loss for the lender in case of early
repayment. However, investors such as pension funds and
insurance companies or even other MFIs might be reluctant to
take on interest rate risk and demand fixed-rate issues (―Spanish
case‖, see below). This is also reflected in the current
32
predominance of fixed-rate covered bonds.
3. Hedging interest rate risk with derivatives as done, for example,
by Spanish issuers. They hedge their interest rate risk resulting
from predominantly variable-rate mortgage loans and fixed-rate
Cédulas via swaps.33 However, hedging comes at a cost.
Furthermore, this does not solve the initial problem but just
distributes it within the financial system.
4. Changing legislation so that it allows a splitting into tranches or
34
(re-)introduction of redeemable covered bonds. However, this
would lead to additional costs since any splitting of the covered
bond universe into sub-segments would lead to less liquidity and
hence higher risk premiums in the sub-segments.
Funding costs for covered bonds would rise in any of these cases
and options discussed, except for option 1.
Summary and outlook
Covered bonds and MBS make asset-liability management easier,
allowing better management of banks’ exposure to maturity, interest
rate and liquidity risk. While MBS markets ground to a halt in the
crisis, covered bond markets showed greater resilience. Due to
―dual recourse‖, high-quality collateral, generally high liquidity, longterm predominantly fixed-rate issuance, standardisation, and the
fact that loans are not derecognised from the issuers’ balance sheet,
covered bonds seem to be a funding instrument that contributes to
financial stability.
31
32
33
34
August 12, 2011
Ahlswede, Sophie. „Easy way out― will raise costs for everyone. DB Research.
Research Briefing. 23 March 2011.
ECBC (2010). Covered Bond Fact Book 2009. Descriptive Review of Statistics.
2009.
Volk, Bernd (2011). Covered Bond Market Overview 2011.
Schaefer, Stefan. There is no free lunch. DB Research Financial Market Special.
EU Monitor 36. July 6, 2007.
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EU-Monitor 86
Diversified funding base essential
However, a diversified funding base is essential to avoid
dependence on particular instruments, markets or investors. This
applies to covered bonds just as to any other funding source. Due to
several reasons it is neither desirable nor economically sensible to
exclusively increase the share of covered bond funding from a
stability perspective.
Current investor demand is leading to MBS issues resembling
covered bonds with respect to the collateral used. However, this is
likely to be a reaction to developments in the crisis (quality of ratings
and collateral, overly complex securitisation structures) that will
partially change again, once regulation addressing these issues is in
place, the broader economic recovery has picked up and investors
perceive risks to be adequately priced.
Prepayment risk as crucial pricing
factor
Prepayment risk is an important factor when it comes to pricing MBS
or covered bonds. The cost of funding increases when prepayment
risk is passed on to investors or has to be hedged because resulting
costs are not fully covered by users of the prepayment option. A full
and objective cost compensation should enhance the attractiveness
of covered bonds as a funding tool, contributing to financial stability.
Funding costs are set to rise
Funding costs for banks will rise further once the regulatory
initiatives mentioned above start to bite. Therefore, it is argued that
lending rates may have to increase in order to compensate for lower
credit volume growth and higher funding costs. The competition for
35
deposits has already pushed up the cost of deposit funding.
With regard to the initial question - which funding mix is best with
regard to financial stability? - the following observations can be
made:
Covered bonds are not a panacea
Misaligned incentives resulting from funding instruments have
played a role in the crisis. However, we cannot blame the choice on
funding instruments alone: for example, RMBS account for a large
part of outstanding mortgages in Belgium and Portugal but these
countries did not experience a lending and house price boom as
36
similar to Spain or the UK. Obviously, not all securitisations in the
boom phase have had negative repercussions on financial stability.
Policy makers should therefore differentiate and be careful with
overly simplistic analysis with regard to securitisation. Similarly,
despite the fact that covered bonds have substantial conceptual
advantages and have fared well during the crisis, exclusive reliance
on that instrument is not advisable. When it comes to funding
mortgage business, a well-balanced mixture, attuned to the
characteristics of the business funded, is the best bet for financial
stability.
Sophie Ahlswede (+49 69 910-31832, sophie.ahlswede@db.com)
35
36
ECB (2011).
Just, Tobias. The European housing markets: three different dynamics. DB
Research. Talking Point. 1 August 2011.
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August 12, 2011