Securitisation and covered bonds in Europe
Options for lenders in the wholesale funding market include securitisation and covered bonds but which is best? Both have their merits and drawbacks, says John Holland
Covered bonds (known as Pfandbrief in Germany) have shown themselves of late to be attractive at lower funding costs than residential mortgage-backed securities (RMBS).
But RMBS can take a higher loan-to-value (LTV) ratio than the 60 per cent eligibility for cover funds allowed under German Pfandbrief regulations. European RMBS enjoyed a stellar year in 2005, with issuance growth volume of almost 30 per cent on 2004, despite a credit crunch in many countries and increase in their arrears owing to a higher interest rate environment.
Securitisation has a fundamental ability to turn relatively illiquid financial assets into more liquid capital market instruments This means mortgage-backed securities (MBS) – both residential and commercial - have long been considered more balance sheet-efficient, as the issuing bank holds less regulatory capital and can minimise credit costs.
Covered bonds on the other hand have been making significant inroads as recent and future regulation changes. We must take into account Basel II’s future loosening of regulatory capital requirements and altering of eligible protection definitions for special purpose vehicles used in securitisations..
And some private German banks particularly have taken advantage of last July’s changes in the mortgage bank regulations, which allow them to issue Pfandbriefe. (This is despite the problems at AHBR - Allgemeine Hypothekenbank Rheinboden - which led to rating downgrades, and a corresponding hit to their Pfandbrief portfolio. The ailing mortgage bank was taken over late last year by US private equity giant Lone Star.)
As a result or perhaps in spite of such hiccups, covered bonds remain a relatively recent phenomena in the UK, where asset and mortgage-backed securitisation has held sway for many years. Whereas the covered bond market (Europe’s leading debt market today) has an even older pedigree in parts of (northern) Europe.
High yielding assets
In the past few years covered bonds have become a prominent asset class on the European debt capital market and now attract serious attention from UK investors. This is due to high credit ratings and greater yield relative to government bonds.
Covered bonds are considered to be the best yielding assets at present in the AAA and AA categories, even when the rating of the issuer is not as high as that. It’s what makes them attractive to many risk-conscious investors.
Another main benefit has been to refinance public sector and mortgage loans at a lower rate by pooling mortgage loans, which help keep costs down where margins in public sector financing already tend to be thin. It has also helped to decentralise public sector financing and resulted in a new guaranteed liquidity asset class with high credit quality and low default risk.
This combination of advantages led to high volumes in Europe, particularly in the second half of the 1990s, and lately the aforementioned overseas interest, not only from the US and UK, but also Asia.
The lack of state guarantees, which the introduction of the European Economic and Monetary Union (EMU) and corresponding proscribed limits on public sector debt levels saw to, meant that the onus has fallen on European banks’ management and their appointed trustees and supervisors to live up to the same high asset quality market standards associated with the UK or US.
One might argue that the emergence of covered bonds as a prominent asset class reflects the shifting of risk from the investor to the issuer. The loans which comprise covered bonds remain on the balance sheet while asset-backed securities are taken off and issued through a special purpose vehicle. As a result covered bonds are sometimes treated like corporate bonds.
MBS on the other hand are comprised of monthly mortgage payments of residential homeowners which are then bundled into securities. The interest rate paid approximates the mortgage rate paid by the homeowners.
In addition, the amount of research into the risks of mortgage-backed securities, particularly RMBS, has until recently made them pricier relative to covered bonds. But it is Basel II’s expected introduction at the beginning of 2007 which is helping push the convergence of risk in both asset classes, securitised and covered. This is because the risk weighting on bank assets will fall dramatically in either case, improving banks’ capital requirement position.
European differences
On a European national level the growth in covered bond participation has been far from harmonised. Spain, for example, which paved the way for covered bonds back in 1981, is in both covered and securitised issuance - it issues Cedulas deriving from mortgage loans on exclusively Spanish properties.
France and Luxemburg only allow banks specialising in public sector and mortgage lending to issue French ‘Obligations Foncieres’ and Luxembourgeois ‘Lettres de Gage’. Credit diversity is also moving ahead in central and eastern Europe as well as the Baltics but there too national standards still vary widely.
Ireland and Greece have also been rapidly ramping up their participation in the mortgage markets and interest in covered bonds has proceeded at pace. In Ireland the rate of outstanding and newly issued ‘jumbos’ (the jumbos form one of the largest parts of the European bond market) stood at 5 per cent and 12 per cent respectively of the European total.
Now that the UK, Belgium and the Netherlands have begun exploring the covered bond option it will be interesting to see if a legal framework to protect investors against also comes into force. At the moment UK covered bonds, covered by Common Law, are regarded more as a corporate bond with a high rating.
As earlier alluded to, various Basel II committees are looking at refining rules on securitisation as well as covered bonds, which bring their respective advantages closer to convergence.
Legalities
While legal, tax and regulatory frameworks remain fragmented across Europe, the European Mortgage Federation has called for improved cross border transaction transparency, introducing common price calculations for comparison sake, and eliminating distortions such as subsidies and other guarantees in the European mortgage market.
The European Central Bank (ECB) has also criticised the high cost to investors and issuers as a result of lack of integration of the mortgage capital market. Higher funding costs for originators and greater difficulty for foreign investors to enter fragmented domestic markets also need to be addressed, says the ECB, before the benefits of the mortgage market can be reaped
