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 1

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

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

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 4

5. The 7 Pillars of a CB system 1. Types of assets 2. Quality standards 3. Additional components of the cover pool 4. Segregation of assets 5. Coverage mechanism 6. Supervision 7. Management of insolvency situations 5

6. Assets 1. 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) 2. Quality standards Basic standards (legal, contractual ) to eliminate risk factors - LTV, valuation: key elements 3. 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 6

7. Coverage 4. 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) 5. 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 7

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 ) 8

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 (pari passu typically) 9

10. Challenges 1. Depositors’ subordination and asset encumbrance 2. Withstanding financial crises 3. Fitting in national contexts 10

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 11

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 12

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

14. A Global Resilience to the Financial Crisis 2008-2009 New issues in Europe remained strong Source: ECBC 14

15. … but with shorter maturities Source: Euromoney: 15

16. CB spreads parallel sovereign bonds Why? 16

17. Governments step in before the CB mechanism is enforced in stress situations Spain: Cedulas Hipotecarias  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 17

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) 18

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 19