20 October 2010 EUROPEAN COVERED BONDS (CB) MARKET

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Andra Benson
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1 EUROPEAN COVERED BONDS (CB) MARKET 20 October 2010 Covered bonds are debt obligations that are backed by a dedicated underlying assets portfolio. These assets give to the bearers of these debt obligations a higher security than the security provided by standard debt obligations. The financial crisis has evidenced the merits and resilience of this type of security which plays nowadays a significant role in the European bond market. The covered bonds Eurozone market s size is about 950 billion and is quite concentrated on three countries: Spain (33%), Germany (28%) and France (24%). Comparison between the main European legal frameworks Formally, one has to distinguish between Covered Bonds which are compliant with criteria of the UCITS directive (Article 22.4), and those which are not UCITS compliant. UCITS criteria are (mainly) the following: the issuer should be a credit institution established within European Union, issuer is specifically regulated by a legal supervisor, the bearer is protected by an underlying assets portfolio, on which it benefits from priority recourse in case of issuer or originator default. Structured Covered Bonds are not specifically regulated in order to protect their bearers and as such, they are not UCITS compliant. Structured Covered Bonds are generally issued by credit institutions (it is always the case for French banks issues) which are subject to the general supervision by the banking supervisor. In the French case, the issue framework aims at protecting bearers of the structured CB against consequences of a default of the issuer or originator. On the French market there exist three regimes : the specific regime of Caisse de Refinancement de l Habitat (CRH, dedicated credit institution created by a law of July 11, 1985), Obligations Foncières (according to a law adopted in 1999, which creates Societes de Credit Foncier SCF, which are dedicated credit institutions), and structured or contractual covered bonds, which are issued since 2006 outside the SCF legal framework. The law on banking and financial regulation adopted by the French Parliament on 11 October 2010 will provide structured Covered Bondfor a legal framework which will enable these assets to meet the UCITS criteria. Stuctured covered bonds issuers will be entitled to opt for the new regime, upon Autorité de contrôle prudentiel s agreement (ACP is the supervisory authority for credit institutions and insurance companies mainly). Provided the issuer meet all criteria stated in the updated version of the "Code Monétaire et Financier», it can apply for the status of société de financement à l habitat (SFH)1 and issue subsequently UCITS compliant covered bonds entitled «obligations de financement de l habitat. In Germany, CB market is essentially composed by Pfandbriefe and in Spain, the market is essentially composed by Cédulas/Multi-Cédulas. Obligations Foncières, Pfandbriefe and Cédulas/Multi-Cédulas are UCITS compliant and are regulated by a national specific framework. Yet there are some differences between them, the main differences are the following (detailed table in annex 2, from the reference website as far as covered bonds are concerned: European Covered Bonds Council 2 ): - Pfandbriefe and Obligations Foncières allow a spectrum of underlying assets much wider than French structured covered bonds and Cédulas (residential real estate loans only for these two regimes), - Maximum LTV (Loan to Value) is lower in Pfandbriefe and in Obligations Foncières (generally 60%) than in other regimes (80%). Specificities of French market 1 Articles L et L of Code Monétaire et Financier- COMOFI will define Société de Financement de l Habitat status. Should a credit institution opt fo this status, it shall notify l Autorité de contrôle prudentiel within a twelve months delay as from the date the law has been enforced (article 41 de la loi du 11/10/2010) 2 1

2 This section presents the 2 main structures of the current French market (CRH excepted): sociétés de crédit foncier (SCF) and structured covered bonds. Some other dedicated structures (SPV like) which are close to structured products like ABS, exist also in France (comparison between CB and ABS in annex). Obligations foncières issued by SCF show the following features : - SCF is a dedicated credit institution, - Underlying assets portfolio which constitutes assets of the SCF: residential real estate loans, commercial real estate loans and loans to the public sector, - Legal privilege for the bearer of Obligations Foncières and bankruptcy remoteness against the parent company bankruptcy, - Underlying assets: guaranteed loans are capped at 35% maximum (as opposed to mortgage loans). Issuance of structured CB which has begun in 2006 outside the legal scope of obligations foncières is due to merge into the new legal framework of obligations de financement à l habitat. Current Structured covered bonds show the following features: o The issuer is a subsidiary of the originating credit institution and is itself a credit institution, o Underlying assets remain in the balance sheet of the parent company, o o Underlying assets: residential estate loans (individual customers only), no cap for guaranteed loans. Only one asset in the structure : the issuer who has raised funds by issuing the covered grants a loan to the originator (the parent company), the loan is being secured by underlying assets of the originator s balance sheet. In this structure, bonds holders were not, before the opting to obligations de financement de l habitat status now allowed by the new French legal framework, protected via a true sell procedure warranted by specific statutory provisions (as is the case for obligations foncières with the privilege legal ), but via a pledge based on article L of the Code Monétaire et Financier. Consequences of recent developments in the French legal landscape Articles 71 to 76 of the banking and regulation Law voted by the French Parliament on 11/10/2010 will grant structured covered bonds with a regulatory framework which appears very similar to that of long lived French covered bonds called obligations foncières : the new framework enhances security features of structured covered bonds by replacing the pledged by the privilege legal clause as defined by article of the Code Monétaire et Financier which enforces a strong legal provision related to the underlying pool, whereby the statute and the rights of bond holders are protected against the seizure of the pool by any other creditors. Besides privilege legal provisions, the new law also inserts a number of requirements related to a specific public supervision and to loanto-value levels consistent with those required for obligations foncières. Furthemore, the new law would align liquidity and solvability requirements for all French covered bonds (structured covered bonds and obligations foncières) with those recently required for Pfandbriefe (minimal legal overcollateralization of 2% and covering the liquidity gap permanently on 180 days). Therefore, the introduction of a Société de Financement de l Habitat status along with a new type of regulated covered bonds is foreseen to reinforce the French covered bonds market transparency, safety, and will make of all of them fully UCITS compliant. 2

3 Annex 1 : Eurosystem Covered Bond Purchase Program (CBPP) : Objectives and first results Eurosystem Covered Bond Purchase Program : overview The purchase program has been launched in May 2009 by the 16 Eurosystem Central Banks (Banque de France included) and has been completed as expected on June 30, billion of covered bonds issued by Eurozone credit institutions have been bought in total. Aims of CBPP : Reduce spreads ; Restore liquidity in the market (primary and secondary markets); Help banks to refinance themselves / ease the economy financing. Results : Primary market s market share in June 2010 reached 27% (the annual average is 25%) 150 EUR billion covered bonds ha ve been issued during the last 12 months Spreads have generally narrowed Before the financial turmoil, French banks covered 20% of their financing needs by issuing guaranted debt obligations ( covered bonds ). After Lehman bankruptcy, market confidence in covered bonds has weakened: it has become more and more difficult for banking issuers to raise funds. CBPP annoucement then regular purchases have enable to narrow covered bonds spreads: Graph : Yield spreads between 5 years swap curve and covered bonds in basis points Bps CBPP announcement 7 May 2009 CBPP start 6 July / / / / / / / / /2010 Germany France Ireland Portugal Spain Liquidity has significantly improved On primary market, whereas there was only 16 billion Euro covered bonds issuance during the 4 first months of 2009, CBPP annoucement in May triggered new issuance: since June 2009,150 billion euros have 3

4 been issued over 12 months and in particular during the first quarter 2010 (monthly historical record with almost 30 billion euros issued on primary market during January only). New markets (Italy, Netherlands ) have emerged. Secondary market functionning has also improved : market making activities have progressively recovered. Lastly, regarding the macro-financing objective, the covered bonds tribute to banks financing has strongly increased since the launch of CBPP and in comparison with previous years. To conclude, CBPP has proven its efficiency in very difficult market conditions for covered bonds. In this field, the text voted by the French Parliament on 11/10/2010 allows SCF and the future sociétés de financement de l habitat to subscribe or repurchase their own covered bonds, with the aim of refinancing themselves with the Eurosystem, in the case when these issuers were not able to fully cover their financing needs by other means at their disposal. Thereby, should market conditions worsen again, French covered bonds issuers would have this new tool at their disposal that enables them to reinforce their liquidity in extreme situations. 4

5 Annex 2: comparison of main European markets (source : European Covered Bonds Council) Issuer Owner of the cover assets Special covered bond legislation Assets that may be included in cover pools Geographical scope for public sector assets Geographical scope for mortgage assets LTV limits used for calculating collateralisation rates for the cover pool Role of the banking supervision regarding covered bonds UCITS compliance CRD compliance France Allemagne-Pfandbriefe Espagne-Cédulas General Law Based CBs Obligations Foncières (Structured CB) / et new Obligations de financement de l habitat (OH) Specialized credit Specialized credit Universal credit institution institutions in both cases, institutions with a special license supervised by the banking supervisors Credit institution, but pledged to the issuer (transfer to the issuer upon trigger event) Universal credit institution / Specialized credit institution The issuer directly The issuer directly The issuer directly No in the past / yes for OH Yes Yes Yes Residential real estate loans Not applicable Exposures to public sector entities Residential and commercial Mortgage loans Group originated Senior MBS Senior MBS issued by third parties.. Domestic, Multilateral development banks, EEA, CH, USA, Canada, Japan, NZ AUS, Other Exposures to public sector entities Mortgage loans Ship loans Aircraft loans Exposures to credit institutions Domestic, Multilateral development banks, EEA, CH, USA, Canada, Japan Market practice : Domestic Domestic, EEA, Other Domestic, EEA, CH, USA, Canada, Japan Market practice : Residential 80% Banking supervision in all cases. Specific public control in the interest of bond holders for obligations de financement de l habitat (OH): to check whether eligibility criteria are fulfilled and documented; checking the quality of cover assets; monitoring of exposure to market and liquidity risks; evaluation of operational risks; to check minimum mandatory overcollateralization requirements (at least 2 %) No for past structured CB/ Yes for OH No in the Basle standard approach (RWAs validated by banking supervisors in case of IRBs). Residential, Commercial Residential 60%, Commercial 60%, Agricultural 60%, Ships 60%, Aircraft 60% Banking supervision in general. On top, a specific public controller in the interest of the covered bonds holders (To check whether eligibility criteria are fulfilled and documented; Checking quality of cover assets; Monitoring of exposure to market and liquidity risks; Evaluation of operational risk ; To check minimum mandatory overcollateralisation requirements: at least 2 %) To check whether eligibility criteria are fulfilled and documented; Checking quality of cover assets ; Monitoring of exposure to market risk and liquidity risk ; Evaluation of operational risk ; To check minimum mandatory overcollateralisation requirements Mortgage loans EEA EEA Yes Yes Yes Yes Yes Yes Residential, Commercial To check whether eligibility criteria are fulfilled and documented ; Checking quality of cover assets ; Monitoring of exposure to market risk and liquidity risk; Evaluation of operational risk; To check minimum mandatory overcollateralisation requirements 5

6 Annex 3 : US draft legislation : «US Covered Bonds Act of 2010» European covered bonds have well survived the recent turmoil. Conversely, funding the US real estate market has been more difficult since the crisis; indeed this market segment was used to lie broadly loan securitization for refinancing (itself), via Freddie Mac and Fanny Mae agencies. The turmoil on the one hand and the resilience of European covered bonds market on the other have been beneficial to the idea of introducing in the USA a legal covered bonds framework guided by the relevant European legal frameworks. To this end a draft law which should become US Covered Bonds Act of 2010 has been dropped with House of Representatives on March 18, As for all European covered bonds, future US covered bonds will be backed by an underlying portfolio of high quality assets, and covered bonds bearers will benefit from priority recourse on these assets in case of issuer difficulties. There will also be a legal supervisor for the issuers (the Secretary of the Treasury), a legal overcollateralization and a principle of insolvency remoteness in favor of the issuer. Issuers will be credit institutions in the current draft law, as it is the case for Obligations Foncières issuer (and soon Obligations Habitat issuers), Pfandbriefe issuers and Cédulas issuers. As far as assets classes are concerned, the US legislator is less selective than European legislators, as will be eligible in the US future law not only real estate loans and public sector loans, but also auto loans, credit card loans, students loans and SME loans. 6

7 Annex 4 : ABS/Covered Bonds Comparison These two asset categories are both backed by an underlying assets portfolio, which may sometimes s identical in nature (real estate loans in particular). Then it could be somehow difficult to distinguish between them. Yet economical parameters enable to distinguish between them. Issuer Underlying assets Investor exposure Maturity ABS Generally a Special Purpose Vehicle No banking supervision Any class of assets, and in particular residential real estate loans (RMBS), commercial real estate loans (CMBS), corporate loans (CDO/CLO), consumer loans, auto loans, credit card loans Directly and only on the underlying assets portfolio. In case of default, (non performing loans), investors bear the loss according to the seniority rank of their securities, according to the tranching. Corresponds to the underlying assets maturity. Yet some structures may provide (on request from investors) a maturity date indicative which is shorter: the structure is then hybrid, and closer to a covered bonds (credit risk on the issuer) Covered Bonds Generally a credit institution Banking supervision Limited by law (structured covered bonds excepted): see annex 2 Double: - first on the issuer: the issuer ensures timely payment relating to issued securities. - second, in case of issuer default, on the underlying portfolio. These assets are legally dedicated to investors. Fixed by the issuer, without necessarily matching with the maturity of underlying assets: the issuer may fix a 5 years maturity, whereas underlying assets have a 20 years maturity (real estate loans); investor s risk is on the reimbursement capacity of the issuer. 7

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