Integration of EU mortgage markets: It`s the funding, commissioner!

Integration of EU mortgage markets: It`s the funding, commissioner!

October 19, 2006
Financial Market Special
EU Monitor 38
Integration of EU mortgage markets
It's the funding, commissioner!
The integration of the mortgage credit markets in the EU is in the interest
of consumers and the financial services industry.
The European Commission has presented related proposals, stating
that the objective is to increase product diversity, to lower the cost of
mortgage credit and to make the market accessible to broader
sections of the population. Up until the end of 2006, two expert groups will be
discussing how these goals can be achieved. Building on the results of these
discussions a White Paper setting out concrete measures is due to be published in
spring 2007.
However, regulatory action can only have the desired effect in
achieving further market integration if applied in the right place. Some
of the measures considered by the Commission do not meet this criterion; this
applies particularly to intervention on the product side.
Rather, what is required are selective steps which facilitate a
Europeanisation of mortgage funding and the trading of mortgage
loan portfolios. This would provide originators and investors with additional
capital and risk management options. Resulting cost benefits could be passed on
to clients in the form of lower mortgage rates.
Covered bonds, and especially the jumbo segment, are a model
example of competition-driven integration in the mortgage credit
market. Covered bonds open up a wide range of opportunities for investing in
international mortgage portfolios or funding them on a cross-border basis.
The trading and securitisation of mortgage portfolios also have the
potential to become European funding and risk management
instruments. To achieve this, the Commission first needs to remove remaining
Author
Stefan Schäfer
+49 69 910-31832
[email protected]
Editor
Bernhard Speyer
Technical Assistant
Sabine Kaiser
Deutsche Bank Research
Frankfurt am Main
Germany
Internet: www.dbresearch.com
E-mail: [email protected]
Fax: +49 69 910-31877
Managing Director
Norbert Walter
legal barriers – such as data protection regulations – which can prove a stumbling
block for cross-border trading in mortgage loans. Additionally, investors and rating
agencies must be enabled to reliably assess the credit risk of internationally
sourced portfolios.
EU Monitor 38
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October 19, 2006
Integration of EU mortgage markets
Introduction
Retail business has trailed behind so far on the road towards a
single market for financial services in Europe. Consumers have only
limited access to cross-border products, while financial services
providers themselves face diverse market entry barriers, the product
portfolios offered vary from country to country, and there is often
considerable price variation from market to market.
Action so far
2003: Forum Group on Mortgage Credit
The Forum Group on Mortgage Credit was set
up by the European Commission in March
2003. This body consisting of more than twenty
expert members was mandated to first identify
the chief factors which present barriers to the
integration of the European mortgage credit
markets. Building on these insights it was then
to draft recommendations on how a single
market for mortgage credit could be achieved.
The Forum Group published its report in
December 2004.
2005: Green Paper/Consultation Process
and Implementation Study
In July 2005 the European Commission
published its Green Paper “Mortgage Credit in
the EU“. In this paper it considers whether the
Commission could contribute towards a better
integration of the mortgage credit markets and,
if so, what action it should take. It discusses
aspects of consumer protection and mortgage
collateral as well as legal issues and the
funding of mortgage credit.
With the publication of the Green Paper a
consultation process was initiated, with market
participants being invited to submit their
responses by 30 November 2005. The
consultation process ended with an open
hearing in Brussels at the beginning of
December 2005.
Parallel with the drafting of the Green Paper
the Commission mandated the consulting firm
London Economics to conduct a study of the
costs and benefits of a further integration of the
EU mortgage credit markets. This was
published in September 2005.
2006: Expert Groups
2006 has been devoted to exploring specific
issues. One expert group (Mortgage Funding
Expert Group – MFEG) set up in April and
consisting of members from the financial
services industry and consumer protection
associations as well as members appointed by
the Commission has been concerned with
funding issues. This group will be in session
until this November and will then present its
findings. The same time frame applies to the
second expert group (Mortgage Industry and
Consumers Dialogue Group – MICDG), in
which industry and consumer association
representatives are working to reach a
consensus view on as many problem areas as
possible. The results of both working groups
will then be incorporated in the White Paper
which is due to be published in spring 2007.
October 19, 2006
The European Commission and the financial services industry
therefore both believe that the market for mortgage credit is still
nationally segmented and harbours integration potential. Crossborder lending especially still leads a shadow existence. However,
views differ as to the nature and scope of the action needed and
whether regulatory intervention is necessary.
The Commission appears to see consumer confidence as the main
problem, and therefore is mostly concerned with consumer policy
issues in its Green Paper published in July 2005. For the banks, on
the other hand, the main focus is on dismantling barriers which
impede the effective operation of market forces. The industry sees
the need for action primarily in the other areas discussed in the
Green Paper: legal issues, collateral issues and mortgage funding.
The European mortgage credit market:
nationally segmented but efficient
The EU mortgage credit market is nationally segmented
The mortgage credit market is a key market in any economy. Not
only does property ownership have high priority for people
personally and for society at large, mortgage lending is of major
importance at the macroeconomic level. The impact the mortgage
credit market has on households’ disposable incomes and on banks’
earnings performance makes the segment an important focus not
only of economic and especially monetary policy but also of the
regulatory authorities which oversee the financial services industry.
There would appear to be good reasons why this politically so
important segment of the banking business should have been
conducted largely within national borders so far:
Close knowledge of the local real estate markets is a vital input
factor for a bank’s credit risk management, while detailed knowledge
of the legal issues in the respective markets (such as land register
entries, the calculation of collateral values, foreclosure etc.) is
equally essential for a bank’s management of the mortgage loan
contracts and any liquidation measures that might be necessary.
Foreign lenders first need to accumulate this know-how and build up
proximity to the customer, while the local competitors in the foreign
markets can often draw on long experience and established
customer relationships. This creates costs for new entrants, which
helps to shield national markets from foreign competition. Besides
the market entry barriers, there are the fixed overheads which a
bank faces if it needs to maintain parallel business structures for
different countries. Consequently, operating in two or more countries
at the same time is costly for a bank and only becomes an attractive
proposition – if at all – once a certain critical mass has been
achieved. For these reasons, cross-border mortgage lending and
the entry of foreign competitors on the local markets remain the
exception.
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EU Monitor 38
Besides, there are also factors on the demand side which make
mortgage lending a regional or national rather than a pan-European
business. When households take up a mortgage loan, this is usually
the most important financial decision with the longest impact which
they make in their whole lives. The consumer’s confidence in the
bank is thus of paramount importance. The easiest way for this
confidence to be built is through the personal contact and the
proximity and the cultural closeness which customers have to the
bank from which they obtain the mortgage loan. But that is not the
only way: brand names, for instance, create confidence. So the
Internet could become more important as a distribution channel in
future. This would enable even lenders located further away and
from a different cultural background to leverage a strong brand
name of their own or that of distribution partners to build confidence
among potential customers so as to be able to sell their mortgage
products also across borders.
Relative mortgage
volumes: big differences
Mortgage credit outstanding as % of
GDP, 2004
NL
DK
GB
SE
IE
PT
DE
ES
FI
LU
BE
MT
FR
Against this backdrop what does the Commission want to achieve
with a deeper integration of the market? The aim is to improve the
diversity of mortgage products available to consumers and at the
same time to reduce the level of interest rates as well as the
differences in interest rates from market to market. These goals are
to be welcomed. However, as we argue below, they can only be
partly realised with the measures proposed in the Green Paper. In
the following sections we discuss how each of the three goals –
“availability of mortgage loans“, “interest rate variation between
markets“ and “interest rate level“ – can best be achieved.
GR
AT
CY
EE
IT
LV
HU
CZ
LT
SK
PL
SI
National product portfolios converge
0
50
100
Source: European Mortgage Federation,
Hypostat 2005
1
Product diversity influences credit
volume
4
A first, purely quantitative indicator of the availability of mortgage
products is the volume of outstanding mortgage loans as a
percentage of gross domestic product. There are differences (see
Figure 1), which are in some cases considerable and are due to
very different reasons – e.g. social attitudes to home ownership,
demographic factors or state intervention in the past which has
impeded the emergence of a flourishing mortgage credit market.
The member states in Central and Eastern Europe, where a market
for home loans could only emerge from 1990 onwards, are an
extreme case. The negative correlation between the rate of growth
of the mortgage credit market and the volume of outstanding
mortgage loans as a percentage of GDP (see Figure 2) indicates
that these states are in a catch-up process.
The diversity of the mortgage products available also has a positive
influence on credit volume (see Figure 3). The more mature the
market, the broader the offering of products tailored to different
customer preferences. So-called “non-standard” products especially
are an important aspect. These are mortgage loans to consumers
whose credit risk, for various reasons, is higher. Some national
markets have considerable ground to catch up here.
October 19, 2006
Integration of EU mortgage markets
The higher the level of mortgage credit outstanding, the lower the growth rate
X-axis: mortgage credit volume as % of GDP, Y-axis: annual growth in mortgage credit in % (1998-2004)
SK
160
140
120
100
80
60
40
20
0
LV
LT
HU
EE
GR
SI
PL CZ
0
CYAT
20
IT
10
MT
BE
FR FI
30
LU ES DE
40
IE
SE
50
UK NL
PT
60
70
DK
80
90
Source: European Central Bank, 2005, EU Banking Structures, October 2005, p. 23.
The more mature the
market, the more products
Completeness-Index* (%, X-axis) and
mortgage volume relative to GDP
(%, Y-axis)
120
NL
100
DK
80
PT
DE
UK
ES
IT
20
0
40
60
80
*The consultancy firm Mercer Oliver Wyman
has developed an index which can be used
to measure the maturity of Europe's eight
largest mortgage credit markets. The
"Completeness Index" aggregates the data
on the available range of products, market
access by different consumer categories, the
diversity of the existing distribution channels
and the quality of information and advice
provision.
Sources: Mercer Oliver Wyman, Study on the Financial
Integration of European Mortgage Markets, 2003,
European Mortgage Federation, Hypostat, 2004
However, the fact that the product offering varies from country to
country and is not always complete is a momentary status.
Competition in the national banking markets ensures that product
portfolios are constantly broadened. In France and Scandinavia, for
instance, so-called “reverse mortgage“ products are enjoying
growing popularity, while for some time now consumers in Germany
have been able to obtain mortgage loans with loan-to-value ratios of
up to 120 percent. In both cases these are product categories
which, because they were not widely available a short while ago,
were seen as an argument for regulatory action in Brussels.
So the range of mortgage products available is tending to widen –
even without legislation and regulatory intervention. This suggests
that in the market for home loans lenders and consumers are now
catching up on a development which has already been taking place
for some years in other segments of the banking business: customer
loyalty is waning, product innovation is on the increase, the Internet
is becoming a significant distribution channel, specialists are
establishing themselves in niche markets and financial brokers are
muscling in as intermediaries between banks and customers.
60
40
FR
2
3
The last three aspects especially – Internet, niche players and
intermediaries – make it more probable that cross-border mortgage
lending will also increase as this development progresses.
Consumers are attaching less and less importance to personal
contact with banks established in their local area, and their
confidence in financial intermediaries and online distribution is
growing. This makes market access for foreign lenders easier. They
can lower the costs of direct market entry by drawing on the
reputation and market knowledge of independent intermediaries.
This will be beneficial in furthering still greater product diversity.
Hence, in light of present and future developments in the markets a
competition-driven broadening of the range of products available
can be expected. Commission intervention on the product side from
consumer policy considerations is therefore unnecessary.
Price variation, too, is limited
The “law of one price” applies in a fully integrated market, in other
words prices for the same products should not differ. Another aim of
the Commission’s market integration efforts is therefore for
mortgage products to be provided in all member states at the same
– and the lowest possible – price. The mortgage credit market is
already very close to this goal at least as far as price variation is
concerned. Although at first sight interest rates differ, considerably in
some cases, these differences can be explained, at least in part, by
October 19, 2006
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Margins converge
Margins in EU mortgage credit business
in percentage points (not risk-weighted)
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1998
2000
2002
2004
Bottom quintile
Median
Arithmetic mean
Top quintile
Source: European Central Bank, 2005
EU Banking Structures, October 2005
4
Euro causes interest rates to
converge
the different features of the products compared. Adjusted for default,
interest rate and prepayment risks the spread between the highest
and lowest interest rate is 45bp. This finding of a study published by
Mercer Oliver Wyman in 2003 for seven of eight major markets
investigated contrasts with the conclusions of the London
Economics cost-benefit analysis in 2005. According to this analysis,
sweeping market integration could lower mortgage rates by 47bp on
average. However, given the pressure on margins in the mortgage
lending business it is highly questionable whether this claim is
feasible in reality. A more recent study by the European Central
Bank (see Figure 4) confirms this observation. It reveals that while
there are still appreciable differences in interest rates, margins in the
mortgage credit segment have been steadily converging for years.
Above all, very high margins deviating strongly from the median are
now seldom. Against this backdrop it can be concluded that the
price differences between the national markets, too, do not appear
to indicate any pressing need for regulatory intervention by the
Commission on the product and pricing side.
Scope for lower interest rates is limited
So the last remaining principal aim which the Commission wants to
achieve with market integration is to lower the level of mortgage
rates. The level of interest rates is the result of the interaction of
supply and demand in the national mortgage markets.
Since the Commission wants to open up access to the mortgage
credit market for broader sections of the population, and thus
increase demand, no dampening influence on rates can be
expected from this side. A reduction of the incidental costs
associated with taking up a mortgage loan – notary’s fees, property
transfer tax, land registry charges – would help to lower the cost of
mortgage loans for households. But these cost components lie
within the national jurisdiction of the member states, so the
Commission has little scope to influence them.
This leaves the supply-side factors. The price of a mortgage loan is
the sum of the lender’s profit margin, management and distribution
costs, risk costs and funding costs. The interest rates on mortgage
loans are largely independent of the degree to which the mortgage
credit market is integrated. Over and above the risk-free interest
rate, the biggest cost block to be factored into the bank’s pricing is a
central macroeconomic variable: the overall level of interest rates.
Here, European Monetary Union set in motion a convergence
process which has led to a far-reaching harmonisation of interest
rates at least in the euro zone.
All the same, the already heightened price competition in the wake
of market integration may intensify due to online distribution, but the
effect should be limited owing to the already low margins mentioned
earlier; however, a convergence of the, so far largely national,
mortgage credit markets can have a beneficial impact on cost
efficiency, capital efficiency and credit risk.
Cost efficiency rises if the lender is able to achieve economies of
scale. Owing to the structural differences between the markets these
are more likely on the funding side than in distribution. Here, the
greater liquidity of a pan-European market for the commonest
refinancing instruments would have a positive impact on funding
costs.
Market integration can improve
efficiency and simplify risk
management
6
Capital efficiency improves if lenders and investors, operating
Europe-wide, invest their capital where it earns the highest returns.
October 19, 2006
Integration of EU mortgage markets
Again, it is less likely that this advantage can be achieved by
investing in organic growth in the respective markets. Rather, the
better option is to trade loan portfolios, allowing investments to be
made selectively in individual markets. This would also provide both
the sellers and the buyers of the portfolios with a risk management
instrument since this enables them to selectively diversify their credit
risk internationally and thus reduce their risk costs, too.
Need to concentrate on secondary
markets and funding
So it is only as regards funding and risk costs where the further
integration of the market could present potential for reductions
which, driven by competition, would then feed through in lower
mortgage rates. Consequently, the Commission should concentrate
on encouraging the creation of a European secondary market for
mortgage loan portfolios and simplifying cross-border funding.
Integration through Europeanisation of
the secondary and funding markets
Funding and risk management in the mortgage credit
segment
A Europeanisation of risk management and funding is the only way
in which it will be possible to lower the price of mortgage loans. To
fund their mortgage lending European banks mainly use deposits,
unsecured (structured) bonds, covered bonds and securitisation in
the form of residential mortgage backed securities (RMBS).
Euroland: Home loans
outpace deposits
(January 1999=100)
200
If banks can obtain funding on better terms, this will lead to lower
interest rates for the consumer given the highly competitive nature
of the market.
180
Deposits and structured bonds play a big role
160
In discussing funding and risk management in mortgage lending, the
focus of our attention will be on portfolio trading, covered bonds and
MBS. Nonetheless, in Europe, mortgage loans are funded to a large
extent via deposits. However, in the wake of the property and
mortgage boom witnessed in many EU countries in the last decade,
the growth of mortgage credit has substantially outpaced the growth
in deposits (see Figure 5). At the same time, funding mortgage loans
with deposits has the drawback that deposits have short to medium
periods of notice while most mortgage loans are medium to long
term. Alternatives to deposit funding have therefore acquired greater
importance.
220
140
120
100
1999
2001
2003
2005
Sight deposits and term
deposits up to 2 years
Home loans
Source: European Central Bank
5
Structured bonds are one alternative to deposits. For banks with
very good ratings structured bonds can be a relatively cheap source
of funding. This is true especially compared with covered bonds,
which place considerable demands on a bank’s systems and
staffing.
Deposits and structured bonds are not necessarily used just for
funding mortgage lending, so a detailed discussion of these funding
instruments is likely to be less valuable in shedding fresh light on the
scope for the integration of the EU mortgage credit market than a
discussion of portfolio trading, covered bonds and “true sale” MBS.
Covered bonds and MBS are complementary products
The latter two instruments are not substitutes but complementary
products. Covered bonds are instruments which stand out for their
simplicity for the investor. Covered bonds combine high safety with,
in most cases, high liquidity and also offer a spread versus
October 19, 2006
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EU Monitor 38
Ways of funding fixed-rate loans
benchmark government issues. Given the strict statutory
requirements which the issuers and cover assets have to fulfil the
credit risk for investors is low. The rating of covered bond issues and
the issuer’s rating are largely – in the ideal case completely –
independent of each other.
There are essentially three different ways in
which residential mortgage loans can be
funded: with deposits, by issuing covered
bonds – like the German Pfandbrief – or
securitisation in the form of so-called
residential mortgage backed securities
(RMBS).
Funding with deposits will not be discussed in
more detail here. The maturities and nature of
the interest payments make the funding of
fixed-rate loans with deposits complicated and
therefore, depending on the share of fixed-rate
loans in the respective market, only attractive
for part of the mortgage lending business.
These problems do not arise with the
placement of (covered) bonds or securitisation
of the loans. Both (covered) bonds and RMBS
can be structured according to the maturity of
the underlying loans. If the maturities on the
assets and liabilities side of the bank’s balance
sheet cannot be fully matched, then derivatives
are used to close the interest rate risk
positions.
The figure below compares the asset swap
(ASW) spreads for covered bonds, unsecured
bonds of European financial services
companies (with AAA ratings) and German
RMBS (also with AAA ratings). The low credit
risk of covered bonds makes them the
cheapest capital market funding instrument
from a macroeconomic perspective. However,
this statement at the macroeconomic level
does not rule out the possibility that in
individual cases it might be possible for
unsecured bonds to be issued on better terms
than covered bonds depending on the
framework conditions within which a bank
operates.
Pfandbriefe are a very
favourable funding
instrument
(ASW Spreads* in basis points)
21
25
20
15
10
10
0
Pfandbriefe Uncovered
bonds
RMBS**
*The "asset swap spread" reflects a capital market's
isolated credit risk.
** Banks in Germany have mainly used so-called
"synthetic" RMBS so far. In this case only the credit risk
is transferred to the capital market while the loans
remain on the balance sheet. This kind of RMBS is
therefore not a funding instrument.
Source: Dt. Bundesbank, Monthly Report March
2006
8
However, there are differences between covered bonds and MBS
not only from the investor’s but also from the originator’s
perspective. The German-style covered bond, the “Pfandbrief”, for
instance may only be secured by mortgage loans up to a loan-tovalue ratio of 60%. Since MBS are not subject to any such
restrictions, they can be used to fund loans with higher loan-to-value
ratios. While covered bonds are therefore a basic funding
instrument, mortgage backed securities (MBS) tend to be used more
as a supplementary instrument and – especially with synthetic
securitisations – for risk management.
Trading of mortgage credit portfolios on European
secondary markets
Asset/liability and risk management as the main motive
The trading of mortgage credit portfolios makes it possible for the
selling banks either to reduce their risk-bearing assets or to optimize
their risk structure. In the first case lenders sell loans in order to free
up capital. In the second case the bank’s aim is to alter the structure
of its assets, for instance in order to reduce a regional concentration
of its credit risks.
Risk diversification would also be a key motive for banks to buy
mortgage credit portfolios. Moreover, the purchase of mortgage
loans from certain countries can serve not only to reduce risk but
also to enhance expected returns. After all, this enables banks in
Europe to invest in national mortgage credit markets even if they do
not wish to conduct any direct business of their own in those
markets. Capital employment is optimised since the banks have a
broader spectrum of risk-return combinations at their disposal.
Business and legal issues
There are a number of business and legal aspects which need to be
considered in connection with the sale of real estate loans.
From a business point of view image problems with present and
potential customers can be an argument against selling loan
portfolios. Another is the loss of cross-selling potential, although this
only applies in the generally fairly rare case that the seller does not
continue to be responsible for administering and processing the loan
contract under a service agreement concluded with the buyer.
5
2
MBS, on the other hand, represent a diverse range of products
offering the investor a choice of different credit risk classes. Instead
of relying on statutory regulations investors base their assessment
of credit risk on rating agencies’ quality judgments and select the
MBS tranche that best suits their individual risk-return preferences.
6
The sale of a portfolio can also adversely affect client relations
indirectly even if the selling bank continues to be responsible for the
client relationship. This applies to the relations not only with clients
who are directly concerned but also with those who are not. Given
the high importance of mortgage loans for the borrowers, clients
might regard this as a “breach of confidence” since, with the sale of
the loans, the bank de facto terminates the credit relationship.
October 19, 2006
Integration of EU mortgage markets
How high is the portfolio’s credit risk?
Legal barriers need to be overcome
Besides carefully weighing up the foregoing points, it is essential to
assess the credit risk as thoroughly as possible in order to
determine the purchase price. In the case of a mortgage loan
portfolio, this includes information for instance about the general
development of the respective regional property market, the
collateral and, finally, the credit-worthiness of the borrowers. Data on
the regional property markets is usually available from public
sources, but details regarding the collateral might only exist in
registers which are difficult to access while assessing the credit risk
means having access to the databases of credit reporting agencies
or similar institutions as well as the customer data.
From a legal point of view there are the following problems:
— Firstly, it has to be ensured that the sale of a portfolio does not in
itself present legal obstacles. The sale of a mortgage loan
comprises the assignment of the loan and the transfer of the
collateral. As far as the assignment of the loan is concerned, the
different data protection regulations applying in the member
states, and especially banking secrecy, could be a barrier.
Furthermore, there are customer rights regarding the continuity
of the terms of contract and possible early repayment rights that
need to be taken into account upon a change of creditor.
Collateral is usually transferred by a change of entry in a public
register of some kind. Even if this does not pose legal difficulties,
the costs might be so prohibitive as to make such a portfolio
transaction unfeasible from commercial considerations. After all,
if defaults occur, it has to be ensured that the purchasing bank
can realise the collateral.
— It must be possible for investors to access the databases of
national credit reporting agencies and similar information sources
on a non-discriminatory basis so as to be able to make a proper
assessment of a portfolio’s credit risk.
— As to the data protection aspects, it also needs to be borne in
mind that it is not only the actual purchaser who needs to have
access to the customer data but also any other interested parties
besides the party with which the deal is closed – at least in cases
where a portfolio is not sold to one specific investor in a private
placement. For the due diligence process the other interested
parties have to be allowed access to the data as well so as to
enable them to bid on a well-informed basis.
Securitisation of loan portfolios
In the case of the securitisation of home loans in the form of
residential mortgage backed securities, a distinction needs to be
made between “synthetic” and “true sale” securitisation. Since, with
synthetic securitisation, only the credit risks are transferred and
there is no transfer of title, we will concentrate in the following on socalled “true sale” securitisation. Here, there are a number of basic
similarities with a sale, but there are also considerable differences.
Like a sale, securitisation is a risk
management instrument
October 19, 2006
One common feature is that the loans are taken off the balance
sheet of the bank which securitises or sells them. So, like a sale,
securitisation can be used to control risk (especially for
diversification purposes) and to free up equity capital. Conversely, it
enables investors to invest selectively in specific risk classes.
Another point which a portfolio sale and true sale securitisation have
in common is that in both cases there is a transfer of title. Since the
constitutive elements of a mortgage loan comprise not only the
creditor’s claim on the debtor but also its collateralisation, title is
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EU Monitor 38
conveyed by assigning the claim and transferring the collateral.
Some of the difficulties which can arise in connection with the
assignment of the claim (banking secrecy/data protection) and the
transfer of the collateral when selling a portfolio were discussed
above and also apply in principle to securitisation. Likewise, in both
cases a service agreement regulates who is responsible for the
further management and processing of the loan contracts. This
usually remains with the bank which sells or securitises the loans.
So this bank retains the contact with the client and thus the crossselling potential.
Risk assessment processes differ
Fannie Mae and Freddie Mac under fire
The two corporations Fannie Mae and Freddie
Mac were set up by the US Government to
create a secondary market in mortgage loans.
They do not therefore provide real estate
finance directly but purchase mortgages from
banks. These are then securitised and placed
on the international capital market as mortgage
backed securities (MBS). Together, the two
corporations control over 40% of the US
mortgage market, whose total size is in the
region of eight trillion USD. Funding is through
the issuance of bonds whose total volume is
around USD 2.4 trillion and thus equivalent to
almost one fourth of US gross domestic
product. Given that the two corporations are
closely linked to the US Government most
market participants assume an implicit
government guarantee should they get into
financial difficulties. It is assumed that Fannie
Mae and Freddie Mac are “too big to fail“. This
lowers the risk premium paid on the capital
market by an estimated 30 to 40 basis points
compared with private competitors.
One of the main differences is the risk assessment process. When
purchasing a portfolio the investor (usually a bank) conducts its own
assessment of the credit and other risks within the framework of a
due diligence process, while MBS investors rely on the ratings
issued by the leading rating agencies. Another important difference
is the liquidity of the secondary market. While loan portfolios are
investments which are highly specific, RMBS are offered to investors
with different risk preferences as standardised securities in different
credit quality categories. The third difference is that, with portfolio
trading, title passes directly from seller to buyer, while with
securitisation a “special purpose vehicle” (SPV) is interposed
between the originator and the investor.
These three characteristics reflect the essential difference between
a concrete investment in a portfolio and a more abstract investment
in securitised, exchange tradable rights to cash flows (in the form of
interest and principal) generated by the underlying loan portfolio.
A liquid pan-European MBS market, like a liquid secondary market
for mortgage credit portfolios, is not possible without simplified
transferability of the claims and especially the collateral, good
access to credit databases, insight into the customer data and land
registry records as well as effective scope for enforcement. Hence,
as far as the recommendations for Commission action are
concerned the discussion of MBS transactions leads to similar
conclusions as for portfolio trading. With two exceptions:
— The portfolio’s credit risk is not assessed by banks interested in
acquiring the portfolio but by rating agencies. The legal basis for
third-party access to customer data therefore has to be
constructed in such a way that rating agencies, too, have access
to the information which they need.
In fact, financial problems at the two federal
mortgage associations would pose a serious
problem for the stability and functioning of the
US financial sector simply because of their
sheer size. The risk resides among other
things in the maturity transformation. While
long-term loan portfolios predominate on the
assets side, funding is short term. Derivatives
are used to hedge the interest rate risk, with
the counterparty risk being concentrated on
just a few big banks.
— Since the portfolio is transferred to an SPV rather than being
In recent years both corporations have come
under fire. According to an investigation by the
US Securities and Exchange Commission
(SEC) the accounts at Fannie Mae were
allegedly manipulated in the years 1998 to
2004. There were also accounting irregularities
at its sister association Freddie Mac. A loss of
confidence among international investors could
hurt the funding activities of both corporations
and lead to distortions on the US capital
markets.
No measures beyond that are necessary. This applies especially as
regards the proposal to create a European counterpart to Fannie
Mae and Freddie Mac in the USA. The heavy criticism rightly
directed against these two corporations for some time suggests that
the creation of such an institution does not make sense. Rather, in
this special area, too, action by the European Commission should
focus on facilitating the effective operation of market forces. The
Pfandbrief and covered bond segment is an example of the
decentralised, market-driven creation of a European asset class
which, in particular, also simplifies the funding of mortgage loans.
10
taken onto the acquiring bank’s books directly this implies the
need for the SPV to be insolvency-proof. If the securitising bank
becomes bankrupt, the SPV must be protected against recourse
to it by the bank’s creditors.
October 19, 2006
Integration of EU mortgage markets
Funding with covered bonds
“Covered bond”: No generally valid
definition
There is no generally binding definition of the
term “covered bond” that applies Europe-wide.
The legal framework for covered bond issues
is anchored at present in the national law of
the respective member states. However, two
EU directives which make reference to covered
bonds, either implicitly or explicitly, allow a first
approach to defining this category of bond.
In the UCITS Directive, the EU’s legal
framework for investment funds, it is defined
what requirements a bond must fulfil for
investment funds to be able to invest not only
five percent but an extended 25 percent of the
fund’s assets in such securities of the same
issuer. The requirements set forth in Article 22
(4) UCITS are:
— The bond must be issued by a credit
institution.
— The issue must be made within a special
statutory framework which provides for
special public supervision of the issuer.
The bond must be covered by assets
which are protected in the event of the
issuer’s failure.
The merely implicit reference to covered bonds
means that debt instruments which do not fulfil
the UCITS requirements may still be referred
to as covered bonds – this applies for instance
to British covered bonds whose issuers are not
subject to special public supervision.
—
The explicit reference to covered bonds in the
Capital Requirements Directive (CRD) does
not provide effective brand protection either.
The CRD defines covered bonds as debt
instruments which fulfil the requirements of the
UCITS Directive and where only specific types
of finance (mortgage loans, loans to public
entities, ship finance) and – albeit subject to
quantitative restrictions – MBS and interbank
claims may be used as cover assets. Bonds
which fulfil these requirements enjoy privileged
treatment for capital adequacy purposes.
Nonetheless, bonds not fulfilling these
requirements can still be called covered bonds.
During the past decade products similar to the German Pfandbrief
(covered bonds) have grown enormously in popularity in almost all
EU member states. Parallel with this, the jumbo Pfandbrief, which
made its debut in 1995, has captured an important position in the
international financial markets.
The covered bond market is a model example of the competitiondriven integration of the European mortgage credit market from the
secondary market and funding side. While until some way into the
nineties the issuers of covered bonds, the investors and the assets
usually originated from the same EU member state (with the
exception of the German Pfandbrief which was already an
international product back then) these instruments have since
evolved into a European asset class enabling international investors
to invest in covered bonds from more than twenty countries with, in
part, internationally sourced cover assets.
The trademark of covered bonds, and especially the Pfandbrief, is
their good credit quality coupled with a generally relatively large
degree of standardisation and high liquidity. However, the boom in
covered bonds witnessed for some years raises the question
whether the strong brand value can be preserved in the long run
without brand protection. The European Covered Bond Council
(ECBC), which represents the interests of some eighty issuers,
investment banks, rating agencies and other market participants, is
seeking to develop minimum standards for covered bonds. These
are intended to signal high product safety to the investor. However,
no statutory regulation is planned. Rather, the aim is to build up
group pressure to encourage issuers only to issue covered bonds
which comply with the high standards. If the ECBC succeeds, this
would round off a model example of market-driven integration of
mortgage funding in Europe.
Covered bonds as a European asset class and European
funding instrument
That statutory frameworks for the issuance of covered bonds have
become established in parallel in many EU countries does not in
itself imply any Europeanisation of mortgage funding and thus the
hoped-for cost benefits as yet. Real Europeanisation requires two
things:
— that nationally operating originators have no difficulty funding
their business Europe-wide (which means, conversely, that
investors throughout Europe have no difficulty investing in
individual markets), and
— that internationally operating originators have no difficulty funding
their internationally sourced loan portfolios with a single
instrument (which means, conversely, that investors have no
difficulty investing in a European loan portfolio with the purchase
of a single security).
The first objective is achieved simply by the fact that many countries’
covered bonds have become so well known throughout Europe that
issuers can address a European investing public. This is especially
true of the jumbo Pfandbrief. The jumbo Pfandbrief is a German
covered bond issued with special contractually warranted qualities.
The contractual and statutory provisions guarantee high credit
quality and liquidity.
Since, under German law, the assets covering a Pfandbrief can
consist of loans secured by mortgages originating from all EU
October 19, 2006
11
EU Monitor 38
member states (and beyond), banks can fund an internationally
diversified mortgage credit portfolio with a single instrument. The
second objective is therefore achieved as well. The jumbo
Pfandbrief is an instrument with which internationally active real
estate lenders can fund their international loan portfolios through
international investors.
Access to the European capital market via a single funding
instrument can also be achieved indirectly for originators which
operate nationally if covered bonds which are in circulation can be
included in the cover for a newly issued covered bond. This is the
case for instance with Luxembourg’s “lettre de gage hypothécaire“.
Conversely, the purchase of such a security, regardless of the
securities contained in the cover assets, represents an indirect
investment in an international real estate loan portfolio.
Covered bonds make cross-border
funding and investment possible
These examples indicate how European funding can lower the cost
of mortgage credit. Originators can fund their – national and
international – loan portfolios Europe-wide, while investors can
invest in specific markets as well as in cross-border and even panEuropean portfolios. The covered bond segment thus offers banks
and investors wide-ranging opportunities for cross-border funding
and investment.
Purely competition-driven
development
The covered bond market generally and the jumbo segment
specifically have evolved as a result of imitation and innovation
competition among the individual states and covered bond issuers
(and their associations). The popularity of covered bonds can be
explained primarily by their high safety, which in turn is due to the
statutory requirements regarding the quality of the cover assets and
their protection in the event of the issuer’s failure. If any action is
needed on the part of the European Commission to promote the
further development of this segment of the capital market, then this
is where it should be focused.
Summary: Pre-conditions for European funding and
risk management in mortgage lending
Covered Bonds: Germany
and Denmark are dominant
The following pre-conditions need to be fulfilled to enable banks
active in the mortgage segment to achieve cost benefits through a
Europeanisation of the secondary market:
Market shares in terms of covered
bonds outstanding
Others UK
2% 3%
DK
32%
— In the case of portfolio transactions and securitisation interested
CH
3%
buyers and rating agencies respectively must be in a position to
reliably assess the credit risk of portfolios. This means they must
have access to the necessary information.
FR
4%
SE
11%
— Data protection regulations must not be allowed to stand in the
way of portfolio trading or securitisation. This must apply
especially in the case of internationally diversified portfolios and
cross-border transactions, too.
ES
18%
— In the case of mortgage backed securities and covered bonds
DE
27%
Source: European Covered Bond Council
12
7
the SPV and cover assets must be protected in the event of the
issuer’s insolvency. Here, the Directive on the Reorganization
and Liquidation of Banks and Credit Institutions takes effect
which stipulates that the law of the issuer’s home country applies
within the EU. So, for a German issuer of Pfandbriefe the rules of
the German Pfandbrief Law regulating the protection of the cover
assets apply regardless of which EU states creditors file claims
from and regardless of the EU states from which the loans
securing the Pfandbrief originate. While this makes it easier to
assess what protection the SPV or cover assets enjoy, it is still
October 19, 2006
Integration of EU mortgage markets
necessary for the market participants to be familiar with the
respective rules and regulations of the issuer’s home country.
— Transfer of the collateral, which is an essential pre-condition for
the sale of a mortgage loan, must be possible without
prohibitively high costs. So-called funding registers enable the
collateral to be administered by the originator on a trust basis if a
portfolio is sold or securitised or if it is included in the cover
assets of a covered bond issued by another bank.
— It must be possible for the collateral to be realised in the event of
default without incurring prohibitively high costs. The valuation of
the collateral must be transparent and verifiable for the
buyer/investor or rating agency.
To create these conditions a number of measures are necessary,
most of which are already considered in the Green Paper.
State of play in the regulation of
mortgage lending at the EU level
What action does the Commission
therefore need to take?
The fact that there are as yet no regulations at
the EU level relating explicitly to the mortgage
lending business obviously does not mean that
this is a completely unregulated area. In their
mortgage lending banks operate within a
regulatory framework marked by several
standardised EU-wide rules at both the
institution and the product level.
The Commission has already addressed most of these issues in its
Green Paper. The comments in the “Legal Issues“, “Mortgage
Collateral“ and of course the “Funding of Mortgage Credit“ sections
of the Green Paper are of particular relevance. The Commission’s
statements regarding the need for action in the area of “Consumer
Protection” are less productive.
At the institution level this framework derives in
the main from the Second Banking Directive
and the Capital Requirements Directive. At the
product level there are a great many directives
which also apply to the mortgage credit
business – including the directive on door-todoor sales.
The European Code of Conduct on Home
Loans is an act of voluntary regulation which
was negotiated between European consumer
organisations and credit industry associations
and was signed in March 2001. This
standardises the information which consumers
receive from a bank when they enquire about a
loan. Besides general information about the
mortgage loans available, if interested in a
specific product clients also receive
personalised information in the form of a
“European Standardised Information Sheet“.
This contains product-specific details of the
amount of the loan, the nominal interest rate,
the effective annual percentage rate, the life of
the loan, any options for early repayment, the
nature of the interest payment, etc.
In a recommendation circulated in March 2001
the European Commission called upon
mortgage lenders to sign and implement the
voluntary Code of Conduct. To monitor the
acceptance and application of the Code the
Commission set up an online register with the
names of those lenders who apply the code – it
includes almost the whole of the German
banking community.
October 19, 2006
Consumer protection
Under the heading “Consumer Protection“ the Commission
addresses the issues of “consumer information“, “advice provision
and credit intermediation“, “early repayment“, “annual percentage
rate“, “usury rules and interest rate variation“, “credit contract“ and
“enforcement and redress“. None of the measures which the
Commission discusses here will help further the Europeanisation of
the secondary markets and mortgage funding.
Legal issues
Here, the Green Paper discusses the issues of “applicable law“,
“client credit-worthiness“, “property valuation“, “forced sales
procedures“ and “tax“. The questions which the Commission raises
touch upon one of the three central pre-conditions for the integration
of the secondary markets and funding in the mortgage credit sector:
the scope for potential buyers and investors or, respectively, the
rating agencies to reliably assess the credit risk of portfolios.
— “Client credit-worthiness“: Here, the Green Paper’s main concern
is with foreign banks’ access to national credit databases, such
as that provided in Germany by the Schufa private credit
reporting agency. At present, credit bureaus provide cross-border
credit status reports on the basis of bilateral agreements but such
agreements are not in place everywhere by any means. In many
cases foreign banks have no possibility at all to obtain
information about clients’ creditworthiness.
— “Property valuation“: The procedures for property valuation have
evolved over time from different traditions and relate essentially
to three main issues: the selection and qualification of the
valuers, the definition of the basis of valuation (lending value vs.
market value) and the method of valuation (comparative value
method, income approach to valuation or replacement cost
13
EU Monitor 38
EULIS and Euromortgage
The aim of the European Land Information
Service (EULIS) pilot project is to enable
global access to the national European land
registers via a common Internet portal. So far
eight EU regions are involved: England and
Wales, Finland, the Netherlands, Lithuania,
Norway, Austria, Sweden and Scotland. It is
planned to incorporate other regions, including
some of the new EU member states.
The functionality of the EULIS portal is
confined in the main to providing land register
data and applications for billing. Users can
access the EULIS portal by registering online
with their respective home land registry. The
national providers continue to be responsible
for administering and maintaining the
databases; the information is merely
transferred to the EULIS portal. This is in order
to guarantee the authenticity of the land
registry records.
The range of services offered includes countryspecific data on the registration and transfer of
properties and mortgages in the respective
national language, translations of technical
terms into the languages of the countries
participating in the project and explanations
about the role and powers of public authorities.
The Euromortgage has been put forward as a
universal instrument for the collateralisation of
mortgage loans which can be used as flexibly
as possible to meet the high demands of
modern lending practices. In some EU member
states property charges possess a rigid
mandatory accessoriness, which means that
the agreement regarding the mortgage
collateral cannot exist independently of the
mortgage credit to be secured. This
construction has historical origins and is
aligned to the traditional mortgage loan where
neither lender nor borrower changes.
With the Euromortgage the mandatory
accessoriness would be replaced by a flexible
contractual link so that the credit contract and
the collateral contract can exist independently
of each other. Additionally, it would also be
possible to extend the collateral to more than
one property and to secure loans with
properties on a cross-border basis.
It is still uncertain how the idea of the
Euromortgage will be implemented. It is
conceivable that the Euromortgage might coexist alongside the national collateral
instruments and supplement them. A standard
EU-wide legal framework could be established
in the form of an EU regulation, directive or –
failing consensus – through closer cooperation.
14
approach). Here, the Commission should level the way for
mutual recognition of the different approaches on the basis of
common minimum standards. This would make it easier for
potential investors to bid. However, full harmonisation is neither
desirable nor practicable.
— “Forced sales procedures“: Like the property valuation
processes, differences in forced sales procedures, and in their
effectiveness and duration, have arisen over time from different
traditions. The regulation of forced sales procedures is a central
area of the member state’s civil and judicial sovereignty. Any farreaching intervention by the Commission would therefore be
difficult. On the other hand, the possibility to realise collateral is
an important characteristic of mortgage loans. How quickly and
at what cost this can be done has a significant influence on the
price of a loan. So, if rules differ too widely, this makes it difficult
not only for foreign investors to obtain information but also for
them to assess international loan portfolios. To remove such
information asymmetries the Commission could set up an
information system to collect and update information on the cost,
duration and effectiveness of these procedures in the member
states. This would not only make access to information easier for
foreign lenders, investors and rating agencies but would also put
pressure on member states with particularly inefficient systems.
Mortgage collateral
Under the heading “Mortgage Collateral” the Commission addresses
the issues of “land registers” and the “Euromortgage“. Both of these
issues are central to the Europeanisation of funding and risk
management in the mortgage credit market.
— “Land registers“: Here, the concern is with access and the
completeness of the data. Cross-border access is possible de
jure. However, if this can only be done by directly inspecting the
physical, locally filed registers, then the costs can be prohibitive.
The Commission should therefore encourage the creation of
electronic land registers which can be accessed online. The
EULIS project is a good starting basis. It must also be ensured
that a land register reflects all charges that could affect property
ownership rights.
— “Euromortgage“: Under this point the Commission discusses the
idea of introducing a standard, EU-wide instrument for securing
loans on property. At present, diverse forms of property charge
co-exist which, even at the national level, are often no longer
compatible with the demands of modern lending practices
(subsequent alteration of loan contracts, securitisation, portfolio
transactions, securing a loan with several properties etc.). The
problem is accentuated if the secondary and funding markets are
internationalised. The Euromortgage model aims to resolve this
by creating a flexible credit-securing instrument which is not
linked to specific financng structures but has only limited
“accessoriness“. This replaces the fairly rigid mandatory
accessoriness which widely prevails with a more flexible
contractual link between the loan which is secured and the
collateral. With the introduction of a Euromortgage, only the loan
receivable needs to be transferred when trading portfolios,
securitising mortgage backed securities or issuing covered bonds
while the charges are still held on a trust basis by the originator
or another party. This would simplify the creation of the funding
registers mentioned earlier, also at the European level.
October 19, 2006
Integration of EU mortgage markets
Funding of mortgage credit
Under the heading “Funding of Mortgage Credit“ the Green Paper
lists the different funding mechanisms, mentions the idea that a
European funding and secondary market could be a suitable starting
point for further market integration, and makes the transferability of
mortgage loans a central condition for further progress in this area.
However, more concrete measures in this direction are not
discussed. This applies particularly with regard to two central issues
highlighted here which could prove to be stumbling blocks for the
integration of the EU secondary and funding markets:
— The Green Paper as a whole does not consider data protection
problems relating to the transfer of loan receivables and in the
preceding rating and due diligence process.
— The protection of cover assets, SPVs and funding registers in the
event of insolvency is not discussed. These registers are
important, as argued earlier, should the transfer of collateral be
associated with prohibitively high costs in portfolio transactions
but especially in the case of asset backed securities or covered
bonds.
Conclusion
The Commission should take the discussion on the integration of the
European mortgage credit market which it itself has initiated as a
test case for the “better regulation” idea. This means carefully
assessing the impact of legislation, giving explicit consideration to
the options of non-intervention and self regulation and seeking to
make any regulatory action taken as cost efficient as possible for
lenders and consumers. As far as the mortgage credit market is
concerned, one-sided intervention on the product side cannot fulfil
this requirement. Conversely, selective measures which make the
effective operation of market forces in the secondary market and
funding easier will benefit the financial services industry and
consumers alike.
All considerations should be directed at progress towards integration
of the secondary market and funding. However, any action needed
in this regard must not lead to “European solutions” along the lines
of a European “Fannie Mae” or “Freddie Mac“. Rather, the
Commission should concentrate on taking selective steps which will
allow policy competition and market forces to operate more
effectively. Pfandbriefe and covered bonds are an example of how
these latter forces can create a European funding segment for
mortgage credit.
Stefan Schäfer (+49 69 910-31832, [email protected])
October 19, 2006
15
EU Monitor
ISSN 1612-0272
Integration of EU mortgage markets: It's the funding, commissioner!
Financial Market Special, No. 38 ...................................................................................................... October 19, 2006
EU asset management N Towards the creation of a single market in Europe
Financial Market Special, No. 37 ............................................................................................................. June 8, 2006
Early repayment of fixed-rate mortgages: There is no free lunch
Financial Market Special, No. 36 ...............................................................................................................July 7, 2006
Economic Patriotism N New game in industrial policy?
Reports on European integration, No. 35 ............................................................................................... June 14, 2006
EU retail banking N Drivers for the emergence of cross-border business
Financial Market Special, No. 34 .............................................................................................................. April 7, 2006
Estonia, Lithuania, Slovenia: Poised to adopt the euro
Reports on European integration, No. 33 .................................................................................................. April 3, 2006
Romania & Bulgaria clearing hurdles for EU accession
Reports on European integration, No. 32 ................................................................................................ May 11, 2006
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