docIntegration of EU mortgage markets: It`s the funding, commissioner!
download 
Report Transcription
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 stefan-a.schaefer@db.com Editor Bernhard Speyer Technical Assistant Sabine Kaiser Deutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: marketing.dbr@db.com 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 2 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. 3 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 5 EU Monitor 38 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 7 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 9 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, stefan-a.schaefer@db.com) 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 All our publications can be accessed, free of charge, on our website www.dbresearch.com You can also register there to receive our publications regularly by e-mail. Ordering address for the print version: Deutsche Bank Research Marketing 60262 Frankfurt am Main Fax: +49 69 910-31877 E-mail: marketing.dbr@db.com © Copyright 2006. Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Germany. All rights reserved. When quoting please cite “Deutsche Bank Research”. The above information does not constitute the provision of investment advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Deutsche Bank AG or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Deutsche Bank. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made. In the United States this information is approved and/or distributed by Deutsche Bank Securities Inc., a member of the NYSE, the NASD, NFA and SIPC. In Germany this information is approved and/or communicated by Deutsche Bank AG Frankfurt, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht. In the United Kingdom this information is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange regulated by the Financial Services Authority for the conduct of investment business in the UK. This information is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co. and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this information is approved and/or distributed by Deutsche Securities Limited, Tokyo Branch. In Australia, retail clients should obtain a copy of a Product Disclosure Statement (PDS) relating to any financial product referred to in this report and consider the PDS before making any decision about whether to acquire the product. Printed by: Druck- und Verlagshaus Zarbock GmbH und Co. KG ISSN Print: 1612-0272 / ISSN Internet and e-mail: 1612-0280
