1. Asia Pacific Union for Housing Finance Delhi Conference January 2012 The Expansion of Mortgage Covered Bonds: Market Drivers, Policy Options Olivier Hassler ohassler@worldbank.org 1

2. Foreword: The World Bank Support to Housing Finance Development 2

3. A Critical component of Social and Economic Development… World needs c 4,000 houses an hour to keep up with demand (UN-Habitat, 2005) Urbanization requires huge investments – or slums prevail Individual and social impact of immediate decent housing Possible wealth ladder Impact on the economy Construction multiplier effect Link home owner ownership /micro or small business Limits of government finance Promotion of savings and development of capital market 3

4. …But faces challenges Among others, HF : Can have an adverse effect on banking stability (linkage with real estate market cycles or bubbles, risky lending practices) Imply long term finance to make large investments affordable, a feature often hard to match The World Banks 4 Pillar Strategy: Build sound foundations of HF systems Expand access of LI households to HF Promote affordable housing supply Develop adequate funding for housing 4

5. What are Covered Bonds 5

6. CB Essence : to Provide Security to Investors 1. A Double Recourse Mechanism: Mortgage portfolios are pledged to bondholders (Cover Pool) Bondholders privilege on the CP in case of insolvency CP segregated from other assets The CP must be sufficient to service the bonds at any time Quintessential principle: insolvency not an Event of Default no automatic acceleration of the maturity of the CB 2. Quality Requirements for the Assets Strict eligibility criteria: first mortgage, Max LTVs (80% for residential typically, insurance /guarantees if more), valuation rules, limits on CRE 3. On going supervision by specific controllers/trustees However, not a totally Bankruptcy Remote Instrument 6

7. The Expansion of Covered Bonds 7

8. A Fast Growing Market Amounts outstanding - Billion Euros - Chile, Korea not included Source: ECBC 8

9. The Benefits of Covered Bonds For lenders Long term funding, fixed rates available But ALM mismatches generally (bullet repayment vs amortizable loans) Rating enhancement can be significant (several notches possible) Cost effective, cheaper than securitization But spreads widened in Europe (AAA: 150 bp +) – largely sovereign effect For investors High level of security, with yield pick up Market liquidity: no valuation problem, large volumes, market making achievable under certain conditions, repos From a macro perspective: financial stability factor Long term investments stimulated by security conditions But government supported CB issuers during crises (France, UK, Germany) No moral hazard (credit risk retained) Access to Central Banks repos with small haircuts 9

10. A Greater Resilience to the Financial Crisis New issues in Europe remained strong - Source: ECBC- ( But with shorter maturities) 10

11. Changing Funding Patterns Importance of short term liquidity risk re-discovered Wholesale short term funding for mortgage portfolios out Stable core deposit bases revalued Securitization affected by the crisis (image, new regulations) Geographic expansion of covered bonds, including in jurisdictions that up to now prevented commercial banks from issuing secured debt New legal frameworks Legal frameworks considered/prepared - Australia - India - Korea - Belgium - New Zealand - Brazil - Canada - Japan - Mexico - Morocco - USA 11

12. Options for Key Features 12

13. Structural Options Specialized lenders ( initially) vs commercial banks (general case now) Asset mix (residential, CRE, public entities), or specific cover pools by asset types? Ring fencing options: CP register (fungible assets, dynamic pool) Special subsidiary fungible assets, (dynamic pool) – France, Australia bond specific CP (static pool, pass through structure) Denmark / Chile models 13

14. Management of Insolvency Situations Ring fencing legally binding Specific insolvency administrator CP becomes static. Risks to address for continuation: Lower recovery Back-up loan servicer Liquidity shortage possibility to borrow, soft bullet arrangement If portfolio liquidation unavoidable: Legal value of voluntary OC In case of shortfall: recourse to the general insolvency estate (pari passu typically) 14

15. Assets/Liabilities Matching Cash flow coverage: a not precise enough principle Liquidity risk: Substitute assets Pre-maturity test and liquidity reserve (Germany, France: 6 months in advance) Market risks: NPV coverage Derivatives included in the CP Better matching = lesser OC requirement 15

16. Depositors Subordination Depositors ranking behind secured creditors: a concern of many prudential Authorities. Ways to address it: 1. Link CBs issuance to soundness criteria Licensing criteria Minimum solvency ratios Italy : limits for cover pool size: None if Capital ratio > 11% 60% if Capital ratio = 10%-11% & tier 1 capital > 6.5% 25% if Capital ratio = 9%-10% & tier 1 capital > 6% 2. Hard limits - from 4% to 20% in various jurisdictions Regulation Cases by case approach (UK, Netherlands) 3. Impose capital requirement to OC Denmark (capital center), Netherlands 4. Contribution to Deposit Insurance Schemes 16

17. Conditions of Success beyond Legal Frameworks Institutional Investors: investment guidelines Specific asset class, adjusted risk concentration rules, etc. Investing banks: Lower risk weight Repo-ability Reporting and market information Transparency (dynamic pool composition, on going LTVs, NPL, etc.) allows less OC Loan by loan information (UK) maybe excessive (no asset transfer) Support to market liquidity market making ideally, but hard to hold commitments in stressed contexts 17