The Market for Covered Bonds in Europe

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					Fixed Income &
Relative Value

                                                                                                                                             Deutsche Bank@
       Global Markets Research

                                  04 March 2003
                                                                                 The Market for Covered Bonds in

                                 Table of Contents                               •   In order to assess relative value between the heterogeneous set of ‘covered
                                                                                     bonds’ in Europe, we use a standardised framework in which we can compare
                                 Evaluation criteria for ‘covered                    and contrast each type of bond.
                                 bonds’ in Europe .................... 2
                                 Germany .............................. 11       •   In the first part of this study, we discuss the key credit issues involved with
                                 Denmark............................... 15           covered bonds. We follow a two-step approach, looking, first, at the provisions
                                 France .................................. 18        designed to reduce the risk profile of the issuer (specialist bank principle) and,
                                 Luxembourg ......................... 22             second, concentrating on the various safety aspects surrounding the cover assets
                                 Spain .................................... 26
                                 Ireland .................................. 30
                                                                                     (credit quality of cover assets, bankruptcy-remoteness, taking derivatives into cover
                                 Switzerland........................... 33           etc.).
                                 Austria .................................. 35
                                                                                 •   European covered bond laws have been passed or are in the process of being
                                 Finland ................................. 37
                                 Sweden ................................ 39          passed in a number of European countries. In the second part of this study, we
                                 Poland .................................. 41        present the different European covered bond legislation. We use the standardised
                                 Czech Republic.................... 43               framework developed in the first part of the study to compare and contrast the
                                 Hungary................................ 44          different European products from an investor’s perspective.
                                 Main publications ................. 51
                                                                                 •   The proliferation of covered bond legislation has been furthered by the success of the
                                                                                     Jumbo market-making platform. We discuss the key features of the primary and
                                                                                     secondary markets for Jumbo covered bonds in Europe and we also give an
                                                                                     overview of the repo market for covered bonds.
                                                                                 •   The European covered bond market has entered a period of consolidation.
                                                                                     Issuers are struggling with deteriorating market conditions and are losing market
                                                                                     share to other public and quasi-sovereign issuers. We give an overview of the
                                                                                     relative performance of different types of covered bonds issuers and products.
                                                                                     Deteriorating profitability within the industry and rating concerns have led to
                                                                                     an increasing differentiation between issuers of covered bonds. An active
                                                                                     strategy of issuer differentiation requires an understanding of the industry-wide
                                                                                     trends towards consolidation and the need for a diversification of business activities.
                                 Norbert Meisner

                                 Euroland Strategist
                                 (49) 69 9103-1266

                                 David Folkerts-Landau
                                 Managing Director, Head of
                                 Global Markets Research
Deutsche Bank@                                          The Market for Covered Bonds in Europe                                         04 March 2003

                                                                               on the amount of interest rate risk a bank may carry outside of the
Evaluation criteria for ‘covered bonds’                                        cover asset pools or cover assets.
                                                                               The ‘inner protective wall’
Characteristics of ‘covered bonds’
                                                                               High asset quality and a high level of bankruptcy-remoteness of
For the purposes of this study, we use the term ‘covered bonds’
                                                                               the cover assets define the ‘inner protective wall’ for the holders
when we wish to refer to different types of mortgage bonds in the
                                                                               of covered bonds. Both conditions need to be met simultaneously to
European Union (EU), whether these are backed by mortgage
                                                                               provide the investor with a top level of security. The quality of the
assets, public sector loans or other types of assets such as
                                                                               assets may not guarantee repayment of interest and principal to the
mortgage backed securities.
                                                                               creditor if they are not bankruptcy remote. Vice versa, the
The term mortgage bond, even though it is commonly used to define              bankruptcy remoteness of the assets or the asset pool will not
covered bonds throughout the European Union, typically                         provide sufficient protection if the quality of the assets is not high
encompasses a wider range of assets                                            enough.
European covered bonds are typically issued by specialised                     Several factors determine the quality of the cover assets -
credit institutions with a narrowly defined scope of business
                                                                               •     The assets must not include excessive risk relating to interest
activities and subject to special banking supervision. The cover
                                                                                     rate, currency, liquidity and other risks.
principle (see below) applies to all European covered bonds and
ensures that the claims embodied in the bonds be covered to the full           •     If substitute collateral can be used, its quality and the amount
extent by specific assets of at least equal nominal value. In practice,              permitted must be strictly limited.
compliance with the cover principle has led to a variety of legal
                                                                               •     If increasing use of derivative instruments is being made, it
systems, which give bond creditors a priority claim on the underlying
                                                                                     must be ensured that the solvency of the asset pool is not
assets. While most countries have comprised the cover assets in
                                                                                     threatened by an early unwinding of asset cover hedges in
separate asset pools designed solely to separate the cover assets
                                                                                     case of a default of a mortgage bank and that the risk from a
from the other non-privileged assets, other countries do not
                                                                                     potential default of a derivative’s counter-party is confined
distinguish between privileged and non-privileged assets. Still, all
                                                                                     within narrow limits.
countries with the exception of Switzerland provide the covered
bond creditors with a privileged claim on all cover assets on the              The credit quality of the cover assets
balance sheet.
                                                                               In most jurisdictions, the issuers of covered bonds are allowed
The ‘outer protective wall’                                                    currently to engage in two types of business activities, i.e. mortgage
                                                                               and public sector lending. The assets that may be taken into cover
The specialist bank principle plays an important role for European
                                                                               are defined in detail by the respective legislation of each individual
covered bonds.
In the more recent covered bond laws, national legislators have
                                                                               Mortgage lending: Under most European covered bond laws ‘first
opted for the specialist bank principle. This is generally
                                                                               lien’ mortgages within the European Union or the European
accompanied by tight restrictions on the freedom of business for the
                                                                               Economic Area can be taken into cover. While Spain only allows
issuers of covered bonds. In general, credit institutions in the EU
                                                                               domestic mortgage assets as cover for its Cedulas Hipotecarias,
enjoy the freedom to determine themselves the business activities in
                                                                               Luxembourg allows OECD-wide mortgage and public sector assets
which they want to engage and the supervisory authority
                                                                               to be used for its ‘covered bonds’. Limits on the amounts of loans
concentrates on monitoring the ‘regularity’ of the business. In
                                                                               granted against real property exist in all countries and are designed
essence, legislators are imposing particularly tight provisions on the
                                                                               to protect the ‘covered bond’ creditor against the potential erosion of
issuers of covered bonds in order to remove the risk of any such
                                                                               the market value of the underlying mortgage asset. Loan-to-value
institution from becoming insolvent. In this sense, the specialist bank
                                                                               ratios (LTV) in the EU range between 60-80%. See the table on the
principle can be viewed as the ‘outer protective wall’ to the
                                                                               following page.
covered bond creditor. By focusing on a restricted number of
business activities, which are considered to be fundamentally ‘safe’,          Besides the setting of conservative LTV ratios, careful valuation of
the specialist bank principle helps to ensure against any insolvency           real property is a critical safety element to the ‘covered bond’ holder.
of the issuers of ‘covered bonds’.                                             The issuing bank has to make an estimate of the value of the
                                                                               mortgage asset. The rules, which regulate the valuation of real
A good illustration of the specialist bank principle is the limitation of
                                                                               estate are mostly laid down in legal provisions by public authorities
non-eligible mortgage lending business, which German mortgage
                                                                               (in Germany, Denmark, France, Spain and Portugal) but may also
banks are allowed to carry on their balance sheets. Since the non-
                                                                               be found in the articles of the respective mortgage bank associations
eligible businesses (those where the 60% loan-to-value ratio is
                                                                               (Sweden and Finland).
exceeded), is considered riskier, by its very nature, the legislator has
fixed a limit of 20% of the overall mortgage lending business for this             Loan-to-value ratios for European covered bonds
particular risk activity. The legislator may also place restrictions on
the type of assets in which the bank’s liable own funds or any                     Country           Risk weighting of 10%      Risk weighting of 20%
surplus liquidity can be invested to further strengthen the risk profile           Austria                    Yes                         -
of a mortgage bank. Further, the legislator or as in the case of                   Belgium                    Yes                         -
Germany the supervisory authority may also define specified limits                 Denmark                    Yes                         -

2                                                                                                                            Global Markets Research
04 March 2003                                                   The Market for Covered Bonds in Europe                                           Deutsche Bank@

  Finland                           yes                           -                                       Private
                                                                                                                         Public bank   Zero risk-
                                                                                                                              Jumbos   w eighted
  France                            yes                           -                                   mortgage bank
                                                                                                                               2%       Jumbos
  Germany                           yes                           -                                       Jumbos
                                                                                                             12%                          2%
  Greece                            yes                           -
                                                                                                                                            Euro Freddie
  Ireland                            -                           yes                                                                             M ac
  Italy                              -                           yes                                                                                1%
  Luxembourg                        yes                           -
  Netherlands                       Yes                           -
  Portugal                           -                           yes
  Spain                             Yes                           -                               Euroland
  Sweden                             -                           yes                             Sovereigns
  UK                                 -                           yes
  Source: Deutsche Bank
                                                                                         Source: DB Global Markets Research
Generally, since the valuation needs to ensure that the ‘covered
                                                                                       Definition of eligible and non-eligible asset-side business
bond’ holder will be secured until the maturity of his bond, the
duration characteristics of any collateral should play an                              The quality of cover assets is, of course, a key criterion for the
overwhelming role as opposed to the market value of the collateral.                    quality of the ‘covered bonds’. It is up to the national legislator to
                                                                                       define those assets that are eligible as cover assets. The question of
Public sector lending: In most jurisdictions, the issuers of covered
                                                                                       eligibility may be approached in different ways, however.
bonds are not only active in mortgage lending but also focus on
public sector lending. Public sector lending or ‘communal credit’                      The simplest and still the dominant approach consists of establishing
typically refers to credits granted to the public sector, i.e. central,                an exclusive list of eligible cover assets. Another more flexible
regional and local government authorities and other public bodies                      approach may consist in defining a broad asset class and to allow
and institutions guaranteed by one of the aforementioned public                        mortgage banks to select assets out of this class subject to certain
authorities.                                                                           rating constraints. The French mortgage bank act has opened up the
                                                                                       debate by making the eligibility of cover assets partially rating
  Mortgage bonds and Public mortgage bonds (volume
                                                                                       dependent. Should the quality of cover assets be determined by law
  outstanding at end-1999, EUR m)
                                                                                       or by rating? We concede that there is a direct link between the
                                          Public-sector All mortgage   %Mortgage       quality of the assets and the implied margins that prevail on the
  Country              Mortgage Loans             loans        bonds       loans       asset-side of the banks. The better the credit, the lower will generally
  Germany                     235,797          820,477     1,056,274        22%        be the margin to be earned on the underlying assets. One would
  Denmark                     153,118                 0      153,118       100%        therefore expect a natural trend towards including more risky assets
  Sweden                       80,694                 0       80,694       100%        within the asset pools to generate a better margin. An issuer might
  France                       33,386            4,330        37,716        89%        be ready to include lower quality assets within the asset pool to
  Austria                       4,959            7,220        12,179        41%        improve the margins on the asset side. Such issuers may, however,
  Spain                        11,533                 0       11,533       100%        find it increasingly difficult to sell their ‘covered bonds’ to investors if
  Netherlands                   1,171                 0        1,171       100%        the credit quality of the assets composing the asset pools
  Finland                       1,163                 0        1,163       100%        deteriorates. Obviously, the credit quality of the assets and thus the
  Portugal                        100                 0          100       100%        rating of the assets will have a bearing on the rating of the ‘covered
  Total                       521,921          832,027     1,353,948        39%        bonds’. Since the mortgage banks compete on both the assets and
  Source: European Mortgage Federation and national sources
                                                                                       the liability side, they will always have to strike a fine balance
Public sector lending may be done in the form of direct loans, loans                   between the quality of the assets and the quality of the ‘covered
secured by a public authority or in the form of direct purchases of                    bonds’.
public sector bonds. While Austria confines public sector lending to
                                                                                       If banks do not include any type of credit risk within their asset pools,
the domestic market, most countries allow public sector lending
                                                                                       then they will be forced to generate margin from market risk, e.g.
within the EU or the European Economic Area or as in the case of
                                                                                       interest rate mismatches. We can debate whether it would be better
Luxembourg within OECD countries.
                                                                                       for mortgage banks to have more leeway in choosing their assets
Other assets for public sector lending: A mortgage bank need not                       from a credit perspective (under specific rating constraints) or
only purchase mortgage or public sector assets. As the example of                      whether legislators still need to define in detail the list of assets.
the French mortgage bank act shows, mortgage backed securities
                                                                                       The legislator will undoubtedly try to provide a minimum safety
may also be used as coverage for the issuance of ‘covered bonds’.
                                                                                       standard for the types of assets to be included within the definition of
Further, the quality of a non-eligible assets may be enhanced via a
                                                                                       ‘cover assets’ or cover asset pools. Whether the minimum standard
guarantee provided by a financial institution or an insurance
                                                                                       needs to be fixed via a ratings approach or by a legal list of assets
company. Thus, a more flexible approach to the selection of eligible
                                                                                       remains to be seen, however. Current trends, also evident in the
cover assets and a wider range of cover assets may be introduced
                                                                                       BASLE II proposals, clearly give an increasing weight to the ratings
by national legislators as shown by the French example.
  Relative market shares of EUR Bond Markets (in EUR bn,
  November 2001)

Global Markets Research                                                                                                                                          3
Deutsche Bank@                                          The Market for Covered Bonds in Europe                                          04 March 2003

Segregated assets or segregated asset pools                                    substantial mark-to-market and liquidity risk. Significant duration
                                                                               gaps may result to losses for the investor if the asset pool would
A somewhat more fundamental concern is the separation of
                                                                               have to be unwound before maturity. While this cannot be the case
privileged and non-privileged assets.
                                                                               under normal conditions, unless the nominal cover no longer exists,
In order to separate the cover assets from other assets in case of             it still exposes the investor to an additional potential risk. Even more
bankruptcy, they must be defined in some way as a privileged claim             important, the larger the duration gaps the more important is the
of the covered bond creditors. Typically, this is achieved by holding          reliance on market liquidity fund any duration gap between assets
the cover assets in specific cover pools segregated from the other             and liabilities. Duration mismatches between cover assets and
assets on the balance sheet and by entering the cover assets into a            liabilities will drive a wedge between assets and liabilities as the
special register. Only the cover asset pools are continued in case of          market starts to move or the yield curve starts to shift. Accordingly, it
default while the other assets are liquidated if the mortgage bank             is of crucial importance that interest rate risks are adequately
goes bankrupt. While holders of the covered bonds typically have a             managed and limited in size.
priority claim on the cover assets under most national legislation,
                                                                               The amount of interest rate risk that issuers of covered bonds may
they may also have a claim on the other assets on the balance
                                                                               assume differs from country to country. Every European covered
sheet, where they rank pari passu with all other creditors of the
                                                                               bond law with the exception of Denmark and Switzerland allows for
bank. This is the case in Germany and it is an important difference
                                                                               a limited amount of interest rate mismatching. Typically, the covered
to ABS transactions where the claims of the creditors are limited to
                                                                               bond laws require that the cash flows from the assets (principal and
the assets in the asset pool.
                                                                               coupon income) will, at least, match the cash flows due on the
Thus, the creditor of a covered bond receives an option on the other           covered bonds over the lifetime of both the cover assets and the
assets of the issuing bank. The higher the financial strength or the           ‘covered bonds’. This can also be achieved via sufficient over-
better the senior unsecured rating of the issuing bank, the more               collateralisation or via adequate substitute collateral and does not
valuable this option is. More importantly, in some cases the                   require that the maturities match exactly.
legislator has even provided the covered bonds creditors with some
                                                                               Interest rate risk within the eligible and the non eligible
kind of ‘super priority’ on all the assets on the balance sheet as in
the case of France. Under French law, no other creditor can claim
out of any asset on the balance sheet of the French mortgage bank              While maturity mismatches represent a potential source of risk to the
until all privileged creditors have been satisfied. This is equivalent to      creditors of ‘covered bonds’, they can also be a source of profit to
de facto subordination of all unsecured creditors of a French                  the issuers.
mortgage bank. What this is actually worth in practice is a different
                                                                               The rating agencies do not perceive a limited amount of duration
matter since it makes little sense for French mortgage banks to carry
                                                                               mismatching as an obstacle to accord a top ‘AAA’ rating. Standard
any other assets on their balance sheet as those privileged assets
                                                                               and Poors (S&P) regularly receives extensive information on the
securing the outstanding covered bonds. For more details, see the
                                                                               issuing institutions’ interest rate risk exposure. S&P uses the cash
French country section.
                                                                               flow information to stress test the risk-adjusted cash flows under
Interest rate, currency, liquidity and other market risks                      different yield curve scenarios to see whether the collateral pools will
                                                                               suffice under any circumstances to satisfy the obligations from
The right of the borrower to prepay a loan may also threaten the
                                                                               outstanding ‘covered bonds’. More precisely, S&P are prepared to
security of the bond holder by introducing the risk of an early
                                                                               accept a certain amount of ‘controlled maturity mismatching’ if the
prepayment on the cover assets. The proceeds from an early
                                                                               issuer of ‘covered bonds’ provides sufficient over-collateralisation to
prepayment may potentially only be reinvested at a yield inferior to
                                                                               compensate for this risk.
those paid on the liabilities, which may potentially erode the margin
embedded in the underlying cover asset pool. The possibility of                Typically, the issuer will not assume excessive risk in its collateral
borrowers to prepay on their mortgage loans varies significantly               pools since this may threaten the covered bond rating and erode its
between countries. While German mortgage banks are protected                   refinancing costs as an issuer. In an industry with structurally low
against prepayments through substantial prepayment penalties,                  margins, any deterioration in funding conditions has severe
Danish borrowers may prepay after a formal two-month notification              repercussions. It is therefore more likely that issuers carry any
to the mortgage bank without prepayment penalty. The possibility to            potential ‘excessive’ interest rate risk in the non-eligible part of their
prepay introduces an additional element of risk into the asset-liability       businesses. While this is not an immediate risk to the ‘covered bond’
management process of a mortgage bank. If the borrower can                     creditor, it is a concern to the unsecured creditors as it might
prepay but the bonds issued are non-callable, as is the case in                threaten the mortgage bank itself without necessarily endangering
Germany and France, the right to prepay without substantial                    the cover asset pools, if the cover asset quality remains sufficient to
prepayment penalty is a potential risk for the mortgage bank.                  satisfy the ‘covered bond’ creditors.
Interest rate and currency risks: More important than prepayment               Until very recently, there have been no explicit constraints or
risk are interest rate and currency risks. Currency risks currently            controls on the amount of the interest rate risk that mortgage banks
need to be hedged in all ‘covered bond’ laws, while the scope to               may hold in the non-eligible part of the asset side business.
assume interest rate risk varies significantly between the different           Germany was the first country to introduce explicit upper limits on
jurisdictions. Even if the cover principle requires the ‘covered bonds’        the amount of interest rate risk for the whole banking portfolio, i.e.
in the pool to be secured by assets of at least equal interest and             eligible and non-eligible business. See the Germany country section.
nominal, interest rate risk within the cover asset pool introduces

4                                                                                                                            Global Markets Research
04 March 2003                                           The Market for Covered Bonds in Europe                                       Deutsche Bank@

More recently Ireland has also introduced strict limits on the amount          funding and thus reduce the liquidity risk. Such a strategy would be
of interest rate risk that may be assumed by Irish mortgage banks.             particularly important when the existing asset pool can only be
                                                                               refinanced at unprofitable conditions that would eventually lead to a
On the mortgage lending side, the risk from non-eligible loans in
                                                                               gradual erosion of the margin, which had been locked into the cover
excess of the loan-to-value ratios has been limited in a number of
                                                                               asset pool.
countries, conscious of the particular risk character of this type of
activity. No such regulations exist for the public sector lending              Imposing limits on foreign lending where the priority
businesses with the exception of the recent regulatory change in               claim of the ‘covered bond’ holder is threatened in a
Germany. Mortgage banks may thus carry significant amounts of                  bankruptcy scenario
public sector assets on their books.
                                                                               The different European covered bond legal frameworks only apply
Liquidity risk                                                                 within their respective national frontiers. This aspect is particularly
Liquidity risk is an issue that has received closer attention recently         relevant in the event of the potential bankruptcy of a mortgage bank.
due to the downward adjustments in the ratings of a number of                  As the issuers have become much more active in cross border
‘covered bond’ issuers. In an ideal world where the maturities of              lending, other legislative environments need to be taken into
cover assets and liabilities match exactly and a margin has been               account. If a mortgage bank went bankrupt and an insolvent cover
locked into the cover asset pools, a deterioration in funding                  asset pool would have to be liquidated, the priority claim of the
conditions due to a reduced rating does not systematically threaten            ‘covered bond’ creditors on the cover pool assets would need to be
the cover asset pool. In a world where maturities between cover                enforced. If these assets are located in another country with different
assets and liabilities do not match, the solvency of the pool relies on        bankruptcy laws, a situation of rivalling claims over the cover pool
continued access to market liquidity, at rates, which are not                  assts may arise. Different national legislations may not recognise the
prohibitively high so as to erode the margin inherent in the cover             priority claim of the ‘covered bond’ creditors. This raises the risk of
asset pool. In an extreme situation, where the ‘covered bond’ issuer           ‘covered bond’ creditors entering into a difficult, lengthy legal dispute
has become insolvent, access to market liquidity may not be                    that may endanger the timeliness of payment on ‘covered bonds’. To
possible at rates, which will keep the cover asset pool solvent over           limit the amount of legal risk arising from cross-border lending, the
time. Under these conditions, it would therefore be crucial that the           German mortgage bank act imposes a 10% limit on foreign
solvent cover asset pool is transferred to a backup servicer, most             mortgage and public sector lending activities where the priority claim
likely another mortgage bank, in a timely manner to be able to                 of the Pfandbrief holder on the cover assets is not guaranteed.
continue to fund the cover pool assets in a profitable manner. While           Within Europe, the legal risks involved in cross-border lending have
the legal framework governing most ‘covered bond’ laws leave little            been alleviated through the EU liquidation guideline (European
doubt about a timely transfer of a solvent cover asset pool to a               Parliament and Council Directive 2001/24/CE on the reorganisation
backup servicer, the need for a quick transfer is exacerbated by a             and winding-up of credit institutions). This directive, which has to be
higher the duration gap between cover pool asset and liabilities.              implemented by the Member States of the EU until 2004, ensures
                                                                               that the winding-up of a credit institution with branches in another
The liquidity risk of a ‘covered bond’ creditor is higher, the lower the
                                                                               Member State will be subject to a single bankruptcy proceeding
senior unsecured rating of the issuer. In other words, the liquidity
                                                                               initiated in the Member State where the credit institution has its
risk is higher, the higher the likelihood that credit lines to the issuer
                                                                               registered office and will thus be governed by a single bankruptcy
would actually be cut. If the ‘covered bond’ rating of an issuer has
                                                                               law. While the EU liquidation guideline strongly alleviates the risks of
been lowered, the issuer could still take measures to reduce the
                                                                               cross-border lending within the EU from the ‘covered bond’ holder
exposure of the cover asset pool to liquidity risk. The issuer might for
                                                                               perspective, a small risk remains that some unsecured creditor may
example actively shrink his balance sheet by selling assets and
                                                                               try to obtain a claim on the asset before the official bankruptcy
buying back outstanding ‘covered bonds’ to reduce the need for
                                                                               proceedings have been opened up.
capital market funding and thus reduce the liquidity risk. Such a
strategy would be particularly important when the existing asset pool          Since many European ‘covered bond’ laws have recently been
can only be refinanced at unprofitable conditions that would                   amended to cover a wider geographical lending area - typically
eventually lead to a gradual erosion of the margin, which had been             beyond EU borders - the issue of cross-border lending has become
locked into the cover asset pool. Further, the availability of substitute      more important again. The legal issues discussed above and, which
collateral or other liquid assets in the cover asset pools, which may          have been alleviated within the EU by the liquidation guideline,
quickly be sold, can also represent a sufficient liquidity cushion to          remain non-negligible for lending outside of the EU. The latest
counter any unforeseen short-term liquidity needs.                             amendments of the German and the French law provide the issuers
                                                                               of both legislations to extend public sector credit to European
Another problem is that market conditions may force an issuer with
                                                                               Economic Area countries, the US, Japan and Canada and to the
already poor funding terms to accept a rising interest rate or liquidity
                                                                               central governments of the Central European Accession countries.
risk because investors are no longer willing to provide competitive
longer-term funding. As a result, the duration gap may rise due to             Even though we clearly see the diversification benefits from
market conditions and the liquidity risk would increase further.               including a wider range of high quality assets in the cover asset
However, if the ‘covered bond’ rating of an issuer has been cut                pools, the benefits from diversification have to be weighed against
strongly, the issuer could still take measures to reduce the exposure          the higher legal risks involved. Further, where the possibility is given
of the cover asset pool to liquidity risk. The issuer might for example        to extend credit to countries with weak ratings, the share of weaker
actively shrink its balance sheet by selling assets and buying back            quality assets should be strictly limited.
outstanding ‘covered bonds’ to reduce the need for capital market

Global Markets Research                                                                                                                               5
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                           04 March 2003

Generally, the legal risks in cross-border lending are however more           insolvency of the mortgage bank, the derivatives linked to the asset
important in mortgage than in public sector lending. If a mortgage            pool will not be unwound but will be continued until all creditors of
bank provided a loan to a non-European public sector entity via a             covered bonds have been satisfied. The French law provides
bond purchase, holding the respective bonds with a European                   insufficient protection, however, against the risk that a swap counter-
settlement house such as Euroclear or Cedel, there should be no               party will go bankrupt. In this case, the swap would have to be
risk of legally enforcing the asset in case of default of the mortgage        unwound and the asset pool could be exposed to a loss from the
bank. If the mortgage bank provided a direct loan to the same                 residual claims on the defaulted swap counter-party. In order to limit
institution, the situation could become more difficult, since the claim       the exposure of the creditor to the default by a swap counter-party,
from the loan would be more difficult to enforce than the simple sale         additional measures are necessary.
of the bond. If the legal claim on a mortgage asset has to be
                                                                              The latest amendment to the German mortgage bank act has
enforced, the situation may easily become more difficult. As an
                                                                              tackled this issue. The new legislation fixes a limit of 12% on the
example, consider a German mortgage bank providing a mortgage
                                                                              amount of derivative instruments in relation to the asset pools. Thus,
loan in USD to the US. Assume that the amount of the loan up to the
                                                                              if the prudential exposure limits are reached, the mortgage bank will
60% LTV has been raised via a Pfandbrief bond and been swapped
                                                                              be required to take adequate measures to raise the amount of
into USD. Simultaneously, the future cash flows out of the USD loan
                                                                              collateral via over-collateralisation or to reduce the claims or
up to the 60% LTV will also have been swapped back into EUR.
                                                                              liabilities due under derivatives contracts. This should prevent the
Another 20% has been funded in USD as an unsecured loan held by
                                                                              amounts due to the mortgage bank under these contracts from
US investors. In the event of bankruptcy, the unsecured US creditors
                                                                              becoming too large in relation to the other cover assets and thus
of the unsecured USD loan may demand to be satisfied out of the
                                                                              leading to an excessively large counter-party exposure from these
USD mortgage serving as collateral for the EUR Pfandbrief. As US
                                                                              hedges. In order to limit the amount of derivatives to 12% of the pool
legislation does not recognise the priority claim of the Pfandbrief
                                                                              assets, they have to be valued. This required the transition from a
holder, this could potentially deal a loss to the Pfandbrief creditor.
                                                                              valuation principal based on nominal coverage to a present value
Under these circumstances, the 10% limit in Germany is a very                 based coverage.
important additional security element for the buyers of German
                                                                              Nominal coverage did not provide sufficient protection against
Pfandbriefe, which almost no other European ‘covered bond’ law
                                                                              interest rate risk to the ‘covered bond’ creditor nor did it capture the
with the exception of Ireland currently offers. More importantly,
                                                                              interest rate risk exposure. The amendment of the German law
legislation will tend to be all the more different, the wider the
                                                                              therefore required the passage from ‘nominal cover’ to a present
geographical lending area. More specifically, the extension of the
                                                                              value basis using appropriate discounting techniques.
geographical lending area to Japan, the US and Canada will make
the 10% limit even more relevant. This is the case for France and             Preferential claim and bankruptcy remoteness
Germany. The absence of such a limit should be considered a                   A preferential claim on the assets within the cover pool will not
serious problem in the case of Luxembourg where the mortgage                  guarantee, in itself, a high level of bankruptcy remoteness of the
banks are allowed to extend mortgage and public sector loans to the           cover asset pools. In the event of insolvency of the issuer of a
OECD area without restrictions.                                               ‘covered bond’, the creditor must not only have a preferential claim
                                                                              on the assets in the cover pool but the asset pools also need to be
How to treat derivatives used as cover asset hedges in
                                                                              continued. If the ‘covered bonds’ became due, this would entail early
the case of bankruptcy of the issuer
                                                                              liquidation of the underlying assets in the cover pool. It is thus critical
The use of derivative instruments in the European mortgage bank               that the ‘covered bonds’ do not become due in order to avoid any
business has greatly increased in recent years. With the widespread           mismatch between the cash flowss of the cover assets and the
use of derivatives, the potential risks related to these instruments          ‘covered bonds’. If the ‘covered bonds’ became due, they would
have also gone up and have raised the need for new regulation in              become due at par. The assets, however, will not necessarily be
this area. The growing size of individual transactions, particularly          sold at par Thus even an inherently solvent asset pool may not be
since the inception of the Jumbo Pfandbrief market, has raised the            sufficient to satisfy all claims if the ‘covered bonds’ are paid back
amount of risk in these transactions and thus the need for                    before maturity.
appropriate hedging techniques. If the purchase of an asset and the
                                                                              While the continuation of the asset pools beyond the default of the
sale of a covered bond do not coincide in time, which is the general
                                                                              issuer of ‘covered bonds’ is an essential security mechanism, it is
rule, then long positions in the asset or short positions in the covered
                                                                              not provided by all European ‘covered bond’ laws. While Germany,
bond will typically be hedged through the use of swaps.
                                                                              France, Luxembourg, Ireland and Finland have introduced the
There are several important aspects to note in the use of derivative          necessary legislation to make sure that the asset pools can be
instruments by a mortgage bank. First, the increasing use of swaps            continued, there is no such legislation in the case of Spain, Austria
or other derivative instruments as a hedging tool for cover assets            and Switzerland.
has raised the exposure of the asset pools to the counter-party risk
                                                                              Still, we cannot automatically conclude from the legal possibility of a
incurred via these transactions. Second, it needs to be clarified what
                                                                              continuation of the asset pools that it is even practical. While it is
will happen to the residual claims or liabilities resulting from a swap
                                                                              clear from a legal point of view that the asset pools will be continued
hedge related to the asset pool in case of the bankruptcy of a
                                                                              in Germany, it is far less clear who will continue to service the pools
mortgage bank.
                                                                              and the ‘covered bonds’ once the mortgage bank has ceased to
France was the first country to protect the investor from any risks           exist. In this regard, the French legislation and particularly
emanating from derivatives in case of a default. In case of an                Luxembourg legislation is more explicit.

6                                                                                                                            Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                     Deutsche Bank@

ABS mechanics may serve as a good yardstick to judge the quality              deteriorated, would have an incentive to include weaker rated but
of the legal provisions regarding the continuation of the asset pools         higher yielding assets in the cover pool to protect his margin.
in case of default of the mortgage bank. In an ABS transaction, it is         Investors should therefore be aware that the ‘covered bond’ rating is
crucial that there is no recourse on the issuer and that the cashflows        based on a given cover asset pool at a particula+r point in time and
from the pool serve only to satisfy the creditor of the ABS. While            that the quality of the cover asset pool and the rating can go down in
these requirements are met by the German, French and                          the future. It is therefore important to judge the business model of
Luxembourg legal provisions, the issue of the back-up service                 the issuer and his potential to profitably manage the asset pool in
provider may not be sufficiently resolved in Germany and France. In           the future without deteriorating its quality.
case of an ABS transaction, the quality also depends on the quality           Rating considerations
of the servicer. The higher the financial strength of the servicer, the
                                                                              The rating agencies have adopted different methodologies for rating
smaller the likelihood that a back-up servicer will be needed and the
                                                                              European ‘covered bonds’. Where the ‘cover asset’ pools are legally
less important will be this issue. In the case of the bankruptcy of the
                                                                              insulated from the rest of the bank and will be continued after the
issuer of the ‘covered bonds’ there will obviously be the need for a
                                                                              default of the issuer, Standard and Poors (S&P) would typically
back-up servicer. In Germany, it remains somewhat unclear who will
                                                                              separate the ‘covered bond’ rating from the senior unsecured rating
continue servicing the asset pools and who will pay the cost. It is
                                                                              of the issuer. Moody’s instead maintains that the ‘covered bond’
generally assumed that another mortgage bank will readily take over
                                                                              rating cannot be isolated from the senior unsecured rating of the
the solvent asset pool in which case somebody will have to pay a
                                                                              issuer. As a result, Moody’s focuses more on the link between the
servicing fee, most likely out of the asset pool. In Luxembourg, the
                                                                              parent rating and the subsidiary’s rating. Standard and Poor’s would
financial supervisory authority will have to name a back-up servicer
                                                                              focus on the cash flow and asset quality characteristics of the ‘cover
and the fee will again be paid out of the asset pools. In both cases,
                                                                              pool assets’ and derive its rating from the analyis of the ‘cover
the claims of the creditors on the pool will be diminished. It should
also be clear that the financial strength of the mortgage bank is an
issue in the sense that it has an influence on the likelihood that a          Moody’s: With a few exceptions Moody’s has opted for the
back-up servicer will be required. The costs involved with finding a          fundamental approach when rating European ‘covered bonds’.
back-up servicer would justify that those mortgage banks with a               Moody’s argues that the fundamental approach is more appropriate
higher stand-alone rating would achieve more favourable funding               than the structured finance approach (followed by Standard and
conditions with their Pfandbriefe.                                            Poor’s) where the rating of the ‘covered bonds’ is a function of the
Legal protection for enforceability of over-collateralisation after           credit quality of the originator’s assets refinanced by the debt they
insolvency of the issuer                                                      secure rather than of the asset pools themselves. Generally,
                                                                              Moody’s will follow the ‘fundamental approach’ when:
Rating agencies, notably Standard and Poor’s, would typically
improve the rating of a ‘covered bond’ if a certain amount of over-           -    (1) cover assets remain consolidated on the originator’s
collateralisation (OC) exists. Moody’s argues however, and we                      balance sheet
would tend to agree with this view, that it is not the existence of OC
                                                                              -    (2) bondholders have a full recourse against the issuer but no
but the legal enforceability of OC after the insolvency of the issuer,
                                                                                   direct and separate claim against any specific asset subset
which is key for the rating implications. If OC remains within the
                                                                                   within the cover pools
pool, it will provide an important cushion to ‘covered bond’ creditors.
Since OC is, however, not protected under most legal frameworks, it           -    (3) there are no incremental, contractual provisions adopted by
is doubtful that it will be available to ‘covered bond’ creditors beyond           the issuer beyond the scope of legal requirements geared
the insolvency of the issuer. If the law protects only the nominal                 towards achieving a specific rating level
coverage but not any additional OC, such as in Germany, some of
                                                                              Within this framework, Moody’s would first assess the
the OC may actually be released to the unsecured creditors before
                                                                              creditworthiness of the credit institution issuing the ‘covered bond’.
all ‘covered bond’ creditors have been satisfied. In the case of
                                                                              The ‘covered bond’ rating may then be notched up from the senior
France, the priority claim of ‘covered bond’ creditors is formulated in
                                                                              unsecured debt rating of the issuer, reflecting additional protection
a different way. Creditors of Obligations Foncières (OF) possess a
                                                                              provided by the security structure, collateral and cash flow matching
‘super-priority’, since no other creditor may satisfy his claim on the
                                                                              of each individual ‘covered bond’ market and issuer. Importantly, this
assets of the bank before the creditors of Ofs have completely
                                                                              approach postulates an upper limit for the ‘covered bond’ rating,
satisfied their claims. More important still, the creditors of OFs can
                                                                              which depends on the senior unsecured debt rating of the issuer.
satisfy their claims out of all the assets on the balance sheet. In
France OC should therefore remain legally protected until all                 We would like to draw the attention particularly to point (3) in the
‘covered bond’ creditors have been satisfied.                                 Moody’s fundamental approach’. While the issuers of ‘covered
                                                                              bonds’ are certainly striving to obtain the best possible rating and
Another problem related to the enforceability of OC is the
                                                                              thus the most favourable funding terms, there is no guarantee for the
‘substitution risk’. Since the cover asset pools of the issuers are of
                                                                              ‘covered bond’ creditor that the rating may not actually deteriorate. A
dynamic nature, they can remove certain assets from the pool and
                                                                              key uncertainty for the creditor of a ‘covered bond’ relates to the
replace them with other, potentially weaker, eligible assets. We are
                                                                              ‘dynamic nature of the cover asset pools’. The composition of the
therefore in a situation, where the investor has not guarantee that
                                                                              cover asset pools on which the bonds are secured will change over
the issuer will continue to strive for the best possible rating by
                                                                              time as new assets come into the pool while other assets expire.
keeping the quality of the cover asset pool at the highest possible
                                                                              The issuers of ‘covered bonds’ may also replace specific assets in
level. On the contrary, an issuer, whose funding conditions have
                                                                              the cover asset pool with other eligible assets. Further, a change in

Global Markets Research                                                                                                                            7
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                           04 March 2003

the regulatory environment may also change the composition of the             that these can be separated from the other assets of the bank in
asset pools. The most straightforward example of such a change                case of bankruptcy of the issuer. This should guarantee the
was the extension of the geographical lending areas in both                   continued servicing of the cashflows from the covered bonds in case
Germany and France. An investor, who had purchased a Pfandbrief               of default. Under these conditions, the ‘covered bond’ rating can be
or an Obligation Foncière based on the expectation that the bond              isolated from the senior unsecured debt rating of the issuer. The
would be secured only by European mortgage or public sector                   rating of the covered bond would then be derived solely on the basis
assets will have to accept that other non-European assets will start          of the quality of the assets in the cover asset pool.
entering the asset pools. While this need not change the quality of
                                                                              Whether the assets will be sufficient to satisfy the claims of the
the asset pools if the legal framework maintains a high quality
                                                                              ‘covered bonds’ creditors will be decided on the basis of a cashflow
profile, it certainly introduces an element of uncertainty compared
                                                                              analysis. S&P will first estimate the default probabilities for the
with a static ABS asset pool. From this perspective, the rating
                                                                              cover assets in the pool. The cashflows from the assets will then
outlook and the rating process is definitely a continuum, which will
                                                                              be reduced by the estimated losses from the pool. After this has
always reflect changes in the legal environment and the situation of
                                                                              been done, a net present value for the adjusted cashflows from
the issuer. The ‘covered bond’ rating will therefore only be a
                                                                              the assets can be calculated to see whether there is sufficient
snapshot of the current quality of the underlying cover asset pools at
                                                                              collateral to cover the future liabilities. In a last step, S&P simulate
a particular point of time.
                                                                              the cashflows under different yield curve scenarios to see whether
It is important to recognise that a number of important legal changes         the collateral would still be sufficient under these scenarios.
have been introduced in Germany over the last two years that have
                                                                              The amount of over-collateralisation necessary to obtain a given
significantly strengthened the legal framework protecting the
                                                                              rating will then depend on the quality of the collateral under these
Pfandbrief. We would only mention, the limitations to interest rate
                                                                              cashflow simulations. Typically, S&P requires an amount of 3% of
risk, the possibility to take derivatives into cover, the requirement to
                                                                              over-collateralisation to rate public Pfandbriefe ‘AAA’. A ‘AAA’
maintain present value based coverage and thus over-
                                                                              rating on mortgage Pfandbriefe can require an even higher amount
collateralisation. These changes cure some of the shortcomings of
                                                                              of over-collateralistation. It needs to be borne in mind that the S&P
the legal framework criticised by Moody’s. Despite all these
                                                                              rating need not be stable if the quality of the cover assets and the
important improvements, there has been no change in the rating
                                                                              legal framework deteriorate, which is a possibility given the dynamic
approach of Moody’s, which continues to stick to the three notches
                                                                              nature of the asset pools.
upgrade for mortgage and the four notches upgrade for the public
Pfandbriefe. As a result, the Pfandbrief ratings of the weaker                If the senior unsecured rating of an issuer of ‘covered bonds’
Pfandbrief issuers have gone down in line with the senior unsecured           declines as has often been the case in the recent past, the liquidity
ratings of the issuers. We have however reached a point for a few             risk will increase. As a consequence the cost of refinancing both
issuers, where the senior unsecured rating has become so weak                 unsecured and secured debt will go up. Thus, it will become more
that a further downgrade would take the Pfandbrief rating to such             difficult to refinance the ‘cover asset pools’ unless the is an exact
low levels that it would no longer make sense to maintain the fixed           matching of the maturities of assets and liabilities. Standard and
notching span. Therefore Moody’s has already announced that it                Poor’s takes the liquidity risk into account by using higher risk-
would consider widening the rating span again if the senior                   adjusted discount rates to simulate the cashflows of the ‘cover asset
unsecured ratings would further go down towards the ‘BBB’ area.               pools’ also under the assumption of a liquidity crisis.
The apparent necessity to start widening the rating span between
                                                                              ‘Covered bonds’ enjoy preferential treatment in
senior unsecured and ‘covered bond’ rating again if the senior
                                                                              investment policies of investment funds and insurance
unsecured rating falls too low reveals the shortcomings of the
mechanistic notching approach.
                                                                              A minimum standard for EU covered bonds: The basic
Moody’s also voices criticism with regard to foreign asset origination
                                                                              characteristics of covered bonds can vary significantly across the
in general due to the uncertainties around enforcing the bondholders
                                                                              different national legislation. While no common legal European
privilege outside the home market. It is however not apparent in the
                                                                              standard for ‘covered bonds’ is on the horizon, article 22 (4) of the
notching approach that Moody’s is differentiating between countries
                                                                              undertakings for collective investments in transferable securities
which limit foreign lending due to the legal uncertainties involved
                                                                              (UCITS) directive defines a common minimum standard for ‘covered
and those who do not.
                                                                              bonds’. Preferential treatment in the investment policies of the
Moody’s also stresses the severity of loss distinction between                UCITS can be given to bonds, which conform to the UCITS directive.
‘covered bonds’ secured on public sector assets or on                         Similarly, in article 22 (4) of the life insurance directive and in article
mortgage assets. In a fire sale scenario Moody’s rightlyfully argues          22 (4) of the non-life insurance directive, preferential treatment is
that it would be easier and less time-consuming to sell the public            given.
sector assets than the mortgage assets. However, Standard and
                                                                              Privileged investment limits for ‘covered bonds’: According to
Poor’s would probably agree with this position since it requires on
                                                                              article 22 (4) of the UCITS, member States of the EU have the
average a higher level of over-collateralisation for mortgage than for
                                                                              discretionary right to raise the limits for the holdings in the bonds of
public sector asset pools.
                                                                              one single issuer from the standard 5% to 25% in the case of bonds,
Standard and Poors: Standard and Poor’s (S&P) follow a different              which fulfil the following criteria:
approach. For them, it is critical that the legal framework provides
                                                                              (1) the bond must be issued by a credit institution registered in the
the creditor with an absolute priority claim over the cover assets and

8                                                                                                                            Global Markets Research
04 March 2003                                           The Market for Covered Bonds in Europe                                    Deutsche Bank@

(2) the credit institution must be subject by special law to special           a preferential treatment for ‘covered bonds’ under the new UCITS
    public supervision designed to protect bond holders (‘specialty            directive given the significant interest member states are likely to
    principle’)                                                                have in such a step.
(3) the sums deriving from the issue of these bonds must be                    ‘Covered bonds’ also have a privileged role in ESCB monetary
    invested in conformity with the law so that for the whole                  policy operations. The European Central Bank also recognised the
    maturity period, the bonds are covered (‘cover principle’)                 high security standard of ‘covered bonds’, specifying that bonds that
                                                                               fulfil article 22 (4) of the UCITS directive are eligible as tier 1
(4) in the event of a failure of the issuer, the assets must be used
                                                                               collateral for monetary operations within the ESCB. European banks
    on a priority basis for the reimbursement of principal and
                                                                               therefore hold a significant amount of ‘covered bonds’ as collateral
    payment of accrued interest
                                                                               for their liquidity transactions with the ESCB. If ‘covered bonds’
Notification: Member States must send a list of the bonds together             benefit from a 10% solvency ratio, they may be cheaper to hold as
with the list of issuers authorised, which are considered to fulfil the        collateral than government bonds for the regular liquidity
criteria as laid out in article 22 (4) of the UCITS.                           transactions with the ESCB. The combination of a low solvency ratio
                                                                               and a recognised level of security generates a substantial amount of
Favourable treatment in the investment policy of insurance
                                                                               buying interest from banks independently from any interest that final
companies is also accorded to ‘covered bonds’, which fulfil the
                                                                               investors such as investment funds or insurance companies may
UCITS directive. In directive 92/49/EEC of 18 June 1992 on the co-
                                                                               show in ‘covered bonds’.
ordination of laws, regulations and administrative provisions relating
to direct insurance and amending directives 73/39/EEC and                      ‘Covered bonds’ offer some key advantages to investors
88/357/EEC (third non-life insurance directive), Member States are             over other asset classes
allowed to raise the limits for the investment policy of the insurance
                                                                               The preferential treatment of ‘covered bonds’ in the area of
companies to 40%. The content of this directive is the same as in
                                                                               investment policy, solvency ratios and ESCB collateral provides
article 22 (4) of the UCITS directive. The same is true of article 22
                                                                               them with a competitive edge over other similar asset classes.
(4) of the third life assurance directive of 10 November 1992, which
                                                                               ‘Covered bonds’ will typically play an important role for those
also allows member States to raise the upper limit for the investment
                                                                               investors who are legally bound to invest only in securities with the
policy of assurance companies from the standard 5% up to 40% in
                                                                               highest security standards and simultaneously need to invest in
the case of specific bonds which fulfil the UCITS directive.
                                                                               large size and to risk exceeding the 5% investment limits. Thus,
For non-collective investment funds not regulated by the UCITS                 insurance companies and investment funds, focusing on high quality
directive different investment limits according to national law apply.         assets will typically hold large amounts of covered bonds. While
In Germany investment funds regulated under the law on investment              liquidity is less of an issue for insurance companies, it plays a key
funds (Gesetz über Kapitalanlagegesellschaften (KAGG)) can                     role for investment funds, with an active fund management strategy.
according to § 8 a invest up to 5% of fund assets into the securities
                                                                               Pension funds have also become an increasingly important investor
of one single issuer or a maxium 10% if this is explicitly agreed in
                                                                               group for Pfandbriefe. The need to invest large sums and to buy
the terms of the contract and if the sum of the securities held from
                                                                               high quality assets makes European covered bonds a natural
this issuer does not exceed 40% of the fund assets. In the
                                                                               investment for European pension funds. Since the European
calculation of these investment limits such securities meeting the
                                                                               pension fund industry is still in an early stage and bound to develop
requirements of the UCITS directive will be only weighted with 50%
                                                                               more forcefully in coming years, we expect to see more demand for
of their value thus doubling the investment limits for this type of
                                                                               Pfandbriefe from this source.
                                                                               Asset-backed securities have made a strong advance into the
‘Covered bonds’ benefit from preferential solvency ratios
                                                                               classical covered bonds investor base. While secondary market
within the EU
                                                                               liquidity remains the key strategic advantage of European covered
The UCITS directive is not only important with regards to the                  bonds over other asset classes, asset-backed securities provide
investment policy of the big money centres but also with regard to             comparable characteristics in terms of safety. Further asset-back
the solvency ratios for the credit institutions. For a period of five          securities can often be more tailor-made for individual investors
years, the Member States may fix a risk-weighting of 10% for the               offering advantage over Pfandbriefe for the less liquidity-oriented
bonds defined in article 22 (4) of the UCITS directive, as amended             investors.
by directive 88/220/EEC. The high security standard of covered
                                                                               Liquidity in ‘covered bonds’ is higher than in any other
bonds is thus not only reflected in preferential investment policies
                                                                               asset class except for government bonds
but, also, in a low risk weighting for EU credit institutions relative to
other ‘unsecured’ bonds issued by EU credit institutions, which                Liquidity in European ‘covered bonds’ has significantly improved
would be weighted at 20%. Currently, Belgium, Denmark, Germany,                over the past five years with the inception of the Jumbo market. The
Finland, Spain, Austria, France, Luxembourg, the Netherlands and               ‘Jumbo concept’ has created a market platform that provides
Greece have fixed a 10% solvency ratio for the list of ‘covered                investors with a deep and transparent secondary market, which
bonds’ defined under article 22 (4) UCITS. It is not yet clear, if or          otherwise only exists for government bonds.
how the risk weighting for Pfandbriefe would change under the new
BASLE II proposals. Today, the Pfandbrief and other ‘covered
bonds’ are weighted 20% just as any other financial institution
outside of the EU. It is likely, however, that the EU will again accord

Global Markets Research                                                                                                                           9
Deutsche Bank@                                                         The Market for Covered Bonds in Europe                                                  04 March 2003

 Overview of European ‘covered bond’ products
                               Germany        Denmark       France        Luxembourg    Spain   Ireland   Switzerland   Austria   Finland    Poland     Czech Republic   Hungary
 Specialist banks                 Yes           Yes          Yes             Yes         No      Yes         No*         Yes       Yes        Yes            No           Yes
 Name protection                  Yes           Yes          Yes             Yes        Yes      Yes         Yes         Yes       Yes        Yes            Yes          Yes
 Business activities
 - Mortgage lending               Yes           Yes          Yes             Yes        Yes      Yes         Yes         Yes       Yes        Yes            Yes          Yes
 - public sector lending          Yes            No          Yes             Yes         No      Yes          No         Yes       Yes       Yes**           No            No
 - other activities                No            No          Yes             No          No       No          No          No      Yes***       No            No            No
 Mortgage register                Yes           Yes          Yes             Yes         No      Yes         Yes         Yes       Yes        Yes          Yes****        Yes
 Legal priority claim in
 case of default                  Yes           Yes          Yes             Yes        Yes      Yes          No         Yes       Yes        Yes            Yes          Yes
 Provisions for property
 valuation                        Yes           Yes          Yes             Yes        Yes      Yes         Yes         Yes       Yes        Yes            No           Yes

                                  60%         60/70/80%   60/80/100%         60%       70/80%    80%          2/3        60%       60%        60%            70%          60%
 Limit on non-eligible
 business                         20%            No          No              No          No      Yes          No          No        1/6       10%            No            No
 Trustee                          Yes            No          Yes             Yes         No      Yes          No         Yes        No        Yes            No           Yes
 Substitute collateral            Yes           Yes          Yes             Yes         No      Yes         Yes         Yes      No*****     Yes            Yes          Yes
 Limit on substitute
 collateral                       Yes            No          Yes             Yes         No      Yes          No          No        No        10%            10%          20%
 Special supervision              Yes           Yes          Yes             Yes        Yes      Yes          No         Yes       Yes        Yes            Yes          Yes
 UCITS 22(4)                      Yes           Yes          Yes             Yes        Yes      Yes          No         Yes       Yes        Yes            Yes          Yes
 Derivatives taken into
 cover                          No******         No          Yes             Yes         No      Yes          No          No        No         No            No            No
 Cover assets to be
 continued in case of
 default                          Yes            No          Yes             Yes         No      Yes          No          No       Yes        Yes            Yes          Yes
 Limit on interest rate risk      Yes           Yes          No              No          No       No         Yes          No        No         No            No            No
 Cover principal                  Yes           Yes          Yes             Yes         No      Yes         Yes         Yes       Yes        Yes            Yes          Yes
 Limit on outstanding
 Pfandbriefe                      Yes           Yes          No              Yes         No      Yes         Yes          No        No        Yes            No            No
 Lending area                     EEA           Any          EEA            OECD        Spain   OECD+     Switzerland    EEA      unclear   EU*******   Czech Republic   Hungary
 Segregated asset pools           Yes           Yes          No              Yes         No      Yes          No         Yes       Yes        Yes            No            No
 Early prepayment risk             No           Yes          Yes             No         Yes      Yes         Yes         Yes       Yes         No            No            No
 Currency risk                     No            No          No              No          No       No          No          No        No         No            No            No
 Legal protection of
 overcollateralisation         Not explicit     Yes          Yes             Yes        Yes      Yes          ---         No        No         No            No            No
 Limit on foreign lending activities
 * In Switzerland the originating banks are no specialist banks even though the Pfandbriefzentralen may be considered as specialist banks
 ** Not to Polish local government entities
 *** Buying shares in housing corporations
 **** Not legally obliged but must provide evidence on cover assets
 ***** Only for a limited time period
 ****** Legal amendment will soon allwo to take derivatives into cover
 ******* Mortgage lending restricted to Poland

 Source: DB Global Markets Research

10                                                                                                                                                  Global Markets Research
04 March 2003                                       The Market for Covered Bonds in Europe                                      Deutsche Bank@

                                                                           expertise in foreign real estate markets before using these assets as
Germany                                                                    collateral for the Pfandbrief.
                                                                           Further, the latest amendment of the German mortgage bank act
German mortgage banks remain the dominant issuers of covered
                                                                           has paved the way for German mortgage banks to venture into a
bonds in Europe and they have been the driving force behind the
                                                                           number of other low risk areas, all related to the core mortgage
ongoing reform and innovation behind the market. The very success
                                                                           lending activity. These are real estate consulting, the
of German Pfandbrief has led an increasing number of countries to
                                                                           administration and procurement of mortgage loans, real estate
adopt their own covered bond laws to participate in the success of
                                                                           valuation, location analysis, advisory activities on property and
the German Pfandbrief model. After years of dynamic growth and
                                                                           financing issues.
above-average earnings growth, the German mortgage bank
industry and the Pfandbrief market have entered a period of                Property valuation and loan-to-value ratios: The German law
consolidation, however.                                                    provides clear guidance to mortgage banks with regard to the
                                                                           valuation of real estate. Typically, the lending value to which the
There are three types of Pfandbriefe, mortgage Pfandbriefe, public
                                                                           loan-to-value ratio will apply will be distinctly lower than the market
Pfandbriefe and ‘Schiffspfandbrief’ as regulated by the German Ship
                                                                           value of the property. When establishing this lending value, only the
Mortgage Bank Act. The latter Pfandbrief category only plays a
                                                                           permanent characteristics of the property and the yield, which any
minor role however.
                                                                           tenant can ensure on a long-term basis by proper management,
There are also three categories of Pfandbrief issuers, pure mortgage       shall be taken into account. A conservative 60% loan-to-value ratio
banks, mixed mortgage banks and public banks.                              applies to both residential and commercial property.
The specialist bank principle                                              Limiting the amount of non-eligible business: In some countries,
                                                                           a limit is imposed on the amount of non-eligible business. By
The specialist bank principle (see page 2) remains a key
                                                                           definition, the non-eligible business, which does not fulfil the high
characteristic of the German mortgage bank act. The specialist bank
                                                                           safety standards for Pfandbrief collateral, will be more risky than the
principle has even been strengthened by additional legislative and
                                                                           eligible assets. As a result, the German legislator has imposed a
supervisory action recently. While an increasing amount of mortgage
                                                                           limit on the amount of non-eligible mortgage assets a German
bank business is actually done by banks operating under the status
                                                                           mortgage bank may carry on its balance sheet. The non-eligible
of a mixed mortgage bank, the legislator has not departed from the
                                                                           mortgage loans, i.e. mortgage loans exceeding the 60% LTV should
general idea of the specialist bank principle in Germany.
                                                                           be limited to 20% of the total amount of mortgage loans on the
Limit on the amount of outstanding Pfandbriefe: There is an                balance sheet.
absolute limit on the total amount of outstanding Pfandbriefe, which
                                                                           Substitute collateral: The amount of substitute collateral is limited
is fixed at sixty times the bank’s capital.
                                                                           to 10% of the respective asset pool.
The credit quality of the cover assets
                                                                           Segregated assets or segregated asset pools
Scope of business activities: Currently, German mortgage banks’
                                                                           The cover assets are segregated from all the other assets on the
business activities are restricted to the European Economic Area,
                                                                           balance sheet and held in two different asset pools. The assets in
Switzerland, the US, Canada, Japan and the central European
                                                                           the public sector loan pool secure the public Pfandbriefe and the
Accession countries.
                                                                           mortgage assets secure the mortgage Pfandbriefe. The cover
More specifically, German mortgage banks are allowed to provide            should be maintained at all times and the cover assets should be
public sector credit to central governments and to government              listed in a separate mortgage register. The trustee for this is
entities other than the central governments, whose BIS risk-               appointed by the supervisory authority and paid for by the mortgage
weighting does not exceed a maximum 20%, in the European                   bank.
Economic area, Switzerland, the US, Canada and Japan. Institutions
                                                                           Interest rate, currency and other market risks:
guaranteed by one of these government entities will also be eligible
for lending as fore example the German Federal States or the               Cover principle: All Pfandbriefe respect the ‘cover principle’, i.e. the
German Landesbanks. Public sector lending in the central European          requirement of a matching of cash flows from cover assets and
accession countries instead is limited to the central government           ‘covered bonds’ over the lifetime of the ‘covered bonds’.
entities. Public sector lending may either be conducted via the
                                                                           Early prepayment: While a private sector mortgage borrower
granting of loans or via the purchase of bonds issued by one of the
                                                                           retains the right to early prepayment of a loan under German
public sector entities mentioned above.
                                                                           mortgage lending, the mortgage bank can fix a prepayment penalty.
The German legislator has been more cautious with regard to                The mortgage bank may only impose a prepayment penalty for the
mortgage credit. Mortgage lending refinanced by the issuance of            first 10 years, however.
Pfandbriefe remains limited to the European Economic Area, the EU
                                                                           A prepayment penalty can be contractually agreed between the
and Switzerland. Mortgage lending funded by senior unsecured
                                                                           mortgage bank and a public sector borrower, however, for whatever
mortgage bank debt is also possible in the US, Canada, Japan and
                                                                           may be the duration of the loan, i.e. the right to early prepayment
the central European accession countries. The geographical
                                                                           without a prepayment penalty can be ruled out for more than 10
limitations on mortgage lending via the Pfandbriefe are intended to
leave the German mortgage banks some time to build up a local

Global Markets Research                                                                                                                         11
Deutsche Bank@                                          The Market for Covered Bonds in Europe                                         04 March 2003

The definition of eligible and non-eligible asset-side business:               clearly alleviate the liquidity risk exposure. However, we have
Rating aspects play no role in the definition of eligible and non-             observed that some German mortgage banks have started to reduce
eligible asset-side business. Which assets are eligible for Pfandbrief         liquidity risk under the impact of deteriorating ratings by reducing
funding or eligible only for unsecured funding is defined exclusively          their balance sheets and thus the need to obtain capital market
by law and has no relation to rating considerations as is the case for         funding. These strategies show that German mortgage banks are
example in the French law.                                                     increasingly aware of this risk and have pursued active strategies to
                                                                               limit the interest rate risk.
Currency risk: German mortgage banks are not allowed to incur
any currency risk. If the currency of the issued Pfandbrief differs            Limit on foreign lending activities: The German mortgage bank
from the currency of the cover assets, the mortgage bank has to use            act imposes a 10% limit on foreign mortgage and public sector
appropriate hedging techniques to eliminate this currency risk.                lending activities, where the priority claim of the Pfandbrief holder on
                                                                               the cover assets in case of default of the mortgage bank is not
Interest rate risk: The cover principle requires German Pfandbriefe
to be secured by assets of at least equal nominal value including
interest. Duration mismatches, which may drive a wedge between                 This would typically be the case in different jurisdictions, which do
the cover assets and the Pfandbriefe as the market is moving                   not have ‘covered bond’ laws and thus do not provide a similar
strongly or the curve starts to shift are not ruled out by the German          importance to the security of the claim of the Pfandbrief holder. Even
mortgage bank act. While duration mismatches may potentially                   within the European Union, there a significant differences in
expose the mortgage bank to a significant amount of risk, the fact             legislation. Thus, the status of the Pfandbrief creditor relative to its
that mortgage banks are buy-and-hold investors allows them to treat            assets in case of the bankruptcy of the mortgage bank is not clear in
duration mismatches differently from a bank whose position would               some cases. Under these circumstances, the 10% limit is a very
be mark-to-market. Still, it is important for German mortgage banks            important additional security element for the buyers of German
to limit the amount of interest rate risk to a manageable level,               Pfandbriefe, which almost no other European ‘covered bond’ law
particularly within the non-eligible business. In our opinion, this issue      currently offers. More importantly, legislation will tend to be all the
has been solved by a new supervisory control system for the interest           more different, the wider the geographical lending area. Specifically,
rate exposure of German mortgage banks.                                        the extension of the geographical lending area to Japan, the US and
                                                                               Canada makes the 10% limit even more relevant. To judge by
Under the new ‘traffic light system’ to control interest rate risk
                                                                               spread differentials between German and French ‘covered bonds’,
exposure, mortgage banks have to calculate the net present values
                                                                               the market is actually not paying a premium for German bonds due
of their interest bearing and non-interest bearing assets and
                                                                               to this particular safety feature. This may change as European
liabilities on a daily basis. The derived measure of interest rate risk
                                                                               mortgage banks become increasingly active beyond EU borders.
is then put into relation to the bank’s own funds and should not
exceed a value of 10%. If the interest rate risk measure reaches the           Taking derivatives into cover
maximum level of 20% the supervisory authority will intervene and
                                                                               After the latest amendment of the German mortgage bank act
could in the extreme replace the management of the bank.
                                                                               German mortgage banks are allowed to take derivatives into cover.
Interestingly, the new reporting system does not target directly the
                                                                               The large and diversified asset pools of German mortgage banks,
interest rate risk exposure of the asset pools but of the whole bank.
                                                                               which have been built up over successive interest rate cycles,
This emphasises the concerns of legislators to reduce the overall              should however reduce the exposure to derivatives contracts
level of risk exposure of mortgage banks as enshrined in the                   compared with newly created mortgage banks with small asset
specialist bank principle. By capturing the overall amount of interest         pools. Still, the possibility to take derivative hedge contracts into
rate risk of a mortgage bank and limiting it to a sustainable level, the       cover clearly improves the credit quality of the Pfandbrief. In order to
legislator strengthens the ‘outer protective wall’ and prohibits that the      continue the asset pools after the default of the mortgage bank, it is
asset pools will be put to the test.                                           critical that the cover asset hedges will not be unwound early but
                                                                               instead continued until the respective cover assets and liabilities
The German mortgage banks have to submit these risk ratios on a
                                                                               have expired. An early unwinding would potentially disrupt the cash
monthly basis to the German supervisory authorities. Even if these
                                                                               flow structure of the asset pools. The new legislation also fixes a
risk ratios, which have been made public by a number of German
                                                                               12% limit on the amount of derivative instruments in relation to the
mortgage banks, are not entirely comparable (differences exist with
                                                                               asset pools. This should prevent the amounts due to the mortgage
regard to the duration assumed for the liable own funds), they give a
                                                                               bank under these contracts from becoming too large in relation to
broad indication of the amount of interest rate risk that the different
                                                                               the other cover assets and thus leading to an excessively large
mortgage banks are taking.
                                                                               counterparty exposure from these hedges.
Liqudity risk: The recent downward trend in Pfandbrief ratings has
                                                                               Legal protection of over-collateralisation
made this issue more topical. Even if appropriately hedged maturity
mismatches can have a negative impact on profitability if funding              Moody’s has criticised the German mortgage bank act for not
conditions deteriorate over time. However, the German supervisory              protecting any available over-collateralisation. Paragraph 35 (1) of
authority has effectively introduced a system, which limits the                the German mortgage bank act stipulates ‘if the insolvency
interest rate risk exposure of German mortgage banks. Further, the             proceedings are opened in respect of the mortgage bank’s assets,
requirement to hold present value based coverage for                           the assets recorded in the mortgage register shall not be included in
Pfandbriefe introduces an implicit amount of over-collateralisation to         the insolvent estate Inasmuch as these assets are not needed to
compensate for existing interest rate mismatches. These provisions             satisfy the Pfandbrief creditors, the administrator may include them

12                                                                                                                          Global Markets Research
04 March 2003                                           The Market for Covered Bonds in Europe                                        Deutsche Bank@

in the insolvent estate.’ This raises the question how much over-              will lose their ‘AAA’ rating if the senior unsecured rating passes
collateralisation would actually be required to make sure that the             below Aa3 (maximum three notches).
Pfandbrief creditors can be paid back and when any available over-
                                                                               However, Moody’s not only follows the rating changes of the parent
collateralisation that is not necessary to satisfy the Pfandbrief
                                                                               banks but it also takes a view on the mortgage bank industry in
creditors would have to be be paid out to the unsecured creditors.
                                                                               general. According to Moody’s, the interest rate environment and
To address this issue a new amendment to the German mortgage
                                                                               margin conditions in the industry have deteriorated and should
bank act is currently being planned that would require German
                                                                               negatively affect the future profitability trends in the industry.
mortgage banks to hold a specified percentage of legally compulsory
                                                                               According to Moody’s, those banks, which may be singled out for a
over-collateralisation that would then be legally protected until the
                                                                               downgrade are those which (1) have a low standalone rating and (2)
last Pfandbrief has been redeemed.
                                                                               suggest a significant decline in future profitability trends. A decline in
Preferential claim and bankruptcy remoteness                                   future profitability is currently likely at those mortgage banks which
                                                                               are predominantly focusing on the increasingly difficult public sector
The Pfandbrief creditors have an absolute priority claim on the
                                                                               lending business without a strong diversification from the mortgage
assets in the pool. There is no specific link between individual assets
                                                                               lending side.
in the pool and individual Pfandbriefe but all mortgage Pfandbriefe
are covered by all mortgage assets comprised in the pool. The same             UCITS
principle holds for the claims of holders of public Pfandbriefe on the
                                                                               German Pfandbriefe wholly fulfil the criteria of the UCITS directive
public sector asset pools. The content of the preferential claim of the
                                                                               article 22 (4). Thus, the investment limits for investment companies
Pfandbrief holders had been redefined by the Third Financial Market
                                                                               for holdings in the bonds of an individual issuer can be raised from
Promotion Act. In case of bankruptcy of the mortgage bank, the
                                                                               5% to 25%. Simultaneously, compliance with the UCITS directive
cover funds constitute separate assets from the other assets on the
                                                                               also leads to favourable investment limits under the life assurance
balance sheet. This implies that cover asset pools will continue to
                                                                               directive raising the upper limit for investments in specific bonds
exist until the last Pfandbrief has been redeemed. Similar to other
                                                                               from 5% to 40%.
covered bond laws, the German Mortgage Bank Act is not explicit
with regard to the problem of the back-up servicer. If the mortgage            Further, the compliance of Pfandbriefe with the UCITS directive also
bank is liquidated and the asset pools are continued, somebody else            allows Pfandbriefe to obtain a preferential treatment under the BIS
has to take charge of the servicing of the Pfandbriefe and the pools.          rules with a 10% risk-weighting rather than 20%.
It is generally assumed that another mortgage bank would take over
the pool and then be paid a servicing fee out of the asset pool. While
this is the likely course of events, there are no explicit provisions for      The German Jumbo Pfandbrief market remains the reference
this. The planned new amendment to the mortgage bank act is likely             covered bond market in Europe but market conditions have changed
to provide more detailed legal provisions with regard to the servicer          significantly over the past two years. The industry is currently
and the servicing of the pools after the insolvency of the mortgage            characterised by profound merger activity and strategic
bank.                                                                          reorientation. The current problems in the industry, such as poor
Gentleman’s agreement                                                          margin conditions and deteriorating funding conditions, will remain in
                                                                               place for some time to come. The amendment to the German
On a number of other important issues German mortgage banks
                                                                               mortgage bank act will open up new business possibilities to the
decided to adhere to gentleman’s agreements. Such tacit
                                                                               German mortgage banks in a number of areas and will
agreements have been concluded with regard to the investment
                                                                               simultaneously sharpen the security profile of the German
restrictions for available cash or surplus liquidity. Since the
                                                                               Pfandbrief. While the amendment to the German mortgage bank act
German mortgage bank act does not impose tight quality restrictions
                                                                               will alleviate the pressure on the mortgage bank industry, it is not
for the investment of available cash the German mortgage banks
                                                                               likely to prevent profound structural changes, however.
agreed to only invest available cash into assets rated at least A-/A3
by one of the three rating agencies.                                           The abolition of state guarantees (‘Gewährträgerhaftung and
                                                                               Anstaltslast’) by 2005 will induce further changes in the Pfandbrief
                                                                               market, which is currently characterised by the coexistence of public
There has recently been increased volatility in German Pfandbrief              and private Pfandbrief issuers. Private mortgage banks will no
ratings. Moody’s has started to downgrade the Pfandbrief ratings of            longer be able to lend to German public banks as these lose the
a number of German mortgage banks. These downgrades have                       state guarantees and investors will no longer receive the additional
been motivated by several factors.                                             public sector guarantees they currently acquire if they purchase a
                                                                               new Landesbank Pfandbrief. The new freedoms of business beyond
In some cases, the downgrades were solely motivated by
                                                                               the European borders will offer new business opportunities for some
downgrades in the senior unsecured debt ratings of the parent
                                                                               of the more internationally oriented mortgage banks, while the
banks and automatically translated in rating adjustments at the
                                                                               domestically oriented institutions will have to focus more on
subsidiaries. Since the Moody’s public Pfandbrief rating can be a
                                                                               domestic niche business.
maximum four notches above the mortgage bank’s senior unsecured
rating, the public Pfandbriefe will lose their ‘AAA’ rating if the senior      While we believe the German Pfandbrief is likely to keep its
unsecured rating passes below A1, even if the collateral pool                  dominant position in the European ‘covered bond’ market, there is
provides for sufficient over-collateralisation. Mortgage Pfandbriefe           increasing competition form alternative products such as ABS or
                                                                               MBS, which diverts demand away from the Pfandbrief.

Global Markets Research                                                                                                                               13
Deutsche Bank@                                        The Market for Covered Bonds in Europe            04 March 2003

 The 20 biggest issuers of Covered Bonds in 2002
 (issuance in EUR bn and market share in %)
                            Volume (in EUR bn)   Market share (in %)
AHBR                                 9                  15%
HVB                                   5.75              10%
DEPFA                                  4                7%
AYTCED                                 3.5              6%
HVBRE                                  3.5              6%
BBVSM                                  3                5%
CAJAMM                                 3                5%
HYPESS                                 3                5%
DGHYP                                  2.6              4%
LBSACH                                 2.5              4%
LBW                                   2.25              4%
CIFEUR                                1.75              3%
DEXMA                                 1.750             3%
BHH                                    1.5              3%
CAIXAB                                 1.5              3%
DHY                                    1.5              3%
LRPG                                   1.5              3%
BADWUR                                1.25              2%
CFF                                   1.25              2%
BANEST                                 1                2%
 Source: DB Global Markets Research

14                                                                                             Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                         Deutsche Bank@

                                                                              Specialist bank principle
Denmark                                                                       Danish mortgage banks are specialist banks and subject to special
                                                                              supervision by the Danish Financial Services Authority
The Danish mortgage bank system is among the oldest in Europe,
                                                                              (Finanstilsynet). Their activities are restricted to mortgage-related
having been in continuous existence since 1797. The Danish
                                                                              business. There is no geographical limitation to their mortgage
mortgage bond market is, consequently, the second largest in
                                                                              lending activities but they must notify the FSA if they engage in
Europe, despite the relatively small size of the country itself.
                                                                              cross-border mortgage lending. The European Union’s passport
The classical Danish mortgage bond is a callable, amortising                  principle applies to Denmark, allowing foreign mortgage banks to
structure with an initial maturity of 20 or 30 years and quarterly            operate in Denmark. The issuance of Danish mortgage bonds is,
coupons payable on the first of January, April, July, and October.            however, subject to the strict balance principle regardless of the
The coupons are set according to prevailing market interest rates for         domicile of the parent bank (see below).
tax-related reasons. The bonds are continuously tapped over a
                                                                              The restriction to mortgage banking business limits the leverage of
period of three years, after which the issue is closed and a new
                                                                              mortgage banks, in contrast with the situation in Germany. Because
issue is opened.
                                                                              the banks are subject to the Basle rules for bank capital and their
Typically two or three bonds with different coupons are open at any           assets carry at least a 50% risk weighting, they have to hold at least
one time and supply is in those closest to par value. The mortgage            4% in capital against any mortgage.
banks co-ordinate the opening of new issues so that the maturity
                                                                              The credit quality of the cover assets
dates and cash flow structures of the bonds of different mortgage
banks are very similar. For this reason, the bonds of different issuers       Danish mortgage bonds must be covered by mortgage loans
(‘colours’ in market parlance) used to trade at virtually identical           granted in accordance with the valuation principles laid down by the
prices before market segmentation in recent years brought about a             banking regulator. The permissible loan-to-value ratios depend on
larger focus on individual credit ratings and lending practice.               the type of property under consideration. It should be noted that the
                                                                              legislation regarding loan-to-value ratios has been used, in the past,
The prepayment of these callable bonds is driven by the individual
                                                                              as a tool of macro-economical policy. The current limits are given in
mortgage prepayments available to each Danish mortgage
                                                                              the table below.
borrower. Estimating the probable prepayment behaviour and,
hence, the fair price of the prepayment option is the main                      Permitted loan-to-value ratios in Denmark
complication in investing in callable Danish mortgage bonds and
appears to have restricted foreign interest in the product. Because             Owner-occupied houses, houses available for rent            80 %
prepayment behaviour is not wholly rational, prepayment models                  Agricultural properties                                     70 %
need to take into account a significant amount of uncertainty, which            Second homes, weekend cottages, business properties         60 %
                                                                                Source: Danish mortgage credit act.
is only partially alleviated by the large amount of historical
prepayment data that is publicly available. That said, prepayments            Banks will typically also grant loans above these limits to mortgage
do appear to become more ‘rational’ recently, a process driven                borrowers but these higher tranches are not refinanced with
partially by financial innovations (see below). We find that investors        mortgage bonds.
in general are reluctant to take positions in bonds with prepayment           Although mortgage banks have to pass prepayment risk on to the
options that are close to or in the money, resulting in a structural          bond holders, they do assume the default risk of individual mortgage
cheapness of these issues.                                                    borrowers. For this purpose, mortgages and the associated
Recently, a new mortgage product, called Flexlån, has widened the             mortgage bond issues are pooled into so-called capital centres.
range of mortgage products available to borrowers in Denmark.                 Each capital centre maintains a cash pool that is built from a spread
These loan structures are refinanced with shorter maturity non-               that mortgage borrowers pay over the coupon rate of the mortgage
callable bullet bonds. Mortgage borrowers face a floating interest            bond that is used to refinance their mortgage.
rate and they appear to prefer Flexlåns over conventional loans in            It used to be the case that all mortgage borrowers in a series
times of steeper yield curves. This is leading to a strong interest in        assumed a joint liability for the repayment of a set of mortgage
these non-callable bonds currently and they are issued at correspon-          bonds. In practice, these series maintained a cash pool to cover
dingly rich levels. Secondary market liquidity is relatively poor due to      delinquencies while mortgage borrowers faced the risk of increasing
the short initial maturity of these bonds and the appetite of buy-and-        interest payments if these cash pools had become depleted.
hold investors for these issues.                                              Mortgage credit legislation allowed mortgage banks to treat these
The key theme of banking in Scandinavia is consolidation and the              cash pools as capital under some circumstances. At this point, no
Danish market is no exception. This is leading to larger, more                more such bond series are open.
diversified banking conglomerates that contain Danish mortgage                Interest rate, currency and other market risks
banking activities one of their activities. This brings the industry
structure closer to what is present in the other European countries.          Prepayment risk: Danish mortgage borrowers are allowed to
One of the effects will be a closer contact between mortgage banks            prepay without penalty. The risk of early prepayment is, however,
and customers, leading to more rational prepayment behaviour of               not assumed by the mortgage bank but passed on to the bond
callable bonds. More importantly perhaps, we have seen the first              holders.
upgrade to ‘Aaa’ status of mortgage bonds by Moody’s, in part due             Interest rate risk: Mortgage banks are not permitted to take any
to an improving group capital structure of the issuing mortgage bank.         open risk positions beyond about 1% of their equity capital, which

Global Markets Research                                                                                                                            15
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                                04 March 2003

compares with a maximum 10% in Germany. For a long time, the                  provision for this case is a clear weakness of the Danish mortgage
guiding principle in this regard has been the strict balance                  bank law. It is thus possible that the capital centres would have to be
principle. It stipulates that mortgage bonds must be covered by               unwound and that the mortgage assets would have to be sold at a
mortgage loans of an identical cash flow structure (amount, timing,           discount potentially exposing the bond holders to a loss.
and maturity). The balance principle in its strict form had been under
review by the FSA and is now milder in that the total risk stemming
from cash flow deviations can amount to 1% of the equity capital of           Danish mortgage bonds are rated by Moody’s and, in one case,
the bank.                                                                     (Nykredit) by Standard and Poor’s. While Moody’s had earlier
                                                                              treated Danish mortgage bonds in similar fashion to asset-backed
Currency risk: The Danish mortgage banks are not allowed to take
                                                                              securities, current ratings are more in line with the covered bond
any currency risk.
                                                                              products in other European countries.
Limit on foreign lending activities: Danish mortgage banks are
not restricted in the foreign mortgage lending activities. This is a            Danish mortgage bond ratings
potential risk, particularly in the presence of a wide geographical             Danske Kredit                                            Aaa
lending area.                                                                   Nykredit                                               Aa2/AA-
Taking derivatives into cover                                                   Realkredit Danmark                                       Aaa
                                                                                Totalkredit                                              Aaa
Derivatives can not be part of the collateral pools and are, in fact,           Unikredit Realkredit                                     Aa1
not necessary because the balance principle limits the deviation of             Source: Bloomberg
the mortgages on one side and the bond cash flows on the other. A             Credit ratings do not play an important role for domestic fund
cashflow transformation through derivatives is therefore not                  managers, who perceive a strong systemic support for the mortgage
necessary.                                                                    banking system and are familiar with the credit history of the
Segregated assets or segregated asset pools                                   product. Credit ratings are of more interest for foreign investors and
                                                                              for those it is important that there is now AAA-rated paper available.
Mortgage assets are segregated from the other assets of the bank
for the purpose of satisfying unsecured lenders of the bank (see              UCITS
below). Because mortgages form the only collateral class for                  Article 22 (4) in the 1982 UCITS guideline was motivated by Danish
secured borrowing, they need not be segregated from other types of            fund managers’ difficulties in achieving the name diversification
cover assets.                                                                 stipulated by the original 1979 guideline due to the low number of
The Danish mortgage credit act stipulated a segregation of                    Danish mortgage banks. Danish mortgage bonds, therefore, satisfy
mortgage pools in the form of capital centres. These arose                    this article practically by construction.
historically from the joint liability assumed by mortgage borrowers for       Market profile
the total repayment of the bond series that was secured with their
mortgage loans. This joint liability could be extended, on a mutual           The Danish mortgage banking market is characterised by
basis, across bond series, leading to pools of mortgage bonds that            consolidation and integration with the other Scandinavian banking
were effectively linked in default risk to a particular pool of mortgage      markets. The table below lists the main Danish mortgage banks.
borrowers. These pools of bond series are referred to as capital                Danish mortgage banks
centres and form the basis for the credit rating of mortgage bonds. In
practice, there are ways to transfer capital between capital centres            Name                   Summary
via the mortgage bank itself and capital centres are therefore not              BG Kredit
wholly bankruptcy remote. Practically, all new bond issues of an                                       Subsidiary of Den Danske Bank, granting loans to
issuer will now come from the same capital centre and the technical                                    owner occupied homes including weekend cottages.
details do no longer play an important role in the market.                      BRFKredit              Organised as a trust, lending mainly to owner-occupied
                                                                                                       homes as well as rental, commercial, and industrial
Preferential claim and bankruptcy remoteness
Mortgage bond holders have a preferential claim on the mortgage                                        Financing mainly of agricultural, horticultural, and
assets in the issuing capital centre in case of default on a mortgage           Dansk Landbrugs        forestry properties. DLR was subject to special
bond payment. It should be noted that there has not been a default              Realkreditfond         legislation regarding capital adequacy which is being
in the Danish mortgage bond market since its inception in 1797. The             (DLR)                  phased out.
capital centre should still remain solvent in case of default of a              Danske Kredit          Subsidiary of Den Danske Bank, lending to all property
mortgage bank, since the cashflows of the underlying mortgages                  Realkredit-            categories excluding some publicly subsidised building
correspond exactly with the mortgage bond cash flows. This                      aktieselskab           projects.
suggests that the cash centres should be largely bankruptcy remote                                     Set up by the "Finansieringsinstituttet for Industri og
if they continued until the maturity of all outstanding bonds. There is         FIH Realkredit A/S     Håndværk", lending is focused on manufacturing and
no clear legal framework for the continuation of the capital centres in                                craft industries.
case of the mortgage bank’s default nor are there any provisions                Landsbankernes         Set up by a number of banks, this bank lends primarily
with regard to a potential backup servicer. Compared with Germany,              Reallånefond           to major construction projects, mainly subsidised
where the legal possibility to continue the asset pools beyond the                                     housing projects.
default is enshrined in the mortgage bank act, the lack of a legal

16                                                                                                                               Global Markets Research
04 March 2003                                                 The Market for Covered Bonds in Europe   Deutsche Bank@

  Nykredit A/S          Formed through mergers with other mortgage banks,
                        Nykredit is the largest Danish mortgage lender. Grants
                        loans for all property categories.
  Realkredit Danmark Formed through mergers with other mortgage banks.
  A/S                   Grants loans for all property categories.
  TOTALKREDIT           Originally Provinsbankens Reallånefond,
  Realkreditfond        TOTALKREDIT is an independent trust lending to
                        owner-occupied homes.
                        Subsidiary of Unibank granting loans to all property
  Unikredit Realkredit- categories excluding some publicly subsidised housing
  aktieselskab          projects.
  Source: DB Global Markets Research

The Danish mortgage bond market is the covered bond market with
the longest structural continuity in Europe. Foreign investor
participation is still underdeveloped due to the difficulty in estimating
the prepayment behaviour of the callable bonds that still form the
bulk of the market. The more sophisticated non-domestic funds have
started to invest in the market, however, and we expect this trend to
continue. We expect new products to emerge as the Danish banking
sector integrates more tightly with other Scandinavian markets.

Global Markets Research                                                                                            17
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                         04 March 2003

                                                                              The credit institutions, which are members of the FGAS, pay
France                                                                        contributions to the fund to cover the potential risks from defaults.
                                                                              Contrary to other European ‘covered bond laws’, the French
A new mortgage bank act was passed in France in June 1999,
                                                                              mortgage bank act has been, to a large extent, inspired by
setting up ‘mortgage credit companies’, Sociétés de Crédit Foncier
                                                                              securitisation techniques. This may not come as a surprise, since
(SCFs), which can issue ‘covered bonds’ under the name ‘Obligation
                                                                              France had already created a special national securitisation vehicle,
Foncière’. The new mortgage bank act significantly strengthens the
                                                                              the ‘Fonds Communs de Créances’ (FCC), and has extensive
position of bond holders investing in French ‘covered bonds’ in
                                                                              experience with another institution issuing mortgage backed
comparison with the mortgage bonds that had been issued by
                                                                              securities via a special vehicle the ‘Caisse de Refinancement à
‘Crédit Foncier’ or ‘Credit Foncier et Communal d’Alsace et de
                                                                              l’Habitat’ (CRH). Thus, the range of refinancing vehicles available,
Lorraine’ (CFCAL) under the French Bankruptcy Act from 1985.
                                                                              including ABS, before the new mortgage bank act had been passed
Specialist bank prinicple                                                     was already large compared to other countries. The new mortgage
                                                                              bank act thus adds a modern ‘covered bond’ law to the existing
To ensure that its ‘covered bonds’ are in accordance with article 22
                                                                              refinancing vehicles. France has designed the new law to be in line
(4) of the UCITS directive, France has enacted legislation aimed at
                                                                              with existing securitisation vehicles.
specific monitoring of the activities of the sociétés de crédit foncier
(‘mortgage credit companies). They are specialised institutions with          A number of securitisation elements have thus entered the new law.
a narrowly defined scope of business activities. Institutions holding a       The notion of over-collateralisation is established by law. A cover
‘mortgage credit company’ may however engage in all types of                  ratio is defined, which puts the total amount of assets in relation to
banking activities since the legal construction of ‘mortgage credit           the total amounts of liabilities with a preferential claim. This cover
companies’ clearly separates them from the holding parent bank. In            ratio must always be larger than unity and compliance is monitored
particular, there is no recourse of the ‘mortgage credit company’ on          by the trustee. To define the amount of over-collateralisation
the holding bank in case of default of the ‘mortgage credit company’          necessary, the cover assets are subject to specific weightings
or vice versa.                                                                defined by regulation. Although some of the weightings for the cover
                                                                              assets are defined by law, others are explicitly linked to a specific
There is no limit on the total amount of outstanding ‘Obligations
                                                                              In attributing specific ratings to the various assets used as cover for
The credit quality of the cover assets
                                                                              the privileged liabilities, France clearly departs from the approach
Scope of business activities: The amended French mortgage                     still used in most other ‘covered bonds’ legislation. The notion of
bank act allows for a wide geographical lending area. The public              eligibility as cover assets is extended to allow a wider and more
sector lending business comprises loans to governments of the                 hybrid range of assets to be eligible for the issuance of French
European Economic area, Switzerland, the US, Canada and Japan                 ‘covered bonds’. While all other European ‘covered bond’
and the respective territorial entities or their groupings or public          regulations define an asset to be eligible for cover or not, the French
institutions belonging to the European Economic Area. Secured                 law allows assets to be also partially eligible. Partial eligibility
mortgage loans of French ‘mortgage credit companies’ may be                   recognises that assets of different quality may be used as cover
based on a mortgage located within the European Economic Area,                assets but the assets with weaker ratings will not be recognised in
Switzerland, the US, Canada or Japan. In principle, mortgage credit           full for the cover ratio. A cover asset with a Moody’s minimum rating
companies may grant loans secured by mortgages or by any type of              of Aa3 would be weighted at 100%, while an asset with a minimum
immovable property, built or unbuilt, to be used for residential or           rating of A3 would only be weighted at 50%. This implies that an
commercial properties.                                                        asset weighted at 100% can be funded completely by the issuance
                                                                              of ‘Obligations Foncières’. An asset weighted at 50% may only be
Property valuation and loan-to-value ratios: The French
                                                                              funded in the order of 50% via ‘Obligations Foncières’ while the rest
mortgage act requires the mortgage credit companies to assess
                                                                              would have to be raised via ‘unsecured’ funding. Interestingly,
conservatively the buildings offered as guarantees or financed by
                                                                              substitute collateral defined as risk free assets such as ‘safe’
secured loans excluding all speculative elements. For the purposes
                                                                              securities and ‘liquid’ assets will be weighted only at 95%. As a
of property valuation, the French law refers to the concept of
                                                                              result, the use of substitute collateral will thus automatically lead to
‘mortgage value’. This concept is from the European Parliament and
                                                                              some over-collateralisation.
Council Directive 98/23/EC, 29 June 1985. The ‘lending value’ is
used as the basis for the loan-to-value ratios. These ratios have             Eligibility of asset-backed securities
been fixed at 60% of the lending value and at 80% of the lending
                                                                              The novelty of the French law, however, is not only to allow for
value if the assets of the mortgage credit company consist only of
                                                                              different eligibility criteria for cover assets via specific rating-
loans secured by residential buildings. The LTV ratios may be
                                                                              dependent weighting schemes but it also allows for a genuinely
further increased to 100% if sufficient additional guarantees are
                                                                              wider range of cover assets. The proximity to the securitisation
provided by a public institution, a credit institution or an insurance
                                                                              approach is nowhere as explicit as in allowing MBS as coverage for
company or by the ‘Fonds de garantie de l’accession sociale
                                                                              ‘Obligations Foncières’. The legislator limits the flexibility of using
(FGAS). The FGAS guarantees specific housing loans to low and
                                                                              MBS, however. At least 90% of the assets of such securitisation
middle income families. The government provides a guarantee on
                                                                              vehicles must be of the same nature as those that would qualify as
the respective loans provided according to the criteria of the FGAS.
                                                                              regular cover assets, such as mortgage and/or public sector loans.
                                                                              Thus, mortgage backed securities from the European Economic

18                                                                                                                         Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                                    Deutsche Bank@

Area, Switzerland, the US, Canada and Japan can be bought under               - 50% for fixed assets resulting from the acquisition of buildings
the condition that the claims underlying these mortgage backed                coming out of an enforcement procedure;
securities are composed by at least 90% of these assets which
                                                                              - 95% for “safe” securities and “liquid” assets (as defined in the
would also qualify directly as cover assets. This potentially provides
                                                                              French law);
French mortgage credit companies with a very wide range of
business activities. Further, the French law is somewhat                      - 100% for regular eligible assets (i.e., mortgage loans and public
ambiguous with regard to the LTVs. It is not clear whether only               sector loans).
mortgage loans with the same LTV ratio as eligible assets or also
                                                                              The ratings conditions for the weightings of the assets used for the
assets with lower LTV ratios can be purchased via MBS. Generally,
                                                                              numerator are shown in the table below.
there is no limit on the volume of the MBS assets within the total
assets of an SCF. As an investment, SCFs may, however, purchase                 Treatment of SCF secured loans and FCC units (Weights
only up to 20% of these assets as substitute collateral. The                    attributed with corresponding minimum rating)
originating bank, which manages the SCF, may therefore securitise
                                                                                Weights                          Secured Loans                    FCC units
a mortgage portfolio and use the created securities as backing for
the issuance of OFs.                                                            100%                              Aa3/AA-/ AA-                   Aa3/AA-/ AA-
                                                                                50%                                 A3/A-/ A-                      A3/A-/ A-
FCCs were created 10 years ago and are a specific French                        The ratings are according to Moody’s/S & P/Fitch, respectively
securitisation vehicle regulated under French law. Assets may be                 Source: French banking and regulation committee on SCFs
sold to a FCC, which will finance the purchase of these assets, via
                                                                              Interest rate, currency and other market risks
the sale of shares in the FCC to investors. The advantage of the
specific legal structure is that the shares created by the FCC are            Cover principle: All ‘Obligations Foncières’ respect the cover
treated legally as securities for French money managers. Even if              principle, i.e. the requirement of a matching of cash-flows from cover
securitisation vehicles other than the FCC are possible, these still          assets and ‘covered bonds’ over the lifetime of the ‘covered bonds’.
represent the cheapest means of securitisation in France. Due to
                                                                              Early prepayment: French ‘mortgage credit companies’ are
the clear legal framework and the standardisation of the product, the
                                                                              exposed to the risk of early prepayment. The French Consumer
costs involved with legal and tax issues in a non-standardised off-
                                                                              Code (13 July 1979) provides for a ceiling on the early repayment
shore ABS transaction can be avoided.
                                                                              penalty. The borrower may actually repay his loan at par in advance
Guaranteed loans                                                              at any time, subject to compensation, which may not exceed six
                                                                              months of interest or 3% of the loan. The French mortgage banks
Apart from asset-backed securities, an SCF may also acquire
                                                                              had been exposed to significant prepayment ahead of EMU as
guaranteed loans. These can be purchased as cover assets,
                                                                              French long-term rates had converged on German rates. Since then
provided that these assets do not exceed 20% of total assets. A
                                                                              rates have generally developed in a much narrower range and thus
financial institution or insurance company providing the guarantee
                                                                              have reduced the attractiveness of early repayment. Still, French
must hold capital amounting to at least EUR 12 million. Additionally,
                                                                              ‘mortgage credit companies’ remain structurally exposed to a
the borrower must supplement the loans with 5-20% of their own
                                                                              risk of early repayment contrary to German mortgage banks.
capital. Thus, only 80-95% of the guaranteed loans will actually be
                                                                              This potentially introduces an element of risk into French cover
financed by the SCF. While guaranteed loans are also possible
                                                                              assets, which is absent from other countries’ cover asset pools.
under the German mortgage law, the guarantor must be a public
sector institution as defined by the German Mortgage Bank Act (§5             Interest rate and currency risks: The French law requires
(1) 1), therefore limiting the scope of possible guarantors as                ‘mortgage credit companies’ to use appropriate financial instruments
compared with French law. The scope of guaranteed lending might               to hedge the cover assets adequately. The law does not explicitly
further be reduced in the future, as one important type of guarantor,         require a direct matching of the maturity of assets and liabilities,
the Landesbanks will eventually disappear, once their guarantees              however. There is no explicit requirement to match currencies but
have been abolished in mid-2005.                                              the requirement that the bonds be covered at all times implies that
                                                                              currency risk should be neutralised. The French ‘mortgage credit
The conditions under which an SCF might actually acquire FCCs
                                                                              companies’ have to use relevant instruments to manage their
and guaranteed loans as cover assets are stipulated in number 99-
                                                                              interest rate risk. Interestingly, the task of verifying and testifying that
10 of the Banking and Credit Regulation Committee on SCFs. The
                                                                              the cash-flows from the cover assets match the cash-flows from the
Committee imposes no absolute quality standard on a FCC or
                                                                              liabilities at all times is conferred upon the trustee (‘Controlleur
guaranteed loan to be purchased by an SCF. In practice, however,
                                                                              Spécifique’), who has to point any mismatches to the supervisory
article 6 of chapter II requires any SCF to maintain permanently a
                                                                              authority. Thus, the role of the French trustee goes well beyond
cover-ratio (weighted eligible assets/privileged resources) of at least
                                                                              the tasks of the German trustee. Since French law requires the
1. The denominator of the ratio consists of the OFs and all other
                                                                              trustee to be chosen from the list of auditors appointed by the
privileged resources. Privileged resources include those not
                                                                              company management on approval by the supervisory authorities,
becoming due in case of default of the mortgage credit company,
                                                                              much more stringent conditions are placed on the qualification of the
notably the residual sums due from the derivatives taken into cover.
                                                                              trustee. The control of interest rate risks actually goes further than
The numerator of the ratio consists of all the assets weighted as
                                                                              the German mortgage law in assigning the control function to the
                                                                              trustee but it stops short of a comprehensive present value-based
- 0%, 50% or 100% for secured loans and FCC units in accordance               control mechanism similar to the one introduced in Germany in early
with the ratings conditions laid down in the following table;                 2001.

Global Markets Research                                                                                                                                         19
Deutsche Bank@                                           The Market for Covered Bonds in Europe                                          04 March 2003

Liquidity risk: The absence of precise legal requirements to match              likely to carry out a large amount of unsecured funding since the
maturities implies that French mortgage credit companies are                    mortgage credit company should obtain a similar funding result for
potentially allowed to incur a certain amount of interest rate risk. But        the unsecured business as its parent bank. Thus, it is unlikely that
even if interest rate risk is entirely hedged, as in the case of DEXMA,         any loans other than those eligible for refunding via Obligations
because both assets and liabilities have been asset-swapped, the                Foncières’ will be transferred from the parent bank to the mortgage
mortgage credit company could potentially still remain exposed to a             credit company.
liquidity risk if the rating and thus funding conditions were to
                                                                                Segregated assets or segregated asset pools
deteriorate over time. Since the French issuers are all highly rated
and have exhibited the highest level of rating stability in recent              The French law makes no distinction between bonds secured by
years, such a scenario where liquidity risk would rise due to                   mortgage loans or by public sector loans. Thus, theoretically, a
deteriorating ratings is highly unlikely. Theoretically, however, a             ‘mortgage credit company’ may issue an ‘Obligation Foncière’
weakly rated French issuer whose rating starts to deteriorate might             secured on both mortgage loans and public sector loans. A
see the liquidity risk rise if interest rate mismatches, even if hedged,        ‘mortgage credit company’ may also choose, however, to hold just
were too high.                                                                  one category of loans as is typically the case currently. Practically, it
                                                                                is unlikely that a French ‘mortgage credit company’ will hold any
Limit foreign lending where the priority claim of the
                                                                                other assets on its balance sheets as those, which are used as
creditor of ‘Obligations Foncières’ is not guaranteed
                                                                                cover assets for the issuance of ‘Obligations Foncières’.
French law imposes no limit on the amount of foreign assets, which
                                                                                Preferential claim and bankruptcy remoteness
may be bought as coverage for ‘Obligations Foncières’ even if it is
not clear that the priority claim of the creditor of the ‘covered bond’ is      The holders of ‘Obligations Foncières’ have a preferential claim on
not guaranteed under all circumstances. The absence of such a limit             the cover assets. In case of default of the mortgage credit company,
should be considered as a severe drawback when the share of                     the cover assets and the residual sums from the derivatives taken
foreign assets in the portfolios is large. Currently, the absence of a          into cover together with the ‘Obligations Foncières’ will be continued.
limit to French foreign lending should not represent a major risk. The          Further, no other creditor may satisfy his claim on the assets of the
planned extension of the geographical lending area for French                   bank before the creditors of the ‘Obligations Foncières’ have
‘mortgage credit companies’ has the potential to become an                      completely satisfied their claims (‘Super-Priority’). More important
increasing risk to the creditors of ‘Obligations Foncières’.                    still, the creditors of ‘Obligations Foncières’ can satisfy their claims
                                                                                out of all the assets on the balance sheet as stipulated in article 98
Taking derivatives into cover
                                                                                (1) and with reference to article 94. The fact that the creditors of
The French mortgage bank act was the first to tackle the important              ‘Obligations Fonciéres’ not only have recourse on the privileged but
issue of how to treat the financial instruments used to hedge the               also on the non-privileged assets represents a de facto
cover assets.                                                                   subordination of all the assets on the balance sheet in case of
                                                                                default of the mortgage bank. The net worth of this additional
There are essentially two types of problems linked to the use of
                                                                                preferential claim on all the other assets in case of the default of the
financial instruments for the purpose of hedging cover assets. First,
                                                                                mortgage bank is difficult to assess. We would assume that the
the ‘mortgage credit company’ will incur counterparty credit risk and
                                                                                ‘mortgage credit company’ does not hold any significant amount of
second there may be no recourse on the claims embedded in the
                                                                                assets other than those used as cover for ‘Obligations Foncières’. In
financial instrument if the ‘mortgage credit company’ goes bankrupt.
                                                                                this regard, the security mechanisms of ‘Obligations Foncières’ in
The French mortgage bank act has addressed the second problem.
                                                                                case of bankruptcy can be considered as strong, even if the
It requires ‘mortgage credit companies’ take the residual sums from
                                                                                ‘superpriority’ of the OF creditors may not be that relevant in
derivatives that are used to hedge the cover assets into cover.
Under these provisions, the residual sums from derivatives can be
continued together with the other cover assets even after the                   Ratings
bankruptcy of the ‘mortgage credit company’. French law provides
                                                                                There are currently three issuers of ‘Obligations Foncières’ in the
no security mechanism with regard to the potential default of a
                                                                                liquid Jumbo segment - Dexia group via its ‘mortgage credit
derivatives counterparty, however, as we described in the
                                                                                company’ DEXMA, Crédit Foncier de France via its CIE
                                                                                Financement Foncier and another ‘mortgage credit company’, which
Legal protection of over-collateralisation                                      has only very recently started to issue, CIF Euro mortgage. The
                                                                                ‘Obligations Foncières’ of all three issuers carry a ‘AAA’ rating from
The French law on mortgage credit companies provides legal
                                                                                Moody’s and Fitch IBCA. Still, DEXMA, which has the strongest
protection for any existing over-collateralisation since ‘no other
                                                                                senior unsecured rating, is trading richer versus swaps than CIE
creditor of an SCF may take advantage of any right whatsoever over
                                                                                Financement Foncier or CIF Euro mortgage.
the assets and rights of this company until the creditors benefiting
from the privilege in the meaning of this article have been fully paid’.        CIF Euro mortgage and the other two issuers are difficult to compare
This provision effectively bars any unsecured creditors from                    since CIF Euro mortgage is rated solely under the structured finance
satisfying his claim from the assets of the mortgage credit company             approach as it only carries ‘AAA’ rated MBS on its balance sheet. A
until all secured creditors have been fully satisfied. The value of this        positive spread between DEXMA and CFF is justified since Dexia
‘super-priority’ of the covered bond creditors over the unsecured               Group has the stronger Aa2 senior unsecured debt rating compared
creditors offered by French law should be a function of the available           with a Aa3 for Crédit Foncier de France.
over-collateralisation. French mortgage credit companies are not

20                                                                                                                           Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                     Deutsche Bank@

French ‘Obligations Foncières’ may be rated a maximum 3 notches               In five years from now, CIF Euromortgage plans to have reached an
above the senior unsecured debt rating of the parent bank by                  outstanding of EUR 10 bn and plans an annual issuance volume in
Moody’s. Crédit Foncier would thus lose its AAA rating if the senior          the order of EUR 2-3 bn. Since the share of FCC CIF Assets units
unsecured debt rating of Crédit Foncier de France declined by one             within the balance sheet of CIF Euromortgage will grow continuously
notch, while Dexia group still has a one notch cushion against the            the rating outlook for the ‘Obligations Fonciéres’ will depend
loss of the AAA on its ‘Obligations Foncières’. While Moody’s allows          essentially on the quality of the FCC units sold to the ‘mortgage
German public Pfandbriefe to be rated a maximum 4 notches above               credit company’.
the senior unsecured debt rating of the mortgage bank and thus one
notch better than for ‘Obligations Foncières’, there is the same
notching approach for German mortgage Pfandbriefe and French                  The French ‘mortgage credit companies’ have been criticised for
‘Obligations Foncières’.                                                      lacking the character of a ‘real’ bank employing personnel, which
                                                                              would work towards a common business strategy. The lack of
                                                                              personnel is criticised for making it difficult for the supervisory
French ‘Obligations Foncières’ wholly fulfil the criteria of the UCITS        authorities to supervise these entities effectively since the acting
directive article 22 (4). Thus, the investment limits for investment          persons would not actually be personnel of the ‘mortgage credit
companies for the holdings in the bonds of one individual issuer can          company’ without a genuine interest in the ‘mortgage credit
be raised from 5% to 25%. Simultaneously, compliance with the                 company’. Still, one may argue that the ‘mortgage credit company’ is
UCITS directive also leads to favourable investment limits under the          fully consolidated at its parent bank, which therefore has an interest
life assurance directive raising the upper limit for investments in           in the company for which it assumes the business operations.
specific bonds from 5% to 40%.
The compliance of ‘Obligations Foncières’ with the UCITS directive
also allows these bonds to obtain a preferential treatment under the
BIS rules with a 10% solvency ratio.
Market profile
Currently, all three French ‘mortgage credit companies’ have been
issuing ‘Obligations Foncières’ in the liquid Jumbo format. New
issuance of ‘Obligations Foncières’ in the Jumbo segment had been
slow year-to-date but picked up in October. French ‘Obligations
Foncières’ have captured a market share in new issuance of just 6%
since the start of this year compared with 4% for Spanish Cedulas
and 54% for German mortgage bank Jumbo Pfandbriefe.
The lack of supply of ‘Obligations Foncières’ in the Jumbo format
this year has led to a richening of ‘Obligations Foncières’ relative to
Jumbo Pfandbriefe on in asset swap terms. This richening is likely
going to be transitory as it is mainly driven by a relative drying up in
the supply of French ‘covered bonds’ relative to Jumbo Pfandbriefe.

  Issuance by type of underlying

  Cedulas                                              4%
  Mortgage Pfandbrief                                  10%
  Obligation Foncière                                  6%
  Other                                                11%
  Public Pfandbrief                                    44%
  Zero risk-weighted issue                             25%
  Source: Deutsche Bank Global Markets Research

Among the three issuers of Jumbo ‘Obligations Foncières’, CIF Euro
Mortgage Credit companies has the lowest senior unsecured debt
rating with an Aa1 at Moody’s. As we pointed out before, Moody’s
follows a notching approach for European ‘covered bonds’.
According to this methodology ‘Obligations Focières’ can only be
rated up to three notches above the senior unsecured debt rating of
the ‘mortgage credit company’. Euromortgage is rated solely via a
structured finance approach. The structuring of the mortgage
portfolios takes place before the assets are sold to the ‘mortgage
credit company’. An additional credit enhancement is provided at the
level of the ‘mortgage credit company’.

Global Markets Research                                                                                                                          21
Deutsche Bank@                                       The Market for Covered Bonds in Europe                                           04 March 2003

                                                                            European ‘covered bond’ laws to the EU or to the European
Luxembourg                                                                  Economic Area had increasingly been perceived as a brake on
                                                                            business activities. The amendments to the German and French
Luxembourg passed a ‘covered bond’ law on 1 Nov. 1997, which                mortgage bank acts, extending the geographical limit for the lending
was then amended on 22 June 2000. The new law, which is, to a               activities, have reduced the advantage that Luxembourg mortgage
large extent, modelled on the German mortgage bank act, provides            banks had enjoyed by being able to lend outside of Europe.
Luxembourg mortgage banks with a very wide geographical range
                                                                            In Germany, the mortgage bank act establishes a link between risk-
for the mortgage and public sector lending business. Luxembourg
                                                                            weightings and the eligibility for asset cover. Germany makes public
mortgage banks can issue two types of covered bonds, ‘lettres de
                                                                            sector lending within the EU conditional on a maximum 20% BIS risk
gage publiques’ (LGP) and ‘lettres de gage hypothécaires’
                                                                            weighting for the respective institutions. Under traditional BIS
(LGH). The main difference compared with the German mortgage
                                                                            legislation, all OECD sovereigns are assigned a 0% risk weighting
bank act is the significant extension of the geographical scope of
                                                                            and the local public sector entities will receive a 20% risk weighting.
business activities. As a result, German mortgage banks opened up
                                                                            BIS risk weightings are currently not an optimal guide, however, to
subsidiaries in Luxembourg to exploit the business opportunities
                                                                            assess the risk in cross border public sector lending. This could be
offered by the Luxembourg law. Today, these German mortgage
                                                                            changing under the new BIS proposals, which assign risk weightings
bank subsidiaries are the key players in the market. Eurohypo
                                                                            on the basis of external ratings. Some sovereigns could lose their
Luxembourg (Eurohypo is the result of the merger of Eurohypo
                                                                            0% risk weighting and some even risk exceeding the 20% level.
Europäische Hypothekenbank, Deutsche Hypothekenbank
                                                                            (See table on next page)
Frankfurt-Hamburg AG and Rheinische Hypothekenbank AG),
Pfandbrief Bank International (a subsidiary of Hypovereinsbank))            In this light, the extension of lending beyond the EU need not lead to
and Erste Europäische Pfandbrief Bank (Commerzbank 75%, Dr.                 a deterioration in the asset pool cover as long as lending to some of
Schuppli group 25%) have focussed on the international public               the weaker credits is avoided. Lending to public sector entities with a
sector lending business, which their parents have not been able to          risk weighting up to 20% would imply lending to public authorities
do out of Germany until the latest amendment of the German                  rated in a range between A+ to A- according to the new BIS
mortgage bank act. While the Luxembourg subsidiaries had                    proposals. If this ceiling is also respected beyond the EU, no
focussed on international public sector lending, the parent mortgage        deterioration in asset quality should result. See the table on the
banks refocused on the domestic and international mortgage lending          following page.
business out of Germany.
                                                                            Thus, the extension of public sector lending to all OECD countries
The specialist bank principle                                               would certainly lead to the inclusion of riskier assets into the asset
                                                                            pools than is currently the case in most other European ‘covered
The Luxembourg mortgage banks have been set up as specialist
                                                                            bond’ laws. The Luxembourg mortgage banks have therefore
banks with a narrowly defined scope of business activities under
                                                                            committed themselves to exclude the weaker OECD countries from
special banking supervision. The provisions on mortgage banks
                                                                            their lending activities. Under these conditions, the quality of the
have not been included in a new mortgage bank law but as a
                                                                            asset pool may even be strengthened from a pure credit perspective
separate chapter in the law on the financial sector. The Luxembourg
                                                                            via the diversification effect of including better diversified high quality
‘covered bond’ law departs from the general principle, which gives
                                                                            public sector assets.
Luxembourg banks the freedom to carry out any type of banking or
financial activity. By limiting the scope of business activities, the       Further, the law allows lending to or purchasing bonds from a credit
risks that could result from other types of activities are strongly         institution domiciled in the EU, the EEA or the OECD if this loan or
curtailed.                                                                  bond is itself guaranteed by claims on public authorities. This should
                                                                            open the way for Luxembourg mortgage banks to purchase other
The total amount of outstanding ‘lettres de gage publiques’ and
                                                                            European ‘covered bonds’ secured on public sector assets and
‘lettres de gage hypothécaires’ may not exceed 60 times the bank’s
                                                                            refinance these via ‘lettres de gage’. Luxembourg mortgage banks
capital. This puts an absolute limit on the amount of public sector
                                                                            have actually bought German Pfandbriefe as substitute collateral in
business that can be done. Theoretically there would be no limit if
                                                                            the startup phase to build up their cover asset pools. The mortgage
the mortgage bank purchased only zero risk-weighted public sector
                                                                            banks may also buy and sell securities, receive deposits, take out
                                                                            loans and engage in custodian business.
Credit quality of the cover assets
                                                                            Property valuation and loan-to-value ratios: The principles
The scope of business activities: The core business activities are          underlying the valuation of property are defined by law. The
mortgage and public sector lending. ‘Lettres de gage publiques’             mortgage bank has to estimate a ‘recovery’ value for the property,
(LGP) and ‘lettres de gage hypothécaires’ (LGH) will be secured on          which has to be calculated conservatively, only taking into account
public sector loans and real property from within the OECD area.            the durable characteristics of the property. Property used for
The Luxembourg law thus offers one of the widest geographical               residential, industrial, commercial and professional use can be used
scopes for the business activities of its mortgage banks among              as collateral. The loan to value ratio is fixed at a uniform 60% of the
European ‘covered bond’ laws. The motivation behind the                     estimated ‘recovery’ value of the property.
extension of the asset-side business towards the OECD area had
                                                                            Over-collateralization and Substitute collateral: There is no
been the exacerbated competition in public sector lending within the
                                                                            formal requirement for Luxembourg mortgage banks to hold over-
EU, which has eventually eroded the original margins in this
                                                                            collateralization. Over-collateralisation is also not explicitly protected
business. The limitation of asset-side business in most other

22                                                                                                                         Global Markets Research
04 March 2003                                                   The Market for Covered Bonds in Europe                                       Deutsche Bank@

by law but the provisions in article 12-8 (4) and (5). suggest that the                    Interest rate, currency and other market risks
Luxembourg law integrally protects nominal cover plus any available
                                                                                           Early prepayment: Currently, the mortgage banks active under
over-collateralisation until the last ‘lettre de gage’ has been paid
                                                                                           Luxembourg law only conduct the public sector lending business
back. While this provision seems to not entirely satisfy Moody’s
                                                                                           where the possibility of early prepayment can be ruled out.
analysts, we would regard it as relatively strong. Compared with
Germany, the Luxembourg mortgage bank law allows for a rather                              The definition of eligible and non-eligible business: Luxembourg
high 20% of substitute collateral within the respective asset pools.                       mortgage banks may also conduct a limited number of businesses
                                                                                           other than those associated with the issuance of ‘lettres de gage
Segregated assets or segregated asset pools
                                                                                           hypothécaires’ and ‘lettres de gage publiques’. These activities
The cover assets are comprised into two separate asset pools. The                          include the issuance of bonds that are not covered by the statutory
trustee has to control that the cover is effectively maintained at all                     cover used for the issuance of ‘lettres de gage’. To cover 100% of
times and that the cover assets are listed in a separate mortgage                          the necessary capital of a loan, the mortgage bank may issue bonds
register. A special trustee is proposed by the mortgage banks and                          to fund that part of the loan, which exceeds the 60% loan-to-value
appointed by the supervisory authority. He must have the                                   ratio. By its nature, this business is riskier than the issuance of
qualification of an auditor but is not allowed to be identical to the                      ‘covered bonds’. While Germany fixes a limit for this non-eligible
auditor of the bank.                                                                       business there is no limit in Luxembourg.
                                                                                           Currency risk: If the currency of the nominal amount or the interest
                                                                                           of the mortgage bonds (or both) differ from those of the cover

Eligibility criteria for public sector lending under Luxembourg mortgage bank statutes
                             Foreign Currency                                                             Risk                 Investment
                                  Rating                                 Membership                     weighting                 area

                                                 Standard &
          Country                 Moody's          Poor's   Fitch IBCA     OECD       EEA       EU       Basle I    Basle II      PBI       EEPK    EuroHyp
Australia                          Aaa              AA+         AA           x                            0%         0%            x          x
Austria                            Aaa              AAA         AAA          x         x         x        0%         0%            x          x        x
Belgium                            Aa1              AA+         AA           x         x         x        0%         0%            x          x        x
Canada                             Aaa              AAA         AA+          x                            0%         0%            x          x        x
Czech Republic                      A1               A-        BBB+          x                            0%         20%
Denmark                            Aaa              AAA         AA+          x         x         x        0%         0%            x         x         x
Finland                            Aaa              AAA         AAA          x         x         x        0%         0%            x         x         x
France                             Aaa              AAA         AAA          x         x         x        0%         0%            x         x         x
Germany                            Aaa              AAA         AAA          x         x         x        0%         0%            x         x         x
Greece                              A1               A          A            x         x         x         0%        20%                               x
Hungary                             A1              A-         A-            x                             0%        20%
Iceland                            Aaa              A+        AA-            x         x                   0%        20%           x                   x
Ireland                            Aaa             AAA        AAA            x         x         x         0%        0%            x         x         x
Italy                              Aa2              AA         AA            x         x         x         0%        0%            x         x         x
Japan                              Aaa             AA-         AA            x                             0%        0%            x         x         x
South Korea                         A3              A-          A            x                             0%        20%
Liechtenstein                      Aaa             AAA          -                      x                   0%        0%            x         x         x
Luxembourg                         Aaa             AAA        AAA            x         x         x         0%        0%            x         x         x
Mexico                             Baa2           BB+???      BBB-           x                             0%        50%
The Netherlands                    Aaa             AAA        AAA            x         x         x         0%        0%            x         x         x
New Zealand                        Aaa             AA+         AA            x                             0%        0%            x         x

Norway                              Aaa            AAA        AAA            x         x                   0%         0%           x         x         x
Poland                              A2             BBB+       BBB+           x                             0%        50%                     x
Portugal                            Aa2             AA         AA            x         x         x         0%         0%           x         x         x
Slovak Republic                     A3             BBB        BBB-           x                             0%        50%
Spain                               Aaa            AA+        AA+            x         x         x         0%         0%           x         x         x
Sweden                              Aaa            AA+        AA+            x         x         x         0%         0%           x         x         x
Switzerland                         Aaa            AAA        AAA            x                             0%         0%           x         x         x
Turkey                              B1              B-          B            x                             0%        100%
United Kingdom                      Aaa            AAA        AAA            x         x         x         0%         0%           x         x         x
United States                       Aaa            AAA        AAA            x                             0%         0%           x         x         x
Source: DB Global Markets Research, as of Nov. 18, 02

Global Markets Research                                                                                                                                       23
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                       04 March 2003

assets, the mortgage bank must use appropriate hedging techniques             Preferential claim and bankruptcy remoteness
to eliminate this risk. The residual sums resulting from those
                                                                              In the same amendment, some clarifications were provided
currency hedge contracts also have to be taken into cover.
                                                                              regarding the continued servicing of cover assets and ‘lettres de
Interest rate risk: There is no requirement to match maturities               gage’ in case of the bankruptcy of the mortgage bank. The creditors
exactly. Any disparities in maturities need, however, to respect the          of ‘lettres de gage’ and derivative holders have an absolute priority
‘cover principle’, which requires cash-flows to be matched over the           claim on the cover assets. The Luxembourg financial supervisory
lifetime of the bond in nominal terms. This provision is essentially the      authority would be in charge of the administration of the qualifying
same as in Germany and France. If the mortgage banks use interest             asset pools and associated ‘lettres de gage’ when the bankruptcy of
rate swaps to hedge interest rate risk, the residual sums from these          mortgage bank has been announced. In case of default of the
contracts have to be taken into cover. Luxembourg is, however,                mortgage bank, the asset pools are separated from the other assets
currently considering whether to require Luxembourg mortgage                  of the bank. The amended law assigns the task of the continued
banks to provide present value based coverage for the outstanding             servicing of the cover assets and the ‘lettres de gage’ to the
‘lettres de gage’. This would effectively lead to a compensation for          supervisory authority, which may name a new backup servicer,
the existing interest rate risk in the cover asset pools.                     which would be another ‘covered bond’ issuer within the EU, the
                                                                              EEA or the OECD and monitored by the competent authorities of
Liquidity risk: The law does not currently require backup liquidity
                                                                              this country. The law remains silent, however, with regard to the cost
facilities. In the presence of high interest rate risk, which is not
                                                                              associated with paying a servicing fee to the backup servicer and
limited yet in Luxembourg, a Luxembourg mortgage bank may
                                                                              who would have to pay for the related cost.
therefore theoretically be exposed to a larger liquidity risk than in
Germany where an absolute limit on interest rate risk has been                Legal protection of over-collateralisation
imposed. Since present value-based coverage has to be maintained
                                                                              We consider over-collateralisation to be integrally protected by the
at any time, existing interest rate risk is actually being compensated
                                                                              Luxembourg mortgage bank act. Even if the issue is not explicitly
                                                                              stated, it follows from Article 12-8 (5) and (6) that all outstanding
Limit on foreign lending activities: This is a problematic issue in           lettres de gage will be paid back at maturity and that any available
the case of Luxembourg. The unconditional respect of the priority             cover assets will only be made available to the unsecured creditors
claim of the creditor of ‘covered bonds’ on the cover assets is a key         after all ‘privileged’ lettres de gage creditors have been entirely
safety feature. While this issue is more important for mortgage               satisfied. Still, Moody’s does not recognise over-collateralisation in
lending, it may also become important for public sector lending if            Luxembourg to be legally protected and thus the lettres de gage do
there are conflicting claims on the cover assets abroad. To ensure            not benefit from a more favourable notching as is the case for Irish
that the creditors can actually enforce their claims on the assts, it is      Covered Bonds. However, there is no compulsory over-
important to limit the amount of foreign assets within the asset pools        collateralisation within the cover asset pools of Luxembourg
where the priority claim is not guaranteed. To take the potential risk        mortgage banks and there are no plans going in this direction.
of conflicting claims on the cover assets into account, the law opted
                                                                              Investment restrictions on available cash
for a broader definition of rights on real property.
                                                                              Luxembourg imposes clear restrictions on the potential investment
The underlying idea is to take the different legal provisions on how to
                                                                              uses for available cash. Surplus liquidity may thus only be invested
enforce the rights on real property in different countries into account.
                                                                              in high quality assets such as deposits with appropriate credit
While the current legal definition therefore seems to leave a lot of
                                                                              institutions, securities and claims on public authorities or debt
scope for interpretation, the mortgage banks are meant to interpret it
                                                                              instruments guaranteed by a public authority.
in a narrow way. In particular, they must ensure that only such
property is eligible for lending where, under the given national legal        Ratings
institutional frameworks, the absolute priority claim on the cover
                                                                              Luxembourg ‘lettres de gage’ are not rated by Moody’s but they
assets is guaranteed. The ‘covered bond’ creditor, however, has to
                                                                              have ‘AAA’ ratings from S&P and Fitch IBCA. The higher level of
rely on the mortgage bank to prove the effectiveness of this narrow
                                                                              risk, which potentially results from the wider geographical
                                                                              lending area could result in a narrower rating span above the
Taking derivatives into cover                                                 senior unsecured rating of German Pfandbriefe according to
                                                                              Moody’s. In a special comment on ‘lettres de gage’, Moody’s
Following the 22 June 2000 amendment, Luxembourg mortgage
                                                                              indicated that it would rate ‘lettres de gage’ a maximum two notches
banks are allowed to take derivatives into cover if these are
                                                                              above the senior unsecured rating of the issuing institution. As a
necessary for hedging the cover assets and/or liabilities. This
                                                                              result, none of the Luxembourg mortgage banks would obtain a
security mechanism is particularly important for ‘start-up’ mortgage
                                                                              ‘AAA’ rating from Moody’s. Therefore, the issuers have naturally
banks with comparatively small asset pools. This will prevent the
                                                                              opted for an S&P rating, which allows a ‘AAA’ rating via sufficient
unwinding of the derivatives linked to the cover assets or the ‘lettres
                                                                              over-collateralistation. There are currently three issuers of
de gage’ if the mortgage bank goes bankrupt. It provides no
                                                                              Luxembourg Pfandbriefe: Erste Europäische Hypothekenbank
protection, however, against the potential losses from the default of
                                                                              (EEPK), Eurohypo Luxemburg (EUHYP) and Pfandbriefbank
a derivatives counter-party.
                                                                              International (PBI). In order to maintain a very low risk profile, all
                                                                              three mortgage banks unilaterally excluded the weaker OECD
                                                                              countries from their lending activities, to include only high quality
                                                                              assets into their asset pools.

24                                                                                                                        Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe   Deutsche Bank@

Luxembourg ‘lettres de gage’ fulfil the criteria of the UCITS directive
article 22 (4). Thus, the investment limits for investment companies
for holdings in the bonds of one individual issuer can be raised from
5% to 25%. Simultaneously, compliance with the UCITS directive
also leads to favourable investment limits under the life assurance
directive raising the upper limit for investments in specific bonds
from 5% to 40%.
The compliance of Luxembourg ‘lettres de gage’ with the UCITS
directive also allows these bonds to obtain a preferential treatment
under the BIS rules with a 10% solvency ratio.
Some doubts remain about the future business strategy of
Luxemboug mortgage banks. Since the latest amendment of the
German mortgage bank act the geographical scope for the mortgage
lending activities of German mortgage banks has also been
extended. As a result, the relative strategic advantage of doing the
international public sector lending business out of Luxembourg has
been reduced. The convergence in European covered bond laws
raises the longer-term question, whether it will not be more
economical for the respective mortgage banks to concentrate their
activities in one country. The Luxembourg mortgage banks have
concentrated on higher margin but also lower volume business. The
Luxembourg mortgage banks have been operating profitably in this
niche without becoming big players in the market for Jumbo covered
bonds, where they are rather infrequent issuers.

Global Markets Research                                                                                     25
Deutsche Bank@                                          The Market for Covered Bonds in Europe                                         04 March 2003

                                                                               to restore the necessary over-collateralisation. The special
Spain                                                                          supervision clearly strengthens the security of CHs.
                                                                               While the issuers of CHs enjoy complete freedom of business, other
Since Spain introduced the ‘Ley del Mercado Hipotecario’ (Mortage
                                                                               European issuers of ‘covered bonds’ are severely restricted in the
Market Law) in 1981 and its subsequent amendments, any credit
                                                                               scope of their business activities. The reduced scope of business for
institute regulated by the Bank of Spain has the right to issue
                                                                               specialised banks is typically meant to reduce the risk profile of the
Cédulas Hipotecarias (CH). For a long time, Spanish credit
                                                                               issuing entity.
institutes have made only limited use of this instrument as retail
deposits remained the preferred instrument of funding. In the recent           It might be argued that a universal bank may be exposed to a higher
past CH have become an increasingly important funding instrument               level of risk than a specialised mortgage bank and that this may be
for the large mortgage portfolios of Spanish banks since the cost of           the source of higher rating volatility.
unsecured funding has gone up. As a result, Spanish issuers have
                                                                               Where the ‘covered bonds’ rating is linked to the standalone rating of
been issuing increasing amounts of CH over the last two years.
                                                                               the issuer, the likelihood of changes in the stand alone rating is
    Issuance of Jumbo format bonds (in EUR bn)                                 critical. Even if the special legal structure around German, French or
                                                                               Irish covered bonds theoretically insulates them from changes in the
                                      2000    2001      2002     2003*         senior unsecured rating of the parent, Moody’s still establishes a link
    Cédulas                             2        7        15      18           between both contrary to Standard and Poor’s. Thus, even if such
    Luxembourg Lettre de Gage         1.25     0.5         1      1.5          specialised institutions such as the German mortgage banks may
    Obligation Foncières               6.5     7.5       4.95     5.5          have a lower risk profile, they are also typically owned by a larger
    US_Agency                          10       15        15      15           universal parent bank. Thus, in practice under Moody’s rating
    German States, KFW, EIB            9.7     34.7      41.5     49           approach, the standalone rating of a German mortgage bank owned
    Pfandbriefe                       86.4     65.1       48      44           by a universal bank would be equally affected by any erosion in
    Irish Covered Bonds                 -        -         -       4           universal bank’s rating, as would be the standalone ratings of the
    Total                            115.85   129.8     124.5     137          issuer of CHs. In both cases, a downward adjustment in the
                                                                               standalone rating of the owner of the mortgage bank just as the
The internationalisation of the Cedulas Hipotecarias market also               issuer of CHs would have an impact on the ratings of the ‘covered
benefitted from some longer-term structural changes in the Spanish             bonds’ as well as on CHs. As a result, in recent year’s the rating
market. Since the introduction of the euro in 1999, the market has             volatility of German Pfandbriefe has even been higher than that of
undergone significant changes. In particular, the changes in the               Spanish Cedulas Hipotecarias even if the structure of the Pfandbrief
taxation of non-resident dividend, interest and other income have              should theoretically insulate it to a large degree from changes in the
made the Spanish market more attractive for foreign investors. Law             senior unsecured rating of its parent.
41/1998 of 9 December 1998, on the income of non-residents,                    Limit on outstanding Cédulas Hipotecarias: There is no limit on
clarifies that the income from securities issued in Spain received by          the total amount of outstanding CH, except for the limits implied by
non-resident natural or legal persons without a permanent                      the legally required amount of over-collateralisation.
establishment shall be considered free of tax. The abolition of such
hindrances to foreign purchases of Spanish bonds and the start of              The credit quality of the cover assets
issuance of CHs under the successful Jumbo format has made it                  Scope of business activities: While the issuers of CHs may
possible for the Spanish ‘covered bonds’ market to develop                     engage in all kinds of financial activities, CHs may only be backed
internationally. A number of bonds, some with particularly interesting         by domestic mortgage loans since mortgages need to be registered
structures, have been issued such as the Macro Cedulas and more                in Spain. At the end of 2002 Spain passed a new financial law,
recently the new Cedulas Territoriales.                                        which introduces a new instrument, ‘Cédulas Territoriales’ (CT). The
The specialist bank principle                                                  CT are secured on domestic and European Economic area public
                                                                               sector loans. The outstanding amount of CTs should not exceed
Spain is one of the few countries where ‘covered bonds’ are not                70% of its public sector loan portfolio, implying a high 43% minimum
issued by specialised credit institutions. Any credit institution              level of over-collateralisation. Still, the projected characteristics of
regulated by the Bank of Spain may issue Cédulas Hipotecarias                  CTs imply that the credit worthiness of CTs would still be linked to
(CH). The Bank of Spain has far-reaching powers to intervene and               that of the issuer because there is no mechanism in the law, which
can prevent the issuance of CH if a breach of regulations is                   ensures timeliness of payment.
                                                                               Property valuation and loan-to-value ratios: Eligible mortgages
Such a situation may, for example, emerge if the amount of                     must be first mortgages on property wholly owned by the mortgagor.
outstanding CHs exceeds 90% of eligible mortgages. In this event,              Loan-to-value ratios of 70% for commercial and 80% for residential
the issuer will have to re-establish sufficient collateral before issuing      (construction, restoration and acquisition of housing) mortgage
new CHs. Alternatively, the issuer could                                       lending are applied to the ‘appraisal value’ based on the criteria as
-      deposit cash collateral or government bonds with the Bank of            set out by the Spanish Ministry of Economy and Finance. The Bank
       Spain within 10 working days,                                           of Spain will check that the property is valued according to the legal
                                                                               criteria. Property valuation is often conducted by external surveyors.
-      buy back / amortise early outstanding CH,
-      add new qualifying mortgages

26                                                                                                                          Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                        Deutsche Bank@

The quality of the cover mortgage pool is subject to changes over             circumstances, it is critical for the holder of CHs that interest rate
time. The dynamic nature of the business implies that new assets              mismatches within the collateral be limited. Compared to European
will enter the mortgage pool while others may be sold.                        ‘covered bond’ laws, where the collateral pools will be continued
                                                                              beyond the default of the issuer, interest rate mismatches put the
Segregated assets or segregated asset pools
                                                                              CH creditors more at risk.
The eligible assets, which serve as collateral for the creditor of CH,
                                                                              Limit on foreign lending activities: This issue has become more
are not separated from the other assets on the balance sheet. The
                                                                              relevant since the introduction of Cedulas Territoriales, which can be
outstanding CH are backed by the total mortgage pool of the issuing
                                                                              secured on non-Spanish assets. This issue is still not relevant for
bank after deducting the parts assigned to both ‘bonos hipotecarios’
                                                                              Cedulas Hipotecarias, which are secured exclusively on Spanish
and ‘participaciones hipotecarias’. Since there are no separate asset
pools, which would need to be surveyed, there is also no trustee.
                                                                              Taking derivatives into cover: Since the collateral used to cover
Interest rate, currency and other market risks
                                                                              CH is not separated from the balance sheet and is not continued in
Cover principle: Spanish law does not fulfil the cover principle.             case of default of the issuer, there is equally no need to continue
There are no formal requirements that the cash-flows, including               any derivative hedge contracts after the default of the mortgage
interest and principal need to match over the lifetime of the CH.             bank. In the event of bankruptcy both assets and derivative hedges
Thus, interest rate mismatches risk leading to a higher severity of           would have to be unwound.
loss, if the assets had to be liquidated early in the event of a default
                                                                              Preferential claim and bankruptcy remoteness
of the issuer.
                                                                              The creditors of CH have a preferential claim on the eligible assets
Early prepayment: While borrowers will retain the right of early
                                                                              in the pool after deduction of parts assigned to ‘bonos hipotecarias’
prepayment, prepayment penalties will be different depending on the
                                                                              and participaciones hipotecarias’ and rank behind other minor claims
maturity of the loan and will usually be fixed in advance since the
                                                                              such as workers’ last 30 days of salaries and certain tax liabilities. If
borrower would otherwise have the right to prepay without penalty.
                                                                              the covering assets are not sufficient to satisfy all the claims of the
While prepayment penalties on fixed rate loans will typically be of
                                                                              creditors of CH, they rank pari passu with all other senior unsecured
the order of 2.5%, prepayment penalties on variable rate loans will
                                                                              creditors for the remaining assets on the balance sheet.
be in the order of 1%. The most popular mortgage product on the
Spanish market is variable-rate mortgages. Fixed-rate mortgages               It is important to note that the legal framework for Cédulas
account only for a rather small 5-10% of the overall market. Under            Hipotecarias does not provide it with a level of bankruptcy
these circumstances, early prepayment actually plays only a minor             remoteness as is the case for other European ‘covered bonds’.
role and does not introduce a risk to asset-liability management.             While the conservative LTV ratios and the amount of additional over-
Variable-rate mortgages will typically be linked to Euribor.                  collateralisation provide important security to the creditos of CH, this
                                                                              may not be enough in case of serious financial distress. In the case
The definition of eligible and non-eligible assets: Only mortgage
                                                                              of a default of the issuing bank, the covering eligible mortgage
loans, which fulfil the conservative valuation criteria and loan-to-
                                                                              assets will remain on the balance sheet of the bank together with all
value ratios can be used as collateral for the issuance of CH. Other
                                                                              other non-eligible assets. Until the seniority of all claims to the
mortgage assets, which do not fulfil the stringent valuation and loan-
                                                                              bankruptcy estate has been established, a disruption in cash-flows
to-value ratio may, of course, coexist together with eligible bonds on
                                                                              to the holders of CH can occur. Thus, the creditworthiness of the
the issuer’s balance sheet.
                                                                              issuer has an important direct link to the rating of CH.
Currency risk: Since the issuers of CHs are currently only allowed
                                                                              Legal protection of over-collateralisation
to purchase Spanish domestic mortgages, there is no currency risk
in CHs. When Spanish issuers will start issuing CTs, which may also           Spanish banks may hold but are not required to hold additional over-
be secured on assets denominated in other currencies than the                 collateralisation beyond the legally required 11%. In practice, the
euro, this may change. The question of whether this potential                 amount of outstanding CH tends to be relatively small compared to
currency risk would have to be hedged is not regulated in Spanish             the total size of the eligible mortgage portfolio. As a result, over-
law and thus left to the discretion of the issuer.                            collateralisation well in excess of 100% is quite typical. Further,
                                                                              over-collateralisation will increase since the LTV is increasing as the
Interest rate risk: There are no special legal provisions, which
                                                                              respective mortgage loans mature. The CH creditor is therefore
would impose a limit on the amount of interest rate risk assumed by
                                                                              protected by a much higher amount of collateral than is suggested
an issuer with regard to the outstanding CH. The absence of any
                                                                              by the legally required 11%. However, the issuers is obviously not
formal requirement to limit maturity mismatches or to match cash
                                                                              required to maintain such a high level of over-collateralisation. An
flows implies an additional loss potential. If the issuer went bankrupt
                                                                              increased amount of CH issuance, partial securitisation of the
and the assets had to be sold to satisfy the holders of CH, interest
                                                                              mortgage portfolio or simply a deterioration in the credit quality of the
rate risk and early liquidation of mortgage assets, independent of
                                                                              mortgage portfolio can reduce the amount of available over-
market conditions, would incorporate the risk that the market value
                                                                              collateralisation to the minimum level of 11%. Since over-
of the mortgage collateral may not be sufficient to redeem the CHs
                                                                              collateralisation beyond the 11% level is neither legally required nor
at par. This is particularly important for CHs, since there are no legal
                                                                              legally protected, the investor can only rely on 11% over-
provisions in the Spanish law, which would require a continued
                                                                              collateralisation being actually available under all circumstances.
servicing of eligible mortgage assets and CHs beyond the default of
                                                                              Even if at a specific point in time over-collateralisation significantly in
the issuer and thus mitigate interest rate risk. Under these
                                                                              excess of 11% may be available, the creditor must be aware that it

Global Markets Research                                                                                                                               27
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                              04 March 2003

might be reduced by market conditions or a policy change by the               90% legal issuance limit, the more likely it will be that a discount
issuer.                                                                       from the eventual sale of the loan portfolio affects the likelihood that
                                                                              the holder of CHs can be repaid at par.
                                                                              Both Moody’s and S&P see a potential conflict between the issuance
Both Moody’s and ‘Standard and Poor’s express concerns about the
                                                                              of CHs and the position of unsecured creditors. To the extent that
regulations governing the default of an issuer of CHs. Since eligible
                                                                              the priority claim of CH holders extends to the entire mortgage pool,
cover assets cannot be separated from the balance sheet of the
                                                                              an increased level of issuance of CHs could reduce the amount of
issuer in a default scenario, it seems straightforward to establish a
                                                                              assets, which would be available for recovery to the unsecured
link between the probability of default of the issuing bank and the
                                                                              debtors. The de facto subordination of the senior unsecured debtors
Cedulas Hipotecarias. Therefore, Moody’s argues that the rating of
                                                                              may put pressure on the issuers’ unsecured debt ratings. In general,
CHs can only be established on a case-by-case basis taking into
                                                                              Standard and Poor’s advocates a similar rating approach to CHs.
account the creditworthiness of the issuer and the quality of the
                                                                              Generally, they would allow CHs to be rated two notches above the
cover assets. The security mechanisms built into CHs suggest a
                                                                              senior unsecured rating, adding that the quality of the underlying
reduced severity of loss in a default scenario and justify, in Moody’s
                                                                              pools have to be examined on a case by case basis.
view, a rating for CHs that could exceed the senior unsecured rating
of the issuer by a maximum two notches. The issuer may decide to              UCITS
add further security mechanisms such as backup credit lines or
                                                                              Spanish CHs fulfil the criteria of the UCITS directive article 22 (4).
additional collateral that would have to be taken into account in the
                                                                              Thus, the investment limits for investment companies for the
rating attribution process. Moody’s argues that the new Cedulas
                                                                              holdings in the bonds of one individual issuer can be raised from 5%
Territoriales can be rated a maximum three notches above the
                                                                              to 25%. Simultaneously, compliance with the UCITS directive also
senior unsecured rating of the issuer. Again Moody’s would argue
                                                                              leads to favourable investment limits under the life assurance
that the rating can only be established on a case-by-case basis.
                                                                              directive raising the upper limit for investments in specific bonds
Moody’s justifies the better notching for CT compared to CH with the
                                                                              from 5% to 40%.
ample over-collateralisation for CT and the generally expected good
quality of the public sector loan book.                                       The compliance of Cédulas hipotecarias with the UCITS directive
                                                                              also allows these bonds to obtain a preferential treatment under the
The issuance of so-called ‘Macro Cédulas’ has been one way to
                                                                              BIS rules with a 10% solvency ratio.
address the rating agencies’ criticism of the legal provisions
governing the default of an issuer. Under this structure, the investor        Conclusion
does not purchase CHs directly but buys shares issued by the
                                                                              Spanish issuers have become increasingly important in the
Spanish securitisation vehicle (‘Fondo de Titulización’), which
                                                                              European covered bond markets with the issuance of Cedulas rising
would itself be secured by CHs. As the legal construction of the
                                                                              steadily in recent years. Since most of the issuers of Cedulas are
‘Fondo de Titulización’ makes it bankruptcy remote, it could be
                                                                              rated in the ‘AA’ area, most of them receive ‘Aaa’ ratings from
structured in a way such as to obtain a ‘AAA’ rating from Moody’s.
                                                                              Moody’s. Most Cedulas issues, with the exception of the AYTCED
To this end the Spanish savings banks, which have been the issuers            ‘Macro Cedulas’, are not rated by Standard and Poor’s.
of the CHs, provided a special EUR 601 m cash collateral line to be
able to pay interest on the ‘Macro Cedulas’ for six months or to pay            Moody’s ratings of Spanish Cedulas issuers
interest on the notional amount of the two biggest Cedulas (out of                                                           Moody's ratings
the 15) for two years. Apart from providing cash collateral, the                                                Cédulas
Spanish savings banks provide significant over-collateralisation in                                              Rating       Senior unsecured ratings
excess of the legally required 11%. The combined pool of mortgages              Banco Bilbao Vzcaya
serving as collateral for the ‘Macro Cedulas’ issue of EUR 2.05 bn              Argentaria (BBVSM)              Aaa           Aa2          Stable outlook
amounts to a total EUR 25 bn. The key advantage of this particular              Banco Espanol de Credito                                   Under rev. for
issue was, however, that Moody’s could apply the structured finance             (BANEST)                        Aa2            A1           downgrade
approach in rating this transaction while the issuers could still use           Caja de Ahorros y Monte de
CHs as a funding tool for their mortgage assets. The example of                 Piedad de Madrid (CAJAMM)       Aaa           Aa2          Stable outlook
‘Macro Cedulas’ shows the link, which exists between securitisation             Caja de Ahor. y Pen. de Barc.
techniques and ‘covered bonds’ and the increasing use that is being             (CAIXAB)                        Aaa            Aa2         Stable outlook
made of securitisation in this area.                                                                                       Struct. Fin.
Standard and Poor’s draws a clear distinction between the legal                 AyTCedulas (AYTCED)             Aaa       Rat.approach     Stable outlook
framework governing the issuance of CHs and the ‘covered bond’                  Source: Moody’s
legislation in Germany, France and Luxembourg. From the S&P                   Only the Cedulas issued by Banesto, a subsidiary of Santander
standpoint, the latter legal provisions regarding the issuer default          Central Hispano, are rated only ‘Aa2’, due to the weaker ‘A1’ senior
allow separation of the rating of the issuer from the rating of the           unsecured rating. Spanish banks have generally better resisted the
‘covered bonds’. In the case of Cédulas hipotecarias, it is not clear         global economic and financial crisis. Than their German
what will happen to the loan portfolio after the insolvency has               counterparts As a result, Cedulas ratings have proved
occurred. The lack of legal provisions suggests that, most likely,            overwhelmingly stable when the German Pfandbrief market was
acceleration of CHs can occur. This would imply an interest rate risk         negatively affected by a wave of downgradings. The strong and
for the holders of CHs. The closer the over-collateralisation is to the       stable performance of CH has raised the demand for this product

28                                                                                                                              Global Markets Research
04 March 2003                                       The Market for Covered Bonds in Europe   Deutsche Bank@

and facilitated the increased issuance activity. At a time when the
standalone ratings of the issuers have become increasingly
important for the pricing of Jumbos, Cédulas hipotecarias have
actually seen their spreads narrow relative to many of the German
private mortgage banks’ Jumbo Pfandbrief issues and relative to
Luxembourg Pfandbriefe.
Spanish issuers have come to play an increasingly important role in
the market for Jumbo format ‘covered bonds’ and their market share
has been going up steadily over the last few years. We expect
Cedulas issuance to continue to grow in the near future.

Global Markets Research                                                                                  29
Deutsche Bank@                                           The Market for Covered Bonds in Europe                                          04 March 2003

                                                                                definition). Substitute assets should be used only on temporary
Ireland                                                                         basis and may not exceed 20% of cover asset pool.
                                                                                Limit foreign lending where the priority claim of the Pfandbrief
The Republic of Ireland has enacted the “Asset Covered Securities
                                                                                holder is not guaranteed
Bill, 2001” on 18 Dec. 2001. The bill enables the introduction of the
new financial instrument in the Irish market. The Minister of Finance           Given the more risky nature of mortgage and public sector lending to
has signed a Commencement Order and the Act entered into force                  zone A and B countries, absolute limits have been fixed for the
on 22 March 2002. DEPFA ACS Bank has been the first issuer of an                inclusion of regular or substitution assets located in one of those
Irish covered bond.                                                             countries. For both mortgage and public credit institutions, the limits
                                                                                for regular cover assets and substitution assets situated in zone A
The specialist bank principle
                                                                                countries in relation to the total asset pool has been fixed at 15%.
As in most other ‘covered bond’ jurisdictions, the Irish confer the             The limit for zone B countries has been fixed at 10%. (Article 33 and
right to issue ‘covered bonds’ upon specialised credit institutions, so-        47 (2) (5))
called “designated credit institutions” (DCI). A special licence from
                                                                                Interest rate risk: The cover principle in combination with the
the supervisory authorities is required to carry out the activities of a
                                                                                requirement to continue the asset pools beyond the default of the
designated credit institution. The Irish law accords a special licence
                                                                                mortgage bank already provide a (low) level of protection against
for mortgage lending or for public sector lending (Part 3 Article 13.
                                                                                interest rate risk. However, an explicit limitation of interest rate risk
(1). (5)). A DCI needs to apply separately for registration as a
                                                                                or the requirement to hedge interest rate risk through appropriate
designated mortgage credit institution or as a designated public
                                                                                hedging techniques is necessary to prevent a disruption of cash
credit institution. However, a DCI may also apply for two licences
                                                                                flows from major fluctuations in interest rates in the remote event
and carry out both types of activity. Generally, DCIs will be allowed
                                                                                that an insolvent asset pool would have to be unwound early. Still,
to engage only in a narrowly defined number of business activities in
                                                                                even if appropriately hedged, significant amounts of interest rate
order to limit their overall risk profile.
                                                                                risks introduce an element of liquidity risk into the asset pool that
Limit on the amount of outstanding ‘covered bonds’:                             has to be taken into account.
Theoretically a ‘designated public credit institution’ faces no
                                                                                Interest rate risk is strictly limited in Ireland. A special regulation to
quantitative limit to its lending and issuing activities from a regulatory
                                                                                the law stipulates that the changes in the net present value of
standpoint, as long as it buys only zero risk-weighted public sector
                                                                                interest sensitive assets (inside and outside of the cover asset pool)
assets. In order to introduce some cautionary limit to overall lending
                                                                                and all interest sensitive liabilities under different yield curve
activities, a quantitative limit on issuance was imposed. The amount
                                                                                scenarios may never exceed 10% of the mortgage banks total own
of ‘public credit securities’ issued may not exceed the total liable
                                                                                funds at any time.
own funds by more than 50 times. Since mortgage lending by the
nature of the activity requires the use of liable own funds, no                 Liquidity risk: The legal limit on the amount of interest rate risk that
quantitative lending or issuing limit needs to be imposed.                      a designated credit institution may incur also alleviates any potential
                                                                                liquidity risk. Substantial duration mismatches raise the need for
Segregated assets or segregated asset pools
                                                                                future transitional financing to bridge the duration gap between
The cover assets are comprised into two separate asset pools. The               assets and liabilities. A distressed issuer may only obtain such
cover assets monitor (trustee) is obliged to check that the DCI                 transitional finance at prohibitive market conditions and thus expose
complies with the law in managing the cover asset pools. The                    the cover asset pool to a loss. Limiting the amount of interest rate
derivative contracts entered into to hedge the cover assets also                risk therefore contributes to limiting the amount of liquidity risk.
need to be entered into the register.                                           However, the Irish law also provides for the possibility to enter into
                                                                                hedge contracts designed explicitly as liquidity facilities. These
The credit quality of cover assets
                                                                                ‘liquidity hedges’ would then be treated in the same way as other
Scope of business activities: The mortgage and public sector                    ‘cover assets hedge contracts’. A designated credit institution will
lending activities of Irish ‘designated mortgage and public credit              itself decide whether it sees the need to enter into such hedge
institutions’ cover a wide geographical scope. ‘Designated mortgage             operations.
and public credit institutions’ will be able to include mortgage and
                                                                                Currency risk: Irish mortgage banks are not allowed to incur any
public credit assets from countries of the European Economic Area
                                                                                currency risk and have to employ adequate hedging techniques to
(EEA) plus assets from zone A and B countries according to the
                                                                                eliminate any currency mismatches. The currency of mortgage credit
European banking directive under narrowly specified conditions. In
                                                                                assets and each substitution asset included in the pool should be
our view, the wide geographical scope for the business activities can
                                                                                the same as the currency of the securities issued. (Article 32 (8) d
potentially introduce an excess credit risk compared to for example
                                                                                and article 47 (8) d). The geographical scope for the lending
the German or the French mortgage bank act. However, it is highly
                                                                                activities of European mortgage banks has increasingly been
likely that most mortgage banks operating under the Irish law will
                                                                                extended. Irish law provides designated credit institutions with a far-
submit themselves to some sort of self-limitation and exclude ‘risk
                                                                                reaching geographical scope for their lending activities. To the
countries’ from their lending activities.
                                                                                extent that cross-border lending increases but the funding remains in
Substitute collateral: The Irish law defines substitution assets as             the domestic or in a few major currencies, the need for currency
deposits with an eligible financial institution and Tier 1 assets (ECB          hedging increases and with it the exposure to counter-party risk from
                                                                                such currency hedges within the cover asset pools. More attention

30                                                                                                                            Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                       Deutsche Bank@

should therefore be paid to the importance of the derivatives                 into by the designated credit institution are treated in the same way
business as the international business grows.                                 as the other cover assets and will not be affected by the insolvency
                                                                              of the institution itself. Thus, the cover asset hedges can be
Property valuation and loan-to-value ratios: The regulatory
                                                                              continued beyond the insolvency just like the cover assets to
authority specifies requirements with regard to the valuation basis
                                                                              maintain the solvency of the cover asset pools under any
and methodology, time of valuation and any other matters that are
                                                                              circumstances. This is also important with regard to the limitation of
relevant for establishing a ‘prudent market value’ for the mortgage
                                                                              interest rate risk, as we have pointed out before. The use of
assets before applying the loan-to-value ratios. The mortgage loan-
                                                                              derivatives will mainly serve to hedge out any interest rate or
to-value ratio applied to this ‘prudent market value’ is 75% for
                                                                              currency risk.
residential property and 60% for commercial property. More
generally, the law requires the aggregate prudent market value of             Legal protection of over-collateralisation
‘mortgage credit assets’ and any substitution assets comprised in
                                                                              The Irish law does not formally require designated credit institutions
the pool to exceed the aggregate prudent market value of ‘mortgage
                                                                              to hold a certain amount of over-collateralization (OC). However, a
credit securities’. Further, for the first 12 months in respect of the
                                                                              regulation passed in 2002 provides legal protection for any existing
pool, the interest payable on the ‘mortgage credit assets’ and
                                                                              OC in the cover asset pools if the mortgage bank would default. The
substitution assets shall never be less than the interest payable on
                                                                              cover assets monitor would have the responsibility for maintaining
the ‘mortgage credit securities’ (Article 32 (8) C). The Irish law
                                                                              any amount of OC in the pool even in the event of an insolvency.
proves particularly strict with regard to the amount of commercial
                                                                              While the legislator does not require a designated mortgage bank to
lending permitted. The amount of ‘mortgage credit assets’ secured
                                                                              hold a specified fixed percentage of OC, it provides legal protection
on commercial property may not exceed 10% of the total ‘mortgage
                                                                              for any available OC.
credit pool’ including substitution assets (Article 31 (2)). The other
European mortgage laws do not impose any specific limit on                    Preferential claim and bankruptcy remoteness
commercial relative to overall mortgage lending. The perception is
                                                                              Preferential claim: We basically see two different models for the
that commercial mortgage lending is generally of a more risky
                                                                              way the priority claim of the secured bond holder may be formulated:
nature. This is also reflected in lower LTV ratios for mortgage
                                                                              the German and the French model. In Germany, the Pfandbrief
relative to residential mortgage lending for example in the French
                                                                              holders will have an absolute priority claim on the assets in the pool
mortgage bank law. Still, mortgage banks tend to be particularly
                                                                              but will rank pari passu with all other creditors with regard to the
active in the area of commercial mortgage lending such that a
                                                                              assets outside of cover asset pools or non-privileged assets. French
quantitative restriction for this type of lending should put Irish
                                                                              law not only gives secured mortgage bond holders a priority claim
‘designated mortgage credit institutions’ at a disadvantage relative to
                                                                              over the privileged assets (asset pool) but also over all other assets,
their German and French counterparts.
                                                                              which implies de facto subordination of all other creditors relative to
Limiting the amount of non-eligible business: The law also                    the holders of secured mortgage bonds. This provision confers an
requires that the total nominal amount of mortgage loans on the               extra degree of security to the bond holder since he does not only
balance sheet of a designated mortgage credit institution should              have the priority claim over the privileged assets in the pool but also
never exceed 80% of the ‘prudent market value’ of the mortgage                ranks first to the unsecured creditors.
property, which serves as collateral. (Article 31(1)). This requirement
                                                                              While this provision is theoretically an advantage compared with the
is economically similar to the German requirement that the
                                                                              German law, it is not likely to be so relevant in practice. French
unsecured lending in excess of the 60% LTV should not exceed
                                                                              mortgage banks (SCFs) have been constructed in a way that they
20% of the total mortgage assets. Thus, on average an Irish
                                                                              should have mostly cover assets on their balance sheet while the
mortgage bank should never provide mortgage credit in excess of
                                                                              non-eligible assets should be kept on the balance sheet of the
80% of the ‘prudent market value’ of the property – while
                                                                              parent bank. Therefore, the privilege for covered bond holders to be
simultaneously respecting the LTV ratios for the respective types of
                                                                              satisfied before any other assets have been paid back has little
real estate. The law thus effectively prevents too aggressive lending
                                                                              practical relevance. Since the SCF does not acquire any assets on
practices up to 1005 of the ‘prudent market value’ of the property
                                                                              its own initiative, the parent bank should only transfer any assets if it
and creates a safety cushion for the lender.
                                                                              gets a genuine funding advantage. While this is the case for
Trustee: Every DCI is required to appoint a qualified person as a             refunding via ‘Obligations Foncières’, the SCF will have no funding
cover assets monitor for the institution. A DCI may either appoint a          advantage for the non-eligible business relative to its parent bank for
cover assets monitor for each individual asset pool or one for both           the non-eligible business. Thus, it would logically make no sense to
asset pools. The cover asset monitor is appointed at the proposal of          carry significant amounts of non-eligible business on its balance
the DCI and approved by the supervisory authority. If the                     sheet. The Irish law is opting for the German model, which we do not
supervisory authority considers the cover assets monitor not to be            view as a disadvantage since the French ‘super-priority’ of secured
suitably qualified it may appoint a suitably qualified person.                mortgage bond holders should not be that relevant in practice.
Generally, the qualification requirements for a Irish cover asset
                                                                              Legal provisions regarding insolvency of the issuer: The Irish
monitor are higher than those in the current form of the German
                                                                              law provides a clear and detailed formulation of the servicing of the
mortgage bank act.
                                                                              privileged assets and liabilities in case of insolvency or default of the
Taking derivatives into cover                                                 mortgage bank. The claims of secured mortgage bond holders on
                                                                              the ‘cover asset securities’ and claims resulting from ‘cover asset
The Irish law requires derivatives to be taken into cover. The
                                                                              hedge contracts’ will still be valid and legally enforceable against the
derivatives contracts serving as hedges for the cover assets entered

Global Markets Research                                                                                                                             31
Deutsche Bank@                                            The Market for Covered Bonds in Europe                                        04 March 2003

‘designated credit institution’, which had issued the ‘cover asset               protected in the event of insolvency. This makes the Irish law clearly
securities’. Equally important, the Irish law states explicitly what will        one of the safest in Europe, which should also be underpinned by a
be done in case of potential or matured insolvency with regard to the            very favourable rating situation for Irish issuers. The Irish market in
cover asset pools. The Regulator may either name an ‘alternative                 itself provides little depth to generate new mortgage or public sector
service provider’ to perform the functions of the ‘designated credit             lending business. A more sizeable business activity out of Ireland
institution’ or locate a new parent entity or act itself as an ‘alternative      would therefore be mainly due to foreign big mortgage banks,
service provider’. Any fees or costs payable to any person in its                notably German mortgage banks such as DEPFA.
capacity as ‘alternative service provider’ will rank in seniority to the
claims of the holders of ‘cover asset securities’. The detailed
description of the terms and conditions of finding an ‘alternative
service provider’ is an advantage over the German mortgage bank
law, which leaves this issue much more open to legal interpretation.
Moody’s applies the fundamental approach to rating Irish covered
bonds. Due to the bankruptcy-segregation, covered bonds should
display a reduced frequency of default. Moody’s therefore rates Irish
covered bonds secured on public assets three notches and covered
bonds secured on mortgage assets two notches above the senior
unsecured rating of the issuing bank itself. Moody’s has however
indicated some flexibility in its rating approach if and where
designated credit institutions hold a certain amount of
overcollateralisation, which is, as we have pointed out, protected by
Irish law. Since the law also intends to protect any additional hedges
entered into to protect against liquidity risk, we might assume that
Moody’s would also react positively if a mortgage bank entered into
such a liquidity hedge by allowing for a wider notching spread over
the senior unsecured rating. Moody’s cites reduced credit, interest
rate and cash flow mismatching risk as key strengths of Irish
covered bonds. At the current stage, there is no local designated
credit institutions have any rating yet. German banks such as Depfa
has DCI status in Ireland.
The Asset Covered Securities Act, 2001 introduces for the first time
in Ireland the possibility for credit institutions to issue bonds, which
meet the criteria, set out under Article 22(4) of UCITS Directive. Irish
covered bonds fulfill all the criteria required by Article 22(4) of the
UCITS Directive. The Irish authorities have already notified the EU
commission that its ‘covered bonds’ fulfil the UCITS directive even
though no list of issuers has as been established yet.
The Irish mortgage bank law strikes a fine balance between an
increased level of flexibility on the asset side business and a
concern to limit the amount of additional potential risk from this
source. While the geographical extension of the lending area for
mortgage and public sector lending potentially introduces additional
legal and credit risk into the asset pools, the limitation of such
lending within the asset pools shows a concern to keep a high safety
standard within the asset pools. The provisions regarding the priority
claim of the ‘covered bond’ creditor, the continuation of the asset
pools in the event of the default of a mortgage bank, the requirement
to take derivatives hedge contracts into cover and the detailed
provisions regarding the appointment of an alternative service
provider are in line with the best and safest European ‘covered bond’
laws. More importantly still, the Irish law seems at the forefront with
regard to the planned regulations regarding the legal protection of
over-collateralisation and the introduction of liquidity facilities

32                                                                                                                           Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                        Deutsche Bank@

                                                                              claims on the assets of the ‘Pfandbriefzentrale’. Thus, there is no
Switzerland                                                                   non-eligible business on the balance sheet of the
                                                                              ‘Pfandbriefzentrale’. Since the non-eligible business, mostly the
Since 1983, Switzerland has had a general ‘Pfandbriefgesetz’                  unsecured mortgage loans in excess of the loan-to-value ratio, are
(‘covered bond law’). The system differs significantly from the               by their nature more risky, the absence of such loans would seem to
‘covered bond’ markets described in this publication. There are no            strengthen the security of the Pfandbrief creditors. Unfortunately, the
mortgage banks in Switzerland, which would issue Pfandbriefe in               cover assets for the Pfandbriefe are typically not on the balance
their own name. Instead, the legislator has given the privilege of            sheet of the ‘Pfandbriefzentrale’ but on the balance sheet of the
Pfandbrief issuance to two central institutes (‘Pfandbriefzentralen’),        member institutes. As the latter will also have other unsecured
which can issue Pfandbriefe to fund the mortgage backed loans of              liabilities there might be potentially conflicting claims, especially
their member institutes. The members of the ‘Pfandbriefzentralen’             since the creditor of a Swiss Pfandbrief does not have a legally
can be any domestic financial institution. Given the size of the Swiss        enshrined preferential claim on the cover assets.
market, the issuance activity of the ‘Pfandbriefzentralen’ is relatively
                                                                              Segregated assets or segregated asset pools
big. New issuance declined from CHF 5bn in 2001 to CHF 4.5bn in
2002. Pfandbriefzentrale (market share: 55%) and Pfandbriefbank               The Swiss Pfandbrief law requires both the ‘Pfandbriefzentrale’ and
(market share: 45%) hold a comparatively similar market share in              the member institutes to keep cover assets, which they may hold on
the Swiss Pfandbrief market.                                                  their balance sheet separate from any other assets. This is made
                                                                              possible by the requirement to register the mortgage cover loans in
The specialist bank principle
                                                                              a separate mortgage register. There is no trustee who would monitor
As noted above, there are no specialised mortgage banks in                    the registration of the cover assets. The correct registration is
Switzerland. The ‘Pfandbriefzentralen’ are essentially refinancing            however subject to regular controls. This task therefore falls upon
vehicles, which do not typically originate mortgage loans                     the supervisory authorities.
themselves. Instead, they refund the loans of their member institutes
                                                                              Interest rate, currency and other market risks
and get a claim on the mortgages, which secure those loans. The
member institutes instead are no specialised institutions but may             Cover principle: The Swiss Pfandbrief law fulfils the nominal cover
engage in any type of banking activity. Neither the                           principle, which requires the Pfandbriefe to be covered at all times
‘Pfandbriefzentralen’ nor the member institutes can be considered             by assets of at least equal nominal amount including interest.
as specialised mortgage banks nor are they subject to any special             Further, if the nominal value of the collateral is no longer sufficient to
legal supervision. The general supervisory authority checks annually          cover the Pfandbriefe, the member institutes have to provide
whether the ‘Pfandbriefzentralen’ comply with the legal provisions.           additional cover to restore nominal balance.
Limit on the amount of outstanding Pfandbriefe: The amount of                 Interest rate risk: The Swiss Pfandbrief and the Danish mortgage
Pfandbriefe issued should never exceed fifty times the liable own             bonds are the only ‘covered bonds’, which require an exact matching
funds of the ‘Pfandbriefzentrale’. This implies that Pfandbriefe issued       of maturities between ‘covered bonds’ and the cover assets. There
by a ‘Pfandbriefzentrale’ have to be covered by 2% of own funds.              is thus no interest rate risk in Swiss Pfandbriefe.
The credit quality of the cover assets                                        Early prepayment: It is mainly the member institutes, holding the
                                                                              cover assets, who face the risk of early prepayment on the mortgage
Scope of business activities: The ‘Pfandbriefzentralen’ are only
                                                                              loans. The ‘Pfandbriefzentrale’ however is only allowed to accept
allowed to engage in mortgage lending activities limited to the Swiss
                                                                              early prepayment if the member institutes simultaneously provide
territory. Particularly, they are not allowed to engage in public sector
                                                                              the ‘Pfandbriefzentrale’ with Pfandbriefe of the same characteristics
lending and may not acquire any foreign assets. This situation
                                                                              and the same amount. The risk of early prepayment is thus mainly
explains why European mortgage banks are particularly active in
                                                                              concentrated at the level of the member institutes and not at the
providing public sector finance to Swiss local governments. The
                                                                              level of the ‘Pfandbriefzentrale’.
limitation to Swiss mortgage lending allows for a high quality type of
mortgage assets, which is at the same time homogenous in quality              Currency risk: There are no provisions regarding currency risk,
and well diversified, which strengthens the quality of the Swiss              since Pfandbriefe can only be secured by mortgage assets situated
Pfandbrief.                                                                   in Switzerland and are thus free of currency risk.
Property valuation and loan-to-value ratios: The loan-to-value                Taking derivatives into cover
ratio is calculated on the basis of the market value of the mortgage
                                                                              There are no provisions, which would oblige the ‘Pfandbriefzentrale’
for which only the ‘durable’ characteristics of the mortgage may be
                                                                              or the member institutes to take derivatives into cover. To the extent
taken into account. The loan-to-value ratio is a maximum two-thirds
                                                                              that the maturities of Pfandbriefe and the underlying mortgage loans
of that market value in the case of residential property but can be
                                                                              have to match exactly, there is obviously only a very limited need for
lower depending on the nature of the pledge.
                                                                              the use of derivatives, notably swaps. Such a need would be more
Limiting the amount of non-eligible business: This would appear               pressing where significant maturity mismatches between assets and
as a major strength of the Swiss Pfandbrief system. Since the                 liabilities or significant time gaps between the contracting of a loan
‘Pfandbriefzentralen’ are not allowed to issue any other liabilities          and the eventual issuance of a same maturity Pfandbrief exist. In
than Pfandbriefe, the Pfandbrief creditors are the only creditors of          both cases, the need for the use of derivatives would naturally arise
the ‘Pfandbriefzentrale’. This is important in so far as the absence of       but neither situation characterises the Swiss Pfandbrief, where only
any unsecured liabilities implies that there can be no conflicting            mortgage loans are being contracted and maturities have to match.

Global Markets Research                                                                                                                              33
Deutsche Bank@                                         The Market for Covered Bonds in Europe                                    04 March 2003

Preferential claim and bankruptcy remoteness                                  Invalidity Pensions (BVG), pension funds are allowed to invest 75%
                                                                              of the assets in Pfandbriefe.
In the event of bankruptcy, claims secured by a pledge are settled
first from the proceeds from the realisation of the pledge. All
Pfandbriefe rank equal in the case of bankruptcy. However, the
Swiss Pfandbrief law does not provide Pfandbrief holders with a
specific legal preferential claim on the cover assets underlying the
Pfandbriefe to shelter Pfandbrief creditors from any conflicting
claims, which might arise for the proceeds from the sale of mortgage
collateral in the event of bankruptcy.
A strength of the Swiss system is, however, that the Pfandbrief
creditor not only has a claim on the mortgage bank as in most other
European jurisdictions but on the ‘Pfandbriefzentrale’ and on the
member institute. Only if both Pfandbriefzentrale’ and member
institute have become insolvent and if the security from the
realisation of the mortgage would not suffice anymore would the
Pfandbrief creditor be threatened with a loss. Even if the cover
assets need to be kept separate from the other assets there are no
provisions to continue to service assets and Pfandbriefe beyond the
default of the member institute, which originated the mortgage loan.
If the member institute went bankrupt, the cover assets would have
to be sold to satisfy the Pfandbrief creditors out of the proceeds of
the sale. This leaves open the theoretical possibility that the
proceeds from the sale of the assets may not allow to fully pay back
the Pfandbrief creditor at par. The legal framework thus does not
make the Swiss Pfandbrief bankruptcy remote contrary to the
German or French framework. However, Moody’s stresses the
possibility to split off the asset pool of a stressed member bank to
prevent a disruption of cash flows. If a member bank does not fulfil
its payments obligations via the Pfandbriefzentrale, the
Pfandbriefzentrale may then use the proceeds from the sale of the
cover assets to satisfy the Pfandbrief creditors
For a long time, Swiss Pfandbriefe issued by the two
‘Pfandbriefzentralen’ have not been rated. Since January 2002
Moody’s has rated the Pfandbriefe issued by Pfandbriefbank
Schweizerischer Hypothekarinstitute. Moody’s has assigned a ‘Aaa’
rating to all outstanding Pfandbriefe of Pfandbriefbank. The top
ratings are based primarily on the strong institutional framework
within which Pfandbriefbank operates. Moody’s considers the
probability of default associated with Pfandbriefbank’s ‘covered
bonds’ as negligible considering 1) the high quality of the collateral
for the loans made to the member banks, 2)some over-
collateralisation, 3)a large and diversified pool of borrowers and
4)legislation allowing the splitting off of the asset pools of stressed
member banks to prevent a disruption of cash flows from the pools.
Pfandbriefzentrale der Schweizerischen Kantonalbanken ist not
rated by Moody’s or S&P.

Since Switzerland is not part of the European Union compliance with
the UCITS directive may not appear like a relevant issue. However,
Swiss Pfandbriefe may still not fulfil the criteria laid down in article
22 (4) of the UCITS directive. Nevertheless, in Switzerland on the
basis of the Federal Act on Old Age and Surviving Dependents and

34                                                                                                                     Global Markets Research
04 March 2003                                           The Market for Covered Bonds in Europe                                     Deutsche Bank@

                                                                               Austrian case since there are no provisions to continue the asset
Austria                                                                        pools in the event of the default of the mortgage bank. The absence
                                                                               of a clear limit on interest rate risk and the lack of a legal
The Austrian mortgage bank law was established in 1938. The law,               framework, which would allow to continue the asset pools
with some revisions, is still in force. The Austrian mortgage law              beyond the default of the mortgage bank, definitely represent a
strongly resembles the German mortgage bank act.                               weakness of the Austrian mortgage bank act in comparison to
                                                                               other European ‘covered bond’ laws..
Specialist bank principle
                                                                               Currency risks: Austrian mortgage banks have to take adequate
Banks need a special licence granted by the national ministry of
                                                                               measures to eliminate any currency risks, if and where the currency
finance to engage in mortgage and public-sector lending. Mortgage
                                                                               of the cover assets and the Pfandbriefe are different.
and public sector backed ‘covered bonds’ may be issued by the
Austrian Landesbanks and private banks. Austrian mortgage banks                Taking derivatives into cover
are equally subject to special banking supervision as most other
                                                                               The Austrian mortgage bank act does not allow taking interest rate
European mortgage banks.
                                                                               derivatives into cover. Thus, the cover hedges will be unwound in
The credit quality of the cover assets                                         case of default of the mortgage banks and may thus expose the pool
                                                                               to a loss, particularly in the case of significant interest rate
Scope of business activities: Besides the regular mortgage
lending business, mortgage banks may also grant loans to public
authorities in Austria, Switzerland and the European Economic Area             Preferential claim and bankruptcy remoteness
(EEA) but only to those authorities with a maximum BIS risk-
                                                                               The creditors of covered bonds enjoy a preferential claim on the
weighting of 20% according to article 6(1) of the council directive
                                                                               cover assets. In case of bankruptcy, the cover pools will be
89/647/EEC. The ‘cover principle’ requires Austrian mortgage banks
                                                                               liquidated and the Pfandbrief creditors will be paid back at par.
to make sure that the outstanding Pfandbriefe are covered by assets
                                                                               Depending on market conditions, the cover assets may have to be
of at least the same nominal amount.
                                                                               sold below par and the creditors may incur a loss if the assets are
Property valuation and loan-to-value ratios: The value of the                  not sufficient to pay back the Pfandbriefe. The Pfandbrief creditors
property on which the loan-to-value ratio applies should never                 rank pari passu with the other (unsecured) creditors of the bank.
exceed the resale value of the property. In the property valuation,            Since there is no legal provision for a continuation of the asset pools
only the durable, non-speculative aspects of the property may be               in case of default of the mortgage bank, the creditor is exposed to a
taken into account. The mortgage bank may issue guidelines for                 much higher risk from interest rate mismatching and potential losses
property valuation, which require the approval of the supervisory              from an early liquidation of cover assets.
authority. If the amount of collateral is less than required, e.g. due to
early repayment of loans, mortgage banks are obliged to take cash
or government bonds into cover to provide for sufficient collateral.           Austrian mortgage banks are subject to special supervision by the
                                                                               ministry of finance, which also assigns independent trustees to the
The loan-to-value ratio is fixed at 60% for both commercial and
residential mortgage loans. There is no explicit mention made of the
amount of substitute collateral. The use of substitute collateral is           Ratings
most likely meant to be of only temporary nature.
                                                                               The issuers of Austrian Pfandbriefe, the Landeshypothekenbanken
Segregated assets or segregated asset pools                                    are all, with the exception of Salzburg, majority-owned by the
                                                                               respective Länder (Federal States). Thus, all these issuers enjoy
Mortgage banks are required to maintain separate cover asset pools
                                                                               high senior unsecured ratings in the ‘AA+’ and ‘AAA’ area due to the
for mortgage Pfandbriefe and for public Pfandbriefe. In contrast to
                                                                               backing from the respective Länder.
Germany, a mortgage bank may have multiple cover asset pools
backing mortgage and public Pfandbriefe. This allows for the                   UCITS
possibility to fund individual real estate projects and to issue
                                                                               Austrian Pfandbriefe fulfil the criteria of the UCITS directive article
individual Pfandbriefe against these assets. An asset pool may thus
                                                                               22 (4). Thus, the investment limits for investment companies for the
be tailor-made to the type of mortgage asset in which an investor
                                                                               holdings in the bonds of one individual issuer can be raised from 5%
may be interested.
                                                                               to 25%. Simultaneously, compliance with the UCITS directive also
Interest rate, currency and other market risk                                  leads to favourable investment limits under the life assurance
                                                                               directive raising the upper limit for investments in specific bonds
Early prepayment: The borrower has the right to prepay on his
                                                                               from 5% to 40%.
                                                                               Market structure
Interest rate risk: While the cover principle requires Austrian
Pfandbriefe to be secured by assets of at least equal nominal value            At present, there are two private mortgage banks and eight
including interest over the lifetime of the Pfandbrief, there is not           Landesbanks, which issue mortgage and public-Pfandbriefe. The
explicit requirement to match maturities. As in the German mortgage            volume of ‘covered bonds’ outstanding has been stable over recent
bank act, duration mismatches might drive a wedge between the                  years and amounts to EUR 9.9 bn (October 2002), of which EUR
cover assets and the Pfandbriefe if the market moved strongly or if            3.96 bn are mortgage Pfandbriefe. Despite the very high ratings of
the curve started to shift. This is all the more important in the              Austrian Pfandbriefe, which is not least due to the strong senior

Global Markets Research                                                                                                                            35
Deutsche Bank@                                     The Market for Covered Bonds in Europe            04 March 2003

unsecured ratings of the ‘Landeshypothekenbanken’, there is hardly
any foreign participation in Austrian Pfandbriefe with a few minor
exceptions. Due to the lack of liquidity in individual Pfandbrief
issues, the market is almost exclusively domestic. Apart from the
‘Landeshypthekenbanken’, the Austrian mortgage banks, there is
also the ‘Pfandbriefstelle’, which is owned by the
‘Landeshypothekenbanken’ and can also issue Pfandbriefe for its
member institutes. A similar institutional role is played by the
‘Pfandbriefzentrale’ in Switzerland.

36                                                                                          Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                      Deutsche Bank@

                                                                              bonds has not yet been collected or if the amount of collateral is not
Finland                                                                       sufficient due to the early redemption of outstanding loans. The law
                                                                              does not specify the amount of substitute collateral permitted nor the
The new Finnish mortgage bank act came into effect on 1 January               time frame until it has to be replaced by regular collateral. Moody’s
2000. This aligned Finnish ‘covered bond’ legislation with the more           criticises the temporary nature of substitute collateral. Insofar as
recent trends in European ‘covered bonds’ legislation. But no                 asset pools are inherently dynamic, the fact substitution assets are
‘covered bonds’ have yet been isssued in Finland, which may be                no longer possible in an insolvent mortgage credit bank leaves cover
ascribed to the disappointing rating assessments for Finnish                  asset pools exposed to asset quality deterioration and/or repayment.
‘covered bonds’: The rating agencies criticise the lack of risk               Secondary activities must relate to the core business and also
mitigators regarding interest rate risk, cash flow mismatches and             require regulatory approval.
liquidity risk.
                                                                              Excess liquidity: Any available cash may only be invested into low
The specialist bank principle                                                 risk assets as defined by the law on credit institutions.
The new Finnish mortgage bank act enshrines the specialist                    Segregated assets or segregated asset pools
bank principle for mortgage banks. Finnish mortgage banks are
                                                                              Finnish mortgage banks have to keep two separate asset pools and
restricted to a narrowly defined number of business activities. They
                                                                              two separate registers for public and mortgage assets. The
are allowed to issue bonds covered by mortgages
                                                                              supervisory authority has to be kept informed on a monthly basis
‘kiinteistövakuudellinen joukkovelkakirjalaina’ or by public sector
                                                                              about the pool assets.
loans ‘julkisyhteisövakuudellinen joukkovelkakirjalaina’. Mortgage
banks will also be subject to special supervision to ensure that they         Interest rate, currency and other market risks
comply with the mortgage bank act. They will have to provide the
                                                                              Early prepayment: The right of the borrower to prepay on his loan
supervisory authority with information on cover assets on a monthly
                                                                              is not ruled out but the conditions for early prepayment shall be
basis. Most Finnish mortgage banks are affiliated with a larger
                                                                              settled between creditor and borrower.
universal bank parent.
                                                                              Interest rate risk: While the nominal cover principle requires
Limit on the amount of outstanding Pfandbriefe: There is no limit on
                                                                              Finnish covered bonds to be matched by assets of at least equal
the amount of outstanding covered bonds.
                                                                              nominal value including interest, this does not prevent interest rate
The credit quality of the cover assets                                        mismatches. Since the asset pools will be continued, however, the
                                                                              risk stemming from interest rate mismatches will tend to be
Scope of business activities: Mortgage banks may only in
mortgage and public sector lending or other activities closely related
to such business. Mortgage covered bonds will be secured on real              Currency risk: There is no mention of currency risk in the Finnish
property and public sector loans from within the EEA and the EU               mortgage bank act, even though the possibility to provide mortgage
respectively. A specificity of the Finnish mortgage bank act is the           loans to EEA member states potentially entails currency risks for
possibility to buy shares in housing corporations and use these as            Finnish mortgage banks.
collateral. These shares are quite liquid and provide the holder with
                                                                              Limit on foreign lending activities: A mortgage credit bank is
a direct claim on the real estate serving as collateral.
                                                                              prohibited from holding assets in any country outside of the EEA.
Cover principle: The covered bonds have to be secured by regular
                                                                              Taking derivatives into cover
or substitute cover assets of at least equal nominal value including
interest.                                                                     There are no provisions relating to the use and the potential risks
                                                                              from using derivatives to hedge cover assets.
Property valuation and loan-to-value ratios: A mortgage credit
granted may not exceed 60% of the ‘current value’ of the shares or            Supervision
real estate used as collateral. This uniform loan-to-value ratio
                                                                              Finnish mortgage banks are subject to supervision by the Financial
applies across the different types of mortgage collateral. The ‘current
                                                                              Supervisory Authority (FSA). The law does not foresee independent
value’ shall be assessed in accordance with good real estate
                                                                              trustees. Mortgage banks have to submit information regarding the
evaluation practice. To this end, the ministry may issue further
                                                                              collateral in the register on a monthly basis.
provisions regarding property valuation.
                                                                              Preferential claim and bankruptcy remoteness
Limiting the amount of non-eligible business: In excess of the
60% loan-to-value ratio, which applies to the mortgage credit                 Creditors of Finnish government bonds enjoy a preferential claim on
granted against the collateral used for the issuance of covered               the cover assets in the mortgage pool. Since January 2000, the
bonds, further credit may be extended. The total amount of credit in          asset pools will no longer be liquidated but will be continued until the
excess of the 60% LTV shall not exceed one-sixth of the total                 maturity of the outstanding covered bonds.
amount of mortgage credit granted. The amount of business, which
is not eligible for ‘covered bond’ financing is thus maintained at a low
16.7% of total mortgage loans. This is e.g. more restrictive than in          Moody’s would rate Finnish mortgage bonds backed by mortgage
the case of Germany (20%).                                                    assets up to one notch above the senior unsecured rating of a
                                                                              specific Mortgage Credit Bank and two notches for public sector
Substitute collateral: Substitute collateral may only be used
                                                                              loans. The rating of the ‘covered bond’ would typically be notched up
temporarily if sufficient collateral for the issuance of the covered

Global Markets Research                                                                                                                            37
Deutsche Bank@                                         The Market for Covered Bonds in Europe            04 March 2003

from the senior unsecured debt rating of the issuer. Since the new
law was passed, no Finnish covered bonds have been issued and
we do not expect a significant amount of issuance to come to the
market soon. Thus, there have not been any ratings assigned to
Finnish covered bonds. Still, given the design of the Finnish
mortgage bank act, we would have to expect Finnish covered bonds
to obtain strong ratings given the product standards set up in the
‘covered bond’ law.
Finnish covered bonds fulfil the criteria of the UCITS directive article
22 (4). Thus, the investment limits for investment companies for the
holdings in the bonds of one individual issuer can be raised from 5%
to 25%. Simultaneously, compliance with the UCITS directive also
leads to favourable investment limits under the life assurance
directive raising the upper limit for investments in specific bonds
from 5% to 40%.
Finnish covered bonds are also weighted at 10% for the solvency
Market structure
At the moment, there are three mortgage banks in Finland: OP-
Kotipankki (owned by the Cooperative banks´ group), Suomen
Asuntoluottopankki (owned by Sampo) and Suomen

38                                                                                              Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                     Deutsche Bank@

                                                                              Interest rate, currency and other market risks
Sweden                                                                        Cover principle: The mortgage bonds must be backed by claims on
                                                                              mortgage assets of at least the same nominal value, including
The Swedish mortgage bond market has considerable depth and is
the most liquid sector in the Swedish bond market after the
government sector. Mortgage bonds may be issued as bearer or as               Early prepayment: Mortgage loans may be prepaid before maturity
registered bonds. The mortgage institutions issue benchmark bonds             but the borrower must compensate the mortgage company for the
with bullet maturities up to five years. Floating rate mortgage loans         interest rate differential.
play an important role in the Swedish market alongside fixed rate
                                                                              Interest rate risk: Mortgage companies are not prohibited from
mortgage loans. Most of the Swedish mortgage companies are
                                                                              incurring interest rate risk. Since there are no provisions for a
affiliated to large universal bank groups. Nevertheless, the Swedish
                                                                              continuation of the assets in the event of bankruptcy, the sale of the
mortgage bond should not be considered like a ‘covered bond’
                                                                              assets may hinder the possibility of repaying creditors in the
as in most other countries presented so far. However, a new
                                                                              presence of substantial interest rate risk.
mortgage bank act is expected to come into effect July 1, 2004.
The new law would introduce mortgage bonds, which fulfil the                  Substitution risk: There are no restrictions on asset substitution,
criteria of the UCITS directive 22(4). The draft law includes the main        which is continuous in practice.
‘covered bond’ characteristics as they are present in the German,
                                                                              Limit on foreign lending activities: While lending activities remain
French, Irish and Luxembourg law.
                                                                              essentially domestic (75%), there are no legal restrictions to extend
Specialist bank principle                                                     credit beyond the national borders. This represents a potential risk to
Currently, Sweden has no special ‘mortgage bank act’. Mortgage
companies are regulated under the same general laws as other                  Preferential claim and bankruptcy remoteness
credit institutions. The bonds issued carry a risk weighting of 20% in
                                                                              There is no preferential claim of mortgage bond holders over the
contrast with other European covered bonds, which comply with the
                                                                              assets of the mortgage companies. The status of the mortgage bond
UCITS directive. There is also no special supervision.
                                                                              holders is, however, strengthened by the strict limitation of business
The credit quality of cover assets                                            activities of the mortgage companies and by the limitation of
                                                                              refinancing activities to the issuance of mortgage bonds and
Scope of business activities: Swedish mortgage companies may
extend credit secured on property such as house building,
commercial property, agriculture, maritime credit, undeveloped                The security of the mortgage bond creditor is thus wholly
building land, uncompleted buildings. While lending is, in practice,          represented by the strength of the issuing mortgage company’s
limited to the Swedish territory, there are no legal restrictions for         balance sheet and the quality of its assets. Since there is no formal
lending activities outside of the national territory. Mortgage                preferential claim on any particular asset on the balance sheet, all
companies also provide loans against guarantees given by                      mortgage bond creditors have an equally ranked senior claim on all
municipalities and local authorities. There is no distinction between         the assets of the bank. There are no provisions to continue the
bonds backed by mortgage assets or bonds backed by public sector              covering assets in the case of default of the mortgage company. It is
assets. All mortgage bonds have a senior claim on all assets of the           thus obvious that the Swedish mortgage bond is not bankruptcy
mortgage company, i.e. mortgage and public sector assets.                     remote and that the senior unsecured rating of the issuer and the
                                                                              quality of the assets on the balance sheet are critically important in
Property valuation and loan-to-value ratios: The LTV ratios vary
                                                                              determining the risk from holding a Swedish mortgage bond.
between mortgage companies but are usually 75% for private
housing. The lending limit for commercial lending is similar or slightly      Ratings
lower. The LTV limits are not fixed by law but by the company’s
                                                                              Swedish mortgage companies enjoy comparatively strong senior
articles of association. There are no legal provisions regarding
                                                                              unsecured long-term ratings between A1 and Aa3. The rating of the
property valuation but the mortgage company will establish the
                                                                              mortgage bank and the rating of the underlying mortgage bonds are
lending value according to the mortgage bank’s statutes.
                                                                              intrinsically linked. Since the legal framework does not provide the
Segregated assets or segregated asset pools                                   mortgage bond creditor with any privileged claim compared to any
                                                                              senior unsecured creditor of the mortgage company, mortgage
Since the mortgage bond creditor has no preferential claim on any
                                                                              bonds should not be rated above the senior unsecured rating of the
particular assets, there need not be any separation between assets
                                                                              bank. Close inspection of the quality of the issuer and the underlying
on the balance sheet. Consequently, there is no mortgage register
                                                                              assets on the balance sheet are thus the sole protection of the
nor, therefore, any trustees to oversee it. The balance sheets of the
                                                                              mortgage bond creditor in case of default of the mortgage bank.
largest mortgage companies are published on a monthly basis by
Statistics Sweden ( Individual balance sheets for the             UCITS
larger mortgage institutions are published quarterly on the respective
                                                                              The Swedish mortgage companies do not fulfil the UCITS directive
                                                                              article 22(4). The Swedish mortgage companies are not specialised
                                                                              mortgage banks subject to special legal supervision and the
                                                                              mortgage bond creditors do not enjoy a specific formal preferential
                                                                              claim on the cover assets.

Global Markets Research                                                                                                                           39
Deutsche Bank@                                        The Market for Covered Bonds in Europe            04 March 2003

The Swedish mortgage bond should not be considered a
‘covered bond’ market as in the other bonds presented in this
study. In practice, Swedish mortgage bonds thus need to offer a
much higher spread over swaps to investors than ‘covered bonds’.
However, if the legal council would approve the draft of a new
mortgage bank act on July 1, 2004, Swedish ‘covered bonds’ would
comply with the UCITS directive. In detail, the new law would require
(1) to keep separate cover asset pools for mortgage and public
sector lending, (2) a 20% limit is likely to be fixed for substitute
collateral, (3) the geographical lending area is likely to be the
European Economic Area (EEA), (4) the law is likely to require a
matching of interest rates and liquidity, (5) loan-to-value ratios are
expected to be fixed at 75% for residential and 60% for commercial
lending and 65% for farming, (6) in the event of insolvency of a
mortgage company both cover asset pools and derivative hedges
would have to be continued and last but not least ‘covered bond’
creditors would have priority claim over the cover assets. Moreover,
bonds issued previous to July 1, 2004 with the objective to finance
credit of the sort allowed within the cover asset pools should be
given the status of the new ‘covered bonds’.

40                                                                                             Global Markets Research
04 March 2003                                             The Market for Covered Bonds in Europe                                         Deutsche Bank@

                                                                                 Interest rate risk: The nominal ‘cover principle’, which requires
Poland                                                                           interest and principle of the outstanding bonds to be covered at any
                                                                                 time by the pool assets implies a weak form of interest rate risk
The Act on Mortgage Banks and Mortgage Bonds came into effect in                 limitation. There is, however, no explicit limitation in interest rate risk.
January 1998. The law was amended in 2002 and we will include
                                                                                 Currency risks: The Polish mortgage banks are required to
the most important provisions of the amendment in this article.
                                                                                 eliminate exchange rate risk, which may result if the currencies of
Specialist bank principle                                                        the cover assets and the ‘covered bonds’ do not coincide. Obviously,
                                                                                 this may only be the case for public sector lending.
Under the Polish mortgage bank act, only specialist mortgage banks
are allowed to issue ‘covered bonds’. The specialist mortgage banks              Limiting the amount of non-eligible business: Mortgage lending
are subject to special banking supervision and the scope of their                in excess of the 60% LTV is limited, as in the German law, due to
business activities is restricted.                                               the riskier nature of this type of lending. Two limits have to be
                                                                                 respected with regard to this type of lending. This type of lending (1)
The credit quality of the cover assets
                                                                                 shall not exceed six times the liable own funds (after the amendment
Scope of business activities: Polish mortgage banks are restricted               the limit was raised from two times to six times the liable own funds)
to a narrowly defined number of low risk activities concentrated                 and (2) shall not be higher than 30% (after the amendment the
around the two main business activities, which are mortgage and                  percentage was raised from 10% to 30%) of all outstanding
public sector lending. To this end, they may issue either ‘covered               mortgage loans.
bonds’ or unsecured bonds. Mortgage banks may also take
                                                                                 Taking derivatives into cover
participations. The participations taken should be limited however to
10% of the mortgage banks’ own funds. The mortgage lending                       After the amendment of the Polish mortgage bank act mortgage
activities are limited to the Polish territory. The implicit credit risk in      banks are explicitly allowed to use derivatives to hedge against
the Polish mortgage asset pools thus reflects the risk of Polish real            currency or interest rate risk. Derivatives can be taken into cover but
estate. Further, Polish mortgage banks may provide mortgage loans                the law requires however that the derivatives have to be counted
to the Polish government, the central bank, to EU member states                  within the 10% substitute collateral limit.
and a number of supranational institutions or any other public sector
                                                                                 Preferential claim and bankruptcy remoteness
entity carrying a guarantee from one of these institutions. After the
recent amendment to the law Polish mortgage banks may also                       In case of bankruptcy of a mortgage bank, the holders of ‘covered
provide public sector loans to Polish local governments under the                bonds’ have a preferential claim on the cover assets in the pools.
condition that the regional auditor of local government accounts                 The ‘covered bonds’ will not become due in case of default of the
testifies that the local government entity is able to pay back the loan.         mortgage banks and the asset pools will be continued until all
                                                                                 outstanding ‘covered bonds’ have been paid back. The possibility to
Property valuation and loan-to-value ratios: The mortgage banks
                                                                                 continue the asset pools in the case of default reduces the potential
have to observe the legal provisions on property valuation. The
                                                                                 risk from any interest rate mismatches.
recent amendment to the mortgage bank act has modified the
valuation rules to make them even more conservative. The                         Supervision
mortgage bank may conduct the valuation of the property itself or
                                                                                 The mortgage banks are subject to special supervision by the
may rely on an external valuation.
                                                                                 supervisory authority, which is the Polish central bank.
The loan-to-value ratio is limited to a uniform 60% for both
                                                                                 Trustee: A special trustee has to be nominated by the mortgage
commercial and residential real estate of the estimated value of the
                                                                                 bank, which must be approved by the supervisory authority. The
property. Before the amendment Polish mortgage banks were only
                                                                                 trustee has to ensure that there is, at all times, sufficient cover for
allowed to provide a mortgage loan up to 80% of the estimated value
                                                                                 the outstanding ‘covered bonds’ and that the cover is correctly
of the property. After the amendment a mortgage bank may provide
                                                                                 registered. The trustee has to provide the supervisory authority on a
credit up to 100% of the estimated value of the property.
                                                                                 monthly basis with information on the cover asset registers. The
Substitute collateral: The amount of substitute collateral may not               qualification and mandate of trustees are strictly regulated by the
exceed 10% of the total cover assets. Only cash, cash deposits with              mortgage law. Compared with the other supervisory authorities, the
the national banks and bonds according to §16 (1) can serve as                   trustee enjoys an important position.
substitute collateral.
Limit on the amount of outstanding ‘covered bonds’: The total
                                                                                 Polish ‘covered bonds’ fulfil the criteria of the UCITS directive article
volume of covered bonds outstanding is limited to 40 times the
                                                                                 22 (4). Thus, the investment limits for investment companies for the
equity of mortgage banks.
                                                                                 holdings in the bonds of one individual issuer could be raised from
Interest rate, currency and other market risks                                   5% to 25% if EU law is adopted in Poland. This would also
                                                                                 potentially open up the way to apply a 10% solvency ratio to Polish
Early prepayment: The borrower has the right to prepay on his
                                                                                 ‘covered bonds’.
loan. Mortgage banks may, however, contractually rule out the
possibility prepaying for a maximum of five years. If the mortgage               Market structure
loan extends beyond five years, the covered bond secured on
                                                                                 At present, there are four mortgage banks in Poland, the Polish
mortgages must be callable by the mortgage bank after five years.
                                                                                 branches of the German HypoVereinsbank, Rheinhyp, Nykredit A/S

Global Markets Research                                                                                                                                   41
Deutsche Bank@                                     The Market for Covered Bonds in Europe            04 March 2003

Poland and Bank Slaski SA. But more institutions in the process of
applying for a mortgage bank license.

42                                                                                          Global Markets Research
04 March 2003                                          The Market for Covered Bonds in Europe                                     Deutsche Bank@

                                                                              Preferential claim and bankruptcy remoteness
Czech Republic                                                                The creditors of Czech covered bonds enjoy a preferential claim on
                                                                              the cover assets. The liquidation of the issuing bank may not lead to
In the Czech Republic, a new mortgage bank act was passed in July
                                                                              the liquidation of the cover assets. There is, thus, the possibility to
1995 re-introducing the Pfandbrief style ‘covered bonds’ (hypotécní
                                                                              continue to service the cover assets and the covered bonds beyond
zástavní list).
                                                                              the bankruptcy of the bank even though it is not clearly stated how
Specialist bank principle                                                     this should work in practice.
Czech legislation did not limit issuance of covered bonds to                  UCITS
specialist banks, however. Instead, the Czech Republic created a
                                                                              As Czech “mortgage banks” are subject to special supervision and
special ‘covered bond’ law. Banks may apply for a special licence for
                                                                              due to the cover principle Czech Pfandbriefe fulfil the criteria laid
the right to issue ‘covered bonds’. Such banks will, however, not
                                                                              down in article 22 (4) of the UCITS directive.
only be subject to supervision by the Czech National Bank but also
special supervision by the Ministry of Finance. The special                   Market structure
supervision is also a necessary condition for ‘covered bonds’ to
                                                                              At present, there are nine banks that have acquired licences.
qualify for the UCITS directive article 22 (4).
The credit quality of the cover assets
Scope of business activities: Since the issuing banks are not
specialised mortgage banks, they are not subject to any restrictions
on their business activities. Only domestic mortgage property (and
not public sector loans) may serve as collateral for the issuance of
‘covered bonds’.
Cover principle: The ‘covered bonds’ have to be secured by regular
or substitute cover assets of at least equal nominal value including
Property valuation and loan-to-value ratios: There are no legal
provisions or rules with regard to property valuation. This is a major
weakness since the bank possesses substantial leeway to fix the
value of the property to which it will then apply the legally prescribed
loan-to-value ratio. The loan-to-value ratio is fixed at 70% for both
commercial and residential real estate. Apart from the regular cover
assets, the banks may hold up to 10% of substitute collateral. Only
cash, cash deposits with the national bank, public bonds and bonds
issued by the national bank may serve as substitute collateral.
Interest rate, currency and other market risks
Interest rate risk: The respect of the cover principle provides a
weak form of interest rate matching. No explicit limits are put on
interest risk exposure, however.
Currency risk: Since only Czech domestic mortgage assets may
serve as collateral, the mortgage lending activities under the law are
free of currency risk.
Taking derivatives into cover
There are no provisions to take derivatives hedges into cover. Since
the business is essentially concentrated on mortgage lending, we
would assume that interest rate risk exposure is potentially more
limited than in public sector lending.
Segregated assets or segregated asset pools
Banks are not legally obliged to hold a separate register for the
cover assets. They must, however, provide evidence in some way
about the coverage of its bonds. This requirement does not appear
particularly strict since there is no legal requirement for a trustee
who would check compliance with the legal provisions.

Global Markets Research                                                                                                                           43
Deutsche Bank@                                          The Market for Covered Bonds in Europe                                          04 March 2003

                                                                               Interest rate risk: Hungarian mortgage banks are restricted to
Hungary                                                                        mortgage lending using domestic mortgage assets as collateral so
                                                                               that the risk of interest rate mismatches should be relatively minor.
The Act on Mortgage Credit Institutions and Mortgage Bonds was
                                                                               Preferential claim and bankruptcy remoteness
passed in 1997. Since then, only a few minor changes have been
made to the law, which do not materially alter the major                       Both the quality and the bankruptcy remoteness of the cover assets
characteristics of the Hungarian ‘covered bond’ product as described           are relatively strong. In case of liquidation, mortgage bondholders
hereafter.                                                                     enjoy ‘super priority’ on all the assets of the mortgage bank. This
                                                                               means that they will also be satisfied ahead of the unsecured
The specialist bank principle
                                                                               creditors for the non-cover or non-privileged assets to the extent that
Banks issuing    ‘covered bonds’ are specialist banks. The Mortgage            their claims are not covered by collateral. The repatriation of loans is
Law limits the   scope of business activities of specialised mortgage          facilitated by the fact that only mortgage loans given on real estates
banks to a       narrowly defined number of business activities                on the territory of Hungary can be used as collateral. Unfortunately,
concentrated     around mortgage lending and mortgage bond                     the asset pool can be continued - but the law does not require it - by
issuance.                                                                      other mortgage or non-mortgage banks.
The secure nature of business activities is further strengthened by            Supervision
the role the government plays in the mortgage lending business. The
                                                                               Although the mortgage banks are subject to specific supervision, the
Mortgage Law allows state ownership in mortgage banks to be
                                                                               supervisory framework might be initially relatively weak. The merged
higher than in other commercial banks (see Law on Securities §12
                                                                               Hungarian Financial Supervisory Authority was established in 2000
(1)). Due to the political importance of and the high risks involved in
                                                                               and it still has to demonstrate its effectiveness in the field of
households lending, FHB, the first and strongest mortgage bank in
                                                                               specialised supervision. Mortgage banks are subject to quarterly
Hungary has been retained as state-owned. Therefore, covered
                                                                               interest rate risk reporting in Hungary.
loans issued by the FHB remain de facto risk free.
Moreover, mortgage loans provided by specialised mortgage banks
enjoy interest rate subsidies. Subsidies will even increase from 4.5%          Given the relatively weak position of the supervisory authorities, the
to 6% in 2001 in order to compensate mortgage banks for the cut of             role of the trustee increases. The Mortgage Law strictly regulates the
the gap allowed by law between collateral mortgage loan and                    trustees and also requires close co-operation between the trustee
mortgage bond interest rates from 1.5% to 0%. As the mortgage                  and the supervisory authorities.
market develops, more private banks enter the market and
                                                                               Market structure
implementation of the legal framework improves these second outer
protective layers gets less of an importance. The partial or total             The Hungarian market for mortgage bonds is still underdeveloped.
privatisation of FHB – once postponed in 1999 – and the gradual                At present, there are only two mortgage banks registered in
reduction of subsidies should be expected in coming years.                     Hungary: Land Credit and Mortgage Bank Ltd. (FHB) – a 100%
                                                                               state-owned specialised credit institution - and HypoVereinsbank
The credit quality of the cover assets
                                                                               Hungaria Ltd. - the Hungarian branch of Bayerische Hypo- und
The credit quality of the cover assets is also regulated in the                Vereinsbank AG, Germany. The state gives interest rate subsidy to
Mortgage Law of Hungary. Mortgage banks can issue bearer and                   loans provided by specialised mortgage banks. Therefore,
registered covered bonds. The issuers of covered bonds can                     increasing price competition in mortgage lending might inspire other
engage only in the mortgage business but not in public lending.                financial institutions to follow the example of OTP.
The main reason is that public sector lending is relatively                    Mortgage lending in Hungary has been developed from scratch. At
underdeveloped and risky in Hungary, due to the financial difficulties         the beginning, lending to household and small- and medium-size
and substantial financial independence of municipalities and public            enterprises was hindered by bad loans on banks’ balance sheets
enterprises. The quality of assets is also ensured by the fact that the        and the lack of collateral. In addition, slow registration of real-estate
technical rules of real estate evaluation are fixed in a legal provision.      transactions and liquidation procedures are among the reasons that
                                                                               the legislation enabling the creation of specialised mortgage banks
Moreover, the final evaluation of assets has to be approved by the
                                                                               failed to generate much interest.
Hungarian Financial Supervisory Authority (hereafter: PSZAF) The
cover principle of mortgage bonds is identical to that in the German           There have been 14 mortgage bonds issued by FHB since its
law. The amount of collateral should always exceed the total amount            establishment in 1997, with original maturities of 5 to 10 years. HVB
of principle and interest on the mortgage loan, and the loan-to-value          came to the market in 2001 only with two privately placed 5Y
ratio (LTV) of mortgages funded via covered bonds is limited to 60%.           mortgage bonds. In contrast with issuance patterns in the EU
Moreover, the substitute collateral – government or publicly                   member countries, nine out of the sixteen mortgage bonds issued in
warranted papers – can not exceed 20% of the total collateral.                 Hungary have floating rates.
Interest rate, currency and other risks
Early prepayment: Mortgage banks can (but they are not obliged)
by law exclude the possibility of early repayment of mortgage loans.

44                                                                                                                           Global Markets Research
04 March 2003                                            The Market for Covered Bonds in Europe                                     Deutsche Bank@

                                                                                of investors would also no longer buy the issues in the primary
Secondary market trading in European                                            market waiting for the price to decline after launch. To put an end to
                                                                                this ruinous competition for new issues and to ensure a smoother
‘Covered Bonds’                                                                 secondary market performance of new issues after launch and
                                                                                increasing number of new issues have been priced since using the
The market for Jumbo European covered bonds is characterised by
                                                                                ‘pot structure’. The pot system provides complete transparency for
a highly liquid secondary market trading. We estimate daily turnover
                                                                                the issuing bank, the syndicate banks and the investors. The
in the Jumbo covered bond market at EUR 10 bn. The average retail
                                                                                allocation can be conducted according to a pre-agreed modus. No
trading size lies between 10- 20 m. Between each other, market-
                                                                                price competition between syndicate banks to obtain investor orders
makers quote a minimum 15 m and they are obliged to not exceed
                                                                                since the fees are fixed. The performance after the launch is much
the bid/offer spreads shown below.
                                                                                better and particularly much more stable than for a retention
  Bid/offer spreads on the Jumbo market                                         transaction since the issue is priced to sell. The pot system allows to
                                                                                discover the true market price of the issue and thus prevents major
  up to 3Y                                       5 cents                        price fluctuations post launch.
  3-6Y                                           6 cents
  6 - 8Y                                         8 cents                        The number of new issues had declined in 2001 and 2002 as
  8 – 10Y                                        10 cents                       mortgage banks have increasingly been tapping outstanding issues
  15 – 20Y                                       15 cents                       both to improve transparency in the market by reducing the number
  above 20Y                                      20 cents                       of bonds and to improve the liquidity in individual tranches.
  Source: DB Global Markets Research                                            Mortgage banks have to observe the original discount rules when
Under the market making arrangements, a minimum three market                    they tap an issue. For an issue to be subject to the taxation rules of
makers must be nominated, which quote two-way prices within the                 a normal coupon bond, the original issue discount should not exceed
typical trading hours. Only straight bonds with a fixed maturity and            a certain pre-defined discount dependent on the maturity. See table
annual interest payment in arrears qualify as Jumbos.                           below.

Among end-investors, European investors largely dominate with a                   Original discount rule
75% share compared with 20% for Asia and 5% for US accounts. If
                                                                                  up to 2Y                                     1%
we look at the market by investor type, banks and investment funds
                                                                                  2 - 4Y                                       2%
account for the lion share. Pension funds have, however, become a
                                                                                  4 - 6Y                                       3%
very important investor group too. While insurance companies
                                                                                  6 - 8Y                                       4%
remain an important investor group, they have clearly become less
                                                                                  8 - 10Y                                      5%
important over time. Central banks only play a comparatively small
                                                                                  above 10Y                                    6%
role with a market share of less than 5%.
                                                                                  Source: DB Global Markets Research
If we differentiate the market making trading activities by trading
                                                                                Moreover, if an issuer taps one of its issues within a year of it first
platform, we see that the overwhelming share of trading is still done
                                                                                being issued and if the original issue price observed the original
via telephone trading (85%) while electronic trading via
                                                                                discount rules, then the bond may be tapped even if the original
EuroCreditMTS only accounts for a 15% market share.
                                                                                issue discount rules will then not be observed. After one year, the
We can also differentiate trading activity by maturity spectrum. There          bond may no longer be tapped unless the price falls within the
is a significantly higher amount of turnover at the longer end of the           discount limit indicated in the table above.
curve (longer than five years of maturity) than at the shorter end
(shorter than five years of maturity). Trading activity tends to be
most active in the more recent and thus more liquid issues. Since
more than 70% of overall Jumbo issuance in 2000 had an original
maturity of five years and longer the liquidity naturally is at the longer
end of the curve.
Primary market in European ‘covered bonds’
The banks active in Jumbo ‘covered bond’ market making are
typically also those who are active in the primary market. Until 2002
it had been customary that a small group of lead managers plus the
co-leads would manage a new issue by taking the issue on their
books and then selling it to investors (‘retention transaction’). A
group composed of three leads and seven co-leads were a common
syndicate group for the issuance of Jumbo covered bonds. Such a
primary selling group would assume the pricing risk that the new
issue may only be sold to investors below the purchase price. The
competition between investment banks for new issue mandates had
actually become so severe that the spread volatility of new issues
after their launch had become extremely high. An increasing number

Global Markets Research                                                                                                                             45
Deutsche Bank@                                      The Market for Covered Bonds in Europe            04 March 2003

The repo market for European ‘Covered
There is an active repo market in the most liquid European covered
bonds traded on the Jumbo platform. Active repo trading in covered
bonds is done either via telephone market-making between banks or
via electronic trading platforms (Broker Tec or Eurex Repo). Repos
in specific covered bonds may also be available on request in
smaller size in over-the-counter trading, with most banks active in
this market. Telephone market-making remains the dominant form of
repo trading in Jumbo covered bonds (almost 100%). Among the
Jumbo covered bonds, the most active trading remains concentrated
on German Jumbo Pfandbriefe (85%), ‘Obligations Foncières’
account for another 10% while Cedulàs hipotecarias and
Luxembourg ‘lettres de gage’ account for the rest.
Telephone market-making in Jumbos
There are market-maker arrangements for the most liquid Jumbos
with a minimum size of EUR 1.25 bn. For these bonds, market-
makers have to quote two-way prices for up to EUR 15 m with a 25
bp bid/offer spread. DEPFA has a special arrangement for four of its
Global Jumbo Pfandbriefe to be quoted on a 20 bp bid/offer. The
ready availability of Jumbo Pfandbrief collateral makes it trade
generally cheap in the repo market. In the smaller Jumbo issues
around EUR 500m, short squeezes are possible since market-
makers can easily be short a significant portion of an outstanding
issue. Unless a squeeze in a particular bonds causes market
makers to bid up a bond in the repo market, Jumbo Pfandbriefe
generally trade close to government bond general collateral in the
short-term up to two weeks. For maturities up to one month, Jumbo
Pfandbrief collateral will tend to be 2 bp cheaper than German
government bond general collateral. Most of the trading actually
takes place in the short maturities between Spot-Next until one week
The bigger Jumbo issues are typically used for hedging purposes
and trade more actively in the repo market. The average trading size
is around EUR 20 m but trades up to EUR 150 m are possible.
The repo market is by far dominated by banks (80%) mostly for
market making purposes. The mortgage banks themselves actually
play only a minor role in the repo market. Investment funds and
insurance companies account for the other 20% by repoing out their
stocks of Jumbo collateral.

46                                                                                           Global Markets Research
04 March 2003                                           The Market for Covered Bonds in Europe                                        Deutsche Bank@

                                                                               2001 and 2002 were particularly difficult years for German
Conclusions and Outlook                                                        mortgage banks
                                                                               The biggest European ‘covered bond’ market, Germany, was
Jumbo issuance should rise again in 2003 after a period of
                                                                               negatively affected by adverse market and rating trends in 2001 and
consolidation from 2001 until 2002
                                                                               2002. As a result, new issuance of Pfandbriefe dropped sharply in
In 2002, the Jumbo market entered a period of consolidation. New               2001 and was unchanged in 2002. (See table below.)
issuance of ‘covered bonds’ in the Jumbo format declined
significantly in 2002, primarily due to a sharp decrease in the                  Net issuance of Public Pfandbriefe turns negative while
issuance of Jumbo Public Pfandbriefe. At the same time, Spanish                  net issuance of mortgage Pfandbriefe remains strong (in
issuers continued to raise the issuance of Jumbo format Cédulas                  EUR bn)
Hipotecarias. The issuance of French and Luxembourg Jumbo                                  Redemptions                     Gross Issuance
‘covered bonds’ remained lacklustre in 2002. However, increased                            Mortgage                         Mortgage          Public
Jumbo issuance by public issuers, notably the German Federal                              Pfandbriefe Public Pfandbriefe   Pfandbriefe      Pfandbriefe
States, partially compensated for the decline in private mortgage                98           25              93               36              176
bank issuance. The year 2003 has already started on a very firm                  99           25             107               28              187
note with a strong increase in Jumbo format ‘covered bond’                       00           29             113               35              143
issuance. After a period of consolidation in the difficult year 2002, we         01           28             121               35              113
expect the market to grow again in 2003. With the Irish ‘covered                 02*          28             134               38              110
bond’ a new product has been launched in 2003. DEPFA ACS Bank                    03*          37             130               40               95
is likely to continue issuing significant amounts of Irish ‘covered
                                                                                 Source: DB Global Markets Research
bonds’ in the future providing liquidity for this new instrument. (See
table below.)                                                                  There are multiple reasons for the decline in Jumbo Public
                                                                               Pfandbrief issuance. First, the downtrend in German mortgage bank
  Jumbo format bond issues (in EUR bn)                                         ratings has reduced their competitiveness in the public sector
                                                                               lending business. Second, the larger public sector borrowers such
                                        2000    2001    2002    2003*
                                                                               as the German Federal States increasingly access the market
  Cédulas                                 2        7      15     18
                                                                               directly not least because they can obtain better funding in the
  Luxembourg Lettres de Gage            1.25     0.5       1     1.5
                                                                               capital markets than from the mortgage banks. Third, tighter interest
  Obligation Foncières                   6.5     7.5     4.95    5.5
                                                                               rate risk limits for German mortgage banks have further reduced
  US_Agency                              10       15      15     15
                                                                               their lending capacities. Fourth, the continuously tight spreads
  German States, KFW, EIB                9.7     34.7    41.5    49
                                                                               between ‘covered bonds’ and government bonds have reduced
  Pfandbriefe                           86.4     65.1   47.05    44
                                                                               investor appetite for the ‘covered bond’ product. In 2002,
  Irish Covered Bonds                     -        -       -      4
                                                                               redemptions have outstripped gross issuance of public Pfandbriefe
  Total                                115.85   129.8   124.5    137
                                                                               leading to a net reduction in the amount of outstanding public
  Source: DB Global Markets Research
                                                                               Pfandbriefe. Thus, German mortgage banks are not rolling over their
The conditions for a renewed strong increase in the issuance of                public sector loan portfolios, on an aggregate level, but are actually
Jumbo format bonds have actually improved markedly due to the                  cutting back their public sector loan business. This process is likely
dramatic deterioration in European public finances. The increased              to continue in 2003 albeit at a slower pace.
funding needs of European local governments will be funded to a                Private issuers lose market share to public issuers of Jumbo
large degree via the Jumbo market. The larger local governments,               format bonds
such as the German Federal States, are likely to satisfy their funding
                                                                               The relative market share of private and public issuers of ‘covered
needs directly on the capital markets. The acute need for funding is
                                                                               bonds’ has started to decline. The share of private mortgage banks
likely to provide European mortgage banks with better opportunities
                                                                               in total Jumbo issuance has dropped significantly from 68% in 2000
to expand their public sector lending business in 2003 but the
                                                                               over 54% in 2001 to reach 48% in 2002. Even public issuers of
deteriorated margin situation implies that mortgage banks are likely
                                                                               ‘covered bonds’, notably Landesbanks, have seen their market
to continue buying assets on a very selective basis. Again, the
                                                                               share decline even though their funding conditions have developed
better-rated mortgage banks are likely to obtain a disproportionate
                                                                               more favourably in the course of 2001 and 2002 than for the private
share of this business. In this environment, we would expect the
                                                                               mortgage banks. (See table below.)
downtrend in the public sector lending business to be stopped or at
least to slow down. Historically, public sector lending has always               Market shares by type of issuer (in %)
been the motor behind the issuance activities in the Jumbo market
and this is unlikely to change. Increased public sector financing                                                     2000           2001         2002
needs and increasing amounts of Jumbo issuance are however not                   Private mortgage banks               68%            54%          48%
likely to be accommodated at stable swap spreads particularly at a               Public Banks                         15%            11%           7%
time when the spreads between Jumbo ‘covered bonds’ and                          Zero risk-weighted issuers            8%            23%          33%
government bonds are historically tight.                                         Freddie Mac                           9%            12%          12%
                                                                                 Source: DB Global Markets Research

                                                                               The main rise in market share was realised by the zero risk-
                                                                               weighted issuers, which comprise the German Federal States and

Global Markets Research                                                                                                                                   47
Deutsche Bank@                                            The Market for Covered Bonds in Europe                                               04 March 2003

KFW. Freddie Mac has kept its market share relatively constant and                 10
continued as planned with its annual EUR 20 bn issuance                             9
Funding conditions of private issuers deteriorate relative to                       7
those of the public issuers                                                         6
The private mortgage banks experienced, on average, a much more                     5
pronounced deterioration in their funding conditions than the public                4
issuers of Jumbo format bonds. Investors have generally shown an
increasing willingness to pay a premium for public sector issuers
relative to the covered bonds issued by private mortgage banks.
(See chart below.)
  8-10Y private mortgage bank and zero risk-weighted                                Sep-01    Nov-01      Feb-02        M ay-02   Aug-02   Nov-02   Feb-03
  Jumbo issues (ASW spreads in bp)
                                                                                   Source: DB Global Markets Research
 20                  Zero risk-w eightedJumbo format issues
                     Private mortgage bank Jumbo Pfandbrief                      For most, but a handful of private mortgage banks, it has become
                                                                                 increasingly difficult to profitably operate in the traditional public
 15                                                                              sector lending business.
                                                                                 The prospective abolition of public guarantees for the German
                                                                                 Landesbanks will deal another blow to the private mortgage banks.
                                                                                 Lending to public banks has been one of the key drivers in new
                                                                                 public sector lending in recent years. The deterioration of margin
                                                                                 conditions in lending to public banks has already made it
     0                                                                           increasingly difficult for private mortgage banks to provide funding to
                                                                                 public banks at competitive conditions.
                                                                                 The relative performance of German, Spanish, French
  Sep-01      Dec-01       M ar-02     Jul-02   Oct-02    Jan-03
                                                                                 and Luxembourg ‘covered bonds’
  Source: DB Global Markets Research                                             The relative performance of German, Spanish, French and
Since early 2001, a widening asset swap spread differential has                  Luxembourg mortgage banks has been driven primarily by changes
appeared between Jumbo Pfandbriefe issued by private mortgage                    in the rating situation of the respective issuers and to a minor degree
banks and Jumbo Pfandbriefe issued by public banks. (See chart                   by the relative supply of new issues. The negative rating trend in the
below.) Margin conditions in the public sector lending business had              German private mortgage bank sector has actually been the key
already been difficult in 2000 but the deterioration in margin                   determinant behind the relative widening in asset swap spreads
conditions in recent years has made it even more difficult for private           between German and French or Spanish ‘covered bonds’. For those
mortgage banks to profitably operate in public sector lending.                   issuers, whose rating was lowered, the sharp decrease in Jumbo
                                                                                 Pfandbrief issuance could not stop asset swap spreads from
                                                                                 deteriorating in absolute terms and relative to other instruments.
                                                                                 French ‘covered bonds’ have outperformed strongly both versus
                                                                                 German and versus Spanish ‘covered bonds’. French issuers
                                                                                 profited both from their strong rating situation and from the relative
                                                                                 scarcity of French ‘covered bond’ supply. Spanish ‘covered bonds’
                                                                                 had outperformed versus German ‘covered bonds’ until mid 2002.
  Widening ASW spread differential between private and                           Since then, both German and Spanish ‘covered bond’ asset swap
  public issuers of Jumbo Pfandbriefe (8-10Y ASW                                 spreads have been moving very much in tandem. (See chart below.)
  differential in bp)

                                                                                   5-10Y average asset swap spreads for German French,
                                                                                   Spanish ‘covered bonds’ (in bp)

48                                                                                                                                   Global Markets Research
04 March 2003                                                 The Market for Covered Bonds in Europe   Deutsche Bank@

 20                                                                France
 18                                                                Germany
 16                                                                Spain
  Sep-01     Dec-01     M ar-02        Jun-02   Sep-02   Nov-02   Feb-03

  Source: DB Global Markets Research

The Luxembourg issuers have not been active with a large number
of benchmark issues recently. In the absence of fresh supply,
Luxembourg Jumbo ‘lettres de gage’ have played only a minor role
in the Jumbo market. Since the Luxembourg mortgage banks are all
affiliated with a German parent bank, their performance has been
linked essentially to the strength or the rating of the parent bank.

The structure of the industry
The dramatic deterioration in

Global Markets Research                                                                                            49
Deutsche Bank@                          04 March 2003

  Name             Title             Telephone            Email                 Location
Neil Ryden       An Analyst        44 20 7545 2083     London
Julia Cronan     Another Analyst   44 20 7547 2090   London
                                                                              Hong Kong

50                                                                            Global Markets Research
04 March 2003                                     Deutsche Bank@

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