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Where we stand on regulation of European mortgage bonds Back  
As the Asset Covered Securities Bill goes before the Dail, Judith Hardt looks at mortgage bonds in Europe and calls for greater transparency to help investors find their way around the new products in the new market.
Although the introduction of the Euro triggered the introduction of new laws on mortgage bonds all over Europe, countries have adopted different rules, consistent with their national needs and history. This has resulted in regulatory competition and brought about some very interesting developments. At European level, the EU rules on investment funds have become the legal benchmark of these reforms. However more transparency is needed to help investors find their way around the new products in the market.

Although there is no special EU legislation, mortgage bonds are regulated by the rules on investment funds. The 1985 UCITS Directive establishes a ‘single licence’ regime i.e. a passport for investment products to be sold throughout the Single Market on the basis of the approval in one member state. The Directive limited the funds’ investment possibilities into securities issued by a single issuer to 5 per cent. This limit quickly posed problems in highly concentrated markets, such as Denmark, and was amended in 1988 to allow investment funds to invest up to 25 per cent of their assets into mortgage bonds.

Article 22 (4) has become the EU benchmark for mortgage bonds

The increased investment possibilities were however limited to bonds, which were viewed as particularly secure. Article 22(4) of the 1988 UCITS directive therefore set out a number of criteria which these bonds had to meet:
• the bonds must have been issued on the basis of legal provisions to protect the holders of these bonds;
• they must be subject to special supervision by the public authorities;
• the sums deriving from the issue of these bonds must, according to the legal provisions, be placed in assets which provide sufficient cover for the liabilities deriving from the bonds for their entire duration;
• in the event of the insolvency of the issuer, the sums deriving from the issue of the bonds are used with priority to repay the capital and interest becoming due and;
• Member States must notify the Commission
• As a result of Article 22 (4), it is now recognised that the different types of European mortgage bonds share certain common characteristics.

The Directive requires member states to notify the European Commission of the issuers as well as the categories of bonds meeting the requirements. To date, a number of member states have done so. The member states have adopted various ways of informing the European Commission in previous years. After the European Central Bank recognised mortgage bonds that meet the criteria of Article 22 par. 4 as Tier 1 securities, information exchange became however more important especially as more and more countries introduced or reviewed legislation on mortgage banks and mortgage bonds.

Do we need a notification procedure?
Following the adoption of the Action Plan for the Single Market, modernisation of the UCITS Directives gained momentum. Initially, the Commission’s proposal foresaw the deletion of the notification procedure, which was viewed as outdated. The European Mortgage Federation argued against the removal of the notification procedure as the notification increases transparency in the market, both for issuers and investors. The Federation argued that the notification procedure in Article 20 should be modernised instead of being deleted, and that the information should be made publicly available.

The new proposals are currently pending before the European Parliament. At this stage, the principles laid down in Article 22 (4) are maintained and the notification requirement is clarified. The Commission will forward the notification to other member states together with any comments, which it considers appropriate. The Commission will also make the information publicly available. Finally, these notifications may be subject to an exchange of views within the Contact Committee. The new publicity procedure introduced by the 2001 UCITS Directive will substantially improve the transparency of markets and help investors compare the different products.

However, from the investor’s point of view, it is questionable whether this is enough to create a deep and liquid market. More standardisation would further improve liquidity and transparency in the market and would ultimately benefit the issuers as well.

Why capital adequacy rules are so important for European mortgage lenders
Both the Basel Committee on Banking Supervision (BIS) and the European Commission have issued their second consultation documents. The current review of regulatory capital requirements is of fundamental importance for mortgage lenders in Europe since, contrary to their American counterparts, the vast majority of their mortgage loans (over 98 per cent) remain on-balance sheet and are capital intensive (i.e. 50 per cent or 100 per cent weightings).

Europe’s mortgage lenders use a wide variety of methods to fund their mortgage loans. The most common method remains deposits, which fund approximately 62 per cent of the volume of residential mortgage loans outstanding. Mortgage bonds fund approximately 19 per cent of mortgage loans in the European Union. The introduction of the Euro has renewed the industry’s interest in mortgage bonds. Indeed deposit taking credit institutions find it increasingly difficult to attract deposits. There is therefore a need for standardised funding instruments, which allow lenders to fund themselves on Europe’s capital market. Mortgage bonds have emerged as the single biggest component of privately issued instruments, with approximately 18 per cent of the total volume of domestic bonds outstanding in the European Union.

The proposed treatment of mortgage bonds under current rules
According to EU law1, Member States are allowed to apply a 10 per cent weighting to mortgage bonds as defined by Article 22 (4) of the UCITS Directive. In principle, this rule was due to expire in December 1997. However, according to the solvency ratio directive, members states were allowed to maintain this weighting, ‘to avoid grave disturbances in the operation of their markets’. These exceptions had to be reported to the Commission. The situation today is that 10 countries allow the 10 per cent weighting for mortgage bonds.

The current rule is however unsatisfactory because of its provisional character and because it creates distortions of competition between the different member states. Indeed, it does not address the situation of credit institutions from member states (such as former EFTA member states) which cannot argue that the 10 per cent weighting must be ‘upheld’, to avoid grave disturbances in the operation of their markets.

Reacting to the Commission’s first consultative document on capital adequacy, the European Mortgage Federation stressed that the Commission should encourage the emergence and the standardisation of funding instruments in Europe. The Federation encouraged the Commission to extend the rule according to which mortgage bonds, attract a 10 per cent weighting.

Proposed treatment of mortgage bonds under new rules
In its second consultative paper of February 2001, the Commission has taken into account a number of features specific to mortgage credit in Europe, in particular it proposes to maintain the current 10 per cent weighting of mortgage bonds. This proposal is welcomed by the industry since it clarifies and harmonises the regulatory treatment of mortgage bonds across Europe. This uniform treatment further standardises European mortgage markets and it is also in line with the Commission’s policy to develop a deep and liquid EU capital market and to favour the emergence of privately issued instruments as opposed to sovereign debt.

It is however difficult to assess at this stage which calibration should be applied to mortgage bonds under the IRBA. It will be difficult to calibrate the probability of default since there have been no known defaults of mortgage bonds. Since mortgage bonds will attract a 10 per cent weighting under the revised standardises approach, it would be logical to allow a similarly favourable treatment under the IRBA.

Could the treatment of asset securitisation under the IRBA be applied to mortgage bonds? This seems unlikely. In the case of securitisation, considerations of risks are based upon the fact that there is no link between the issue and the originator (and therefore no possible recourse against the originator). This logic cannot be applied to mortgage bonds since they remain on the bank’s balance sheet.

Finally, under the IRBA, the Commission also proposes to apply a higher weighting to the rest of the loan book which has not been refinanced through the issue of mortgage bonds because it does not qualify as secure enough (i.e. portions of loans above the regulatory ceilings for loan-to-value ratios). The Commission argues that this is particularly useful in the case of specialised banks, which would find themselves with a high concentration of risks. The meaning of this paragraph is unclear since most mortgage bond issuing institutions may not fund loans above the regulatory LTV ceiling.

The current EU proposals should be welcomed since they clarify the prudential treatment of mortgage bonds. This measure, together with the improved transparency of the notification procedure will further help to standardise the treatment of mortgage bonds and improve transparency for investors.

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