Duebel Turkey Covered Bonds 06

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Information about Duebel Turkey Covered Bonds 06
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Published on November 23, 2007

Author: Samantha

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Slide1:  Covered Bond Fundamentals Turkey Housing Finance Workshop, June 30, 2006 Istanbul Hans-Joachim Dübel Finpolconsult.de, Berlin Structure of the presentation:  Structure of the presentation Covered bond choice Issuer types & characteristics Credit risk mitigation & management (collateral, cover pool) Interest rate risk mitigation & management (matching requirements Why choosing covered bonds?:  Why choosing covered bonds? Liquidity risk perspective Generate long-term source of funds (deposits are liquid, but callable), Tap liquid quasi-government bond market. Credit risk perspective Pierce corporate unsecured issuer rating ceiling, Mobilize mortgage assets on balance sheet for credit enhancement, Avoid public or third-party private guarantees. Interest risk perspective Match funds to reduce economic (and possibly regulatory) risk capital, Pass-through some or all interest rate risks to capital market investors, Deal with idiosyncratic interest rate risk (prepayments). Pricing perspective Closeness to government bonds creates funding cost advantages. Covered bonds & alternatives in pricing perspective – developed systems:  Covered bonds & alternatives in pricing perspective – developed systems Source: Euroweek/Structured Finance International: European Mortgages and the Capital Markets, October 2004. Swap Spread Differences RMBS and Covered Bonds Swap Spreads of 10 Year U.S. GSE Debt vs. Pfandbriefe in the Eurobond Market Source: Commerzbank Securities, Dresdner Kleinwort Benson, computations by Dübel. Emerging covered bond issuers are successful:  Emerging covered bond issuers are successful Source: European Mortgage Federation. New issuances of European covered bonds in billion Euros Covered bonds – basic variants & alternatives in risk intermediation perspective:  Covered bonds – basic variants & alternatives in risk intermediation perspective Covered bonds are backed by large pools of mortgages, which in the German and Danish case are revolving cover pools, Spain does not use cover pools (overcollateralization by eligible mortgage portfolio of issuer), Danish covered bonds transfer market risk 1-1 to the capital market (pool concept), while German and Spanish covered bonds allow for risk intermediation (portfolio bond concept). Bond instruments differ by the specificity of the mortgage cover enhancing the bond, the amount of market risk management by the issuer. Extreme forms: MBS has clearly specified loan pool cover and involves no market risk management by the issuer, often do without issuer credit support, Unsecured bonds are at the other extreme – the cover is implicitly the portfolio, the issuer is free in market risk management and supports credit fully. Structure of the presentation:  Structure of the presentation Covered bond choice Issuer types & characteristics Credit risk mitigation & management (collateral, cover pool) Interest rate risk mitigation & management (matching requirements Issuers – questions:  Issuers – questions Who is the issuer? Bank only, bank and finance companies Does the issuer Hold cover assets on his balance sheet? Transfer assets to an SPV/SPC guaranteeing/issuing the covered bonds? Issuer characteristics Required to be a specialist (e.g. special bank), or performing special functions? Only specific knowledge about issuance process? Issuer supervision Special supervision or general supervision (or no supervision)? Bank or capital markets supervisor? Solution I – Specialized funding vehicle with bank status:  Solution I – Specialized funding vehicle with bank status France, Finland, Norway, Sweden Source: Verband deutscher Pfandbriefbanken Solution II – Specialized banks without/with non-eligible business:  Solution II – Specialized banks without/with non-eligible business Austria (mortgage banks), Denmark, Hungary, Ireland, Poland Source: Verband deutscher Pfandbriefbanken Solution III – Universal bank with/without qualified covered bond license:  Solution III – Universal bank with/without qualified covered bond license Qualified license: Austria (public banks), Germany, Russia, Latvia, Slovenia, Slovakia Without qualified license: Bulgaria, Czech republic, Lithuania, Spain Source: Verband deutscher Pfandbriefbanken Turkey issuers:  Turkey issuers Both banks and mortgage finance companies can be issuers, Issuers hold mortgage assets on their balance sheets, issue covered bonds from balance sheets, No issuer licensing requirements, yet requirement to maintain ALM standards, Joint supervision of BDDK and CMB. Structure of the presentation:  Structure of the presentation Covered bond choice Issuer types & characteristics Credit risk mitigation & management (collateral, cover pool) Interest rate risk mitigation & management (matching requirements Credit risk - overview:  Credit risk - overview Covered bonds require high asset quality – MBS can cover a wider asset quality spectrum. Conditions are: Bankruptcy remoteness or segregation of assets in a defined pool or portfolio, Defined asset quality standards, Some degree of structuring. Covered bonds typical rating spectrum is a few ‘notches’ above the issuer ceiling. Greater bankruptcy remoteness allows for disconnect a la MBS. Credit risk – bankruptcy remoteness & integrity of the asset pool:  Credit risk – bankruptcy remoteness & integrity of the asset pool Questions: Can bondholder claims be satisfied from the assets without interference from the bankruptcy process of an issuer? Can mortgage assets be segregated (ring-fenced) to create a direct legal link to the bond? Do bonds have to be accelerated in the case of issuer bankruptcy? Solutions: Bankruptcy remoteness de jure - special bank, special purpose vehicle, Alternative: detailed regulation governing asset segregation, Acceleration in most emerging mkts, non-acceleration focus of modern laws (new German act). Turkey: Article 13 Capital Markets Act permits asset segregation, Acceptance by bank regulator (cf Banking Act) is assumed, strengthened by joint supervision structure, All options – acceleration (most likely) & non-acceleration. Credit risk – general asset quality criteria:  Credit risk – general asset quality criteria Questions: Which types of assets – residential only, or including commercial? Which minimum quality – collateral (mortgage) ex, first lien? Minimum disclosure over asset composition & quality? Types of substitute cover, inclusion of derivatives? Solutions: Covered bonds in Europe generally mix asset classes (small domestic markets), Mortgage collateral required; tight limits on land/unfinished; first lien generally required, Disclosure standards are increased, influenced by the MBS market, Derivatives generally included, if serving direct risk management purpose. Turkey: Residential only, tight limits on mixed collateral, Loans need to be collateralized by mortgages, Disclosure standards to be determined by board, Conditions for inclusion of derivatives specified. Credit risk – loan-to-value (LTV) limits:  Credit risk – loan-to-value (LTV) limits Questions: Which loan-to-value ratio – debt position LTV or total LTV limit? Which valuation method? Initial value or permanent value tracking? Solutions: Most legislations limit only the debt position LTV (some limit total LTV: DK, CZ). Valuation – split between open market value and sustainable mortgageable value Collateral value tracking to ensure greater dynamic collateral coverage has become widespread (Ireland, Sweden, UK HBOS) Turkey: Debt position LTV (75%, 50% on comm.) Open market value, collateral value tracking. German vs. Danish LTV concept Credit risk – cover pool structuring :  Credit risk – cover pool structuring Basic alternatives: Structured covered bonds (UK) Danish 1-1 system (80% total LTV) Cover pool includes Registered mortgage assets First lien up to x% (60%-80%, Tk 75%) LTV position, High asset quality (TK authorized housing). Registered derivatives E.g. interest rate swap, limits in TK case high (detail TBD), Net claims of counterparties to the cover pool are pari passu liabilities! Substitute cover Cash or liquid bonds, max in TK case 15%, Prepayment proceeds part of substitute cover, limit enforces reinvestment. Cover Monitor:  Cover Monitor Questions: Qualifications? Functions? Liability? Solutions: Bank or capital markets regulators, qualified experts, auditing companies, Function 1 - Trusteeship: compliance with law, authorize asset additions & removals, assure documentation (simultaneous access to bank files), reporting to regulator & issuer, whistle-blowing to regulator; Function 2 - Full cover audit: every 1-2 years, Either public law or private law liability; professional liability insurance in latter case. Splits of functions exist – e.g. full audit public, trusteeship private – to reduce costs. Turkey Private auditing company, All tasks as above, quarterly reporting to CMB, Professional liability insurance intended (not yet required). Structure of the presentation:  Structure of the presentation Overview over covered bond models Issuer types & characteristics Credit risk mitigation & management (collateral, cover pool) Interest rate risk mitigation & management (matching requirements) Questions:  Questions Static or dynamic matching requirements? Rules on maturity transformation risk/mismatch? What is the appropriate response to the presence of prepayment risk? Is a specialized and sophisticated asset-liability management structure necessary? Static and dynamic matching tests:  Static and dynamic matching tests Turkey by-law applies both types of tests. Only dynamic tests allow for proper risk detection in volatile interest rate context! Static matching tests Value of assets > (1+x%)*value of liabilities (Nominal Cover Matching). Weighted average yield on assets>liabilities (Yield Matching) Interest received > interest paid (Revenue Matching) Dynamic matching tests Net present value of assets > (1+x%)*net present value of liabilities. (Net Present Value Matching). Duration gap limit (difference in duration of assets & liabilities > - 3 months) X = excess cover ratio (see graph) The net present value test ensures that future cash flow gaps are detected:  The net present value test ensures that future cash flow gaps are detected Bank issues relatively long bonds to match funds, but at high interest rates. Static tests all signal OK! Dynamic net present value test discovers cash flow shortfall. Cash flows in the previous example:  Cash flows in the previous example Initial cash flow OK Future deficits warrant correction Mismatch: capital risk arising from positive maturity transformation is a typical concern:  Mismatch: capital risk arising from positive maturity transformation is a typical concern LDG: leverage duration gap – measures degree of mismatch in years. LDG>0 = positive maturity transformation A: mismatched lender funded with deposits vulnerable to interest rate shock. B: Matched lender: no capital risk, but also lower profit ! Negative maturity transformation – arguably the greater problem for covered bonds in Turkey:  Negative maturity transformation – arguably the greater problem for covered bonds in Turkey Issuer too optimistic about future interest rate trends, issues too long bonds. LDG < 0 in this case, as the duration of assets exceeds the duration of assets. Interest rates fall, but bonds cannot be called/prepaid. Negative maturity transformation can be detected by both the net present value test and duration gap values:  Negative maturity transformation can be detected by both the net present value test and duration gap values Covered bond bylaw limits negative duration gap to 3 months, to protect against negative maturity transformation risk. Prepayment risk could lead to particularly extreme negative maturity transformation risk:  Prepayment risk could lead to particularly extreme negative maturity transformation risk TK Law caps prepayment indemnities at 2%, which is marginal given potential gains. Through prepayments, the duration of assets shortens as the duration of liabilities remains constant. Result is severe negative transformation risk: French covered bonds disappeared in the 1980s in an interest rate risk situation similar to Turkeys (B). Lenders often react by funding with short-term liabilities and running mismatch (A). Better option: active debt maturity management. NPV stress test considerations:  NPV stress test considerations Turkey living in June 06 through 1 in 100 years interest rate shock event. What are the implications for stress test parametrization? Static or dynamic stress test? Static test would consider max yield curve shift, similar macro conditions (2-3 years?), Dynamic test would consider historic interest rate ‘volatility’, Static test better suited to deal with structural break June 06. Parallel yield curve shift or recognition of inversion?  lower volatility at the long-end, consider also deposit rates. TK government bond yields during June 2006 5% yield curve shift – implications for overcollateralization I:  5% yield curve shift – implications for overcollateralization I Stress test detects NPV matching shortfall of 9% (7%+2% excess requirement) 5% yield curve shift – implications for overcollateralization II:  5% yield curve shift – implications for overcollateralization II Lender to add 12% overcollateralization ! Close to Spanish mandatory levels (11%). Turkey: rules designed to limit maturity transformation risk:  Turkey: rules designed to limit maturity transformation risk Issuers are held to assess the prepayment risk content of their portfolios and estimate the expected duration of assets, Issuers must not incur negative maturity transformation risk ex-ante, i.e. the maximum allowable negative duration gap is 3 months, Dynamic testing, stress tests, facilitates the detection of negative maturity transformation risks and mispricing, The banking regulator may apply all other applicable risk management limits – esp. on positive maturity transformation – independently from the covered bond regulations. Turkey: covered bond risk management concept summary:  Turkey: covered bond risk management concept summary Issuers need to have suitable risk management systems in place, Derivatives are part of cover pool under specified conditions, Collateral values are tracked to ensure transparency of amount of cover, Dynamic matching tests (net present value, leverage duration gap) are added for additional safety, Lenders are held to assess the expected durations of their mortgage portfolios, which carry prepayment risk, BDDK supervises jointly with CMB. Covered bond capital requirements:  Covered bond capital requirements EU UCITS Directive allowed for 10%- weighting under certain conditions (bank issuer, special regulation, bankruptcy remoteness); otherwise 20%. Basel II regime to replace: Modified standardized approach – related to unsecured risk-weight (implicit notching, see chart), Foundation IRBA allows for PD model of issuer default (min = 0.03%), while LGD to be fixed at min 12.5%/11.25% (AAA rating). Modified standardized approach preferable for emerging market such as TK. END:  END Hans-Joachim (Achim) Dübel Finpolconsult.de aduebel@finpolconsult.de www.finpolconsult.de Managing prepayment risk with (covered) bond maturity corridors:  Managing prepayment risk with (covered) bond maturity corridors Principle: Assess expected duration of assets Either: Mix short-term and long-term covered bonds, or Introduce call option into covered bond (e.g. maturity 5 years, first call after 3 years), or Purchase hedges (never perfect). Result is a corridor of liability durations to match variable asset durations. Example Freddie Mac liability structure ca 1998

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