## _wp0720

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---

### Introduction
- Rapid mortgage growth driven by demand and supply factors: favorable macroeconomic conditions, falling interest rates, international diversification of investments, increased competition, decreasing interest rates, and low demand for corporate debt.
- Consequences and risks:
  - Funding risks: difficulty attracting deposits at low interest rates → need for alternative stable non-core-deposit funding.
  - Asset-duration lengthening from mortgage lending → liquidity and maturity risks.
  - Smaller banks face more acute funding risks due to fewer opportunities for stable non-deposit funding.
  - Increasing supervisory concern about credit risk of mortgage portfolios.
- Role of mortgage covered bonds:
  - Securitization via mortgage covered bonds mitigates risks related to mortgage lending by providing alternative stable funding and ALM tools for issuers and attractive risk/return for investors.
  - Securitization markets increase transparency by pricing portions of loan portfolios and providing market-based indications of underlying credit quality through liquid secondary markets.
- Analytical focus:
  - Evaluation of asset swap spreads as a tool to assess credit risk of jumbo (benchmark) European mortgage covered bonds.

### The European Mortgage Covered Bond Market: legal features and investor protections
- Legal/structural features:
  - Covered bonds secured against a pool of mortgages; investor has a preferred claim in issuer default.
  - EU issuance regulated by laws defining eligible assets and requirements.
  - Assets typically earmarked in separate cover pools; in some countries (e.g., Spain) all mortgages on issuer balance sheet act as collateral.
  - Cover principle: outstanding amount and interest claims must be covered by eligible cover assets.
  - Cover pool remains on issuer balance sheet; eligible assets are substitutable; cover pools are dynamic and of unlimited duration.
- Investor protections and lending implications:
  - Preferential claim on collateral and proceeds.
  - Reinforcements: LTV ratios, prudent property valuation (mortgage lending value), trustees or cover asset monitors.
  - Benefits: reduced borrowing cost relative to other wholesale sources; enables medium- or long-term finance for housing/non-residential property.

### Jumbo Covered Bonds: market transformation, features, and size
- Jumbo model features (European standard):
  - Minimum size = Euro 1 billion.
  - Plain vanilla bonds (fixed coupon, paid annually in arrears).
  - Buybacks allowed.
  - Must be officially listed on an organized market.
  - At least 3 market makers quoting bid/ask prices simultaneously.
- Market size and concentration:
  - Total value of all jumbo covered bond issues in Europe grew rapidly to over Euro 500 billion by end-2004.
  - About one half of that total accounted for by German and Spanish mortgage covered bonds.
- Market development driver:
  - Jumbo model introduced by a German bank syndicate in 1995; led to very liquid secondary market via standardization and electronic platforms.

### Regulatory issues and UCITS treatment
- UCITS directive impact:
  - 1988 UCITS directive 85/611/EEC of 12/20/1985 fostered growth by allowing investment funds increased investment possibilities and relatively low regulatory risk weightings.
  - Directive permits investment funds to invest up to 25 percent of assets in covered bonds of a single issuer if eligibility criteria met.
- UCITS eligibility criteria (preserved verbatim):
  1. the covered bonds must be issued by an EU credit institution;
  2. they must be subject to special supervision by the public authorities with the aim of protecting the bond holders;
  3. the sums deriving from the issue of these bonds must be placed in assets which provide sufficient cover for the liabilities deriving from the bonds until maturity.
- Capital adequacy treatment:
  - Under European bank capital adequacy rules, member states can assign a 10 percent risk weighting to covered bonds complying with criteria (50 percent lower than otherwise).
  - Under Basel II standardized approach: risk weights will be either 10 or 20 percent depending on regulator choice.
  - Under Basel II IRB approach: risk weights estimated between 11 and 4 percent, depending on foundation vs advanced IRB and issue rating.
  - Since buyers are sophisticated institutions likely to apply IRB, risk weights are likely to fall to around 4 percent.

### Asset swap spreads: methodology and rationale
- Purpose:
  - Asset swap spreads proposed as a market measure to assess and monitor credit quality of covered bonds.
- Mechanics:
  - Investor holding fixed-rate bond enters asset swap: pays fixed coupon to swap dealer, receives floating Libor payments plus or minus spread reflecting mostly issuer credit risk.
  - If default occurs, investor sells bond and receives recovery value while still bound under swap unless closed out.
- Rationale for Libor and par/par formulation:
  - Asset swap spread eliminates fixed interest rate risk; Libor chosen for liquidity and homogeneity.
  - Par/par asset swap spreads used: value of asset swap equals difference between par value and market price of bond; net present value of all cash flows set to zero.
- Formula components preserved: C = annual coupon; L(i-1,i) = forward Libor rate; i∆ = accrual factor; df(0,i) = discount factor.

### German Pfandbriefe: structural strengths and empirical observations
- Structural credit-quality features:
  - Regulatory framework revised in July 2005.
  - Cover pool must be covered by related assets of at least equal amount and yield.
  - High-quality cover pool: first-ranking mortgages with LTV ratios no higher than 60 percent.
  - Privileged position of Pfandbriefe holders in issuer bankruptcy via statutory preferential right and separation of cover pool administered by independent trustee.
- Empirical observations (iBoxx € Hypothekenpfandbriefe Index sample):
  - Figure 4 covers 37 jumbo issues matching the index.
  - Since 2003, Pfandbriefe spreads have fallen substantially; most trade at a premium relative to the swap rate (negative spread) within a band between +2 and −10 basis points.
  - Exception: September 2005, Allgemeine Hypotekenbank Rheinboden (AHBR) near bankruptcy; issuer downgraded to non-investment grade (from single A) and Pfandbriefe spreads increased from nearly zero to about 15 basis points.
  - After AHBR takeover and restructuring announced in January 2006, spreads stabilized.
  - AHBR’s covered bonds remained rated AA-AAA throughout the process.
- Ratings note:
  - German Pfandbriefe usually receive a triple-A rating.

### Spanish Cédulas Hipotecarias: structure, market features, and observations
- Legal and collateral constraints:
  - Issuance limited to 90 percent of issuer’s collateral pool.
  - Collateral = first-lien mortgages with LTV capped at 80 percent (residential) and 70 percent (commercial).
  - Collateral does not constitute a special/protected fund in issuer bankruptcy, but holders enjoy preferential rights.
  - Minimum legal over-collateralization = 11 percent; actual over-collateralization much higher.
- Market structure and data points:
  - Club funding: smaller institutions access international markets through joint issuance and pooled issues.
  - About 62 percent of securitization bonds were bought by foreign investors.
  - Figure 7 analysis corresponds to 78 jumbo issues (≥ Euro 1 billion) by major banks and pooled small-institution issues.
  - Cédulas spreads narrowed since 2002; some older 2005 issues show a premium relative to the swap rate.
  - Since early 2005 increased dispersion in spreads due to new, longer-term Cédulas paying higher spreads.
- Interpretation:
  - Institutions secure funding while spreads are relatively narrow, anticipating a possible housing market turn-around.
  - Higher spreads on longer-term instruments may reflect perceived increased riskiness from growing exposure to a possibly overvalued housing market.
  - Empirical work notes Spanish housing market misalignment ≈ 25 percent relative to estimated equilibrium.
- Ratings and enhancements:
  - Spanish Cédulas receive 2–5 notches above the issuer’s senior rating.

### Conclusions and policy-relevant findings
- Growth and attractiveness:
  - Mortgage covered bonds experienced exceptional growth in Europe and became preferred securitization instruments.
  - Well-established regulatory frameworks and relatively low capital charges created favorable conditions for issuers and investors.
- Transferable lessons:
  - European experience can inform mature and emerging markets with similar risk profiles and financing needs.
  - One large US mortgage lender announced the first mortgage covered bond fundraising program to diversify wholesale funding and exploit lower funding costs relative to MBS; likely to encourage other US issuers.
- Advantages for banks and markets:
  - Provide alternative stable and relatively cheap funding amid rising reliance on wholesale funding.
  - Enable small regional institutions to access international markets via club funding and joint issuance, with potential credit enhancement from regional diversification.
  - Improve long-term liquidity management and asset-duration matching.
- Emerging-market considerations:
  - Gap between average long-term rating on emerging-market commercial bank debt and credit quality of mortgage assets creates incentives to issue covered bonds.
  - Issuing covered bonds against on‑book mortgages can yield cheaper wholesale funding than other debt instruments.
  - Benign conditions favor new issuance as international investors assess new covered bond risk profiles; established covered bonds can enhance stability if international capital flows reverse.
- Risk assessment:
  - Asset swap spreads are useful to measure credit risk of mortgage covered bonds and to increase transparency in evaluating banks’ mortgage portfolios as covered bonds develop in other markets.

### Appendix highlights: Asset Swap Calculation (Spanish Cédula example) and Regulatory Framework changes
- Asset swap example (AyT Cédula Hipotecaria, maturity 06/30/2025):
  - Fixed annual coupon = 3.75 percent.
  - Market price on February 27, 2006 = 96.0478/96.2478 (bid/ask).
  - Settlement assumed = March 1, 2006; first payment date = 06/30/2006.
  - Notional assumed = Euro 10 million.
  - Accrued coupon example: C * (Feb 27+2 day to June 30 on actual/actual) = 3.75 *0.358904 = 1.2431507.
  - 6 months forward rate on January 1, 2006 = 2.637 percent; floating leg total = 0.9491663.
  - Discount factors (selected): 3 MO discount 0.993256; 6 MO discount 0.986045; 1 YR discount 0.970816; 2 YR discount 0.938314; 5 YR discount 0.842794; 10 YR discount 0.693147; 30 YR discount 0.302425.
  - Market-to-par difference = Euro 334920.
  - Implied asset swap spread (Bloomberg screen) = 5.5 basis points → indicates very high credit quality relative to AA-rated benchmark curve.
- German Pfandbriefe regulatory changes (New German Covered Bond Law, July, 2005):
  - Mandatory quarterly disclosure: outstanding volumes, stressed NPV overcollateralization, term and fixed-rate structures, percentage of derivatives, cover-pool stratifications, amount of overdue loans (> 90 days) and stratification.
  - Refined cover-pool-specific risk management for concentration issues.
  - Legal issuance basis: BaFin approval; minimum capital = Euro 25 million; trustee mandatory for all issuers.
  - Circulation limit removed.
  - Loans with LTVs > 60% no longer limited (previously 20% limit).
  - Unchanged elements: implicit limitations on mismatches via 2 percent net-present-value requirement and a traffic-light system (100 basis point parallel shift should not exceed 10% of bank liable capital).
- Spanish Cédulas regulatory highlights:
  - Issuers: any Spanish credit institution regulated by Bank of Spain; CNMV authorization required for listing.
  - Relevant laws: Mortgage Market Law 2/1981; Royal Decree 685/1982; Insolvency Law 22/2003.
  - Collateral: entire mortgage portfolio; eligibility restrictions include residential LTV ≤80 percent, commercial LTV ≤70 percent, building-under-construction rules, and exclusion of non-performing loans.
  - Transfer of loans: No (loans remain on issuer balance sheet).
  - Mandatory over-collateralization: issuers can issue up to 90 percent of eligible portfolio; minimum over-collateralization = 11 percent.
  - Prepayment risk: residential prepayments permitted with penalty.
  - Insolvency treatment: non-interruption of payments; insolvency administrators satisfy Cédula claims at original due maturities from mortgage/public-loan revenues.
  - Eligible for Tier 1 repos with ECB: Yes.

*Source: IMF Working Paper excerpt from _wp0720 - 1. Outstanding Volume of German Jumbo Mortgage Pfandbriefe and .....................................5*

### 1. Outstanding Volume of German Jumbo Mortgage Pfandbriefe and .....................................5

### 1. Outstanding Volume of German Jumbo Mortgage Pfandbriefe and .....................................5

### Introduction
- Rapid mortgage growth in recent years has been driven by demand and supply factors, including favorable macroeconomic conditions, falling interest rates, international diversification of investments, increased competition, decreasing interest rates, and low demand for corporate debt.
- Consequences and risks noted:
  - Funding risks for banks due to difficulty attracting deposits at low interest rates, creating the need for alternative stable non-core-deposit funding.
  - Lengthening of banks’ asset duration from mortgage lending, creating liquidity and maturity risks.
  - Smaller banks faced more acute funding risks because they had fewer opportunities to access stable non-deposit funding.
  - Increasing supervisory concern about the credit risk of mortgage portfolios.
- Role of mortgage covered bonds:
  - Securitization via mortgage covered bonds has helped banks in developed markets mitigate risks related to mortgage lending.
  - Benefits to issuers: alternative stable funding source and asset-liability management tool.
  - Benefits to investors: attractive risk/return relative to sovereign and corporate debt, particularly amid deteriorating fiscal stances and corporate troubles.
  - Securitization markets permit greater transparency in evaluation of banks’ portfolios by pricing portions of loan portfolios and providing market-based indications of underlying credit quality through liquid secondary markets.
- Analytical focus of the paper:
  - Evaluation of asset swap spreads as an appropriate tool to assess credit risk of jumbo (benchmark) European mortgage covered bonds.

### The European Mortgage Covered Bond Market
- Definition and legal features:
  - Covered bonds are debt instruments secured against a pool of mortgages where the investor has a preferred claim in the event of issuer default.
  - Issuance in EU countries is regulated by laws defining criteria for eligible assets and other specific requirements.
  - In most cases, assets are earmarked as collateral for the outstanding covered bond and kept in separate cover pools; in some countries (such as Spain), all mortgages on the balance sheet of the issuer act as collateral for the bonds.
  - Follow the “cover principle”: outstanding amount and interest claims on covered bonds must be covered by the amount of eligible cover assets.
  - Special legal regime provides “special” protection to investors: law governs eligible assets, asset/liability management (ALM), credit enhancements, and over-collateralization requirements.
  - Cover pool remains on the balance sheet of the issuer and eligible assets are substitutable; individual covered bonds do not face individual claims within the pool— all mortgage loans face the total volume of all outstanding mortgage bonds.
  - Cover pools are dynamic and of unlimited duration: when a loan meets legal requirements it is included in the existing pool; when repaid or no longer meets criteria it is withdrawn immediately.
- Investor protections and lending implications:
  - Holders of mortgage bonds have a preferential claim on the collateral and the proceeds arising from it.
  - Loan-to-value (LTV) ratios, prudent property valuation rules (e.g., mortgage lending value), and trustees or cover asset monitors acting in the interest of covered bondholders reinforce safety.
  - Covered bonds allow lenders to obtain funds in capital markets at a reduced borrowing cost relative to other wholesale sources, enabling medium- or long-term finance for housing, non-residential property or urban development at more convenient and stable rates.

### Jumbo Covered Bonds: Market Transformation and Statistics
- Jumbo model as European standard:
  - The jumbo model became the European standard for issuance of new covered bonds and the main driver for a very liquid secondary market through bond standardization and listing on widely used electronic platforms.
  - The jumbo model was first introduced by a syndicate of banks in Germany in 1995.
- Main features of the jumbo model:
  - (i) the minimum size is Euro 1 billion;
  - (ii) jumbos need to be plain vanilla bonds (fixed coupon, paid annually in arrears);
  - (iii) buybacks are allowed;
  - (iv) the bond must be officially listed on an organized market (typically an electronic platform);
  - (v) there must be at least 3 market makers that quote bid/ask prices simultaneously to maintain a liquid market.
- Market size and concentration:
  - Total value of all issues in the jumbo covered bond market in Europe grew rapidly to over Euro 500 billion by end-2004.
  - About a half of that total is accounted for by German and Spanish mortgage covered bonds.
- Empirical data source noted:
  - Figure data source: Banco Bilbao Vizcaya Argentaria.

### Regulatory Issues
- Role of EU law and UCITS:
  - Covered bond legislation has been developed in most European countries.
  - The rapid growth of European covered bonds has been fostered by the 1988 UCITS directive 85/611/EEC of 12/20/1985, which allows mortgage covered bonds to benefit from increased investment possibilities and relatively low regulatory risk weightings.
  - The directive allows investment funds to invest up to 25 percent of their assets in the covered bonds of a single issuer as long as the issuer and the bonds satisfy specified eligibility criteria.
- UCITS eligibility criteria (preserved verbatim):
  1. the covered bonds must be issued by an EU credit institution;
  2. they must be subject to special supervision by the public authorities with the aim of protecting the bond holders;
  3. the sums deriving from the issue of these bonds must be placed in assets which provide sufficient cover for the liabilities deriving from the bonds until maturity.

*Source: IMF Working Paper excerpt from _wp0720 - 1. Outstanding Volume of German Jumbo Mortgage Pfandbriefe and .....................................5*

### 4.      the bonds under consideration must be covered and should grant preferential rights to

### 4.      the bonds under consideration must be covered and should grant preferential rights to 

### Covered bond criteria and regulatory treatment
- The bonds under consideration must be covered and should grant preferential rights to the bondholder in the event of the bankruptcy of the issuer, i.e. the sums deriving from the issue of the bond are intended as a priority to repay the capital and interest becoming due.
- Under European bank capital adequacy rules, member states can assign a 10 percent risk weighting to covered bonds complying with these criteria.
- This represents a risk weighting that is 50 percent lower than would otherwise be the case.
- Under Basel II:
  - Under the standardized approach of Basel II, the risk weights will be either 10 or 20 percent depending on the modality of the standardized approach chosen by the regulators.
  - Under the Internal Rating-Based (IRB) approach, risk weights are estimated between 11 and 4 percent, depending on whether the bank applies the foundation or advanced IRB and on the rating of the issues.
  - Since banks buying covered bonds are mostly sophisticated institutions, which are likely to apply IRB, a boost for covered bonds is to be expected as risk weights are likely to fall to around 4 percent.

### Investor appeal and market features
- Mortgage covered bonds attract banks, insurers, pension funds, asset management companies, and central banks.
- With the booming of the jumbo market, the secondary market for these instruments has become highly liquid at a wide range of maturities (up to 20 years).
- Covered bonds provide portfolio diversification across different markets and offer comparable ratings to sovereigns but considerably higher yields.
- Demand for covered bonds has increased over the last 2 years relative to both corporate and sovereign bonds.
- Examples of ratings and enhancements:
  - German Pfandbriefe usually receive a triple-A rating.
  - Spanish Cédulas receive 2-5 notches above the senior rating of the issuer.

### Key factors rating agencies assess
- (i) The quality of the country’s regulatory framework and, in particular, the strength of the investor protections in the regulatory framework such as the collateral eligibility criteria, quality of prudential supervision, LTV ceilings, mandatory overcollateralization, insolvency treatment, and ALM requirements;
- (ii) The creditworthiness of the issuer;
- (iii) The credit quality of the specific issue and, in particular, the quality of the asset pool and the possible structural enhancements.

### Assessing credit risk via asset swap spreads
- Asset swap spreads are proposed as a market measure to assess the credit quality of covered bonds and monitor the evolution of their risk profile.
- Mechanic summary:
  - An investor holding a fixed rate bond enters into an asset swap to eliminate fixed interest rate risk: pays the swap dealer the fixed coupon and receives floating Libor payments plus or minus a spread reflecting mostly the credit risk of the issuer.
  - If default occurs, the investor sells the bond and receives the recovery value while still obliged under the swap unless closed out.
- Rationale:
  - The asset swap spread mainly measures the market’s assessment of the credit risk of an issuer.
  - Asset swap spread eliminates fixed interest rate risk; Libor market chosen for larger liquidity and homogeneity.
- Methodology details:
  - Par/par asset swap spreads used, where the value of the asset swap is equal to the difference between the par value and the market price of the bond, setting the net present value of all the cash flows to zero.
  - Formula components preserved exactly: C is the annual coupon; L(i-1,i) is the forward Libor rate; i∆ is the accrual factor in the corresponding basis; df(0,i) is the discount factor from the present to coupon payment i.

### The jumbo covered bond market: German Pfandbriefe
- Structural features conferring high credit quality:
  - Well-established regulatory framework revised in July 2005.
  - Collateral pool must be covered by related assets of at least an equal amount and yield.
  - High quality of the cover pool encompassing first ranking mortgages with LTV ratios no higher than 60 percent.
  - In case of bankruptcy of the issuer, privileged position of Pfandbriefe holders guaranteed by a statutory preferential right and the separation of the cover pool (administered by an independent trustee).
- Empirical observations:
  - Figure 4 analysis covers 37 jumbo issues which match the iBoxx € Hypothekenpfandbriefe Index.
  - Since 2003, Pfandbriefe spreads have fallen substantially; most trade at a premium relative to the swap rate (i.e. negative spread) within a relatively narrow band between +2 and −10 basis points.
  - Exception: September 2005, Allgemeine Hypotekenbank Rheinboden (AHBR) near bankruptcy; issuer downgraded to non-investment grade (from single A) and Pfandbriefe spreads increased from nearly zero to about 15 basis points.
  - After AHBR takeover and restructuring announcement in January 2006, spreads seem to have stabilized.
  - AHBR’s covered bonds remained highly rated (AA-AAA) throughout the process.

### The jumbo covered bond market: Spanish Cédulas Hipotecarias
- Structural and legal features:
  - Issuance of Cédulas Hipotecarias is limited to 90 percent of the issuer’s collateral pool.
  - Collateral constrained to first-lien mortgages with LTV capped at 80 percent and 70 percent for residential and commercial mortgages, respectively.
  - Collateral backing Cédulas Hipotecarias does not constitute a special or protected fund if the issuer goes bankrupt, but holders enjoy preferential rights in bankruptcy.
  - Minimum level of over-collateralization required by law is 11 percent; actual overcollateralization is much higher (see Figure 5).
- Market structure:
  - Club funding is a key feature: smaller credit institutions (regional savings banks and credit cooperatives) access international capital markets through joint issuance and pooled issues.
  - Example market data and observations:
    - About 62 percent of the securitization bonds were bought by foreign investors.
    - Figure 7 analysis corresponds to 78 jumbo issues (at least 1 billion Euro) by the largest commercial and savings banks, as well as pooled-issues of small credit institutions.
    - Cédulas spreads have narrowed since 2002; some older issues in 2005 show a premium relative to the swap rate.
    - Since early 2005 increased dispersion in spreads due to new, longer-term Cédulas Hipotecarias which tend to pay higher spreads.
- Interpretation:
  - Credit institutions appear to secure funding while spreads are relatively narrow, anticipating a possible turn-around in the housing market cycle.
  - Higher spreads on longer-term instruments may reflect perceived increased riskiness associated with growing exposures to a possibly overvalued housing market.
  - Note on Spanish housing market: empirical work finds evidence of a misalignment of about 25 percent with respect to the estimated equilibrium.

### Conclusions and policy-relevant findings
- Mortgage covered bonds have experienced exceptional growth in recent years in Europe and become one of the preferred securitization instruments.
- Well-established regulatory frameworks and relatively low capital charges have created a favorable environment for issuers and investors.
- The successful European experience can provide lessons for other mature and emerging markets with similar risk profiles and financing needs.
- One large US mortgage lender has announced the first mortgage covered bond fundraising program to diversify wholesale funding sources and take advantage of lower funding costs relative to the issuance of MBS in the US; this development is likely to encourage other US issuers to follow suit.
- Main advantages of mortgage covered bonds for mature and emerging markets:
  - Help credit institutions gain access to an alternative stable and relatively cheap funding source amid increasing reliance on wholesale funding.
  - Enable small regional credit institutions to access international capital markets through “club” funding and joint issuance, with possible credit enhancement via regional diversification of mortgages.
  - Allow better long-term liquidity management and matching of asset duration with long-term bonds.
- Additional points for emerging markets:
  - The gap between average long-term rating on emerging market commercial bank debt and the credit quality of their mortgage assets creates incentives to raise funds through mortgage covered bonds.
  - As commercial banks maintain mortgages on their books, issuing covered bonds against those assets can allow cheaper wholesale funding relative to other debt instruments.
  - Current benign conditions appear favorable for new issuance, as international investors may require time to assess new covered bond risk profiles.
  - In the event of a reversal in international capital flows, credit institutions with well-established mortgage covered bonds would have enhanced stability and diversification of funding sources.
- On risk assessment:
  - Asset swap spreads are useful to measure the credit risk incurred by holding a mortgage covered bond and to increase transparency in evaluating banks and their mortgage portfolios as covered bonds develop in other markets.

*Source: European Covered Bond Council, 2006; IMF staff analysis as presented in the supplied content.*

### References

### _wp0720 - References

### Asset Swap Calculation: an Application to Spanish Covered Bonds (Appendix I)
- Transaction setup:
  - Security: Cédula Hipotecaria issued by AyT maturitiy 06/30/2025, fixed annual coupon 3.75 percent (ISIN: ED996101 Corp).
  - Market price on February 27, 2006: 96.0478/96.2478 (bid/ask).
  - Settlement assumed: March 1, 2006; first payment date: 06/30/2006.
  - Notional assumed: Euro 10 million.
- Cash-flow components (as defined):
  1. Stream of fixed rate coupons from contract initiation to bond maturity.
  2. Difference between quoted price at contract date and the notional value of the bond.
  3. Cash flows from the floating leg: forward interest rates paid on reset dates (e.g., indexed to a 6 months rate) set one period in advance.
- Accrued coupon example:
  - C * (Feb 27+2 day to June 30 on actual/actual) = 3.75 *0.358904 = 1.2431507.
- Floating-leg specifics:
  - 6 months forward rate determined on January 1, 2006 = 2.637 percent.
  - In this example the total amount of the floating leg = 0.9491663.
- Discounting and valuation:
  - Discount factors for short term (3.8 months) lie between 0.993256 and 0.9908 as inferred from the Libor/discount curve.
  - The asset swap spread A is determined by setting the net present value of all cash flows to zero so that the total net present value equals the difference between the market value P and par (100).
  - In this case the market-to-par difference equals Euro 334920.
- Result:
  - The appropriate asset swap spread implied by the calculations and the Bloomberg screen is 5.5 basis points.
  - Interpretation offered: a 5.5 basis point spread indicates very high credit quality for this Cédula Hipotecaria relative to a benchmark curve for AA-rated counterparties.
- Supporting data presented:
  - Table of Libor rates and discount factors (selected entries preserved):  
    - 3 MO rate 2.657, discount 0.993256.  
    - 6 MO rate 2.769, discount 0.986045.  
    - 1 YR rate 2.965, discount 0.970816.  
    - 2 YR rate 3.2223, discount 0.938314.  
    - 5 YR rate 3.468, discount 0.842794.  
    - 10 YR rate 3.7, discount 0.693147.  
    - 30 YR rate 3.992, discount 0.302425.  
  - Source for market data: Bloomberg.

### Regulatory Framework for Pfandbriefe (Appendix II — Mortgage Pfandbriefe: A New Regulatory Framework)
- Key changes under the New German Covered Bond Law (July, 2005) vs Old Regulations:
  - Transparency requirements increased to mandatory quarterly disclosure; issuers must report:
    1. Volume of outstanding covered bonds (by type) including their nominal, net present value as well as stressed net-present-value overcollateralization;
    2. Term structure and fixed interest rate structure of the cover pool and covered bonds in buckets; and
    3. Percentage of derivatives registered in the pool.
    4. Stratifications of the cover pool by size, origin, and type of loan;
    5. Amount of overdue loans (greater than 90 days) and stratification thereof (by origin).
  - Refined risk management: banks required to have cover-pool-specific risk management addressing concentration issues.
  - Legal basis to issue covered bonds: banks need approval by BaFin and must meet minimum requirements including minimum capital of Euro 25 million, adequate risk management of cover pools, and willingness to regularly tap the market.
  - Trustee: Mandatory for all (previously only needed for private mortgage banks).
  - Circulation limit: No longer in place (previously 60x liable capital for private sector mortgage banks; 48x for mixed mortgage banks; no ruling for public sector banks).
  - Loans with LTVs > 60%: No longer a limit (previously a 20% limit).
- Elements of the Old Law that remain unchanged:
  - Interest rate/maturity/forex and liquidity mismatches: only implicit limitation via the 2 percent net-present-value requirement that must be maintained at all times; shortfalls must be made up by additional cover and the bank must have adequate risk-management systems.
  - Additional constraint: traffic light system — a 100 basis point parallel shift of the yield curve should not exceed 10% of the banks liable capital.
- Sources cited for this regulatory summary: Standard and Poors (2005) and IMF staff.

### Regulatory Framework for Cédulas Hipotecarias (Appendix II)
- Issuers:
  - Any Spanish credit institution regulated by the Bank of Spain.
- Supervisor:
  - The Ministry of Economy & Finance through the Bank of Spain supervises at the issuer level.
  - The National Stock Market Commission (Comisión Nacional del Mercado de Valores) must authorize any Cédula Hipotecaria issue prior to its listing.
- Relevant laws:
  - Mortgage Market Law 2/1981, further developed by Royal Decree 685/1982.
  - Insolvency Law 22 /2003 of July 2003 amended the Mortgage Market Law improving the position of Cédula Hipotecaria holders in issuer insolvency.
- Collateral:
  - The entire mortgage portfolio.
- Eligibility criteria for mortgages to be eligible collateral:
  - Only residential mortgages with a Loan-to-Value (LTV) ≤80 percent; commercial mortgages with LTV ≤70 percent.
  - All properties must be fully insured and valued by real estate surveyors approved by the Bank of Spain.
  - Only properties wholly owned by the mortgagors.
  - For buildings under construction: value of mortgages on buildings under construction cannot exceed 20 percent of the total eligible portfolio.
  - For buildings under construction: only 50 percent of the value of the land and 50 percent of the value of the construction may be taken into account.
  - Non-performing loans are ineligible.
  - Mortgage loans that originally exceeded the maximum LTV may become eligible if principal repayment or market value increases reduce LTV within established levels.
- Transfer of loans:
  - No; the loans remain on the issuer’s balance sheet together with any other assets.
- Cover register:
  - No; Cédulas Hipotecarias are secured by all mortgages held on the issuer’s balance sheet at any given time.
- Mandatory over-collateralization:
  - Credit institutions can issue Cédulas Hipotecarias up to 90 percent of the eligible mortgage loan portfolio.
  - Minimum mandatory over-collateralization = 11 percent.
- Real estate valuation:
  - All properties collateralizing eligible mortgage loans must be valued by surveyors approved by the Bank of Spain.
  - Ineligible assets are not mandatorily subject to this type of valuation.
  - Valuations by the issuer’s own valuation services are permitted if authorized by the Bank of Spain; in practice most valuations are undertaken by third party assessors.
  - ECO/805/2003 introduced the concept of “mortgage value” (described as more sustainable and less volatile than the market value).
- Geographical constraints:
  - Practically only property in Spain may be used to secure loans due to the need to register the loan in the national Property Register.
- Interest rate and maturity matching requirements:
  - The average interest rate on variable Cédulas Hipotecarias must not exceed the average rate on qualifying variable mortgage loans.
  - In practice most Cédula Hipotecaria issued are fixed-rate.
  - No matching required in terms of maturity of assets and liabilities.
- Substitute collateral:
  - No, the cover assets only comprise mortgage loans.
- Prepayment risk:
  - Yes, residential mortgage loan prepayments are permitted with a penalty.
- Should the issuing bank become insolvent:
  - Insolvency Law provisions: non interruption of payments of principal and interest on Cédulas Hipotecarias during insolvency proceedings.
  - Insolvency administrators will satisfy Cédula claims at their original due maturities from revenues obtained from the mortgages/public sector loans.
- Preferential claim of covered bondholders:
  - Special privilege; preferential claim on the whole mortgage loan portfolio.
- Separate cover pool administrator in insolvency:
  - No.
- Eligible for Tier 1 repos with ECB:
  - Yes.
- Sources for this regulatory summary: FitchRatings and IMF staff.

*Source: _wp0720 - References (PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0720.pdf_