Obstacles to secondary-market development

The secondary market for mortgage funding is still highly fragmented within the EU. However, the markets for mortgage-backed securities and covered mortgage bonds have been growing rapidly in several Member States.⁴²

The use of such instruments on a larger scale could facilitate cross-border entry, since such instruments represent the only means of funding loans in a new market without incurring the high costs of gaining access to a local deposit base. This holds particularly true for mortgage specialists, which usually do not have access to large deposit networks even in home markets.⁴³ Yet many obstacles to the development of a truly pan-European secondary market development remain. For example:

o In several countries, banking regulations and practices discourage the use of secondary market instruments vis-à-vis deposits.

40 Industry representatives on the Forum Group recommended (FGR) 17 the removal of interest caps and compulsory indexation of variable rate loans (FGR 17), and an end to caps on early repayment fees (FGR 18). Representatives of consumer organisations did not support these recommendations.

41 FGRs 2-7 were common recommendations, while only consumer representatives supported FGRs 8-12.

42 Both instruments are defined in section 2.1.3.

43 A truly pan-European secondary market would also benefit domestic lenders as it would bring about both higher instrument liquidity (and thus reduced spreads) and collateral/risk pooling.

Box 1

Restrictions on variable-rate mortgages

European regulatory regimes concerning interest rate adjustment in existing contracts differ significantly and establish a significant cross-border lending barrier. For example, the standard variable rate (SVR) contracts that are the norm in the UK would be illegal in Spain.

Debates over permissible adjustment regimes involve three main questions: first, which type of cost-of-funds adjustment mechanisms lenders should be allowed to use; second, whether spreads charged over those cost-of-funds should be allowed to vary, and third, whether caps should be mandatory when using variable-rate contracts.

Regarding the first two questions, Spanish regulators have mandated the use of official indices for adjustment and the use of fixed lifetime spreads over those indices. By contrast, the UK still allows lenders to use their discretion in adjusting interest rates.

Official indices can provide lenders with a relatively broad choice of benchmark interest rate.

For example, in Spain lenders can choose from five indices, including indices closely related to the cost of funds for each subsector of the banking industry. The UK Miles Review (HM Treasury 2004a) did not recommend such restrictions. Rather, it recommended measures to reduce discrimination between new and existing borrowers, which may arise under lender discretion. Lenders would be required to offer all products to new and existing borrowers simultaneously and provide more information about the process of prepayment.

Besides the issue of discrimination, a question remains over the risk of various lending approaches for the consumer and lender. Consumers face two risks when lenders have discretion. First, lenders could decline to pass on declines in the central bank interest rate to consumers. While it would appear that UK SVR contracts create this risk, empirical evidence presents a more subtle picture. Empirically, UK SVRs have trailed both interest-rate increases and declines. This suggests lenders do not make systematic large profits from the SVR mechanism, but rather smooth the cycle to stabilize demand.

A second risk consumers face under any variable-rate mortgage is that interest rates become very high. Contractual – usually lifetime - caps to variable rates have become widespread in Denmark, Germany and France, but remain rare in Spain and Britain. It appears that since in the former countries fixed rate lending is the norm for mortgages, both the demand for and supply of interest rate protection is high. This leaves Spain and Britain with the question of whether risk protection for borrowers is adequate. The UK Miles Review proposed to raise consumer awareness of the risks of variable-rate financing and promote fixed-rate lending. In addition, lenders could be mandated to offer contracts containing interest-rate caps. In this way, consumers would be educated about the potential risks they assume in exchange for saving the premium charged for fixed-rate loans.

Regulations regarding variable-rate mortgages must also consider risks to lenders. Lenders face the risk that credit restrictions will change in a manner not reflected in the permissible index interest rate. Under SVRs, lenders can pass such changes on to the entire portfolio of loans, while in the Spanish case lenders can pass them only to new borrowers. This suggests that strict rate-adjustment limits may shift risks between borrower groups. Thus, it may be desirable for rate-adjustment laws to permit adjustment on the basis of an interest rate or index that reflects identifiable changes in risk premia.

o Some countries, for instance, subsidise the generation of deposits, of which a significant part is subsequently recycled into the mortgage sector.⁴⁴

o Capital requirements that are inconsistent with the goal of providing benefits of portfolio diversification to banks and other investors reduce the demand for the services of capital market intermediaries.⁴⁵ o Banking regulations do not discourage mismatched funding of

long-term mortgage loans through short-long-term deposits.⁴⁶

o The situation with respect to separation of assets and pooling of collateral from the balance sheet of universal bank originators for the creation of capital market instruments is also problematic.⁴⁷

o All these factors increase the costs of the design of appropriate funding instruments.

o The secondary market instruments themselves require minimum standards in order to become permanent credible alternatives to deposits in the long run. So far, covered bond legislation does not exist in some Member States (see A1.4.3) and there are no European minimum standards. Also, the development of a market for mortgage-backed securities is hampered in some countries by inconsistent regulation.

44 Examples are France, which earmarks deposits for social housing finance, and subsidised contract savings for housing schemes in both France and Germany.

45. The key issue here is the lack of recognition of the risk mitigation, management and transfer services that capital market intermediaries in mortgage finance may perform for banks and other investors.

Consider as an important example a swap transaction in which a number of banks sell mortgage assets to a wholesale (mortgage) bank acting as capital market intermediary and repurchase pro-rate a mortgage bond backed by a diversified portfolio of their assets from it. Under Basel II rules proposed to be implemented in the EU (see Proposed Amendment of Codified Banking Directive (2000/12/EC) and Capital Adequacy Directive (93/6/EEC)), more regulatory capital has to be held by the swap transaction parties together (by the bond issuing bank for asset default risk, and by the investing banks for issuer counterparty risk) than by the individual banks investing in their non-diversified portfolio alone (for asset default risk).

Thus, the Basel II regulations appear to assume that, from the perspective of final investors (e.g. bank depositor), the diversification service provided by the capital market intermediary would increase, rather than decrease, the overall risk content relative to the non-diversified exposure. In typical applications in mortgage finance this assumption is highly unrealistic: capital market intermediaries in mortgage finance, due to their scale and focus, are in fact able to diversify over large numbers of jurisdictions with different economic and housing market profiles.

46 While the Basel Committee has issued recommendations for supervisory review of interest rate risk mismatch on the banking book, there is no explicit capital charge foreseen for this risk under the new Basel II framework (Basel 2004).

47 The Forum Group Report addresses the problems regarding separation and pooling of assets and bankruptcy remoteness in paragraphs 45, 46 and 48 and calls for harmonisation of the respective laws.

o There is finally in Europe a pronounced lack of large capital market institutions in mortgage finance with diversified value-added functions. European secondary market liquidity could benefit from larger and operationally more diversified issuers without suffering from an overly concentrated market structure, as the U.S. does.⁴⁸ A new type of institution, contrasting with the currently prevailing multi-collateral, single-product institutions, could even focus on residential mortgage finance alone.⁴⁹