Patente Municipal

The market for covered bonds—occasionally referred to by the moniker for German covered bonds "Pfandbriefs" (literally "letter of pledge" in German1_{)—is not yet well known inside the} United States but has actually existed for more than two centuries, and has gained a higher profile in the European market over the past several years. In fact, that market has grown so large that it is now an integral part of the European investment landscape, and U.S. policymakers are seriously considering the model as one possible tool with which to better shape the U.S. housing finance market going forward.

Covered Bonds

The element of most fundamental importance to covered bond investors is the same as for any other bond. What can one rely on to ensure that a bond's cash flows will be paid in a timely and complete way?

In the U.S. the trend in mortgage finance, in particular, has for many years been toward complete securitization of mortgage debt. In that process, lenders initiate loans backed by property, which could then be sold to investors, and thus eliminated from issuer balance sheets. Much of the mortgage issuance in the U.S. is 'wrapped' with guarantees from Government agencies (such as Ginnie Mae) and quasi-government agencies (such as Fannie Mae and Freddie Mac) and sold to investors with the promise that those agencies will make up for any missed borrower payments or defaults. In other cases, mortgages are grouped in pools (carrying various labels such as RMBS, CDOs, and so forth) whose cash flows are structured so that investors demanding the highest credit quality (and who are willing to take comparatively low yields) can purchase specific 'tranches' of securities backed by those pools with the promise that investors in other tranches (who are willing to take on more risk in exchange for higher yields) will bear most of the risk. The credit and mortgage crises of 2007 and 2008 have dimmed the appeal of these models.

Europe has for some time favored a different scheme. With regard to real-estate and public debt financing, in particular, that market has favored the 'covered' bond model by which those debts, once incurred, remain on the balance sheets of issuers inside of a so-called 'cover pool'. Issuers raise assets for cover pools by selling 'covered bonds' to investors, which maintain a claim on the cover pool, but also a claim on the general assets and credit of the issuer.

Construction Rules for Morningstar Bond Index Family | November 17, 2008

© 2008 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 44 Reproduction or transcription by any means, in whole or part, without the prior written consent of Morningstar, Inc., is prohibited.

Clearly, part of what differentiates a cover pool from the assets supporting a typical mortgage- backed security (as might be issued in the United States) is that the cover pool remains on the balance sheet of its issuer, usually a bank or special financial institution set up for this purpose. There are other major differences however, including the fact that in most of Europe, a variety of regulations must be followed on the part of issuers so as to ensure that cover pool assets remain solvent and sufficient to pay back the cover bonds that are relying on them.

This is particularly valuable to some investors—and helps to expand their ranks—because it makes many covered bonds eligible for special treatment under regulations that require certain financial institutions to monitor and maintain capital reserves. As long as they comply with the standards laid out by article 22 (4) of the European Union's UCITS2_{, many jurisdictions and their} regulators will allow covered bond holders to hold greater concentrations of covered bonds than other securities on the credit strength inherent in their typical structures.

Depending on the origin of a particular covered bond issue, its cover pool will most typically consist of loans secured by residential or commercial real-estate (referred to as Hypotheken- Pfandbrief in German), or by loans made to entities in the public sector such as federal, regional, or municipal governments or agencies (Offentliche Pfandbriefe), though there are a few other classes eligible for inclusion in cover pools.

Asset classes that are eligible as collateral for covered bonds3_: • Exposures to public sector entities;

• Exposures to institutions;

• Mortgage loans (commercial & residential); • Senior MBS issued by securitization entities; • Loans secured by ships

A major point of differentiation between a cover pool and the assets of a securitized mortgage pool, however, is that cover pools are dynamic. As long as an issuer is solvent, it typically can and will actively manage the assets of the cover pool.

One reason is simply to address any deterioration of assets that no longer meet eligibility for the cover pool. Another is that the size and number of loans underlying a mortgage-backed security typically shrink in size as borrowers pay back principal, sell property and pay off mortgages, or simply refinance at lower rates. The par value of a covered bond, however, generally never changes as they are usually issued with plain-vanilla, non-callable structures from which investors receive regular interest payments and a lump sum at maturity. When those bonds are backed by cover pools holding mortgages, however, then the issuer must necessarily reinvest principal and buy new securities in order to keep the pool sufficiently capitalized to back the covered bonds that are issued from it.

The dynamic nature of cover pools is noteworthy in that it introduces less-obvious risk factors. One is simply that actively managing portfolios reduces their predictability, and raises the possibility that poor ongoing management or oversight could impair the quality or value of cover pool assets.

Construction Rules for Morningstar Bond Index Family | November 17, 2008

© 2008 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 45 Reproduction or transcription by any means, in whole or part, without the prior written consent of Morningstar, Inc., is prohibited.

The other is that an issuer may have difficulty properly hedging the interest-rate risk inherent in mortgage cover pool assets. Because the timing of cash flows from the mortgages in a cover pool—which, as noted, return principal both on an amortization schedule and in very lumpy fashion when properties are sold or refinanced—won't match the timing for cash flows the pool most provide to plain-vanilla covered bond holders, those managing the pool must engage in hedging of some sort. Hedging the interest-rate risk of mortgages is notoriously difficult, though, and banking industry problems of all sorts have historically proven the point. On the most basic level, if analytical models prove faulty, or markets act unpredictably, it's possible for the average lives (a metric similar to maturity that's used to estimate the timing of principal return) of mortgages in the cover pool to shorten or lengthen dramatically and unexpectedly. If the tools used to hedge those risks aren't perfectly aligned with them, losses can occur.

The good news, of course, is that in many jurisdictions, the very definition of a covered bond involves regulation and oversight as laid out in article 22 (4) of the European Union's UCITS4 directive. The complex language of that legislation is summarized as follows by the European Covered Bond Council5_:

1) The covered bond issuer must be a credit institution.

2) Covered bond issuance has to be governed by a special legal framework. 3) Issuing institutions must be subject to special prudential public supervision6_. 4) The set of eligible cover assets must be defined by law.

5) The cover asset pool must provide sufficient collateral to cover bondholder claims throughout the whole term of the covered bond.

6) Bondholders must have priority claim on the cover asset pool in case of default of the issuer.

That said, covered bonds do exist outside of this legislative framework and are typically considered 'contractual' in nature given their reliance on a domicile's 'general law and jurisprudence'7 _{with regard bondholder protections in cases of bankruptcy. Those that do not} comply with article 22 (4) of the European Union's UCITS directive, however, are not included in the Morningstar European Covered Bond Index.

Construction Rules for Morningstar Bond Index Family | November 17, 2008

© 2008 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 46 Reproduction or transcription by any means, in whole or part, without the prior written consent of Morningstar, Inc., is prohibited.

1 _{Bank of International Settlements – BIS Papers No 5. Page 48} 2 _{UCITS: Undertakings for Collective Investments in Transferable Securities} 3 _{European Covered Bond Council (ECBC) Website: About Covered Bonds} http://ecbc.hypo.org/Content/Default.asp?PageID=311

4 _{Ibid, See Note 2}

5 _{European Covered Bond Council, European Covered Bond Fact Book, 2007. Second Edition (Brussels, Belgium: 2007) – Page 24} 6 _{ECBC Essential Features of Covered Bonds}

http://ecbc.hypo.org/Content/Default.asp?PageID=367

Typical features of “special” supervision include:

• a special cover pool monitor

• periodic audits of the cover pool by the cover pool monitor

• ongoing management and maintenance of the cover pool upon the credit institution’s insolvency to ensure the timely payment of covered bondholders

Construction Rules for Morningstar Bond Index Family | November 17, 2008

© 2008 Morningstar, Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. 47 Reproduction or transcription by any means, in whole or part, without the prior written consent of Morningstar, Inc., is prohibited.