Norwegian covered bonds--a rapidly growing market.

• Author: Bakke, Bjorn

1. Introduction

   OMFs (obligasjoner med fortrinnsrett) are the Norwegian version of a type of bond known internationally as covered bonds. (2) A covered bond is a bond which gives investors recourse to a specified pool of the issuer's assets. Bonds giving investors a direct claim on the assets put up as collateral were first issued in Germany back in 1769, and a number of other European countries introduced similar bonds over the next century. (3) However, bonds with characteristics similar to those of today's covered bonds were not issued until 1899, when a new mortgage bank law was passed in Germany. A number of other European countries have also long had legislation essentially corresponding to modern covered bond laws, but legislation of this kind has not been introduced in most countries until recent years.

   Bonds backed by assets have proved robust in times of economic crisis. In Germany, there has not been a single default since 1769. Nor have there been any defaults in Denmark, France or Spain, where covered bonds also have a long history, since laws were introduced on the issuance of mortgage-backed bonds. (4) Nor were there any defaults on these instruments during the financial turmoil that erupted in summer 2007.

   For a long time, the markets for covered bonds were mainly national with limited volumes outstanding and limited turnover. An important watershed came with the introduction of German Jumbo Pfandbriefe in 1996. A Jumbo Pfandbrief has a fixed coupon, a volume outstanding of at least EUR 1 billion, and multiple market-makers. These requirements meant that Jumbo Pfandbriefe were much more liquid than other bonds from private issuers, and this brought increased interest from foreign investors as well. The volume of covered bonds outstanding globally grew from EUR 100 billion in 1996 to EUR 600 billion in 2000 and is currently estimated to be more than EUR 2,400 billion.

   Norwegian banks have been able to issue covered bonds through separate mortgage companies since the rules on OMFs entered into force in June 2007. Banks' lending has grown more quickly than deposits in recent years, and this lending has been funded by issuing unsecured bonds or taking out loans from other financial institutions. Because OMFs give the investor a preferential claim on a pool of cover assets, they can usually be issued on better terms than unsecured bonds or loans. OMFs may also be a more stable source of funding than the other options available to a private bank. OMFs could therefore be an important alternative to unsecured bonds and loans from financial institutions as a source of funding in the coming years.

   OMFs will probably also be an important investment opportunity for banks and pension and insurance companies. This is partly because investment in OMFs can help them to comply with new regulatory requirements for liquidity and capital adequacy. In addition, banks can use these bonds as security for loans from central banks or in repurchase agreements. Banks' risk in terms of both debt and receivables may therefore be affected by how robust OMFs prove to be in periods of turmoil in financial markets and/or weak macroeconomic performance. The robustness of OMFs is therefore important for financial stability.

   The article is structured as follows: Section 2 provides an overview of the key characteristics of covered bonds and the Norwegian rules, and discusses the features of the Norwegian mortgage companies issuing OMFs. Section 3 looks at the market for OMFs, while section 4 analyses various types of risk associated with these instruments, and section 5 discusses their potential implications for financial stability. Finally, section 6 provides a brief summing-up.

2. What are covered bonds and OMFs?

   Covered bonds issued in different European countries have different characteristics and so there is no universal definition. (5) However, the European Covered Bond Council has defined the following minimum standard:

   --The bond is issued by--or bondholders otherwise have full recourse to--a credit institution which is subject to public supervision and regulation.

   --Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution.

   --The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times.

   --The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies.

   Covered bonds that meet these requirements can be divided into two categories:

   --Covered bonds issued under special legislation, which includes requirements for cover assets, liquidity management and supervision. This special legislation and supervision limit the risk to bondholders.

   --Covered bonds issued under general legislation, where the features of the bonds are determined by separate agreements between issuer and investor (known as structured covered bonds). Bonds of this type can be issued in countries where there is no special legislation. Another motive is that separate agreements give the issuer greater flexibility, for example when deciding which assets can be included in the cover pool.

   Most European countries have introduced special legislation on the issuance of covered bonds. This legislation varies slightly from country to country, but has in most cases been harmonised with the requirements of the EU's Undertakings for Collective Investment in Transferable Securities (UCITS) Directive and Capital Requirements Directive. The UCITS Directive sets out requirements for funds that are to be marketed and sold to small investors in the European Economic Area (EEA). A fund of this type may not, in the first instance, invest more than 5 per cent of its assets in financial instruments issued by any one company, but this limit rises to 25 per cent for covered bonds that meet the directive's criteria. The Capital Requirements Directive contains guidelines for the calculation of the capital that credit institutions must hold for their various categories of asset. When calculating this capital requirement, assets are assigned different weights according to the risk associated with them. Secured assets are given a low risk weight, which means that credit institutions do not need to hold as much capital for these assets as for other assets from private issuers. The Capital Requirements Directive sets out criteria that covered bonds must satisfy in order to qualify for a low risk weight (10 per cent). (6)

   The Capital Requirements Directive assumes that the requirements of the UCITS Directive are met and makes a number of additional requirements. Covered bonds that comply with the Capital Requirements Directive will therefore always comply with the UCITS Directive, but not vice versa. For a covered bond to have a low risk weight under the Capital Requirements Directive, the issuer of must be subject to public supervision which safeguards the investor's interests, and the investor's loan must be secured against assets which will be used to cover his claim in the event of insolvency. This requirement must be met throughout the life of the bond. The Capital Requirements Directive contains detailed criteria for determining which assets may be used to secure bondholders. (7)

   The OMF model

   Under Norwegian law, OMFs must be issued by a separate mortgage company (see box with further details). These mortgage companies are primarily formed, owned and controlled by banks. The majority of Norwegian banks own such a company together with other banks, but a number of large and medium-sized banks have chosen to set up their own mortgage companies. A few banks do not have any links with companies issuing OMFs. OMFs are clearly distinct from traditional securitisation of loans in the form of asset-backed securities (ABSs) (see box setting out the key differences).

   The mortgage companies turn residential or commercial mortgages into funding for the banks. This is achieved by the banks transferring these loans to the mortgage companies, which then issue OMFs secured on the loans. (8) The banks normally give the companies short-term credit when the loans are transferred. The mortgage companies repay this credit either by obtaining liquidity through the sale of OMFs or through the bank receiving OMFs with a value corresponding to the loans transferred. The bank's balance sheet is therefore affected by lending being replaced with OMFs or sale proceeds. These proceeds may be used to repay the bank's liabilities.

   The largest item on the asset side of the mortgage companies' balance sheets is residential and commercial mortgages, while the largest item on the liability side is OMFs issued. Under the law, the value of substitute collateral and residential and commercial mortgages up to an LTV of 75 per cent and 60 per cent respectively must be greater than the value of OMFs outstanding (see box on the Norwegian legislation). Bondholders have a preferential claim to the portion of these loans beyond the 75/60 per cent limit, but only loans up to 75/60 per cent will count in the cover pool when calculating whether the company meets this matching requirement.

   If property prices fall, it may be necessary for the mortgage company to bring in new loans in order to maintain the value of the cover pool. For example, a mortgage company can increase the size of its substitute collateral or have new residential, commercial or public sector loans transferred to it. This can be financed by the company increasing its own borrowings from the banks. Both assets and liabilities will grow if this kind of solution is chosen (see Charts 2.1 and 2.2). One alternative is to buy back issued OMFs and finance this by issuing an unsecured bond. The unsecured bond will then replace the OMF on the liability side, while the asset side will be unchanged.

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