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Mortgaged Backed Securities

A New Source of Financing Retail Mortgages for German Banks

©2006 Masterarbeit 146 Seiten

Zusammenfassung

Inhaltsangabe:Summary:
In order to ensure that the mortgage market remains buoyant, lenders require constant access to sufficient funds. Traditionally, mortgage lenders rely on retail deposits, mortgage covered bonds or dedicated savings to provide this source of funding. However, those providers who do not have the luxury of an established and reliable retail deposit base, or high credit rating necessary for cheap money market credit, are forced to think of alternatives. Securitization of originated mortgage loans can provide the answer.
Financial institutions that originate loans are able to turn their loans into marketable securities through a process known as securitization. The originators of the loans are commonly referred to as the issuers of asset-backed securities (ABS). ABS constitute a relatively new but fast growing segment of the debt markets in Europe. The combination of a number of legal and economic factors has provided a favorable climate for securitization in Europe, especially in the United Kingdom (UK) and in its country of origin, the United States (US). In turn, these countries have experienced considerable growth in securitization volumes over the past years. In contrast, due to a weak economy and an unfavorable legal, tax and regulatory environment the German securitization market was not able to develop in much the same way.
However, the German economy has started to recover in the current year and is forecasted to continue growing in 2007. This economic growth will in turn drive the domestic mortgage demand. In addition, based on the state and structure of the German mortgage market it is becoming increasingly attractive for foreign investors. Thus, both the economic recovery and an increased mortgage demand will drive the funding requirements of German banks. Moreover, the significance of securitization as an alternative refinancing instrument for residential mortgages is likely to grow, not least because the elimination of the legal, tax and regulatory hurdles has enhanced the attractiveness of true-sale securitization in Germany.
The title of the thesis is called, Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks. As raising finance is elementary to the growth and profitability of banks, the hypothesis of the thesis inevitably boils down to the question, whether the application of mortgage backed securities (MBS) increases the ability of German banks to raise finance for […]

Leseprobe

Inhaltsverzeichnis


Harold Keller
Mortgaged Backed Securities
A New Source of Financing Retail Mortgages for German Banks
ISBN-10: 3-8324-9932-6
ISBN-13: 978-3-8324-9932-7
Druck Diplomica® GmbH, Hamburg, 2006
Zugl. FOM - Fachhochschule für Oekonomie und Management Essen, Essen,
Deutschland, MA-Thesis / Master, 2006
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Acknowledgements
First of all I would like to thank my primary instructor Prof. Dr. Eric Frère, without whom I
would not have been able to write this thesis.
Special thanks go to the interviewees of HVB, DG Hyp and Eurohypo and the Euroland
Investment Grade Credit team at WestLB Mellon Asset Management, for providing me
with market practice information and insightful comments necessary for my work.
Last but not least, I would like to thank my parents for their educational and financial
support and a special thanks to my grandmother for her unconditional trust and support.
"Declaration in lieu of oath
I hereby declare that I produced the submitted paper with no assistance from any other
parties and without the use of any unauthorized aids, and that all passages reproduced
verbatim or nearly so, from any publications whatsoever have been clearly identified as
quotations and all the relevant bibliographical references have been provided. In addition
to that I hereby declare that the written paper corresponds with the digital version.
Furthermore, I declare that this paper has not been submitted to any other examination
board either in its present or in any other similar version."
Essen, the 12th of July 2006

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
I
Table of Contents
Executive Summary... VIII
1.
Problem... - 1 -
1.1
Definition of Problem... - 1 -
1.2
Reasoning and Motivation... - 1 -
1.3
Methodology ... - 2 -
2.
Asset Securitization... - 3 -
2.1
General Concept ... - 3 -
2.2
True-sale Method ... - 5 -
2.2.1 The Process and Structure... - 6 -
2.2.2 The Participants in the Process... - 6 -
2.2.2.1
Originator... - 6 -
2.2.2.2
Servicer ... - 7 -
2.2.2.3
Trustee ... - 7 -
2.2.2.4
Special Purpose Vehicle... - 8 -
2.2.2.5
Rating Agency ... - 9 -
2.2.2.6
Credit Enhancer... - 10 -
2.2.2.7
Investors... - 12 -
2.3
Synthetic Method ... - 13 -
2.4
True-sale vs. Synthetic Method... - 14 -
2.5
Market Risks ... - 15 -
3.
Mortgage Backed Securities ... - 16 -
3.1
Definition of a Mortgage ... - 17 -
3.2
Mortgage Securitization ... - 17 -
3.3
Residential Mortgaged Backed Securities... - 18 -
3.4
Common Cash-Flow Structures ... - 20 -
3.5
Objectives of Mortgage Securitization... - 21 -
3.5.1 An Alternative Method of Funding ... - 22 -
3.5.2 A Method of Risk Transfer... - 23 -
3.5.3 A Method of Balance Sheet Management ... - 24 -
3.5.4 The BIS Capital Adequacy Requirements ... - 26 -
3.6
History and Market Development ... - 30 -

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
II
4.
Traditional Refinancing Instruments... - 35 -
4.1
Retail Deposits... - 35 -
4.2
Dedicated Savings ... - 35 -
4.3
Mortgage Covered Bonds ... - 36 -
4.4
Mortgage Covered Bonds vs. Securitization ... - 38 -
5.
The German Mortgage Market... - 40 -
5.1
Economic Environment ... - 40 -
5.1.1 Macroeconomics ... - 41 -
5.1.2 Demographics ... - 48 -
5.2
Housing Market ... - 49 -
5.2.1 Fundamentals... - 50 -
5.2.2 Market Size ... - 52 -
5.2.3 Mortgage Interest Rates ... - 57 -
5.2.4 House Prices ... - 58 -
5.2.5 Government Housing Policies ... - 61 -
5.3
The Banking Environment... - 62 -
5.3.1 Banking Structure... - 62 -
5.3.2 Banking Regulation ... - 64 -
5.4
The Pfandbrief and Bausparsystem ... - 66 -
5.4.1 Bausparsystem... - 67 -
5.4.2 Pfandbrief ... - 68 -
5.5
Chapter Conclusion... - 71 -
6.
The German RMBS Market... - 73 -
6.1
Market History and Development ... - 74 -
6.2
The True Sale Initiative ... - 79 -
6.3
Regulatory Environment... - 81 -
6.3.1 Principle I Guidelines... - 81 -
6.3.2 Circular 4/97 ... - 82 -
6.4
Legal Environment ... - 83 -
6.4.1 The Legal Transfer of Assets ... - 83 -
6.4.2 Refinancing Register Act ... - 84 -
6.4.3 Insolvency Regulations... - 85 -

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
III
6.4.4 Data Protection and Banking Secrecy... - 86 -
6.5
Tax Environment ... - 87 -
6.5.1 Trade Tax ... - 87 -
6.5.2 Value Added Tax... - 88 -
6.6
Competitor Overview... - 89 -
6.6.1 Savings Banks... - 90 -
6.6.2 Co-operative Banking Sector... - 91 -
6.6.3 Eurohypo AG... - 91 -
6.6.4 HVB Group ... - 92 -
6.6.5 The BHW Group... - 93 -
6.6.6 Foreign Lenders ... - 93 -
6.7
Chapter Conclusion... - 95 -
7.
Research Findings and Interpretation ... - 98 -
8.
Recommendation, Outlook & Critical Comments ... - 108 -
Bibliography... IX
Appendix ...XXII

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
IV
List of Abbreviations
ABS ...Asset-Backed Securities
AG ...Aktiengesellschaft
BaFin ... Bundesanstalt für Finanzdienstleistungsaufsicht
BAKred ...Bundesaufsichtsamt für das Kreditwesen
BCG...Boston Consulting Group
BdB...Bundesverband deutscher Banken
BGB...Bürgerliches Gesetzbuch
BIS... Bank of International Settlements
BMF... Bundesministerium der Finanzen
BVR ... Bundesverband der dt. Volksbanken und Raiffeisenbanken e.V.
CAGR ... Compounded Annual Growth Rate
CEO... Chief Executive Officer
CDS ... Credit Default Swaps
CLN ... Credit Linked Notes
CMBS ...Commercial Mortgage Backed Securities
CMO ... Collateralized Mortgage Obligations
CBO...Collateralized Bond Obligations
CDO ...Collateralized Debt Obligations
CLO ... Collateralized Loan Obligations
Corp... Corporation
DSGV ...Deutscher Sparkassen und Giroverband
e.g. ... exempli gratia
EC ... European Commission
ECB ... European Central Bank
EMF... European Mortgage Foundation
etc...et Cetera
EU ...European Union
EUR... Euro
GDP...Gross Domestic Product
GewStDV... Gewerbesteuerdurchführverordnung
GewStG...Gewerbesteuergesetz

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
V
GmbH ... Gesellschaft mit beschränkter Haftung
i.e... id est
IddWK... Institut der deutschen Wirtschaft Köln
Ifo-Index ... Ifo Business Climate Index
InsO...Insolvenz Ordnung
IRB ... Internal Ratings-Based Approach
KfW... Kreditanstalt für Wiederaufbau
KWG... Kreditwesengesetz
LTV...Loan to Value ratio
MBS... Mortgage Backed Securities
OECD ... Organization for Economic Cooperation and Development
p ...page
pp. ...pages
PB... Pfandbrief
PwC...Price Waterhouse Coopers
RMBS ... Residential Mortgage Backed Securities
ROE... Return on Equity
SchBG ...Schiffsbankgesetz
SEC ... Securities and Exchange Commission
SME...Small and Medium-Sized Enterprises
SPV ...Special Purpose Vehicle
TSI... True Sale Initiative
UK ... United Kingdom
US ... United States
UstG ... Umsatzsteuergesetz
VAT ... Value Added Tax
vdp... Verband deutscher Pfandbriefbanken
VdpB...Verband der privaten Bausparkassen
VÖB... Bundesverband öffentlicher Banken
vs... versus
REIT ... Real Estate Investment Trust

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
VI
List of Figures
Figure 2.1: Main Asset Classes of ABS... - 3 -
Figure 2.2: Typical RMBS True-Sale Securitization Structure ... - 6 -
Figure 2.3: Standard & Poor's Rating System ... - 9 -
Figure 2.4 Risk-Return Profile ABS ... - 13 -
Figure 2.5: Securitization Costs... - 15 -
Figure 3.1: Comparison of the Cost of Funding... - 23 -
Figure 3.2: BIS Capital Adequacy Ratios of German Banks... - 24 -
Figure 3.3: The Impact on ROE through ABS ... - 25 -
Figure 3.4: The Three Pillars of Basel II ... - 27 -
Figure 3.5: European ABS Market by Country ... - 31 -
Figure 3.6: European Mortgage Market Gross Advances... - 32 -
Figure 3.7: Development of the European Securitization Market ... - 33 -
Figure 3.8: European Securitization Transactions by Method ... - 34 -
Figure 4.1: Mortgage Covered Bonds in Europe (2004) ... - 36 -
Figure 4.2: Special Character of Mortgage Covered Bonds ... - 37 -
Figure 5.1: GDP in EUR of Major European Countries (2005) ... - 42 -
Figure 5.2: GDP per Capita of Selected European Countries (2004) .. - 43 -
Figure 5.3: GDP Growth across Europe ... - 44 -
Figure 5.4: Short Term Interest Rates ... - 46 -
Figure 5.5: Ifo Business Climate Index ... - 48 -
Figure 5.6: Population across Europe (2005) ... - 49 -
Figure 5.7: Owner Occupancy Rates in Europe (2002) ... - 51 -
Figure 5.8: Balances Outstanding in Germany... - 52 -
Figure 5.9: Market Potential of Selected European Countries... - 54 -
Figure 5.10: Market Size against GDP ... - 54 -
Figure 5.11: Development of Net Lending in Germany... - 55 -
Figure 5.12: Gross Advances in Germany... - 56 -
Figure 5.13: Development of Mortgage Interest Rates in Germany... - 57 -
Figure 5.14: Gross Margins of Mortgage Loans (2004) ... - 58 -
Figure 5.15: Development of House Prices in European Countries ... - 59 -
Figure 5.16: Real Estate Market Price Assessment (2004) ... - 61 -

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
VII
Figure 5.17: The Three Pillars of German Banking ... - 63 -
Figure 5.18: Banking Groups in the Three Pillars... - 64 -
Figure 5.19: Regulatory Overview of Germany ... - 65 -
Figure 5.20: Mortgage Funding in Germany (2003) ... - 67 -
Figure 6.1: Potential of German Securitization Market (2002)... - 76 -
Figure 6.2: Securitization Potential based on Bank Receivables... - 77 -
Figure 6.3: The German Securitization Market by Method ... - 78 -
Figure 6.4: Development of the German Securitization Market ... - 78 -
Figure 6.5: TSI Securitization Platform ... - 80 -
Figure 6.6: Securitization Matrix ... - 97 -
Figure 7.1: A SWOT Analysis of the German RMBS Market... - 108 -
List of Tables
Table 3.1: Risk Weights under Basel II... - 29 -
Table 5.1: Inflation Rates of major European Countries ... - 45 -
Table 5.2: German Unemployment Rates ... - 45 -
Table 5.3: Balances Outstanding Compared to GDP in Europe... - 53 -
Table 6.1: Outstanding Mortgage Debt by Banking Group (2004)... - 90 -

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
VIII
Executive Summary
In order to ensure that the mortgage market remains buoyant, lenders
require constant access to sufficient funds. Traditionally, mortgage lenders
rely on retail deposits, mortgage covered bonds or dedicated savings to
provide this source of funding. However, those providers who do not have
the luxury of an established and reliable retail deposit base, or high credit
rating necessary for cheap money market credit, are forced to think of
alternatives. Securitization of originated mortgage loans can provide the
answer. Financial institutions that originate loans are able to turn their
loans into marketable securities through a process known as
securitization. The originators of the loans are commonly referred to as the
issuers of asset-backed securities (ABS). ABS constitute a relatively new
but fast growing segment of the debt markets in Europe. The combination
of a number of legal and economic factors has provided a favorable
climate for securitization in Europe, especially in the United Kingdom (UK)
and in its country of origin, the United States (US). In turn, these countries
have experienced considerable growth in securitization volumes over the
past years. In contrast, due to a weak economy and an unfavorable legal,
tax and regulatory environment the German securitization market was not
able to develop in much the same way.
However, the German economy has started to recover in the current year
and is forecasted to continue growing in 2007. This economic growth will
in turn drive the domestic mortgage demand. In addition, based on the
state and structure of the German mortgage market it is becoming
increasingly attractive for foreign investors. Thus, both the economic
recovery and an increased mortgage demand will drive the funding
requirements of German banks. Moreover, the significance of
securitization as an alternative refinancing instrument for residential
mortgages is likely to grow, not least because the elimination of the legal,
tax and regulatory hurdles has enhanced the attractiveness of true-sale
securitization in Germany.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 1 -
1. Problem
1.1 Definition
of
Problem
The title of the thesis is called, Mortgage Backed Securities - A New
Source of Financing Retail Mortgages for German Banks. As raising
finance is elementary to the growth and profitability of banks, the
hypothesis of the thesis inevitably boils down to the question, whether the
application of mortgage backed securities (MBS) increases the ability of
German banks to raise finance for residential mortgages and thereby
reduce their financing costs, diversify risk and improve their capital ratios.
With this problem defined as such, a number of further questions arise
with it: how does asset-backed securitization function, what risks are
involved when securitizing assets, what are the objectives for a bank to
deploy asset securitization as financing instrument, where does the
instrument come from and how has it developed, who are the investors,
what other refinancing instruments are at a bank's disposal, what are the
drivers for securitization and consequently do German banks need to
make use of MBS as refinancing instrument to service the market and
keep up with international competition.
1.2
Reasoning and Motivation
The master thesis is written within the framework of an MBA program from
the FOM, Essen. The choice of topic is based on the fact that ABS has
been the cause of heated debates in the German financial market for the
past few years. In turn, while other European financial markets have long
adopted and embraced securitization, the German market posed many
hurdles for the financial industry. Therefore, the motivation of the topic is
to examine what the instrument is all about and what the exact reasons
were, why securitization has not developed in the German market as it has
developed in the US and other European markets, e.g. the UK.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 2 -
1.3 Methodology
The thesis provides the answers to the questions raised in the problem
definition by explaining the concept of securitization, providing historical
background to this method of financing and a brief overview of the US and
European markets. Further, the characteristics of the German residential
mortgage backed securities (RMBS) market are examined in detail. It
builds upon a wealth of pertinent literature as well as secondary
information and primary interviews to provide an insightful and balanced
view of the German RMBS market.
The executive summary provides the reader with a concise overview of the
main contents and findings of the thesis. Chapters 2, 3 and 4 provide the
concept, asset types, process and participants, market risks, methods
objectives history and development of securitization as well as an
overview of alternative refinancing instruments. Chapter 5 in turn provides
an overview of the German macroeconomic environment and its impact on
the German mortgage market followed by chapter 6 which provides a
more in-depth analysis of the German securitization market as a whole.
Chapter 7 then summarizes, interprets and concludes on the research
findings and finally, chapter 8 provides the reader with the
recommendation, outlook and critical comments.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 3 -
2. Asset
Securitization
2.1 General
Concept
ABS constitute a relatively new but fast-growing segment of the debt
market in Europe, having made its European debut in 1987 in the UK
(Bradt 1991, p. 1). ABS are bonds or notes backed by financial assets
(Adams 2004, p. 1). These assets are pooled to make otherwise minor
and uneconomical investments worthwhile, while also reducing risk by
diversifying the underlying assets (Braun 2005, p. 63). The securitization
makes these assets available for investment to a broader set of investors
(Adams 2004, p. 2). Typically, the securitized assets might be highly
illiquid and private in nature (Braun 2005, p. 63). The financial assets in
the pool backing the asset-backed securities range from mortgages and
credit card debt to accounts receivables (Braun 2005, pp. 63-68). The
below figure illustrates the various asset classes, whereby the thesis will
focus on MBS in general and residential mortgage backed securities
(RMBS) in particular.
Figure 2.1: Main Asset Classes of ABS
Source: Breidenbach (2003), p. 4.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 4 -
The asset class CDO stands for collateralized debt obligation and
comprises securitized structures for various types of corporate assets.
CDOs are again categorized as CLOs which stands for collateralized loan
obligations and refers to securitized loans typically of a commercial nature
and CBOs called collateralized bond obligations, where the underlying
assets are corporate bonds (Braun 2005, p. 67). According to Schwarcz
(2002, p. A-9) securitization is a win-win financing tool for both originator
and investors compared with other forms of financing, as many companies
can better utilize their most valuable assets by accessing low cost capital
market funding.
Securitization of assets began in the US in 1970 when the Government
National Mortgage Association (GNMA) issued its first mortgage-backed
security (Bradt 1991, p. 2). Initially, its development began because of the
US federal government's desire to develop a secondary mortgage market
for residential mortgage loans (Bradt 1991, p. 2). By the mid-1980's,
securitization was being applied to non-mortgage assets, namely
consumer loans, credit cards and other receivables.
ABS vary from most other kinds of bonds in that their creditworthiness
derives from sources other than the paying ability of the originator of the
underlying assets (Adams 2004, pp. 1-4). In an ABS transaction, the
originators of such assets, typically credit institutions, first found a single-
purpose company called special purpose vehicle (SPV) and then assign
the previously defined asset pool to it (Braun 2005, p. 63). The SPV funds
the assets takeover by issuing notes and selling them on the capital
market (BayernLB, 2006). To be able to issue the notes on the capital
market, the SPV has to be rated by one or more of the three leading rating
agencies, Standard & Poor's, Moody's and Fitch (BayernLB, 2006). The
notes will be issued in different ratings or risk classes. Moreover, there
may be different maturities within each rating class called tranche notes.
The AAA tranche is usually called the "highest tranche" and the first loss
or equity piece the "lowest tranche" (BayernLB, 2006).

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 5 -
ABS may be set up according to the assignment as synthetic or true-sale
structures. Synthetic structures only transfer the respective risk ­ typically
the assets' default risk ­ to the SPV using a derivative instrument. In this
case, the SPV parks the note sale revenue in safe investments until the
tranches mature (BayernLB, 2006). Under the true-sale structure, the
originator outright sells and bindingly assigns the assets to the SPV. The
SPV then transfers the note issue revenue to the seller of the assets
(BayernLB, 2006). Although the thesis focuses on true-sale structures, for
the sake of clarification and completeness, both methods will be described
and compared below. In addition, where relevant and necessary for
research purposes the methodologies will be compared to each other.
2.2 True-sale
Method
True-sale securitization essentially means that the transfer of assets from
an originator to SPV constitutes a sale under each applicable law
(Schwarcz 2002, p. 2-4). The purpose of an originator to have a true-sale
securitization is to segregate the securitized assets from the credit risks of
its other assets and its entity (Braun 2005, p. 68). The main advantage of
a true-sale securitization is that it allows an originator to take the
securitized assets off its balance sheet (Bradt 1991, p. 1). The most
important aspect of true-sale securitization is to make the transaction
bankruptcy-remote from its originator (Braun 2005, p. 68). This means that
if the transfer of the underlying assets to an SPV constitutes a true-sale, a
potential bankruptcy of the originator will not affect the SPV`s right to the
underlying assets and their collection (Braun 2005, p. 68). Therefore,
investments to the ABS are secured (Braun 2005, p. 68). Bankruptcy
remoteness, along with certain other aspects, discussed later on, enable
the ABS to receive their own credit rating, independent of that of the
originator and in turn the ABS may well have a higher rating as the
originator (Adams 2004, p. 10). In other words, the originator is able to
obtain cheaper funding it cannot otherwise get. The securitization process
is explained in greater detail in the following sections.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 6 -
2.2.1
The Process and Structure
As mentioned above, in a typical securitization process, the originator
transfers the chosen pool of loans to a bankruptcy-remote SPV. This entity
then issues the securities that back the loans, which are sold on to
investors, and the cash flow from the loans is used to pay returns to the
investors (Adams 2004, pp. 1-4). In some cases, the SPV conveys the
assets to a trust, the beneficiaries of which are the investors (Adams 2004,
pp. 10). A typical true-sale securitization process is illustrated in the figure
below.
Figure 2.2: Typical RMBS True-Sale Securitization Structure
Borrower
Borrower
O
rig
ina
tin
g B
ank
Servicer
Trustee
SPV
Rating
Agency
Investors
M
o
rt
gag
e
lo
ans
Transfer
of Risk
Purchase
Price
Collection of Cash Proceeds/
Mostly fulfilled by Originator
AAA
AA
A
BB
RMBS
Tranches
Credit
Enhancer
RMBS
Securities
Cash
Proceeds
Cash
Proceeds
Equity Piece
Borrower
Borrower
O
rig
ina
tin
g B
ank
Servicer
Trustee
SPV
Rating
Agency
Investors
M
o
rt
gag
e
lo
ans
Transfer
of Risk
Purchase
Price
Collection of Cash Proceeds/
Mostly fulfilled by Originator
AAA
AA
A
BB
RMBS
Tranches
Credit
Enhancer
RMBS
Securities
Cash
Proceeds
Cash
Proceeds
Equity Piece
Source: David (2001), p. 30.
2.2.2
The Participants in the Process
As can be seen from the figure above there are several participants in a
true-sale securitization structure. The various participants involved are
explained in more detail below.
2.2.2.1 Originator
The originator is the owner of the receivables, e.g. mortgage loans
(Röchling 2002, p. 25). In the case of a true-sale transaction the originator
will sell the receivables to a SPV (David 2001, p. 27). Therefore
securitization reduces originator risk and generates liquidity inflow for the

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 7 -
originator at transaction commencement without having to wait for
repayment of the assets (BayernLB, 2006). Due to data protection and
banking secrecy regulations, discussed later on in the thesis, the originator
in most cases simultaneously acts as the servicer (Braun 2005, pp. 64-
65).
2.2.2.2 Servicer
The servicer is responsible for the collection and distribution of the cash
flows to the investors or a trustee that arise from the assets (interest
and/or principal payments), arrears management and collateral
management (Peterek 2003, p. 24). As mentioned, the role of the servicer
is mostly fulfilled by the originator. In all cases the servicer will receive a
fee, which is disbursed by the SPV (Bär 1997, p. 104 ff).
2.2.2.3 Trustee
The trustee is the "agent" of the investors that controls and checks cash
flows, loss allocations, adherence to provisions etc. (HVB, 2006a). The
trustee is necessary especially to comply with data security laws. For
instance, the trustee gets customer-specific data to check against
concentration rules that upon verification are made anonymous and then
passed on to the respective other recipients of this information (BayernLB,
2006). The servicer submits the prepared reports, documents, and
portfolio registers to the trustee to have them checked for conformity. The
trustee then has to approve the material for release and distribution to the
recipients (BayernLB, 2006). A trustee is usually a chartered public
accountant independent of the originator or other parties to the structure
(Rosar 2000, p. 25). The trustee is contractually obliged to observing due
diligence as for his own affairs and is liable for contract violations (Ohl
1994, pp. 45 ff).

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2.2.2.4 Special Purpose Vehicle
As mentioned, the SPV has the sole purpose of raising funds for the
purchase of the receivables through issuing securities, e.g. MBS on the
capital markets (David 2001, pp. 27ff). Further, the receivables must
provide a steady stream of cash flows in order to pay principal and interest
on the securities. The most important aspect of the process is the legal
separation of the assets from the originator, ensuring that the payments
are derived exclusively from the performance of a segregated pool of
assets and removing the investor from any insolvency or bankruptcy risk
on the part of the originator (Bund 2000, pp. 16-18). The SPV is thus
bankruptcy-remote, which guarantees the investor that in case of
insolvency of the originator it still has full claim on the cash flows of the
receivables (Baker & McKenzie, 2004). In the essence to achieve a
bankruptcy-remote transaction, the transaction needs to qualify as such in
theory and practice (Baker & McKenzie, 2004). This important feature
gives the debt issue a higher rating than the originator could command in
its own right and therefore results in a lower cost source of financing
(Bund 2000, pp. 16-18). Thus, the rated securitization allows the issuer to
approach investors restricted to rated offerings (Bund 2000, pp. 16-18).
Depending on the number of originators, SPVs are differentiated in "single
seller-vehicles" and "multi seller-vehicles" (Schwarcz 1994, pp. 138-141).
Single seller-vehicles securitize receivables of only one originator, either
on a once-off or revolving basis and multi seller-vehicles securitize
receivables of several originators (David 2001, pp. 27 ff). Multi seller-
vehicles are generally used for high volumes and thereby decreasing the
costs through economies of scale (David 2001, pp. 27 ff).
A further aspect of an SPV is that it only has structurally necessary
balance sheet positions that in the most minimal case may be limited to
the purchased assets on the asset side and the notes issued on the equity
and liability side (BayernLB, 2006).

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
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2.2.2.5 Rating Agency
To achieve the above described benefits, the securities issued by an SPV,
need to be rated by a rating agency, e.g. Standard & Poor's, Moody's and
Fitch, to indicate their credit worthiness and hence their risk. A typical
rating system applied by Standard & Poor's is shown in the figure below.
Figure 2.3: Standard & Poor's Rating System
Regulatory action. Placed under an order of rehabilitation and
liquidation.
R
Extremely vulnerable financial security. Questionable ability to
meet obligations unless favourable conditions prevail
CCC
Vulnerable financial security.
B
Financial security may be adequate, but capacity to meet long-
term policies is vulnerable.
BB
Vulnerable Range:
Adequate financial security. More vulnerable to economic
changes than highly rated companies.
BBB
Good financial security. More susceptible to economic change
than highly rated companies.
A
Excellent financial security. Highly safe.
AA
Superior financial security. Highest safety.
AAA
Secure Range:
RATING CATEGORIES
Regulatory action. Placed under an order of rehabilitation and
liquidation.
R
Extremely vulnerable financial security. Questionable ability to
meet obligations unless favourable conditions prevail
CCC
Vulnerable financial security.
B
Financial security may be adequate, but capacity to meet long-
term policies is vulnerable.
BB
Vulnerable Range:
Adequate financial security. More vulnerable to economic
changes than highly rated companies.
BBB
Good financial security. More susceptible to economic change
than highly rated companies.
A
Excellent financial security. Highly safe.
AA
Superior financial security. Highest safety.
AAA
Secure Range:
RATING CATEGORIES
Source: Standard & Poor's (www.standardandpoors.com).
The rating agency must analyze all specifications of the ABS transaction
and then evaluate the risk and quality of the ABS (David 2001, p. 27 ff). In
addition the rating agency reduces the information asymmetry between
the SPV and the originator on the one hand and between the SPV and the
investor on the other hand (Kley and Everling, 2001). The rating process
itself starts with a feasibility study which evaluates the prospective issuer's
ability to securitize its assets according to criteria including management,
history, strategy and sustainability of its market position (BayernLB, 2006).
An agency's ratings committee will also review the deal's financial
structure in order to determine the levels of credit enhancement required;

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
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the historic performance and credit quality of the underlying receivables,
including assessment of potential collateral losses under given scenarios;
as well as any relevant legal issues such as rights of
creditors/bondholders and status of bankruptcy law (BayernLB, 2006). The
strengths and weaknesses of the origination process and underwriting
practices will also be examined, while the servicer will need to provide
evidence of robust collection and servicing methods (BayernLB, 2006).
Rating agencies usually require what is called a true-sale opinion from a
law firm before the securities can receive a rating higher than that of the
originator (Adam 2004, p. 25).
2.2.2.6 Credit Enhancer
In many cases, issuers of securities use credit enhancement techniques to
guarantee the desired credit risk profile for the securities issued (Adams
2004, p. 11). Credit enhancement is a mechanism that elevates the credit
quality of the assets' cash flow stream above the stream's inherent credit
quality (Wenman 1991, pp. 164-171). It does so by incorporating elements
within the securitization structure that are designed to protect investors
from potential losses incurred on the underlying assets (Wenman 1991,
pp. 164-171). By doing so, the credit enhancement enables the ABS to
carry a higher credit rating than the originator itself (Adams 2004, p. 10). In
addition, credit enhancement enables the rating agencies to grant a rating
to an issue and thereby provide additional reassurance (Millard and
Remus 1991, p. 47) Credit enhancement encompasses a variety of
internal and/or external provisions that may be used to reduce the credit
risk (David 2001, p. 83). To name a few common supports:
Subordination (internal), where subordinated tranches of the
issue absorb losses resulting from default or underperformance
relating to the underlying asset (David 2001, pp. 85-86).
Subordination of a small proportion of the debt issued is the

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 11 -
most popular form of credit enhancement, although it should be
noted that the market for the lowest class of debt is limited, and
finding buyers for the subordinated notes will be a key
determinant of success (David 2001, pp. 85-86).
Over-collateralization
(internal)
- a capital structure in which
assets exceed liabilities (Wenman 1991, pp. 164-171). For
example, an issuance of EUR 75 million of senior securities
might be secured by a pool of assets valued at EUR 100 million,
in which case the over-collateralization for the senior securities
would be 25% (David 2001, pp. 83-84). This method is rarely
used, owing to its high costs and the inefficient use of capital
(Wenman 1991, pp. 164-171). Over-collateralization, therefore,
tends only to be used to a limited degree and in conjunction with
other forms of credit enhancement (Wenman 1991, pp. 164-
171).
Third party loan guarantees (external) - a parent company or
other third party may be contractually bound to meet the
obligations of one party should that party default (Wenman
1991, pp. 164-171). Guarantees provided by an AAA
counterparty were the dominant form of credit enhancement in
the early 1990s (Millard and Remus 1991, p. 53). However, the
adverse impact when support providers were downgraded,
together with legal disputes over the terms of policies by general
insurers, have made this form of enhancement less popular, and
its provision is now almost exclusively done by a small group of
specialist AAA-rated monoline insurers (Millard and Remus
1991, p. 47).
Letters of credit (external) ­ are the oldest and most popular
form of credit enhancement (Kotecha 1992, p. 195). Basically a

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 12 -
letter of credit is an agreement between a bank and another
party under which the bank agrees to make funds available to or
upon the order of the other party upon receiving notification
(Kotecha 1992, p. 195).
One of the key reasons behind the rapid growth of the ABS market in the
US was the widespread availability and investor acceptance of external
credit enhancement (Kotecha 1992, p. 193). Further Kotecha (1992, p.
193) argues that with credit enhancement in place, ABS have become
safe, liquid and high yielding investments.
2.2.2.7 Investors
ABS are typically bought by institutional investors, e.g. banks, insurance
companies, asset managers and investment agencies (David 2001, pp.
68-72). However, the main investors of ABS are banks themselves (BCG,
2004). Generally investors not only consider the potential return but also
liquidity and security aspects are taken into account (Baums 1993, p. 5).
Additionally, as mentioned, there are investors who are restricted in
investing in highly rated, e.g. AAA class assets (Willburger 1997, p. 78).
ABS securities are able to offer investors the above mentioned investment
criteria and better returns than other securities with similar risks (Ohl 1994,
p. 331). Please see below figure for a risk-return profile of ABS in
comparison to other financial instruments.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 13 -
Figure 2.4 Risk-Return Profile ABS
Risk
Return in %
2
10
6
14
18
22
2
4
6
8
10
ABS
Sovereign Bonds
Covered Mortgage Bonds
Corporate Bonds
Second lien Bonds
Emerging Markets
Commodities
Risk
Return in %
2
10
6
14
18
22
2
4
6
8
10
Risk
Return in %
2
10
6
14
18
22
2
4
6
8
10
ABS
Sovereign Bonds
Covered Mortgage Bonds
Corporate Bonds
Second lien Bonds
Emerging Markets
Commodities
Source: MBA lecture notes, Frère (1995).
In addition, ABS offer investors an additional asset class and therefore the
possibility to further diversify their investment portfolio (Bund 2000, p. 19).
Moreover, when investing in ABS the investor is no longer dependent on
the originator, as the securities are issued by the SPV and therefore the
potential danger of default risk is mitigated (Bund 2000, p. 19). Although
this form of financing only became available to Europe during the late
eighties, ABS have established themselves as a recognized asset class in
Europe (Bär 1997, p. 407).
2.3 Synthetic
Method
As opposed to true-sale securitization, synthetic securitizations are
structured transactions in which financial institutions use credit derivatives,
such as credit default swaps (CDS) or credit linked notes (CLN) to transfer
credit default risks to a third party without removing the underlying assets
off the balance sheet (Herrmann 2002, p. 197). In other words, the
commercial effect of a true-sale is synthesized or replicated (Braun 2005,
p. 69). Further, a synthetic securitization is not subject to the same legal

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 14 -
requirements as a true-sale securitization in that it does not need to
constitute a sale (Bund 2000, pp. 240-241). Therefore, synthetic
securitization is a comparatively cost-effective mechanism for repackaging
credit risk portfolios in response to incentives in regulatory capital
requirements set by the Basel I Accord (Basel Committee 2001, p. 15).
This is discussed in greater detail in section 4.3.
Those banks who engage in a synthetic transaction are most likely to have
favorable funding requirements, meaning they are able to access on-
balance sheet funds at competitive spreads, especially in the area of
mortgage-based financing (Bund 2000, pp. 240-241). As this has been the
case with German banks and due to the unfavorable legal and regulatory
environment German banks have preferred synthetic securitization over
true-sale structures in the past (Deutsche Bundesbank 2006, p. 51).
2.4
True-sale vs. Synthetic Method
When comparing the true-sale structure to the synthetic structure there are
three major differences. Firstly, while a true-sale securitization is an off-
balance sheet financing tool, a synthetic securitization is an on-balance
sheet tool. As mentioned above, if the underlying pool of assets is sold
and transferred to an SPV then the originator is able to remove the assets
off his balance sheet and it is therefore said to be a true-sale transaction
(Deutsche Bundesbank 2006, p. 51). By doing so a bank is able to free
risk adjusted capital and thereby improve its return on equity (David 2001,
p. 34). This effect will be discussed in greater detail later on in the thesis.
A synthetic transaction as mentioned does not constitute a sale and
therefore the assets remain on the balance sheet. In turn, the leverage
ratio stays untouched and no improvement of the return on equity is
achieved (Braun 2005, p. 69).
Secondly, due to the fact that a true-sale constitutes a sale under all
applicable laws and requires the setting up of a SPV as opposed to a

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 15 -
synthetic securitization, the synthetic transaction has a cost advantage
over the true-sale method (Basel Committee 2001, p. 15). The figure
below compares the costs of true-sale vs. synthetic securitization. Please
note that the figures are purely an indication and do not reflect the real
costs incurred when structuring a synthetic or true-sale securitization.
Figure 2.5: Securitization Costs
Securitization Costs
Credit
Enhancement
Sum
Setup
costs
Add.
Credit
Enhancement
Sum
Upfront
fee
Synthetic Structure
True-Sale
14
12,5
26,5
8
17,5
52
Securitization Costs
Credit
Enhancement
Sum
Setup
costs
Add.
Credit
Enhancement
Sum
Upfront
fee
Synthetic Structure
True-Sale
14
12,5
26,5
8
17,5
52
Source: Boston Consulting Group (2004), p 14.
Thirdly, the two methods differ from each other in terms of their underlying
objectives. While the main objective of a true-sale securitization is to
obtain cheaper funding, the main objective of a synthetic transaction is to
hedge credit risks more efficiently (Basel Committee 2001, p. 15). Further
motivations and objectives from an originating perspective will be
discussed in chapter 3.
2.5 Market
Risks
As with all fixed-income securities, the prices of ABS also fluctuate in
response to changing interest rates in the general economy, i.e. when

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 16 -
interest rates fall, prices of ABS rise and vice versa. However, prices of
ABS with floating rates are much less affected because the index the ABS
rate adjusts to reflects the interest changes (Adams 2004, p. 19).
A further interest rate risk exists, when the change in rates influences the
pace of prepayments of the underlying loans. This in turn affects the
yields. In general it can be said, that non-mortgage assets are not highly
sensitive to interest rate fluctuations. Therefore these assets are not
usually subject to early prepayments due to a change in interest rates.
However, mortgage-like assets do face interest-rate-based risk of
prepayment (Adams 2004, p. 19). Of which fixed rate mortgage loans are
the most sensitive type of collateral for ABS, as borrowers are more likely
to repay their home loan once interest rates fall (Adams 2004, p. 19).
Prepayment results in the originator receiving the principal on a mortgage
balance earlier than the length of term (Chinloy and DiNunno 1991, pp.
149-150). Whereas regular amortization is the difference between the
mortgage payment and the interest paid. Prepayment can either occur as
a partial or complete prepayment of the outstanding mortgage loan. Both
these types of prepayments need to be differentiated when pricing a
mortgage security, as an aggregation of partial and complete prepayments
could result in a mispricing (Chinloy and DiNunno 1991, pp. 149-150). It
should be noted that § 609a of the German Civil Code allows for the
exclusion of a prepayment right in German mortgage and consumer loan
contracts (Fugel 1991, p. 381).
3. Mortgage Backed Securities
In order to ensure that the mortgage market remains buoyant, lenders
require constant access to sufficient funds. Traditionally, mortgage lenders
rely on retail deposits, covered bonds or dedicated savings to provide this
source of funding. However, not all providers have the luxury of an
established and reliable retail deposit base, or high credit rating necessary
for cheap money market credit and therefore are forced to seek for

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 17 -
alternative funding sources. Securitization of originated mortgage loans
may provide the answer. Before describing the instrument itself, a brief
definition of a mortgage is given below.
3.1
Definition of a Mortgage
A mortgage is a method of using property as security for the payment of a
debt (Senft 1990, pp. 97-101). Technically, the term "mortgage" refers to
the legal device used in securing the property, but it is also commonly
used to refer to the debt secured by the mortgage (Senft 1990, pp. 97-
101). In most jurisdictions mortgages are strongly associated with loans
secured on real estate rather than other property, e.g. ships, and in some
cases only land may be mortgaged (Senft 1990, pp. 97-101). Arranging a
mortgage is seen as the standard method by which individuals or
businesses can purchase residential or commercial real estate without the
need to pay the full value immediately (Senft 1990, pp. 97-101). Generally,
when reference is made to retail mortgages, the mortgage refers to
residential real estate (Senft 1990, pp. 97-101). In this thesis the term
mortgage means a financial contract containing an annuity relating to the
debt taken out to finance residential real estate.
3.2 Mortgage
Securitization
Mortgage securitization is a sale of debt instruments secured by a
segregated, income-producing pool of mortgage loans (Fabozzi et al.
2000, p. 19). The mortgage loans are repackaged into securities, creating
credit-enhanced claims against the cash flow of the portfolio, which are
then sold to institutional investors (Bär 1997, p. 47). Such securities are
asset-backed since payment on them is based on payments made by
borrowers of the loans (Bär 1997, p. 47). The mortgage issuer then
effectively gets the mortgage obligation paid off on issue of the MBS rather
than waiting for the mortgage period to elapse. The investors of MBS do
not own the assets, but they own the securities offering returns dependent

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 18 -
upon the performance of the assets (Bär 1997, p. 47). Most importantly,
the whole process ensures that ownership interests in the assets are more
readily marketable and thus more liquid (BayernLB, 2006).
MBS are distinguished by the type of underlying mortgage loans. If the
pool of mortgage loans consists of commercial mortgages to finance
commercial property, the instrument is referred to as commercial
mortgaged backed security (CMBS) and if the pool consists of residential
mortgages, the instrument is called RMBS (Bär 1997, p. 47). As RMBS are
center to the thesis, this instrument is described in greater detail below.
3.3
Residential Mortgaged Backed Securities
RMBS structures transfer residential mortgage risk to the capital market.
The individual assets are relatively small; therefore RMBS portfolios
combine a huge amount of mortgages to attain the best possible minimum
asset pool volume for securitization. Hence, RMBS portfolios are very
granular, i.e. they have a highly diverse borrower base with very low
concentration of debt per individual (BayernLB, 2006).
Since RMBS structures pool a high number of securitized assets, rating
agencies do not rate RMBS risk by individual borrower or asset analysis
but rather by stochastic calculus (BayernLB, 2006). The agencies use
specific models that are usually adapted to the assets' country of origin.
Investors should take the same approach and seek to learn about
individual mortgage markets to understand why certain collateral
characteristics are the way they are in different countries (Morgan Stanley,
2005). Regulatory, tax and structural issues have a substantial effect on
both the supply of, and demand for, mortgage credit as well as product
design. Taxation of property and mortgage interest rates also vary across
Europe, which can make a substantial difference to the relative
attractiveness of home-ownership. Given all these factors, levels of owner
occupation and mortgage debt to GDP differ from country to country
(Morgan Stanley, 2005). This will be discussed in greater detail in chapter
5.

Mortgage Backed Securities - A New Source of Financing Retail Mortgages for German Banks -
- 19 -
Key risk rating criteria include mortgage maturity, loan-to-value ratio (ratio
of loan amount over property value - LTV), type of residential real estate,
object location, and type of use (Morgan Stanley, 2005). LTVs are crucial
in that they determine both the probability of default and loss severity of
individual loans, therefore the lower the LTV ratio the lower the risk of
default (Morgan Stanley, 2005). It is important to note that LTVs vary
substantially by country based on cultural factors, product design, legal
limitations and the tax-deductibility of mortgage debt (Morgan Stanley,
2005). In terms of type and use of such residential real estate, owner-
occupied property is preferable to buy-to-let objects and single family
homes are better than multi-family homes (BayernLB, 2006). The reason
for this, is that rental objects typically have a higher default rate than
owner-occupied homes and market participants consider multi-families a
higher risk as they tend to be harder to sell (Morgan Stanley, 2005).
Objects in the asset pool should ideally be demographically typical for the
area in terms of occupancy and toward economically more prosperous
areas (BayernLB, 2006). The individual objects should rather be in
metropolitan and suburban locations than in rural ones, especially if they
are expensive as the buyer base for rural objects is more limited and may
require price concessions in a foreclosure situation (BayernLB, 2006).
Moreover, RMBS transactions have the lowest rate of credit enhancement
of all ABS categories (BayernLB, 2006). This indicates that portfolio risk is
deemed very low. Investors seeking to invest in existing RMBS structures,
should analyze the past portfolio performance. Indicators such as
delinquency rates, losses incurred and obviously a portfolio breakdown
according to the aforementioned criteria should be used to asses the
performance (BayernLB, 2006). Of all criteria, the recovery rate on
defaulted debt is the most important measure for the value of the
securitized portfolio (BayernLB, 2006). The recovery rate states the
percentage of value recovered from foreclosing on the asset as well as
from the debtor itself.

Details

Seiten
Erscheinungsform
Originalausgabe
Jahr
2006
ISBN (eBook)
9783832499327
ISBN (Paperback)
9783838699325
DOI
10.3239/9783832499327
Dateigröße
1 MB
Sprache
Englisch
Institution / Hochschule
FOM Essen, Hochschule für Oekonomie & Management gemeinnützige GmbH, Hochschulleitung Essen früher Fachhochschule – Wirtschaftswissenschaften
Erscheinungsdatum
2006 (Oktober)
Note
1,3
Schlagworte
kreditwesen deutsche banken mortgage basel sythetic structure
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