The tight legal framework within which the participants of the Pfandbrief market must operate is one of the foremost reasons why Pfandbriefe appeal to both domestic and international investors. In addition to being bound by the general provisions set out in the German Banking Act (KWG), the law by which all German banks are governed, German Pfandbrief banks are also subject to the requirements of the Pfandbrief Act.

The Pfandbrief Act (PfandBG), which came into force July 2005, superseded the Hypothekenbankgesetz (Mortgage Bank Act). Under the old legislation, mortgage banks were bound by the specialist bank principle and were permitted to engage only in public sector and mortgage lending activities. However, with the inception of the new Act, any institution may now issue Pfandbriefe provided it has core capital of at least €25 million and meets the requirements set forth under the Act with regard to the management, monitoring, and control of risks. Furthermore, in order to engage in Pfandbrief business a license is needed from the Federal Financial Supervisory Authority (BaFin) and in doing so, the institution must submit to BaFin a business plan stating that it intends to engage in Pfandbrief business on a regular and sustained basis. Only real estate-secured mortgage loans are eligible as cover assets for mortgage Pfandbriefe and the property serving as cover must be located in an European Economic Area (EEA) state, the United States, Canada, Japan, or Switzerland. A further precondition for inclusion in the mortgage cover pool is proof that the Pfandbrief bank has the necessary expertise in the respective market. For public Pfandbriefe, loans to European Union (EU) member states, the other G7 states, and Switzerland as well as to their regional and local authorities qualify as cover assets. Loans granted to other European Organization for Economic Co-operation and Development (OECD) states may also serve as cover.

In addition to what could be considered low risk fields of activity; a strict regional restriction is added in order to reduce risks in connection with cross-border business. Under this restriction, loans may only be granted to borrowers situated within the member states of the European Union, the EEA, the European OECD countries as well as the non-European G7 countries.

Further security is provided to the investor by the fact that Pfandbrief bonds are required to be covered by assets, which have at least the same value and bear the same interest rate. Moreover, Pfandbrief banks are required under the Net Present Value Directive to keep excess cover of a least 2% of the volume of Pfandbriefe outstanding in the cover pools.

It is necessary for these underlying assets to be segregated into two separate cover pools, one for mortgage loans and the other public sector loans, thus reflecting the two types of business within which the mortgage banks are involved. In the case of mortgage Pfandbriefe, covering assets are "first-charge" mortgages.

In the event of a Pfandbrief bank's becoming insolvent, the Pfandbrief creditor would receive a preferential claim over the assets in the respective cover pool, which is there solely to protect them. They would not be required to participate in the insolvency procedures, but instead have any claim satisfied on schedule in accordance with the terms of the respective issue out of the cover assets. However, if the claim cannot be satisfied on time, in respect of coupon payments and redemptions because the cover pool is insolvent, separate proceedings will then commence in regard to the pool affected.

The Pfandbrief legislation contains further protective measures to safeguard investors in mortgage Pfandbriefe. Namely, a limit imposed on those mortgages being used as cover to a maximum of 60% of the "prudently" calculated mortgage lending value. This provides a safety cushion against the potential cyclical fluctuations in the market value of the cover pool asset.

The comparatively low risk that a portfolio of both residential and commercial mortgages entails is also expressed in the equity weighting of 50% for mortgage loans with a lending limit of up to 60%.

These elements obviously offer exceptional safety to investors in the Pfandbrief market and should therefore limit the impact of any adverse market movements on the back of any detrimental news in regard to the parent companies.

The jumbo Pfandbrief market, on its own, is Europe's fourth largest bond market, surpassed only by the government markets of Italy, Germany, and France. The name is derived from the large issue volume, with the size requirement of €500 million. In comparison, the average size of the traditional Pfandbrief is approximately €150 million, which tends to prohibit the trading-oriented investor and favor the "buy-and-hold" types.

The minimum issue size requirement for the jumbos is only of theoretical significance as the majority of issues are launched in considerably larger sizes. Indeed, since August 2006, the minimum issue size is €1 billion. It can therefore be seen that the volume of jumbo Pfandbriefe is equal to that of the bonds brought by medium-sized sovereign issuers within the Eurozone. The overall Pfand-brief market is the biggest bond market within Europe as of mid 2007. Of course, this figure includes structured Pfandbriefe, the smaller traditional variety, as well as the jumbo sector.

The market-making obligations further enhance the liquidity of the jumbo Pfandbriefe. Namely, that jumbo Pfandbriefe are syndicated by at least three market makers who pledge to quote two-way (bid/offer) prices simultaneously, for lots up to €15 million during the usual trading hours—9.00 A.M. to 5.00 P.M. (GMT + 1) for the life of the issue. The issuer itself may also perform the function of market maker and should obtain an undertaking from the assigned market makers not to exceed the following bid/offer spreads when quoting:

The maximum bid/offer spread is adjusted according to the remaining life of the bond.

There are further nuances to the market that should be noted. Admission to either the official or the regulated market at one German stock exchange is compulsory for jumbo Pfandbriefe; an official listing must be obtained immediately after issue or not later than 30 days after the settlement date. However, only a fraction of Pfandbrief trading is settled through the stock exchange. By far the greater share of trading is executed off the floor, for the most part via the telephone or, to an ever-greater extent, through the numerous electronic trading systems including the EuroCreditMTS. To be eligible to trade on this platform, bonds must fulfill stringent credit criteria. They must have a triple-A rating from either Moody's or S&P and a minimum volume outstanding of €3 billion. Jumbo Pfandbriefe are responsible for more than 80% of the issues traded on EuroCreditMTS.

Over and above this, there are certain recommendations in place regarding the issuance of jumbos:

In addition, all jumbo Pfandbriefe with a volume outstanding of €1.25 billion or greater and with a residual life of more than two years are greatly assisted by the market making pledge given by 17 institutions to provide a repo market in these issues.

Global Pfandbriefe issues are aimed specifically at the large financial centers around the world. For example, in order to facilitate investor access to the market, particularly in the United States, the first globals were issues almost exclusively in accordance with Securities and Exchange Commission (SEC) Rule 144a. This prevents the need for investors to go through the costly SEC registration procedure and avoids the need for annual accounts in line with U.S. accounting regulations. It does, however, restrict sales to so-called "qualified investors" with a portfolio of at least $100 million. A number of mortgage banks have gained a frequent issuer status in the United States, in accordance with Rule 12g 3-2 (b), which grants exemption from the extensive registration and reporting requirements. Under this rule, the publishing of a separate U.S. prospectus is not required; the standard documents presented in the issuer's home country are sufficient. Despite these helpful measures, the process of marketing Pfandbriefe in the United States is still very much in its infancy and the competition for the attention of investors is huge.

By definition, jumbo Pfandbriefe are always plain vanilla structures: jumbos are fixed-interest bullet bonds, the coupon on which is payable annually in arrears. The calculation of interest accrued is done uniformly using the actual/actual method in line with international practice. While this standardization helps to enhance the transparency of the market, it inhibits the ability for these issues to be targets to an investor's specific needs, and this is where the structured issues come into their own.

Aside from the traditional and jumbo Pfandbriefen, the mortgage banks also offer structured Pfandbriefe for those investors who seek a more individually tailored product to suit their portfolios. These products are structured to particularly suit the investors' interest rate expectations and their desired risk/return profiles. Structured Pfandbriefe allow the mortgage banks to combine the asset quality of the Pfandbrief with the advantages offered by derivatives.

A recent important addition to the range of refinancing tools has arrived in the form of MTN and CP programs. Pfandbriefe issued under these programs offer a greater range of maturities and can be denominated in different currencies. For the mortgage banks they offer a superior degree of flexibility in refinancing, as a variety of bonds can be issued as and when required. They offer a reduction in costs as the workload involved in issuance is much less, and, finally, they open the market to an increased range of investors with specific investment criteria.

Transactions in Germany are usually settled through Clearstream Banking AG, Frankfurt, a subsidiary of Deutsche Borse AG, formed as a result of the merger of Deutsche Borse Clearing AG and Cedel International. The remainder are settled via Euroclear or Clearstream International.

The mortgage bond market in France dates back to 1852 when, on February 28, the Decree of 1852 established mortgage banks that were authorized to lend funds to property owners. These loans were repayable by long-term annual instalments. However, it was not until June 1999 when modifications to this law broadened the appeal of Obligations Foncières (OFs) for international investors. These modifications to the Mortgage Act had two main objectives: to lower refinancing costs for the issuer and to offer investors secure and liquid products.

France had seen Germany's mortgage banks, with the success of the Pfandbrief market, being able to raise refinancing facilities at considerably lower costs than their French counterparts. They wanted quickly to follow suit. The French banks realized that failing to do so could result in their domestic market share being eroded by aggressive competition from across the border.

Another major reason for amendments to the Mortgage Act was to attempt to restore a widespread confidence in the French mortgage-lending sector after the real estate crisis that occurred in the early 1990s. The new requirements set in place were successful in doing just that.

The year 1999 saw the creation of a new type of financial institution in France, the Societe de Credit Foncier (SCF) or mortgage loan company, provided for under the new law. Their creation sets the Obligations Foncieres aside from other newly created European mortgage-backed sectors such as Spain's Cédulas Hipotecarias by the fact that their issuance is restricted solely to these Sociétés de Credit Foncier.

SCFs have the sole purpose of refinancing eligible assets, mainly through the issuance of OFs. While they have the legal status of banks, they are prohibited from engaging in traditional banking activities and from holding equity stakes in any subsidiaries, which mean that they operate very similarly to an SPV. French issuers also manage only one asset pool comprising both types of loans, and whether the pool consists of public-sector loans, mortgage loans, or a mix of the both depends on the business model of the issuer.

Their bankruptcy remoteness is greatly enhanced through one of the most reassuring features of the French law and that is its specific exclusion of the SCF from any bankruptcy proceedings initiated at the level of its parents). The SCF is therefore less vulnerable to the default of its parent credit institution.

However, these legal provisions do not completely isolate the creditworthiness of the SCF from external factors, but only limit the extent to which credit risk contamination may occur. For this reason, Moody's, when granting ratings, begin their analysis by assessing the creditworthiness of the SCF itself. They achieve this by principally analyzing:

The fact that the bankruptcy of a parent cannot be extended to an SCF is welcome, however, as a Moody's report published in October 1999 states:

Although Moody's continues, "We consider that this element of weakness is mitigated by the strong likelihood that the French regulator would exert pressure on an SCF's shareholder(s) to extend support to this subsidiary."

Having thus arrived at a senior unsecured debt rating for the SCF, Moody's then turns its attention to the specific characteristics of the OFs issued by the mortgage loan company. Given that the OFs exhibit a reduced frequency of default, a reflection of the "bankruptcy-remote" element of SCFs in regard to parent(s), and the lower loss potential due to their secured nature, Moody's grant a rating to OFs of "up to three notches above the senior unsecured debt rating of the SCF"

Like Pfandbriefe, Obligations Foncieres bondholders retain preferential rights with regard to the event of bankruptcy over any other claims. The similarities do not stop there. Issuers and market makers have agreed that the minimum size of issuance should be €500 million, that the issue is supported by a market making commitment from at least three banks, quoting continuous prices with bid/offer spreads of between 5 and 20 cents. Also, it almost goes without saying, all OFs must be rated by at least two of the internationally recognized ratings agencies.

While currently lacking in size in comparison to its German neighbor, the OFs are rapidly proving to be a worthy competitor.

The year 1999 also witnessed, again due to a modification of legislation, the debut of the first international issue of the Spanish Cédulas Hipotecarias or "mortgage notes."

Like other covered bonds, their initial existence dates back many years previous, in the case of Spain's offering, to 1869. A considerable number of cédulas have been issued in the domestic retail market since that time.

In 1981, the introduction of the "Ley del Mercado Hipotecario" (Mortgage Market Law) and its subsequent amendments allowed Cedulas Hipotecarias to be issued by almost any credit institution.

The first jumbo-style issue was brought to the market in March 1999, and since then 21 more bonds have been launched. However, despite the enthusiastic start, only one bond was issued in 2000 and one of the existing issues was tapped. The year 2001 showed more promise, with a total of five new issues, and the number of issuers increased from two to five.

Spanish cedulas are, so far, exclusively backed by mortgage loans; the legal framework for the issuance of "Cédulas Territoriales," public-sector loans, is still in the preparation stage.

Unlike the OFs, cédulas do not possess the protection of bankruptcy remoteness in regard to their issuing entity; the probability of default between them is inextricably linked. Understandably, the ratings of these issues are therefore determined by the creditworthiness of the issuer and the whole process of rating is conducted on a case-by-case basis, analyzing the issuing institution as well as the specific characteristics of the security itself.

Under Spanish law, the underlying assets for the Cedulas Hipotecarias do not count as special assets. They are not separated from the bankrupt's assets in the event of the issuer becoming insolvent, as is the case with the German and French Pfandbrief-style bonds, and this obviously places the holder of cédulas in a much weaker position by comparison. However this weakness is considered to be largely offset by the fact that cedulas have the highest level of surplus cover (overcollateralization) in Europe of at least 11%, which is imposed by law.

Cédulas have a "bond issuing ceiling" of up to 90% of the volume of "eligible mortgages" (loan-to-value ceiling of a maximum of 70% for commercial properties and 80% for residential properties). Even in the event of a full use of this ceiling, Cédulas Hipotecarias have an overcollateralization of over 11%, as the mortgage loans also serve as collateral, although they cannot be included in the calculation of the maximum volume outstanding because of the higher loan to value levels. If this limit is exceeded at any time, the issuer has to restore the overcollateralization limits by:

It should be noted that due to the limited use of Cédulas Hipotecarias so far, the actual degree of overcollateralization is at least within triple digits and this mandatory requirement is a major strength of the Cédulas system.

The quality and size of the mortgage portfolio and the surplus cover are also subject to regular monitoring by the Bank of Spain.

All in all, the secured nature of this type of product strongly reduces the loss potential in a default scenario and to date, since their inception back in 1869, no Cédulas Hipotecarias has ever defaulted. Whereas the German jumbo Pfandbrief still retains ite number 1 position, the Spanish jumbo market has gained ground in the importance stakes over recent years. Indeed in 2005, the Spanish market actually overtook the jumbo Pfandbrief market in terms of volume of issuance and went on to produce that same feat in the following year.

In November 1997 the Grand Duchy passed a new law that authorized the creation of a brand new financial entity known as the Banque d'Emission de Lettres de Gage, a mortgage bond-issuing bank.

The Luxembourg law was modelled closely on the German Mortgage Bank Act governing the issuance of Pfandbriefe. Like Germany, the Lettres de Gage are subdivided into two categories: one backed by public sector loans (Lettres de Gage Publiques) and the other by mortgages (Lettres de Gage Hypothecaires). The bondholders also enjoy the same preferential rights over the covering assets which rank above all other existing claims, while the matching principal familiar in the German market also applies to the Luxembourg law.

There are, however, some key variances from Germany's mortgage law and perhaps the most important arises from the different geographical restrictions on lending business between the two. In the case of Luxembourg, public-sector loans from the whole OECD area are eligible for refinancing via covered bonds without restrictions.

There are two diametrically opposing views as to the effect this difference has on the security aspect of the Lettres de Gage; the first is that the Luxembourg could be considered to be more secure than its German counterpart. This is thought to be due to the fact that in their search for diversified assets to use as collateral for their Pfandbrief-like product, Luxembourg banks will diversify their exposure to top-rated OECD sovereigns such as Australia and Japan.

However, competition among the mortgage banks to deliver superior returns on investments will lead them to pursue assets in lower-rated OECD member countries such as Turkey and Mexico.

In the market we observe that German banks are keen to be involved in this wider business opportunity. This is borne out by the German mortgage bank involvement in the three main Luxembourg Pfandbrief banks. Pfand-briefbank International (PBI) is part of the HVB group, Europaische Hypothekenbank S.A is a 100%-owned subsidiary of the Eurohypo group and Erste Europaische Pfandbrief und Kommunalkreditbank (EPB), the third specialist bank to receive a Pfandbrief license is jointly owned by Commerzbank (75%) and a Geneva-based holding company of the financier Dr. Wolfgang Schuppli (25%). The latter also holds a 49% stake in HypoEssen and, through another holding, a 100% stake in Dusseldorfer Hypothekenbank AG.

The Luxembourg market is still relatively small in comparison to its European cousins.

The Irish covered market is the most recent in Europe. When Ireland sought to create their covered bond market, they looked at all the relevant laws already in place throughout Europe, and cherry-picked the most attractive factors from an investor's perspective. What made this initiative even more impressive was the fact that Ireland has no history in issuing mortgage bonds.

Toward the end of 2001, the Irish Asset Covered Securities Act was passed allowing banks recognized by the Central Bank of Ireland as "Designated Credit Institutions" (DCIs) to issue Irish Asset Covered Securities.

When the legal framework was first put forward in early 2000, some of the proposed features of these issues were considered to be unique attractions from an investor's perspective. Their impact, however, has been somewhat nullified by progresses made in other markets, for example, the recent amendments to the German Mortgage Bank Act. Nevertheless, the concept of Irish covered bonds still represents an improved version of the German Pfandbrief. Ireland's rules for investor protection are the most stringent in the market—with strict supervision of the Central Bank of Ireland and an Independent Cover Asset Monitor approved by the regulator, controls on assets eligible for cover pools and no possibility of risk from duration mismatching.

The Irish steering committee decided against adopting a policy such as that used by Luxembourg's Lettres de Gage with regard to "eligible assets." They felt that allowing loans made in any OECD country as collateral for their bonds would compromise the credit quality of their Irish Asset Covered Securities. Instead, Ireland has limited the asset pool to the EEA, along with G7 countries and Switzerland.

A maximum of 10% of the cover pool can be commercial property loans and substitution assets cannot exceed 20%. To limit cash flow mismatching risk, the Irish bonds exhibit tight matching requirements. For example, the nominal value of the cover assets must at all times exceed the value of the corresponding securities. The aggregate interest from the assets must also exceed that of the covered bond and the currency of the cover assets must be similar to the related bonds. In addition to this, the duration of the cover assets must be greater than the duration of the bonds.

Critically, it is only in Ireland where the regulator has further stipulated that "the weighted average duration of the cover assets should not exceed the weighted average duration of the Irish covered bonds by a period greater than three years."

There is a loan-to-value limit imposed of 60% for residential mortgages and 100% for public-sector loans and hedging contracts against interest rate risk are permitted in the collateral pool.

The Irish product provides an interesting enhancement to the range of high quality products available in this sector. The legal framework combines all the traditional elements of covered bonds from existing European markets with innovative augmentations that serve to strengthen credit quality further.