Having proven their mettle in crisis conditions, covered bonds are gaining popularity outside their traditional enclave of continental Europe. A number of emerging markets are looking into the product, and a few have recently made concrete moves. Turkey, for instance, saw its first covered bond a couple of months ago.

In Latin America, players are focused on the region's behemoths: Brazil and Mexico.

Brazil holds the most promise. Covered-bond boosters point to a stable of strong, well-capitalized banks and mortgage volumes that are climbing quickly - even as credit expansion slows from the dizzying numbers of 2009-2010. At any rate, mortgage growth, many argue, will outstrip the traditional funding sources in two years.

"In about 24 months the volume of savings deposits will probably not be sufficient to meet demand so clearly players will have to find alternative sources of financing," said Victor Moscoso, director at Brazilian Capital, an asset management unit of Brazilian Finance & Real Estate.

But introducing the product in the near term in Brazil is not a foregone conclusion - the authorities still need convincing and other alternatives, such as RMBS, have only recently been given a fighting chance against historically high-yield local treasuries.

In Mexico, meanwhile, there is not the same urgency but there is a specific proposal before Congress, and at least one large originator, government-owned Infonavit, is preparing for the product to be introduced. In addition, banks that have shied away from RMBS may find covered bonds more to their liking.


Not so Laissez-Faire

What is unlikely to happen in either Brazil or Mexico is the emergence of serious activity before a regulatory framework for covered bonds is in place.

There are jurisdictions that have - initially at least - taken the unregulated route. This has offered issuers a good deal of leeway in how they structure their deals. But the regulated path is becoming ever more popular. Spurred in part by continental investors who wanted a more codified, uniform product, the U.K, for instance, joined the club of regulated covered bond markets in 2008, following several years of a bespoke approach. Australia, New Zealand, the U.S. and Canada are advancing in this direction as well. Future countries are bound to follow suit.


Brazil: From Talk to Action?

Mortgage covered bonds are attracting attention in Brazil for a compelling reason: the traditional vehicle for mortgage funding in the country - savings deposits - is growing at a rate far slower than the speed of origination. By one account, the former is rising 15% a year while outstanding mortgages are bulking up by 30%. Another source of funding is the Labor Tax Severance Fund (FGTS per its Portuguese acronym), which finds its way to low to middle-income mortgages originated largely by Caixa Economica Federal. Brazilian banks are required to plow 65% of their savings deposits (known as the poupanca) into real estate lending, but the housing deficit has hovered stubbornly around eight million units, according to a recent report by Standard & Poor's.

All of this means that, barring a crash in mortgage origination, funding will have to come from outside deposits or the FGTS to sustain the momentum.

"We are discussing alternative forms of funding for the mortgage market," said Dyogo Henrique de Oliveira, deputy executive secretary of the Brazilian Treasury. "[The poupanca and FGTS] are responsible for almost all the mortgage market in Brazil and this system seems to be getting close to a limit."

As Moscoso indicated, if nothing is done, the mortgage-funding spigot might run dry in two years.

And while Brazilian authorities have been engineering a drop in overall credit growth, mortgage lending is still growing at a brisk, if somewhat slower, pace (see Chart 1). To be sure, no one is concerned about anything like a bubble in the sector, with total mortgage volume still below 4% of GDP. In addition, while the government is eyeing consumer lending with caution, it is still seeking to stimulate mortgage borrowing - primarily through Caixa.

Players also point to the long-term potential for falling lending rates in a country where they are notoriously high - another trend that is likely to sustain the appetite for mortgages. The benchmark Selic rate is now at 12.5% following a few hikes this year.

"If you take into account that eventually interest rates will go down, it would be important to have more instruments to finance real estate projects, and also to recycle the portfolios of banks," said Alberto Kiraly, head of investment banking at Banco Votorantim.

All of this has stirred interest in mortgage covered bonds.

De Oliveira said covered bonds are part of the Treasury's discussions with the market, adding that the Brazilian Association of Home Loans and Savings Banks (ABECIP) has proposed this option. ABECIP did not return requests for comment.

"We are studying this with an open mind," de Oliveira said. "To create this new kind of bond we would have to make a big effort in the Congress and in other institutions and ministries." He added that the Treasury has not taken a position on the instrument.

While Banco Votorantim could not issue traditional covered bonds - it has no mortgage book - its investment banking unit has an interest in the product's potential introduction.

"As an underwriter and a financial intermediary, we are quite keen to have this instrument," said Kiraly. "This is a very good initiative; it's quite welcome." But, as de Oliveira suggested, there would have to be changes to existing legislation.

"We would need a change in the bankruptcy law," said Tiago Lessa, a partner at Sao Paulo-based firm Pinheiro Neto. "This is due to the fact that in Brazil, for you to segregate the assets or the receivables, insolvency law has to permit this." He added that while secured bonds have a history in Brazil, additional provisions in the collateral arrangements would be needed for banks to be able to issue a true covered bond.

Other players noted that in Brazil labor and taxes have a priority of claims in the event of a bankruptcy - this is one area of local law that some say is untouchable. In addition, investors in unsecured debt or secured debt may not take kindly to being subordinated to a new kind of creditor.


Covered Bond & MBS: Friends or Foes?

Covered bonds are, of course, not the only way out of the funding shortage forecast for Brazil's mortgage originators. There are always RMBS, which already have a track record in the country in the form of certificates of real estate receivables (CRIs). There is an advantage to RMBS - regulations that, two years ago, extended a tax exemption for retail investors holding CRIs to those holding shares in real estate investment funds (FIIs) with holdings in CRIs. This was significant because, before the rule change, for the vast majority of regular investors the tax exemption in a CRI was moot because the minimum amount of investment is R$300,000. Through an FII in CRIs, an investor can spend as little as R$1,000 and still enjoy the tax exemption.

But despite this incentive, CRIs have yet to find favor among banks. Caixa made its first foray into CRIs in May, but the market is still almost exclusively the realm of developers, not banks. Part of the reason is that banks are reluctant to cut loose mortgage portfolios that count toward the poupanca rule, the one requiring them to shovel 65% of their deposits into on-balance-sheet real estate assets.

"Up to now banks haven't needed to do [RMBS]," said the Brazilian Treasury's de Oliveira. "They have resources from the poupanca, so they don't need to access other markets." He added that the Caixa deal was more a test of the market more than a need to obtain funding.

But the looming funding shortage players are talking about is a new phenomenon, meaning that the tax incentives for CRIs could yet nudge banks to issue RMBS.

"Clearly, the MBS is being given the opportunity to launch itself," said Brazilian Capital's Moscoso. He added that in potentially pushing for covered bonds, the authorities should be careful not to write off RMBS. "We believe that there can be a co-existence."

While Votorantim's Kiraly said that CRIs are more tailored to housing developers, he foresees both the covered bond and RMBS market growing in tandem as well. "I think they'll be complementary."

Whether covered bonds will have the same potential investor audience as CRIs is an open question. Kiraly said that if investing in a covered bond did not carry the same tax benefits as CRIs, the audience would be similar to those that invest in FIDCs: institutional investors such as pension funds and asset managers.


Mexico: On Agenda but Not Urgent

Covered bonds are also a topic of conversation in Mexico, with a proposal that players hope will be taken up by Congress in the September-November session. There is skepticism, however, that legislators will get to it soon.

In contrast to Brazil, Mexican banks and government agencies have a history of issuing RMBS, although issuance has fallen since 2008, while the bulk of issuance has narrowed down to two originators (see Chart 2 on page 14). Meanwhile, the recent crisis, shoddy construction loan underwriting and over-optimistic predictions have taken non-bank originators known as Sofols out of the RMBS game for an indefinite period. While the volume of outstanding mortgages is not growing as quickly as in Brazil, there is still a housing deficit that is about nine million units and growing by 200,000 annually, according to S&P.

Especially given the relative comfort investors worldwide have with covered bonds vis-à-vis RMBS, there is certainly interest in Mexico.

Boris Otto, a partner at Chadbourne & Parke Mexico, said that legislation is necessary for banks to issue this instrument, as they cannot under current law segregate their collateral in the way that is standard for a mortgage covered bond. "If one sought a simple structure, recognizable to the market as a covered bond, you couldn't do it with the banks," he said. This is why there is a proposal to amend the law, he added.

One area that would need change is the ability of a bank to modify or replace the cover pool, which cannot, for instance, be done with a specific guarantee backing secured debt.

For Infonavit, the largest mortgage originator in the country, issuing covered bonds would require a change in the law that governs this government entity. Presently, Infonavit is not allowed to issue corporate debt directly. Allowing it to do so is part of a package of reforms of Infonavit's bylaws that Congress might take up in the September-November session. The legislature might consider approving pieces of the reform instead of the entire bundle at once, which includes other measures such as opening the door to issue fixed peso-denominated mortgages, said Jorge Marquez, director of structured finance at Infonavit. The agency is now allowed to issue mortgages only in multiples of the minimum wage. At any rate, when Infonavit is given the okay on covered bonds it plans to move forward.

"The interest of Infonavit in issuing covered bonds or corporate debt directly rests on [the fact] that it would be more cost effective," Marquez said.

He added that this year, on average, the agency's RMBS has priced at about 220 basis points over local treasuries. "Debt directly from our balance sheet, I think, would come out below 100 basis points," Marquez said. "Covered bonds have a dynamic pool [so] you're constantly improving the collateral."

He expects that Infonavit would keep to the domestic market with covered bond issuance, and that the product would bear a close resemblance to the European version. "We don't want to vary much from what's already known as a covered bond," Marquez said.

Otto added that a covered bond market might also spread issuance more widely among bank and government-owned originators while kindling a secondary market. Infonavit and another agency, Fovissste, have been taking the lion's share of both origination and RMBS issuance in the past couple of years, a situation that is not "healthy" for a mature market, Otto said.

Recent data point to the possibility that Mexican banks may be turning around a falling trend in mortgage origination (see Chart 3). The likes of Banorte, Santander and Scotiabank all announced deep rate cuts on their mortgage products in mid July in a bid to woo lower-income borrowers, the segment once catered to by the Sofols (see Mexico Banks Move Down Mortgage Food Chain on www.structuredfinancenews.com).

But with the global market turmoil experienced in August and renewed fears of a sharper global slowdown, lending could suffer.

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