Under Basel II, some originators will soon have the option to call outstanding mortgage bonds at an earlier date, which could put investors who buy these notes at high cash premiums in the secondary at a loss.

Structures incorporate the Basel II call dates so that the originator has the option to bring the underlying mortgage back on balance sheet if it becomes more cost efficient to do so. Under Basel II the risk weighting for the mortgage loans will drop from 50% to 35%.

"Issuers have increasingly used Basel II call options. Without reading every prospectus it is hard to say exactly what proportion have introduced an option, but they have appeared in many of the recent European RMBS deals examined," said a securitization analyst at the Royal Bank of Scotland. "One key difference is that many U.K. deals use language that if Basel II is implemented by a given date the notes may be called, whereas the European calls typically are if the seller faces increased costs or reduced benefits from the new rules. This suggests U.K. issuers could call the deals to reduce spreads in a tightening environment, although they have indicated they wouldn't call for this reason."

Analysts at Dresdner Kleinwort Wasserstein estimate that approximately 19 U.K. deals - including all the recently issued master trust issues (excluding Granite 2003-1, Mound Financing Plc 3X and Permanent Financing 3) - currently have the option to exercise the earlier call date. "Of the RMBS currently marketing, Lothian 4 includes a Basel II call but Hermes IX does not," reported analysts.

Deals backed by more esoteric assets, like reverse mortgages or buy-to-let mortgages, typically do not include the call option. "I think this is more of an issue for the regulated banks," said one market source.

Outside of the U.K. the two most recent RMBS issues, Celtic 8 and EMERM 3, as well as Delphinus 2004-2, Arena 2005-1 and the majority of German RMBS are among the issues to include Basel II calls - the ground covered is quite extensive. For example, under terms of the Arena deal, the regulatory call option would allow the seller the quarterly option to repurchase the mortgage receivables in the event of a regulatory change. A regulatory change is defined as a change in the Basel Capital Accord promulgated by the Basle Committee on Banking Supervision or new international rules and instructions, which includes the solvency regulation on securitization of the Dutch Central Bank, applicable to the seller.

The definition also includes any new or altered bank regulations enacted to alter the Basel Accord, or a change in the manner in which the accord or bank regulations are interpreted. Also included are regulatory changes applied by the Basel Committee, or by a relevant international or national body, which, in the seller's opinion, may adversely affect the seller's rate of return on capital or increase costs of the transaction.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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