Russia's mortgage-finance market is sloughing off the toxic residue of the financial crisis, but the strength of the comeback is being largely conditioned by government support.

Still, appetite from private-sector investors might be enough to absorb moderately-sized deals, sources said. And there are signs of a modest revival: origination is climbing again, Russian mortgage agency AHML recently closed a RUR13.5 billion ($448 million) RMBS - its first in a couple of years - and covered bonds are expected to draw new converts such as Societe Generale unit Delta Credit.

But a question mark still hangs over more substantial longer-term demand for structured paper from local buy-siders in the private sector. And with the bulk of transactions projected to be in rubles, foreign investors will have to be willing to take on local currency risk or shell out a premium for hedging.

At any rate, the local government is certainly not waiting for overseas demand to return to Russian RMBS.

Since last year, Russia has redoubled efforts to stimulate bonds backed or secured by mortgages, while launching new initiatives to bring mortgage rates to more affordable levels.

"The development of a mortgage securities market in Russia is an important component of the national program that envisages an opportunity for Russian citizens to obtain affordable housing," said Vladimir Dragunov, a partner at Baker & McKenzie's Moscow office. "The two main government institutions [in the sector] - VEB (state development bank Vnesheconombank) and AHML - have launched special programs to help originating banks refinance the development of the mortgage securities market in Russia."

VEB: Deep Pockets

The government opened the door for VEB to invest its pension assets as well as its own funds in RMBS when the law on state pension fund investments was amended in 2009. VEB is understood to have purchased a portion of a covered bond - the country's second - issued by local originator VTB24 in late 2009.

In the 2Q10 VEB held RUR1.77 billion in government securities. At the same time, the bank's total investment portfolio amounted to RUR723 billion.

Originators are taking note.

"Eight banks have applied to participate in the VEB program so far, including three state-owned banks - Gazprombank, Sberbank and VTB - and five private ones - Uralsib, Bank of Khanty-Mansiysk, Investtradebank, Orient Express Bank and Housing Finance Bank," said Alexander Dolzhich, director of structured and syndicated finance at Gazprombank. "State-owned banks have applied for a total of RUR65 billion, while private banks have applied for RUR45 billion."

Looking ahead, Delta Credit already expects to sell VEB a portion of RUR5 billion in covered bond issuance planned for 2011, according to Sergey Grishaev, head of treasury at the Societe Generale unit.

While both state and private banks can tap VEB funds there are rules that could keep away weaker institutions. As with the Russian Central Bank's repo criteria (see ASR 4/09), there is a minimum rating requirement. In the case of VEB funding, for a bond to be eligible it must be investment grade on the national scale. The required credit enhancement would prove too costly for some private-sector banks, according to Ignat Dirks, executive director of structured and syndicated finance at Gazprombank.

AHML: New Issue

The other major instrument of government policy in the mortgage sector is AHML, an agency whose primary mandate is to purchase ruble-denominated mortgages from bank and nonbank originators from across the country and package them into RMBS. It also buys bonds from other institutions and enhances deals by providing guarantees.

The issuer recently broke its two-year silence in RMBS to issue a RUR13.5 billion deal led by Citibank. While it closed July 15, because of local rules that prevent a bond from trading for the first month of its life, the issuer is holding on to the transaction and plans to start filtering an A1 piece into the market around September. "When the market was good, investors weren't bothered by the one-month blackout period," said Nikita Gusakov, Citi's head of local debt capital markets for Russia. He added that in the current climate it was best to wait. "We didn't want to put additional pressure on the market by placing the bond within the blackout period."

Still, Citi will eventually try to sell the 31-year legal final deal to market investors. A RUR6.1 billion A1 tranche bears a 9% coupon, while a RUR6.1 billion A2 piece has a 6.5% coupon that steps up once the A1 piece starts amortizing, about 1.5 years from closing. Moody's Investors Service rates the deal 'Baa1' and 'Baa3', respectively.

Gusakov said that the manageable size of the deal should enable the bank to sell it entirely to the private sector.

While originators and other players in the space welcome the government's aggressive push to revive RMBS, many would like to see private-sector investors return with pockets deep enough to support more than the sporadic issue.

"Currently we do not feel that there is a meaningful market demand for Russian RMBS, whether domestic or cross-border, apart from the state agencies," said Dolzhich. "However, given a significant compression of spreads [and] exhaustion of credit lines in the corporate bonds space since January 2009, investors may wish to start looking into more complex structures once again, including RMBS."

Finding local investors with an appetite for long tenors is a major obstacle, said Grishaev. "A lack of investors with long money is the biggest problem for developing the MBS market in Russia," he said. "Besides VEB we think that Russia's top-50 banks, some local funds and foreign investors will form [the basis for MBS] demand."

 Covered Bonds: Gaining Ground

Covered bonds are also on the minds of players, as evidenced by Delta Credit's plans to debut an issue next year. But for banks rated at the Russian sovereign ceiling, the product might not provide the ratings uplift that is available in other countries, sources said. In the case of the RUR15 billion in 5-year covered bonds issued last year by VTB24, Moody's gave the transaction 'Baa1' - the same rating it has on the bank. The agency granted only "limited consideration to the underlying collateral pool." But investors naturally can decide for themselves whether the added security is worth a potential premium.

For its part, the VTB24 deal was sold not only to VEB and AHML but also to a few domestic investors in the private sector.

Other originators apart from Delta Credit are eyeing this alternative as well.

"We consider covered bond issuance as one of the tools in our funding armory, which has good chances to be used if the price is attractive," said Gazprombank's Dirks. "On balance, we believe that issuing a covered bond is an attractive route for established issuers, which allows [them] to tap certain pockets of money bound by institutional restrictions, such as pension funds."

Apart from seeking ways to stimulate mortgage via bond issues, the government is also fomenting origination more directly. Banks that receive government support, for instance, must provide loans with rates at or below 11%.

In addition, a RUR150 billion program set up by VEB is specifically aimed at spurring construction. The funds are earmarked for RMBS and covered bonds backed by mortgages on only new properties. The impact could be far-reaching, sources said.

"Applying very straight-forward math, assuming VEB will be buying 70% of senior tranches, which carry 10% credit enhancement, that will bring about RUR238 billion of new money to the property market," said Dirks. "Assuming an average property price in Russia of RUR47,700 a square meter, that brings us to almost five million square meters of new housing."

Mortgage Supply Swings Back

Origination has already been on the rebound thanks to a recovering economy and a particularly dismal 2009, when the effects of the global crisis were felt most acutely. Indeed, the economy shrank by 10.9% in 2Q09, its most severe contraction on record. The International Monetary Fund forecasts growth of 4% for this year.

More or less following the larger macro rhythm, Russian mortgage origination peaked in the third quarter of '08 at RUR198 billion, according to AHML (see graph on p. 27). It then bottomed out in the first quarter of '09, which witnessed only RUR25 billion of fresh supply. The agency projects consistent growth in origination this year, with lenders cranking out more than RUR100 billion in the final quarter.

Apart from cutting the demand for mortgages and ratcheting up delinquencies, the crisis might have accelerated the trend toward more ruble-denominated loans as opposed to dollar ones (see graph). With few exceptions, the percentage of ruble-denominated loans rose steadily from the third quarter of '05 to late '09. But it climbed particularly fast when the crisis hit and the ruble went into a tailspin, indicating there was a sudden dearth of borrowers taking out dollar loans. The ruble-denominated share of overall mortgages has held above 90% over the last year.

The ruble depreciation also hit the dollar-denominated RMBS especially hard. "As the local currency started depreciating against the dollar there was an increase in delinquencies in those deals - not only in Russia but in the Ukraine and Kazakhstan as well," said Olga Gekht, a senior analyst at Moody's.

The agency has downgraded a handful of RMBS backed by dollar collateral in Russia since late 2008. It has even warned of the potential risk that the Russian government would re-denominate dollar loans into rubles (ASR 3/3/09). This danger, however, has subsided since the economy - and the ruble - have gotten back on their feet.

Deals faced other currency troubles as well.

A noteholder meeting in January approved the conversion of payments on the notes from euros to rubles, at an exchange rate in line with the deal's closing. The A1 tranche is now fully exposed to FX risk.

The originator certainly sees a lesson here. "The circumstances of Lehman's bankruptcy, namely the speed at which a single-A-rated institution went bust, brings [into] question whether a credit rating is an appropriate metric to assess counterparty risk in the periods of extreme market volatility and dislocation," said Dirks. "We believe this issue will take some time to be resolved, especially in the structured finance space."

At any rate, it is clear that in the foreseeable future, straight ruble RMBS and covered bonds are likely to be the preferred route for local originators.

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