Market conditions are primed for the realisation of Brazilian banks’ efforts to build a covered bond market. The only thing missing is the legislative framework being considered by the country’s central bank, and reform of an outdated bank capital rule.
The combination of falling interest rates, a growing middle class, an inadequate mortgage market structure and issuer appetite has almost exhausted Brazil’s limited mortgage finance options.
Rumours are circulating that this year – six years after the country’s first attempts to structure covered bond-like instruments – a regulatory framework for the instrument will emerge.
In July 2011, the Brazilian Association of Real Estate Loans and Savings Companies (Abecip) provided Banco Central do Brasil with a suggested framework for a covered bond-like instrument known as letras finceira imobiliarias (LFIs).
A Banco Central do Brasil spokesperson declined IFLR’s request for comment on the grounds it does not speak on proposals or possible future decisions by the bank.
But LFIs are gaining support and those familiar with the proposal believe it to be adequate. It segregates an overcollateralised cover pool that would survive insolvency, and offers investors tax incentives, said Howard Goldwasser, a partner at K&L Gates.
The 65% rule
The market and authorities are both aware of the need for covered bonds. "They know they need to take this further step if they want to develop a proper mortgage market in Brazil," said Guilherme Balieiro from BBVA credit research.
What’s held this back to date is the legal requirement for banks to channel 65% of savings deposits into mortgage lending.
The rule was implemented in times of high inflation, to ensure there was sufficient funding for mortgages. It has been outdated for some time, but Brazil’s rapidly growing middle class combined with lowered interest rates means banks are now pushing the limits of this requirement.
This 65% rule and lack of standardisation by developers means off-balance sheet residential mortgage backed securities (RMBS) have not developed.
The incompatibility of RMBS with a rule that encourages banks to keep mortgages on their balance sheets accentuates the need for a long-term funding alternative for mortgage origination, according to Goldwasser.
And covered bonds, albeit for different reasons, have fared little better.
Goldwasser was involved in attempts to structure Brazilian covered bonds as early as 2006. He said that without legislation, it proved difficult to use mortgage assets as collateral without moving them off a bank’s balance sheet. It also proved difficult to isolate the cover pool so that it survived any bank insolvency.
If LFIs are to succeed as a mainstream form of mortgage finance, loans counting towards the 65% rule must be eligible for covered bond pools, on the basis that they remain on-balance sheet.
“This law should evolve. The 65% rule should change to give banks the flexibility to issue covered bonds,” said Balieiro. “It should be clarified if loans financed through savings can be included as collateral for covered bonds.”
On the frontline
If this is done, the likes of Itaú, Banco Bradesco and Banco do Brasil – names foreign investors are familiar with – are expected to make offerings.
“Brazilian banks already active in the international markets will be on the frontline to issue covered bonds," said Balieiro.
These banks have seen the popularity among foreign investors of covered bonds issued under new frameworks in the likes of Australia and New Zealand.
One notable absentee is expected to be Caixa Economica Federal (CEF), the government-owned bank which has a 75% share of the residential mortgage market. CEF has access to cheaper funding than private banks so has less of a need to issue LFIs.
This would increase competition and be good for the country’s banking sector as a whole.
Aside from confirmation that mortgages counting towards the 65% rule can be included in LFI pools, the instrument’s success will come down to three factors.
Firstly, investors must have access to the underlying assets without a specified contractual right to do so.
"The future of covered bonds depends primarily on dual recourse. The framework must replicate foreign systems where the investor has access to the collateral in case of default," Balieiro said.
Secondly, any perception that Brazil is entering a real estate bubble must end. People have been shut out of Rio de Janeiro, Sao Paulo and Brasilia’s housing markets because of rising prices. To draw the interest of foreign investors, this perception must be shown to be wrong.
Finally, it must be shown that Brazil has a strong and liquid secondary market where investors could sell their mortgage assets in the event of an insolvency.
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