Switzerland: Alternative financing sources

Author: | Published: 1 Oct 2009
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Since late spring 2007, the disruption in the credit market has forced banks to create new structures to gain access to liquidity and refinance credit portfolios. Regular financing through the unsecured interbank lending market and, loan assets securitisation and sale of such portfolios to the capital markets used to be a standard means of refinancing. In the current climate, the latter sources of refinancing simply do not exist – the interbank lending market almost came to a complete halt after the collapse of Lehman Brothers in September 2008 – and are expected to recover very slowly. As a result, banks are trying to use alternative structures.

In recent deals, credit portfolios have been sold and transferred to selected investors at substantial discounts rather than to the broader capital markets. Governments around the world have intervened to support financial institutions. Securities satisfying certain collateral eligibility criteria set up by central banks have been created to allow banks access to various liquidity programmes introduced by central banks. Also, clients have been offered early redemption solutions at a discount. In recent deals, UBS and Credit Suisse issued Swiss Pfandbriefe (covered mortgage-bonds) through the Swiss mortgage-bond bank (Pfandbriefbank) in private placements aimed at Swiss local retail banks. Volume, private placement, and the lending of the proceeds to one specific member bank only are new elements to these structures. Most recently, UBS publicly announced it would set up a covered bond programme under which it will issue covered bonds through its London branch. Such covered bonds are guaranteed by a newly set up SPV and ultimately backed by Swiss mortgages. Such covered bonds will be issued outside the legal framework of the Swiss covered bond system.

Past deals seen in the Swiss market

Sale of loan portfolios to a single or limited number of investors

Rather than selling loan portfolios to the broad capital market, financial institutions have started to seek selling opportunities with selected investors. Pressure on the liquidity markets resulted in prices for loan portfolios decreasing dramatically; this presented investors with some attractive investment opportunities. Also, some borrowers started to purchase their own loans or to negotiate an early redemption at a discount. The quality of the underlying asset is far from the only element relevant to the price-building process. However, legal and operational limitations may make it somewhat cumbersome and time-consuming to transfer large portfolios of residential mortgage loans.

Two major transactions involving Swiss banks have been publicly announced and closed already at an early stage of the financial crisis: In May 2008, UBS sold a pool of mortgage loans to BlackRock for a purchase price of $15 billion (originally acquired at $22 billion). Even though 75% of the purchase price was financed by a secured facility provided by UBS, the sale resulted in a significant improvement to UBS's risk profile. First, UBS hedged itself against further price fluctuation of the loan portfolio up to 25%. Second, the risk weighting of the secured loan advanced to BlackRock is less severe than the risk weighting of the pool of mortgagee loans. A second deal announced in summer 2008 involved the sale by Credit Suisse of a mortgage loan portfolio to GE Real Estate. This portfolio involved a small number of large mortgage loans forwarded to high-quality borrowers and secured by real property located in the UK, Germany, Spain and Switzerland. There have been a large number of smaller deals, mostly involving single loan transactions and often only involving a subordinated tranche of a loan.

Sale of subordinated tranches of mortgage loans to borrowers or third party investors

During the years 2004 to 2007, the CMBS wave hit Switzerland and numerous Swiss commercial mortgage loans were sold to the market through CMBS structures, most often as part of a larger pan-European mortgage loan portfolio [See Box A for typical structure].

Box A: typical Swiss CMBS

In order to structure the portfolio to be refinanced and in order to create LTVs (loan-to-value ratios) in the pool that would be acceptable from a rating perspective, the loans that went into the structures have most often been split in advance, creating an A Tranche and a (subordinated) B Tranche. In the Swiss context, this split occurred by the Swiss issuer (holding the Swiss assets) refinancing itself for each Swiss commercial mortgage loan through two tranches: The A Tranche financed by the issuer (thus becoming part of the CMBS issue) and the subordinated B Tranche financed by another investor. Often, originators financed the B Tranche in a first instance before placing such B Tranches in the market. B Tranches have been relatively high-return investments. The Tranches were structured as loans or notes.

During the last year, the market for such B Tranches was very active in Switzerland as banks that still had B Tranches on their books were urged to refinance such assets. However, no investors was willing to buy a B Tranche at nominal value and accordingly, B Tranches have been sold in most cases at a discount. In such an environment, borrowers (or affiliates of borrowers) were the most important B Tranche buyers. They started to buy B Tranches with their own mortgage loan as underlying. Economically, this resulted in an attractive opportunity for such borrowers to reduce the loan amount at a discount. Also, as the return on the B Tranches is higher than on the A Tranches, the reduction in interest costs is more than proportional to the reduction of the nominal amount of the mortgage loan.

Sale of loan portfolios to structures sponsored by governments or national banks

Another source of liquidity has been made available to banks by setting up government or national bank-sponsored structures to which troubled assets have been transferred. For example, under the Emergency Economic Stabilisation Act 2008, the US House of Representatives and the US Senate created the Troubled Asset Relief Programme (Tarp), giving the secretary of the treasury the authority to purchase or insure troubled assets or use other means to stabilise the markets. UBS and the Swiss National Bank set up a special purpose vehicle (SPV) that was funded with equity of CHF6 billion (made available by UBS which raised such funds by issuing a mandatory convertible bond to the Swiss Federation) and debt provided by the Swiss National Bank, and bought an entire pool of troubled assets from UBS [See Box B]. In August 2009, the Swiss Federation exited the transaction. After early conversion of the mandatory convertible bond, its stake has been placed in the market.

Box B

According to public sources, UBS is currently trying to repurchase the assets transferred to the SPV in order to achieve again full independence (as many other banks did in the last couple of months).

Creating ABS that are eligible as collateral for central banks

Various national banks established liquidity programmes under which secured short-term facilities could be provided to banks. The aim was to allow banks to access liquidity for collateral that would otherwise not be liquid in circumstances when the unsecured interbank markets are under stress. Accordingly, many asset-backed securities (ABS) transactions, some also involving Swiss assets, have been set up and structured in a manner so as to create ABS notes that meet the eligibility criteria of the relevant national bank. Such notes are created even in situations where there is no imminent need to trade these notes with national banks, as they simply want to be in a position to have ABS readily available that are more liquid than the underlying assets.

Swiss mortgage bond system

The Swiss mortgage bond system was introduced in 1930 and is generally regulated by the Mortgage Bonds Act (1930). Within the legal framework of the Swiss mortgage bond system, Pfandbriefe are issued to investors. The funds raised by the Pfandbrief agencies are then lent to the member banks against mortgage security (consisting of mortgage loans). Thus, the system allows member banks to refinance their Swiss mortgage lending business. The Pfandbrief is a covered bond-like investment instrument and is (indirectly) fully secured by real property located in Switzerland. The mortgage bond system essentially involves four parties [See Box C].

Box C: Parties involved in mortgage bonds

Pfandbrief agencies

Pfandbrief agencies issue Pfandbriefe to investors and lend the funds to their member banks on a secured basis. Only two Pfandbrief agencies have been authorised by the Swiss regulator. The Pfandbriefzentrale with cantonal banks as members and shareholders and the Pfandbriefbank with non-cantonal banks as members and shareholders.

Member banks

Member banks may borrow funds from the relevant Pfandbrief agency, secured by mortgage loans (and the related mortgage security) granted by the member bank to its clients (mortgagors). Such lending will match a certain issue of Pfandbriefe by the relevant Pfandbrief agency.

Swiss cantonal banks may become members of the Pfandbriefzentrale. Further, any bank licensed to do business in Switzerland may become a member of the Pfandbriefbank, provided that: (i) it is headquartered in Switzerland; and (ii) at least 60% of its balance-sheet assets consist of Swiss mortgage loans. The Pfandbriefbank waived the second requirement and reduced the threshold to 10%. Foreign banks may not become member banks and, accordingly, will not have access to the Swiss mortgage bond system. Most of the banks that are licensed to do business in Switzerland and headquartered in Switzerland are members and thus have access to the system. The Pfandbriefbank has roughly 240 member banks.

Mortgagors

The ultimate asset able to be refinanced through the Swiss mortgage bond system is a mortgage loan granted by a member bank to the mortgagor.

Investors

Investors subscribe for the Pfandbriefe. Each holder of a Pfandbrief is – by law – secured by the loans granted by the Pfandbrief agency to its member banks, and such loans are again secured by the cover pool. Hence, Pfandbriefe are rated triple-A by Moody's.

Security System

Pfandbriefe are ultimately secured by the mortgage security securing the mortgage loans granted by the member banks to the mortgagors (by law under the Mortgage Bonds Act).

  • Investors in Pfandbriefe have a direct security interest in all loans granted by the relevant Pfandbrief agency to its member banks.
  • The loans granted by the Pfandbrief agency to a member bank are secured by a direct security interest over the mortgage loan (and the related mortgage security) granted by the member bank to its mortgagor.
  • The mortgage loans granted by the member banks to the mortgagor must be secured by mortgage security over real property located in Switzerland.

Both Pfandbrief agencies and the member banks must maintain a collateral register. Subject to proper registration of the cover pool assets in such collateral register, the security interest exists by law (no further documentation is needed).

Cover pool

The rules on the cover pool are minimal requirements set up by the Mortgage Bonds Act. Each Pfandbrief agency may set up more restrictive principles (and both Pfandbrief agencies have done so).

Loans made available by Pfandbrief agencies to their member banks plus interest thereon must be covered by eligible mortgage loans in an amount of not less than 100% of the loans. Interest mismatches must be covered additionally. Both Pfandbrief agencies increased the coverage ratio with regards to principal and interest. Such requirements may occasionally change.

Cover pools may be dynamic and assets may have to be added in case the relevant coverage requirements would not be met. Also, according to regulations set up by the Pfandbriefbank, impaired loans or non-performing loans must be substituted. Cash or marketable bonds issued by the government, the cantons or the municipalities may serve as substitute assets in order to cover any (temporary) shortfall.

Real property located in Switzerland

The mortgage loans must be secured by real property and land located in Switzerland (or Pfandbriefe that satisfy all criteria). Public sector assets do not qualify as eligible collateral. Also, real property exposed to a decline in value due to exploitation (e.g. mines) is not eligible.

Loan-to-value ratios of mortgage loans

The LTV of mortgage loans may not exceed two-thirds of the fair market value of the property. Even more conservative LTVs apply for agricultural land and construction sites. Pfandbrief agencies may impose stricter LTVs where they see fit (eg, the Pfandbriefbank requires an LTV of one-half with regards to commercial property and holiday homes).

Holding of mortgage loans and mortgage security by operation of law

As the security interest is created by operation of law under the Mortgage Bond Act, no physical transfer of title to the mortgage security is required (as would be the case outside the framework of the Mortgage Bond Act). The servicing of the asset remains with the member bank, thus avoiding issues relating to banking secrecy, outsourcing rules and data protection, that would otherwise materialise.

Valuation of real property

The act provides certain valuation principles, compliance with which by the Pfandbrief agencies is monitored by the Financial Market Supervisory Authority (e.g. valuations must be conducted periodically and by steadily applying the same valuation rules; revaluation may be required where a fundamental change of circumstances has occurred).

Characteristics of Swiss mortgage bonds system

Access for Swiss banks only

Only banks headquartered in Switzerland may become members (and accordingly shareholders) of the Pfandbriefbank. With regard to the Pfandbriefzentrale, the circle of members is limited to cantonal banks. Thus, no foreign banks have access to the Swiss mortgage bond system. The act, allows for loans to be granted to non-member banks. However, increased coverage requirements and the non-availability of the security register system make it less attractive to enter the system.

Conservative legal framework

Due to the various structural elements and requirements, the system is regarded as reliable and stable, even during financial crises. The bonds issued by the Pfandbrief agencies are rated triple-A by Moody's. With regards to Pfandbriefe issued by the Pfandbriefbank, in November 2005 Moody's wrote:

"The triple-A long-term rating assigned to the Pfandbrief issues (covered bonds) of Pfandbriefbank Schweizerischer Hypothekarinstitute (Pfandbriefbank) ... is underpinned by the strong institutional framework within which Pfandbriefbank operates, as well as by the specific characteristics of the Pfandbriefe which result in a negligible expected loss for investors. The triple-A-rating is not an issuer rating but is only applicable to the covered bonds issued by Pfandbriefbank."

On-balance sheet financing

Typical for a covered bond and other than in the framework of most of the ABS issues, the issue of Pfandbriefe is an on-balance-sheet lending transaction; that is, the assets remain on the balance sheet of member banks and the Pfandbriefzentrale.

No limited recourse

Whereas the limited recourse element is typical of ABS transactions, the investor in a Pfandbrief is secured not only by the cover pool, but also has full regress to both the relevant Pfandbrief agency (directly) and the member banks (indirectly).

No segregation of assets in cover pool

Typically in an ABS issue, specific assets cover a specific issue of an ABS. However, under the Swiss mortgage bond system, all assets of the cover pool cover all issues of a series of Pfandbriefe. Accordingly, investor risk with regards to different series of Pfandbriefe does not vary, since the same cover pool and the same Pfandbrief agency and member banks provide security for such Pfandbriefe.

Past deals

Structure

In recent deals, both UBS and Credit Suisse raised funds with local retail banks that had excess cash readily available. Up to several billion Swiss francs were raised in each deal. The first deal was announced in December 2008. In the framework of these deals, funds have been made available by a selected number of lenders (rather than by a larger number of investors) by subscribing to specific series of Pfandbriefe issued by the Pfandbriefbank and by the Pfandbriefbank, then lending the funds raised to UBS and Credit Suisse against mortgage security.

Particularities of unilateral covered bond issuance

The transactions were set up within the framework of the Swiss mortgage bond system in order to facilitate the transaction and strengthen the security package analysis. The new element is that single specific transactions are arranged with the aim of allowing a very limited number of subscribers to lend funds to specific borrowers. Normally, the transaction under which institutions lend funds from the Pfandbrief agencies and transactions under which the investors subscribe for Pfandbriefe are not arranged as a single transaction but coordinated in order to ensure the matching of interests and terms. The standard procedure is that, before the issuance of a new series of Pfandbriefe (usually CHF200 million and CHF300 million), the Pfandbrief agency offers its member banks the refinancing of existing loans that are due for repayment or the granting of new loans.

The unilateral transactions seen since December 2008 show that the Swiss mortgage bond system may become or has become a refinancing tool in situations where secured refinancing transactions are difficult to structure or an off-balance sheet securitisation is not possible due to a lack of market. The benefit of using the mortgage bond system is that the security interest is created by law (by register), with no physical transfer being necessary. This allows the member bank to continue to service the assets contained in the cover pool. Also, the monitoring of the cover pool is facilitated due to the registration system as well as under the control (and additional supervision) of the Pfandbriefbank. From the lenders' (or investors') perspective, excess liquidity may be invested into an interest-bearing instrument that is liquid and secure even in times of economic crisis. The system offers attractive terms for refinancing where it would otherwise be costly and complicated.

However, the downside is the stringent LTV requirements for assets included in the cover pool.

Most recent announcements

In early September 2009, UBS announced to set up a programme under which it will issue mid and long term covered bonds through its London branch to investors. The covered bonds are guaranteed by an SPV incorporated under the laws of Switzerland that is ulti-mately backed by part of UBS' Swiss mortgage loan portfolio. For purposes of backing the guarantee, UBS provides security in favour of the SPV over part of its Swiss mortgage loan portfolio. However, the mortgage loans will not be sold to the SPV and will remain on UBS' balance sheet. Also, the client relationship will be maintained by UBS.

This is the first transaction under which a Swiss bank will issue covered bonds outside the legal framework of the Swiss mortgage bond system.

The way ahead

The market for the sale of loan portfolios will still be a source of refinancing. As markets recover, newly set up government-sponsored transactions will probably no longer be pursued or needed.

With regards to transactions in the legal framework of the Swiss mortgage bond system, it may be expected that further transactions will follow in the near future. According to public information, a total of up to CHF20 billion of volume may be expected for the year of 2009. Such volumes and the particularities of unilateral covered bond issues might require some adjustment of the legal framework. The Pfandbriefbank would need further equity in order to comply with the leverage ratios imposed by the Mortgage Bonds Act (by way of capital increase or subordinated debt provided by the member banks). Also, the Pfandbrief agencies would be exposed to an increased risk related to single loans made available to member banks in the framework of such transactions.

One solution to mitigate this risk would be to bring back a (limited) element of limited recourse into the structure. That is, investors agree not to enforce under the Pfandbrief they are holding unless the relevant member bank repaid the respective loan or the relevant assets of the cover pool were enforced. Otherwise, the Pfandbrief agency would risk running short of liquidity in situations where the Pfandbrief became due and payable and the relevant member bank had not repaid the corresponding loan.

With regard to covered bonds issued outside the framework of the Swiss mortgage bond system, it may be expected that once UBS successfully places covered bonds through its newly set up covered bond programme, other banks might follow in order to refinance their Swiss mortgage loan portfolio.

About the author

Johannes Bürgi is a partner in the banking and finance team of Walder Wyss & Partners. He advises banks, insurers and other companies in matters involving banking, finance, capital markets and securities law, as well as corporate and competition law. In finance, he focuses on structured finance transactions (securitisation, alternative risk transfer), project finance and asset finance including complex real estate financings.
Contact information

Johannes Bürgi
Walder Wyss & Partners

Seefeldstrasse 123
P.O. Box 1236
CH-8034 Zurich

Tel: +41 44 498 95 59
Fax: +41 44 498 98 99
Email: jbuergi@wwp.ch
www.wwp.ch


About the author

Thomas Meister is head of the tax team. He is working in the fields of domestic and international corporate tax, including tax optimisation, corporate and real estate finance, structured finance, corporate reorganisations, transaction structuring and M&A.
Contact information

Thomas Meister
Walder Wyss & Partners

Seefeldstrasse 123
P.O. Box 1236
CH-8034 Zurich

Tel: +41 44 498 95 73
Fax: +41 44 498 98 99
Email: tmeister@wwp.ch
www.wwp.ch


About the author

Lukas Wyss is a senior associate in the banking and finance team of Walder Wyss & Partners. He advises banks, insurers and other companies in matters involving banking, finance, capital markets and securities law. He also advises on corporate matters. In finance, he focuses on structured finance transactions and asset finance, including real estate financings.

Born in 1975, Lukas Wyss was educated at Zurich University, Lausanne University and Columbia University, New York.

He has working experience as a District Court law clerk and as attorney at law firms in Zurich and New York.

Lukas Wyss speaks German, English and French. He is registered with the Zurich Bar Registry and is admitted to practice in all of Switzerland.
Contact information

Lukas Wyss
Walder Wyss & Partners

Seefeldstrasse 123
P.O. Box 1236
CH-8034 Zurich

Tel: +41 44 498 95 73
Fax: +41 44 498 98 99
Email: tmeister@wwp.ch
www.wwp.ch