BOX 2: THE DEFINITION OF PFANDBRIEF TRANSACTIONS

Although many European countries have already put in place legal frameworks for Pfandbrief-style products, the German Pfandbrief (literally 'letter of pledge') is the eponym of this type of covered mortgage bond.21 Although the creation of the first Pfandbrief instrument was attributed to an executive order of Frederick II of Prussia in 1769,22 it was only when the Mortgage Bank Law was passed in 1899 that the Pfandbrief took its present form. The first legal guidance for the issuance of Pfandbrief-style products was actually adopted in France in 1852 with the Loi sur l'obligation foncière et communale. The oldest mortgage credit market can be traced to Denmark, when the Great Fire of 1789 created vast demand for housing finance in its wake. In Sweden, a mortgage market has existed at least since 1860 under the legal provisions of the more general Law on Credit Companies, but no specific mortgage bank law has been issued so far.

While the Pfandbrief is a classical on-balance sheet refinancing tool of mortgages and public loans with both origination and issuance completed by one and the same entity, MBS transactions are off-balance sheet transactions and involve at least one more party (besides the mortgage originator). Pfandbrief serve primarily as funding instruments, whereas MBS issues are also employed for credit risk transfer and balance sheet restructuring, with the aim of efficient management of economic and regulatory capital. Originators of MBS sell contingent claims on asset cash flows in order to remove and legally segregated ('bankruptcy remote') reference portfolio of securitised assets from the balance sheet. In contrast, in a typical German Pfandbrief transaction, reference assets are 'ring-fenced' on the balance sheet of government-licensed issuers and repayments to investors are independent from the repayment of securitised assets. Issuers of Pfandbrief deals are fully liable with their registered capital if reference assets fail to generate sufficient cash flows for the repayment of investors. Hence, this arrangement implies a double protection of investors against credit risk and the solvency of the issuer. Given the value of this institutional guarantee depending on the issuer's financial strength, Pfandbrief transactions generally receive high ratings. However, in comparison, MBS transactions are devoid of any institutional guarantee and solely return cash flows generated from the pool performance of the designated reference portfolio. Issuers of MBS transactions compensate issuers for the higher asset exposure due to the lack of institutional protection by including various kinds of internal and external liquidity and credit support, such as bridge-over facilities, surety bonds, third-party guarantees, excess spreads, over-collateralisation and reserve accounts. Finally, Pfandbrief issues are typically subject to stringent federal laws (requiring a weighted average loan-to-market (or appraised) value (LTV) of at least 60 per cent as a statutory benchmark), while private-label MBS issues are free from these legal requirements, except in so-called agency-MBS in the US, where the quasi-government agencies Fannie Mae (FNMA), Freddie Mac (FHLMC) and Ginnie Mae (GNMA) provide institutional guarantees in return for certain restrictions imposed on mortgages eligible for purchase in MBS structures.

In general, Pfandbrief transactions represent a very secure and liquid asset class of fixed income instruments with an established track record and cyclical resilience. MBS issues are equally liquid (at least in the US market) and feature an unchallenged degree of structural flexibility allowing for customised features and investor arrangements, such as variations to amortising repayment (in contrast to bullet repayment structures of Pfandbrief issues) and security design.