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Walking away from a mortgage

25 April 2016

Romania has become only the second country in Europe to allow a mortgage borrower to walk away from their obligations under a mortgage by returning the property to the lender. There are plenty of qualifications to this new law (and at the time of writing the exact implementation is still unclear), but it is undoubtedly a problem. It is also an interesting test case. Despite the understandable objections being made to the new law it will have attracted a lot of interest from politicians in other countries. It seems only a matter of time before such a law is introduced elsewhere.

The timing of the new law is somewhat annoying. It comes almost immediately after Romania finalised its secondary legislation which, taken with the new covered bond law passed last year, represent an excellent basis for the development of a state of the art covered bond market (in the interests of full disclosure I must admit to a strong personal interest in the new bond law. Bias notwithstanding, it really is good).

How much of a problem is a ‘walk away’ law for the covered bond market? I think not as much as many people have said for three reasons, one of which is specific to Romania.

The specific is the easy one: Romanian mortgages are currently very good credits with low loss numbers.

Turning to the general: when risks are introduced, mitigants appear. Sadly in the case of Romania - which has a very small mortgage market currently - these mitigants are bound to have the effect of limiting mortgage market growth: higher deposits will be needed, mortgages will be restricted to the better off. Not what Romanian needs currently, but an effective control of risk.

But the biggest comfort factor is that this is precisely the sort of risk that a well-structured covered bond market is designed to address. The probability of a mortgage defaulting will be higher, the loss given default is higher, but we can cope with that. A dynamic, contractual, over-collateralisation test will size the extra over-collateralisation needed. Asset substitution rules will ensure that borrowers who exercise their new right will rapidly be replaced by better, more responsible mortgage borrowers. (Again, in the interest of disclosure, at time of writing no issuer has drafted their programme yet, but they will, and these mitigants will be there and will be effective).

Arguably, this type of law makes covered bonds better, or at very least, more necessary. As risk never leaves the issuer’s balance sheet the law brings down the average credit of the banking system – precisely the problem that covered bonds are there to protect against.

But this is not just a test case for a ‘walk away’ mortgage law. It is a test case for any decisions by governments that fundamentally impair the quality of the mortgage pool – the redenomination of foreign currency denominated mortgages at an off-market rate, for example.

I’m sure this will be a major topic of discussion at the inaugural Euromoney/ECBC/EBRD CEE Covered Bond Forum.

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