How Should China Finance the Growth of its Housing Market?: Europe’s Experience with Covered Bonds

China’s housing market has grown enormously in the past few years. In fact the value of the urban housing stock has recently surpassed 200% of GDP, doubling the size of household’s bank deposits.

Notwithstanding the sheer size of its housing market, China still lacks the financial instruments to allow this market to grow further. In fact, it is too much of a cash market when compared to industrial countries and even more so if we consider China’s lower income per capita and, thus, the relatively limited power of Chinese households to pay for their house. 

Given the circumstances, exploring how other countries have financed the growth of theirhousing market seems all the more interesting for China.

Comparison of mortgage financing methods

There are basically three funding methods available to finance residential mortgages.

The simplest method is for banks to fund mortgage loans utilizing their retail deposits. While it is a straightforward way to start the mortgage financing business for banks, this method also runs the risk of maturity mismatch, as the term structure of bank deposits is much shorter than that of mortgage loans. In addition, the banking system bears the primary risk when housing markets experience boom-bust cycles. At this juncture, the Chinese residential mortgages are primarily financed via this method.

The second method of mortgage finance, which has grown very rapidly in the last few years, starting with the Angloxason financial system, is through securitization. Mortgage loans once sitting on the banks’ balance sheet are packaged and sold as securities in the secondary markets in the form of mortgage-backed securities (MBS).

The third method to finance mortgages is through covered bonds or mortgage bonds issued by a bank itself and guaranteed by its mortgage portfolio. The main difference between covered bonds and securitized assets is that the former remain on the bank’s balance sheet. The second important difference is that the covered bond is guaranteed not only by the collateral associated with the underlying loan (the so-called “cover pool”) but also by the issuer’s creditworthiness.

In the US, the majority of mortgages are funded through MBS. These securities allow ordinarily non-liquid assets (such as mortgage loans) to be packaged into liquid securities. A pool of loans is transferred to a special purpose entity or a conduit so that these assets can be taken off from the institution’s balance sheet, thus removing the capital charge associated with them. This technique was facilitated by the establishment of the Government Sponsored Enterprises (GSE), such as Fannie Mae and Freddie Mac, which buy mortgage loans from banks and then securitize them. Another goal of these agencies was to develop a secondary market for MBS in order to increase mortgage funding sources and extend home ownership in the US. However, if banks or other mortgage originators do not exercise their due diligence on the mortgages they originate, the MBS market can experience serious problems. The US subprime mortgage crisis is a case in point. 

Indeed, as the housing market cooled and mortgage defaults rose, higher than expected losses pushed the MBS market to a halt. GSE were also put under heavy strain, prompting active intervention from the U.S. government and landing Fannie and Freddie in conservatorship. After this event, fully private securitized models became nearly non-existent, posing a question as to which model should be embraced for future funding of residential mortgages in the US.

It appears that the covered bonds method for mortgage financing has survived the current global financial crisis relatively well. Indeed, there are several advantages associated with the covered bonds. First, cover bonds are a relatively simple instrument in as far as the identification of the ultimate risk bearer straightforward. Second, the covered bonds do not seem to be as sensitive as MBS to changes in the underlying asset. This might be due to the fact that the creditworthiness of the bank stands behind the operation.

There are a number of other advantages from the issuer perspective, such as the low cost of issuance, the relatively long maturity of the bond, the transfer of part of the interest rate risk to capital investors (as most covered bonds have are at fixed rate), etc.  From the investor perspective, cover bonds have the advantage of offering collateral (the mortgage) but also the bank’s creditworthiness, the same bank which has evaluated the risk of such mortgages. This clearly reduces moral hazard.

  • High credit quality, and their rating is higher than the issuer.  

Furthermore, covered bonds tend to be very liquid as they quite standardize. The pick-up in yield makes them as alternative to government bonds. From the perspective of economic authorities, the introduction of covered bonds could help develop China’s relatively incipient bond market. Furthermore, they could be used as collateral for money market operations. This will become all the more important as China moves to more market-determined monetary policy instruments and away from reserve requirements.

The development of covered bonds in Europe

Germany and Denmark were the first two countries to use the cover bond instrument, followed by other countries such as France and Spain.

All in all, Europe’s covered bonds are a €2 trillion asset class (Chart 1), among them, 55% are mortgage and 41% are public sector oriented. Most bonds, 53% of total, are “jumbo” bonds, namely larger than € 1 billion issue. In two years, these instruments have grown from funding about 20% of housing loans in 2005 to more than 40% at the end of 2007.

Even during the current turmoil, the covered bonds have continued to provide liquidity to housing markets in Europe and still represent a higher-yielding alternative to government bonds.




Historically and still in many countries issuance of covered bonds allowed only by specialized credit institutions (mortgage banks), these countries include: Denmark, Germany, Hungary, France, Poland. The rationale for the specialized credit institutions is for safety and transparency.

While, many countries allow diversified universal banks to issue covered bonds, like Spain, Sweden, Chile, Czech Republic, Ireland. The rationale behind is that banks exist there, and it has costs to set up specialized lender.


The US subprime crisis argues against securitization (i.e. taking mortgages out of the banks’ balance sheets) as long as risk cannot be assessed properly. So far, covered bonds seem like a safer option for investors with advantages for issuers and the public in general, in terms of financial sector development.  Although this is a new instrument for Asia (only Korea has started recently with the first issuance of covered bonds), Europe has a long experience with these instruments. Given China’s large needs for housing finance in the future,  it would seems useful for China to experiment with this method of housing finance going forward.



Alicia Garcia Herrero

Chief Economist for Emerging Markets


2 Responses to "How Should China Finance the Growth of its Housing Market?: Europe’s Experience with Covered Bonds"

  1. Miguel Otero Iglesias   October 2, 2009 at 4:25 am

    Hola Alicia,I went this year to China to do research on Chinese financial elites for my PhD and the topic of covered bonds instead of US-style securitization came up in a lot of interviews. It seems that the Chinese are quite keen in developing these type of instruments.

  2. Wilson   October 2, 2009 at 10:02 am

    Hola Alicia,Basically covered bonds are same as mortgaged back securities, except the risk is not transferable to others.One may aruge since the risks are not transferable, the banks would be more careful in their lending practices and in reviewing the borrower’s quality. Yet if the lending standard would be as stringent as the bank’s previous practice, there would not be higher interest charged on the loan, thus in the first place, they will not be able to offer a much higher interest to woo investors into buying those bonds in the first place!Covered bonds and MBS are the same when boil it down to the naked facts.They are same in the sense that it increases the leverage that the overall economy is using.Given all these fancy terms for these instruments, when one was young they look so sofisticated, but now that we have all grown up, these things are not complicated or “amazing” at all.At the end of the day, it also boils down to if you have the cash or not. If the house buyer has no cash. Too bad, work harder or buy a smaller home.Same thing for the banks, if you do not have as much deposits, work harder in getting more deposits or lend less.The Western society is so addicted to borrowing, and is now in a detrimental state because of this. If even China jumps on the bandwagon and joins the borrowing and spending spree too, who is going to bail out the US next time?For any given asset class, if it is already highly priced and not affordable, that means it is temporarily mispriced. The mispricing would lead to more supply as investors would want to make profit. Then as the supply increase, the price itself would adjust.There is no point to increase the leverage which while it is true would make housing more common for everyone, but it would lead to a bigger bubble for a mispriced asset.Nobody has been guaranteed a house and a car then “driving happily together with a family to the Diner in the typical American movie fashion”.China currently does not need covered bonds at all. If they want to increase house ownerships they could lower the down deposit ratio from 30% to lets say like 15% or to the extreme like in the US during 2006, zero down!With the covered call, bankers who will have to pay bond holders a higher interest will again have the incentive to make short term profits, lowering their lending quality standards to make more loans, and at the end of the day it will also be a disaster.Covered bonds and MBS are not much different. Or in the Australian term ” They are the same sh#t, just different color”