In its Covered Bond Market Insights report, S&P Global Ratings presents the local covered bond market, summarizes how the relevant legal framework works, compares key characteristics of existing programs, and provides an overview on the current local mortgage market and recent market developments.

Overview: France Is A Market Leader

In 2022, European covered bond issuance reached levels unseen since 2011. The strong rebound was seen mainly in France and Germany, together representing more than 53% of total European benchmark issuances. Closely behind Germany, France was the second largest European covered bond issuer in 2022, with €42.7 billion of benchmark issuance--26% of the European total. The rebound in France was driven by slowing deposit growth funding (due to rising inflation and higher post-pandemic consumer spending), tighter monetary policy, the need to at least partially replace maturing borrowings under the European Central Bank (ECB)'s targeted longer-term refinancing operations, and higher spreads attracting investors' attention.

The French covered bond market is one of the largest globally by stock to date, with over €376 billion of bonds outstanding as of June 2023 (source: Harmonised Transparency Template reporting of French issuers). Eighteen French covered bond programs belong to 13 banks and one corporate entity. The main collateral types backing the programs are residential loans (mortgage and guaranteed), and--to a lesser extent--public sector exposures. The large outstanding volume and continued issuance flow indicate covered bonds continue to be a primary funding source for French banks.

Chart 1

Chart 2

Covered bonds mark a very strong first half of the year

French investor-placed benchmark covered bond issuance in 2023 has so far been very strong and has significantly overtaken the decade high 2022 year-to-date volume. Rising interest rates caused French banks to issue heavily early this year and some have already completed most of their funding plans. Therefore, unless banks decide to prefund some of their 2024 origination, we expect issuance to slow in the second half of the year as funding needs decrease.

High Council for Financial Stability legally binding guidelines restrict lending practices

The French High Council for Financial Stability (HCSF) introduced new lending guidelines. The guidelines started as recommendations for two years, and then became legally binding from Jan. 1, 2022. Their application is supervised by the Autorité de Contrôle Prudentiel et de Résolution. The guidelines impose restrictions on all new home loan origination in France. The main features are:

• A more stringent affordability metric with debt service-to-income (DTI) ratio limited at 35%.
• The loan term should not exceed 25 years; two extra years are allowed for property construction-related loans.

Only 20% of the quarterly residential loan origination is allowed to deviate from the strict guidelines. Out of the allowed deviation, 70% is reserved for primary residence acquisition with at least 30% for first-time buyers and 30% for nonprimary residence (limit was 20% until July 1, 2023). This leaves up to 6% possible deviation from the guidelines for buy-to-let loans, compared with 4% before July 1, 2023.

Along with usury rate misalignment and higher interest rates, the new HCSF guidelines on residential real estate market lending standards in France have contributed to cooling new loan origination down (see chart 3).

Chart 3

Rising interest rates caused a misalignment with the lending rate cap

Interest rates charged by lenders on new residential loans have been increasing, but at a different pace to market interest rates. Banque de France, the French central bank sets a usury rate (a maximum allowable interest rate) to all new loan origination in France. The usury rate caps the interest rate lenders can charge borrowers; all costs included. It is calculated based on the average level of interest rates applied by credit institutions during the previous quarter and can exceed this level by one third only.

Due to rapidly rising interest rates since the second half of 2022, the quarterly resetting frequency has caused the usury rate to lag bank funding costs, thus challenging the profitability of new loan origination. This means certain banks during the second half of 2022 and at the start of 2023 reduced mortgage application acceptances and excluded some potential borrowers from contracting new loans. To alleviate this issue, the reset frequency was changed to monthly from Feb. 1, 2023--although this measure is temporary.

Buy-to-let incentives are evolving

Old tax incentives related to buy-to-let loans are being phased out progressively in 2023 and 2024 and new tax incentives, similar to the old ones, are being introduced from 2023. The new tax incentives need to respect stricter limits related to energy performance, minimal living space, and quality of life conditions.

Climate and resilience law

The new law, effective Aug. 24, 2022, sets limits on renting out properties according to their Energy Performance Certificate (EPC). For all new rental contracts or rental renewals and extensions (usually every three years), the rent charged on private properties with EPCs of F and G can no longer increase.

Energy consumption and CO2 emission limits will extend progressively in the coming years. This means that the properties without the minimum level of energy performance will be gradually excluded from the rental market (see table 1).

Historical and listed buildings will be granted exemptions from these limits.

Table 1

Banks are now starting to collect EPC data and offer loans for property renovation aimed at energy efficiency improvement, in addition to the primary mortgage loan. We understand the offering of energy efficiency improvement loans alongside mortgage loans will become more common in the coming years.

Implementation of the EU's Covered Bond Directive

The EU Covered Bonds Directive and Regulation were transposed into French legislation by enacting changes to the French Monetary and Financial Code and to Regulation 99-10 by decree-law (ordonnance) n. 2021-858 dated June 30, 2021, decree n. 2021-898 dated July 6, 2021, a ministerial decree (arrêté) dated July 7, 2021, a ministerial decree (arrêté) dated Dec. 1, 2022, decree (décret) n. 2022-766 dated May 2, 2022, and decree (décret) n. 2023-102 dated Feb. 16, 2023. These amendments apply to covered bonds issued from July 8, 2022.

The main changes comprise:

• Soft bullet maturity extensions are allowed if the parent defaults on the principal/interest payment on a secured loan under the facility agreement, if the issuer defaults on the principal/interest payment on the covered bonds' scheduled maturity date, or if the issuer/parent becomes insolvent.
• Soft bullet extensions cannot invert the outstanding bonds' maturity order upon société de crédit foncier (SCF)/société de financement de l'habitat (SFH) insolvency. However, maturity inversion is not forbidden if the maturity extension was triggered by a previous event associated with the parent.
• Premium covered bonds require enhanced monitoring activity by the cover pool monitor to ensure compliance with article 129 of the Capital Requirements Regulation.

Other changes relate to elements of the regulatory coverage ratio and its calculation, as well as enhanced disclosures and reporting.

The Legal Framework: A Well-Balanced System

The French covered bond legislation encompasses two main legal frameworks: SFH and SCF. An additional framework is exclusively dedicated to one issuer, the Caisse de Refinancement de l'Habitat. The SFH framework restricts eligible collateral to residential loans and is dedicated to the issuance of "obligations de financement de l'habitat". The SCF framework can accommodate multiple collateral types, including public-sector exposures, residential loans, and commercial real estate loans. Covered bonds issued under this framework are named "obligations foncières". Both give credit to a loan-to-value ratio below an 80% threshold for standard residential loans and prescribe a 15% cap to the share of cover pool substitute assets--in the form of exposures to credit institutions.

SFHs and SCFs--the covered bond issuer--are specialized credit institutions licensed and supervised by the "Autorité de Contrôle Prudentiel et de Résolution", the French banking regulator. They are created as a wholly owned affiliate of a bank, for refinancing the banking group to which they belong, and are remote from the bankruptcy of their parent. SFHs and SCFs have usually no employees or other resources and are managed by their parent. As regulated entities, SFHs and SCFs are subject to regular compliance audits with legal covenants from the specific controller, a cover pool monitor.

Bondholders have dual recourse to receive payments on the notes: to the SFH/SCF's parent bank, and to the cover pool assets if the parent bank becomes insolvent.

Assets can be segregated within the SFH/SCF by way of a transfer of security to a loan granted by the SFH/SCF to the parent bank (secured loan structure, see chart 4) or through a true sale where they are sold outright to the SFH/SCF (see chart 5).

In the secured loan structure, the SFH/SCF issuer uses the covered bond issuance proceeds as a loan to the parent bank. This then transfers the collateral assets to the SFH/SCF as security for the loan. Collateral will remain on the parent bank's balance sheet so long as it is solvent. Once the parent bank becomes insolvent, security over the collateral--which will be granted pursuant to the EU Collateral Directive as implemented in French law--will be immediately enforceable and transferred to the SFH/SCF. The terms of the loan typically match the terms of the covered bonds, enabling the SFH/SCF issuer to make full and timely payments on the covered bonds.

In our view, these frameworks strike a good balance between effective protection of covered bondholders, flexibility to include multiple asset types, and clear program management thresholds for minimum overcollateralization, liquidity coverage, and maturity mismatch requirements.

Chart 4

Chart 5

Table 2

Table 3  |  View Expanded Table

Features Of French Covered Bond Programs

Home loans

A fixed-rate lending market.   The fixed-for-life nature of French residential loans makes them less sensitive to rising interest rates. However, higher interest rates significantly reduced new home loan origination during the second half of 2022 and the first half of 2023. As of July 31, 2023, year-to-date new home loan origination excluding renegotiated loans stands at €83 billion, versus €137 billion during the same period in 2022, a decrease of more than 39% (see chart 3).

Due to the prevalence of fixed-for-life residential loans in the French market, SFH covered bond programs mainly issue fixed-rate notes and rely on a natural hedge with no ad hoc interest rate swaps. We assess the extent to which these natural hedges affect overcollateralization requirements through our cash flow analysis.

An emphasis on DTI.   The main borrower eligibility criterion under French banks' credit underwriting policies is the DTI ratio. This is in contrast to other mortgage markets such as the U.S. or the U.K. where more importance is given to loan-to-value ratios. Underwriting standards are generally conservative, and the maximum DTI is typically between 33%-35%. As a result, French residential loan performance is less linked to house prices than in the U.S. or U.K. Alongside a strong social benefit support system, this means portfolio performance tends to be less cyclical.

Guaranteed loans as market standard.   French residential loans are secured either by a traditional mortgage deed or a guarantee (known as caution) provided by an insurer or a credit institution. France is a full recourse market, meaning there is a full recourse on the borrower's possessions that goes beyond the secured property. The recovery process differs depending on the guarantor, as it can intervene either at the beginning or at the end of the process. In the first case, the lender recovers the guaranteed amount from the guarantor, which then manages the recovery and, if applicable, the eventual property foreclosure. In the second case, the recourse to the guarantee is triggered only when all other recovery options are exhausted with the guarantee covering only the final loss. Loans guaranteed by cautions are a unique feature of the French market. As of today, cautions represent over 60% of outstanding home loans.

Public-sector exposures.  Public-sector underlying collateral types are relatively diverse, comprising loans to French local and regional governments (LRGs), public hospitals, other public entities, and export finance loans guaranteed by export credit agencies in France and abroad. Our credit analysis includes an assessment of the creditworthiness of the various obligors and guarantors.

Mortgage Market Overview: Housing Market Frenzy Is Cooling Down

We project the French economy will expand by 0.7% in 2023 and 0.9% in 2024 (only 0.8% on average per year) from 2.5% in 2022. This is a result of the ECB's monetary tightening, high inflation, and the economic slowdown in Europe.

The French government's anti-inflationary measures in 2022--including caps on gas and electricity price increases and fuel rebates--made inflation in the country one of the lowest in Europe. Although it accelerated in the first quarter of 2023, as electricity and gas prices increased and fuel rebates came to an end, we expect inflation to decelerate to 5.6% for the rest of 2023, from 5.9% in 2022. However, the residual costs of higher producer and energy prices will still weigh on core inflation.

The French labor market remains resilient to the economic downturn. The employment rate increased to a record 68.6% in first-quarter 2023, the highest since data collection started in 1975. According to Eurostat's monthly data, the unemployment rate reached 7.0% between February and April 2023, the lowest monthly level since April 1983, down from 8.2% in December 2019. We expect the interest-rate-related fading momentum in industrial production and construction will lead to a temporary increase in the average annual unemployment rate to 7.5% in 2024 (see "Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth," published March 27, 2023, and "Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain," published June 26, 2023).

Table 4

Chart 6

Property market outlook: House price inflation will undergo sustained correction; buy-to-let origination should slow down

After 2021 marked a record number of real estate transactions and continued house price growth, and 2022 showed a similar trend although with slowing house price increases, we now forecast home prices to undergo a sustained correction over the next two years. New residential building permits are down 40% from their peak (see "European Housing Markets: Sustained Correction Ahead," published July 20, 2023). The price-to-income ratio and price-to-rent ratio began leveling off in the second half of 2022 and the first quarter of 2023, respectively. Home loan terms increased significantly, with the loans with over the 20-year term reaching 66.4% of total new home loan origination in March 2023--compared with 61.4% in 2022 and 57.0% in 2021. Because the new HCSF guidelines stipulate that home loan terms cannot extend beyond 25 years, and the average loan maturity is now over 22 years, increasing loan maturity can only marginally improve affordability.

We expect house price inflation to cool in as a result of higher interest rates on home loans and increased cost of living pressure. We expect house prices to decline by 2.6% in 2023 and 4.0% in 2024 before recovering 1.5% in 2025 and progressing at 2.5% in 2026.

We currently view the French housing market as being overvalued by roughly 18%, which we adjust for in our credit analysis (see "Cost Of Living Crisis: Mapping Exposures In European RMBS And Covered Bond Markets," published June 27, 2022).

Despite the HCSF guidelines update allowing higher derogation for buy-to-let loans, new regulatory requirements limiting the buy-to-let tax incentives to energy efficient properties complying with new quality of life standards only, coupled with the significant drop of new residential building permits, point to a further slowdown in buy-to-let loan origination.

Chart 7

Chart 8

Local And Regional Government Lending: Deleveraging Under Way; Higher Financing Costs Appear Manageable

Tightening borrowing conditions and the economic slump weigh on French LRGs. Total LRG debt contracted by 3.6% in 2022 and we expect this to continue in 2023 and 2024. As a response to budgetary pressure, slower economic growth, and high inflation, French LRGs will have to adjust their overall spending.

However, recent local tax reforms mean the share of VAT receipts as percentage of French LRG revenue has grown. This makes LRGs more sensitive to economic cycles and reduces their direct exposure to local economies.

We expect LRG's debt to stabilize and capital expenditure to decrease. French LRG's average debt maturity is 11 years and 75% of it has a fixed interest rate, which moderates the effect of rising interest rates on French LRGs' debt positions.

Overall, we expect French LRGs' creditworthiness to remain resilient to the economic slowdown and budgetary pressures (see "French LRGs Remain Resilient To Headwinds," published March 7, 2023).

Comparison Of French Covered Bond Programs

French covered bonds benefit from the support of highly rated issuers. In our analysis of French covered bond programs, the parent bank is the first recourse for bondholders. Therefore, strong issuers benefit the programs' creditworthiness. A highly rated parent can translate into unused notches of ratings uplift, offering some buffer against decreasing available credit enhancement.

However, the negative outlook on the long-term rating on France has translated into the negative outlook on the ratings on two French covered bond programs, due to their sensitivity to the sovereign rating.

Even though French covered bonds tend to perform strongly on average, some of their program characteristics and credit and cash flow results differ. Below we present and compare the key characteristics of the French covered bond programs that we rate.

Table 5a  |  View Expanded Table

Table 5b  |  View Expanded Table

Chart 9

Ratings Outlook: High Issuer Credit Ratings And Unused Notches Underpin Stable Ratings Despite Lower Excess Spread

Most French covered bond programs are rated 'AAA' (see chart 10).

Chart 10

Table 6 shows our average credit enhancement calculations across programs. The target credit enhancement is the overcollateralization required to achieve the maximum potential collateral-based uplift. It covers asset default risk (or credit risk) and market value risk, which is the credit enhancement that we expect to be required to refinance the cover pool in a stressed environment.

Most French mortgage covered bond programs' credit and market risk increased as a consequence of rising interest rates affecting the cost of new issuances, among other things. Their excess spreads, which represent the difference between the interest gained on the assets and the coupon due on the covered bonds, started to compress in 2022; a trend that accentuated in the first half of 2023. With residential loans having mostly fixed-for-life interest rates and with loan terms increasing, along with a limited increase in new loan origination interest rates due to the usury rate, the weighted-average interest rate on these assets has not been able to increase as fast as the weighted-average cost on the newly issued covered bonds, thus reducing the excess spread of French mortgage covered bond programs. Decreasing excess spread is also noticeable in French public sector covered bond programs.

Although some of the 2023 new issuances are positioned at longer maturities (seven-to-10 years), similar to other European countries, much of the 2022 covered bond issuance was concentrated in shorter maturities (three-to-five years). This shortened the overall weighted-average life of French covered bond issuances, contributing to higher asset-liability mismatches and increasing refinancing risk, which in turn inflated targeted credit enhancement.

However, French covered bond programs have comfortable available credit enhancement levels that are more than enough to cover the higher requirements.

Table 6

Chart 11

Chart 11 shows our average cash flow calculations across countries. On average, French programs present relatively low credit and market risk.

Related Criteria

• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Global Framework For Payment Structure And Cash Flow Analysis Of Structured Finance Securities, Dec. 22, 2020
• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
• Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015
• Covered Bonds Criteria, Dec. 9, 2014
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014
• Principles Of Credit Ratings, Feb. 16, 2011

Related Research

• European Housing Markets: Sustained Correction Ahead, July 20, 2023
• Covered Bonds Outlook Midyear 2023: Rising Interest Rates Will Test Asset Performance, July 19, 2023
• Global Covered Bond Insights Q3 2023: Strong Issuance Is Here To Stay, June 29, 2023
• Credit Conditions Europe Q3 2023 The Slow Burn of Rising (Real) Rates, June 27, 2023
• Economic Outlook Eurozone Q3 2023: Short-Term Pain, Medium-Term Gain, June 26, 2023
• France ‘AA/A-1+’ Ratings Affirmed; Outlook Remains Negative, June 2, 2023
• The French Covered Bond Legal Framework: A Closer Look, April 3, 2023
• French LRGs’ Creditworthiness To Remain Resilient To Headwinds, March 7, 2023
• Cost Of Living Crisis: Mapping Exposures In European RMBS and Covered Bond Markets, June 27, 2022
• S&P Global Ratings' Covered Bonds Primer, June 20, 2019
• Glossary Of Covered Bond Terms, April 27, 2018