Securitisation of Assets in Russia:

A New Legal Framework

Vladimir Dragunov
Partner
Baker & McKenzie, Moscow

December 9, 2003

Russian President Vladimir Putin has recently signed a new federal law On Mortgage-Backed
Securities (the “Law”). The Law had to follow a long and thorny path past Russian regulators before
finally coming into effect on November 18, 2003.

The drafters of the Law envisaged that it would help foster the development of the Russian mortgage
market, which currently faces a number of difficulties. High interest rates, ranging from 10 to 18% p.a.,
on mortgage loans in foreign currency, high transactional costs due to mortgage notarisation
requirements (currently 1.5% of the property value), difficulties in the enforcement of mortgages and
inconsistencies in the legislation that make it difficult to evict former owners from properties – all of
these factors impede the growth of the market.

There are only a few major players on the market. Although the mortgage portfolios of the Russian
banks are still rather small (see Table 1), they are expected to grow following the adoption of the Law,
and taking into account the increasing demand for and supply of residential and commercial properties.
A good indication of this is that several Russian banks have recently announced the launch of
mortgage programs, including Vneshtorgbank (up to five hundred million dollars), National Reserve
Bank (up to one hundred million dollars), Sberbank and some others.

The Law is primarily concerned with the domestic securitisation of both commercial and residential
property mortgages. Some concepts of the new law, however, may well be applied to other classes of
assets and in cross-border securitisations. The latter generally encounter less regulatory difficulties and
cross-border securitisation of certain assets, including MT100/103 payments, credit and debit card
vouchers, lease payments, loan portfolios and trade receivables, can already be implemented under
existing legal environment.

Types of Mortgage-Backed Securities

The new law provides for the

Table 1
following two types of mortgage-
Mortgage Programs in Russia
backed securities: a mortgage-backed (October 2003)
bond (“MBB”) and a mortgage
participation certificate (“MPC”), which Number
Launch Loan Portfolio
Bank of Loans
spring from the “pay-through” and Year (mln $)
“pass-through” concepts underlying Delta Credit Bank 1998 75 2000
most securitisation structures. Raiffeisenbank 2002 20 450
Moscow Mortgage
The concept of the mortgage-backed Agency
2002 21,5 37
bonds, already recognized under
existing securities legislation, has Source: Information Service “Ipoteka”
AB Securitisation of Assets in Russia:
a New Legal Framework

been further developed in the new law. Mortgage-backed bonds are bonds secured by a mortgage
pool. Having the status of an issuable security they require registration with the Russian Federal
Securities Market Commission (“FCSM”). MBBs can be issued in both documentary and non-
documentary forms. Generally, under Russian law, registered securities can only be issued in non-
documentary form, while bearer securities may only exist in documentary form, absent any legislative
exceptions. A mortgage-backed bond, being a debt security, entitles its holder to receive only the
nominal value of such bonds, plus a fixed interest. The mortgage pool is pledged by the issuer, for the
benefit of all holders of the bonds, in order to secure payments under the MBBs. The absence of a
security agent concept under the new Law, which would be similar to a common law security trustee,
makes the enforcement of the security more cumbersome and protracted. There is, for example, a two-
month stay period following the default under the bonds, during which all bondholders are required to
file their claims against the issuer.

Mortgage Participation Certificates

Mortgage-Backed Bonds

Mortgage Agent
MBBs
M
A I S S U E
P T N
S A L E A
L R
E U G MPCs
D Bank / Mortgage Agent S E
G T M
E E % %
N
T
Mortgage Mortgage
Pool Pool

Unlike mortgage-backed bonds, mortgage participation certificates have no nominal value. Similar to a
unit in a mutual fund, MPCs records an undivided right of ownership of their holders in the mortgage
pool. The structure of MPCs is built around the Russian concept of trust management, which, unlike the
common law concept of trust, does not entail the transfer of legal and equitable ownership. The
purchase of an MPC triggers an acquisition of a share in the mortgage pool and an automatic
conclusion of a trust management agreement with the issuer acting as a trustee in relation to the
mortgage pool. The trustee only manages the pool of assets, while the certificate holders retain joint
ownership of the pool. Mortgage participation certificates are registered securities and may be issued in
non-documentary form only. As MPCs do not have the status of an issuable security they do not require
registration with the FCSM.

Mortgage Pool

The new law introduces a new concept of a mortgage pool, previously unknown under Russian law.
Essentially, mortgage pools are pools of certain assets, which are used to back the issue of MBBs and
MPCs. The Law provides for a specialized depository to keep and maintain a register of the mortgage
pool. The latter must be licensed to conduct operations with investment, unit investment and non-state
pension funds.

Importantly, it is not necessary that the mortgage pool be comprised solely of mortgage loans, it may
also include other types of assets, such as cash (both roubles and foreign currency), MPCs recording

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AB Securitisation of Assets in Russia:
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ownership in another mortgage pool, or other assets, as shown in Table 2. The Law provides several
detailed requirements as to the composition of the mortgage pool, intended to ensure the creation of a
low-risk financial instrument. These include both general requirements and specific ones relating to
MBBs and MPCs, respectively.

The general requirements include, for example, the following. At least 50% of the assets included in a
pool should generate periodic payments of principal and interest except during a repayment holiday of
no longer than the first twelve months. Only eligible mortgages may be included in the pool. In order to
qualify as an eligible mortgage, a loan should meet the following general requirements: (i) the principal
amount of the loan may not exceed 70% of the market value of the mortgaged property; (ii) the
mortgagor may not substitute or sell the immovable property without obtaining the prior consent of the
mortgagee; and (iii) the immovable property should be insured for the benefit of the lender. Unfinished
buildings and properties may not exceed 10% of the total value of a pool.

Specific requirements in relation to MBBs Composition of a Mortgage Pool

include mostly various financial ratios. Thus,
at the time of registration of the MBBs with
Eligible Mortages
the FCSM, the total value of the mortgages
in the pool should be at least equal to the
value of the MBBs, including principal and Cash
interest. Throughout the life of the MBBs the
value of the mortgages may not fall below MPCs
80% of the nominal value of the MBBs and
the value of the total pool should be at least Government
equal to the value of the MBBs, including Securities
principal and interest.
Real Estate

Specific requirements in relation to MPCs

mostly relate to the type of assets that may be included in the pool. Generally, only mortgages, MPCs
recording rights to other mortgage pools and cash generated by such assets may be included into the
pool to back-up the MPCs.

Specialized Mortgage Agent

There has been a long debate, in the context of the adoption of the Law, as to whether banks should be
permitted to issue mortgage-backed securities. It was finally established that mortgage-backed
securities may only be issued by either credit institutions or by specialized mortgage agents. While
MBBs may be issued by both credit institutions and specialized mortgage agents, MPCs may only be
issued by specialized mortgage agents.

Banks issuing MBBs would need to comply with certain additional ratios, to be established by the
Russian Central Bank, including total value of mortgage loans to bank’s capital, total value of the
mortgage pool to the value of the MBBs, as well as specific liquidity ratios, regulatory capital
requirements, currency exchange and interest rate limits.

Following the examples of other countries, including France, Italy, Spain and Greece, the Russian
regulators have, for the first time, tried to create a special purpose securitisation vehicle - a specialized
mortgage agent (“SMA”). An SMA may only be incorporated in the form of a joint stock company that
has as its sole purpose the acquisition of mortgage pools. It must hold a valid FCSM license for the

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AB Securitisation of Assets in Russia:
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management of investment funds, unit investment funds and non-state pension funds. A specialized
mortgage agent may not have its own staff and must transfer book keeping and financial reporting to a
specialized entity.

The powers of the SMA listed in the Law are, in a number of instances, poorly defined and narrower
than required. It is unclear, for instance, whether the SMA may reinvest the proceeds derived from a
mortgage pool and acquire additional assets (e.g., in the event of an early prepayment). This raises the
issue of whether the SMA is able to efficiently manage the pool. Given that the regulatory authorities (in
particular, the FCSM) have the right to file a petition for the liquidation of the SMA in the event that it
engages in prohibited activities, one would have expected clearer provisions in the Law.

True Sale

In general, Russian law recognizes both a “true sale” of receivables and an assignment of receivables
by way of security. As a rule, the originator would be liable to the SPV for the invalidity of the assigned
receivables. The SPV would have no recourse against the originator in the event the debtor fails to pay
the receivables, unless otherwise agreed upon by the originator and the SPV.

A “true sale” can be achieved under Russian law, provided that the intention of the parties and the
wording of the agreement are clear that the receivables are transferred by way of a sale, rather than by
way of security or otherwise. When interpreting the provisions of the assignment agreement between
the originator and the SPV, a Russian court would first take a literal reading of the agreement. If the
meaning is still unclear after such a reading, the court may look to the joint intentions of the parties and
examine the prior course of their dealings and correspondence, their post-signing behaviour, etc. A
failure to establish a proper structure for the transaction and to put in place proper agreements
documenting the “sale” of the receivables may result in the transfer of receivables being re-
characterized by a Russian court as a servicing agreement, a loan secured by a pledge of receivables,
an agency agreement, etc.

In the past, Russian courts have queried in a number of case the possibility of assigning future
receivables under existing agreements from the Russian law standpoint. In a number of cases, such
assignments have been invalidated for various reasons. Although not specifically dealing with this
matter, the Law should hopefully remove this legal uncertainty by expressly providing for various
options to transfer the mortgage pool, including by way of assignment (sale), exchange and capital
contribution.

Bankruptcy Remoteness

Generally, in a securitisation transaction the issuer of the asset-backed securities, an SPV, should be
structured as a “bankruptcy remote” entity, i.e., there should be little on no risk of the SPV becoming
subject to voluntary and involuntary insolvency proceedings. In addition, the insolvency of the originator
should not contaminate and affect the activity of the SPV. The structure of a transaction should provide
the means to ensure that assets are available to make interest and principal payments in a timely
manner, notwithstanding the insolvency of the originator.

The Law, however, has no specific provisions that would ensure that a bank or an SMA issuing
mortgage-backed securities may be truly considered as bankruptcy remote entities. The MPC structure
provides an important benefit here, in that the holders of the MPCs have joint ownership of the
mortgage pool and hence, upon the insolvency of the originator, such pool is not included into the

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bankruptcy estate of the originator. As mentioned, the regulatory authorities, however, have the right in
certain limited cases to file a petition for the liquidation of the SMA, which may simply kill the concept of
a “bankruptcy remote” SMA.

The situation with the Russian banks issuing the MBBs is even worse. The Russian response to the
need of having a bankruptcy remote issuer is that a bank should simply maintain a certain minimum
ratio of the total value of the claims of preferred creditors to bank’s capital. Although this ratio is yet to
be determined by the Central Bank, it is clear that by and of itself, it would not be sufficient.
Accordingly, at present, holders of MBBs issued by banks may be subordinated by claims of private
depositors of the bank, by claims of individuals for personal injuries and moral damages, by claims of
employees for wages and severance pays, or by claims for payment of royalties to authors.

It is conceivable that some form of significant credit enhancement from the Russian state or a top-rated
foreign institution would be required in order to achieve a high rating for the securities and a low funding
cost within the existing environment. The fact that currently non-state pension funds may only invest in
mortgage-backed securities that are listed on an exchange and guaranteed by the Russian State, gives
an indication as to the possible scenarios for further development of the market.

Conclusion

Russians often say that “a bad law is better than no law at all.” While the new Law is not perfect, one
would be right to say that nobody expected it to be that way. It is clear that the law is just a first step
toward the creation of a domestic securitisation market in Russia for residential and commercial
mortgages and that additional regulations, including those from the Russian Central Bank, would follow.
In addition, existing laws still must be reconciled with the new Law to make sure it all works.

A comprehensive approach is necessary to address the shortcomings of the new Law. Among other
things and in addition to the problems that have already been mentioned, regulators need to consider
further reform of related insolvency, corporate, tax, currency control and securities laws. If these issues
are addressed in a meaningful fashion, the obstacles to domestic securitisation would be greatly
reduced. A securitisation-friendly legal framework would ultimately foster the growth of the market.
Securitisation would become simpler, cheaper and easier than is possible under current Law.