The German Pfandbrief remains the grandee of the European covered bond market, with a history stretching back over 200 years. Its popularity comes from the iron-clad guarantee backing the bond, an instrument with the remarkable achievement of no defaults over its long history. Over the past five years, however, the European covered bond business has grown increasingly competitive, and the Pfandbrief's position as the dominant asset class has weakened. In 2000 German issuance accounted for around 80% of overall covered bond volumes in Europe, but this had dropped to around 50% by the end of 2004.
In July this year the German parliament passed a major reform of the Pfandbrief law, to coincide with the withdrawal of state guarantees for German public sector banks (Landesbanks). The initial motivation for the new German Pfandbrief Act was to enable Landesbanks to continue issuing Pfandbriefe to meet their funding needs now that they no longer have recourse to the highly rated state-guaranteed paper they relied on to obtain more attractive funding costs.
"The rating of unsecured debt is much lower than for secured for many of the Landesbank institutions that have been issuing Pfandbriefe," says Ted Lord, head of covered bonds at Barclays Capital in Frankfurt. "Savings can be noticeable, at least several basis points." Market participants estimate that the differential between unsecured and secured debt ranges from 10 to 25 basis points for long-term funding based on historical spread levels.
Parallel with the increased Landesbank issuance, analysts predict a dramatic shift in the collateral base from public sector loans to mortgages. Currently around 70% of the !1 trillion Pfandbriefe in circulation are backed by public sector loans. This percentage is expected to reverse over the next five years with mortgage-backed issuance becoming the dominant asset class, since issuers can no longer collateralise the covered bonds with public sector loans.
Issuers have thus far favoured public sector Pfandbriefe due to the greater burden of analysis in issuing mortgage-backed Pfandbriefe, where the underlying contains a large number of single loans. But with around !1.2 trillion of outstanding mortgage loans in the country, of which only !250 million is acting as collateral for Pfandbriefe, the potential for mortgage-backed covered bonds is huge. "The Pfandbrief market has the biggest potential of all real-estate markets in Europe," says a covered bond analyst at a major European bank.
The other major initiative of the reforms to the Pfandbrief law has been the removal of the specialist banking principle, which has opened up the market to a plethora of new domestic players looking to tap into the benefits of issuing Pfandbriefe. Participants are predicting a big increase in the types of players entering the business.
While many of the higher-rated universal banks in Germany have elected not to apply for Pfandbrief licences, due to the advantageous issuance levels available on senior unsecured debt, there has been an increased move among the less well-rated banks to issue covered bonds. Several banks with specialist mortgage subsidiaries have been looking to reintegrate these businesses into the parent company and issue under one banner. In August WestLB closed its Dublin mortgage subsidiary, transferring the operation to its head office in Düsseldorf, from where it will issue all future Pfandbriefe. Similarly German player Aareal Bank, based in Wiesbaden, has announced plans to reintegrate its specialist mortgage subsidiary, Aareal Hyp, back into the parent bank early next year.
A number of smaller savings banks are also looking to enter the market to take advantage of the cheaper refinancing benefits offered by Pfandbriefe. Sparkasse Kölnbonn was the first German savings bank to issue rated Pfandbriefe in 2002, and it has so far issued !634 million in public sector and !100 million in mortgage-backed Pfandbriefe. But for a mid-sized savings bank with a balance sheet of !28 billion, Sparkasse Kölnbonn has found that setting up a Pfandbrief business requires a significant investment of resources. And the effort of organising covered funding will increase under the new law.
The bank has to provide a five-year business plan to BaFin, the German financial regulator, outlining its issuance proposals, as well as providing ongoing risk management reports on the asset pool every three months. Even though it has issued Pfandbrief in the past the bank will have to show the regulator that it has sufficient equity.
But the work needed to obtain the licence is worthwhile, says Sandra Steinbüchel, responsible for funding in the capital markets division at Sparkasse Kölnbonn in Cologne. "Issuing Pfandbriefe is better for us because of the lower spread available than on unsecured issuance," says Steinbüchel. "While the new law is more restrictive it does ensure the quality of the covered bond." Steinbüchel says that the bank hopes to increase the amount of Pfandbriefe issued to meet more than half of its refinancing requirements over the next five years. And with a !6 billion mortgage portfolio the bank has no shortage of mortgage assets to draw on.
Landesbanks, and savings banks like Sparkasse Kölnbonn, have also been looking to buy mortgage assets from smaller savings banks which they can use as Pfandbrief collateral. Under the old rules savings banks had to physically transfer mortgage assets to the issuer bank, which proved costly. The new guidelines allow a savings bank to continue to hold the assets while it acts as a trustee for the Landesbank, overseeing the collateral. This may suit some of the smaller savings banks without the necessary means and size to issue on an individual basis.
"Pfandbrief issuance has to be done on a sustainable basis – it's a strategic decision," says Bernd Volk, credit analyst for covered bonds at HypoVereinsbank (HVB) in Munich. "If you are a small bank you have to decide whether you want to pool your assets with a number of banks and then launch Pfandbrief or go it alone."
While the main purpose of the new Pfandbrief law has been to open the market to further issuers, the legislators also took the opportunity to tighten controls on the market. Problems with the mortgage banking industry in 2001 and 2002 led to a wave of downgrades of the Hypotheken banks which also dragged down the Pfandbrief rating of some issuers and threatened to undermine the stability of the covered bond system.
The primary reason for the downgrades of Pfandbriefe at the time was the notching system used by some ratings agencies, such as Moody's. While Moody's has changed its approach now, one of the focuses of the new law has been to emphasise the delinkage between the underlying asset pool and the issuer's credit quality, to prevent this kind of downgrade occurring again. "The law came in because the underlying credits of issuing banks had been downgraded," says Tim Skeet, managing director of origination with responsibility for German and French speaking fixed-income origination at ABN Amro in London. "The regulators needed to tighten up the system and give the Pfandbrief structure a greater degree of bankruptcy remoteness."
By increasing the transparency requirements on issuers the legislators have made it easier for investors to compare Pfandbriefe without having to look at the issuer's background. This could strengthen the product's position in the European market, in the face of heightened competition from new issuers. "The new law makes it less important as to who the issuer is – it is pro-European," says Harald Eggerstedt, senior fund manager at Cominvest, in charge of a !500 million mortgage portfolio at the asset management company. "It was important to see the manager's history under old rules, which could be difficult for a UK investor, for example. The law has increased the homogeneity of the product."
The strength of the German Pfandbrief was well illustrated earlier this year when German mortgage bank AHBR and HVB both successfully launched and priced Pfandbrief deals with only a modest price concession. At the time AHBR was the object of fairly dramatic rumours in the German press concerning its financial health and HVB had come out with unexpected and dramatic credit writedowns. Both deals were in the eight to 10 year maturity range. With such huge demand for German covered bonds, the broadening and strengthening of the Pfandbrief law can only be taken as a positive.
|Structured covered bonds closing the gap on Pfandbriefe |
Structured covered bonds issued out of the UK and, as of August this year, the Netherlands have been a cause for concern for participants of the German Pfandbrief market. "Germans have been critical of structured covered bonds, which they perhaps saw as a threat to the soundness of their product," says Tim Skeet, managing director of origination with responsibility for German- and French-speaking fixed-income origination at ABN Amro in London. "They believed that doing a quasi-securitisation and calling it a covered bond would compromise the quality and transparency of the market."
According to German market participants the difference between UK-issued structured covered bonds and German Pfandbriefe is not that great, except in the legal basis underlying the two issuer systems. Indeed Pfandbriefe use many of the structural mechanisms employed by covered bonds coming out of the UK: for example, the covered pools are managed using derivatives, the interest rate and exchange rate risk is hedged and several liquidity buffers are provided.
But the legal basis for traditional covered bonds in Germany is something that, say the proponents of Pfandbrief, gives it an added strength. "The Pfandbrief is a very important product for Germany, its roots are very deep," says Louis Hagen, secretary-general of the Association of Pfandbrief Banks in Berlin. "There is systemic support for the Pfandbrief in Germany. In the UK, where the regulators haven't taken measures to enact a specific law, there is no specific surveillance of covered bonds like you have in Germany."
The loose definition of covered bonds in the UK has led to accusations of issuers throwing together varying structures under the tag of a covered bond. "The situation at the moment is remarkable," says Hagen. "You could almost sell anything under the covered bond label. Lots of investors are desperate to find a little yield pick-up on a very safe product. The industry must ensure that investor confidence is not misled."
According to Hagen, the UK market provides more complications for the investor. The different covered bond models in the UK make it more complex for an investor to analyse individual issues. "This is unlike Germany now where all outstanding Pfandbriefe have to follow the same rules making it a very homogenous market," says Hagen.
But despite their differences, Hagen says that UK covered bonds are not at any greater risk of default than their German equivalents. Certainly demand for the UK covered bond business has risen sharply in recent times. Spreads between traditional Pfandbriefe and UK structured covered bonds have contracted to 1.5 basis points on a five-year bond from around 3.5 basis points at the beginning of last year.
With more and more jurisdictions entering the business, competition in the European covered bond market grows ever more intense. The Pfandbrief template was initially copied by the French, Luxembourg and Spanish markets soon after the adoption of the euro. Newer players like the UK, Ireland, Netherlands and Italy have also looked to tap into the increased investor demand for these products.
Across Europe pension fund managers are looking to allocate more of these products to their portfolios. "People are really comfortable with this asset class while many of the traditional government bond issuers are swimming in oceans of red ink," says Ted Lord, head of covered bonds at Barclays Capital in Frankfurt. "We recently have had one of our clients, a large European pension fund, switching 70% of its portfolio from government bonds into covered bonds."
|How the new Pfandbrief Act works |
The new law…
At the same time as the new Pfandbrief Act, the German parliament also passed a new law removing the state guarantees held by German Landesbanks. Loans granted to Landesbanks after July 18 can no longer be included in public cover pools.