Covered Bond Roundtable 2012: Part 1

IFR Covered Bond Roundtable 2012
21 min read

To view the digital edition of this roundtable, please click here.

Keith Mullin, IFR: Good afternoon to you all. Thank you so much for attending IFR’s Covered Bond Roundtable. I’d like to kick off with a fairly broad theme. If we look at overall bank capital and funding, it’s clear that bank shareholders are unhappy about the returns they’re getting partly because banks are falling short of target ROE and broadly speaking bank shares have performed very poorly.

We’re also in the midst of a big debate around bail-in of senior unsecured bondholders. Even though it’s not scheduled to kick in until 2018, there’s been a lot of pushback from investors, some of whom have said they will not fund banks if they’re going to be bailed in even if they’re protected by a larger subordinated cushion and there’s a re-pricing of the market.

We’ve got depositors in some cases being asked by banks with retail networks to transfer deposits into retail bonds, which as a source of funding has a limited lifecycle. On the secured side we’ve got an ABS market that is to all intents and purposes closed. So there’s huge pressure on covered bonds at a time when some banks are potentially running out of assets to cover.

It’s a pretty negative picture. So where do we go from here? Jose, could you kick us off with some broad themes around the bank funding picture?

Jose Sarafana, Covered Bond Analyst: Well the first thing is that covered bonds are a very well protected asset class. So in terms of the crisis and high volatility, covered bonds have advantages over senior unsecured bonds because investors feel safer with them. What we can typically say is the better the quality of the bank, the narrower the spread between the covered bonds and the senior unsecured bonds. During times of crisis of course, this is where covered bonds should theoretically do particularly well. The bail-in debate also helps covered bonds.

Nevertheless, sovereign risk is dominating the debate. At the end of the day, covered bonds have three entities guaranteeing them, at least in Europe: first the bank; second the cover pool and thirdly the State, which will bail out the bank if it has a problem. So the sovereign factor is extremely important for pricing covered bonds. We can observe this by looking at groups, like for example Santander, SEB or Unicredit; banks from different jurisdictions whose covered bonds have very different spreads. So at the moment, the dominant factor is sovereign risk, and covered bonds have somehow been caught between the sovereign crisis and their comparative advantage over

I haven’t found anyone who can say precisely at what levels secured funding beyond classical covered bond will be available to banks, especially in a new and evolving regulatory environment.

IFR: So is your central thesis that governments will continue to bail out banks?

Jose Sarafana, Covered Bond Analyst: I’m pretty convinced of that. We have seen that, of course in Spain with a very drastic example [Bankia]. The question a year or two ago in Ireland was what would happen if an Irish Bank went bankrupt and who would it not pay first? The answer was, well, if they can’t pay the subordinated debt, OK fine. If they can’t pay the senior, that’s worse. But if they can’t pay on the covered bonds, then it’s really a crisis, because following non-payment or default, when that issuer wants to come back to the market, they start with covered bonds, which are the safest even for a weak bank.

So the idea was if a bank was forced to default, it definitely wouldn’t be on the covered bonds because that would be the first instrument they’d turn to regain market access. So I think in terms of the crisis and the high volatility we’ve been experiencing, covered bonds are still the best protected asset class.

IFR: That’s fine, but investors have said regularly that covered bonds can’t be the only funding tool that banks use. But it seems like they’re the only tool available. So in terms of where they sit in a bank’s funding model, are you saying now that issuing covered bonds is the only way in terms of public capital market that banks can fund?

Jose Sarafana, Covered Bond Analyst: I would say the bigger the stress on the bank the more important covered bonds are. If the quality of the bank is extremely strong and nobody thinks that it will default then it can easily sell a senior unsecured bond.

Arnold Fohler, Head of Debt Capital Markets, DZ Bank: We definitely have a split situation here that’s very much driven by the psychological nature of the market. Sovereign risk creates headline risk, which drives investors to buy or not to buy irrespective of whether the product is valid in itself and whether banks want to move to covered bonds at some point later on.

Psychological risk and the way investment decisions are taken are driven by headlines. You don’t want to be called by your boss to justify yourself because, for example, Spain or whatever other country is in the press. That attitude is driving the market. So we currently have a split market and, certain issuers are only able to fund via covered bonds and not via senior unsecured market.

Jens Tolckmitt, Chief Executive, VDP: If you take a medium-term perspective, I don’t think the picture you end up drawing with regard to the bank funding model will substantially change. So we’re currently in crisis mode and covered bonds have certainly held up quite well. But our concern is that none of the other options that you mentioned – equity, unsecured debt, deposits, securitisation – will be available in the same amounts due to their treatment in the new regulatory environment.

And after the crisis, they certainly won’t be available at the same price as before. What’s left over for banks to fund themselves is really a concern because we’re strong believers that the relatively important role covered bonds played during the crisis was due to the fact that they were not used for everything on a bank’s balance sheet.

My feeling is that this will be the case after the crisis, too. Also, investors are aware that there is a certain limit – as yet undefined – to the use of covered funding, not just classical covered bonds but overall secured funding on the balance sheet of a bank. And in our view that’s one of the main challenges for the banking industry going forward: funding itself on competitive terms relative to other groups in the financial sector but without relying solely on covered bonds because there is a limit to using them in a broader sense.

We definitely have a split situation here that’s very much driven by the psychological nature of the market.

IFR: Can you be more specific about the limitations on covered bonds as a funding tool?

Jens Tolckmitt, Chief Executive, VDP: Well from an investor’s perspective, certainly unsecured funding is getting riskier, and they will demand a higher risk premium for that. And for an issuer, at the end of the day, it’s always about the funding mix and the cost of the funding mix. It doesn’t help if a certain issuer can fund itself cheaply on, say, 50% of the balance sheet and the other 50% is expensive. The funding mix is decisive and investors will ask for higher premiums.

Secondly apart from the traditional covered bond framework that we currently have, i.e. the classical, covered bonds we know all over Europe, we’re not really aware of where pricing will end up. At least I haven’t found anyone who can say precisely at what levels secured funding beyond classical covered bond will be available to banks, especially in a new and evolving regulatory environment.

And thirdly, you can see that regulators are getting increasingly concerned about the fact that covered funding seems to be the most prominent way of funding banks in the current environment and going forward. And they will certainly, at some point, step in and define limits to what may be refinanced via covered funding.

Richard Kemmish, Head of Covered Bonds, Credit Suisse: I’d agree with your point about not really knowing what the fair value is for secured instruments. And I’d argue that covered bonds are either too cheap or too expensive at the moment. But I don’t know which. Taking Jose’s point, if you say that fundamentally it’s about the probability of State intervention, if the State is going to support the covered bond market through thick and thin, why don’t Pfandbriefe trade like KfW?

If they’re not, then everyone ought to be significantly wider and not materially different from the securitisation market. OK, we’re a better product than securitisation from a credit perspective but not by the number of basis points that the market currently dictates. And I think it’s just unclear which of those models is really prevailing or will prevail going forward. The whole point about the amount of funding that is in the LTRO, the fact that regulators are getting concerned about over-encumbrance and the policy implications of that, starts to me to question: are we absolutely certain that the government will always stand behind this?

Now there are two separate things. There’s government stepping behind it and underwriting a failing bank which in practice they’ve done in the case of every single covered bond issuer that’s gone wrong in whatever country it’s been in, even in the case of Washington Mutual. And stepping in as a regulator and saying: “Yes we’ll respect the Pfandbrief Law or respect the UK regulations or whatever” and make sure that it happens. But if there’s a shortfall of cash: “bad luck; that’s what you bought”. I think it’s uncertain from most cases where government would actually go and that’s the core of the uncertainty and the pricing for me.

Andreas Schenk, Head of Treasury, Deutsche Pfandbriefbank: I think the important thing is also that many issuers are looking at covered bonds at the moment. But covered bonds don’t solve everything. They’re really limited; what you can do really depends on the jurisdiction. You have structured covered bonds where you can do more or less everything because they’re not issued under law. But in Germany what can and can’t be funded under the German Pfandbrief Act is very clearly regulated.

Many weaker banks can’t fund the whole balance sheet or even a large portion of the balance sheet via covered bonds. They’re really limited to the assets which are eligible under the German Pfandbrief Act, for example. It also depends also on the business model. In Germany, we have specialised banks that are really only doing business allowed under the Pfandbrief Act, and we have others.

Covered bonds will have a specific role. We should also look at the criteria as to what is covered bond-eligible. It’s important for investors that you can’t allow everything under the covered bond and therefore banks definitely have to look for alternative funding. Or they have to concentrate on low risk business which is really eligible under the Pfandbrief Act.

Richard Kemmish, Credit Suisse: Well you’ve got three main types of asset class. You’ve got those which are eligible – mortgage and public sector loans; those which are not but are able to disintermediate the banking system (hence the boom in corporate DCM) and everything else where a new solution is required, primarily SME loans.

Jens Tolckmitt, VDP: I was referring to using the idea of covered funding beyond the classical covered bonds. Obviously if you look at Germany, but it’s also true for other countries, the classical covered bond in my view does not call for any concern with regard to the encumbrance level within a bank. It’s the universal banks where there are deposits, where regulators normally get concerned. The amount of covered bonds that can be issued against traditional eligible assets, i.e. mortgages and public sector assets is quite limited.

The question is: is covered the new unsecured funding, implying that banks will use covered funding for a lot of other asset classes? This is where regulators get concerned and where investors will get concerned and you will see a certain reaction against this scenario. I’m pretty sure of that.

Georg Grodzki, Head of Credit Research, Legal and General Investment Management: We should maybe do a reality check for a moment and look at the balance sheets of European banks to gauge the extent to which the position of senior unsecured creditors is really threatened by covered bondholders. The average encumbrance of assets by covered bonds or repo transactions amounts to something between 20% and 25% of total assets. Now that’s not necessarily the right way to look at it; you should look at the proportion of unencumbered assets to senior wholesale long-term liabilities. But it’s a good first cut.

So yes the proportion of encumbered assets as a percentage of total assets has risen, but it’s not anywhere near a level where in itself it could really pose a danger. As an increasingly rare senior unsecured bond investor, we at L&G feel far more threatened by our position relative to other creditors by the talk about bail-in and the talk about depositor preferences. The encumbrance of some assets, usually the better quality ones, is a concern as well.

But if you run scenario calculations on the increase in loss-given default, you have to factor in (due to depositors becoming factually senior to other senior debt holders or due to the risk of being bailed-in) that the increase in LGD for those reasons is far higher than the increase in LGD on average implied by the rise in asset encumbrance. Now that’s a broad statement. Of course for every bank it’s different, but at the moment I would not blame covered bond issuance for senior unsecured eurozone and European bank debt becoming harder and harder to sell. I think the talk about bail-in and the talk about depositor preference does far more damage in that respect.

IFR: On that point of Georg, is it simply a question of you will not buy bail-inable debt. Or is it a question of price?

Georg Grodzki, L&G Investment Management: Very good point. If you run a few numbers and use the most widely applied models for calculating, say CDS spreads, or calculating implied LGD and probabilities of default (PD) in CDS spreads, and if you then plug in an LGD of way more than the current standard assumptions of 40% – say you take it to 90% for senior unsecured – you arrive at a credit spread which is 280bp higher.

Now that’s an academic exercise because we wouldn’t touch senior unsecured bank debt if it were priced 280bp wider than even the current elevated levels because no bank has a viable business model if it’s senior unsecured is priced at that level. So therefore it’s not a question of price because the high spread is almost self defeating. Therefore we would just shy away from senior unsecured debt if it becomes bail-inable (a) in a way which does not respect the hierarchy of stakeholders, i.e. if we’re not convinced that regulators would treat any lower ranking classes of debt holders more harshly than senior, for example equity holders, and (b) if there’s no recovery.

But even if these conditions were to be met, I find it very hard to imagine an investment-grade fund such as the majority of ours considering senior unsecured bail-inable debt in any meaningful size. Senior unsecured ratings are already drifting down at high speed and are now clustered around Triple B; some European banks are now non-investment grade. If bail-in kicks in in a hard fashion, a lot more senior unsecured debt ratings will go to Double B. But even if they weren’t, the risk of them going to Double B is enough of a deterrent to even consider that.

So it’s not a question of price and it could well become no-go territory for investment-grade issuers, regardless of what the rating agencies conclude with respect to investment-grade status. We would not consider bail-inable senior unsecured debt as investable in all but a few exceptions.

I should add if there is a significant chunk of deposits i.e. factually super-senior creditors, that makes it even harder to get convinced. But even in the absence of that, senior unsecured bail-inable debt does not present an appealing proposition.

IFR: Michiel: do you share those views?

Michiel de Bruin, Head of Euro Government Bonds, F&C Investments: These are fairly uncertain times and one thing investors normally don’t like is uncertainty. The market doesn’t like it either, as we’ve seen over the last few weeks. So I think from that perspective, if we come back to covered bonds for a moment, if you have an option to look at covered bonds with all of their support, they’re a very good alternative.

And with regard to previous comments about the country and collateral, I also think the ECB is also showing ample support for the covered bond market. Let’s not forget about that. I think covered bonds are really key for the European economy. There are a lot of discussions about encumbrance but I think that covered bonds will remain.

Coming back to the senior unsecured question, if you look at Lehman, nothing was really paid back, so we carefully analyse our potential investments, including senior unsecured bank debt, to assess their investment possibilities. For us, it’s too early to say we won’t invest in senior unsecured bank debt. We still do, but the focus of our clients is very clearly shifting. The sector is still in deleveraging mode, so investors will likely look to go a little bit higher up the credit space and start looking more at covered bonds.

German mortgage and public-sector lending - Jan 1 to Mar 31 2012
Commitments
in €bn20112012Chg (%)Outstandings*
Mortgage loans22.11418.306-17.2629.617
Residential property loans12.22710.43-14.7334.749
Commercial property loans9.8877.876-20.3294.868
Public-sector loans8.0867.233-10.5600.372
Total30.225.539-15.41.229.989
Note * As at March 31 2012
Source: VDP