Covered Bond Roundtable 2012: Part 2

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IFR: I wanted to pick up on Arnold’s point about the split market. The sense that I got from that was that certain banks have access to the senior market, but how much does that split have to do with jurisdiction? So if you’re a strong bank in a jurisdiction that’s having difficulties, for example Spain or Italy, what access do you have or could you have this year?

Arnold Fohler, DZ Bank: If you’re talking about an issuer from Spain or Portugal issuing covered bonds, I cannot imagine that there’s currently a realistic chance for them to tap the market given the headline risk, irrespective of whether the underlying collateral pool is OK or not. It’s simply driven by the psychology of the market, by overall sentiment. There’s only a very small number of really analytically driven investors prepared to look at it.

But the majority, which makes up the order book, will be driven by broader issues like: “we don’t invest in Spain etc these days because our CRO is telling us not invest into those countries”. That’s what we’re observing. This is what has brought me to this idea of a split market, which is open only for a few issuers/regions. It’s tougher for banks to fund in the senior unsecured market and there are limited windows of opportunity. We had a Dutch borrower that recently did a senior transaction. That deal worked but it worked particularly because it was backed by a strong domestic bid, i.e. the majority of demand came from the Netherlands and the Netherlands is on the good side of the current split market.

But even then it was tough, it was a challenge for the banks involved. It worked because the timing was OK. It might not have worked a week before or a week later.

Richard Kemmish, Credit Suisse: I think the key point you made there is “would not work with the ordinary order books that you get”. And I think what we’re seeing in the covered bond market is it’s becoming far more parochial and far more driven by domestic investors. If I am a Spanish bank needing to build up my Liquidity Coverage Ratio (LCR) buffer I’m not going to do it if I fund at ‘x’ over and I’m buying Pfandbrief 200bp tighter. I’m going to do it by buying another Spanish bank’s covered bond assets. The same probably applies to domestic pension funds, domestic insurers, all those kind of people. We’re also seeing credit investors and ABS investors, who tend to have a far less nationally defined view of relative value, switching into the merits of covered bonds. If I’ve got exposure to Bankia in senior unsecured, wouldn’t I rather have it in covered bond form, so doing those kinds of switches?

Andreas Schenk, Deutsche Pfandbriefbank: We’re always talking about windows of opportunity. I think it’s important, especially in Germany, that we have a strong private placement market. For us as issuers, that’s true for Pfandbrief and sometimes to a larger extent even for unsecured debt. I think I can speak for all Pfandbrief issuers and say that every issuer has placed more in private placements than in benchmark transactions. So if we’re talking here about windows, I think we’re only talking about benchmark transactions for unsecured and for Pfandbriefe.

Deutsche Pfandbriefbank hasn’t tapped either market with unsecured debt in the last couple of months but over the past 18 months to two years, we’ve done a lot of private placements. That’s also something we have to take into consideration. There are markets that are open even if they’re only for small amounts and you have to do a lot of tickets, but in the end, they add up.

Arnold Fohler, DZ Bank: On that point, and picking up on what Richard was saying, we saw more registered covered bond issuers tapping the German investor base (life insurers and pension funds) before the crisis and when Spain wasn’t dominating the headlines than we’re seeing right now.

I’m not sure to what extent there, for example, is a domestic Spanish market for Spanish issuers, but I get the feeling that the pan-European market is getting smaller and smaller the longer the crisis lasts. To some extent, we’ve had the LTROs, which have bought us time. But it didn’t address the systematic weaknesses. It’s becoming tougher every day for financials to fund themselves.

Jose Sarafana, Covered Bond Analyst: An important element is the regulatory aspect. As Georg said before, we’ve had a lot of downgrades in the senior unsecured market. Under CRD IV/Basle III, poorly rated paper consumes a lot of capital. So if covered bonds are a lot better rated than senior paper, it’s a lot cheaper to hold. That’s another advantage for the covered bond market.

Regarding national divisions, we have to look at how different investor bases behave. In the case of, say, a Dutch investor, a German investor, a French investor, they will have their benchmark portfolios, whereas an Italian or Spanish investor will have their sovereign debt as their benchmark so they have a different attitude towards their own markets.

A big problem of the current crisis is that most investors have to mark-to-market. They have to figure out where spreads are moving in the next three months, and if they’re concerned, they’ll just eliminate assets where they think there could be a lot of volatility. But that increases volatility in the end. There’s a completely pro-cyclical attitude at play in the market. Investor behaviour is exacerbating the crisis thanks to the regulatory imposition of mark-to-market. It forces a short term view of the market.

There’s a completely pro-cyclical attitude at play in the market. Investor behaviour is exacerbating the crisis thanks to the regulatory imposition of mark-to-market.

IFR: You mentioned CRD IV and Basel III. What does the panel think is the biggest regulatory challenge for covered bonds at the moment?

Jens Tolckmitt, VDP: I would say that broadly speaking, covered bonds have fared quite well under all these regulatory initiatives, making it – as we have discussed at length now – the funding instrument of choice and the investment of choice for both issuers and investors. So I don’t really see a major challenge for covered bonds in the current regulatory framework as it is emerging right now. I’d say that they have actually profited from it.

My concern is with regard to the future and it’s two-fold. On the one hand, we’ve discussed the issue of asset encumbrance. Currently, it seems – and there are already signs of it in the latest discussions at a European level around the Capital Requirements Regulation (CRR) or the implementation of Basle in the European legislative framework – that regulators are not only becoming aware of asset encumbrance but they are also making concentrated efforts to deal with asset encumbrance regarding covered bonds, which I think is the totally wrong approach.

It’s not covered bonds especially not classical covered bonds that are causing an unhealthy level of asset encumbrance. It’s a lot of different kinds of secured funding that combined may have a negative effect on asset encumbrance. But it’s not covered bonds alone. The regulatory discussion in my view is a little bit biased towards covered bonds. Everybody who’s concerned about asset encumbrance is thinking about how to solve the problem by restricting the level of covered bonds that can be issued by one particular issuer. I think that’s the wrong way.

That’s one thing. The second is that with all the preferential treatment that covered bonds have gained in current or in evolving regulatory initiatives, scrutiny over covered bonds will become greater. So having preferential treatment means the industry and the product will be under much more scrutiny in the future as to whether they deserve or can justify this preferential treatment.

My feeling is that we as an industry will have to work to safeguard this preferential treatment because it’s not given automatically. In fact, I think it’s less automatic than it was before the crisis. We have to prove that our product merits this kind of preferential treatment, not only today but in the future as well. And there will be regular reviews in which regulators will be checking on us.

Arnold Fohler, DZ Bank: I do share your view that so far the product has profited from what is already carved in stone. The threat I see is the uncertainty which comes from the regulatory environment. There’s not a single banker in Europe who knows clearly which business model he should utilise to run his bank for the next two or three years because there’s pressure and there’s uncertainty coming from the capital side and EBA, for instance. And there’s uncertainty coming from CRD IV implementation and so on and so forth. So the overall uncertainty is the biggest threat to the industry and then from there, it might spill over into the product. But for the product in itself, it’s so far so good, I would say.

Richard Kemmish, Credit Suisse: Everyone keeps saying that governments, through Solvency II or CRD or the purchase programme or whatever, are supporting covered bonds, I don’t think they are. I think they’re supporting the banking system and they’re using covered bonds as the medium to do that. There’s nothing within any of those things that actually makes the covered bond a stronger product, it’s just putting more and more reliance on it. And by necessity meaning that the banking system is more and more forced to put more of its balance sheet on that. It isn’t really supporting the product per se or improving its creditworthiness.

But to come to the question, I think there are two things that I’d be concerned about from a regulatory perspective. One of them is MIFID. I think that’s going to be a very significant risk to the way we trade covered bonds at a time when we could really do with support in terms of liquidity.

And the second one, I think, is a much broader public policy thing. Which is that in extreme scenarios governments are going to feel more inclined to step into the contracts regarding the underlying assets that back covered bonds. We’ve already seen that in the case of Hungary where the government stepped in and changed the FX rate on Swiss franc denominated mortgages granted in the country.

What else are we going to see to protect mortgage borrowers who are part of pools in other countries when they go into distressed scenarios? That could be a concern. It’s nothing to do with covered bonds but as a consequence of public policy, it could impact the credit quality of covered bonds.

IFR: Can you finish that thought about MIFID? What is the specific point you were making?

Richard Kemmish, Credit Suisse: There are several aspects to it. The most obvious one is simply that MIFID will essentially require us to trade on multilateral trading platforms for transparency reasons. Given that when the crisis hit that was seen not to work in covered bonds and everyone retreated to phone-based trading, there’s no practical way that I can see that MIFID can stretch and be compatible with phone-based trading. We’re going to have to find whole new ways of trading the product. That’s a very, very disruptive thing and it wasn’t seen to work last time.

The other element is quite technical, but it sets the bar for the ways and types of people who will trade it, which is that under MIFID, very few people are going to be able to act as systemic internalisers. The nature of the covered bond market is that liquidity isn’t in a handful of large investment banks that are capable of becoming systemic internalisers. It’s with end-investors; it’s with small and medium-sized investment banks and regional banks which provide a huge amount of liquidity but will not be able to qualify as systemic internalisers. It’s a very technical thing but I think that’s a concern for the liquidity we have.

Michiel de Bruin, F&C Investments: I agree. If you look at covered bond trading, it’s not necessarily the big houses any more who are always involved. You really also have to look at local players to get the best out of the market. And apart from the regulatory aspects, liquidity is also very much driven by risk on/risk off. And it has dried up a bit; at the beginning of the year there was much more liquidity. So I think we’re moving in liquidity cycles at the moment. As for the regulatory initiatives like Basle III or Solvency II, we’re expecting a lot more questions from our client base about covered bonds and we’ll possibly see more interest because of these developments.

Jose Sarafana, Covered Bond Analyst: I agree with the MIFID issue, but I think the biggest problem now is just the volatility story because of the ratings, because of the problems the banks have. That’s the first problem. The second problem is that we have a lot of covered bond issuance and covered bonds are cannibalising other products and that has something to do with the crisis. So everything is moving in the same direction.

We need the crisis to stop for at least two years so that everything can rebalance and then we can see whether everything works under normal circumstances. But unfortunately, we can’t stop the crisis in Spain or Greece just like that. So the problem is that we have to look at everything in a stressed scenario at a time when regulators are invoking these regulations for the first time. They’re trying to fine-tune everything but they’re doing so in a crisis environment. I don’t know whether that’s a good thing.

Because if you have a lot of covered bond issuance instead of senior unsecured and if people are then getting worried about encumbrance, it’s not because covered bonds aren’t a strong product; it’s because the alternatives are missing. Regulatory fine-tuning should be done under normal circumstances but unfortunately we don’t have the time because of the strict schedule: by 2018 everything should theoretically be finished.

Michiel de Bruin, F&C Investments: On encumbrance, I understand the discussion and it’s something we also follow very closely. You could see that as a cyclical issue: it’s something that is happening now to keep the financial system functioning. It’s not necessarily a bad thing. It’s something you need to keep a close eye on, but maybe the system is functioning because of all the measures that are being taken. And maybe it’s only because of the measures taken by the ECB and through covered bond issuance that some financial institutions are able to continue functioning.

It’s not necessarily the big houses any more who are always involved. You really also have to look at local players to get the best out of the market.

IFR: One thing that’s hanging over the market is discussion around whether we’re moving towards LTRO3. Can we expect another injection of central bank liquidity to take us through the crisis?

Georg Grodzki, L&G Investment Management: It’s depressing that you even have to ask that question, which is an implicit admission that LTRO2 only bought us four months and LTRO3 will probably buy us even less time. It’s very worrying that the ECB has become the lender of first resort for many European banks, that it’s becoming a regional development bank rather than a central bank, and that the business model of banks is being destroyed by regulatory over-activism and inconsistency.

As investors, we still have the option to retreat and go outside the euro and outside the eurozone both in terms of currency but also of issuer origin. And that’s what not just we are doing but many others are doing as well. There have been plenty of stories about big global funds reducing their exposure to the eurozone and we see that trend continuing.

For a short period of time LTRO3 may provide some relief but it’ll be very short-lived relief and it’s toxic relief because it will make the ECB look more and more bloated with assets of increasingly dubious quality and for its reputation as a central bank it’s going to be devastating at some point. So it could further accelerate the process of the unravelling of the euro. LTRO3 is a temptation which would be best resisted. Banks which can’t fund themselves in the market should not be funded and should be closed down.

IFR: That’s the ultimate point, but I don’t sense the political will to allow that to happen.

Georg Grodzki, L&G Investment Management: Yes, there is a lot of pride in the way of economic common sense and there’s a lot of reputation to be lost for some people who have been investing their names in preserving the illusion that eurozone governments can’t default. For two years, we were supposed to believe that they can’t. And it was a very expensive two years. And there is also this futile thinking which maintains that no eurozone bank should default.

Everywhere else in the world banks are defaulting. In Denmark, banks are defaulting and senior unsecured creditors are taking losses. As a senior unsecured creditor, I don’t object to that. It’s the market at work. Regulators should not step in the way of that kind of cleansing process, even if it costs senior unsecured creditors money.

It is incomprehensible why within the eurozone these basic economic principles should not be in force. And it’s a very costly denial which European monetary policymakers as well as politicians are upholding that would make it far more expensive, if it ever happened, to acknowledge the inevitable and allow a shake-out in a system which is overdue.

In the United States, which has plenty of problems of its own and I don’t necessarily want to advocate it as a model, but at least they got on with that job in a fairly pragmatic fashion. Their banks are now are able to fund themselves in the wholesale market at affordable spreads. Their banks are profitable and they will show European banks a clean pair of heels moving forward. It’s deplorable that it has become this way, but we should belatedly take note.

Jose Sarafana, Covered Bond Analyst: I must say I completely disagree with you. Let’s just take the example of Portugal. The country is in a crisis and because of that sovereign crisis none of the banks are capable of refinancing themselves because the capital markets are closed to them. I think it’s absolutely the wrong signal to just let all the banks in Portugal go bankrupt.

Because due to the stress scenario that we now have – which is exceptional – it would mean that even well-run banks would go bankrupt. If we were in a normal situation and one bank went under, then we could see what would happen. But the Lehman crisis in particular showed the huge impact on other banks. If Hypo Real Estate had gone bankrupt, it would have been a huge problem for many European banks but thanks to the German Government it was saved.

I don’t see how we could advocate that a leading bank in a country could go bankrupt because all the other banks would immediately be affected as well. Europe is not the US and countries aren’t states where we can say: “OK let’s allow all the Californian banks to go bankrupt and have others take over”. The US is one country with different states. In Europe we have sovereign entities and we cannot say: “OK because you’re a small country let’s close down all the banks in that country”. It doesn’t work like that.

Georg Grodzki, L&G Investment Management: Well at the moment there isn’t very much which is working. Let’s acknowledge that. We clearly haven’t solved the problems at all by supporting, to use your example, all the Portuguese banks if that’s really what we’re doing. Portugal should take its fate into its own hands and leave the eurozone.

I certainly don’t see why banks that have allowed themselves to become overly dependent on investors (who take sovereign risk into account when deploying their funds in banks that have taken a big gamble and grown well beyond the size that can be supported by domestic institutions and depositors) should not be radically retrenched to an order of magnitude that is commensurate with their natural sources of funding.

Taking the example of Portuguese banks, over 10 years they were very aggressive in expanding into regions well outside their home region. That gamble went wrong and to that extent, they’re not worth saving certainly not the management and certainly not their shareholders. They should be wiped out. If in the process, some of the senior debt holders suffer as well, that should be seen as necessary.

If we had allowed banks – and it might have been Anglo-Irish – to exit the system, we might now be much further ahead in the process of rebuilding the financial system of Europe. We haven’t progressed an inch because we’re just covering the problems up by bloating the ECB’s balance sheet more and more until a point when it becomes the laughing stock of global central banks.