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IFR: OK. So where does the panel see the crisis now? Do you think that we’re in the eye of the storm and that things are going to get better or do you think we still have the worst to come?
Jose Sarafana, Covered Bond Analyst: I think the problem that we have with Bankia is that it started with a very small amount and all of a sudden it needed €23bn to bail it out. The worry is if that can happen to Bankia, what will happen to all the other Spanish banks? We don’t know yet. If Portugal goes bankrupt, it’s likely to be manageable. But what happens if Spain or Italy go under? Can they be bailed out? Would that be a problem? I think that’s still ahead.
IFR: You do wonder how Bankia was allowed to be get into the mess it’s in. Like many other Spanish banks, it engaged in highly speculative activity. I wonder where you draw the line in bailing out banks that have been engaging in openly speculative behaviour. I’m surprised the bank actually managed to get its IPO away last year because the problems it was facing were pretty clear. And when they did come, everyone expressed shock and horror.
Georg Grodzki, L&G Investment Management: Think about the losses which would not have been inflicted on retail investors who can’t be blamed for having made the wrong decision a year ago; the losses which would have been prevented a year ago if the inevitable (and the obvious to some at least) had been acknowledged and Bankia had been subject to a proper resolution and downsizing instead of the costly detour of an IPO and another recapitalisation of an institution which lost its raison d’être because of the massive gamble it took on the domestic property market. We haven’t progressed an inch. We’re still throwing more and more fresh money at a problem instead of solving it.
And what’s standing in the way is the beliefs of some central bankers and politicians that there are certain taboos which is that banks in the eurozone under no circumstances should be touched and should not be dealt with in a way that banks in the US or Denmark are being dealt with. As far as the issue of a national financial pillar is concerned, you can preserve its ability to operate its branches and execute payments transactions. You can protect depositors and you can keep it going in the same way as you can keep a utility going while its debt and its balance sheet are being restructured.
But you avoid pouring taxpayers’ money down a bottomless pit. And you sort it out even if that means senior debt holders don’t get paid immediately. You may have to wait years. Look at WAMU where proceedings are still ongoing. But ultimately it’s healthier. It would clear the air and remove the uncertainty which quite rightly has been brought out a number of times during this discussion as weighing on the minds of investors.
The Spanish government has not covered itself in glory and been forthright and admitted there is a problem and been honest and realistic about the scale of the problem. And we now have a trail of two years, at least, of overly optimistic assessments of the problems, followed by gradual adjustments of those estimates, and we still don’t know what the truth is. And we have wasted two years, and billions of dollars and, to come back to the point, even retail investors’ money, which is the saddest aspect of this whole process.
IFR: On the issue of how banks run their business models, Andreas, I wanted to bring you into this topic because you touched on it earlier on. I’m curious about the interaction of modes of funding versus business model. In other words, is your business model today determined more by your access to funding than it perhaps was two years ago?
Andreas Schenk, Deutsche Pfandbriefbank: Definitely. The business plan, the business model, even the steering of the bank is run more from the liabilities side of the balance sheet. That’s clear. We look at what we can fund in the market, and then we decide how we invest the money and what we want to do on the assets side. That’s something which really has a clear focus in our bank.
And it’s not a once-a-year issue. We look carefully at our annual business plan at every asset-liability committee meeting, every month. We discuss the new assets on the balance sheet and what we can fund on the liabilities side.
Gap analysis between asset and liabilities is much more important now compared to the past. We really look at our balance sheet structure and we have a very clear picture in our mind as to what we want our balance sheet structure to look like. It definitely costs money but I think it’s important that we run this bank into the long term.
We also had the LTRO, which had a crowding-out effect even on very effective and competitive funding instruments like covered bonds or more specifically Pfandbriefe in the first quarter of this year.
IFR: Isn’t that a backwards way of running a bank?
Andreas Schenk, Deutsche Pfandbriefbank: Not really. The business model needs to be defined by the liabilities side of your balance sheet. On the assets side, there are so many opportunities out there which you could think about and look at. But if you cannot fund them, it’s not really reasonable or sensible to take them onto the balance sheet. And therefore, it’s clear that the business model is designed by your liabilities side.
There are different types of banks out there. We’re in a very special situation because we are a specialised bank and Pfandbriefe is our main funding source. And therefore, our business model is limited. In the past, the bank did business that was not cover-pool eligible. That’s something we are not doing at the moment. We are really relying on our main funding, Instrument, on Pfandbriefe and we are concentrating solely on business which is Pfandbriefe-eligible.
Arnold Fohler, DZ Bank: Just to stress that: Andreas is right. Maybe, there are a few exceptions but the liabilities side, access to the capital markets, is determining the business models of most banks. And it’s more the debt side than the equity side for sure. Even though everybody’s talking about EBA and capital ratios, in the short term, it’s all about the liabilities side. I wouldn’t say it’s defining banking backwards. Maybe before, the industry as a whole was driven too much by the assets side and now it’s just flipped back to the other side.
There will certainly be a time – I’m not quite sure when that will be and I do share the view that the worst is not over yet – when hopefully we will end up operating in a more balanced way between the asset and liability sides driving the business. But that’s still far away. The ECB has bought us time. I’m not sure whether the banking industry has made use of it. Some banks have taken the opportunity to raise cheap money and have bought, say, government debt at 5% and are just praying they can make a margin from it. But I do share the view that the worst is not yet over.
I don’t think our industry is adjusting fast enough. The insights are there, the intellectual capacity is there, but politicians are afraid of seeing retail clients queuing up in front of branches. That’s what they want to avoid. They can’t cope with two crises at the same time, so they’d rather try to safeguard the banks in order to, hopefully, overcome the sovereign debt crisis. And banks know that and are buying on time just as much as the politicians are. But at some point, it’s going to be payback time for financial and sovereigns. And I guess that’s what’s coming.
Richard Kemmish, Credit Suisse: Fundamentally, unlike America, we’re very bad at re-pricing the assets side of our balance sheet in Europe. The LTRO is just going to exacerbate that or has exacerbated that by sustaining the notion that you can still have 3% mortgages in Spain even when the government is borrowing at 6%. It’s that structural rigidity which, to some extent, relied on the cross-selling that you can do in the European banking system, which you just can’t do as much any more in a shrinking market. It’s more difficult to use mortgages as a loss leader.
IFR: Banks are now hooked on ECB funding because the relative costs are so dramatically in favour of it. What do you see as the next step? How are banks going to get away from the opium of ECB funding?
Richard Kemmish, Credit Suisse: Good question. I guess the right thing to do with the LTRO is to make it more expensive. I think it was Keynes who said something like: “Emergency funding should always be available against good assets at any time in infinite amounts for solvent banks at a punitive rate“. And at the moment, it’s being given away for free. If the next LTRO is a lot more expensive than the last one – it has a long way to go – but it starts to become more economically sustainable and stops people writing assets at silly levels.
Georg Grodzki, L&G Investment Management: Yes because the LTRO is not just being used – or abused – to fund banks. It’s also quite consciously subsidising their earnings. And simply speaking, that’s very bad. As Richard was saying, it prolongs the absurdity and keeps alive the optical illusion that something is working whereas in fact it broke down some time ago and it’s delaying the structural adjustment, the re-pricing of assets that should happen. And therefore, LTRO re-pricing would be a first sensible step to return to what will be normal one day again, which hopefully is different to what we have now.
IFR: I know this was intended to focus on covered bonds, but in some ways you can’t really separate covered bonds from the broader themes out there. But moving back to the topic at hand, it’s been interesting that in Germany, there have been a good few issuers tapping the market at very tight pricing but still offering investors a nice premium over Bunds. Why we haven’t seen much issuance from German issuers to this point?
Jens Tolckmitt, VDP: We had overall issuance to the end of April of €22bn but this went largely unnoticed because not much of it was in benchmark or jumbo size. So we did have issuance, but we also had the LTRO, which had a crowding-out effect even on very effective and competitive funding instruments like covered bonds or more specifically Pfandbriefe in the first quarter of this year.
Starting from the end of last year, there was no need to take liquidity from the capital markets, which had a dampening effect on volumes. We conducted two surveys on intended Pfandbriefe issuance volumes over the year – one before the LTRO and one after the LTRO – and they were basically the same, so we expected that there would be a point in time when jumbo issuance would pick up. And this now seems to be the case. I think, the market was simply opened up by one issuer and others followed it straight into the market but we would have seen this development anyway. And there is no real sign yet of LTRO3.
We’re always talking about this 10bp-15bp new-issue premium over secondary levels that we have to pay if we want to tap the benchmark market. This isn’t the case in the private placement market, so private placements have been much more efficient.
IFR: That’s interesting because beyond German issuers, the market certainly isn’t open for anybody else, with the exception maybe of some of the Nordic issuers,
Arnold Fohler, DZ Bank: Point one for me as a DCM banker is that the LTRO killed a lot of mandates that would otherwise have come to the market. There was a number of German issuers that had already awarded mandates prior to the first LTRO in December by cancelled them. And now, with the escalation of the crisis, it became a matter of supply and demand, based on the perception of quality and absence of headline risk.
There is still money out there. Whether it came from the LTRO for those banks that made use of it or whether it’s in the system as a whole, that money is looking for opportunities to invest. And for what it’s worth, the Pfandbrief has its reputation, so you saw Berlin Hypo coming at a very aggressive cost level from the investor‘s perspective [€1bn five-year at mid-swaps plus 9bp] and that is what others like Munich Hypo [€1bn 10-year at 10bp over mid-swaps] and HSH [€500m four-year at mid-swaps plus 18bp] took advantage of. It’s cheap money but simply explained by the lack of supply coming from other jurisdictions.
[LBBW also sold a €600m six-year at mid-swaps plus 7bp, while Deutsche Bank sold a €500m 10-year at mid-swaps plus 12bp.]
Andreas Schenk, Deutsche Pfandbriefbank: It’s important to recognise, as I mentioned earlier, that we’ve seen a lot of Pfandbrief private placements. We’re always talking about this 10bp-15bp new-issue premium over secondary levels that we have to pay if we want to tap the benchmark market. This isn’t the case in the private placement market, so private placements have been much more efficient.
If you compare pricing in the benchmark market and private placement market, benchmarks are much more expensive for us. But because investors need price guidance on the curve, they want to see public issuance so we intend to tap both markets. Even if the market isn’t there for a benchmark, it doesn’t mean it’s not there for private placements.
What we’re seeing at the moment is that issuers don’t have to pay a new-issue premium in the benchmark market. We just did a €500m transaction [seven-year at mid-swaps plus 60bp] and it was the first time that a substantial new-issue premium wasn’t there. I think it’s also a question of supply and demand. And at the moment, we’re seeing a lot of demand for Pfandbriefe.
Arnold Fohler, DZ Bank: Just to add to that, the private placement market was always there, but earlier this year they were geared towards the longer maturities where the LTRO wasn’t helping. So there was a shift to that end of the maturity spectrum.
Jens Tolckmitt, VDP: The mechanism that Andreas described came into play immediately after Lehman. At that time, we had a prominent German newspaper declaring the death of the Pfandbriefe market because there hadn’t been any jumbo issuance for four months but issuers had funded themselves on a large scale through private placements. I think what we saw in the fourth quarter of last year through to the first quarter of this year was a similar situation of market stress like we had after Lehman. And there was a similar reaction to that, where smaller issues targeted at the strong German investor base worked well.
Benchmark issues or jumbo issues have always been more expensive than private placements. This doesn’t mean the market has not been working, but merely that it has worked in a different way and has reacted flexibly to the challenges out there.
Richard Kemmish, Credit Suisse: But even taking into account private placements, surely Pfandbriefe volumes are significantly down. Isn’t that a function of a much broader issue of the amount of liquidity in the banking system and the deleveraging of the German banks?
Jose Sarafana, Covered Bond Analyst: That’s one of the main reasons why Pfandbriefe are trading so tight: more bonds are maturing than being issued.
Jens Tolckmitt, VDP: That’s true and it’s been the case a number of years now. If you look at this year, estimated volumes are down from last year’s estimates and are more at the level of actual issuance last year. This is a sign of several things, including the liquidity provided by the LTRO, which was known about when we did our first survey. But the market doesn’t only work for benchmarks; it also works for private placements and it works quite well.
IFR: Back to this issue of split markers, France is an interesting jurisdiction at the moment and one that some people are almost putting into peripheral Europe. I’m curious to know what the panel thinks about the prospects for issuance of French banks this year.
Arnold Fohler, DZ Bank: France is suffering from the CIF Euromortgage/3CIF issue, and that goes back to the psychological element at play in the market. Certainly within DZ Bank, I have not spoken to anybody who is concerned about the quality of French covered bonds; it’s simply the way this problem has been handled, and the lack of information which created an element of uncertainty.
It will take a while before French issuers are able to tap the market but I’m sure they will emerge again. But the CIF incident has definitely driven spreads much higher than would otherwise be justified. I would not put France into peripheral Europe at all, but it has suffered reputationally.
Richard Kemmish, Credit Suisse: I think, a month from now, we won’t be talking about CIF at all. It’s a relatively short-term thing; I think, there’s absolutely no problem with the underlying assets and the credit quality. For me, the only problem in France is a technical one: the level of French government debt. Given the reliance of French issuers on French domestic investors, why would they buy covered bonds when they can buy OATs at wider spreads or a lower differential? As long as OAT levels are inflated, that’s going to hold back the spread performance of French covered bonds.
IFR: Isn’t that what we saw in other countries as well, like Spain and Italy?
Richard Kemmish, Credit Suisse: To some extent, but it’s more of an issue in France because there’s so much more of a stronger investor base there. It always has been very heavy reliance on that.
Jose Sarafana, Covered Bond Analyst: One extremely important thing with the CIF case was the perspective of government intervention. We all agree that communication wasn’t optimal, but from the ratings perspective, the agencies assumed there would be government intervention. Without that, I think, France would have been in a much worse situation.
Michiel de Bruin, F&C Investments: We still regard France as a core country. But we’ve seen more volatility in the government bond market there. We also watch covered bond volatility and we look at the relative level of the two and on the basis of that can decide whether it’s interesting enough for us to either go into covered bonds or government bonds. Interestingly enough, in February SocGen generated a book of €7bn [for its €1,5bn OFH] so you can see so how quickly investor sentiment can change.
Jose Sarafana, Covered Bond Analyst: The problem is that the investor perspective is mostly short run due to mark-to-market. They’re evaluated every quarter so the most important thing is what happens in the next three months. So either we are very optimistic or we’re suddenly getting more pessimistic and perhaps in three months time, investors will be jumping on the train and getting all optimistic again. We saw this very much with Ireland last year. So it is the pro-cyclical attitude of investors that’s behind a lot of the actual crisis.
Michiel de Bruin, F&C Investments: Not just investors.
These are all new developments, things that as an industry, we’re going to have to get our heads around and come out of our little parochial shell that we’ve been in for the last 200 years.
IFR: What do you think has been the most interesting development in covered bonds in the past year? Is it the emergence of Australians; the Canadians getting rid of their guaranteed mortgages; or maybe it’s closer to Europe? What’s the panel’s view?
Michiel de Bruin, F&C Investments: What I think is pretty interesting is that on several occasions now you’ve seen, in stressed scenarios, covered bonds trading through the sovereigns. That’s relatively new and is an indication that the recourse to assets does mean something.
Jose Sarafana, Covered Bond Analyst: That we’re able to impose a haircut on the Greek sovereign but not on the Greek covered bond.
Michiel de Bruin, F&C Investments: I think it also shows that the ECB is supporting the banks first and foremost, and not the sovereigns, which of course is not within its mandate.
Jose Sarafana, Covered Bond Analyst: Looking forward, if we see a US covered bond law, that would be a Big Bang. Looking back to the last year, I think, that most of the things that have impacted covered bonds are not, at the end of the day, covered bond topics. They’re either the banking industry as a whole, or the state of sovereign finances, things that haven’t so much questioned or tested the covered bond structure of a particular country in itself. It’s always external forces that have impacted the covered bond market.
Georg Grodzki, L&G Investment Management: The continued polarisation in the market between issuers of various jurisdictions, the slow response of the rating agencies which have taken more issuers down to junk at the covered bond rating level, and the observation that ABS seem to be less sensitive to sovereign stress contagion than covered bonds, which doesn’t make a good advertisement for covered bonds in countries whose sovereign ratings are under pressure.
But it’s still a fact that the linkage between covered bond and senior unsecured bank ratings and the linkage between senior unsecured bank and sovereign ratings means that covered bonds can be affected more than RMBS, for example, by sovereign stress, at least in rating terms and probably also stress terms.
So we have seen a lot more creeping interventions in the market. To some extent, as was pointed out, the LTRO clearly was some kind of headwind for the covered bond market because of the cheap funding opportunities it offered, but by and large, the tailwinds are still in force and maybe they’re too strong already.
Arnold Fohler, DZ Bank: The dependence of the financial industry on the covered bond is a concern and definitely something I had not foreseen. And that’s dependence in a negative sense. In a positive sense, the covered bond in itself is still a product which is being used in other jurisdictions, like Australia and New Zealand. And there are consultations in Singapore and the US.
Regarding the US, my concern is that if the US adopts a wide interpretation of cover pools – including, for example, SMEs and credit card receivables – that might be a threat to the covered bond as a brand. The sheer size of the US market, if and when it comes, could kill what has been established over many, many years in Europe. Elsewhere, there’s still momentum for covered bonds but there’s also too much dependence on them.
Andreas Schenk, Deutsche Pfandbriefbank: Assets have become more important. That’s something I’ve learned during the last year. You can always optimise your funding instruments if there are more possibilities for Pfandbriefe, but I think in the end, the value of the product lies in the fact that you don’t have much flexibility so there is a clear focus on an instrument that is regulated by law and not everything can be included in them; only high-quality assets that are clearly defined. That is really important and is becoming more and more important.
Jens Tolckmitt, VDP: I think most things have been said but I would put it a more positive spin on what Arnold said before. Covered bonds – and I’m talking now about classical covered bonds – have moved over the past two or three years from being a very specific funding instrument for some very specific things towards being a strategic addition to the funding mix of basically every bank that is able to use them.
But to a certain extent at least, I would also be concerned about the idea of extending the use of covered bonds beyond this classical base. What’s been happening over the last year and will develop further in the future is exactly what Andreas was saying, that the understanding among issuers, jurisdictions and on a supranational level is that quality has been key to the relative good performance of this product during the crisis. That’s taking hold more and more.
For example, it can be seen in the move towards more transparency; it’s shown in the attempt to define what a classical covered bond is, and to ring-fence this high-quality asset class. And it’s also shown in individual issuers’ behaviour with regard to their own cover pools. Everybody is aware that it was quality that was holding up this product.
I really do hope that this move is going to safeguard the product which is in a certain sense protecting the product ideal. The product ideal is in danger of being extended too much, simply because people think that they can duplicate in other areas what has been done with this high-quality product. And I don’t think it will work that way.
Richard Kemmish, Credit Suisse: I guess one of the biggest and most interesting developments which is going to have implications is the number of new investors and the new types of investor we’re getting in this market, whether they be Brits who see the explosion of the sterling covered bond market, whether they be credit investors, refugees from the bail-in debate or even hedge funds participating more and more. They’ve got the joys of this product and they’re very welcome, but they’re coming with a whole different view of some of the fundamentals such as relative value and what drives relative value.
We have very set ways in the covered bond market. We have a very well-established construct of relative value determining which bond prices where. The new entrants are coming with a very different approach. What Jens alluded to: the label initiative and the transparency and the importance of that are certainly going to influence and push that.
Another theme is that more covered bonds are being downgraded and are no longer Triple A. But the traditional market doesn’t really know how to cope with that in price moves. That’s being challenged by more investors and they’re challenging the way we trade and think about liquidity of covered bonds, for example, asking, for example, for CDS on covered bonds. These are all new developments, things that as an industry, we’re going to have to get our heads around and come out of our little parochial shell that we’ve been in for the last 200 years.
IFR: Gentlemen: thank you for your insightful comments and a very lively debate.