Covered Bonds Roundtable 2008: Part Four
IFR: This brings us on to the next point of the discussion: what will be the effect of government guarantees on covered bonds?
Reusch: This is an interesting point, because the idea behind these guarantees, to my knowledge, is to ensure that the senior unsecured market will get back on track. You have already identified certain assets on the balance sheet which serve as collateral. Therefore regardless of whether a bank takes part in the guarantee scheme or not any given issuance has an explicit or implicit guarantee.
I don't think that going forward we will see a regulator accepting a repetition of the Lehman Brothers case. Until then, everybody thought that no system relevant bank would go bust.
You could observe this in investors' behavior until the Lehman event because people asked why they should invest in a covered bond if a bank cannot go bust. The view was that as nothing happened to Bear Stearns, so nothing would happen to Lehman Brothers. Therefore it was more appealing to buy more of the senior unsecured and get the nicer spread pick up.
This has now proven to be wrong. Covered bonds implicitly have a guarantee already. In Ireland, the government has guaranteed debt up to September 2010, including covered bonds. In Germany, following the rescue of Hypo Real Estate, the government made it very clear that they would ensure that nothing would happen to German Pfandbrief, which has not defaulted in over 200-years.
In a number of countries there is a political willingness to force people into covered bonds. I think the US Treasury made it very clear to participating banks that covered bonds are an asset class they like, because it is on-balance sheet financing. Everything which is on the balance sheet by nature should be the better asset, as you have it under your control.
This is not a covered bond problem, it is a problem for a lot of asset classes. Looking back the last 12 to 15 months we see that selected segments of the covered bond markets resisted the massive spread widening for a very long time, even though liquidity in the secondary market was very difficult.
Three or four months ago it was no problem to sell a public sector Pfandbrief even below Euribor. Muenchener Hypothekenbank has proven that this is even possible with 42% participation from central banks.
I think investors will dedicate more credit work to this point going forward as this is the base to their future investment decisions. I think they are looking for more simplicity - transparency is key, you need to know what is in the covered pool, how this risk is managed, how the liquidity situation is managed by this issuer, et cetera, et cetera.
In my opinion these components will be much more significant drivers than in the past. Quite honestly, people have been relying more on the fact that it was Triple A and offered a nice pick up. I would question if everybody has always done detailed credit work.
Aoyama: I think it is a case of yes and no for investors. Let's say, for example, that from now on covered bonds will be divided into two types: public sector Pfandbriefe or supra, government supported Pfandbriefe. We see those as still Triple A and not much credit work is needed. However, let's say a bank issued a structured mortgage covered bond, we would see those types of covered bond as a credit product.
Also, take a Spanish bank covered bond for example. If the bank passes our criteria and I am really comfortable with the credit, I would rather go to the lower capital structure tier 1 instead of a covered bond. You take more credit risk and related spread pick-up. So there are two ways of investing.
Guire: I think any of the countries that have implied, explicit, or even spoken about a government guarantee on any covered bonds have done nothing for the spreads.
Gianfermi: One very interesting case point is Ireland. Just after the guarantee which was applied to senior and covered bonds, we had a lot of customers asking "where can you offer?" They came back within hours and said "by the way, I just bought some senior paper at 300bp over mid-swaps."
So it's the same thing. The guarantee is taking over the collateral, so a senior issue becomes the same as a covered bond. You will buy the cheaper one, because the guarantee is greater than the collateral support, so you don't need the collateral.
Guire: So it destroys the covered bond market.
Reusch: But again you are limited to a certain maturity. The maximum maturity, as far as I see from all the guarantee schemes, is up to five years. So from this perspective, for all these investors who are just seeking the best value, they are limited to maximum of five years.
Maschl: Consider that the Muenchener Hypo, at sub-Libor, came before Lehman happened. We now have a new curve environment. One thing I am wondering is how can credibility come back to any instrument in the money markets or the capital markets?
You have correctly pointed out that senior bonds now need to be guaranteed, because otherwise they couldn't be placed, or they would be placed at horrible spreads. So I pose the question: why is the guarantee for three year maturities rather than for, say, three month maturities only?
As mentioned before, we are in the situation where banks do not readily extend money market lines. This is the root of the problem. If we agree that it is necessary to establish rescue packages, then shouldn’t it be considered additionally for covered bonds?
Reusch: I see where you are coming from. I agree with the argument that you would be more inclined to go for senior than anything else, because you get a better yield for stock.
Guire: If the Irish guarantee extended to the Bank of Ireland covered 2016 issue and the Bank of Ireland as a bank, then you would take Bank of Ireland unsecured.
Maschl: Then you could bring back this maturity argument.
Aoyama: This also brings us back to the healthiness of the country. If we look, by way of example, at Ireland, the guarantee package appears to be really large compared to their GDP. Then in such cases I would prefer covered bonds, because the recovery value will ultimately be much higher. While the government has a willingness to offer guarantee, one has to assess its capability to uphold it.
Whether it is cheap or expensive depends on the fundamentals.
IFR: So are you suggesting that Ireland has over extended itself?
Gianfermi: Well, the CDS is showing that!
Guire: There are a lot of things pointing in that direction. HBOS would be a different story, because a ten year transaction would make unsecured debt look more attractive.
Aoyama: Yes. We are a small fixed income team, but we now need to think about the wealth of the country and how strong it is.
So Ireland is perhaps one case point. Iceland and its relatively large banking sector was another very good example. Personally, I believe the same can be said for Switzerland too. It is not in difficulty financially, but, relatively speaking, the banking sector is huge compared to GDP.
Poli: In Germany the €500bn bail out represents about 30% of the GDP.
Aoyama: But Germany as a country has very good trading surplus.
Poli: I agree.
Siemssen: Then you come back to the government fundamentals. You have smaller countries such as Ireland, Switzerland and Luxembourg which are now facing potential problems because they are too small to support the size of the financial centres that they have built up. That is fine from the perspective of larger countries like Germany, France or Spain, as the banking sector is relatively proportionate to their GDP. But in instances where this is not the case, the banking sector and banks balance sheets will have to shrink and the fixed income market will be one of the central means of doing this.
Guire: It is interesting that we are talking about covered bonds, a super secure product, sold as a rates product six months ago, and we are also talking about trying to wrap it with government guarantees to make it even more secure. If the due diligence was done then why has the covered bond market been destroyed?
For example, with HBOS there is distrust in the collateral pool which is why the price ballooned out. The fact that these short dated bonds are now effectively guaranteed has not led to a tightening of the spread. Trust has not come back because the UK government has said "okay, this one's safe, this bank is safe", and therefore by definition the covered pool and the covered bonds are safe. It hasn't done anything for spreads.
Gianfermi: The market is dominated by perception. That is why Barclays’ recent guaranteed issue came at a spread of swaps plus 25bp, which has caused the recent repricing of the market.
Reusch: One should not forget that the guarantee is not for free. The guarantee costs something, and these costs will ultimately be charged to those who provide the collateral – the mortgage or the public sector debt.
The additional costs incurred will ultimately be passed on to the general public asking for a mortgage. From this perspective, the guarantees are not cheap. I think in the case of Barclays, the all in funding is about 1.75%, for a three year transaction.
Maschl: To bring in another argument. I do not think that anybody doubts the quality of the collateral, or the quality of the covered pool. The only thing I am convinced of is that market participants doubt the issuing bank. They are concerned about a potential default, and whether it could take time until the covered pool in question is either sold to a third party, or the risk is sold so that from a present value basis, the bonds can be repaid. It's not the cover pool that is necessarily in doubt.
From another perspective, if I was in the treasury of the government, seeing the implications on the CDS spreads as we have seen so far, I would be assessing what could help reduce the risk in terms of percentage to GDP. Perhaps a cover pool could reduce the risk of the government that gives this guarantee? It could make sense to provide trust through the quality of the covered pool, but also giving additional trust out of the guarantee.
Guire: I think the guarantees from the UK and Europe are designed to unlock the lending market, not to remedy the covered bond market. The covered bond market has to find its place this new world. Coming back to the beginning of the discussion, I think if an issuer comes to the market with a well sounded, fair price, taking account of where the government guaranteed issuance is coming, and is prepared to leave some money on the table, we will start seeing the signs of some issuance coming back.
IFR: Are we going to see more covered bonds going to government repo?
Guire: They are blocked out. I think that’s where they all are!
Stilianopoulos: They are going to the ECB.
Reusch: For as long as there is a reduction in the investor base, there are a number of possibilities that you can argue. You can massively reduce your balance sheet, which will be difficult. You can immediately stop lending, which is something that happened with some issuers in Spain.
If these possibilities do not apply and the money markets and repo markets are still disrupted, then as it has been documented there are not that many possibilities left. You can ask the government to give you the money or you can retain your issues with the ECB.
Guire: I would like to hear what people think fair value might be for five year OePfa issuance, because I can't decide.
Aoyama: Investors are currently waiting for a bus that never comes. I think banks are still deliberating because of the potential redemptions coming from hedge funds, as well as bank balance sheet constraints and illiquid repo market conditions.
That is why the spread, or the valuation placed on assets by the market, is not fundamental – it is the result of supply imbalance. But as it is coming to the end of the year the banks, as well as hedge fund investors, need to reduce their balance sheet exposure.
Equity markets are volatile and this is an increasingly important factor towards the end of the month, when hedge funds need to clear their balance sheet and also repo transactions are approaching maturity.
Overall it remains a period of turmoil, but I expect some of the current imbalances to be addressed in the short term when the deleveraging pressure is reduced. The question then will be what is fair value?
Guire: That is my question.
IFR: When you say end of the month, do you mean the end of October or the end of every month?
Aoyama: At the end of every month, and then the end of the year is an even bigger question, of course.
IFR: So everything could get back to normal by the time next year starts?
Aoyama: Well, it may take time. Deleveraging is such a substantial driver at this moment. I am not sure how the market can absorb everything within a relatively short space of time. So it may take six months, it may take one year. But it will come.
IFR: Do you think the decision with regard to Goldman Sachs and Morgan Stanley to become bank holding companies was contributory to that to a large extent? By putting them under the same regulation as commercial banks, which is more restrictive than had been previously the case, and the impact on their prime brokerage businesses?
Aoyama: Yes, and this is the case for all of the prime brokers and investment banks. It is the case that as a deposit-taking bank they will need to think about their balance sheets again. For Goldman Sachs and Morgan Stanley it is the same story. Then the question is, who else is left?