Down, but not out
The German Pfandbrief market is facing tough competition from a relatively new kid on the block: state guaranteed bank bonds. This, coupled with continued aversion to bank risk in general, has prompted a serious decline in jumbo covered bond issuance. But, dig a little deeper and figures show that this asset class is actually still providing a stable source of refinancing for German banks. Rachelle Horn reports.
With a total outstanding volume of some €800bn, roughly one fifth of the entire German bond market, the importance of Pfandbriefe, Germany’s highly prized covered bond market, cannot be underestimated. But few asset classes have come out unscathed from the crisis, and despite being widely regarded as the strongest of all covered bonds, Pfandbriefe have been no exception.
In the first quarter of this year, only €3.25bn of jumbo Pfandbriefe (excluding taps) were publically issued in the market – a staggering 62% less than the same period of 2008. Post-Lehman brothers risk aversion to most bank related debt, and the dramatic rescue of Hypo Real Estate - Germany's second largest issuer of Pfandbriefe - accounts for some of this decline, but it is stiff competition from the newly created government guaranteed bank bonds that has stuck the final nail in the coffin.
While jumbo Pfandbrief volumes have been on the decline, issuance of government guaranteed bank debt (currently permitted for maturities of up to three years) during the first three months of 2009 amounted to a sizable €21bn in Germany. As such, it is seriously competing for investors' attention.
Worse still, of the three jumbo German covered bonds that have actually been placed since the collapse of Lehman Brothers, all were in a five-year maturity. Demand used to be concentrated in the short-end of the Pfandbrief curve, but since the onset of the GGB market this part of the curve has suffered an erosion of demand.
Despite the impact on the Pfandbrief asset class, in mid-February Germany's federal cabinet agreed on a new local law that would extend the Financial Market Stabilisation Act. As part of the move it granted an extension of the maximum maturity for government guaranteed bank bonds to up to five years, putting further pressure on the beleaguered jumbo Pfandbrief.
The law is now pending approval of the lower house of the German parliament, and if it goes through, it could finish off what little remaining demand is left between a three and five year maturity. It poses a significant threat to the German model of mortgage financing, which is already on its knees after continued secondary spread widening.
The Government’s ‘motives are as clear as they are credible: to align the framework conditions in Germany with those in effect across Europe and prevent distortions of competition. The draft law extends the maximum guarantee term from currently 36 months to 60 months, thus following the EU commission's policy regarding state aid, which permits a term of between three and five years for one third of guarantees.
Yet the move flies in the face of a very clear warning from the Association of German Pfandbriefbanks (vdp) that it will further increase competition. "The issuers accept the inevitable distortions that government-guaranteed unsecured bank bonds create in the capital market," said Henning Rasche, vdp president. "But a widening of the scope of such guarantees would result in an unfair disadvantage for Pfandbrief sales."
Covered bond analysts at BayernLB have supported this argument since, under the new provision, "not only ailing banks but also ‘healthy banks’, for whom Pfandbriefe are actually an important funding tool, would shift over to the new asset class."
On the other hand, Pfandbriefe could benefit from higher returns compared to state-guaranteed bonds, and a steep yield curve will encourage investors to move out of safe havens and into more risky investments like spread products. "We can also expect to see a shift to medium and longer maturities in the medium term," the analysts said. Banks cannot survive forever on short dated funding and Pfandbriefe may well provide the opportunity for banks to lengthen their duration.
Private placements prevail
The German Pfandbrief banks have four Pfandbrief types at their disposal: mortgage Pfandbrief, used for the funding of property loans and secured by real estate; public Pfandbriefe, covered by lending's to the federal government and to regional municipal authorities; ship Pfandbriefe; and the newly introduced aircraft Pfandbrief.
And while the headlines have focused on the dramatic decline of the jumbo market, this is actually just one piece of a very large funding puzzle. Of the different Pfandbrief types, the market is made up of registered Pfandbriefe (issued in private placement format), traditional bearer Pfandbriefe and Jumbo bearer Pfandbriefe. Each segment accounts for about one third of outstanding volumes.
Registered and bearer Pfandbriefe differ in regard to their transferability. The bearer Pfandbrief may be transferred at any time by way of a simple purchase transaction. Registered Pfandbrief has to be assigned to the new buyer and the issuer notified accordingly. For this reason, registered Pfandbriefe are bought primarily by long term-oriented institutional investors such as insurance companies and pension funds, which keep the Pfandbriefe in their portfolio until maturity.
In the case of the bearer Pfandbriefe, on the other hand, the big-volume Jumbo Pfandbriefe in particular (minimum issuing volume €1bn) was created to provide a more liquid instrument.
According to Christoph Anhamm, head of covered bond development at RBS, the indication of the total volume of Pfandbrief issuance seen in January 2009 was actually €7.3bn, (a fourth drop in a row from €13.8bn in September 2008), which compares to a level of around €12.6bn in January 2008. Though clearly down, what these figures do suggest there is activity away from the so-called benchmark. This asset class is obviously still providing a valuable source of financing for Germany's banks.
"What we hear from some of the typical covered bond investors, such as the insurance companies, is that there is a shift in focus from the jumbo market into the registered Pfandbrief market," said Anhamm. "If they do not get liquidity from the jumbo covered bond market then they will look to take advantage of some of the benefits of the registered market, such as not having to mark to market."
Despite the declining volumes, the vdp has a positive stance on issuance in February and March data, to be released by Bundesbank with a time lag of 8 weeks.
According to the vdp's reading, the negative trend should be halted in February and issuance in Q1 2009 should stabilise at monthly levels between €8bn and €10bn. The vdp believes first quarter Pfandbrief issuance will be around €30bn, largely on the back of stabilising sales of traditional Pfandbriefe and some activity in Jumbo Pfandbrief in February and March following a six month hiatus.
“Demand for German Pfandbriefe is currently developing satisfactorily, despite the wave of government-guaranteed bank bond issues," said Rasche. "Our member institutions expect the positive trend of recent weeks to endure during the course of the year – provided the banking industry is stabilised further and investor confidence continues to strengthen.”
The private placement market also offers a cost advantage of around 20bp to 30bp compared to funding through jumbo Pfandbriefe, which pre-crisis would have been a differential of nearer 3bp to 5bp.
Pfandbriefe’s funding potential was illustrated in March when Deutsche Bank announced it will utilise the asset class for the first time. As a flagship lender with a strong Double A rating, Deutsche Bank's planned entry into this market is a significant endorsement for the flagging product.
Though some banks in Germany are using both Pfandbriefe and government guaranteed bonds for financing, Deutsche Bank has vowed not to turn to Berlin for help. A spokesman at the institution told IFR that in the current market situation it sees Pfandbriefe as a cost-effective extension of its financing base. "We are looking for a licence to issue Pfandbriefe and are in contact with the German regulator, BaFin," said the spokesman. The bank has not established a programme before because the cost-advantage of Pfandbriefe was less significant for a bank such as Deutsche in previous years, he added: this has now changed.
Though the jumbo segment is still struggling, the private placement market is still very active and the establishment of a new Pfandbrief programme will certainly add another string to Deutsche's bow. But while private placements are providing a stable source of financing for the banks, volumes are often less predictable in this segment, which also lacks some of the advantages that come with issuing in jumbo format, such as the opportunity to access international investors.