Landesbank Berlin’s announcement that it will reject the Pfandbrief framework in favour of its own structure rocked the domestic market. Opinion is divided: its advocates commend the German Pfandbriefe for being the purist of covered bond structures, while others maintain that smaller savings banks struggle to gain access to funding. Rachelle Horn investigates where the trade-off between high standards and inaccessibility lies.
Over the years, the music has increasingly been playing outside of Germany where covered bonds are concerned, as new jurisdictions and sophisticated structures have served to dominate the headlines.
With origins dating as far back as the 1700s, the Pfandbrief has long been marketed by its domestic professionals as the back-bone of the covered bond universe. However, it has been well documented that Germany's presence on the international covered bond stage has been slowly eroding over recent years.
According to data from Thomson Financial, total Pfandbrief volume has remained relatively steady over the past five years. In 2006, the amount of Pfandbriefe issued totalled US$86.37bn, up 28% from the amount issued in 2002, but down 4.7% from 2005 (see graph).
In contrast, volumes in the remaining covered bond markets have soared. With Spain leading the charge, a total of US$312.79bn was issued in 2006, which represents an astonishing increase of 174% the amount issued in 2002.
So, when news emerged that Landesbank Berlin was set to pioneer the first German structured covered bond outside the Pfandbrief law, far from embracing the new development, the reaction in the domestic market was not all positive.
In a move that analysts suggest could have enormous potential to open up an unexplored asset base, the programme will provide investors with exposure to a new Triple A rated German product with savings bank risk. The basic premise behind LBB's structured covered bond programme is that it will provide bonds backed by residential mortgage pools originated by German savings banks, which have otherwise found it difficult to access funding through the new Pfandbrief law.
To introduce the structure and assess investor appetite for the product, LBB’s first transaction under the so-called Daheim No 1 programme is expected to be a three-year bullet secured by LBB's own cover pool.
With Pfandbriefe now trading at their tightest levels, some investors are decidedly upbeat about the prospect of a new structured segment and the potential spread pick-up over Pfandbriefe. However, the proposed structure has caused something of a political stir in the domestic market, with some questioning why the institution would deviate from the sacred Pfandbrief format, in spite of the apparent difficulties faced by the smaller savings banks.
The Association of German Pfandbriefe Banks (vdp) has openly spoken out against the need for a structured covered bond. Louis Hagen, executive director of the vdp and chairman of the European Covered Bond Council, explained, "We are working towards a homogenous and deep market that other countries are still only starting to build. While splitting up the German covered bond market may add to diversification, we feel that the added heterogeneity will take away potential liquidity."
Unsurprisingly, the majority on the sellside seems positive about the prospect. "This is a very natural development in Germany due to the fact that the savings banks have more mortgages on their balance sheets than they might be able to use through the opportunities presented by the Pfandbrief law," said one syndicate banker.
Despite the potential benefit of a new asset class, the fragmentation of the market will invariably mean more credit work for investors, and as the world of covered bonds becomes increasingly opaque, one debate that has continued to run in Europe is the call for a clear definition.
Indeed, the call for clarity has also been echoed by the investor community. "The borders are expanding and I think there is a danger of undermining the covered bond brand name," said Torsten Strohrmann, fixed-income fund manager at DWS.
Analysts are now deliberating exactly where the trade off between maintaining a high standard of Pfandbriefe and improving the accessibility to the framework now lies. “In my view, the Pfandbrief law should be less strict and more yielding,” said one.
Indeed, so political is the situation, a number of sources have told said that some German underwriting houses are not even bidding for the mandate for fear of upsetting the staunchest of Pfandbrief supporters.
Plight of the savings banks
According to the Bundesverband Deutscher Banken (the association of German Banks), there are 2,400 banks in Germany, including 400 banks with a balance sheet of less than €100m.
Following the removal of the Landesbanks’ state guarantees, the new Pfandbrief Act of 2005 and the subsequent development of the financing register enabled savings banks to pledge mortgage assets to Landesbanks. This move was expected to bring about a gradual resurgence of the Landesbanks and, while the well pre-funded sector could afford to bide its time, even the vdp’s Hagen admits that the Landesbanks have been less active than previously expected. The problem that is reportedly being faced by the savings banks is that their lending books are often too small to warrant the cost of financing through the new legislation.
"The work and the cost involved in attaining the privilege to issue Pfandbriefe can often be too high for the smaller savings banks," explained Christian Scheibe, director in the treasury department at Landesbank Berlin. "We therefore decided to look for a more efficient way for savings banks to achieve attractive funding levels in the market, utilising the mortgage loans on their balance sheets. At the end of the day, the savings banks and investors must meet somewhere."
While its advocates maintain that the legislation should be strict to ensure a pure structure, one covered bond analyst was of the opinion that "this development shows the UK's HM Treasury may have got it right in setting broad guidelines rather than strict rules in its upcoming legal framework for UK covered bonds."
Hagen, however, vehemently dismisses the claim that the savings banks have been denied access to funding through the Pfandbrief framework. "The funding register was introduced to create the legal framework for the use of assets on the balance sheet of savings banks," he explained. "Some Landesbanks are working on using the register in order to fund savings banks assets."
While Hagen explained that some 20 savings banks have already issued Pfandbriefe for themselves, DWS’s Strohrmann said that he was waiting to see more savings banks issue via the Pfandbrief register.
Should the LBB issue be a success, it is highly probable that other Landesbanks will take a structured route. And, it would appear that LBB is not the only bank looking at ways to make funding easier for the small savings banks. Landesbank Baden Wuerttemburg (LBBW), for example, is purportedly working on a trust model that aims to use a funding register as a platform for Pfandbrief issues.
However, one thing is for certain, the market is now looking for a trade-off. With the Spanish multi-seller Cedulas model now looking appealing, analysts say that there are already tentative plans underway to aggregate the individual Pfandbrief issues from the savings banks.
Sources suggest that the vdp has hinted at a relaxation of some elements of the Pfandbrief law, and with the legislation facing criticism for being unworkable by some of the smaller savings banks, one covered bond analyst explained “I think they need to realise that less is more.”
According to LBB’s Scheibe, five savings banks have so far signed up to the programme, though the goal will be to encourage more into the scheme. Away from the technical aspect of pooling the collateral, one covered bond analyst said that the problems in attracting the savings banks may be more political.
"The pooling model would be easy if the savings banks were willing to sell their assets. However the CEOs of the savings banks are often paid according to the size of their balance sheets, and, in my view, they may not be so keen to relinquish this," he said.
The unquestioned acceptance of the Pfandbrief had not previously facilitated an alternative structure, and no matter how much some of the domestic institutions may bemoan the move away from the traditional Pfandbrief, the covered bond universe is an increasingly diverse place.
A wave of structured covered bonds has passed across Europe over recent years. Most notably, BNP Paribas recently took the decision to ignore the legal framework in France in favour of its own structure.
It is impossible to predict how much this sector will total in years to come, but it seems that, where France has led the way, Germany will reluctantly follow.