IFR Covered Bonds Roundtable 2017: Part 3

IFR: From a rating agency perspective, how do you look at this new style senior debt coming in? Is this new layer that is being built a good thing for covered bonds?

Martin Lenhard, Moody’s: That’s not exactly my area of expertise because it’s our bank rating method that’s affected. In our bank rating method we look at the liability structure of the bank balance sheet, and assess the support that is provided to the more senior tranches in that liability structure. That’s why we have different ratings depending on the type and thickness of the liability tranche. If the tranches are thick enough, we could have different ratings for preferred and non-preferred seniors.

IFR: That wouldn’t necessarily impact the covered bond rating.

Martin Lenhard, Moody’s: No, our covered bond rating uses as anchor point, what we call the counterparty risk assessment, which is above that. All these bail-in-able instruments provide support for that anchor point so it doesn’t matter what is actually providing that support, only how much of the support is available in total.

Ralf Grossmann, SG: Having a bigger layer of unsecured and hybrid debt, for example, makes the covered bond safer.

Martin Lenhard, Moody’s: Yes, that was the big change we made to our rating methodology in 2015 following the Bank Recovery and Resolution Directive. We changed the approach so we have different ratings for different types of liabilities. Before that we used the senior unsecured rating as a measure for the probability of default for the bank, which would then also affect the covered bond. The introduction of the bail-in feature meant we could no longer do it this way.

IFR: We’ve seen a lot of covered bond issuers going from hard bullets to soft bullets, but it seems it is yet to happen in Germany. Is that likely to happen?

Jens Tolckmitt, vdp: It’s definitely on the cards, we have been working on an amendment to the Pfandbriefbank that allows for that in case of insolvency of the bank.I would call it a limited soft bullet structure because our proposal would give you a limited extension of maturities. It will not happen before the elections, but I’m pretty sure it will be taken up soon after.

Discussions are still ongoing but the overall proposal has been received and understood by the German legislature. The question is how exactly you do it. We like to listen to market participants and find out what they would like, how they would like it structured, so if there were other proposals or ideas we would advise against rushing ahead without considering them. But for now, with the general elections coming up in Germany, it is unlikely that anything in that respect will be happening in Berlin until Q2 2018.

IFR: Will that soft bullet structure provide big benefits?

Bodo Winkler, Berlin Hyp: It depends on exactly how it is designed. From an investor’s point of view it might be beneficial to know maturities can be extended in a bank insolvency scenario, to prevent default in the cover pool. On the other hand we need some discussion about what happens then with the interest rate. Does it still match the original requirement when the covered bond was issued?

All the structures that are already in the market are so different, it is impossible to give one correct answer. So it is a prudent approach the vdp is taking, discussing it with market participants and the regulator and the legislature, to come up with a sensible approach. It needs to add a broader benefit than simply helping with the rating agencies.

Jens Tolckmitt, vdp: That’s a very important point. Sometimes there is an assumption that it is simply about reducing over-collaterisation in the pools, that it is purely about economic reasoning. But we at the vdp think differently: We are looking at how to make life easier for the cover pool administrator put into place once the bank becomes insolvent. For many years already we have been working under the assumption that there will be no automatic rescue of a Pfandbriefbank just because of the Pfandbriefe, neither by the government, nor by the industry. The cover pool administrator has to work out such a difficult situation alone and under time pressure so we should make that job as smooth as we possibly can.

One of the main reasons for thinking about soft bullet structures in Germany is simply that the liquidity situation for such an administrator would be much easier with the possibility of soft bullet.

Bodo Winkler, Berlin Hyp: We still talk of maturity extension, don’t we, rather than a soft bullet?

Jens Tolckmitt, vdp: Limited maturity extension, soft bullet, yes.

That is the reasoning. Is it worth adding this to make the job easier for the administrator? We think it is worth adding.

IFR: How have we seen that market evolve in terms of issuers moving from hard bullets to soft bullets?

Ralf Grossmann, SG: Almost all our deals are now soft bullet. The markets have transformed into soft bullets. There are some exceptions of course.

Ted Packmohr, Commerzbank: That is what we see in Germany, Austria and Spain.

Ralf Grossmann, SG: It’s fair to ask what exactly will happen in the case of an insolvency. The refinancing risk is obviously a big element of that. You have several possibilities of course and buying more time by extending the repayments of bonds benefits investors as well, which investors are starting to understand. But there is still a belief among many that if there was a covered bond default with a hard bullet somebody would step in.

I don’t really believe that any more. Back in 2008 Chancellor Merkel stood up with the finance minister and said no Pfandbriefe will default, but I don’t think that could happen again.

But it is an interesting debate because you look at how Italy dealt with Monte dei Paschi di Siena, maybe there are still some ways to get around it.

Jens Tolckmitt, vdp: The key point is we cannot be sure. Maybe it will happen again in certain situations for certain reasons that might go beyond the respective covered bond. The justification may not be the covered bond but the broader banking system, if other banks also have a problem. You cannot and should not count on it. That’s why we are working on solutions that will work if nobody steps in.

Martin Lenhard, Moody’s: I have heard investors say they like the hard bullet covered bond, that is what they are used to, and in my opinion it is partly due to their assumption that someone will rescue the structure if the issuer defaults shortly before a covered bond’s maturity date. But from our perspective it is obvious that a one-year soft bullet removes a lot of the operational risk that arises in the case of an insolvency or a default.

Ted Packmohr, Commerzbank: While I agree, let me play devil’s advocate. A soft bullet also adds some operational risks. We had two Norwegian issuers that missed their repayments for technical reasons, because the soft bullet maturity was stored as the relevant maturity in their internal systems. We also had a Portuguese issuer making use of the soft bullet extension for its retained deals because it was seen as a free option.

So it really depends how it works in practice. I would argue that if a soft bullet is available, the likelihood it will be used increases quite drastically. The regulator will argue that once this instrument is in place it should actually be used, rather than relying on other instruments. It is not clear cut and it’s understandable that many people still have some reservations with regards to pricing. We have to think about how to do this and get it right.

Martin Lenhard, Moody’s: I would argue that it’s also positive for other investors that are not directly exposed to the default. If you are an administrator of a programme where the issuer has defaulted and you need to raise €500m because the maturity is in a week’s time, there is going to be the risk of a fire sale. If you can extend by a year it means assets do not need to be sold at any price. That leaves more covered pool assets available to support the still outstanding covered bonds.

Ted Packmohr, Commerzbank: Don’t get me wrong, I’m not arguing against soft bullets. I fully understand that pricing advantage there and the preservation of collateral value. It adds some very valuable flexibility in handling bankruptcy situations, I completely agree. I’m just saying it also throws up some additional risks and maintenance issues which need to be handled carefully.

Martin Lenhard, Moody’s: There is another interesting issue in the pass-through market, which is not standardised at the moment. There are very different structures that are presented to the market as conditional for pass through. But when we publish our rating reports investors ask us about this inconsistency in terms of what counts as pass through. We have to explain that there are very different structures, because the market is not standardised. Even within a single country the structures can be very different.

IFR: Do you think investors understand the structures? Hard bullets are very simple, investors know what they are getting. But with all these different structures, do investors actually understand what they’re getting into?

Ted Packmohr, Commerzbank: Now we’re talking about the pass-through market, it’s looking at the other extreme. This is less standarised than the soft bullet market, which is also the option that the Germans are contemplating.

Martin Lenhard, Moody’s: What is really positive from an investor point of view in the German market is that all the programmes are very similar because the Pfandbrief Act provides a very strict framework. In other markets many of the structural features are based on contractual agreements because the law is pretty silent on the details. So the German Pfandbrief market is much easier for investors to understand than other covered bond markets where you see a variety of structures.

On the other hand issuers have greater flexibility in those other markets, whereas in Germany they have to do it as the law prescribes.

Ralf Grossmann, SG: Going back to the point about the soft bullet, it would certainly make our life easier if there was a bit more standardisation in terms of how certain clauses should be used, and the explicit wording to use in the prospectus. This should all be addressed by the EU harmonisation efforts so maybe that will improve things.

It is very early days in the conditional pass-through market. I like the Polish approach, where everything is enshrined in legislation, providing more clarity on how it should be used. I think that is quite forward looking.

Jens Tolckmitt, vdp: That is why we are also planning to enshrine our regime in the law. We are looking at how exactly we will do it but once that decision has been taken it will be legislated to provide standardisation and clarity for investors.

Martin Lenhard, Moody’s: It must also be said that while the Polish case is positive in terms of providing consistency between structures, the price you pay for that is that it limits the issuer’s options in respect of structural features. We saw a Polish issuer issuing in euros there were some problems with the swap because they wanted to swap zloty into euros to fully cover the potential exchange rate risk. This requires a swap that builds in the optionality of a conditional pass through. This optionality makes the swap more complex and expensive. In the end, the currency risk was not fully hedged and the law does not offer the optionality to move away from this structure.

IFR: Do you think that limits the market?

Ralf Grossmann, SG: This deal was hedged for 12 months after insolvency. So first of all the bank has to go into insolvency, then it has 12 months to sort it out. That gives a bit of room. Then the swap will terminate.

How this is handled in other countries where we have soft bullets? It’s actually not so different. In countries where you have soft bullet covered bonds the swap will also terminate after the 12-month extension.

IFR: I would like to go into a little more detail on harmonisation and the latest thinking on it that the European Banking Authority published last year. Are we heading in the right direction?

Jens Tolckmitt, vdp: I think we are basically heading in the right direction. As Germans we have always been positive about harmonisation because it benefits the broader perception of the covered bond product as a real quality product. We think it’s essential to have stricter European definitions to ensure the product retains its privileged regulatory treatment on a continuous basis.

We also support the three-step approach: a basic directive; a strengthening of the traditional covered bond; and elements of harmonisation with recommendations that do not necessarily need to be implemented in national jurisdictions.

There should be a clear differentiation between step-one and step-two covered bonds. So you should be very clear that the traditional covered bond is the one that is privileged, and it should be treated and maybe also named differently. Basic or step-one covered bonds should have clearly defined rules governing the assets in the pools, to make sure we do not end up with credit card receivables, for example, being used in covered bonds.

There are two criticisms we would make. The EBA paper is very detailed, and if we are working towards a minimum harmonisation, while keeping the national frameworks – and it is my understanding that this is what the EBA wants – it would be better to be less detailed. There are big differences between the frameworks and too much detail might make the rules impractical in some jurisdictions. But you also have to bear in mind that this is a recommendation from the EBA for the Commission, which will then make a legislative proposal. Maybe the Commission will not end up with the same level of detail. But the industry has to make sure authorities understand this and it is not just a German concern. My feeling is the industry generally feels we should avoid too much detail.

The final criticism is whether we really need a European proposal on how to manage each and every issue raised in the paper. Consider step three and some of the issues there, for example, the question of the composition of the cover pool. It does not seem appropriate that some European institution could in the future be dictating to the national frameworks what is the right composition of a mortgage cover pool. We don’t need European regulation for that. European regulation and European legislation are based on the principle of subsidiarity, European entities should only be telling national regulators how to do their jobs only when it is explicitly needed and a comparable regulation on a national level does not render satisfying results.

The problem with step three of this approach is that it is dealing with topics that the text acknowledges are either not feasible for harmonisation now, or should not be harmonised. Based on experience it does not seem unlikely that in three or five years there may be a drive to harmonise these things as well - and we want to avoid that automatism. We do not want a completely uniform European covered bond framework. Many investors tell us they like the differentiation between different products, they don’t want a harmonised product. We should trust investors to use the transparency provided for in the EBA’s recommendation to make up their own minds about different products.

But the basic approach, again, is positive.

IFR: Do you think there’ll be lobbying from the banks on that point and some pushback?

Ralf Grossmann, SG: I think the key point is that it should not be too prescriptive, that is the main concern. The study did a nice comparison between the different regimes and to what extent they currently comply with the best practice guidelines the EBA has put out. There was almost no red, a bit of yellow and a lot of green, so there’s not a lot that has to change.

The guidelines provide a good framework for the product that allows issuers to continue doing their business. It provides good minimum standards, which is what the market wants. Anything more than that, in which it digs deep into the details, is only going to make things very complicated.

IFR: So the EBA is interfering too much at the micro level?

Ralf Grossmann, SG: That is how the EBA recommendations come across but of course that’s not the end of the story, it’s just the beginning. The Commission has the final say and we are putting our arguments in front of them. I’m sure it will be pragmatic; this is hardly the most important topic on its agenda.

Ted Packmohr, Commerzbank: I’m not yet worrying too much about step three, we are focusing on steps one and two to see where they take us. And it makes sense to deal with this thoroughly now.

It makes a lot of sense to harmonise certain rules and lay out certain requirements in a general covered bond directive. To have certain requirements embedded as a prerequisite for any kind of preferential treatment strengthens the covered bond product as a whole.

But in terms of O/C details, should they come out with a precise number? Should this be 5% or 7%, and does it really make a difference? We can get lost in detail very quickly and the more detail you put in the greater the chance of a mistake.

For example the EBA mentioned that there should be segregation upon resolution, which was surprising because bail-in is one of the resolution measures. We were always under the impression that covered bonds were supposed to survive any kind of bail-in measure and remain available as a funding instrument for the surviving going-concern bank. If the EBA recommends that resolution, ie, that a bail-in should trigger a segregation, that would totally change the rating rules and how we currently look at covered bonds. This is such a technical detail, I doubt it has been completely thought through, or the wording may not be 100% correct. Maybe the EBA is not thinking about bail-in as a resolution measure, even though it is named as such in the BRRD. Or perhaps I have just a different understanding of resolution measures. Bottom line is, if you really dig deep you can always find some conflicts.

But the general approach is the right one.

IFR: That is quite a big conflict.

Ted Packmohr, Commerzbank: That would be a big one, so it does support the view that the more into detail the EBA goes into, the more room there is for conflict.

Ultimately it is down to the European Commission and the legislature tends to be less strict on the details, which you can see with the wording on the LCR for example.

In the end it is important to look at the details, so it makes sense not to get lost in that too early in the harmonisation stage. I fully understand the vdp’s argument about this, but I am also fond of the concept of raising the bar towards more common covered bond standards. This should help ensure the preferential regulatory treatment of covered bonds in the long run, which is a cornerstone of investor demand.

Martin Lenhard, Moody’s: If there’s a product for which the regulator defines some minimum standards, we take comfort from that. It makes it more likely that the current regulatory treatment will be maintained in the future. But with the number of details currently in the proposal there’s the potential for a lot of noise when the national frameworks need to be amended to bring them in line with the requirements.

IFR: Would it potentially have an impact on how you rate these instruments? Or is it too early to say?

Martin Lenhard, Moody’s: It’s too early to say. Our expectation is that if some national frameworks do not meet the requirements, the legislators will work on it and that there will be an interim period to allow the national frameworks to be brought in line. We expect most of the national framework to comply with European requirements at the end of the harmonisation process.

IFR: Is the favourable treatment of covered bonds within the European regulatory framework set in stone? Is there any regulatory initiative currently underway that could threaten covered bonds’ favoured position?

Jens Tolckmitt, vdp: No, it is obviously not set in stone. I don’t see a concrete initiative for change but we have been saying for years that the more preferential treatment an instrument gets, the more scrutiny it will also receive from regulators. Interested parties have different reasons for not favouring preferential treatment for covered bonds. We think the current treatment is justified but you cannot rest on your laurels and only justify it by looking at past achievements. Instead you have to justify it going forward by working on the quality features of the product.

There are different reasons why some don’t like this preferential treatment compared to, for example, securitisation. This is often discussed and it’s the industry’s job to make sure that the relevant majority understands the justification for treating covered bonds differently.

If you look at Basel, this is the first time it gives covered bonds preferential treatment. This has not been the case since Basel I. This shows there is still a positive feeling towards the product, but the industry must work to maintain that positive feeling.

IFR: Let’s get back to Green covered bonds, which were mentioned earlier. We’ve still not seen that many issues in this market. Why not? What are the hurdles, and how big can this market get?

Bodo Winkler, Berlin Hyp: In the last few years we have seen a very dynamic Green bond market. More and more issuers of more and more types are coming to the market from more and more countries. Up to 2014 banks, as issuers, played more or less no role at all in the Green bond market. Last year, in 2016, they were already the biggest issuer group ahead of SSAs, which have dominated the market since its beginning in 2007.

I’m very positive about the Green bond market. There is a huge investor demand for Green bonds and many investors have pure green mandates. When it comes to bank issuance, what we have witnessed so far is that if covered bond spreads are artificially tight, the benefit might be smaller than it has been in the still quite normal functioning senior unsecured market.

When you look at the Green senior unsecured issues of banks, you often found reduced new issue premiums compared with conventional senior unsecured bonds. The same is true for our inaugural Green senior unsecured, which outperformed our conventional bond curve in the secondary market. So there is some a benefit, in addition to the widening of the investor base.

I’m quite optimistic that we will not remain the only issuer of Green covered bonds. There have been already some social covered bonds in the market. Last year the European Covered Bond Council (ECBC) and the European Mortgage Federation kick-started an energy-efficient mortgage initiative, which aims to provide a common definition for a Green mortgage. The other thing that makes me optimistic is the potential end of CBPP3 and the possibility this will lead to a normalisation of market forces again in the covered bond market. If you then as an issuer can add an environmental value the effect would possibly be more comparable to what we see in the senior unsecured market. Maybe banks then might use Green covered bonds as much as they now do Green senior unsecured issuance.

Berlin Hyp for sure will continue to issue Green Pfandbriefe as we are growing our green lending portfolio. I hope and I’m quite sure that others will follow sooner or later.

Juergen Klebe, Deutsche Hypo: We will most likely follow but not necessarily with a Green covered bond. I’m optimistic on Green covered bonds but not in the short term because of how the market is right now. So we find it more useful to be active in the Green senior unsecured market, which is easier for us and more useful because it allows us to ramp it up later. That is easier with senior unsecured.

I think a lot of banks are working on this currently. There is a lot of work that needs to be done before you can issue in this market and that is why we have not seen too much issuance so far. It’s time-consuming.

But it is worth it as a way to find new investors. We can call the savings banks a hundred times and that is great but roadshowing and pre-roadshowing showed us that speaking to a new breed of pure green investors will be really fruitful. That will start with senior unsecured, at some point in the future, when there is a level playing field and fair pricing with traditional covered bonds, we may think about a Green covered bond.

Bodo Winkler, Berlin Hyp: Sustainability is increasingly important for a growing number of companies. For a bank this should be reflected in its lending business. In Berlin Hyp’s case, sustainability and lending for green buildings and refinancing via Green bonds is embedded in the company’s strategy.

It’s important to mention that you can only put your best assets from an environmental point of view to work for Green bond funding. So there is always a natural limit on how much you can do.

IFR: How do you keep the green stuff segregated?

Bodo Winkler, Berlin Hyp: When it comes to covered bond funding we cannot have another cover pool just for Green mortgages. It’s a process of earmarking. We have set up our own framework, including eligibility criteria, which clearly defines what we consider to be green. Mortgages that fulfill these very strict criteria can be earmarked and are subject to a special reporting that we publish on our website.

Ralf Grossmann, SG: That is not yet the case with residential mortgages but the ECBC initiative that was mentioned earlier attempts to properly define Green residential mortgages. That would open up the possibility of covered bonds backed by Green residential mortgages. As of today a lot of issuers could issue that product already but it’s more complicated getting all the data together for a residential mortgage pool. The market will take off, it’s just a question of time.

IFR: To sum up, what should we be watching out for for the rest of 2017?

Ralf Grossmann, SG: The funding discussion for banks is going to be very interesting, so discussions around MREL and preferred versus non-preferred. It’s going to be interesting to see where any senior preferred format will price relative to covered bonds.

Bodo Winkler, Berlin Hyp: This discussion has shown that this year has the potential to be a very interesting year for the capital markets. Not only in the covered bond market but in the broader bank funding toolkit.

Juergen Klebe, Deutsche Hypo: I am very relaxed because Pfandbrief is our prime product. In a world of other covered bonds it’s still prime so we have no concerns about that.

IFR: Thank you very much, everyone, for your time and all these insightful comments, they are much appreciated.