Pfandbriefe Roundtable 2008: Part Three
IFR: Laurent, can MTS assist in what Louis has said on transparency?
Viteau: We can always argue about whether or not there should be market making, but it is the way the secondary market has traded that probably must change slightly.
Five years ago, one of the prerequisites for a liquid bond was to have it trading somewhere where everybody could see it. There was a commitment to put positions on the balance sheet all day long, which is what the investment banks were doing. That applies to all the European governments, agencies and Pfandbriefe of a certain size.
In the last year to 18 months we have come to realise that’s possibly not the best way to ensure sustainable secondary markets. In other words, why should dealers be obliged to put positions on balance sheets and to quote prices all day long, whether it is Pfandbriefe or covered bonds? Maybe it should not be an obligation. Maybe it should not be conducted on the basis of being axed, but instead institutions should be more or less allowed to trade when they want to trade and provide liquidity or take liquidity when they want.
You could even go a bit further: why should it be the dealers only who are committed to provide liquidity in the secondary market? In the equity market, for instance, it is not the dealers who provide liquidity, it is a much wider universe. The liquidity providers and liquidity takers are completely diverse.
Maybe the bond market should go this way as well. It's not going to happen tomorrow and there's probably some more structural change needed, such as the establishment of a central counterparty or some other means of removing counterparty risk. There are investors in the jumbo markets saying they want to have the same access as the investment banks, because they want to provide liquidity. I have heard several investors make comments like that.
Maybe that is the way the market should go. Maybe the secondary market commitment should be slightly different. You should expect the dealer group to be there on request, but also open the market a bit more so that more participants can provide their own liquidity or take it when it is needed.
Pimper: Are we discussing this now because of the crisis or is there a feeling the system needs to be changed anyway? There is no liquidity out there due to the crisis. From my point of view there's no solution that is going to work well in this environment. Maybe a swap market or a government market might work, but swaps used to be such plain vanilla products, whereas right now it is very complex – or has become so in recent months.
Huber: There are three points which make it necessary to establish functioning market making again. First, trading books can refinance themselves at a level where they don't get penalised by having positions, which is still not the case. If you buy something you have to get rid of it as soon as possible, because you have an immense cost of carry.
The second thing is that the hedging instruments are coming back to being normal – certainly swap markets.
Thirdly there is a question of how much credit hedging is needed in a portfolio for covered bonds? This is a whole universe: we will see in the future if it is needed for German covered bonds. When you provide that kind of liquidity, how sure can you be when you hold a position that there won't be something new coming out with much wider spreads which jeopardises your position?
These are the kinds of questions we need to answer before market makers become comfortable enough to really provide liquidity again into the secondary market.
Engelhard: It's good to think about how the world could look, and how these types of schemes which enhance secondary market liquidity could work in the future. At the same time, in the current environment when there is no transparency in Libor and Euribor fixings and where the quotes are compared to where banks could get money, I don't see transparency in pricing and liquidity coming back to jumbo markets.
Viteau: I agree. I think an isolated attempt to establish secondary market making will be unsuccessful unless the overall situation improves.
Hagen: But we are talking about the future. I agree that at the moment there is not much to be done but we were talking about what's needed in the future before investors will buy a jumbo, and what needs to be done to restore investor confidence. Why should the jumbo issue make sense for an investor if there's no liquidity?
Dahmer: But you don't know when or what kind of normalisation there will be in the future. We are hearing things like if you design a product you might be required to hold a percentage on your own books. If that really comes across from the US as a requirement for issuers, that you have to hold 5% of your own product on your own books, or if the arranger of a deal is required to hold a percentage on its books, that may have a big influence on my willingness to provide additional liquidity.
I agree we have to look into the future but we don't know what the normalisation of the market will look like. Whatever we think of, it may be totally different, because the underlying general environment can be totally different.
Volk: I agree with Steffen. We do not yet know how this deleveraging play out. We see if we look at Bundesbank data: a lot of banking groups and their asset structures, and while a few banking groups have not changed a lot, other banking groups in Germany have. Their claims against other banks and the securities on the balance sheet have changed in the last 15 or 20 years, so their asset structures have changed a lot.
It is very difficult to forecast how this will end up, where the deleveraging process will stop and whether new banking and funding regimes will emerge. It is crucial to give some indication of how many banks will be willing to commit their balance sheets again. This is a precondition for liquidity in a potential jumbo market.
Huber: I agree that we have to see to what extent banks will want to return to that market, and how willing they will be to invest.
I was very surprised to see the distribution summaries of the state guaranteed paper. Close to 50% of the investors were bank investors. It gave me hope that high quality products like a Pfandbriefe will still be bought in the future by such investors.
Hagen: I'm not asking for any senseless activity, I'm just saying that it's better to think of how we can get this market back to life, instead of just sitting here and watching like a rabbit caught in the headlights? It's better to try to be prepared than wait until things get better and then come back with the old solutions that we used to use. We wont go back to the normality that existed before the crisis any time soon. If we go back to it it will take a couple of years at least. We have to adjust to that.
IFR: Will we see a change in the investor base? Joerg mentioned that he hopes bank investors will remain comfortable with the product. If we get more illiquidity and higher spread levels, will we see a change in the investors that will buy Pfandbriefe?
Dahmer: For the general covered bond market, I would say yes. For the Pfandbriefe market in particular, I hope the majority of investors will remain rates investors. I can imagine there will be some former ABS and senior investors who will be looking for additional protection. For the Pfandbriefe market I'm quite hopeful that we will remain within the rates world. In other words, Pfandbriefe investors will likely remain largely unchanged.
Huber: That's also my view. There was an article recently that argued insurance companies have too much bank paper in their portfolios. That may be true but I don't think they can get rid of the Pfandbriefe as an investment product. They need the yield pick up, they just can't go into government bonds. They cannot just go into the really high yield products either, so there will certainly be a stable investor base in the future.
When it comes to bank investors, they will also use Pfandbriefe in the future. To the same extent like they used to? I'm not sure. But they will certainly comprise some part of the investor base.
IFR: Olaf have you changed your opinion on the product? How much weight do you put into Pfandbriefe?
Pimper: My personal view of the Pfandbrief market didn't change a lot during the crisis. When the whole crisis started I was thinking it was a good time for Pfandbriefe to prove whether it is a rates product or a credit product. Now, after almost one and a quarter years, it has proven that it is very close to rates.
When we talk about Pfandbriefe, and the jumbo market in particular, the product was very successful in terms of being taken abroad to other jurisdictions. Those jurisdictions brought their own investor bases into this market. So the traditional German jumbo investor base included investors in all these other covered bond jurisdictions.
By the middle of 2007 there was just too much supply, which those investors were unable to absorb. So now there is a particular need for new investors from other countries for the whole jumbo market.
Volk: I don’t think the whole jumbo covered bond market can operate in the same way in the future. Domestic investor bases are becoming more important and they have different needs. I struggle to see the jumbo covered bond market coming back as it was, as a homogenous product. Investors are becoming much more aware of the differences.
I assume that all these nice jumbo statistics that we continuously prepare may lose importance going forward.
Bertram: So you are talking about recovery of the fittest?
Volk: Yes. It will evolve into more of a domestic product market, as long as there is a divergence between European state government bonds.
Dahmer: There are a number of investors who ask about various parameters like the spread, the tenor and the collateral pool, and if that all sounds good they ask if there is a home market. The answer to Pfandbriefe is always yes, there is. So these international investors tend to buy more Pfandbriefe than UK covereds, for example.
Engelhard: I can’t imagine a Pfandbrief issuer would shut the door if a credit investor came knocking at the door, saying ‘I want to buy some Pfandbriefe.’
Bertram: We would be pleased to talk and sell!
Engelhard: Even in the government bond market, in the current environment pricing is subject to bargaining between investors and dealers, for all participants in the marketplace. It's still hard to see a clear difference between rates and credit products anyway. So I think that needs to be put into perspective.
The strong home investor base is still important as one of the major strengths of the Pfandbriefe market. Germany has a current account surplus, as opposed to the deficits of many countries. It is basically a net exporter of capital. It is in a very strong position.
All this clearly lends support to the product. All the strengths we have mentioned before are valid points, and I feel that in relative terms the Pfandbriefe market will hold up well, compared to some others.
The change in the investor base is driven not so much by confidence in the product, or a lack of it, or all the credit metrics which are available, or even the people starting to study the business model or scrutinising the cover pools again. It's more about understanding the dynamics of the deleveraging process.
A lot of bank investors and central banks in the product, and even real money investors, are faced with a net outflow: either a net outflow of proceeds or a deleveraging. This is driving this whole process much more than any perception of whether this is a credit or a rates product, or whether we are dealing with higher or lower recovery or default risks.
IFR: Louis, I understand there will be a change to the Pfandbrief law. Is that correct? Perhaps can elaborate on any major changes that you are going to implement.
Hagen: First of all, this is an ongoing process. There is a government proposal to change or to amend the Pfandbrief law on the table, and the Parliamentary process, the legislative process, is just about to start. We expect that by January of next year the main negotiations in the financial committees of the German Parliament will have been completed. Then, hopefully, by March or April the law or the amendment will pass.
Today the amendment has some changes regarding a new type of Pfandbriefe, the aircraft Pfandbrief. This sounds like a big change, but we do not expect a huge volume of aircraft Pfandbriefe. To date, the major changes have been more on the safety side. There is an explicit liquidity buffer which will be built in the cover pools. The cover pools have to be protected against any liquidity gaps for the next 90 days, and there is already discussion of this point.
On the other side we are trying to ensure that Pfandbriefe can be used, at least indirectly, by more banks. This concerns the so-called funding register, where there have been some legal questions. These questions have to be cleared up, and we hope that by doing this Pfandbriefe will become more attractive to new issuers, and to non Pfandbrief issuers who could make their assets available to Pfandbriefe issuers.
These are the major points, but things have moved on considerably since we began discussing all these changes. Now we are in the midst of a discussion as to whether we should take advantage of this legislative procedure to implement some more regulations for Pfandbriefe, to make the market even safer. These changes will not, of course, have an immediate effect, but in the long run will hopefully have a positive impact in restoring investor confidence.
Restoring is, in fact, not the right word: it implies that there had been a loss of confidence. But of course the confidence has to stay with the Pfandbriefe and hopefully get stronger.
There are further issues that we might add to the amendment of the Pfandbriefe law.
IFR: Is there anything the Pfandbriefe law is missing or hasn't been addressed?
Engelhard: The introduction of an aircraft Pfandbrief regime in this stage of the credit cycle seems to be in some respects inappropriate, when you consider, for example, that banks are not allowed to raise LTV barrier for residential mortgages to 80%. The German mortgage market, particularly the residential mortgage market, is quite stable. It gives the impression that the Pfandbrief product should be homogenous across all types of Pfandbriefe, which seems to me inappropriate. But that's a minor thing – it isn’t going to be a major market anyway.
Liquidity it the really hot debate. We appreciate, of course, that there will be some limitations enshrined in law on the one side, but on the other hand I think it may be an exaggeration, there is a risk we may regulate to strongly. Banks actively running liquidity risks do not tend to do it in this market, and if there are banks around who think they are going to need to use that feature, I think disclosure would be sufficient.
On the commercial mortgage side of things we face the risk of a lengthening of the duration of the mortgage assets – they need to be rolled because the respective borrowers are increasingly unable to refinance. This problem has increased dramatically in the current environment, and this is putting the whole liquidity risk situation in a different perspective.
Volk: With respect to LTV ratios, the housing market problems are occurring in a number of countries, and although it is not evident in Germany so far, Germany is entering a recession. If you sell a house in a distressed environment you will benefit from having a higher cushion, so on that basis it is simply better to having a lower LTV of 60% compared to an 80% LTV. In my view this will help mitigate some investors' concerns and a 60% LTV in this market would send a very strong signal. And for liquidity, 180 days would be better.
Bertram: But don't forget that the 60% LTV is not the market value it is the mortgage lending value.
I am a bit more relaxed than Fritz on the aircraft Pfandbriefe. I believe as we are not mixing these kinds of assets into the mortgage public sector side, if someone is doing it they will differentiate themselves. It’s a different asset class.
Engelhard: As a jumbo you mean?
Bertram: Yes in jumbo format. In terms of liquidity, I believe it is necessary. The investor wants these kinds of commitments, but a law is always stronger than a binding commitment. On the other hand, at BayernLB we have for several years had a commitment on a private basis, which was made publicly available, for liquidity reserves around the 180 days. It is not just that we like it but it makes life easier for the agencies. It makes it easier to get a Triple A rating without long discussions when you have liquidity reserves for 180 days, especially on the mortgage side.
I am absolutely in favour of all the measures to be taken. Maybe if we can beef them up even more it would be quite nice. We have discovered recently that a lot of investors pay for the security of knowing there's someone behind the scenes watching what the issuers do, who will help if there is a crisis. That goes for both BaFin and the Bundesbank.
We've seen competitor covered bond schemes with so many details outlining what is going to happen if a range of different situations, but in the end it looks like the German product has a strong law without too many details.
It's partly due to the fact that our law works a bit differently to the case law in the English market. It looks like investors trust this concept: strong law, conservative mechanisms and someone to watch and help out if something goes wrong, as was the case with Hypo Real Estate. That's more important than having detailed solutions for everything.