Pfandbriefe Roundtable 2008: Part One
IFR: Why did Pfandbriefe contain its spreads so long after the market crisis?
Fritz Engelhard, Barclays Capital: Firstly there is a strong domestic investor base. That has helped the Pfandbrief market a lot. Secondly, it's one of the most established products across the spectrum of covered bonds. And thirdly, it was experiencing shrinking supply, particularly at the jumbo level, while some of the other covered bond markets were seeing supply growing quite strongly.
Olaf Pimper, Dresdner Bank: The first markets to be impacted were those with problems in their mortgage markets. Unlike other countries, Germany is not facing such problems right now.
Bernd Volk, Deutsche Bank: From my side, 75% of the market still comprises public Pfandbriefe – public sector backed collateral or public sector collateral. The international mortgage-market crisis ensures public sector Pfandbriefe are perceived as a safer option.
To elaborate on the supply trends Fritz mentioned: in 1998 we had €257bn of Pfandbriefe issuance; in 2007 we had €135bn. So a declining trend.
Louis Hagen, vdp: Pfandbriefe have a very strong legal framework which has been established for over 100 years. Issuers have a broad diversity of different products available, from registered Pfandbriefe and traditional bearer bonds to jumbo. And the market has very strong systemic support from the finance industry in Germany.
Horst Bertram, BayernLB: The declaration by the German government that the Pfandbrief is a safe product and that the government will do everything necessary to protect it to ensure it remains a safe product had a tremendous impact on the market. From an issuer point of view, for a couple of days we had no issuance in the Pfandbriefe, but a declaration was all we needed to get a private placement in the domestic market. So this declaration was clearly helpful. I don't know if there was a need for a legal binding version, but a clear declaration was extremely important.
IFR: By declaration you mean from the German government?
Hagen: Yes, the commitment expressed in the financial stability law, passed a couple of weeks ago, did not include Pfandbriefe, but the government made a very strong verbal commitment to the Pfandbrief market. It said it was not necessary to include the Pfandbrief market in the rescue package because it is already safe – there has not been a default in over 200 years, after all. If it becomes necessary to implement legal measures then the German government will do so.
IFR: So the government will intervene only if necessary?
IFR: Have investors bought that argument?
Steffen Dahmer, JP Morgan: We have definitely seen a couple of days when the market was really dislocated. It was a brilliant statement, one of the most effective I have seen in the last few weeks of this financial crisis: it cost nothing and meant so much. Look at Hypo Real Estate and Depfa Germany, and where their bonds were trading compared to where Depfa ACS were trading, that shows the impact the statement made.
IFR: One could argue that an outright guarantee has done Irish covered bonds no favours.
Pimper: It seems so. Global spreads didn't change after the Irish guarantee. I agree that there is no need for a government guarantee in Germany for Pfandbriefe. This product is as safe as possible.
IFR: What do we expect the effect of the government bail out schemes to be on the Pfandbriefe as an asset class?
Engelhard: Government guaranteed debt issuance clearly provides competition to covered bond funding for banks, as in other countries. There are clear break-even calculations taking place regarding the all-in costs for government funding versus Pfandbriefe, which is, in general, perhaps the next best solution.
There is still some space left between where banks can raise money via a Pfandbrief issue and the all-in costs for using the government guarantee – which is maybe north of Libor plus 100bp.
IFR: So German issuers will have to accept a new price?
Engelhard: The market is open but in small amounts – around Libor plus 30bp, according to our observations. For a jumbo or benchmark deal issuers may need to make bigger price concessions but there is some space left between where that price is likely to be and the break even point versus a government guarantee.
Volk: The guarantee scheme restricts issuers to three years, so as soon as the market shows some stability and investors are willing to invest in long maturities, or perhaps in placement format, maybe issuers will not be able to use government guaranteed paper for duration.
Engelhard: I disagree to some extent. At this point in time it is particularly difficult for any issuer, be it a covered bond issuer or even a supranational, agency or sovereign, to issue longer maturities in benchmarks. I would not place too much hope in a speedy revival there. When the markets stabilise that is when we will see longer-dated issuance, not at this point in time.
Laurent Viteau, EuroMTS: Perhaps Pfandbriefe will not compete with the government guarantee but will help issuers match their liabilities where they need to issue in longer-dated maturities in benchmark size.
Joerg Huber, LBBW: It really depends whether we are looking at mortgage Pfandbriefe or public Pfandbriefe. In public Pfandbriefe there is still a lot of over-collateralisation, and there is certainly room to issue if you pay the necessary price. On the other hand, new assets in the public cover pool are getting cheap as well. All the state guaranteed paper should be eligible and here you have paper coming in at around Libor plus 20bp. This is up to two years. We will see other paper which is high quality and eligible coming in at double digit spreads, but it will be still more expensive for a borrower to issue than to buy these kind of assets. Nowadays nobody really wants to fund short term, because it is so expensive. Are there public sector borrowers out there who have over collateralisation who can issue?
As for the mortgage market, we need investor confidence to return. The spectrum of German borrowers in the mortgage Pfandbrief area is huge, and the cover pools are so different that issuers really need to disclose information to investors regarding the security and safety in the cover pool.
Hagen: How long can investors continue to invest in these short term bonds or other short term credits? There must be pressure, especially for the usual Pfandbrief investors, to invest in longer maturities. They have to match their assets and liabilities. There should be a chance next year for Pfandbrief issuers to issue longer term Pfandbriefe – longer than three-years maturities.
Huber: We certainly have to see the first issuance under the guarantee mechanism, so investors can see that it works. In theory, following the announcement and what has been written into the law about Pfandbriefe, everybody should feel very secure. Even if nothing works, which hopefully won't happen, the guarantee mechanism would be prolonged beyond 2009.
A lot of investors have long term investment needs. At the moment, they still get quite a high yield when they stay with their money at the short end but that will certainly change over the next couple of months. Pension funds, insurance companies and other investors will need to go in the long term area. If they are looking for jumbo transactions there will be less certainty. A lot of them would certainly like to get into registered issuance.
I think there is a lot of room for longer-dated issuance from the second quarter of next year.
Engelhard: I still have doubts, unfortunately. There are ample opportunities for investors to invest in cheap, high quality paper. Longer dated bonds are trading at Euribor plus 15bp to 20bp. This reflects the illiquidity in the market. You may also argue there are a lot of redemptions taking place, particularly in the Pfandbrief market, with a lot of money flowing to investors. But this argument is flawed: overall we see a deleveraging process, with many banks paying credit back which has funded their Pfandbrief holdings in the past.
More importantly, many real money investors are experiencing net outflows of money. Recent data from Reuters indicate that, in September alone, we saw net outflows of €22bn from bond funds in Europe. In 2008 overall it is a €100bn outflow. These are real money investors.
In the money markets, September saw net outflows of around €66bn. Central banks, a very important investor group, are primarily interested in protecting the stakes of their home currency and their home economies. They need proceeds and it seems unlikely that they will use redeeming Pfandbriefe to invest in Pfandbriefe to any large extent, particularly longer dated paper. So for 2009 I think I am less optimistic than some others here.
Huber: Where do you think the money is going?
Engelhard: Dresdner bank is offering 12 month money for 5.25% for retail investors. That is big competition. In terms of funding from an issuer’s point of view, short term is the future.
But ECB just yesterday made syndicated loans eligible for ECB repo funding. That is a very efficient form of funding that also competes with Pfandbrief funding. Economically it isn’t easy, every bank wants to turn out the funding base, but in terms of immediate costs of funding, it's so efficient to use many other assets which are on the balance sheet of banks and which are not eligible for Pfandbrief cover.
Pimper: I think we can expect a lot of government guaranteed issuance in the next couple of months. I doubt it makes sense for Pfandbrief issuers to compete directly with that. It is better to keep the powder dry and try to go to longer maturities at the end. Right now it seems like agencies will suffer most – they are the ones who tend to compete with government guarantees. Pfandbriefe haven’t suffered much so far, though we haven't seen any German government guaranteed issuance so far either.
Bertram: If issuers use the government guarantee scheme they expect to use it for benchmark transactions, or getting a guarantee for large deposits. It gives room on the private placement side for Pfandbrief issuance.
Everyone is trying to issue in longer term maturities, but I agree with Fritz that in the first half of 2009 things will be slow. But a lot will change over next year. Confidence will return to the market and some investors have to turn to longer maturities – if there is enough money left.
Germany may get its own version of the Basel II insolvency regime. Insurance companies have to go much longer in their duration to match their liabilities. So the trend is relatively positive but I'm not optimistic about the first six months of the year. Overall the competition is coming from so many products, it is a huge task for issuers to get the business done.
Volk: We still see this huge deleveraging process in the financial industry, which is likely to continue. Since 1998 bank balance sheets grew strongly in relation to GDP and this brings us to a strong steepening. We have already seen this and we expect a lot more to come. This is a burden for long dated paper. We saw some long-dated corporate issuance. Covered bonds in general – and Pfandbrief issuers specifically – are a little bit stuck between unsecured levels, which are extremely wide, and state guaranteed levels. But with the systemic risk moving from banks to sovereigns, perhaps issuers are unwilling to pay unsecured levels.
IFR: So what would be the effect of a steepening of the curve then, in terms of maturity?
Dahmer: I believe this is a positive trend. It now makes sense for a lot of investors to look after the longer end of the curve. Two or three months ago there was no need, with this higher Libor fixings – better to stay in three or six month durations while there was so much uncertainty over whether counterparties would be able to pay back.
I am also more confident on the balance sheet side. All these traditional agency names like KFW will try to avoid clashing with these new guaranteed schemes.
If in the middle of 2009 we see rationality return to the market we may see investors say, "okay, I can buy a guarantee Bank X bond at Libor, or I can buy a covered bond of exactly the same name and maturity at Libor plus 20bp. I prefer the Libor plus 20bp because it's more juicy, obviously, but indirectly I feel just as safe as I would with the pure guarantee." For an issuer it would make sense to issue in that way because then you avoid the initial guarantee costs. Maybe that is too optimistic for the middle of 2009, but I hope this kind of rationale comes back into the market.
Hagen: Right now we are facing a psychological problem. We can talk a lot about Pfandbriefe, we can talk about a lot of technical issues, but in the end it's about confidence.
At the international level there are a lot of calls for more regulation, more supervision, more transparency, less complexity, higher credibility – even without taking into account the rating agencies. The Pfandbrief has all of this: it is highly regulated; it has a lot of supervision – more than the usual level of supervision for banks; it is a very transparent and standardised product; it's easy for investors to get their own view on the quality of the Pfandbrief, because of the law and because of the transparency required by the law. The Pfandbrief has everything. Once confidence returns, the Pfandbrief should be the first thing that picks up again.
Viteau: If you look at some of the pillars of the Pfandbrief, you have safety, transparency and liquidity. Investors know the product is still safe but there is less liquidity – though the same is true of government and agencies bonds. The Pfandbrief is certainly less transparent, in terms of pricing source, getting it marked to market and getting a Libor price.
Volk: It's not a matter of credit quality or trust in the Pfandbrief, it's more a matter of liquidity. If you buy a 10-year Pfandbrief at the moment you will struggle to find liquidity if you want to change your position in a few weeks. You have to accept a discount because all banks are in a deleveraging mode. This is maybe one of the reasons why the longer dated maturities are suffering more than shorter dated.
Engelhard: It's true that the Pfandbrief framework is one of the best established and well regulated financial marketplaces. It fulfils all the criteria. However, the business models of many Pfandbrief banks have been called into question. Many investors still need to digest what happened with Hypo Real Estate and Depfa in particular, but also some of the other Pfandbrief banks. This will take time.
The flip side of this is quite good news: we get deleveraging within the Pfandbrief system, back to a more healthy situation. In the end that is good news for the Pfandbrief.
On another point, I am tired of hearing the jumbo Pfandbrief market has liquidity problems. This is a very bad argument. We are in a situation where the backbone of capital markets – your Euribor and Libor fixings in the money market – is underlying all swap contracts in the fixed income contracts. Nobody knows where this underlying will be tomorrow. So we have tons of derivatives in fixed income markets where nobody knows where the underlyings will be later today or in a week's time. Unless these problems are resolved, there is no way things can get back to normal in market making or in general for Pfandbriefe. This is not an issue that is confined to the Pfandbrief jumbo market.
I understand the history of this discussion, but I don't think it's appropriate to single out covered bond markets or jumbo Pfandbrief markets as having a particular problem with this. It is unfair.
IFR: So it is a wider problem?
Engelhard: It is a wider problem in capital markets. Unless the other areas are resolved and we get back to normal terms and conditions then the pain will be felt in all Triple A benchmarks.
Pimper: And it is all part of the same story: it is due to the financial turmoil which we are facing. The Pfandbrief is well prepared to work again once financial markets as a whole work again. There is no repo market right now for jumbo issues. Nobody knows whether Euribor is the real price. As an investor, I'm very happy with my investments: I'm still sure that Pfandbriefe are 100% safe and will be paid back in full, but I also know it doesn't make much sense to go to the secondary market now for a price, because there is no clarity and ultimately the prices don’t make sense. They are just irrational, for now.
Click here for Part two of the Roundtable.