Pfandbriefe Roundtable 2008: Part Two
IFR: Have we seen any flows go through EuroMTS lately?
Viteau: If you talk about covered bonds and the interdealer market, there has been hardly any flow. There was a bit of pick up late August and early September, but then it basically died.
If you look on the client side, at the investor, yes, there have been some flows. They came late in the year, but there have been some flows.
Engelhard: But there is a major discrepancy between what the rule was last year or early this year and what it is now. The secondary market has become much more highly concentrated: I would guess that today maybe 90% of the flows are done by 10% of the counterparties. All the small and mid sized counterparties are on the sidelines, in terms of there being no balance sheet commitment there anymore. This is obviously concentrating the flows in some ways.
Pimper: So the only way to trade is when you have a position in a particular security. It doesn't make sense to call any counterparty and ask them for an outright price. If any trading is possible then it is because a trader is axed. Then you don't increase your balance sheet, you are just switching if there are some nice opportunities in terms of spreads. Sometimes I'm left with the feeling that we are back into those old times where you have a huge bid offer spread on small sizes: this is totally different to what we are used to when the market was working, when we had big tickets with very small bid offers.
Volk: This is the main problem for the Pfandbrief at the moment. It doesn't help Pfandbriefe that other markets have the same problems.
I see the change in business models and what happened to some issuers, but there are a lot of issuers where investors have no fear at all, they completely trust the product. But as long as the market is like it is, for whatever reason, the situation is unlikely to change.
Engelhard: But that's creating tremendous opportunities, of course. Particularly in the short end area, many of the bonds are trading on a cash basis, so in the very short term there are many opportunities for investors in the secondary markets.
Volk: These cheap offers we saw in the Pfandbrief market a few weeks or a month ago are gone. A lot of investors are trying to find very short dated Pfandbrief with a very high yield, but they are no longer available.
Dahmer: Olaf has highlighted it: you see trading with Axes, you see a lot of switch operations to reduce your repo costs. People who are cash rich would have invested in 10-year maturities in 2006 or 2007, now they are staying in cash or buying something that matures in two months time. It is a big change down to the missing liquidity. You don’t want to have a maturity that is longer than your view. That is fair enough, but it doesn’t help covered bonds.
Hagen: I don’t think liquidity is the biggest problem at the moment. In fact it has not been a problem in 2008, even though market making did not function very well. If you look at the new issuance in 2008 from January 2008, compared to the same period in 2007, there was an increase of 23% of Pfandbrief issuance.
But what we are seeing is a shift from the products and a move into registered Pfandbrief. In 1995 registered Pfandbriefe was a quarter of the market. Today it is about 35% of new issuance.
The investors are also different. One of the backbones of the investor base are investors that are less interested in the liquidity issue, because they are more interested in holding the Pfandbrief on their balance sheets. They are more interested in knowing they will get their money back and get their interest paid.
Dahmer: Another issue is the number of placings in the market. Dresdner Bank and Commerzbank are going to merge, as are Merrill Lynch and Bank of America. There are others too, where you have seen the back books are I would say almost gone. Previously high volume back books hold and used as liquidity portfolios are totally unwound, leaving small secondary books.
Whenever you add on a position you try to pass it on to someone else. That is totally different to the world of 2006 and 2007. That's not only different for the covered bond or for Pfandbriefe, it’s for all kinds of Triple A rate products.
We have less players, we have less willingness to add to positions and we have almost no back books anymore. It's a totally different approach.
I am now guestimating but I think we are talking about something like up to €100bn of secondary funds that no longer exist.
Bertram: I believe back books are more important for some issuers than in the past in terms of providing liquidity to buy back some Pfandbriefe. If banks are willing to make a bid on deals of around €550m you are unlikely to see it being bought back.
If you really want to sell your debt you need to be a bit conservative. The one buying back should not be the most aggressive in the market. If people want to get liquidity and they find one issue which is most aggressive by bid, you could be quickly flooded with some secondary paper.
Engelhard: Registered covered bonds do play a bigger role. This has already been established over the past few years. Still, the overall volume of Pfandbriefe is decreasing to the tune of €60bn over 12 months, which is roughly €5bn per month. This reflects the fact that business models based on wholesale funding are finding it more difficult at the moment. The particular advantage of placing registered bonds, non marked to market, mainly with bank investors, was put into perspective quite recently. On 13 October the IASB decided to amend IFRS7, which means securities holdings can be booked under the loans and securities book. Some banks are making a larger use of that provision already.
This has watered down the particular advantage of issuing under the Namenspfandbriefe format to some extent.
IFR: Does the registered Pfandbrief allow issuers to fund with duration?
Huber: Yes. I mean you don't see the same kinds of volumes that we had in the jumbos, but there's constant issuance going on. What I also hear from Pfandbrief banks – the really well established ones – is their traditional domestic investor base say yields on eligible assets are quite attractive. They get very high margins nowadays, so they can, in theory at least, reduce volumes. They still have a good income from the higher margins.
Of course, that can't be a sustainable business model for the next couple of years. But it at least allows you to continue to survive – and show quite good results.
Bertram: The registered Pfandbrief was the only product which allowed issuers to issue in ten-year maturities. That was helpful on the funding side. They mostly went to to insurance companies. We hardly sell any registered Pfandbriefe to other banks.
Engelhard: This is exactly the area where investors may benefit from the steepness of the yield curve, and from their investments in long dated issues – more so in registered bonds but less so in benchmark jumbos.
IFR: So is the jumbo decreasing in importance?
Engelhard: In size, yes. In importance, I don't know.
It depends on whether you are looking at this from an investors' or an issuers' point of view. From an issuers' point of view it is still is a marketplace you can't ignore. It is still very important to satisfy funding needs. From an investors' point of view, too, it remains an attractive product: it is still the largest segment of the covered bond hemisphere.
Huber: When you look at the funding mix of the German Pfandbrief issuers, on average it was about 75% non jumbo and 25% jumbo funded. The 25% was to private placements and registered, et cetera. There were only a few issuers who really needed the jumbo instrument. Most – including LBBW – found the jumbo was not a necessary funding instrument. We used it from time to time, to generate new investors, but it was not a necessary instrument because generally it came more or less on the same level as the private placements. In fact, sometimes it was a bit more expensive for us – and that is the same for a lot of borrowers.
So these days, if you can't do jumbo issuance it is not necessarily a big problem. Of course it stabilises your income, because – especially internationally – you have investors you can't tap with private placements. But overall it's not something which people are especially worried about.
Hagen: Things are exaggerated at the moment. You hear things like “this business model is dead” but it has been shown over the longer term that some business models change, while other business models that we thought were dead come back to life. At the moment it is very difficult to say how the whole banking environment will change.
There will certainly be changes and adjustments, but we don't really know what those will be. So I would be very reluctant to say any business model is dead or has ceased to work. There is still room for specialised banks and there is still room for universal banks. I would not say there is only a future for the universal banks that can tap the retail markets. Specialised institutions may have access to internal funding sources, or indirect access to retail funding.
We really have to face the fact that, from 1995 onwards, the jumbo Pfandbrief market perhaps developed too much. We have seen jumbo issuance peak and it has been declining since 2001. The financial crisis has just increased the speed at which this process is occurring. But the development was already visible.
This won't be the end of the jumbo market. There will always be some demand for specific investors.
Viteau: Is there still a need for some kind of stabilisation? The last 12 or 15 months have been characterised by repricing – no stability at all. The Pfandbrief issuer has gone more with private placement than jumbo. Covered bond issuers have basically stopped issuing covered bond. Maybe the mix will move again. Maybe next year or further down the line jumbo issuance will make a comeback. The size will still be there to some extent for most of the issues.
Volk: If we look at the biggest jumbo issuers in the list, they have either announced they will reduce the volume of their issuance, or they have difficulties accessing the market.
So just taking into account upcoming redemptions and expectations of very low or zero issuance in the very near term, the jumbo Pfandbrief market seems set to shrink significantly in late 2008 and 2009.
Pfandbriefe survived 200 years of very different funding and financial market regimes, and it will continue.
Dahmer: When things are improving next year, what will come back first, mortgage Pfandbriefe or public sector Pfandbriefe? I think in terms of having a sound business model, the mortgage Pfandbriefe, with 6% loan to value, could have the first chance to pick up.
Bertram: There are several answers, but I think on the public sector Pfandbrief side it's really hard for most of the issuers – maybe impossible – to make this business profitable. The redemptions are mainly seen in the public sector Pfandbrief, and this is going to continue. Some of them seem to be shrinking their businesses. So the recovery may start with the simpler products – the mortgage Pfandbrief. The underlying business is sound and there are positive margins. A lot of investors have disappeared from this market, so the remaining ones may find the business increasingly profitable.
Maybe the investor community wants more insight – more information about how the banks are doing this kind of business and what's in the collateral pool.
I'm optimistic about the mortgage sector Pfandbriefe. The next question is are we going to take the right steps to make this product successful? I am relatively negative on the public sector Pfandbriefe business.
Engelhard: It's already reflected in the numbers. Compare the vdp data on the cover assets of mortgage and public sector Pfandbriefe: we have experienced a drop in mortgage sector cover assets in Pfandbriefe programmes, from €682bn to €640bn – a drop of more than €40bn. Yet on the mortgage side we have seen a increase from €214bn to €218bn – a slight increase of €4bn.
So mortgage Pfandbriefe has already gained in importance. It could gain more importance when the Pfandbriefe law is amended, when it gets easier to put mortgage assets into the cover pool of a Pfandbriefe from an operational point of view.
Pimper: But the shrinking market in the public cover pool was more foreseeable with the loss of state guarantees. What we are facing now in the market is a trade off: public sector cover pools are faster to liquidate for investors than the mortgage cover pools. But on the other hand the business model of the public sector banks have been hit harder by the credit crisis.
German Pfandbrief banks face problems arising from their pure public sector funding vehicles. So it looks like the pure business model, with its reliance on the wholesale market, does not work when there is no wholesale market between the banks.
Hagen: It's also a question of how the asset prices develop. We are already faced with higher credit costs for some public entities, public municipalities and the German Laender. It will be more expensive for them to fund themselves, but the real question will be whether the Pfandbrief banks can fund themselves more cheaply?
At the moment, this seems far away. But we have to consider the development on the assets side. In the mortgage business we are already seeing it: loan prices are increasing in the commercial mortgage market, though less so for the private sector or residential mortgage markets, where there is still a lot of competition. In the end I predict we will also see a change to that.
On the public sector side it's much more difficult to predict.
Huber: I don't think that it's so much more difficult. Of course the public sector will continue to shrink: with all of the redemptions of the state guaranteed paper which is still in the cover pools, you will see a natural shrinking.
But we also see demand from the asset side, all the Laenders and municipalities may need to borrow more because of the recession. The tax income will be lower and there will be much more need for raising money.
There are fewer competitors these days. Depfa was one of the biggest players, as was Dexia. They will certainly change their business models to a certain extent. There's certainly room for improvement here, as well as on the public covered bond side.
An additional point is headline risk, which will be of increasing interest to investors in the future. They will look at headline risk: which institutions use the Pfandbrief, be it mortgage Pfandbriefe or public Pfandbriefe; and what is the composition of the different collateral pools. On the mortgage side you have fantastic spread opportunities because of scarce liquidity and the fact there is not much lending going on.
On the residential side, you hardly get these kinds of margins because of the competition, specifically from the savings bank side. These institutions are certainly cash rich: a lot of investors are putting their money into savings banks at the moment, so the competition is here very big.
Investors may believe residential mortgages are much better quality than commercial mortgages, but is the spread differentiation of 50bp justifiable?
Such questions will continue to generate a lot of debate and a lot of research. Investors will dig much deeper into the product they are thinking of investing in. We will see specifically, on the mortgage side, a much higher differentiation. But both products will survive. They might equal out in size, so that one day mortgage Pfandbriefe and public Pfandbriefe are more or less the same outstanding value. But going beyond that to a phase where public covered bonds are extinct is much harder to envisage.
Volk: At the moment public Pfandbriefe is a German product: the share of foreign assets might be very high for some issuers and in some pools, but overall it's 80% German exposure. If you want to avoid certain countries, for example Iceland, following all the headlines we saw coming out of there recently, that is unlikely to be a problem. Icelandic exposure in the cover pools of public Pfandbriefe is negligible. Even eastern European exposure in Pfandbrief cover pools is single digit.
The issuers themselves are also very heterogeneous. We have a few issuers that are almost purely domestic, and others that are more engaged in foreign public sector lending. So investors can focus on the type of exposure that suits them.
Engelhard: Just to be clear, I'm not talking about the possible extinction of the public sector Pfandbrief market. But I think it will be subject to this overall deleveraging process, which means we are facing an overall downsizing of the market.
IFR: Perhaps we can talk over the primary market? Who will reopen the German jumbo Pfandbriefe market next year? What issuer would it take?
Bertram: Everyone should be prepared to be first. A lot of banks will have the state as an owner, or part owner. Most of the banks issuing these kinds of products will be state owned, these days. It will be a question of who is ready first.
If the market is there, everyone will be ready within five minutes. We have already seen a complete change in issuance behaviour this year. Preparing an issue over four weeks was hardly possible. Everyone had to be prepared. If some clever investment banker said there is a market for this, you simply had to go and get your €1bn or your €1.5bn. If the preparatory work was not done before then the issue would have failed anyway.
So I strongly believe everyone is ready, but nobody has clear cut plans. We know exactly what we want to do next year: jumbo if possible, fine; if not, that is still okay.
Huber: There are a handful of banks that could open the market, but headline risk is very important. You can't prepare transactions in three or four weeks, so you really need to prepare it with non deal-related investor actions: roadshows, visits and marketing. It might be necessary to wait until January or February to see how 2008 was for your bank: once figures have come out it will be possible to present that to investors to boost confidence in order to get a successful transaction placed.
Bertram: January or February is relatively optimistic. Some of the issuers may not have their preliminary figures until around the end of March or April. We expect to have something by mid-February.
Pimper: There is a lot of work for you to do from an investor relationship perspective. It's very important that you go out with those numbers and tell the story of the Pfandbriefe again and again – and possibly not only to the old investor base, but to potential new investors, to try and bring them on board.
Huber: For the first transaction it's very important to show the traditional investor base what's going on. Many of them have suffered a lot, and winning them back is a vital first step. When you can show new or international investors that your home base is there, that they will believe in you again, this will be crucial in winning over those new investors.
Dahmer: I totally agree with what has been said. There are a handful of names that could reopen the market. Headline risk is important, and a number of names will want to be the first, but on the other hand there will be a big portion of investors unwilling to participate in the first transaction, who will just wait to see how the deal performs in the secondary market.
In other words I think it is essential that whoever is first has a good secondary performance. This means it is important to get the right combination of issuer and spread, with the work put in before the deal, conducted quickly enough but also with the right partner banks: banks that are committed to the product and have the balance sheet, preferably those who are not in the midst of a merger or another situation, that are likely to generate negative headlines.
Bertram: Who is going to be the first German issuer coming out with a state guaranteed issue? I believe the need to explain the business model is less important than investor observations of the performance of an issue. I think what we will see in the German market will be like what you see in the UK market: people are relatively hesitant to buy unless they have seen it performing well and showing stability. When we have a nice spread tightening there will be more investors coming in.
Dahmer: Pfandbrief issuers have been successful in coordinating issues. Unlike what we saw in Spain, there has not been the scenario of issuers jumping ahead of each other, or a glut of issuance in one week.
Engelhard: It is not my place to call which institution will be the next to issue but I have a more general comment: two months ago I would have said it would be the first to accept the new pricing environment that would issue first. These days I think it is less a factor of at what price you come at. It isn’t even so much a question of selling your story and communicating how good you and the product are: we have seen in this environment how explicitly government guaranteed debt has faced problems in getting funding done. I think primarily it will be a function of timing.
I agree with Horst: we will see the first German state guaranteed bonds priced in the market, and only then will we potentially see some other German Pfandbriefe on top of that.
Dahmer: I was recently on a panel where somebody said something memorable about the need more transparency on what is in the cover pools. We have to agree on the past to make sure we can disagree in the future: in other words we can trade in the future. It is very, very important to have as much disclosure as possible to current investors. I appreciate 100% disclosure doesn't make any kind of sense, but having as much disclosure as possible regarding what kinds of assets you have in the pool is definitely helping such transactions.
Hagen: There might be an interest among issuers for issuing jumbos, but are the investors prepared to buy a jumbo? If they buy a jumbo they will expect liquidity, otherwise it just doesn't make any sense.
Pimper: This is why we need the secondary market to work and the money markets to work again before it comes it a primary issue. But it mustn’t be forced. Issuers need to be very careful about tapping the market with a primary issue.
I would also add that there should be at least some secondary market spread performance before an issuer comes with a new one. So first secondary, and then primary.
Hagen: At the moment we are very much focused on trying to get the basics sorted out, but maybe we must also look at the jumbo market and the secondary market. We need to return to the discussions we had before September – where we need more transparency in the secondary markets and price transparency for the investors; do we need different kind of market making procedures or commitments; is the jumbo bond market we used to have before still a valid concept for the future? These things need to be reconsidered before we come back with the same procedures as in previous years.
Click here for Part three of the Roundtable.