Tuesday, 16 October 2018

Pfandbriefe/Covered Bonds 2005 - From Trafalgar to today

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At the Eurocatalyst annual conference held last year in Berlin, ABN AMRO’s Tim Skeet introduced a panel of German investors and analysts with reference to an anniversary of a significant event fought 200 years ago. Skeet expands here on this historical perspective.

The year 2005 marks the 200th anniversary of the Battle of Trafalgar, which turned the tide of Napoleon’s pan-European ambitions. In October 1805 the British Royal Navy under the command of Admirals Nelson and Collingwood destroyed a combined Franco-Spanish fleet off Cape Trafalgar on the coast of Spain.

As bankers are not always strong on history, such an anniversary will have escaped their notice, and hence its relevance to the fine workings of the carefully calibrated financial markets is unlikely to be readily appreciated. But let us blow the dust off the history books to look back at some events that have contributed to the fever and flavour of today’s financial forums. This is entirely appropriate in the context of covered bonds, as the Germans – and indeed the Danes – are always proud to point out that the instrument’s impeccable historical roots lie in the latter part of the 18th Century.

But it is not just longevity and a slow gestation that provides the foundations for the covered bond market as we know it today, but also a series of key historical and political events from the late 18th century into the early 19th. The clash of ideas that manifests itself in today’s verbal broadsides and musket fire emanating from, amongst others, the German VdH, aimed at Anglo-Saxon style structured covered bonds echoes to the sounds of that real conflict of two centuries ago.

Furthermore, the adoption of Anglo-Saxon principles by the rating agencies derives from – and is bound up with – the momentous events and precedents created so long ago. What precisely is the connection, bankers might well wonder?

That Trafalgar's epic naval engagement should have any bearing on the course of the covered bond market – or attitude of the rating agencies – does not seem obvious. Yet Trafalgar scuppered the French plans to invade Britain as part of that nation’s aggressive early attempts to create the European Union in the French mold. The full military consequences of this battle were sealed in their final form at Waterloo some 10 years later.

The relevance lies in Napoleon’s most significant and enduring legacy to Europe – and consequently a legacy that by dint of this naval defeat never crossed the Channel. The stocky Corsican emperor was more than just a brilliant general. As all French schoolchildren learn, he provided France – and subsequently a large part of Europe – with the Napoleonic Code. This formed the basis of a regimented and ordered legal framework that offered a structure that brought order and method to the continent’s capricious and chaotic erstwhile legal practices.

In the following years of Napoleon’s rule, and beyond, most of the main continental nations adopted the Napoleonic Code, or variations on the theme, as the heart of their legal systems. This would also have been the case for Britain if the Grande Armée had been able to bridge the Channel. Instead, with the defeat of his fleet, Napoleon turned his conquering gaze elsewhere.

Not only, therefore, was haute cuisine and coq au vin kept offshore for another century or so, but the British legal system remained intact – a somewhat haphazard system relying on civil contract law, the power of precedent, and the tried and tested examination of the courts.

This fundamental difference in the two legal systems lies at the heart of some of the misunderstandings and irritations that hang over the debate between the current British situation, the rating agencies and the continental system as defined by law and statutes for covered bonds.

The British system was not then – or now – without its faults. Dickens would satirise British legal practices in the mid 19th Century in the fictional case of Jarndyce vs Jarndyce in the novel Bleak House. Yet English commercial law has become a market standard for much of the Euromarket’s activities, and most recently has spilled over into the previously firmly continental world of covered bonds.

First appearance

History teaches us that covered bonds first emerged in the late 1770s in Prussia, incidentally a key British ally during the Napoleonic wars and whose timely arrival on the field at Waterloo certainly ensured Bonaparte’s final demise.

The next market to embrace the technique – not long after the Prussians – was Denmark, following a conflagration in Copenhagen in 1795. Curiously, it was in 1801 in Copenhagen harbour that Nelson, later to lead the fleet at Trafalgar, decimated the Danish fleet that was poised to take sides with the French.

This engagement saw a one-eyed Nelson disobey orders and thereby give the English language the famous expression, “to turn a blind eye”. This came about as Nelson, who had been ordered to withdraw in the face of an impending counterattack, refused by turning his blind eye to the threat (he had lost an eye in a previous engagement), winning the encounter and getting a promotion in the process.

This, moreover, illustrated the pattern of curious British behaviour that continues to baffle continentals who have developed a clear preference for their own codes, laws and statutes. Now the recent shift in the rating agencies’ approach reflects Anglo-Saxon attitudes to which the continental markets can no longer turn a blind eye. Moreover, recent events at Moody’s underline and confirm this shift in approach, where Alexandra Sleator announced her return to credit work, abandoning her credit-based interest in covered bonds to the structured finance side of the organisation.

British lawlessness in covered bonds is one aspect of a growing concern, and with the application of securitisation techniques and measurements based on British legal structures to the rest of the covered bond market, is justifiably viewed with some suspicion in Frankfurt or Paris.

Pfandbriefe pre-dates Germany

Historians will further note that pfandbriefe, the cornerstone of the whole market, pre-dated the unified modern German State. Germany came into being as a result of the expansionist energies of the Prussian Chancellor Otto von Bismarck.

Having inflicted military defeat on the French under Napoleon III, the Prussians arranged for the signing of a treaty, with due pomp, in the Hall of Mirrors at Versailles in 1871, which included the drawing up a constitution for the new Germany and unifying of the various German states. Thus this series of events put smoke and mirrors at the heart of the consolidation of Europe’s biggest market.

The pfandbrief nevertheless withstood the passage of time, mainly as a curious German or Danish niche market, but finally the 21st Century has reaped change with a series of recent modifications to the relevant laws, culminating in the impending abolition of the once sacrosanct special bank principle that underpinned the operations of the hypobanks. This change is due to come into effect in the summer of 2005.

That the Prussians had arrived with such aplomb on the field of Waterloo in 1815 was the final act of Napoleon’s downfall, and a significant boost to Perfidious Albion. Arguably, these twists of history were further steps towards the pfandbrief "meeting its Waterloo" and subjugation to the rating notches.

It has only been the recent cycle of pan-European integration – starkly contrasting with the expansive nationalism of the 19th Century – that has allowed the covered bonds to emerge within each nation along converging courses. Perhaps, with the impending review of the UK structured covered bonds on the part of the FSA designed to draw the UK into the European UCITS fold, 2005 will see the UK product – in all its Civil Code glory – sit more comfortably alongside its Napoleonic Code counterparts in an act of union echoing the Entente Cordiale whose centenary was feted in 2004.

By way of a curious footnote, the flagship of the British fleet that turned the French tide two centuries ago remains on the Royal Navy’s roster. Now the world’s oldest preserved and intact warship, HMS Victory sits in Portsmouth harbour. This vessel would seem to offer a potentially fitting location for one of the myriad covered bond conferences that fill the bankers’ social calendar.

And in the interests of balance, paying due respect to the French who provided the continent with the transforming legal framework, 1805 also witnessed a spectacular Gallic victory at Austerlitz where Napoleon beat a combined Austrian/Russian army, seized Vienna, and boosted the Emperor’s hold and influence over most of continental Europe.

What appears equally impressive is that notwithstanding the marching of the various armies across Europe – the sieges, battles and conflict – the covered bond market seemingly suffered no defaults. Withstanding the test of time and ravages of war, the covered bond sector stood firm, only now must it deal with the assaults of the ratings of the agency raiding parties with their traditions from the Sceptred Isle.

Thus a naval victory in 1805 brings us in some measure to the sinking of the special bank principle and change in the markets in 2005.

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