Pfandbriefe/Covered Bonds 2005 - Jumbos 10th birthday
The jumbo covered bond market started life 10 years ago in Germany. After the country overcame concerns over its real estate sector with a change of law, new jurisdictions came on board in quick succession with their own formats, bringing diversity and depth. William Thornhill recounts the highs and lows of the last decade.
While the first private sector pfandbrief was issued in 1862 by Frankfurter Hypotheken – with the Mortgage Bank Act following around the turn of the century – there had actually been some public issues even earlier, in Prussia in the late 1770s.
For most of the last century the German market was purely domestic, and by 1990 – with the government issuing increasing sums of debt to finance unification – the pfandbriefe seemed to lose its relevance.
In 1980, total outstanding pfandbriefe volumes represented a little over half of all Deutschmark-denominated debt, but by 1994 this percentage had fallen to a little less than one-third.
In this environment, German mortgage banks decided it was time to re-invent and reinvigorate the sector. In particular, they wanted to formulate a product that would be attractive for institutional investors who, above all else, sought liquid tradable debt. In the lead-up to 1995, a group of Munich-based bankers, known as the Munich Circle, got together and came up with idea of a minimum size issue and a market making agreement.
This club was chaired by Henning Rasche who is now a member of the board of managing directors at Eurohypo. At the end of May 1995 – some 133 years after its first issue – Frankfurter Hypotheken returned to bring the first so-called "jumbo", a DM500m four-year deal that was later increased to DM1bn.
The following month, Bayerische Verieinsbank brought a DM1bn 10-year. In July Deutsche Hypothekenbank issued the first deal with a market making commitment, and Rheinhyp and Hypobank followed in quick succession. Of these first five deals, three would later be merged into Eurohypo (Frankfurter Hypotheken, Deutsche Hypothekenbank and Rheinhyp) and the remaining two were merged into HVB.
EuroHypo's Rasche recalls, "Prior to the introduction of the jumbo, there had been many different issues, and the market was very fragmented. We saw that this development could not go on. Liquidity was not there as there was little homogeneity between the various different issues. We saw a clear need for larger issues with the same broad set of standards. At the same time, institutional investors took a greater interest and accounted for a larger slice of demand relative to private investors. They wanted liquidity and the ability to enter into or exit trades at market prices."
The term "jumbo" was not copyrighted but was a synonym for any big bond. Until then, issues had normally been sized at DM50m– DM200m, so increasing the size five-fold was by no means guaranteed to be a success. Had the idea flopped, market pundits speculate that Rasche may not have been where he is today.
In February 1996, DePfa issued the first Global pfandbrief, a DM2bn seven-year. Over the next few months, standardisation became more apparent with regard to issuing in specific maturity brackets along with definitions on coupons, the requirement for deals to be structured as bullets and to be listed within a specific timeframe. In March that year, some 27 specialist mortgage banks signed up to an agreed set of standards.
Within 10 months of the first jumbo benchmark launch, total issuance had risen to a stunning DM70bn – subsequently exceeding a six-digit sum by September 1996 and doubling again to DM200,000 the following year.
In November 1997, Luxembourg introduced covered bond legislation with the aim of copying the German law but introducing greater flexibility to allow for collateral backing from all OECD countries as well as the possibility of using swaps.
Before then, covered bond banks had been issuing out of Luxembourg against a collateral pool with no explicit law. These were branded "Luxembourg Pfandbriefe". However, they never had the advantages of a low risk-weighting and were never accepted as eligible collateral with Bundesbank. Nevertheless, the process of issuing covered bond-like instruments was a precursor to a comprehensive modern law in which local regulators took a more active approach.
The Luxembourg law was a wake-up call for Germany to modernise its law – as far as to what business mortgage banks could gain exposure. In 1998 the German law was modified, allowing them to access US public debt.
In the same year, Eurex started a jumbo pfandbriefe futures market, but due to problems delivering cash into the basket – along with a general lack of liquidity – the project failed to get off the ground.
While the basic necessities for a jumbo futures market are now in place, in terms of size and depth, practitioners believe a vast amount of deliverables would need to be included in the basket. The Spanish sector would probably be the cheapest to deliver, but rather than being an aid to liquidity, such a development could in fact exacerbate technically-driven squeezes. Apart from that, Bunds and swaps, though not the perfect hedge, are being successfully employed.
When Germany entered monetary union in January 1999, the value size of benchmarks jumped again. Despite a conversion rate of DM1.955 to the euro, jumbos were sized at the higher euro value rather than the Deutschemark equivalent.
AHBR, the nadir
In August 1999 the market reached its nadir, in terms of size, with AHBR's ill-fated €5bn September 2009 issue. Even at the time, many players felt the size was too big even for highly rated names such as DePfa or Eurohypo.
In hindsight it was notable for being largely underwritten and therefore lay on the books of arranger banks for many months – if not years – to come. That the borrower subsequently conducted a buyback was to many minds the final proof that it was too large.
Though the German industry always felt its product was worthy of a top rating, the first formal rating was introduced by S&P – for Frankfurter Hypo's jumbo. By mid 1999 most jumbos had a rating from one or all three of the major agencies.
Enter the French & Spanish
In March 1999 the first "cedulas hipotecarias" benchmark emerged, from Banco Argentaria – a €1bn 10-year. Though Spain subsequently proved a major force in the sector, this transaction was, in the words of one seasoned player "the biggest dog ever". It had no market making commitment, was not prepared and there was little understanding of the risks involved. Within a relatively short period it widened by 10bp.
In September that year, Argentaria, BBV (which subsequently merged with Argentaria to become BBVA) and Caja Madrid brought five-year deals with a proper market making commitment and Spain never looked back.
In June 1999 the French legal framework was passed, with the first jumbo issue (Compagnie de Financement Foncier) following four months later with a €1.5bn 11-year.
The French law was almost born out of default in that it emerged following a housing crisis highlighted by particular problems with the Credit Foncier group which, following the loss of government support, had its senior unsecured rating downgraded. "The law was created to rescue Credit Foncier; it was not a case of saying 'the Germans have a good concept, let's copy it', but rather it was born as a solution to fix their real estate market in mid 1990," described a market commentator.
In October 1999, Moody's upgraded Credit Foncier de France's mortgage bonds to Aa3 from A3. DexMa quickly followed the same month with two issues, a €1.25bn five-year and a similarly sized 10-year. With a parent unsecured rating of AA/AA+, it is the strongest issuer in France, deals exclusively with pure public sector entities and follows strict internal matching guidelines.
Though the French law is held up was being the strongest in Europe, especially in terms of its bankruptcy remoteness, detractors complain that the collateral backing differs significantly – with 3-CIF utilising RMBS as well as public and mortgage loans while DexMa issues are mostly backed by pure public sector collateral.
The introduction of Eurocredit MTS on May 22 2000 proved another major turning point, giving a substantial boost to liquidity and transparency. Initially, 15 jumbos of €3bn went on the system, including three each from AHBR and DePfa, two each from Hypo Essen and Rheinhyp along with others from Deutsche Hypo, Eurohypo, West Hypo and Credit Fonciere de France.
Many issuers in due course tailored the size of their deals to gain eligibility to the platform. "It changed the market as a lot of players wanted to get on the system. Market making worked more seamlessly, making it altogether more professional. Though it may have lessened scope for profitability among a select few, it clearly equalised the playing field," explained Fitch's Horst Bertram.
Some two years after the passage of law, Eurohypo Lux brought the first benchmark, a €1bn five-year in May 2000. Three subsequent euro benchmarks were seen in the following six months, and the last was issued in May 2003.
That so few benchmarks emerged from the region possibly reflected a political backlash over the collateral backing that essentially allowed debt from countries such as Mexico, Turkey and South Korea to be used. So much was the antipathy to this construct that the German regulator was alleged to have questioned the legality of German mortgage banks operating in the region.
In the early years it was not uncommon to find firms profiting from inside knowledge with regard to timing of new benchmarks, mandates and increases. Banks not party to the information loop were clearly at a disadvantage, such that several foreign institutions pulled out or significantly reduced their commitment to the sector, considering it a closed club.
To some minds the alleged "closed club" mentality may have temporarily hindered international development of the sector, but as new names and jurisdictions entered, banking institutions subsequently returned. The allure of fee income clearly outweighed their caution over the prospective costs of market making, a debate that rages on today – see the chapter on Liquidity.
Emerald Isle . . .
Among the latest most vibrant recruits to the sector was Ireland, which formulated a slightly more advanced version of the German law. Versus Germany, it raised regulatory oversight and introduced an explicit measure of duration risk, capping the asset liability match to no more than three-years.
A more diversified pool allowed collateral from the whole EEA area in addition to up to 15% from Non EU G-7 regions. The law was enacted in 2001, signed in August 2002 and the first issue emerged in February 2003, a €4bn April 2008 from DePfa ACS which was then tapped in April for a further €1bn.
. . . and then the UK
Five months later, in July, the UK heretic, HBOS, broke all the rules, launching a look-a-like covered bond but with no legislative backing. At the time, German mortgage banks were beginning to emerge from a period of instability. Real estate problems had prompted Moody's to lower the senior unsecured rating of many specialist banks, and because the agency did not think the law justified a de-linked methodology, pfandbriefe ratings also suffered.
In some cases, spreads traded out to well over 30bp over mid-swaps, leading investors to question the long-assumed safety of what had until then been considered the keystone of the covered bond sector.
In contrast, the UK "structured covered bond" was largely de-linked from its parent's senior unsecured rating, and to some minds – far from being a heretic – it was in fact a life-saver. Had the UK structure emerged a year later – when the pfandbrief law had been modified, so increasing Germany's rating immunity and thereby driving spreads back to their tights – the relative attraction of UK structures may not have been so compelling.
Seven months later, in September 2003, the first Austrian jumbo emerged, a 10-year from Kommunalkredit. Like Ireland, Austria's old covered bond law was updated to more closely resemble Germany's.
In April 2004 the revised German Mortgage Bank Act materialised, helping to cement the product's return to the top table. Amongst other elements, the law stipulated what should happen in the case of insolvency. It ushered in mandatory overcollateralisation of 2% and provided the basis for an extraordinary and sustained spread-tightening back to historic tights.
In June 2004, Aktia Hypo brought the first covered bond from Finland, a seven-year €250m FRN. Finland's Sampo is expected this year with a larger, more liquid benchmark. Elsewhere in Scandinavia, DNB Nor is due this year with the first Norwegian covered bond and, having updated its legal framework, a Swedish benchmark is probably not away.
In spring 2005, Italy's Cassa Depositi e Presiti introduced the first public sector covered bond from the region. Though backed by unique legal regulation, there was no specific covered bond legal framework. As such, it was, like the UK, 20% risk-weighted and similarly enhanced by structural elements. A legal framework for the private sector was approved, and it is hoped that issuers will be in a position to launch towards the end of this year.
After a change of government, hopes for a Portuguese covered bond this year were delayed, and while a 2005 issue has not been ruled out, the inaugural deal might not surface until 2006.
While Germany maintained the dominant place in terms of outstanding jumbo covered bonds, it has nevertheless been eclipsed in the last few years by the emergence of other sectors. Nowhere was this more prescient than in Spain. In April 2004 total outstanding jumbo pfandbriefe, maturing one year or longer, stood at €313bn, down 8.5% from its level two years earlier within the the iBoxx index. In contrast, other collateralised debt soared from €18bn in 2002 to €93bn by 2004.
With the loss of Germany's specialist banking principle coming into effect on July 19 with the new Pfandbrief Act, the sector is once again set for sweeping change. The single law replaces three former laws governing the public sector, mortgage banks and ship banks, and was catalysed by the loss of Landesbank guarantees.
Legal changes mean banks will no longer be limited in their scope of business – eligible collateral will be expanded to the US, Canada and Japan. Transparency will be significantly enhanced, so bringing the public and mortgage sector on to a level playing field.