IFR: liquidity is a perennial subject, but as the market grows and attracts an increasingly international investor base, perhaps it is something that periodically needs to be looked at again. What is the definition of liquidity? And should the market be looking at a greater level of integrity?
Louis Hagen (VDP): Well, the minimum standards for a jumbo pfandbrief have been amended and brought up to €1bn. I think that really defines what both the issuers and market-makers think. And all the other minimum standards, like the market-making commitment, are what everybody agrees can be done to improve liquidity.
Christian Reusch (HVB): A €3bn transaction can be as liquid as a €1bn transaction, to start with. So, first, size really does not matter in terms of liquidity. An issue that has been in the market for a long time will not see much turnover, and if someone tries to buy €50m or €100m it can be easily squeezed. Despite that, bonds can be increased, allowing liquidity to be brought back into the transaction.
There are other special factors. I'm thinking of the cessation of Landesbank issuance with state guarantees. In this case there has been a change of circumstance which makes it impossible to tap certain bonds.
Except for these special circumstances, liquidity can be provided, and as we have seen in the secondary market, issues which had been squeezed have come back a little, which helps calm the situation.
IFR: But still, the market-making commitment is onerous for some, and perhaps the fees are insufficient compensation for this. Shouldn't participants agree to higher standards that more clearly define when the market-making commitment no longer needs to be observed?
Christoph Anhamm (ABN AMRO): I very much share this view. At the moment, there's a problem when taking over the lead management or co-lead management of a bond, and committing yourself to market-making, which must be carried out over a long period.
The longer the dealers make a market, the greater likelihood of any squeezes. So far only around 20 issues have actually suspended market-making – probably forever – but that does not necessarily mean that all of the rest are liquid. We don't have a process in place where you can actually agree on a proper definition between market-makers and the issuer, without people being offended or annoyed. We have had situations where market-making was stopped and restarted – certain circumstances changed or the bond was tapped, or yields changed and investors took profits.
But the process of what defines liquidity has not really been established in a methodical way. The agreement is that market-making should continue as long as liquidity is sufficient, but what does sufficient quantitatively mean? There is no kind of forum or agreement that suits everybody.
Joerg Huber (LBBW): Also, liquidity came into the covered bond market right from the beginning, and market-making was introduced to give investors confidence. Now the problem with market-making and liquidity is no longer of such concern to investors. There is a point where a transaction becomes so expensive that investors do care about it and then everybody would be happy to release some of the paper because it is needed in the market.
So dealing with this is a purely professional problem, and that is something which has been constantly discussed over the past few years. It costs money for investment banks to make a market when transactions get too tight, when they cannot get the paper to cover the short. And that is a problem that certainly has to be solved on a general basis – in the whole covered bond world.
Reusch: But I hear the same story all the time – you get the impression that out of maybe 400 to 600 outstanding bonds there is always a problem of liquidity. This is not true. We are talking about a few specific situations that are related to special circumstances, as mentioned earlier.
The question is what really is liquidity? One market-maker thinks it only exists if you see a price on EuroCredit MTS, for example, which I think is ridiculous. MTS is B2B; we are not dealing with customers. I think it was unquestioned that even if we had suspended market-making among professionals, an investor always got a price. You can always get a bid on that bond – a bid was always there for investors.
Anhamm: A bid shouldn't be the only parameter to justify whether a bond is liquid or not.
Reusch: If you want to get out, it is the only parameter.
Anhamm: At the same time, you can get a bid on almost every bond that has ever been issued in the industry over the last 20 years – apart from an occasion when a particular issue may have suffered from a very serious event.
We're going out with this jumbo concept and liquidity approach and telling investors this is really a liquid product. We can even compare it to state bonds, yet we have to admit that liquidity is actually a more complicated matter than just simply saying 'the bid' is the only parameter that defines liquidity.
Liquidity could be defined by a certain volume that is tradable without affecting the spread more than ‘X’ basis points. We have tried to measure that, and the results are quite frightening. What we found is that something like 30% of the market consists of bonds that would move by more than 2bp if you traded in a size of €30m to €45m.
Reusch: If an investor wants to get out, he can get out, which is true for every bond. But at least with a jumbo, I have never experienced an occasion when an investor was unhappy when he wanted to get out – even if bonds have been suspended from market-making. Pfandbrief have been a success from the beginning, and liquidity was part of the story – and it still is.
Franz-Josef Kaufmann (Eurohypo): We have the linkage between liquidity and market-making – we do not want to split it into two divisions. From this perspective, I think it is very important for investment banks to be committed to the product in the way they have been – on one side investors, and on the other side issuers. Liquidity is the connector between both, and the investment bank is a connector between both client sides.
We have seen in the past how investment banks have stepped out of market-making. It is clear that market-making requires a strong commitment to the product line. The way you define liquidity does not necessarily mean just quoting in good times, it also means quoting in stressful situations as well.
We have seen a bit of stress in the last weeks but I cannot say that we have seen illiquidity, as such.
IFR: Is it time for a rethink in terms of the inter-bank market-making commitment – especially for large tickets?
Reusch: No, there is no problem.
Anhamm: There is one problem. What we have discussed so far is only an occasion when an investor wants to sell. What we actually depend on is whether an investor is able to buy and sell.
Ted Lord (Barclays Capital): Liquidity is also about ensuring comfort with investors and getting the right image across. And when people hear, ‘they do not really have a liquid market-making agreement,’ it could put newcomers off. Therefore, this is really the case for a more frequent discussion among market-makers. If things start to look tight on a certain bond, try and sort out an agreement. Because it does ultimately come back to how much real activity there will be from investors.
Hagen: I agree that what harms the market more are these discussions – it is not so much liquidity. And if I might remind you, about four years ago we had fierce discussions about liquidity and market-making. At that time, some market-makers were being squeezed, so we met in Stuttgart and tried to sort out the problem, yet the issuers had a very clear opinion of what they wanted but the market-makers would not agree. We decided that the way forward was for market-makers to meet regularly and talk about the situation.
Reusch: IFR recently wrote an article about a 'German cabal', which was quite funny because if you want to be in that market, you have to be committed. Commitment means offering a full service for your issuers and investors – with all the consequences. And the consequences, of course, also include market-making.
IFR: We heard a couple of years ago that a particular bank went out and promised everyone it was making markets, only to then hide in the coffee room – or something to that effect!
Reusch: This is still the case – and that is a problem. If you are committed then you must provide market-making according to the rules you have signed. There are enough banks that provide that service. And if some new kids on the block think, ‘OK, we promised something and then if it gets a little bit ugly, say, 'OK, sorry, we're out for lunch', or 'we're on the phone' or 'unfortunately MTS does not work,’ then they're not behaving in the spirit of the market-making commitment.
Anhamm: This discussion of liquidity is not a question of commitment. I think this has to be very, very clear . . .
Reusch: . . . attitude. Probably it is an attitude.
Anhamm: I would not even say that. We have one system, we treat all bonds the same. What we also admit is that we have a decent amount of buy-and-hold investors. But at the same time, we have an increasing number of investors who frequently trade in and out. Those are the ones that complain about market-making. They say, ‘Yes, it is true, we need something to more formally cease market-making [in a particular issue], we need a process to more formally announce taps and so forth in the future.’
Reusch: The easy thing would be to call all the others or call the issuer and talk about how we can solve the problem. What we found out was that in several calls this year, half the guys thought there was a problem, the other half didn't. People should talk more intensely to each other.
IFR: Do we need to raise the threshold? Obviously the covered bond sector needs to reach out to new investors, and in that process cannot just rely on buy-and-hold accounts. A liquid market must surely be on a par with the agency and sovereign sector. Does the present market-making commitment come up to those standards?
Frank Will (RBS): I think liquidity is just one side of the coin. The other side is when a bond has performed well for a couple of months, then some of the market-makers have said, ‘OK, this is squeezed’. And if you talk to investors, sometimes they are happy with that, as they have had the benefit of strong performance.
If issuers are willing to tap it, then they are the losers [from a spread-tightening point of view], so on one side you have liquidity, and on the other side you may have spread-widening as soon as you tap a bond.
Kaufmann: From an issuer's perspective, I think investment bankers and market-makers should be aware that, at Eurohypo, we follow our bonds and look closely at the spread and how they are trading. We do not want to have a bond trading off-market.
If a bond is getting short, then you see the price increasing. That is the time when the issuer tries to get in contact with his lead managers – to ask what is driving the bond, whether it should be tapped and what would be the impact of a tap. And then sometimes the pressure goes out of the bond. Again, it is something that the managers should be aware of – issuers focus very much on liquidity and have a strong interest in bonds that trade at a fair price.
Here I think the actual guidelines for marketing should be considered as the minimum standards for the market. And each issuer can decide whether he sticks to the minimum standards, or whether to offer more to the market. For example, we say, 'If you do a benchmark issue then we will come in a size of €2bn.’ In this way we are showing that we are willing to go to a higher level to ensure liquidity – and hopefully give a higher degree of liquidity to our issues.
Lord: Interestingly, I noticed an increasing number of investors have a minimum requirement now, €2bn.
Anhamm: Exactly.
Lord: That is a parallel that has been going up.
Kaufmann: It is the minimum, a starting basis.
Reusch: Market-making has at least two parties, the issuer and the market-makers. If an issuer recognises that one or other market-maker is probably not doing his job properly, he can find ways to get him to work – or to stop working with him together. I think the market will regulate things on its own – and it has.
IFR: Do you really think the market can regulate itself as it has done in the past? Or does there need to be a more formal association to bring market-makers and analysts together?
Huber: I think the market has so far regulated itself quite well in the interests of investors. And even in those cases where you have about 30% of the transactions that might move quite a few basis points when they see €40m to €50m tickets, they trade on levels which no longer represent fair value. So when a transaction trades at minus 4bp–5bp when other bonds are more in the flat area, you can definitely say, ‘This bond is very, very expensive.’ And you can either just sell off your bonds or be happy with it. On the other hand, I guess there are many more investors who have this criterion that there has to be market-making, rather than that the transaction should be of a €1.5bn or €2bn size.
Anhamm: At the same time, if we did not have €2bn bonds, those investors would simply be out of the market. I would guess that 30% of investors have this €2bn threshold requirement.
Huber: That I doubt.
Anhamm: 50% of the market is €2bn or more.
Reusch: Well, the average of the whole market is €1.65bn. If we go into different segments, there are markets where we have seen larger points or where we have a larger average volume - like in Spain or Ireland, for example. But, for instance, in Ireland we are talking about two, at most three active issuers.
I think there are investors who need a minimum size, I will agree with you. But on the other hand, some of those investors also look very carefully at some of the smaller issues. Just look at the €1bn Sampo transaction which was so heavily oversubscribed. There were undoubtedly investors involved [in the issue] who said, ‘I would like to have a €2bn bond’. Why [did they participate]? Because they saw it as an attractive instrument, or an attractive diversification in terms of assets.
You might also see good performance from rare issuers.
Will: I think the point is really that ‘jumbo’ is the minimum standard. As an investor, if you are just keen to get the big ones, you can still buy it for €2bn or €3bn. But if you would like to have smaller issuers, something like that, they definitely need at least €1bn.
So I think it makes sense to have some sort of minimum agreement for what defines a jumbo. Still, if you say, ‘OK, we are targeting this big investor base and we will really focus on the €2bn and €3bn,’ you can still issue €2bn or €3bn. But to raise the minimum standard to even €1.5bn would be very difficult for a lot of banks to really focus on.
Hagen: From the issuers that we represent in the VDP, there would not be any agreement on raising the threshold to €2bn. You will no longer have diversification. The market is also interesting because you have some small issuers that are rarely in the market, but they are not able to issue a €2bn pfandbrief.
Reusch: We had €5bn transactions some years ago, which were probably not the most glorious transactions for several reasons. Timing was often poor, the home market was not in very good shape, and all parties involved thought, 'OK, even €5bn can be sold easily’. We found that was not the case.
Anhamm: I don't think we are that far away from each other. I agree that it is quite easy to sell smaller-sized bonds. What we have to admit is there are two different sorts of investors: the large frequent, huge portfolios that only care about diversification. They are very keen on any new segment, any new market, country, legislation, and are happy to buy even €250m. And there are others who are less frequent, and it is a smaller part of their portfolio. They really rely very heavily on liquidity – and they have the €2bn threshold.
So the market actually is characterised by these two segments. We just need to make sure that each segment is addressed properly.
Reusch: And I think they are.
IFR: How can pfandbrief reach out to new investors?
Lord: First, get out and meet these investors. One thing that I found fascinating is that outside a small group of pfandbrief issuers, some of these smaller issuers were really questioning, ‘What is the point? The German market has been very, very good in supplying our financing needs.’
I think that that is starting to change in a positive way. More and more non-German covered bond issuers have come into the market, and they immediately make a beeline for Germany to try to get some interest from one of the largest investor markets in covered bonds.
I am a big fan of issuing in dollars. I think you can really get the audience a lot more interested more quickly. Then why is the American market so hard to crack? Get out there, adjust your style to your audience, and possibly do some more of the currencies that they are used to.
IFR: Franz-Josef, as an issuer, what would you be saying to other issuers trying to do that? And not necessarily only in the US?
Kaufmann: First of all, issuers have so far been issuing mainly in euros. The community has been very successful in Asia because of the huge reserves. They are looking more and more at investment alternatives, and that has worked very well.
But we might at some point have to take capital out in US dollars and then probably from the US market – either Tier 2 or even better, Tier 1 capital. If you have assets in US dollars, you not only need to fund the assets at some point, you need to raise capital in dollars to get some natural hedge in your capital position, your capital ratio. And with that wider range of products, you can be very successful in getting new investors and acquiring a bigger footprint in the US market.
There is a lot of work that has to be done with each investor. When you bring a less attractive product in spread terms, a Triple A rated low margin pfandbrief in euros is a rather difficult way! If you come with a product that is of interest and is supported by portfolio management – for example where they see substantial spread performance – then they run through and push the process, introducing your name and the project.
Lord: But the mood has changed. A lot of fund managers have outperformed their peers by investing in foreign bonds - whether it is in US dollars or in euros. So that is really different to even a couple of years ago.
Will: That is one important step. But also, if you talk about Asia, for example, you have two types of investors. One is very sophisticated, they know the products, they know pfandbriefe, they know the sellers, so no problem there. But on the other side, you have investors – maybe small insurance companies, small fund managers – where there is still a big need for education. You need to explain the product, the big advantage of the pfandbrief, the big advantages of covered bonds.
I think the issuers and the investment banks still have a lot of work to do – groundwork and maybe workshops.
IFR: In some instances, by introducing their own covered bond legislation, a country's investors are going to become interested in other jurisdictions. But obviously the VDP has been over to the States on quite a few occasions. What is your experience of it?
Hagen: Well, we're finding it harder and harder to convince our member banks to go through this process now, to host conferences in New York. They say, ‘We can very easily sell pfandbriefe in Europe, we can easily sell in Asia. So why should we invest a lot of money in trying to sell into the US? If they get interested, they will ask us. And then we will be there.’
I have the same feeling, unfortunately, from the investment banks, that they are not so keen in really taking this grassroots approach. They say, ‘Why should we do that? It's a lot of work and what is the outcome?’ So if we really want to do something, I think the issuers and the intermediaries need a strong commitment. Certainly, as Franz-Josef said, dollar issuance would certainly help. But a euro-denominated bond is always very difficult, especially if it is of such a relatively low margin.
So unfortunately, I must say that our experience over recent years has not been positive. When it comes to education, well, I have just learned now that we might have taken the wrong approach!
IFR: Surely reaching out to new investors does improve the performance of those bonds? Or again, is the effort involved in breaking into those areas not really worth that development?
Hagen: Well, I am not an issuer, I am only a lobbyist for them. But I would say that broadening the investor base – and, well, tapping the world's biggest financial market – certainly makes sense and would bring funding costs down even more.
Huber: There is also a cost question. When you talk specifically about US investors, a jumbo pfandbrief is certainly a low margin product. That means when you have to market it very heavily there, and you have to pay all kinds of documentation costs to place paper directly with these kind of investors. One really has to have either a dollar programme where there are assets, where there are natural funding needs, or there has to be at least substantial placement over there which gives you some cheaper funding opportunities in the long run.
So I think, overall, the whole exercise when it comes to US placement is a very thin margin affair. Therefore we have not seen a lot of banks doing it and going across into the US market. The ones which did so quite often failed. And so the question comes up again and again, does it make sense?
On the other hand, if you really have the ability and you want to spend a lot of marketing time etc, with investors, it is certainly much more appropriate to go for small to medium-sized bonds, because there are still quite a lot of investors who have not got involved yet, who are considering it. And by doing that, you can reach much more accounts.
IFR: In Europe, you are talking about?
Huber: In Europe, and also thinking about the Eastern European countries which at some point in time will switch to the euro. So if you start education in the US, which might take you some time for them to get on board, why not do it now in areas . . .
IFR: . . .on your doorstep, where they understand the product, and it's easier to sell to?
Huber: Well, they do not understand the product yet, but it would certainly be an easier approach because they would have the same currency at some point in time. So you prepare these investors for the future.
Reusch: We had a funny experience doing a roadshow in Germany with some small to medium-sized accounts. One issuer marketed to his home town, which he hadn't done for a very long time, and was very surprised that a) investors did buy and (b) as he discovered later on, one lived just 1 kilometre from his head office.
So I think going abroad is a good thing and should be done. Going to the US is worthwhile, but only for those issuers who have enough funding volume, because I think there are a lot of issuers for which it would never make any kind of sense. If you have to do one or two benchmarks a year, I'd say it does not make any kind of sense to go there. But if you have €20bn to €25bn total funding needs, like Eurohypo or others, then I would say, yes, this is something which is for the future and has to be done in an appropriate manner.
And be prepared for the different attitudes, or traditions, these investors have. You should be prepared to win over the person sitting opposite you.
It is a sale – nothing more and nothing less. And I think the banks accompanying the issuers going out to these investors should also do their job in a proper manner. This is part of the job – not only getting the mandate, not only placing the paper, but also doing the proper preparation. This is very important for all sides.
Lord: I support staying power. I tend to like the American market because it is a big market and I think it is worth developing for not only big issuers, but those that could become big later on. But it is a market where people need to stay persistent.
Anhamm: One of the things is to help other jurisdictions to build on the covered bond framework. Be it a structure, a framework, be it the understanding, whatever. What we identified is that any time you have a country joining the market as an issuer, or banks are joining the market as issuers of covered bonds, the demand of the same country for covered bonds exceeds the total issuance of the same country by two to three times for the first two to three years. That demand increases tremendously once you have convinced the investors or issuers of one country to inaugurate their own market.
Because all of a sudden, investors of that home country are forced to understand the principles. And they say, ‘It is not only Italy or Spain or France or Ireland or the UK; there are also other products around which might be even more attractive or which might have other benefits or whatever.’ And this has actually happened a lot.
Hagen: Yes, I completely agree with you, that works in Europe. We thought about that for the US, and came to the conclusion, well, it is ridiculous. Why should we try to convince the Americans that they need pfandbriefe?
Lord: Some of us are still doing that!
Hagen: But that is something that has to come from the US financial market.
Reusch: This material change has to happen in the home market itself.
Hagen: Exactly.
Anhamm: I think it is an education process as well. We have to go there and tell them of the benefits they would gain when picking up the covered bond product. The experience we have – not particularly the US individually or solely, but in general – is that whenever we go somewhere and explain the concept, it is quite funny. People had not actually realised before that this concept existed and how the mechanisms work.
Reusch: But this experience remains mostly in Europe.
Anhamm: No, I disagree.
Huber: Well, I can imagine you also do it in the US. But I can also imagine you can go there, explain it and there is this ‘Ah-ha!’ effect. And six months later, you go there and people have forgotten about it. There are so many different kinds of products that they do not remember. So six months later, you have to start again. From that perspective, you have to hammer it in over two years. You start to get a groundswell of knowledge with investors who are prepared to look at the programme.
Will: Could it also be a chicken and egg problem? Because US investors like to see US dollars.
Reusch: We have seen issuers – even big ones such as DEPFA, which has a very long tradition of marketing the pfandbrief product and its own name – tackling the US market with specific US currency trades, trying to build up a curve there and trying to get US investment banks and underwriters because they know the customer base. For whatever reason, it failed.
Will: The problem convincing US investors is, firstly, whether the market is liquid. OK, there are some US bonds outstanding, but they are not really liquid. But we can convince newer investors if bonds are liquid. But how would you convince a US investor to buy a US dollar pfandbrief?
Reusch: I agree with you. You are competing with US agencies and issuers that are more liquid, more common, and are Triple A rated as well. So I would say it's probably not a wrong thing to do, but we have a long way to go. And it will be a tough sell, even if you do it very consistently and even if you do it consistently in dollars.
IFR: In opening up new jurisdictions and thereby spurring demand, is this not a kind of Trojan Horse to penetrate the US market? Are US issuers actually looking at structured covered bonds?
Lord: There is talk that maybe the system can be changed. And I still go back to the point, that some of these markets really are rewarding but they take time. And just as you have a market that you can tap and utilise, at some point certain investors may not be so active in covered bonds or certain markets may change, and it is nice to have something coming up along the way.
Hagen: Maybe the fact that more and more European countries are entering the covered bond world will make it more attractive for the US market because they will see the pfandbrief not just as this very curious German animal but also in the UK, Ireland and all over Europe.
Lord: Yes, not directly related to the pfandbrief. We have talked about the Sampo deal. What I found interesting was as soon as the news came out that a deal could be bookbuilt and oversubscribed so rapidly, I received 12 enquiries from the North American market – ‘Can I learn a little bit more about this?’ That is what I mean.
IFR: Ted, do you want to make a proprietary forecast, when you can break into the US market?
Lord: I am the eternal optimist. I think it is going to happen a lot faster than people expect, but I do not want to give a date or anything specific.
IFR: Next year?
Lord: I think it could, yes.
Anhamm: I would not exclude that.
Lord: I think it is the old theory – it is the thinking that breeds the results.
IFR: Regarding collateral pools, are investors happy with the increasing degree of foreign exposure that German banks are undertaking, and are they equipped to survive a crisis?
Hagen: In general, the more diversification you have in your collateral pools, the better, because if one country goes down, others may go up. It is seen as very positive by investors and the rating agencies. We have really seen in the last few years that for the public sector, the banks get the chance to diversify into other markets and do foreign business, which is very profitable for the bank.
The pfandbrief itself has the collateral pool as security. But it is even better if the issuer is highly creditworthy, so I would say that diversification is certainly something good. Of course it needs, in our opinion, to have some strict guidelines – investors should know what these banks are doing.
Are they equipped to survive a crisis? Well, yes they are, because they have to adopt very strict and conservative evaluation procedures. And after taking this conservative value, only 60% of that goes into the cover pool. So there are lots of layers . . . safeguards. And so I really think it is very positive to open the US, Canadian and Japanese markets as eligible assets for pfandbrief banks.
IFR: As a result of the change in the law, transparency has been tightened up. Now we are seeing a lot more collateral monitoring.
Reusch: Over the past few years, people have been providing more detailed and regularly updated versions of their pools. Now the law says you have to do it, but most issuers had already committed to the higher standards before the law came into place. If you want to sell your product, you must be transparent.
IFR: Frank, do you feel that the new laws are providing the right degree of transparency, and are there enough layers and safeguards?
Will: Yes, I think transparency has seen a big improvement. But on the other side, if we take a look at exposure to Central and Eastern Europe, it is still increasing rapidly. As an investor you would get all the data you need, so you can take a closer look and make your decision on a case-by-case basis.
It is possible to have a collateral pool that has 9% combined exposure to the US, Japan, Canada and maybe some exposure to Central and Eastern Europe where it is not clear if there is a priority claim. Then there could be a further 10% of the pool that are bank loans. So in this case, investors would need to take a closer look, checking each issuer's pool on a case-by-case basis.
Huber: From the investor perspective, you can now diversify a portfolio, which makes it less risky – and this will be to the benefit of investors. But in addition, you now have the possibility, as was already mentioned, to go into areas that have higher margins, so raising profitability to the benefit of investors.
IFR: With spreads having compressed, banks would be expected to chase the higher yielding collateral, though this is more risky, is it not?
Anhamm: Well, I think one thing is clear; diversification is good from an issuer's point of view. From a disclosure point of view, it is also clear that there is an increasing focus on the underlying assets of the collateral. So if we have better disclosure requirements or more intense requirements, it is certainly to the benefit of investors – they are now in a better position to identify the risks. At the same time, however, I was quite surprised to hear from North European investors that they dislike diversification in portfolios, as this is done by issuers rather than by themselves. Investors want to make the portfolio allocations rather than have a portfolio diversified by the intentions and ideas of the issuer.
They say, 'We as investors think that we can do a better job at diversification. It is our job to diversify, it is the bank's job to do the business'. Some investors have a national preference, and say: 'The problem with the Germans is, while I like the product very much, I get a portfolio which for my tastes is too diversified. I prefer those in Germany which have a very clear domestic focus'. It is not a majority of investors who are saying this but it is still an aspect to bear in mind.
Hagen: With a Spanish product, they say it is purely Spanish mortgages.
Anhamm: That is one of the reasons why that kind of people like it so much.
Reusch: I agree. There are some investors who say, 'OK, I'll buy one that just has Spanish or Finnish mortgages'. OK, then you buy purely Finland or purely Spain. Fine, but then you could have a collateral pool containing only Triple A assets, but that does not protect you from any kind of failures.
Will: Investors do not really care what is behind it, as long as it is of good asset quality and has stable ratings. The big problem is if you end up with an asset limit and then there is some terrible event elsewhere.
Anhamm: That is actually the risk these investors want to take. They say, 'I know better than the issuers. When Germany is going into a slump, then I want to sell at that time.'
Lord: Yes, but what about the poor guy that has got only German risk and it slumps?
Reusch: From what we have seen over the past 12 months, some investors have said: OK, now we would like to invest in Germany. We have seen a lot of non-performing loans being sold to US investors in large blocks, so basically they have the right to choose.
Kaufmann: I think there are very few investors who want to do all the portfolio management and decide on the mix. It's more a question of how to define the portfolio. And on the other side, there is value in diversification. Here the law is pretty clear; it says you need to have decent experience of doing business in that region.
You must also bear in mind that this is a Triple A product, and to sustain that credit rating the rating agencies maintain a close scrutiny of the pool. They are immediately there, raising concerns if something happens. If you have over-exposure that they are not happy with, they will ask for more over-collateralisation. Issuers don't like to over-collateralise too much – so they are mindful of what the agencies will think. So in this way we have a mechanism in place that ensures diversification is used in a way that strengthens the portfolio.
Reusch: The law just sets the parameters. Every company has to find its own way to work within the parameters.
Will: I think it is good that the rules on portfolio diversification are flexible. It means the issuer can take advantage and diversify if it wants to – or not, as the case may be. It is up to the investor to decide which borrower's collateral portfolio it wants exposure to.
Hagen: I think it depends very much on the business model of the issuer. We have issuers that do not lend internationally and they are also Triple A rated, and investors love it because they have other kinds of diversification within Germany. Germany is huge – you have the housing market, the commercial mortgage market and so on, there are lots of possibilities to diversify even within Germany. Rating agencies do not only look at international diversification.
The mortgage banks only started to do business abroad in 1988. And at that time, everybody said: 'Don't do that. You will run into problems'. The banks have been very prudent, they wanted to get to know the market and gain experience. The loan default rates are extremely low – much lower than in German mortgage loans. And you must also know the regulator is vigilant, especially when these banks do business abroad.
Lord: I would like to support Louis here. What we are seeing is that if people have a business line and if they go to pan-European commercial lending, that is considered good. But if they are putting themselves into too many different businesses, then the question could arise as to whether they are a 'jack of all trades but master of none'.
It is a very diverse investor market. The tendency is that diversification leads investors to look more closely at the borrower's business strategy. If they feel comfortable that an issuer can continue to make money and has strong competence in that field, then they are happy to buy.
IFR: Louis, why is it that RMBS is not allowed in the pfandbrief collateral pool within Germany?
Hagen: Well, when we had the change of law there was also a discussion within the association as to whether we should ask for the eligibility of mortgage backed securities or RMBS. We had this discussion with the regulator years ago and we decided that we should not. One of the reasons was because we felt pfandbriefe should not be a 'fund of funds' – they should represent the business you do, the actual loans granted.
The second reason is that that we wanted to keep the product clear. With mortgage pfandbrief, the bank goes through the underwriting procedure and checks everything. They do not depend on rating agencies, it's their own perception of the loan.
Thirdly we looked at quality – you can't argue that RMBS are Triple A. But we think it's up to investors to decide. The question is: why doesn't a Triple A RMBS trade at the same price as a Triple A pfandbrief? We thought that investors would feel misled. If they buy a pfandbrief, they want a pfandbrief – and not a mortgage backed security in disguise. Although, of course, taking mortgage backed securities as collateral would be a very nice business line for a while, it would probably level out.
So those are the reasons we decided not to ask for the eligibility of mortgage backed securities as collateral. And also, I must say, it would have been very hard to convince the regulator and the legislator that we should include them as eligible collateral.
IFR: What were their objections?
Hagen: First, the Triple A eligibility criteria; we would not accept that. For mortgage pfandbrief, we have the mortgage lending value, and we have the risk assessment by the bank. We have all these mechanisms which make certain that these loans are very safe. We do not want to rely on an external assessment. What happens if the Triple A goes down to Double A? It would bring the rating agencies into a position that they really decide . . .
IFR: . . . then they become the regulators?
Hagen: Yes, they become the regulators. So the regulator found it completely contradictory to the basic mechanism of the Pfandbrief Act, if the question of eligibility is a question of rating. That was therefore one of their main arguments. Then they said, 'What you need is to really assess the quality of each loan within the RMBS but the work you would have to do would not be worth it.
Huber: And you probably do not get the data anyway.
IFR: Is the transparency in RMBS collateral pools not quite good?
Hagen: Yes, but they use market values. They do not use the 60% value.
IFR: Right, so you have got none of these safeguards?
Hagen: They have different mechanisms to reach Triple A. It can be insurance, it can be lots of different protections.
Lord: I am actually a fan of it. The issues that I have faced are if you have too much RMBS, then does the covered bond seem to be an arbitrage vehicle between the RMBS market or the plain vanilla variety?
But my experience with a couple of investors is that they had started out investing in German pfandbrief, and then there was that period of credit changes and downgradings in the German market. They actually withdrew and went into covered bonds that had portions of RMBS as they found such collateral was a lot safer. So what we saw was that RMBS within the pool actually kept these investors interested in covered bonds.
Hagen: Maybe that was more because they no longer felt very comfortable with German issuers. At the end of 2002 and beginning of 2003 the German banking sector had a very difficult time. There were lots of investors who left because they did not want exposure to German banks. But if we look at spreads from 2001 to 2005, the spread-widening for pfandbriefe in general was maybe up to 12bp.
Anhamm: More.
Hagen: I'm taking the average. But the pfandbrief market really stayed pretty stable if you compare it, for example, to what a Single A bank had to pay during that period.
Lord: We asked the same question, and they said that the RMBS was an extra safeguard, already on safeguards. It was not simply a credit issue of the sector. That was interesting.
Anhamm: There is hardly any issuer that has more than 10% RMBS – there's only one that I am aware of.
Huber: You also have to be aware that it does not mean that one bank is going out in the market and buying RMBS. That is the big difference. The covered bond banks who are issuing their covered bonds with RMBS in the pool, in their holding structures, are originating them themselves. They won't buy them from anyone else in the market.
Hagen: In keeping with this idea, we decided not to allow other pfandbriefe in the collateral pool.
Kaufmann: On the other hand, including RMBS in the pool could compromise our discussions regarding penetration into the US market and make it that much more difficult.
Anhamm: I agree with you. As long as the proportion of RMBS in the pool is not exaggerated, provided it is relatively limited, then it's OK. On the other hand, if there is too much then you end up in a situation where investors say, 'I've got to dig deeper,' which they don't want. Investors must be convinced it is of high quality and beyond doubt.
Will: What about RMBS where the underlying assets would qualify for the strict eligible asset requirements of the Pfandbrief Act? If you include this kind of RMBS you wouldn't necessarily dilute the quality of the pool. If this were allowed, as is the case in Spain, it would be easier to pool the loans. The German savings banks, for example, have mortgage loans of almost €300bn – and it would be great if we could pool these loans and issue pfandbriefe against them.
Why make it complicated? If they qualify for the standards, why not?
Reusch: I think the German model is very easy. We have a very good solution that clarifies the priority claim of real estate held in fiduciary. I think the Spanish model is completely different. Their pooling model is a different kind of structure as they issue as a fund, nothing else; a special purpose vehicle.
IFR: Is it possible you could see the wider German economy picking up and reform helping to stimulate the housing market? What would it take to improve the situation?
Hagen: Confidence. What you need is confidence.
Anhamm: That is almost a topic for a separate roundtable! You could possibly say at the end of the day there are three different elements driving house prices; a) economic growth and the unemployment level, b) the supply available in terms of land and space to build on, and c), the linkage to taxation and subsidies.
Hagen: The fourth is the German mentality. In the UK an average householder buys and sells in the region of five to six different houses during his lifetime but in Germany it is once, if at all. You also have to compare the German situation to Spain with regard to house prices and how high interest rates were before the euro was introduced.
House prices in Germany have always been at a very high level. In Spain they were very low, but with the introduction of the euro, rates fell, so of course that really pushed a lot of money into the market – which was not the case so much in Germany, since house prices were already high and interest rates low.
Will: Renting in Germany is relatively cheap compared to the UK. So in the UK, there is a strong incentive for people to buy a house or a flat as soon as possible, because at the end of it you do not have to pay much more for your mortgage. But in Germany, it is totally different. If you get a mortgage, even at this low interest level, you have to pay more – it's double what you would pay for renting.
IFR: How is it that mortgage banks and savings banks had a 45% share of the residential mortgage market by the end of June ‘05, yet they did not have the ability to issue?
Hagen: They had it, but they did not know it.
Anhamm: Well, OK, that is too complicated for now. At least they did not use it. We've now come to a situation where we're seeing a change in banking structure. How will the new legislation actually affect them? Does the law affect competition or the comparability of mortgage banks, of the old mortgage banks?
IFR: Obviously the landscape is going to become more competitive?
Hagen: It cannot be more competitive than it is already.
Reusch: The margins in this market are so low that there're almost zero. And there is more competition on the way, with some of the direct banks.
Hagen: I would say the new Pfandbrief Act and the opening of the market to new issuers does not affect the mortgage lending side; it affects the funding side. I think we will see more mortgage pfandbriefe in the future, since some banks that have not used them in the past will use them now. And lots of mortgage loans will now be flowing into mortgage pfandbrief – whereas indirectly they went into public pfandbriefe in the past.
Home ownership is not so relevant, because if homes or apartments are owned either by an individual or by a company, it does not make any difference – it still has to be financed.
IFR: In what way will we expect to see Landesbanks change their business models?
Huber: Landesbanks will lose their state guarantee and access to cheap funding.
When it comes to the pfandbrief law, there are not a lot that are really using it to change their business model. We certainly do when it comes to pfandbrief issuance, but LBBW is a bit of a special animal in this case because we have our own retail network. We have about 200 branches, which generate mortgage lending.
But in addition, we have also developed this system where we can use the new law on fiduciary holdings that gives savings banks an opportunity to use us as a refinancing counterpart for their mortgages.
And that also means in the future we will not issue as many big public sector backed covered bonds, but go more to mortgage covered bonds. In the past, you could use saving banks paper as well as Landesbank paper as collateral. That could be used by Landesbanks and mortgage banks but this is not the case any more. So a lot of assets are now missing – so this will certainly reduce the amount of public sector backed issuance.
Will: If you take a look at the Landesbank volume in 2004, it was something like €200bn unsecured. Most of these assets went to the German mortgage banks as they were eligible assets for public sector pfandbrief.
Going forward, I think it will be very difficult to replace these assets. They can go to Eastern Europe, but even there you have a lot of competition and spreads are tightening as a result.
I think most Landesbanks, or former Landesbanks, will increasingly use pfandbriefe to fund themselves. They are pre-funded for perhaps three to five years, so it's unlikely they will use the unsecured market. But most will become very big players in the [mortgage backed] pfandbrief market.
IFR: Do you think investors might demand a premium for mortgage pfandbrief where the collateral has been pledged under the fiduciary holdings?
Reusch: The only change is that Landesbanks have formally changed, but nothing material in terms of the collateral pool or the rating.
Huber: Investors, though, will look at the quality of the issuer itself because there is already a difference in their ratings.
Kaufmann: I think we have a level playing field and everyone has the same basis for issuance. However, it's clear there are as many prices as there are issues, so there will always be differences. Much depends on how the issuer positions itself. But by definition, I think there is no reason to have a different price for pfandbrief issued by, let us say, a former mortgage bank, by a universal bank or some other bank.
Reusch: It could be different; we could have one single issue with everybody pooling their assets into that – like one big shot doing everything, coming every month with a huge benchmark transaction. But at present you have to differentiate your credit, but everyone is coming from the same starting point, at least from a legal point of view.
Will: Yes, I think the cover pool will be the key focus. However, that's not to say that there could be problems going forward. Landesbanks are very well pre-funded, but it is possible they may not be so profitable in the absence of state guarantees.
For the time being, though, Landesbanks are still in a very good position and still benefit from the positive view of Moody's. I think it is really questionable whether that view is justified, but at the moment they are in a good position and should remain so for the next four or five years.
IFR: Do we think the rating view from Moody's is justified?
Anhamm: Landesbanks are still predominantly held by public sector entities - savings banks, that sort of thing. It might well be that once there is a more intense discussion about future ownership of these banks, it could cause uncertainty, which would not help if an issuer was coming to the market with a new bond. But, at the same time, we have seen AHBR issue despite its low unsecured rating, and the impact on its covered bond funding has so far proved minimal. So it's quite speculative as to how matters might turn out.
Reusch: the market will regulate itself. Investors can differentiate, they can analyse whether a premium is valid or not. Not every pfandbrief has the same rating, collateral pool or trades at the same level – otherwise we would have one single issuer. The market will differentiate in terms of price, and investors can make up their own minds as to whether the credit is a worthwhile investment or not.
Will: We have to come up with convincing credit scoring.
Hagen: I think we have achieved what the mortgage banks wished; they wanted to prevent a two-tier market. Of course there are price differences, but in general it’s a now level playing field.
IFR: Are there any joint efforts by pfandbrief issuers to keep the pfandbrief in the champions league of covered bonds?
Hagen: The VDP will continue to try and achieve what they have done in the past for all pfandbrief issuers.
Reusch: The Landesbanks will probably join the VDP.
IFR: Louis, is there anyone else out there apart from yourself?
Hagen: Well, that is at least our assessment! There might be others who think that they can do the job or who simply think there is no need for an association, but I think everyone around the table knows this story – the pfandbrief's success did not come about without the commitment of issuers. There are some out there who think that they could maybe do the same as we did. But I say you need to develop and build expertise, you need to reach a relatively high level of sophistication, of knowledge and know-how about the product's market – and this needs time. You cannot do all this in one day.
So in the interests of economic efficiency, pfandbrief issuers in all parts of the industry should think about joining the effort to be part of one association.
In the final analysis, this would be something very positive for the German market as a whole. Banks from each sector of the industry could say, 'We all have a common interest, we want the lowest possible funding via pfandbrief issuance, so why not join forces and develop this product further?'
And I guess that in the end this will prevail, because this idea, in my opinion, is very logical.
Huber: In addition, I think the majority of German pfandbrief issuers are working on an individual basis. They are doing this through their issuing behaviour. The community has become very disciplined over the last few years – they listen to investors, they go on roadshows, they react to – and work with – the market and they bring reasonably priced transactions.
Of course, everybody is under pressure to achieve fine pricing. But within that context, they behave very carefully. I believe that this is a factor which has brought the German pfandbrief into the champions league. In reality, it was there all the time, but now it's much more in focus. So I think the joint effort was certainly there from the VDP, but each individual investor has also contributed.
Reusch: And as we have seen, other markets – even some of the most aggressive issuers – have learned their lesson, and Germany experienced this in 2001–02. This was combined with other factors, but they learnt that lesson very early – it is more useful to listen to investors.
What we have seen clearly demonstrates that others have learned a lesson as well. If you would like to tap the market with large liquid benchmarks on a regular basis you cannot ignore your investor base, it will not pay off in the long run.
You can do it once or twice, probably a third time, but the fourth time you will be blacklisted, and then it's tough to get back.
Lord: One thing that I have really enjoyed seeing is the development of a mentality among pfandbrief issuers, that really pursuing an investor base abroad is actually a healthy and worthwhile thing to do. More and more issuers are seeing the benefits of doing that.
And I think this force of reason will prevail. We will have some hiccups along the way, I am sure, but more and more that a collective approach will emerge. I would also encourage the VDP to see that all these new covered bond jurisdictions are actually helping the pfandbrief.
Seriously, the potential for this market is just enormous, when you hear about what countries are looking at pursuing covered bonds. This is good for everyone and especially for Germany. Let's have more of it!
Kaufmann: I suppose we should keep in mind that the starting point for all this is the Pfandbrief Law which gives a strong platform for issuance of high-quality covered bonds. I think it is the responsibility of each issuer to maintain their behaviour in a way that helps us keep our leading position in this dynamic market.
Lord: This is a bit unrelated but along the same lines and is something which I found really fascinating. We had a covered bond conference in Warsaw where a lot of Polish bankers actually viewed the pfandbrief as a Polish product, given where the first one really started. But the point is that it is that attractive that there are still many regions likely to join.
Anhamm: Another important point is that we can actually market pfandbrief as the biggest and best reformed product that we have seen out of Germany. Where else in Germany have we seen a market or a product or a problem that has been addressed so quickly and effectively? The issuers, investors and what have you, saw the situation in 2001 and didn't have much hope for it. But these days it's practically the top star of the market. This is something to be proud of and should be marketed, whatever problems we have in Germany, and here at least is one shining example of reform that perhaps gives hope for the whole country.
Hagen: That is because we listened to you, the intermediaries.