Landesbank Baden-Württemberg has made something of a habit of setting new tight levels in the primary market, so much so that when it launched a Eu1.25bn four year public sector Pfandbrief in February 2007 at a new tight of 7.5bp through mid-swaps, the deal failed to generate much excitement.
But when LBBW priced a Eu1.5bn long five year public sector jumbo at 1bp through mid-swaps this February, the market sat up and took notice, even though the level was well wide of its earlier historical tights.
The reason? The re-offer level was 2bp inside the original guidance, flat to where Landesbank Berlin had sold a three year public sector Pfandbrief a week earlier, and fully 5bp inside where Dexia Municipal Agency had recently sold Eu2bn of long five year obligations foncières until then the Pfandbriefs closest challenger in the quality and pricing stakes.
But while on these two measures the Pfandbrief has clearly shown its mettle, the German markets biggest advantage, and the one that is considered to have done more to allow the product to remain at gravity-defying spreads than anything else, is its domestic investor base, both in terms of its size and its loyalty to the product.
For example, Ralf Welge, head of financial institutions and public sector issuance at Commerzbank in Frankfurt, estimates that in 2007 German investors took around Eu40bn of benchmark covered bond issuance in euros more than the total gross supply of jumbo Pfandbriefe last year, just over Eu25bn.
Market participants also say that many smaller German investors have reverted to their traditional conservatism and, like most investors in a crisis, have turned to what they know best: the Pfandbrief. This has exaggerated the spread differential between the German market and those most notably the UK, Spain and the US which are most reliant on foreign buyers.
And even if investors just plough back their Pfandbrief redemptions into the maturing jumbos same market, the supply/demand dynamic is very favourable for Germany. Barclays Capital, for example, expects higher gross jumbo issuance of Eu35bn in 2008, but with redemptions totalling Eu63bn, net supply will be minus Eu28bn.
German issuers are benefiting from this generally and more specifically. Depfa, for example, launched its first jumbo Pfandbrief through Deutsche Pfandbriefbank since June 2005 in February to coincide with redemptions for its German arm. And even though the Eu2bn five year issue was the units largest benchmark in seven years, it was smaller than the volume of its redemptions around Eu2.75bn due in February.
"Covered bond funding for Depfa in 2008 will be less than or the same as our maturities," says Julia Hoggett, head of capital markets at Depfa in Dublin, "and we took the view that it was best to issue when there are the maximum number of dedicated lines available to us. That is particularly important in a market where you want to know that your core buyers will be there."
Delving into the statistics
The fall in gross jumbo issuance should not be in any way be interpreted as demonstrative of a lack of interest from German banks in the Pfandbrief, however. Indeed Jan Siemon, a member of Aareal Banks treasury team, agrees that covered bonds have come to the fore in the recent crisis; it is just that this does not necessarily equate into higher jumbo Pfandbrief issuance.
"Especially in these times, the Pfandbrief product is very important for Aareal to fund our lending business, and in future it will play a more important role in our funding mix," he says. "But when most people are talking about Pfandbriefe they think only about jumbo Pfandbriefe, but we have different types of Pfandbriefe: jumbos, traditional private placements, and Namenspfandbriefe.
"In these times, we have been very successful at issuing private placements."
According to data from Royal Bank of Scotland, The share of jumbo issuance from Germany fell from 24.7% of the Pfandbrief market in 2003 to 20.3% last year, and in absolute terms from Eu52.2bn to Eu27.5bn.
And in spite of issuers continued enthusiasm for the product, the overall outstandings of Pfandbriefe have fallen, with listed Pfandbriefe falling by Eu63.3bn in the year to September 2007 and the volume of Namenspfandbriefe even declining by Eu1.3bn, according to Barclays analysts using Bundesbank data.
They argue that the biggest factor in the shrinkage of the market is the decline of public sector Pfandbrief issuance, which has been reflected in the jumbo market by net supply of between minus Eu25bn and Eu30bn over each of the past four years.Jumbo mortgage Pfandbrief supply fell by Eu5bn last year, but is expected to pick up. Growth in this sector could come from Landesbanks issuing mortgage instead of public sector Pfandbriefe, an increase in commercial mortgage lending by Germanys banks, or simply the attractions of the product to banks seeking an attractive funding instrument. The latter explained Deutsche Postbanks decision to launch its first jumbo mortgage Pfandbrief in January, a Eu2bn five year issue (see the Introduction on pages 4-8 for more on Postbanks debut).
Not such a simple story
While the Association of German Pfandbrief Banks latest marketing catchphrase, "Simply Pfandbrief Simply Good", might be supported by this years apparent vindication of the its longstanding defence of the conservative nature of covered bonds, at one point even the vdp was questioning whether its message was getting across: before the subprime crisis intervened the vdp was planning to relax the conservative standards that have recently stood the Pfandbrief in such good stead.
The Association of German Pfandbrief Banks recently put forward to the German government and supervisory authority, Bafin, its proposals for the first amendment to the Pfandbrief Act, which came into force in 2005. The result of 2-1/2 years of discussion within the vdp, the proposed package comprises 30 points that run from minor technical details to the introduction of a whole new class of the product: Flugzeugpfandbriefe, backed by airplanes.
The idea for an amendment came about partly because in the rush to get the Pfandbrief Act ready for July 2005, when the Landesbanks would lose their state guarantees, small mistakes crept into the legislation.
"In the beginning, our discussions focused very much on technical issues," says Louis Hagen, executive director of the vdp in Berlin. "This was the initial idea, to rectify those little mistakes."
But then the vdp got ambitious.
"Well, the longer we discussed it," says Hagen, "the more we had the feeling that this could be a more substantial amendment."
The reason for this, he says, was that the association felt that the strict standards and conservatism of the German product were not being sufficiently rewarded by investors.
"This was when spreads were tightening, tightening and tightening," says Hagen, "and the Pfandbrief did not really have a substantial funding advantage over other covered bonds, MBS and even senior unsecured debt.
"So the question was then: if the market is not honouring the high quality of the Pfandbrief, then why not try to use it as in a broader way, using more collateral to raise higher volumes?"
The association therefore considered raising the maximum LTV ratio on residential loans from 60% to 80%, allowing public sector collateral from OECD countries into cover pools, and even letting some residential mortgage backed securities until then the vdps apparent nemesis into Pfandbriefe. Such thinking was radical for the vdp, even if these were hardly high risk assets and would only have brought the German product into line with several other jurisdictions.
"During these discussions we were very much supported by some analysts, who agreed with our points," says Hagen.
Its all in the timing
That consensus fell apart when the subprime crisis struck, the RMBS market shut down, and investors began seeking out the safest assets available.
"But of course all of these discussions suddenly changed in July of last year," explains Hagen, "and in the following weeks there were some very bad headlines about the Pfandbrief banks loosening the quality of the Pfandbrief. This certainly proved to us that there is a high sensitivity in the market and that we should take it very seriously.
"We therefore took the decision that we would not pursue all the ideas about widening the scope of eligible assets."
The idea of allowing RMBS as cover had already been jettisoned and the geographical expansion and increase in maximum LTV went the same way. As one investor bluntly put said of the possible increase from 60% to 80%: "This would be the stupidest time to do that."
What remained of the vdps planned proposals was for the most part more modest. "We are now focusing only on the quality improvements and to make sure that the requirements of the act are not so complicated," says Hagen.
One of the vdps ideas is to introduce a specific regulation on liquidity risk.
"This is regulated under the Pfandbrief Act, but in a very general manner," says Hagen. "We thought it would be a good point to address with a specific regulation because the rating agencies ask banks to hold overcollateralisation against such liquidity risk anyway.
"It was also not clear, when you have a mortgage as collateral and there is additional collateral in addition to the loan the transfer of rent claims, or insurance, for example whether this formed part of the cover pool. We said that these have to be part of the cover pool and registered as well."
The proposed amendment will also make the Pfandbrief fully compliant with the strictures of the Capital Requirements Directive. This means changing the eligibility criteria of public sector assets.
The jumbo jumbo set for take-off
The one exception to the renewed focus on quality for investors rather than flexibility for issuers is the vdps decision to push on with the idea of airplane Pfandbriefe. While this might seem to go against the conservative tide of todays markets and the vdps shift in tone, Hagen argues that it will not affect the quality or perception of the existing mortgage and public sector Pfandbrief asset classes.
"The airplane cover pools will be completely separate from the mortgage and public sector cover pools," he says. "Therefore even if somebody were to say that aircraft are not as safe, it would be about a totally different Pfandbrief model, so even if there was a problem with aircraft Pfandbriefe, it would not have any direct impact on the other Pfandbriefe."
He says that careful analysis was done before extending the Pfandbrief model beyond ships to airplanes, and that this did not mean the vdp would embrace ideas such as credit card and auto loan covered bonds, which have been floated.
"We dont want to make the Pfandbrief a product you can use for any kind of loans," he says. "The collateral must be very safe collateral, so we looked at airplane mortgages and compared these to ship mortgages, and these are very similar, and we looked at airplane industry foreclosure processes, and again these are very similar to in the ship industry."The secondary market in aircraft is also liquid, so it is easy to sell an airplane to another carrier if the original airline defaults."