AHBR's rapid fall from grace last October threatened, briefly, to take the shine off Gemany's new Pfandbrief Law that had only recently been introduced. But while some questions still remain such as what would happen in the Pfandbrief market if an issuing bank were to collapse, prospects for Germany's Pfandbrief market have rarely been brighter. Consolidation of issuers has begun, the product is being pushed harder and further than ever before and new distribution techniques are emerging. Philip Moore reports.
"Crisis? What crisis?" That is how many bankers summarise the Pfandbrief market after the turmoil that arose late last October when the local press warned that AHBR was "close to failure".
In the event, concerns about the failure of the third largest issuer of Pfandbriefe have been dispelled following AHBR's acquisition by Lone Star of the US in December, while spreads on its covered bonds have been supported by the announcement of its plans not to wind down its public sector portfolio by buying back selected Pfandbriefe and not refinancing maturing bonds.
Granted, the uncertainty over AHBR cast a large question mark over the resilience of the market-making system for jumbo Pfandbriefe in times of stress. As one banker says: "How can you be expected to make a market in a bond when you don't know what's going to happen to the issuer?" But while attractive bid-offer spreads on AHBR's Pfandbriefe may have been difficult to find at the end of October, the broader market remained orderly.
Barclays Capital appeared to speak for most banks in the market when it released a bulletin late in the day on October 25th, advising that "the affirmation of Pfandbrief ratings and the fact that regular trading in all other covered bonds continued today, make us believe that market participants generally accept the covered bond principle. This may help limit the pressure on spreads of AHBR Pfandbriefe and also limit the danger of knock-on effects on covered bonds of other issuers."
With contagion from the spread widening on AHBR's Pfandbriefe proving to be very limited, many market participants believe that, with the benefit of hindsight, the scare over AHBR probably strengthened rather than weakened the Pfandbrief market.
"Some people said that this was the worst crisis in the history of the market, but spreads across the market as a whole stayed tight and stable," says Richard Kemmish, covered bond product manager at Dresdner Kleinwort Wasserstein (DrKW) in London. "Even those on AHBR only widened by a handful of basis points as the ratings agencies had a huge vote of confidence that the situation would be resolved. That conclusively demonstrated that the covered bond model works."
As such, he adds, the market's response to the so-called crisis had positive implications not just for the Pfandbrief market, but also for the other markets in Europe that have adopted and refined Pfandbrief-style laws.
Investors appear to share that view, and generally reacted calmly to October's upheaval. "In the couple of days after the debacle all the phone calls I received from covered bond investors were asking if it was a good time to be buying the market," says Ralf Preusser, a European rates strategist at Deutsche Bank in London. "Nobody was asking if they should sell."
Meltdown fears remain
If there are some uncomfortable questions remaining as a result of the AHBR episode they revolve around what would happen in the Pfandbrief market if an issuing bank were to collapse. "AHBR has been rescued by an external investor," says one analyst, "so we still don't know what would happen in the event of a mortgage bank's insolvency. I'm sure the Pfandbrief is safe in terms of payment, but unless you're a buy-and-hold investor you still have the concern about incurring market risk because you don't know if you're going to be quoted two way prices at reasonable spreads."
That issue is also being addressed. "It led to a discussion among market-makers about the need to enhance the dynamics and visibility of market making, so that if a similar thing happens again banks will be much better prepared. So I think that it ultimately strengthened the secondary market," says Marco Bales , head of financial origination at HVB in Munich.
One lesson learned from the disruption caused by the AHBR episode to the market-making in Pfandbriefe, say bankers, is that there is no substitute for dependable flows of information. "Part of the problem at the height of the AHBR crisis was that the flow of information was so poor," says Deutsche's Preusser. "As long as there is good communication between the issuer and the banks it should be possible to maintain a commitment to market-making."
Looking at the much bigger picture, however, bankers argue that even if the AHBR debacle temporarily besmirched the global reputation of the Pfandbrief market in the eyes of some observers, there has been more than enough compensation in the issuance policy as well as in the operating performance and strategic diversification of other heavyweight issuers of jumbos.
"The loans business of the leading German banks has been much stronger than many market participants were expecting a year or so ago," says Ted Packmohr, covered bond analyst at DrKW in Frankfurt. "One of the big stories in the industry in the last year has been that more and more of the mortgage banks have internationalised their businesses, not just by opening representative offices overseas but by increasing their foreign lending. That should be a positive factor for Pfandbrief-issuing banks going forward because it supports their risk diversification."
Others agree that the Pfandbrief product is becoming more diversified. At Deutsche Bank, Preusser says that the failure of new markets such as Italy and Sweden to develop in size may have been frustrating for covered bond investors. But he adds that there is still plenty of scope for choosing between different business models within the existing covered bond universe.
"If you look at the German market, for example, EssenHyp and Eurohypo are both very active in the public sector business," he says. "But while Eurohypo has been successful at sourcing high margin loans with public sector guarantees at origin, Essenhyp's business has been based on the successful management of interest rate risk. Those are the two extremes of the covered bond business model and both are available in highly liquid format."
Commerz leads consolidation
Less clear, say bankers, is how the structural changes in the German banking industry will effect the Pfandbrief market. Following the passage of the new Pfandbrief Law last year, which did away with Germany's cherished Special Bank Principle (under which mortgage banks' activities were restricted to Pfandbrief-related activities), many analysts believed a host of new issuers would descend on the market.
Those newcomers have failed to appear in any meaningful way; instead, long overdue consolidation has gathered momentum in the German banking sector, which analysts believe will leave fewer — rather than more — German borrowers in the European covered bond universe.
Comfortably the most important example of consolidation in the German banking industry (as far as the Pfandbrief market is concerned) has been the acquisition by Commerzbank of the stakes previously owned by Deutsche Bank and Dresdner Bank of Eurohypo.
Given Eurohypo's portfolio of Eu125bn of public sector loans and Eu97bn of mortgage loans, that has made the new Commerzbank Group the largest issuer in the Pfandbrief market. Including Hypothekenbank in Essen, in which Commerzbank has a 51% stake, the bank accounts for some 26% of the jumbo Pfandbrief market, according to a presentation made by Commerz in November.
That dominant share raises a number of intriguing questions about the short term future of Commerzbank Group's strategy in the Pfandbrief market. Above all, it raises the problem of investors potentially reaching their ceilings on lines to Commerzbank's Pfandbriefe. "The credit line problem is clearly a factor that Eurohypo and other market participants are very aware of," says Heiko Langer, senior covered bond analyst at BNP Paribas in London. "It has not yet been a problem and we have not seen any dramatic spread widening in Eurohypo's existing bonds. But it is clear that Eurohypo will need to find ways of broadening its investor base."
Another related question raised by Commerzbank's acquisition of Eurohypo revolves around the future of EssenHyp's role within the broader Commerzbank group. The general view is that EssenHyp will remain a key component of the bank's business model, although some analysts question whether over the long term it will make sense for so many different real estate lenders to co-exist under the Commerzbank umbrella.
Leaving aside questions over the future of EssenHyp, analysts believe that the process of consolidation within the German banking sector will continue. "I would now expect some of the smaller banks that are operating profitably to become takeover targets," says Claudia Vortmüller, head of covered bond research at Commerzbank Corporates & Markets in Frankfurt. "Some of the smaller players in Germany have solved their bad loan problems and are developing a sustainable business strategy which includes expanding in the international commercial real estate markets. We may not see takeovers in 2006 but in the longer run I think we'll see the number of issuing entities decreasing with the emergence of bigger entities focusing principally on international mortgage lending."
This increased focus by Pfandbrief-issuing banks on mortgage lending is expected to lead to a continued erosion of the share within the market of public sector, or Öffentliche, Pfandbriefe, which some analysts say ought to lead to an outperformance of public sector bonds.
"The expiry of the public sector guarantees will progressively reduce the availability of collateral for Öffentliche Pfandbriefe," says Deutsche's Preusser. "Banks like Depfa and Eurohypo which have the local presence to source public sector assets across the world ought to see continued growth in their balance sheets. But some of the smaller issuers that relied on a steady channel of issuance refinanced with public sector Pfandbriefe may find it much more difficult."
While mortgage backed issuance is one increasingly conspicuous characteristic of German banks' strategies in the covered bond market, another is their reduced recourse to the jumbo market, with borrowers apparently placing more emphasis on targeted issuance at tighter spreads.
"In Germany, we continue to see three-quarters of new issuance volume coming not from the jumbo market but from the traditional or private placement segment, where registered, structured and foreign currency paper are all playing an increasingly important role," says Packmohr. "That is a theme not just in the German market but also in other covered bond sectors. Depfa is an excellent example of an issuer that has scaled down its benchmark issuance significantly over the last year."
These two trends, bankers believe, will lead to a continued decline in the size of the jumbo Pfandbrief market over the coming years. At Morgan Stanley in Frankfurt, for example, head of covered bonds Nikolaus Giesbert says that total annual jumbo issuance which amounted to Eu60bn a few years ago is now heading for Eu30bn.
While jumbo volume may be in decline, Pfandbrief-issuing banks continue to explore ways of broadening their investor bases by tapping into different currencies. Hypo Real Estate Bank, for example, is in the process of setting up the first Pfandbrief programme in the Australian dollar market via ABN Amro, according to Tim Skeet, managing director of financial institutions origination at ABN Amro in London.
A flurry of successful dollar transactions towards the end of 2005, meanwhile, has helped to build confidence among some observers that Pfandbrief issuers may at last have started to reap some of the benefits of their marketing in the US. "The US investor market should become more active in covered bonds," says Ted Lord, global head of covered bonds at Barclays Capital in Frankfurt. "The marketing activities of issuers in the US has substantially increased awareness among US investors, many of which are looking to diversify away from treasury and agency bonds."
Others are not so sure. "I've been involved in the jumbo covered bond market since 1995 and seen several issuers come to the market with dollar denominated bonds, and my perception is that even the most successful achieved only limited placement into the US," says Bales, at HVB. "Most international placement of dollar bonds has been in Asia and Switzerland."
That is unlikely to change in the current spread environment, adds Bales. "Why would investors want to buy covered bonds that offer just a 10bp-15bp pick up over government bonds?" he says. "The argument we've always heard from US investors is that if they are going to do the work on analysing an issuer's credit story, they would much rather buy into the senior unsecured or tier one debt of the names that they like."
Deutsche's Preusser agrees that German banks continue to face an uphill struggle in selling their Pfandbriefe in the US. "The problem is that when US investors are approached about covered bonds they still expect to see something that looks like a US mortgage backed security," he says. "They expect amortising securities which pay a good pick-up over US Treasuries."
The European market that comes closest to providing those characteristics, says Preusser, is the Danish mortgage bond sector.
For the time being, say Bales and other bankers, German issuers are likely to continue to see much more demand for their dollar (and for their euro) transactions in Asia than in the US. "If I was organising a roadshow and I had to pick between the US and Asia as a market that would add more value for a German covered bond issuer, I would definitely choose Asia," says Bales.