Last year, Luxembourg's market for lettres de gage failed, once again, to live up to its potential, with new issuance volume contracting from Eu3.4bn in 2000 to Eu2.6bn in 2001. As analysts at SG put it in their review of the European covered bond sector in 2001, activity more or less "dried up" having "probably suffered from the prospects of amendments to the German legal framework and the adoption of new Irish legislation."
In the same update, however, SG predicts that 2002 could mark a revival for the Luxembourg market. Most notably, says SG, "the launch of the first ever mortgage lettres de gage, which might become attractive, insofar as the widening of geographical scope of German mortgage banks' real estate activities to the US, Canada and Japan will not enable them to refinance their loans in these countries through Pfandbriefe issuance". Others share the view that Luxembourg will wake from its slumber this year, with Commerzbank predicting new issuance in the lettres de gage market of up to Eu5bn-Eu7bn in 2002.
In the Grand Duchy itself, Martin Schulte, head of treasury and managing director of Pfandbriefbank International (PBI), is also optimistic about the outlook for issuance this year, but he insists that activity in the lettres de gage market over the last 12-18 months has not been as quiet as the consensus would suggest. "This market started two years ago and if you look at total issuance since then we had a little more than Eu10bn outstanding at the end of last year," he says. "I don't think that's bad. But I think there is a perception that Luxembourg has been quiet because we haven't seen any jumbo issues out of the market recently. The simple reason for that was there was very little investor demand for jumbo issuance in 2001."
That, says Schulte, explains why PBI, which at the end of 2001 accounted for outstanding issuance of about Eu3.2bn, has been focusing on smaller transactions catering to specific pockets of investor demand and driven, in some instances, by reverse enquiry. "We've only issued paper where we've seen clear investor demand," he says. "We didn't issue bonds where there were no investors to be seen."
That strategy, he adds, has continued this year, with PBI issuing some Eu500m in its first six weeks, chiefly in response to reverse enquiry. "The advantage that we and the other Luxembourg-based issuers have is that we are able to provide relatively cheap Pfandbrief issues in a range of different currencies," he explains. "For example, we have issued three and five year structures in dollars and Swiss francs."
Fair enough. But isn't there a danger of the Luxembourg market being marginalised as a result of the introduction of new laws across the border that will align German legislation more closely with the prevailing Luxembourg framework? Schulte dismisses this suggestion on two counts. First, he points out that the changes in the German law amount to a public acknowledgement of the strength and solidity of Luxembourg's legal framework. "It's quite funny, because when we set up our activities here, a number of German issuers argued that the Luxembourg law was weaker than the German one," says Schulte. "We didn't agree, and the Germans have now seen that it is possible to create some interesting new business opportunities without weakening the quality of the Pfandbrief."
Second, Schulte says that although the new German guidelines bring the legal structure of the Pfandbrief market closer to the lettres de gage template, there are still important differences between the two that will ensure that many of the competitive advantages enjoyed by issuers in the Luxembourg market need not be eroded in the foreseeable future. He points out that although issuers in the Pfandbrief market will soon be able to extend the geographical scope of public sector assets used as collateral, this will still be capped at 10% of their total cover pool. In the Luxembourg market, in the words of the latest annual report published by Erste Europäische Pfandbrief- und Kommunalkreditbank (EEPK), bond issues "can be secured without quantitative limitation by mortgage loans... or public sector loans from all EU, EEA or OECD member states."
Of the three issuers of lettres de gage, all have loan books in which their exposure to non-European OECD borrowers is above 10%. So even if German issuers immediately raced to acquire assets up to the maximum regulatory level in OECD economies such as North America, Japan and Australia, their asset pools would still be much less globally diversified than those of the Luxembourg issuers.
The likelihood of the lettres de gage market welcoming any new entrants over the coming year or so is low. However, Schulte says that over the longer term he is optimistic about the potential for the German Landesbanks emerging as issuers in the lettres de gage market. "Many of the Landesbanks already have entities in place here, and they have quite a few assets under management that would be eligible for lettres de gage issuance, so I think some will turn to the Luxembourg market in the future."