The latest threat to the Pfandbrief model comes from Dublin where DePfa, one of the biggest jumbo issuers, has relocated its public sector business. But a favourable, albeit competitive, regime has not been enough to offset contracting lending opportunities to Germany's public sector, which has caused a slump in Pfandbrief issuance this year. Now the mortgage banks are having to consider lower quality public sector loan collateral and compete aggressively to expand their mortgage lending.
The first half of this year suggested that the honeymoon period enjoyed by the jumbo Pfandbrief market in the second half of the 1990s was grinding to a halt. In the first five months of 2001, mortgage and public sector Pfandbrief issuance both slumped by almost 40%, reflecting the sharply diminishing public sector lending opportunities for Germany's mortgage banks.
Nevertheless, Ted Lord, a director at Barclays Capital, is one of many observers who are adamant that in spite of reduced volumes at the primary level this year, Germany's Pfandbrief market remains in fine fettle. His argument is straightforward enough, and is based largely on the performance of Pfandbriefe relative to other asset classes in the highly volatile market environment of the last 12-18 months. "How can investors achieve a good spread with a manageable downside risk in today's market?" he asks. "Clearly not in equities, high yield or emerging market bonds. In the good quality Pfandbriefe and other covered bonds, we have seen spreads widen from perhaps Euribor minus 1bp to plus 1bp or 2bp, which is relatively minor compared with many other asset classes."
This emphasis on quality within the market, however, is important, and becoming more so. As Lord agrees, gone are the days when investors hardly looked beyond the triple-A ratings of issuers in the Pfandbrief market. "Investors are kicking the tyres and checking under the hood," he says. "They are saying they don't mind buying the car, as long as they don't have to take it to the garage for repairs every month."
The reasons for increased investor caution in the Pfandbrief market are not hard to identify. The pressures being exerted on the sector are intense, and they are coming from several directions. Views differ as to how serious the competition is that the Pfandbrief market faces from other jurisdictions. Lord believes that the emergence of covered bond markets in countries such as Italy and Sweden can only be good news for the asset class as a whole in Europe, enhancing investor awareness of the product and meaning that total demand is increased, rather than diluted among a static number of end investors.
Others, however, say that the emergence of the Irish covered bond market in particular poses a real threat to the Pfandbrief model, so much so that one banker says: "If you want to know what's happening in the Pfandbrief market, don't go to Frankfurt or Munich. Go to Dublin." That is a clear reference to what DePfa has chosen to do, splitting in half and relocating its public sector business to Dublin with an all-star cast of ex-investment bankers. The attractions of doing so are clear enough. As one banker puts it, for Pfandbrief issuers the Republic of Ireland now provides a better law than Germany (given its much more relaxed collateral eligibility criteria), a better tax framework, much cheaper housing and incalculably better golf courses. "With a 10% tax rate and the availability of top quality staff, any German financial institution active in the Pfandbrief market not looking seriously at Dublin must be mad," says the same banker.
But another banker views this as an exaggeration. He says that although the Irish law on covered bonds may have ostensibly put the market on an equal footing with Germany's Pfandbrief sector, for the time being the Irish market will have its work cut out to establish the sort of track record investors will demand. "I very much doubt that the Irish market will be able to price itself on a par with Germany," he says. "As we saw with the French market for obligations foncières, some sort of premium will have to be added to the Irish market in order to get the product up and running."
Talk about the emergence of Frankfurt-Am-Liffey may therefore be premature, but Germany's mortgage banks have considerably more than the threat of Dublin to be concerned about. Foremost among these are the fast declining opportunities for public sector lending and - when these opportunities are available - the razor-thin margins available in the assets forming collateral for Öffentliche Pfandbriefe.
This particular pressure has intensified over the last one to two years, stimulating increasingly vocal concerns about risk management at some of the more aggressive issuers in the market for Öffentliche Pfandbriefe. For the time being at least, the heat seems to be off the Pfandbrief issuers in terms of the criticism that many were subjected to over the perceived overexposure to interest rate risk that they were adopting to compensate for contracting lending opportunities in the public sector. It was this perceived overexposure that led to jibes suggesting that some of the Hypothekenbanks should more accurately be described as Hedging-banks.
It also led to the establishment by the German banking regulator, BAKred, of a so-called "traffic lights" surveillance scheme for monitoring the perceived value at risk of each mortgage bank's balance sheet: less than 10% is viewed as fine (green); 10%-20% as intermediate (amber); and more than 20% as distinctly dangerous (red).
Athough detailed information on the preliminary results of this mechanism have been sketchy, as Commerzbank reported in a research bulletin published in July, the German newspaper Börsen-Zeitung published a list of mortgage banks, quantifying the percentage of capital perceived to be at risk at most of the 25 in April 2001. According to the report, of the 25, none had overexposed themselves to the point where they were classified as being in the red zone, and only two were considered by the newspaper to be in the amber zone: Hypothekenbank in Essen, or Essenhyp, (with a 13.16% "at risk" percentage) and Nurnberger Hyp (11%).
Nevertheless, unless there is a wholesale rethink on public spending policy throughout Europe, the problem of lending (or not lending) to the public sector is not going to go away. Broadly speaking, Pfandbrief issuers recognise that they have two options available to them to counteract the sharp decline in the assets available as collateral for the Öffentliche Pfandbrief bonds that have dominated new issuance since the launch of the jumbo Pfandbrief market in the mid-1990s. They can expand their franchise either in terms of geography, or in terms of product mix, or - most likely - both.
Essenhyp, for one, is explicit about its plans to do both. "We have established a desk for international mortgage transactions and additionally plan to open a representative office in London before the end of this year," the bank explained in its most recent interim report (dated June 30, 2001). "We also have great expectations in expanding our business activities to the US and Canada after the amendment of the German Mortgage Banking Act, which is now expected to come into force in mid-2002."
Beyond the broadening of its mortgage-related ambitions, Essenhyp is equally bullish about the international expansion of its public sector lending, noting in the same report that it plans to explore lending opportunities in the US, Canada, Japan and Switzerland, as well as in the economies of the Czech Republic, the Slovak Republic, Hungary, Poland and others.
That ambition raises a number of troubling questions. "Pfandbrief issuers may be permitted to diversify their cover pool collateral into the converging economies of central and eastern Europe," says Iain Barbour, head of structured finance research at Commerzbank Securities in London. "But the question this raises is: if the obligors providing the collateral are no longer all triple-A, at what point does that start to dilute the credit quality of the Pfandbrief unless clear quality criteria are introduced? I think for the time being that is an open question."
Just as open to question is the degree to which banks that, to date, have chalked up strong track records in the field of public sector lending can expect to enjoy similar success as they diversify into the mortgage market. The jury must be out as to how well equipped Essenhyp, for example, is to ride into the mortgage lending market - both domestically and overseas - with all guns blazing. "I don't know what the latest headcount is at Essenhyp," says one analyst. "But the last time I looked it was 115. Now you can't be a serious player in the mortgage market with 115 people, most of whom are experts in playing the yield curve."
Barbour at Commerzbank Securities thinks that a more aggressive expansion into mortgage lending on the part of those Pfandbrief issuers that have traditionally based much of their success on public sector lending - and, by extension, on reading the yield curve - makes a good deal of sense. Not only does it provide an important source of earnings diversification, he argues, it also provides them with opportunities in a very large and before now untapped market.
"Germany has a residential mortgage market that is worth about Eu960bn, making it the largest in Europe," he says.
"Currently, only about Eu240bn of that is funded through the Hypothekenpfandbrief market. Granted, given the loan to value (LTV) limit of 60% there is a cap on how much of the market could be financed through Pfandbriefe, but that still means there is potential for a market of up to Eu500bn potentially eligible for refinancing via the Pfandbrief sector."
Fair enough. The problem is that in spite of their name, mortgage banks have a surprisingly modest share of the German residential mortgage market: according to Commerzbank's analysis, just 20% as of December 2000. And unlike in more concentrated markets such as France, the share of the German mortgage market accounted for by the mortgage banks is extremely fragmented and carved up among 20 or so lenders.
That helps to explain why, since the launch of the jumbo Pfandbrief market in the mid- 1990s, new issuance has been dominated by Öffentliche Pfandbriefe.
All this also goes a long way to explaining why the majority of analysts are convinced that far-reaching consolidation among Germany's mortgage banks is now only a matter of time. "I think we will see rather quick consolidation among the Pfandbrief issuers," says Walter Henniges, director of debt capital markets at Deutsche Bank in Frankfurt.
"We now have about 20 mortgage banks in Germany and I would expect to see that number come down within a few years."
The process is already beginning to unfold. Several of the members of the HypoVereinsbank mortgage lending group have come together, while July saw the official merger between Allgemeine Hypothekenbank (AHB) and Rheinboden Hypothekenbank to form AHBR, which with assets of close to Eu100bn is now Germany's largest "pure" mortgage bank, although the "mixed" banks, HypoVereinsbank and DePfa, are both larger than the new AHBR.
More intriguing still are reports that the mortgage banking subsidiaries of Deutsche, Dresdner and Commerzbank are on the verge of tying the knot.
Learning to manage risk
Looking to the much longer term prospects for the German Pfandbrief market, many bankers and analysts are increasingly of the view that its fortunes will be irrevocably tied up with those of the broader asset backed or structured finance market. Commerzbank's Barbour points out that the dynamics of the German mortgage market have fundamentally changed in recent months and years, driven by the bursting of the property bubble in the former East Germany and the substantial losses incurred in the market as a result by scores of mortgage lenders.
"Mortgage lenders in Germany are suddenly focusing on the true economic risks of their business and are asking how they can protect themselves against the potential downside in the future," says Barbour. "Many are doing so - or plan to do so - by using the residential and commercial mortgage backed securitisation markets in a synthetic way to complement their use of the Pfandbrief market as a liquidity tool. This is already being done by some of the traditional mortgage banks, such as Rheinhyp, HVB Real Estate Bank, DePfa and Eurohypo, and is now receiving the attention of other mortgage lenders, with the savings and commercial banks looking at the ABS market as a means of locking in economic risk and generating liquidity."
Marc Bajer, global head of debt and structured finance origination at Commerzbank Securities in London, adds that there are other reasons for mortgage banks and other lenders to look more actively towards the potential of the asset backed or structured market.
"I think the banks that are active in the residential and commercial mortgage sectors as well as the traditional lending businesses are taking very positive steps to do a better job in terms of recycling capital and bolstering RoEs and becoming much more efficient in the way in which they originate, price and manage risk," he says.
"This all going to promote very significant growth in the structured finance market. I see a minimum of 15-20 deals being done in the public market in Germany next year in this sector, all raising between Eu500m and Eu2bn, and as many again in the private market." *