The German covered bond market’s decade-long contraction could soon be close to an end. It is set to shrink again this year, but by the middle of next year regulatory and technical pressures should have eased meaning thereafter primary volumes could start to improve.
Just over €30bn of benchmark Pfandbriefe will be redeemed this year, roughly double the consensus expectation for benchmark issuance. But in terms of the total volume, Commerzbank’s research team estimates Pfandbrief repayments of €90bn, and issuance of around €60bn.
Five years ago the outstanding market stood at €720bn according data from the Verband Deutscher Pfandbriefbanken (VDP), the German association of mortgage banks. By 2013 this had shrunk to €452bn based on the Bundesbank’s data. This precipitous decline was driven mostly by a fall in public sector, or Öffentlicher Pfandbrief, outstandings. At its pinnacle a decade ago, the Öffentlicher Pfandbrief market had stood at over €1tr in size, but by last year it had withered to just €240bn.
The cause for this shrinkage can be traced back to 2005 when the European Commission abolished guarantees that had protected the German Landesbanks’ top ratings. These ratings allowed them to borrow cheaply and undercut Germany’s private sector banks. The abolition of state guarantees caused the Landesbanks to cut their public sector lending, thereby severely reducing their refinancing needs and Öffentlicher Pfandbrief issuance.
Up until July 2005 the Landesbanks were allowed to issue public sector covered bonds backed by a specific form of guaranteed public sector debt with maximum tenor of 10 years. These bonds were grandfathered and will have all matured by July 2015.
The market’s long contraction has meant that covered bond investors have not been able to fully reinvest their bond redemptions back into newly issued Pfandbrief. The constricted supply has caused a technical squeeze leading spreads to tighten more than in any other covered bond sector. The lack of spread has been compounded by low interest rates, and as a consequence investors have struggled to hit their return targets.
Too tight for some
“The net negative supply outlook is supportive for spreads, but it’s a double-edged sword as we do seem to be running into natural barriers given the low overall yield level and investors’ reluctance to invest at sub-Euribor levels,” said Friedrich Luithlen, head of covered bonds at DZ Bank in Frankfurt.
Of the eight German deals that had been launched in the first two months of this year, as many as half were only just subscribed, with some pricing flat or even through Euribor. In contrast, most other covered bond deals from core European countries, which had offered a few more basis points, were subscribed by 1-1/2 times or more.
Placement statistics for the latest German covered bond issues have “tended to show only modest levels of oversubscription,” says Ted Packmohr, head of covered bond research at Commerzbank in Frankfurt. “Order books of more than €1bn have become rare for new Pfandbriefe.”
Even among German investors, which Packmohr describes at the most loyal group of Pfandbrief buyers, “an increasing number of customers have opted for the SSA segment recently, since it is more attractive in terms of relative value.”
An investor survey carried out by Fitch at the end of 2013 suggested investors were looking to reduce their net holdings in Pfandbriefe. “This net selling interest is a natural result of the declining risk aversion of investors and their hunt for yield,” says Packmohr. “This limits the possibilities for issuers to price new deals at opportunistically tight spreads.”
But German investors that have loyally bought Pfandbriefe, despite its lack of value, have been rewarded in other ways. During the height of the sovereign crisis in late 2011 and early 2012, core European covered bond spreads from regions like France and the Netherlands widened well over the 100bp area over mid-swaps. And in places like Spain and Ireland, covered bond spreads widened to 300bp or more.
Many investors will have breached their mandates and may have had to shed their holdings and crystalize losses on some of these deals.
Conversely, most German Pfandbriefe traded in a spread range of between 20bp and 35bp.
“Those investors that focused on Pfandbriefe have had a good experience during the crisis,” says Luithlen. “It’s been the most stable spread environment in the covered bond market.”
An ease to the squeeze
But the supply squeeze that has caused the Pfandbrief to tighten more than any other market should start to ease from July 2015 as the last legacy public sector deals mature. This will moderate the influence of net negative supply that has been a feature of the market for much of the past decade.
However, while it seems likely that an end to the market’s contraction is in sight, there are barriers to an improvement to new issuance. “The Pfandbrief supply outlook is likely to remain subdued over the short to medium term for a number of reasons,” said Jens Tolckmitt, chief executive of the VDP in Berlin. “Banks are consolidating their balance sheets, there are plenty of other sources of liquidity, and with the ECB taking over supervision, there’s been a certain hesitancy with respect to increasing business.”
These factors are, however, close to being resolved. Germany’s economy is the stand-out performer in Europe and the housing market is growing. Ultimately this means the pace of bank deleveraging should soon slow. This process could be accelerated when there is greater certainty about how the bank leverage ratio will be calculated.
Germany’s savings and mortgage banks typically have a higher level of low risk mortgage loans on their balance sheet compared to universal banks. Mortgage assets consume less capital and in theory the higher average asset quality should mean these institutions can tolerate higher levels of leverage. In contrast, universal banks may devote more of their balance sheet to lending to small and medium sized enterprise so their loan books will consume more capital, thereby reducing their leverage capacity.
To that extent, savings and mortgage banks may already be operating at leverage ratios that are permitted by regulations. The trouble is, no one really knows how leverage regulation will be calculated. “It’s not clear whether the leverage ratio will be differentiated by the risk on balance sheet, or size of bank,” said Tolckmitt. “Once the design is clear we can make a better guess on future [supply] developments.”
As for concern over other sources of cheap liquidity, it’s doubtful the European Central Bank will introduce another long term refinancing operation (for German banks at least) when the present one matures in January 2015. German banks can easily access ultra-cheap funding in the capital markets and don’t need any more help from the central bank.
As for Tolckmitt’s hesitancy regarding prospective supervision, he has reason to believe this can also be equitably resolved. “It’s important to find a modus operandi or structure so both national covered bond supervisors and European supervisors can work harmoniously together,” he says.
Regeneration duo
With the supply hurdles of deleveraging, emergency liquidity and regulatory uncertainty likely to be overcome, reversion to a mean level of Pfandbrief supply could well follow. A regeneration of primary activity is likely to spring from two distinct sources.
The first relates to another regulation that will require banks to consider matching the tenor of their assets with their liabilities. Basel III attempts to make banks safer, not only by improving their debt to equity and loss-absorbing capacity, but also by improving the profile of the opposing cashflows of their assets and liabilities.
The liquidity coverage ratio ensures they have a sufficient amount of assets that can be liquidated at short notice to meet temporary shortfalls in these opposing flows. The net stable funding ratio (NSFR) ensures the scope for temporary liquidity shortfalls between asset and liability cashflows are minimised. This is achieved by having a minimum level of stable funding on the liability side of the balance sheet that mirrors the cashflows derived from the assets.
Germany’s saving banks, or Sparkassen, have always been able to fund their mortgage loan portfolios with their retail deposits, but the NSFR will oblige them to consider extending the duration of that funding.
Deposits can be withdrawn at short notice, unlike the funding provided by long dated covered bond issuance. Issuance of mortgage Pfandbriefe, or Hypothekenpfandbriefe, is therefore the perfect instrument for savings banks to address their NSFR requirements.
“The NSFR will be operational in 2018 and that is likely to mean there will be an incentive for savings banks to increase their ratio of long term funding, either by issuing from their large stock of mortgage loans directly, or pooling them to another institution,” says Luithlen.
Another potential source of supply is from the public sector. For as long as interest rates remain low and liquidity plentiful, German banks will easily be able to refinance their municipal loan books. But if, or rather when, they start to think interest rates will rise they will want to lock in competitive funding over a longer term.
Luithlen estimates around €50bn of short term loans have been taken out by German municipalities, but if rates start to rise, “pressure will grow on them to refinance longer, and the banks that extend this financing will then be more inclined to issue public sector Pfandbriefe.”
A greater domestic focus
These prospective Öffentlicher Pfandbriefe are likely to be backed by a larger portion of German loans, which should help improve their appeal. In fact with the German risk in these cover pools growing for the past five years their credit risk has already improved.
As a result of the falling exposure to foreign assets there’s been a reduction in risk which Moody’s has said is credit positive. “Although the increased domestic focus of German cover pools reduces risk diversification, its positive effects outweigh the negative,” the agency said in March.
Foreign exposure in German public sector Pfandbriefe has decreased by 3.1% over the last five years and foreign exposure in mortgage pools fell 2.4% over the past two years. “The decrease in exposure to foreign assets is credit positive because it has been achieved through a reduction in riskier assets,” Moody’s said.
The agency noted that international public sector exposure in the European Economic Area (EEA) fell from 18.9% in 2009 to 14.7% in the third quarter of 2013. In contrast, non-EEA exposure and EU institutional exposure were stable over the same period. Within the EEA component, euro periphery exposure fell from 8.9% to 4.9% over the same period.
In mortgage backed deals the reduction in foreign exposure was achieved by lowering the exposure to foreign commercial mortgage loans, said Moody’s. Non-EEA commercial loans fell from 6.2% to 4.4% between 2009 and the third quarter of last year.
However, EEA exposure rose from 30.5% to 34.2%, Moody’s said, using data from the German mortgage bank association. In tandem, the share of loans backed by lower risk residential properties has increased while those backed by commercial exposures has decreased.
The greater focus on domestic assets has improved pool homogeneity between issuers, and in case of an issuer’s default, the transfer of assets would be more easily achieved, which is also credit positive.
Reporting for duty
In addition to the improvement in collateral quality, the Pfandbrief market has strived to advance the quality of disclosure. In January 2014 changes to the Pfandbrief legislation, which extends issuers’ reporting duties, took effect.
Pfandbrief issuers will now have to publish details on seven new fields. These include the fixed-interest proportion of their cover pool; the net present value of their foreign currency positions; the weighted average loan to value ratio; the weighted average seasoning of loans in the mortgage pool; the amount of loans that are overdue by more than 90 days must be reported if over 5% of the pool; more detail on the breakdown of covered bond maturities; and a breakdown of the mortgage cover pool by size. Additional data is also required on the nature of supplementary cover assets which must be broken down by country.
Despite some technical shortcomings, Pfandbriefe comply with the transparency requirements of the Capital Requirement Regulation (CRR), says Commerzbank’s Packmohr.
The fixed interest rate periods of cover assets, which have to be published according to the Pfandbrief law, do not necessarily match the maturity structure required by the CRR and if under 5% of the pool disclosure of non-performing loans can be neglected. Moreover, the breakdown of supplementary cover by countries and collateral is simplistic, according to Packmohr.
But he adds: “These are rather technical questions which should not, per se, preclude the regulatory acceptance of Pfandbriefe as CRR eligible. Hence, we assume that the basic prerequisites for a preferential risk weighting of Pfandbriefe remain in place.”
Packmohr’s analysis follows an earlier report by covered bond analysts at Barclays that suggested regulated investors had been applying inappropriately low risk weights to their covered bond investments. Barclays had said there was insufficient data on loan size.
But the VDP told GlobalCapital that the CRR requirement on loan size was more relevant for mortgage Pfandbrief, as the exposure against individual private borrowers mattered more. “It is less relevant with regard to the public sector,” said the VDP. “We think that not only mortgage Pfandbriefe, but also public Pfandbriefe fulfil the transparency requirements of Article 129 (7) of the CRR.”
Commerzbank was less sure whether public sector Pfandbriefe fulfilled transparency requirements, saying that the low preferential risk weight would generally apply “with the exception of legacy guaranteed Landesbank Pfandbriefe [public sector], for which there are no comparable transparency rules.”
The VDP is talking to legislators about amending Article 28 of the Pfandbrief Act to add loan size information.
Packmohr also notes that the capital charge for Pfandbriefe has declined for investors in a number of regimes, such as the UK and the Netherlands. Until December 2013 they had applied a risk weighting of 20% for covered bonds issued by lower rated borrowers, rated in the single-A to triple-B range. These include many Pfandbrief banks.
However, under the provisions of the fourth iteration of the Capital Requirement Directive (CRD IV) which came into effect on January 1 2014, the risk weighting calculation is now applied on the basis of the covered bond rating. For German Pfandbriefe this rating is invariably in the double-A to triple-A range.
“This generally leads to a standard weighting of 10%, for investing banks from the UK,” said Packmohr. “This consequently represents a reduction in the capital cost.”