Pfandbrief market takes crisis and regulation in its stride
The Pfandbrief market is in the middle of a tumultuous year which includes not only the adoption of the EU's Covered Bond Directive but also digesting the bloc's Taxonomy for Sustainable Activities. Of course, this is all happening against the backdrop of the coronavirus pandemic and lockdowns, which have hit the commercial real estate market that underpins much of the product. Jens Tolckmitt, chief executive of the Association of German Pfandbriefbanks (vdp), spoke to GlobalCapital about how the market has coped.
What are the main features of the Pfandbrief legal amendments required by the transposition of the EU Covered Bond Directive and how do these impact investors and issuers?
Jens Tolckmitt, vdp: We are on time with regard to the July 2021 deadline for the transposition of the Directive as well as amendments of Article 129 of the Capital Requirements Ratio that shall apply from July 2022 onwards, which means the Pfandbrief market will continue to benefit from preferential regulatory treatment.
To a wide extent the Pfandbrief Act acted as a role model for the directive. The German parliament stuck to the very wording of the Directive and didn’t introduce any new ideas though the principles-based approach of the directive provides room for discretion at national level.
In addition to transposing the directive, major changes in the Pfandbrief Act relate to the implementation of maturity extension and important technical clarifications around the insurance of properties in the cover pool.
Bafin had a rather strict interpretation of how buildings insurance should be treated, but Pfandbrief banks needed further clarification to bring regulation into line with current market practise, which doesn’t affect investor protection directly, but is important for the lender that finances the property and puts part of it in the cover pool.
Contractual soft bullet maturity extension has been used in many countries for some time and now there is a legal extension in the German law. We discussed the ideas with all stakeholders including the legislator, the regulator, market participants and rating agencies beforehand extensively.
The German kind of maturity extension — that is not at the discretion of the bank... but is exclusively at the cover pool administrator’s and limited to a maximum of one year — is designed to be used only as a measure of last resort and enhances the safety of the product. It’s good for investors because it gives the administrator another option to allow him to do his job — managing liquidity in the pool — in case the issuing bank defaults.
How would you like to have seen the liquidity buffer calculated?
When a bank is no longer in operation and the cover pool administrator has taken over, we argued that the mortgage holder was more likely to get a better follow-up loan from an alternative lender, rather than with the cover pool administrator of the defaulted bank.
The cover pool administrator will most likely simply not be able to price follow-up mortgages at competitive rates like banks that are a going concern. That is why we thought it was not justified to calculate the liquidity buffer based on the full term of the mortgage loan, but rather on the first opportunity the mortgagee has to refinance the loan.
It’s really a question of what’s the most realistic scenario. We have a formula in the Pfandbrief Act that indicates that the liquidity buffer should be calculated on the full maturity of loan and Bafin has stuck to that position for the past few years. Bafin got their way which means the issuer is obliged to fund a larger and more costly liquidity buffer, but whether that makes Pfandbriefe any more resilient is questionable.
What is the vdp moratorium scheme for redemptions?
In the first wave of the pandemic the European Banking Authority declared they would give a preferential regulatory treatment for loans that fell under a legal moratorium, so they were not counted as non-performing. In Germany we had a legal moratorium that was implemented by the government for private customer loans.
We mirrored this and developed a contract-based moratorium that was compliant with EBA rules and which our banks could join, or not. If banks joined our scheme, they were obliged to offer the relief of the moratorium to all loans that qualified for it. There were banks that chose not to join our scheme who renegotiated contracts with their customers bilaterally.
How have deferred loan payments developed?
Payment deferrals have been very low from the start of the pandemic and are lower now. Payment deferrals for residential private property loans peaked at 1.6% of the relevant portfolio, on average, but had fallen to 1.2% by December 2020. Commercial real estate loans deferrals peaked at 2.2 % before falling to 1.1% in December 2020 and multi-family residential loan payment deferrals have remained steady at 0.2%.
How has the commercial real estate market performed, and what is expected to happen?
Hotels and retail loans are certainly not easy sectors but if you look at prices that tells a different story. Retail prices have continued the slight downward trend they showed before pandemic already and you can see, looking at the business of our banks, that they had prepared for that.
Even before the pandemic there was a substantial decline in new loans in this area in 2019. In 2020, the vdp property price index tracking the performance of retail properties lost 2% year-on-year in the last quarter of 2020. Regarding the hotel sector, the lockdown situation is difficult but manageable, too.
Not surprisingly, the situation varies depending on the type of hotel — tourist or business. The development in different asset classes in commercial real estate differs quite substantially. We take the view that as lockdown measures are relieved activity will begin to normalise and we will most likely see a catch-up effect in demand with positive implications also for the most affected asset classes.
In any case, based on the rate of loan deferrals the pandemic has so far not gravely affected the loan portfolios of our banks. There are of course some differences between banks given their regional and sectoral exposures, but at this stage there is no sense of urgency. The sense is that our members are concerned — and more so the longer the lockdown measures last. They monitor closely but they are not alarmed.
We’ve seen a lot of discussion around office price developments particularly with respect to how working from home will develop. But so far there’s not been any substantial decline in demand and prices or rents in Germany. If there is an extended vacancy period then there is also the possibility that investors can adapt buildings for different purposes.
How is this performance likely to impact issuers’ balance sheets and their Pfandbrief cover pools?
Under the Pfandbrief law, 60% of the mortgage lending value of the property is eligible for the cover pool. In the commercial real estate space today, due to price development and low rates, the mortgage lending value should come out around half of the market value. Then the Pfandbriefe would only be able to refinance 60% of that value, which should not be a problem for issuers.
And as long as there is a bank, the cover pools will be actively managed, which means problem loans will be removed from the pool and replaced by performing loans. So, I think investors can be confident about cover pool loans.
How useful has the ECB's Targeted Longer-Term Refinancing Operations been?
A lot of Pfandbrief issuance was retained for ECB purposes in 2020 and in the first quarter of 2021, too. The important point here is that the conditions of TLTRO tenders have been so attractive that you couldn’t choose to ignore them.
I’m pretty convinced, if you look at the take up of recent German deals bought by investors and the spread levels, that Pfandbrief banks will not have a problem accessing the market if the TLTRO fades away. Or put another way, if the TLTRO hadn’t been in place, this wouldn’t have posed a problem — seen from a Pfandbrief perspective.
Beyond the three year maturity of the TLTRO, Pfandbrief issuance is attractive for our banks. We saw several benchmarks issued just recently which attracted strong demand and were mostly allocated to real investors. As long as there is liquidity from the ECB it’s a relatively simple economic decision whether to take this funding, but Pfandbrief in longer maturities will continue to be an attractive option given spreads are at pre-crisis levels.
How aligned are Pfandbrief issuers with the EC’s Taxonomy for Sustainable Activities?
Aside from its overall complexity and sheer volume of regulation, the main challenge from the German perspective was the Taxonomy’s reliance on Energy Performance Certificate classes for the acquisition and ownership of buildings. In Germany, the EPCs for commercial buildings do not offer the alphabetical categories relied upon exclusively in early drafts of the Delegated Acts.
If you want to achieve a policy that gives a boost to the development of sustainable activities, you cannot ignore current market practises and that is why we were initially alarmed. The fact that the Taxonomy was finally changed to include the top 15% most energy efficient buildings was a positive step forward.
There’s a broader question as to how best to achieve a strong development of sustainable economic activities, and as part of that, how that should be achieved in the building sector. The question is whether it’s wise to raise the bar extremely high or start by setting a high bar but enabling the market to meet the requirements.
We are really happy the EC removed the EPC requirement which in Germany and other countries couldn’t have been met. Aside from that, there certainly is the question what the contribution of the financial sector as a catalyst can realistically be — and what additional regulation may have to be imposed on the real estate or construction industry directly.