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Pfandbrief’s soft bullet highlights key differences

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By Bill Thornhill
20 Oct 2020

A proposed change to the Pfandbrief law introducing a soft bullet maturity is designed to harmonise Germany’s covered bond regime with the rest of Europe’s, as envisaged under the EU’s Covered Bond Directive. However, it could highlight the vast differences in how soft bullet covered bonds are repaid following extension triggers.

The German Ministry of Finance published amendments to the Pfandbrief law at the start of October, saying the draft would implement the Covered Bond Directive.

The draft proposes a maturity extension that could be triggered by the cover pool administrator. Following an issuer insolvency, the pool administrator would be able to delay all payments for four weeks.

Provided the administrator is confident that the value of assets in the pool is sufficient to ensure all liabilities can be repaid, it could apply for a maturity extension of up to 12 months, split into two six-month periods.

But Pfandbriefe falling due after the extended bonds’ original maturities would not be repaid early. This means bonds maturing later could be considered effectively time subordinated.

The basic idea of the draft is to keep the new law as close as possible to the original version, and in that sense this was probably the least contentious option.

But this sequence of repayments stands in contrast to those in most other soft bullet regimes. 

Repayments of extended French covered bonds issued under the SFH framework, Dutch covered bonds, UK deals and the Canadian, Australian and Singaporean markets repay on a pro-rata basis following a breach of the asset coverage test (ACT). 

Repayments of these deals would however be time subordinated after an maturity extension trigger - provided there had not been a failure of the ACT. 

Only when the ACT has been breached, all due covered bonds become payable at the same time — there then there is no time subordination, all investors are equal and repayments are made together.

This may mean bondholders are repaid earlier than the scheduled maturity — but if an issuer has defaulted, this may be a blessing.

More problematically, Germany’s proposed time subordinated alternative repayment profile could be considered a riskier option for holders of very long dated covered bonds, as they would remain last in terms of the timing of repayments.

On top of that, the vast majority of an issuer’s covered bond liabilities would fall due within certain a time frame, say five to seven years. So it is unlikely there would be a large portion of outstanding bonds with much longer maturities. This typically occurs only where banks have issued private placements, where maturities can reach 30 years or even 50 years in rare cases.

This can be problematic. The Pfandbrief cover pool administrator can only trigger an extension if he is confident that all bonds can be repaid. 

But if market conditions change before the last deal is repaid, or if the assumptions were even slightly  incorrect, there may be insufficient collateral.

Moreover, until the last bond has been repaid, it is necessary for the cover pool to pay the cover pool administrator’s fees. These mount up if calculated over many years, especially in relation to the outstanding liabilities which would fall over time.

In contrast, if all noteholders are equally ranking and repaid pro rata at the same time, they are theoretically more likely to be repaid in full, especially if the covered bond programme has considerable excess collateral.

In such circumstances, this excess collateral can be returned to the issuer’s insolvency estate and be used to repay unsecured creditors.

In practice, Germany would never allow a Pfandbrief to default. Moreover, the decision to exclude covered bonds from being bailed in under the Bank Recovery and Resolution Directive means that the safety of covered bonds is now beyond doubt.

For these reasons, Germany’s extension proposal may serve to highlight critical differences between European regimes, as opposed to extending the purported harmony.

Ultimately this thorny question may only be resolved by the European Commission, which is responsible for reviewing the transposition of the directive two years after its implementation. It will need to decide just how harmonious it needs its covered bond regimes to be.

By Bill Thornhill
20 Oct 2020