German bankers have been singing the praises of synthetic securitisation, a technique that allows issuers to avoid the country's high tax payable on special purpose vehicles. But there are some members of the choir who are still keen to see the market open up to true sale deals, and the cost savings that accompany them.
Stephan Krauss, a partner at Frankfurt-based law firm Hengeler Mueller, knows a thing or two about the evolution of the German asset backed market in general, and about the market for CMBS in Germany in particular.
In recent years, he has advised on virtually all securitisation transactions in Germany which, as he points out, means that Hengeler Mueller has enjoyed a respectable share of the total European market. He says that in 2002 alone, the firm advised on transactions representing about Eu45bn, or about 22% of the total public market of some Eu200bn.
Krauss recalls that the first securitisation he advised on - which was some 18 months in the making - was the Rheinhyp GEMMs transaction arranged by JP Morgan in 1995, although in terms of the CMBS market in Germany, 1999 was probably the defining year that has shaped the structure and development of the market ever since. That marked the introduction by the German financial authorities of a trade tax on special purpose vehicles (SPVs) which, virtually at a stroke, made true sale securitisation uneconomic for German banks - at much the same time when German banks were looking to accelerate the process of credit risk transfer as a means of maximising capital relief.
According to Krauss, the liability that issuers would incur as a result of this tax varies according to their location within Germany. But he says that the typical cost for a Frankfurt-based issuer might amount to 50bp of a deal's size - high enough to make it prohibitive for banks looking to securitise assets through cash deals.
However, given that the banking industry viewed securitisation not as a funding mechanism but as a means of achieving regulatory capital relief, that did not signal the premature death of the German securitisation market. Far from it. Instead, it encouraged the development of a market in synthetic securitisations, in which mortgage assets remain on the banks' balance sheet while risk is transferred either to sellers of credit risk protection (through so-called 'super-senior' unfunded credit default swaps), or to the capital market (through credit-linked notes).
Kraus says that Germany's first CMBS deal structured along these lines was a Eu267m securitisation of a pool of 634 commercial mortgages by Deutsche Hypothekenbank Hannover (DHB) arranged by Deutsche Bank and launched in November 1999.
The practice of synthetic risk transfer has also gathered rapid acceptance and popularity in the German market for residential mortgage backed securities (RMBS).
Landmark transactions in this sector included Foerde 2000-1, which in May 2000 became the first synthetic German RMBS transaction (Deutsche Bank's famous Haus transactions in 1998 and 2000 were both true sales, the latter escaping the trade tax complication via a grandfather ruling), and the first to involve a partially funded structure, with a super-senior credit default swap.
The Pfandbrief market: going back to its roots?
To a limited degree, the expansion of the German Pfandbrief market in the second half of the 1990s, followed by the launch of internationally targeted covered bonds by issuers in France and Spain, ostensibly provided one example of the growing internationalisation of real estate as an asset class.
In practice, however, Germany's Jumbo Pfandbrief market (the only part of the Pfandbrief sector in which international investors have been active players) is overwhelmingly dominated by public-sector instruments (Öffentliche Pfandbriefe). And although Spain's cédulas hipotecarias are mortgage backed bonds - France's obligations foncières are the only European covered bonds in which collateral can be a melange of residential mortgages and public sector loans - in volume terms as an asset class the European covered bond market remains predominantly one that is backed by public sector loans.
That may now be changing. With public sector lending opportunities for German mortgage banks becoming thin on the ground, a number of the heavyweight issuers in the market for Öffentliche Pfandbriefe are increasingly looking to the potential of mortgage lending. That in turn suggests that there will be a rise in the issuance of mortgage backed Pfandbriefe (Hypotheken Pfandbriefe), but at the same time it implies that there may be more smaller issues in the pipeline, which would look more like the so-called traditional, domestically targeted bonds than the Jumbo benchmarks that were so fashionable in the late 1990s and early 2000s.
For Aareal Bank, for example, which inherited a portfolio of residential mortgages when it split from Depfa, the Pfandbrief market will continue to play an important role as a low cost and efficient means of refinancing via its new mortgage subsidiary, Aareal Hypothekenbank.
But as Christof Schörnig, a member of the board of managing directors, explains, that will not mean that Aareal becomes an issuer of the sort of jumbo, multi-billion euro transactions that have characterised the internationallytargeted segment of the market since 1996.
"This year we will have a funding requirement of between Eu5bn and Eu6bn," he says, "of which about half will be raised via the Pfandbrief market. With a funding requirement of that size, benchmark issuance would not be the cheapest source of refinancing."
That need not diminish the attractiveness of Aareal's Pfandbriefe to local or international investors, Schörnig insists. "On the one hand, we have seen a substantial consolidation in the Pfandbrief market," he says, "which has reduced the number of high quality names available to investors.
"However, on the other hand investors are increasingly reluctant to invest in issues from some of the mortgage banks that have unclear strategies. Instead, they want to invest in banks that have clear and sustainable business models. Aareal Hyp fits into that category, and we have already seen strong demand for tailor-made Pfandbriefe, which has given us funding at very attractive levels."
Schörnig explains that while the Pfandbrief market will be an important refinancing source for Aareal over the coming years, it will be complemented by a range of others. For example, the bank enjoys a steady flow of income generated by its IT and consultancy business, while at the short end of the curve it plans to establish a commercial paper (CP) programme in the near future.
Other sources of funding that Aareal Bank has used productively over the past 12 months have included private placements and structured deals, as well as opportunistic Euromarket issuance in a number of predominantly retail driven markets, with issuance in 2002 including deals denominated in Hungarian forint and Polish zloty. *
The Haus 2000-1 transaction earlier in the same year was the last true sale securitisation of bank assets in Germany, although as Krauss points out, there have been a number of true sale deals securitising other assets such as auto loans.
Although the synthetic securitisation mechanism has been tried, tested and proven in Germany, a number of German bankers say that it is a concept that remains poorly understood outside the country, which is one reason (they add) why the lion's share of synthetic RMBS and CMBS have been, and still are, led by German banks.
Talk to bankers in London and some express a haughty dismissal of synthetic securitisations as a cross that German issuers are forced to bear, simply because they have no alternative.
German bankers themselves see the synthetic market in a somewhat different light, insisting that it is not necessarily a poor relation of the market for true sale securitisations but a viable alternative with plenty of merits in its own right. "There are plenty of advantages associated with synthetic deals," says Patrick Trouet, vice president and head of securitisation at Aareal Bank in Wiesbaden. "In a synthetic deal you can define the risk you are transferring much more precisely than in a true sale. In a true sale all the risk is transferred, whereas with a synthetic transaction you can define whether you are transferring capital or interest or foreclosure costs. There is no question that for banks looking primarily for capital relief, synthetic securitisations are very fine instruments."
Beyond that consideration, say bankers in Germany, the synthetic structure is far simpler to apply to the sort of multi-jurisdictional transactions that are becoming increasingly popular in the European CMBS market.
A deal such as Aareal's recent Global Commercial One, for example, which was a synthetic securitisation of commercial mortgages in 11 countries, would have entailed huge legal complications had it been structured as a true sale - given that it would have meant tailoring the structure to comply with 11 different legal systems in Europe and the US. "Issuers and investors in a market like the UK are used to very homogenous portfolios of, for example, pre-let office buildings in central London," says Peter Schott, head of securitisation and syndication at Aareal Bank's Wiesbaden headquarters.
"In those sort of transactions there is a single registration under a single law, but when you start rolling mortgages from 11 different jurisdictions into one SPV it presents very different challenges."
Be that as it may, German banks would clearly prefer to be given the option of tapping the market for true sale securitisations as well as synthetic transactions. Although they say that in the absence of precedents it is too early for them to compare the economics of the two, bankers say that true sales are a preferable option from the perspective of costs of capital. "It is normally cheaper on a weighted average cost of capital (WACC) basis to do true sales, because with synthetics you generally have to hold capital of 20% against your swap counterparty on the super-senior piece," says David Newby, head of European CMBS at ABN Amro in London. That explains why synthetic securitisations through the Provide and Promise programme sponsored by the zero risk-weighted state owned bank KfW have proved so popular with German banks in search of capital relief (see box).
Bankers in Germany believe that the true sale option will be made available to them sooner rather than later. "I am confident that for the special kinds of SPV you need for a true sale securitisation we will see tax exemption at some point in the future," says Christof Schörnig, a member of the board of managing directors at Aareal Bank.
He says that the finance ministry, supported by the major banks, is presently looking at introducing exemptions for a tax which, in any event, generates very little revenue for the state coffers.
"I believe that by the end of the year we will see true sale securitisations in this market, which are the cleanest way of transferring credit risk from the balance sheet," he says. "That will be important for us from a portfolio management perspective, allowing us to decide on a case-by-case basis which is the most efficient and cheapest instrument to use."
One apparent weakness of the German market for synthetic securitisations, say a number of bankers outside the country, is the continued relative opacity of detail on the reference pool of assets backing CMBS. Data secrecy laws, which are strict compared with a number of other European jurisdictions, dictate that the precise identity of ultimate obligors within the reference pools can only be revealed to ratings agencies and investors with the express permission of the borrower in question.
"There is quite a lot of information that we are unable to give away in offering circulars," Schott concedes. "Certainly investors would like to see the specific addresses of obligors in the reference pools, especially US investors who are used to seeing not just the address of the borrowers but everything down to the shoe sizes of tenants. The fact is that that is simply not possible under German law, which comes as a shock to some US investors. That may have an impact on liquidity in the German market, but I do not believe it has any influence over pricing of German CMBS, in terms of paying a premium over issuers in, say, the UK market."
Promise and Provide: alternative funding options
Since December 2000, an important contribution to the evolution of the market for synthetic securitisation structures in Germany has been made by the Promise and Provide platforms sponsored by the 100% state owned and zero weighted development bank, KfW.
While Promise provides a mechanism for securitising bank loans to small and medium sized enterprises, the Provide programme, launched in October 2001, is playing an increasingly significant role in helping with the securitisation of residential mortgages. Hypovereinsbank (HVB) was the first issuer to use the Provide platform as a means of transferring credit risk on Eu1bn of residential mortgages.
Under the basic structure of the standardised Promise and Provide programmes, typically fragmented portfolios of loans are bundled together by KfW, with the risk transferred to a special purpose vehicle (SPV), which then transfers some of that risk to the capital market through the issuance of tranched credit-linked notes (CLNs). A key attraction for originating banks using the platform is that they are able to achieve 100%, rather than 80% capital relief, given that other counterparties would attract a 20% risk weighting compared with KfW's zero.
In 2002, a further 11 transactions worth Eu19bn were concluded under the twin Promise and Provide programmes, more than double the total amount in the previous two years (of close to Eu9bn).
One innovation launched in 2003 was the first so-called multi-seller transaction. According to KfW: "The securitisation structure developed for this instrument is to be a prototype for follow-up transactions, permitting further smaller on-lending banks to utilise KfW's securitisation platforms."
Although the value of securitisations launched through the KfW platforms had risen to close to Eu30bn by the end of 2002, most of this has been accounted for by unfunded issuance in the form of super-senior credit default swaps. Only about Eu2bn has been placed in the form of CLNs, with KfW reporting that "German investors in particular, but also investors from other European countries and Japan, value the CLNs as a diversified, high yield investment product."
Aareal Bank has used the Provide programme twice - once in a multi-seller format in which the originators were Aareal, Aareal Hyp and Depfa. Peter Schott, head of syndication and securitisation at Aareal Bank, says that the bank would have no hesitation about using the platform again, which he views as a highly effective means of transferring credit risk on portfolios of residential mortgages. "Provide has been a very successful and transparent programme," he says. "It has become a well recognised and uniform brand which has helped to create liquidity."
Looking to the future, one intriguing question about how the Promise and Provide programmes may be adapted to broaden their scope is the degree to which either or both of the programmes could be made available to banks from outside Germany which are likely to be attracted by the scheme as a means of achieving regulatory capital relief.
KfW insists that it has already spread its wings beyond Germany with the launch in December of a Eu1.1bn Promise transaction for Bank Austria Creditanstalt (BaCa). Promise-Austria 2002 plc pooled over 2000 payment claims arising from loans granted by BaCa to more than 1,200 Austrian companies, although many would argue with some justification that as Bank Austria is owned by HVB this can scarcely be counted as a non-German transaction.
Looking to the future, however, according to an official statement by the bank: "KfW is prepared to make its securitisation platforms available as a standardised instrument to suitable institutions with appropriate loans types in other European countries. As is the case with securitisations in Germany, it could assume the role of a neutral intermediary for European banks as well.
"The inclusion of European portfolios would further increase the liquidity of the platforms. In addition, they could contribute to compensating for the fragmentation of the European securitisation market, which has resulted from the various national legal systems."
Offering the Promise and Provide programmes to bank issuers outside Germany would go some way towards countering the arguments of conspiracy theorists who argue that the platforms act, albeit indirectly, as a form of state support for those German banks that have so far made use of the scheme. KfW itself, as well as those bank issuers that have used its platforms, insist that the Promise and Provide initiative is a commercially oriented one, for which users pay a fee that, according to one banker, is "considerable".
Nevertheless, with investors deriving comfort from the imprimatur that the KfW name gives to issuance using the platforms, it is easy to see why misunderstandings about their use can arise.
In one sense, France enjoyed its fair share of action in the European CMBS market in 2002, seeing three notable and successful transactions securitising French commercial property. In another, it remained totally inactive, given that none of the three involved the securitisation of commercial loans held on the balance sheets of French banks.
Of the three transactions in 2002 that involved the securitisation of French commercial property, two emerged from the Morgan Stanley European Loan Credit (ELoC) programme. The first of the two, in May, was a Eu458m CMBS secured on a commercial loan originated by Morgan Stanley to finance the acquisition of office properties sold by and leased back to Eléctricité de France (EdF), which was the first of its kind within the ELoC programme to securitise Continental European assets. The second, which followed in August, was the Eu341.5m ELoC 10 deal, similarly secured on a loan backed by 22 buildings let to the French defence electronics company, Thales.
The other CMBS of French property in 2002, which is described by Gregoire Simon-Barboux, director of securitisation at SG in Paris, as having been a "pure French deal", was the two tranche Eu144m France Industrial Properties No 1 transaction on which SG acted as sole bookrunner in April. This was the second securitisation of European properties launched by the US-based distribution warehouse specialist ProLogis, and was secured on a commercial mortgage loan backed by warehouse properties on the outskirts of Paris owned and managed by the ProLogis European Properties Fund. About 85% of these properties are concentrated in a prime location between Paris and Charles de Gaulle airport.
Although bankers report that take-up of the French ELoC transactions among French investors was relatively muted, domestic demand for the ProLogis deal was strong, with Simon-Barboux saying that about a third of the investors were France-based.
"Clearly, there is good appetite in France for French assets in CMBS transactions," he says. "Investors are comfortable with the assets. They are attracted by the diversification offered in the CMBS market, as well as by the safety of the asset class, the strength of ratings, the low volatility in the market and the healthy spreads."
Three transactions secured on French commercial properties in a 12 month period might not seem like a big deal, but as Simon-Barboux points out, it is not bad going for a market which, not so long ago, doubted that any would be possible. Those misgivings were based on the existence in France of the unique 3/6/9 lease mechanism, which allows tenants to renew or cancel their contracts every three years and hence complicates any form of analysis of long term cashflows.
"The 3/6/9 system twinned with a bankruptcy law that is weak in comparison with markets such as the UK had been considered an obstacle to the development of CMBS in France," says Simon-Barboux.
While extensive discussions with ratings agencies and investors allowed SG to navigate its way past these problems in structuring the ProLogis transaction, Simon-Barboux doubts that the French CMBS market will extend in the foreseeable future to the securitisation of banks' commercial mortgage assets.
"Up to now we haven't seen any of the banks' commercial mortgage portfolios coming to the market either through synthetic or cash securitisations," he says. "In the first place I'd say that the exposure of French banks probably isn't as big as that of the German banks, perhaps because they were slower to return to the commercial lending market after the crisis of the early 1990s than a number of other European banks. That has meant that up to now French banks have had plenty of other efficient ways to refinance their property deals from a cash perspective.
"Additionally, French banks tend to have parts of syndicated loans on their balance sheets which does not help in the process of securitisation. It has always been much easier to securitise an entire loan, rather than the stake of a facility which has been syndicated among other banks, because otherwise it complicates the enforcement procedures in the event of default. But that is not a sole reason for French banks not to securitise commercial mortgages, because you'll find plenty of syndicated loans in the books of German banks."
Nevertheless, Simon-Barboux is not downbeat about the outlook for further CMBS activity in France. He says that changes to the tax regime governing listed property companies that the government is expected to introduce soon will remove the capital gains liability for the transfer of property firms' assets, giving them more flexibility to build larger real estate portfolios more efficiently.
That, in turn, should allow for the structuring of property portfolios that would have sufficient critical mass (with a minimum value of, say, Eu300m) to justify their refinancing via the securitisation market.
And that should be good news for French investors clearly gaining a flavour for CMBS as an asset class. *