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Enter differentiation

28 Mar 2002

Only a few years ago, pricing a jumbo Pfandbrief was straightforward: once you knew the maturity, you simply extrapolated the spread from a relatively clean yield curve. Today, a host of unknowns need to be considered in the European covered bond market: Which legal framework applies? What is in the asset pool? And how liquid will it be? Here, Philip Moore reports on the issues driving this differentiation.

Remember when the Pfandbrief market was so simple? Stefan Dreesbach, head of European agency trading at Goldman Sachs in London, certainly does. "Two or three years ago a mortgage bank was a mortgage bank," he says. "It was seen as an issuer with a solid and sound public sector asset pool and it was sold like a baby Bund with a spread attached."

Today, says Dreesbach and almost everybody else who has been watching the market, it is no longer safe to make such assumptions. On the back of extensive restructuring and consolidation, the tentacles of event risk and balance sheet uncertainty have reached into even this market, and the impact this is having on ratings and bond spreads is plain for all to see. Above all, it has led to a conspicuous tiering of the jumbo market, a process Dreesbach says started about 18 months ago.

"Already we are seeing a much greater degree of name differentiation in the jumbo Pfandbrief market than we saw a year and a half ago," he says. "Nowadays you will typically find DePfa trading in the plus 7bp area at the long end of the curve, whereas the cheapest jumbos are trading at between 15bp and 17bp over. So there is already a 10bp spread between the different Pfandbrief issuers."

Dreesbach says that in the German market at least, he sees no reason why this spread should narrow in the foreseeable future, with investors focusing even more intensively on the individual merits of each issuer: "This will be the year when investors really start to refocus on issuers' fundamental creditworthiness, their business plan and their approach to the capital market, and if anything, we will see even more name differentiation than we have in the last two years."

Others agree, but add that the process of comparing the credit quality of individual issuers in the covered bonds market is still at the embryonic stage, which suggests that those investors willing and able to make relative value assessments ought to outperform those that are not. "Only now are investors starting to think about credit quality," says Ralf Grossmann, head of covered bonds research at CDC IXIS in Frankfurt. "But differences in credit quality are not yet fully reflected in spreads and there are still some big imbalances out there."

Legal legwork

If the business plan of the individual issuer is the first element that investors are being asked to scrutinise much more diligently than ever before, the second is the legal framework under which the bond is launched. This problem has been emerging for some time, with the arrival of the internationally-targeted French obligations foncières (OF) and Spanish cédulas hipotecarias markets calling on investors to compare the different legal frameworks across Europe. That is going to be exacerbated this year with the imminent opening of the new Irish covered bond market. Thereafter, new sectors are also expected to emerge in Norway, Sweden, Italy and Belgium.

While bankers welcome the launch of new markets that bring flexibility to issuers and diversity to investors, they also recognise that the evolution of a patchwork of different regulatory environments may ultimately be self-defeating. This is because it is inevitably forcing investors to closely assess the relative merits of each market, and many - understandably - simply do not have the time, resources or inclination to do so. The result, say bankers, is that relative value analysis between, say, the Pfandbrief market and its counterparts in France and Spain has not taken root among the majority of investors in the covered bond markets. An inevitable by-product has been that many have generally remained dominated by the domestic investor base, if such a thing still exists in Euroland today.

For several issuers, this is a source of frustration. "At the moment we are seeing new laws coming out of so many countries in Europe, and each law tries to improve on the others." says Thor Wicke Monteverde in the capital markets department at DePfa's Wiesbaden headquarters. "What we are hoping is that within perhaps five years we will have a standard basic European covered bonds law. That will mean that at last this market is no longer driven by differences in legislation, but by the fundamentals of issuers' credit profile, their approach to the capital market, and the maturities they are issuing in."

Investors, and particularly those located well beyond Euroland's borders, are also crying out for some commonality of regulation to help them make better and more reliable comparisons across markets. But at the moment they cannot even get a uniform view on covered bonds from the ratings agencies, let alone a standardised law.

Whether that will change in the future is a topic of lively debate, which regularly surfaces at conferences focusing on the covered bond markets. "Clearly the situation is becoming worse for investors because it is getting harder and harder for them to understand the differences between the markets," says Christoph Anhamm, head of European covered bond research at ABN Amro in Frankfurt, "so the ideal solution would be to have an overall European law. Would it be possible to create one? Yes, I think it would be, although at the moment it could only cover the public sector side of the business. That would mean that some countries would need to make compromises, but I think it is feasible because people are accepting that within Europe virtually everything is in the process of being harmonised."

Taken to its logical conclusion, this would suggest that if the Deutschmark can be a casualty of financial harmonisation in Europe, along with uniquely German financial mechanisms such as Anstaltslast and Gewährträgerhaftung, then so too can the German Mortgage Banking Act, irrespective of the fact that it has been around for 200 years or so.

Anhamm believes that establishing a standardised law for covered bonds backed by pools of mortgages would be considerably more challenging. "On the mortgage side things are more complicated, because mortgage markets in Europe are far less commoditised and homogeneous than the public sector markets are," he says. "In the public sector there's not much of a procedural difference between lending to a municipality in Finland or southern Italy. But on the mortgage side there are big differences in terms of cultural attitudes towards housing loans, loan to value ratios, tenors, consumer protection and so on."

That means that if a common law were to come into effect for public sector covered bonds, but not for mortgage bonds (which in the case of many issuers are expected to grow quicker than their public sector stable companions) it is debatable how much better off investors would be in terms of market clarity.

And if all this were not complicated enough, there is now a third way in which investors are having to differentiate between issuers. DePfa's very public repositioning as an issuer that aims to be traded on banks' agency desks will, say bankers, have a very far-reaching impact not just on its own issuing policy, but also on the approach to the capital markets that is adopted by other issuers in the jumbo Pfandbrief market.

By adopting a Kreditanstalt für Wiederaufbau-style approach to premarketing and pricing bonds to sell, DePfa has established a new benchmark that other issuers that are serious about broadening their investor base will increasingly need to replicate. The new DePfa approach is also starting to exert pressure on investment banks to scrutinise their own strategy in the Pfandbrief market, which in the past has usually been defined by a preoccupation with league table ammunition.

One Frankfurt-based banker is surprisingly open about the dilemma and about his own bank's historical strategy in the market. "To me, the recent trends within the agency sector in Europe constitute the most important wake-up call the Pfandbrief market has ever had," he says. "Basically, the way recent agency deals have been executed has exposed the shortcomings of the primary Pfandbrief market. We've constantly seen deals that were not priced on the basis of investor sounding or investor demand, but at levels that were derived by combining issuers' aggressive funding targets and banks' eagerness to print business.

"Let's not kid ourselves: in this respect we've also appreciated the opportunity the Pfandbrief market has given us from a league table point of view. It's a matter of fact that not all the deals led by this bank have been priced to sell."

The DePfa initiative, says the same banker, may enforce changes in this respect. "Very soon - if not already - we're going to find ourselves cornered," he says. "On the one hand we are going to have banks like DePfa and HVB Real Estate telling us that if we want to lead manage their new issues we're going to have to stop doing the opportunistic deals. On the other, we're still going to have clients that are not ready to follow the new way of doing business, but which obviously reward us with business elsewhere that we can't ignore."

DePfa itself corroborates this view. "Think about it from the perspective of an issuer," says its head of capital markets, Wally Hofer-Neder, the poacher turned gamekeeper who was at Commerzbank for 18 years before making the short move to Wiesbaden. "Would you be happy if, as an issuer, the banks you were giving business to were ultimately undermining the credibility of your market? Of course, as an issuer you have to talk to investors about your own credit, but our product is and will remain the Pfandbrief and so we will inevitably always be compared with other issuers in the market. What's the point in our bankers helping to promote the asset class on the one hand by marketing our globals, and on the other hand doing completely the opposite by supporting opportunistic issuance?"

28 Mar 2002