German Pfandbrief issuers have been rumbled. After enjoying the monopoly of mortgage- and loan-backed issuance in the market since 1998, Pfandbrief borrowers from across Europe are getting in on the act. French Dexia Municipal Agency (Dexma), Compagnie de Financement Fonciere and Luxembourg's Pfandbrief Bank International (PBI) have all signed programmes in the last six months and are offering fresh competition to their German counterparts. But who will come out on top in the European Pfandbrief race? In an increasingly investor-driven market those with the power could soon be calling for a standardized pan-European Pfandbrief market. It would be much easier for investors to concentrate on the credit quality of issuers if the regulations that govern the various covered notes, including French obligacion foncieres and Spanish cedulas hipotecarios, were made the same. But the market is undecided as to which model should be the benchmark. Roland Zemelka is the head of the frequent borrowers desk at DG Bank. He specializes in German Hypothekenbanks and Landesbanks. He is certain that other rival Pfandbrief banks in Europe, such as Dexia Group, will soon have an impact on German mortgage banks' issuance. He says: "It is perhaps too early to say just what influence the other European Pfandbrief markets will have on German issuers, it isn't having an impact on their levels now. But other markets are growing and in a couple of years competition could be significant." And this is not all the German issuers have to contend with. Difficult market conditions in 2000 and the growing credit market have affected many highly-rated German Pfandbrief borrowers. Issuance of all European Pfandbrief Euro-MTNs fell in the first eight months of the year with only $4.93 billion-worth traded by September 1, according to MTNWare. For the same period in 1999 over $8.17 billion was sold. Established German issuers are standing their ground. Bettina Klose, head of capital markets at Deutsche Pfandbrief Bank (DePfa), says the bank has noticed little effect of competition from borrowers outside Germany. She says: "It's not really a competitive market right now. Others, such as the French and Spanish issuers, have to do more work to develop their markets in terms of acceptance and size. They have good potential to be competitive, but generally it isn't worrying for us." But the realization of that potential might not be as far away as German mortgage banks would like to think. Issuers such as Dexma are catching up fast. Jean-Luc Petitpont, head of long-term funding at Dexia Group, believes obligacion foncieres are offering stiff competition to German borrowers already. He says: "Dexma had to pay a premium a year ago, but it's established in the market now and that is no longer the case. It has issued in every part of the yield curve and its market-making is very similar to that in the German market, so its issues are very liquid." Dexma, the societe de credit foncier (SCF) of Dexia banking group, was formed in July 1999. It is a special purpose financing vehicle off which the French form of Pfandbrief, obligacion foncieres, can be issued. It signed its euro25 billion ($23.28 billion) Euro-MTN programme in March 2000 and has had no trouble attracting investors. It had issued over $1.39 billion off its programme by September 1 this year. Petitpont points out that obligacion foncieres have many preferable qualities when compared to the German model. French SCFs are required to provide detailed information about the quality of their assets which German law does not require. They are also regulated by auditors whereas German mortgage banks are supervised by trustees who can be from any professional background. Petitpont continues: "We can offer greater transparency than some other European Pfandbriefe, in particular in our assets and liabilities management policy. It is known that we swap all our assets and liabilities into floating rate in order to avoid any currency or interest rate risk. We also show the full breakdown of the assets we hold." Many of Dexma's German competitors consider that obligacion foncieres won't distract investors from their established product. But at the same time they recognise that the market is changing and that they can't be complacent. Wennemar Bodelschwingh is head of capital markets at Eurohypo, the hypothekenbank of Deutsche Bank. He says: "We stand by our product. The jumbo market has over euro350 billion outstanding - this is the one with the volume and the track record. We want to differentiate our product from others in Europe but at the same time we do recognize that the market is changing and that there is growth from other sectors. It is likely that the market will change and that competition will grow in the coming years. The German regulators may have to reassess German Pfandbrief laws so that we can be more competitive." Rules about German mortgage banks' asset buying is something regulators are addressing as Europe-wide Pfandbrief competition grows. German law only allows mortgage and public sector lending institutions to invest in EU countries' assets. By comparison in Luxembourg Pfandbriefe banks can buy assets in any OECD country. As a result they have a wider choice and can find cheaper assets giving them a competitive edge. The Association of German Mortgage Banks believes safeguarding the quality of the Pfandbriefe is crucial. An official at the association says: "The fact that Luxembourg mortgage banks can fund any OECD assets through their Pfandbrief-like lettres de gage is a potential drawback for the instrument. But the Luxembourg issuers are well aware of the dangers inherent in excessive lending to certain OECD countries." He continues by explaining that the German regulator is planning to relax its rule by 2001 although not as far as Luxembourg: "By pursuing an extension of German mortgage banks' business activities to G7 countries - namely the US, Canada and Japan we aim at maintaining their competitive edge without sacrificing the security of their Pfandbriefe," he adds. For Klose at Depfa this would be a welcome change: "The laws are too restrictive. I would prefer quality restrictions on assets rather than geographical ones. I would like to see more possibility for regional diversification in the assets we can hold. The protection of the quality should be the most important thing," she says. Though competition could drive pricing levels down for all Pfandbrief issuers, most can also see the positive aspects of increased rivalry. Christof Schornig, managing director at PBI, the first Luxembourg Pfandbrief issuer in the market, says: "There is competition but we like it that way. Having a large group of Pfandbrief issuers is good for developing the sector as an asset class. With shrinking government debt there is potential to build a new benchmark class and a European Pfandbrief asset class could fill that gap. It would probably be easier to have one legal framework but having the different products gives investors more opportunities for diversity. Each country's Pfandbriefe has different strengths." Schornig used to be treasurer at Depfa and worked with Bettina Klose until he moved to PBI earlier this year. And more borrowers of this type in the market means greater recognition for the product. Some German Pfandbrief issuers say they have noticed the increase in demand from European investors. Bodelschwingh at Eurohypo says: "Three years ago about 10% to 20% of our jumbo Pfandbrief products sold outside Germany. That has now grown to 40%. Having the Pfandbrief concept copied and adapted in other countries has certainly aided the growth of the market and that has to be a good thing." Healthy competition is another reason some market players don't want greater standardization of the different Pfandbrief products. An official at the Association of German Mortgage Banks says: "There was an attempt in the mid-1980s to harmonize Pfandbrief legislation in Europe but it was stopped because it was realized that to achieve the optimum choice for investors, competition of differing systems was preferable to harmonization. We welcome this competition derived from having many systems." Thomas Kaysh, global head of capital markets and treasury at Hypothekenbank in Essen, says: "For investors there is more work involved in credit research on the different products, but for us it is better that there are differences." But DePfa is pushing for a more standardized European legislation and has tried to move progress along at a faster pace: "DePfa has always voted for a uniform European Pfandbrief market, but different legal frameworks in various countries have slowed the process down," says DePfa's Klose. And Christian Reusch, syndicate manager at Bayerische Hypo-und Vereinsbank (HypoVB), also believes standardization would make the market more efficient. He says: "All new markets have difficulties that need to be ironed out before real growth can be seen. If there was greater standardization these problems would disappear and it would be easier for investors. At the moment investors cannot compare the different products." But it would involve a great deal of work and revolutionary change for some borrowers to put all European Pfandbriefe on a level playing field in regulatory terms. Structural differences vary widely in terms of asset pools, bankruptcy remoteness from the parent bank and loan and mortgage repayment safeguards. Reusch, at HypoVB says: "It's hard to say whether one model is best. All of them have good and bad points. The German market has been successful and it could be used as a basis for development but it does have some drawbacks." For Spanish issuers of cedulas hipotecarios, bringing regulations in line with the German or Luxembourg models could pose problems if it was attempted. Spanish covered notes are linked to the default of parent banks unlike German, French or Luxembourg Pfandbriefe. To date no Spanish borrower has issued cedulas hipotecarios in the Euro-MTN market but the potential is there. An official in capital markets at Caja Madrid says: "More standardization of European Pfandbrief products is an interesting idea and would probably be beneficial to investors. They would avoid the legal risk involved with the different products and could concentrate on the issuer's name. But changes of this sort would have to come from some sort of central regulatory body in Europe." Yet many are sceptical. Petitpont, at Dexma, says: "Since there's no Europe-wide law I don't see how we could have standardization. I'm not sure it would be beneficial, but in any case it would not be possible in practice." German Pfandbrief issuers have a comfortable lead in the market for now, with a strong track record, issuance volumes and liquidity. But in the international markets things can turnaround quickly. Reusch, at HypoVB, says: "It's still in the early stages but if you ask the question about increased competition for German issuers in one year's time it might be a different story."
October 13, 2000
