The Pfandbrief or mortgage bond as a product has undergone major changes in recent years. Seen for a long time as an alternative to government bonds, it has now become very much an independent credit product.
During the 1990s German mortgage banks had great success in opening up commercial financing and state loan markets in other European countries, and through the initial years of the decade, domestic mortgage bond business was shaped by the special economic circumstances surrounding German reunification. However, the crises in Asia and Russia in 1998 demonstrated for the first time that mortgage bonds were evolving in a markedly different way from government bonds. Up until then the yield spreads of mortgage bonds as against federal bonds moved within a relatively narrow bandwidth. However, the crisis led to a flight of investors to safe havens such as German federal bonds, leading in turn to a virtual doubling of this hitherto relatively constant spread level.
An important reference parameter for mortgage bonds (as for other credit products) is the swap spread. The huge increase in government spending, occasioned chiefly by the slow-down in growth in 2000 and increased expenditure on anti-terrorism measures after September 2001, has forced swap spreads down to their current historic low point. This has led in turn to great reluctance to invest in bonds which are generally regarded as substitutes for swaps, since operators are increasingly coming to the conclusion that a renewed widening of swap spreads is likely. As a result, sales of mortgage bonds as a refinancing instrument for mortgage banks have also fallen markedly.
Since the introduction of the euro in 1999 the European corporate bonds market has grown rapidly both in terms of volumes and numbers of issuers. As ever, the financial institutions are endeavouring to reduce the risks associated with credit financing, with particular emphasis on securitisation. Meanwhile, in a climate where returns have fallen to their lowest level for many years, investors are continually on the look-out for higher-yield investments. The increased issuance of corporate bonds has had an additional effect on swaps: many corporate bonds are issued along with a fixed coupon, and as a rule transformed into variable interest instruments by the issuer via swap transactions, leading to additional downward pressure on swap spreads.
Among the mortgage banks and most particularly among the state banks (Landesbanken), there is an unmistakable trend for more and more German states, and also the Credit Institute for Reconstruction (KfW: Kreditanstalt for Wiederaufbau: KfW) to tap into the capital market via so-called jumbo issues with a minimum of E1bn, and these new market segments represent severe competition for the mortgage bond sector.
As a result of the generally poor economic situation and the deterioration in banks’ credit portfolios, the need for write-downs and the size of bank’s contingency reserves has greatly risen. This has led to a marked deterioration in the revenue situation at many banks, increasingly leading in turn to the downgrading of their credit ratings. The downward trend in banking sector ratings also shows up clearly in their share prices. Whereas parent company’s good ratings had previously, by and large, been a bonus for the various subsidiary mortgage banks, after the rating downgrades they have become something of an encumbrance. Moody’s ratings approach in particular, based as it is on the issuer’s long-term, senior, unsecured liabilities, has led to the downgrading of ratings for German mortgage bonds.
For issuers of mortgage bonds the market situation has changed significantly as a result of the developments outlined above. The rating downgrades, some of them sharp, are increasingly reducing the attractiveness of mortgage bonds as compared with government bonds. The consequent reduction in issuing activity means that the mortgage banks have largely been debarred from more favourable refinancing at conditions below the swap rate. A reduction in revenues and high refinancing costs in a sector already characterised by low margins has led to a noticeable fall in mortgage banks’ profitability. Mortgage banks’ options in seeking to compensate for this fall are limited by the restrictions in business activities prescribed by the specialist bank principle laid down in the Mortgage Bank Act and also by the model for the monitoring of interest-rate risks introduced in April 2001 by the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht). All in all then, the pressure on mortgage banks’ margins has increased greatly. Among the consequences of this overall situation have been increasing adjustments of business models, hiving off and mergers in the mortgage bank sector in order to establish strategic market positions and generate sustainable revenue flows. The new corporate structures thus created, along with the new weighting within the mortgage market has led, both before and after the_mergers, to revised assessments of these companies, and this is reflected in the ratings assigned to the corresponding issuers. One pointer suggesting that the consolidation phase among mortgage banks is not yet over is that the HypoVereinsbank is considering hiving off its entire mortgage bank holdings (HVB Real Estate, WestHyp, WürttHyp, PBI Lux and the Dutch company FGH) into an independent real estate financing group. Should this prove not to be feasible, an alternative would be to sell off parts of the current portfolio and / or enter into mergers with other partners.
The aim of the amendment of the Mortgage Bank Act coming into force within the framework of the 4th Promotion of Financial Markets Act (4. Finanzmarktförderungsgesetzes) of 1 July 2002 was to adjust the legal foundations for mortgage banks’ commercial activities to the competitive challenge they face through the expansion of regional credit business and the broadening of the specialist banks principle, thus ensuring that they are equipped to stand up to global competition in their core business areas of real estate and government financing. An additional aim was to increase the security of German mortgage bonds through the use of derivatives as primary cover and the obligation to carry out cash-value breakeven analysis. Although these innovations were greeted on all sides as likely to have a positive effect on the mortgage bonds market, to date they have not had any significant effect in the form of upgraded mortgage bond ratings.
What awaits the German mortgage bond market in 2003?
In the opinion of some, the renewed downgrading of HypoVereinsbank by Moody’s on 22 January 2003 was a signal that the valuation of mortgage bonds would this year continue to be one of the major issues, even if most of the downgrades are probably now behind us. Overview 1 shows that the mortgage bond market has lost its homogeneous character thanks to the different rating approaches adopted by Moody’s, S&P and Fitch. As regards public sector Pfandbriefe, the rating assessments made by the various rating agencies may differ in extreme cases by as much as three notches, and in the case of mortgage bonds by up to four notches. Even on the pure credit markets gaps this big are virtually non-existent, and are regarded as abnormal when they do occur. This causes problems for the issuers affected when it comes to issuing new mortgage bonds, but most importantly it leads to investor uncertainty. How investors react to the different rating approaches will be of decisive importance for the future of the mortgage bond market. Will the focus continue to be on the issuing institution’s fundamental risk profile or will it shift more strongly to the structural quality of the coverage fund and the safety net provided by the Mortgage Bank Act? In light of the divergent views held by the rating agencies in these respects, more and more investors are attempting, on the basis of the nowadays copious volumes of data published by the mortgage banks, to undertake their own valuations of mortgage bonds in order to arrive at their own independent assessments of the fair value of a given mortgage bond. However, detailed official regulations governing the placement and treatment of coverage funds and also the recognition of excess cover in the event of an issuer’s bankruptcy will be required if we are to reach a standardised approach to ratings which investors will find easier to interpret.
This would probably then also lead to the maximum rating gap fixed by Moody’s of four notches for public sector Pfandbriefe and three notches for mortgage bonds being widened via the respective issuer ratings.
A further point is that we can assume that issuers will continue to attempt to maintain the current high ratings of their mortgage bonds, or indeed enhance them, via measures to reduce costs and increase profitability. However, the improvement of ratings should be viewed as a longer-term process and also, in view of the current downward rating trends, as very difficult to achieve.
In general the sustained decline in public sector Pfandbriefe (issued to refinance public sector loans) can be expected to continue, as can the corresponding decline in the gross issuance volumes of jumbo mortgage bonds. However, since the noticeable trend of recent years towards growth in mortgage bonds will continue, overall growth in the German mortgage bond market is possible. It can also be assumed that the trend towards increased issuance of traditional mortgage bonds as opposed to jumbo mortgage bonds will continue. One reason for this is that traditional mortgage bonds can be specially tailored to investors’ needs and if necessary enhanced via additional structures. These often involve more attractive conditions and, most importantly, lower management costs for the mortgage banks, since traditional mortgage bonds may be brought onto the market in a comparatively opportunistic manner. Secondly, due to the ever-increasing importance to investors of solvency considerations and the increasing industry-wide deterioration, mortgage banks are increasingly unwilling to issue unsecured securities, and are instead issuing mortgage bonds. Due to their low volumes, most of these do not fall within the jumbo mortgage bond segment, rather being issued as traditional mortgage bonds.
Consolidation, changes of strategy and realignment will continue to be the watchwords for issuers. Alongside the planned hiving off of the HVB mortgage bank subsidiaries and AHBR’s efforts to push through its restructuring programme and increase synergies within the group, with an eye on 2005 the state banks will also be subject to major restructuring and adjustments of their business model.
Looking further afield, it is clear that competition on the European mortgage bond market has increased and that this trend can be expected to continue in future in view of the ever-greater convergence of the European mortgage bond market. So, for example, the gap created by the decline in the issuing of German jumbo mortgage bonds has been filled by an increase in French and above all Spanish covered bond issuers. Meanwhile, despite their sound legal basis, the new Irish asset covered securities (ACS) cannot, at least in the short term, be expected to show the same dynamism as we see in Spain or France, for example.
Jörg Sihler is head of European fixed income at Deutsche Asset Management in Frankfurt
The author wishes to acknowledge the contribution made to this article by a diploma thesis written by DeAM colleague Andreas Denger, who is in his final year of business administration at the Hochschule für Bankwirtschaft in Frankfurt.