Fitting neatly into bond portfolios
Pfandbriefe are essentially a form of asset-backed security that is primarily issued by the German mortgage banks to refinance their loan portfolios. Making up some 20% of the total lending business in Germany, the mortgage banks have been restricted by the German Mortgage Bank Act to lending on residential and non-residential property and to the public sector.
Of the E1,116bn of Pfandriefe outstanding as at September 2001, mortgage banks accounted for E670bn, split E470bn against loans to the public sector and E200bn against mortgages. Mortgage Pfandbriefe must be secured on first mortgages, and public Pfandbriefe on loans of at least equal nominal amount. Pfandbriefe account for almost two thirds of the total German bond market, making the segment the largest individual bond market in Europe, and the sixth largest worldwide. Jumbo Pfandbriefe, issues of E0.5bn and above, are the fastest growing area, increasing by 15% per annum to E400bn, as at January 2002, and are becoming the benchmark for euro denominated bonds.
Although jumbo issues have come to prominence in only the last seven years, Pfandbriefe are by no means a new instrument – they first came to market some 230 years ago. Pfandbriefe are differentiated by their asset-backing issue size and whether the security is bearer or registered. In the main, the structure is simple: a basic straight bond format with single bullet maturity, fixed coupon and annual coupon payments. Maturities range from one to 10 years, although some are longer. Structured Pfandbriefe are variations from the standard Pfandbriefe format that cater for an investor’s individual needs. This can involve step-up coupons and calls or more exotic features.
Global Pfandbriefe have been issued that are aimed specifically at the needs of the international investor. Structured to qualify under Rule 144a, these bonds can only be sold to ‘qualified investors’ with greater than $100m of assets. Frequent issuer status has been achieved by a number of mortgage banks which gives exemption from SEC registration and reporting requirements. As opposed to eurobonds, where accrued interest is calculated on a 30/360 basis, accrued interest on Pfandbriefe is calculated with reference to actual days.
Since 1999, the typical issue size of jumbo Pfandbriefe has increased beyond E2bn. Jumbo Pfandbriefe are noted for their ease of trading, with market-making commitments from at least three trading houses per issue, with recommended dealing spreads. Volumes in the larger issues are comparable with volumes on smaller Euroland governments, like Austria and Belgium. The largest jumbo issues of E3bn or more, are admissible to the electronic trading system EuroCreditMTS, an extension of the EuroMTS system, through which Euro-land government bonds are traded. Trading volumes in German mortgage banks issues via this system have reached E900m per day. Total daily turnover in Pfandbriefe is estimated at E10–11bn.
Liquidity has been improved by the tendency of issuers to augment the size of existing issues, rather than place new paper. Jumbo Pfandbriefe can be added to by the issuing house in tranches of E125m or more, subject to a fixed price re-offering procedure. The jumbo market is assuming characteristics that are common to deep and liquid bond markets, as head of credit research at DZ Bank in Germany, Thomas Herbert, commented at a recent industry conference: “There is heavy activity in jumbo Pfandbriefe repos, a well-populated yield curve from two to 10 years, and issuance of E60–65bn in the last year.” The spread of Pfandbriefe to bunds has declined over the last two years, from 50–60 bps to close to 30bps.
The credit rating attached to issues of Pfandbriefe is linked to the quality of the underlying asset pool and the rating of the mortgage bank. External agency ratings are particularly important for the issuance of jumbo Pfandbriefe of long maturities which are bought by international investors. Practically all public Pfandbriefe issued by the main mortgage banks are rated AAA/Aaa. There is slightly more dispersion of ratings on mortgage-backed issues, which are mainly rated by Moody’s. This high credit quality is maintained through the restriction to low risk lending and the preferential right of creditors to the underlying securities in the event of insolvency. Interest rate risk is minimised by matching the maturities of assets to the maturity of the issue and the pool of assets is monitored by an independent trustee.
The profile of a mortgage bank’s business will have an impact on the rating of the Pfandbriefe it issues. The three main rating agencies have different approaches to their rating of Pfandbriefe. Standard & Poor’s treats a Pfandbriefe as akin to a pure structured finance vehicle, and looks at the quality of the collateral in isolation. Moody’s looks at the bank first and then the collateral, and has recently downgraded some Pfandbriefe issues on the basis of a decline in the ultimate holding company’s rating.
Few mortgage banks are now independent – most belong to a larger banking group. Fitch-IBCA lends more weight to the collateral than the bank, but considers that the risk appetite of the bank will determine the characteristics of the asset pool. Recent legislative changes have made it possible for them to lend outside their home country, initially within the EU and EEA, and now internationally. From this year, German mortgage banks will be allowed to lend in the US, Canada and Japan. Fitch-IBCA analyst Bridget Gandy, at a recent conference, expressed some concerns that an expansion of German mortgage banks operations outside Europe might come with added risk: “Mortgage banks may enter some markets where they have insufficient expertise, for example, municipal loans in the US, when they have no experience of defaults. If the collateral pool contains these assets, there would be an impact on the rating.”
New banking regulations allow for the inclusion of derivatives in the cover pool and market participants generally feel that this enhances the protection for investors in the case of issuer bank insolvency. As a result, derivative contracts on interest rates and currencies are now permitted as a hedge to public sector and mortgage lending. The bank must ensure that separate contracts exist for the pool of assets covering the Pfandbriefe issue versus its own assets. The amount of derivatives contracts is limited to 12% of the pool and holders of Pfandbriefe rank equally to derivative counterparties.
To further modernise the market, a new model for monitoring interest rate risk has been agreed between the Federal Banking Supervisory Authority (BAKred) and the German mortgage banks. This defines an overall interest rate risk limit and requires appropriate disclosure to the BAKred. Increasing transparency and reporting should provide greater comfort to investors on the stability of pool assets. Each month the banks have to report on the change in present value of assets in the pool, both short and long maturity, arising from actual yield curve shifts and the impact of a 100bps shift in the yield curve. Banks must use accepted models and parameters for bond pricing, with reference to the standards for computation of regulatory capital. The regulatory body has the power to take steps if, on either test, the present value changes by more than 20%, and it would make further investigations if the present value was found to fall by more than 10%.
Pfandbriefe issued to refinance public sector lending make up 90% of Jumbo issues, if only because the individual loans are generally larger and easier to agglomerate.
German mortgage banks have funded business in the EU and the EEA to date, but are starting to lend to public bodies in Switzerland, US, Canada and Japan, both regional governments and local authorities, albeit that these exposures must be limited to 10% of the underlying asset pool. Emerging European OECD countries are being targeted, such as Poland, the Czech Republic, Slovakia and Hungary. Mortgage Pfandbriefe so far have been restricted to the EU, EEA and Switzerland, and are unlikely to move beyond this area for the time being.
Mortgage banking typically demonstrates extremely low loss rates, of 0.03% to 0.05% for loans of less than 60% of asset value to the residential and commercial sector. The proposed new Basel II regulations on banking capital set 40% and 50% risk weightings on residential and commercial mortgage loans, subject to a 60% ceiling on loans-to-value and verification of loss rates below 0.3% and 0.5% on different types of commercial mortgages. Most individual countries across Europe apply a 10% risk weighting to Pfandbriefe holdings, and this is transcribed into the EU Consultation paper on the implementation of Basel II.
Pfandbriefe exhibit a number of important differences versus their nearest equivalents, mortgage-backed securities (MBS). MBS are issued by a special purpose vehicle (SPV), or conduit, which is generally set up by a bank to move assets off-balance sheet, whereas the asset pool covering a Pfandbriefe issues remains on balance sheet. Pfandbriefe have access to the full cashflow of the issuer, whereas MBS are reliant on the cashflows of the pool (plus any liquidity facilities provided to the SPV). The pool of assets on which a Pfandbriefe depends is dynamic and infinitely substitutable, whereas an MBS issue typically is secured on a fixed pool of assets.
Pfandbriefe-like instruments and markets exist in other European countries but are generally less well developed. The Pfandbriefe is analogous in issuer type, collateral, legal framework and supervision to the French Obligation Foncières and the Spanish Cedulas Hipotecarias. In France, there are E26bn outstanding jumbo issues, and in Spain E12.5bn. Legislation has been passed for the development of an Irish market, and E50bn of issuance is anticipated. Equally, Italy has the potential for E200bn of issuance.
Pfandbriefe fit neatly into the European bond component of a pension funds fixed income allocation. Legislative changes and investment trends in most European countries support the buying of Pfandbriefe. In Scandinavia, issues emanating from outside Germany are proving popular in the light of downgrades of German mortgage bank issues. Danish pension funds are now able to buy Pfandbriefe post regulatory changes. Italian investors are moving towards ‘covered’ bonds and out of traditional corporate paper and lower yielding BTPs, and favour issues which can be electronically traded. Subject to good secondary market performance the Swiss are increasing their investment in the sector. Traditional buyers of US agency paper, the UK and Dutch insurance companies and pension funds are looking towards European alternatives as US support for these agencies weakens. Significant French-based funds, run by insurance companies, corporates and asset managers, are devoted to the Obligation Foncières and other similar markets.
For many investors the appeal of the Pfandbriefe is the stability of trading. Pfandbriefe typically trade between a spread of 20–50bps over bunds, and their high asset quality means they will never suffer a dramatic expansion in the spread. There is trend for European bond investors to move away from governments and the Landesbanks towards covered bond issues, for improved yield with little loss in credit quality. Pfandbriefe investor Barclays Capital stresses the importance of the secondary market in influencing investor appetite, because it is second wave buying that stabilises the market, and sets the tone for new issues. Tradability should be ensured by bid-offer quotes on minimum amounts of E15m over the life of an issue, and market-making commitments that are underwritten by the bookrunner. Issues eligible for trading on EuroCredit MTS tend to trade with tighter spreads and are more popular with investors.
Barclays advises investors in Pfandbriefe and other covered bonds to look closely at the business model of the issuer and avoid issues that account for a large proportion of the issuer’s balance sheet. Issues should be properly prepared and marketed, with research notes on the credits underlying the bond and opportunities to find out further information at roadshows. There should be a book-building period before issue, to ensure that the pricing is accurate and to reduce the likelihood of the bond trading through the issue price in the aftermarket.
Specific Pfandbriefe indices include the PEX, a synthetic index based on a notional bond and yield reports announced by Pfandbriefe issuers. Real portfolios of Pfandbriefe form the basis of the Pfandtop index, initiated by Reuters, and the iBoxx Collateralised index, run by Deutsche Borse AG. A sub-index of the iBoxx index reflects specifically the jumbo market. The iBoxx is also sliced into different maturity bands. The increasing size of the Pfandbriefe market makes it an important constituent of every Euro-land bond index that is not exclusively government bonds.
As Pfandbriefe have assumed the mantle of non-government benchmark, German mortgage banks are finding their dominant role compromised. In the league table of issuers for 2001, five of the nine leading underwriters were global investment banks, whereas five years ago the roll call was exclusively German. Although all Pfandbriefe are issued in euros by banks and finance houses, the structure could be appealing to large corporates with finance arms such as Ford, and could be denominated in other currencies.
As a result of changes in both the domestic and international environment, the traditional issuers of Pfandbriefe, the German mortgage banks, are having to develop new strategies to compete. They are seeing more competition from external providers, growing IT requirements, greater demands in mortgage and public sector lending and an increased focus on shareholder value. There is a shift in new loans towards commercial cross-border mortgage loans, and away from domestic residential and the public sector. The pace of consolidation has quickened over the last five years, with newly combined groups going on to merge with each other at a later date. A good example would be the 1998 consolidation of three Deutsche Bank subsidiaries to form Eurohypo and of three Dresdner Bank subsidiaries to form Deutsche Hyp. In 2002 these two together with Rheinhyp are merging to form Eurohypo. Some are merging different business streams together, reducing costs via outsourcing, restricting activities to specific business areas, restructuring the public-sector and mortgage operations into separate businesses, or becoming niche players.