DON'T DO IT right, do it first. The idea that any product that breaks new ground enjoys an indelible branding advantage has become a marketing mantra. But in the debt capital markets, the recent fortunes of the Pfandbrief suggest that holding on to that advantage is an increasingly demanding exercise.
Once content to sell itself as the original and still the best covered bond, the Pfandbrief is now in competition with established or growing rival products in at least six jurisdictions, and with mortgage-backed securities (MBS) in Germany itself. Combined with the downgrading of certain German mortgage banks and the loss of the Landesbanken guarantees in July 2005, until last year the Pfandbrief was losing ground to other European covered bonds.
Pfandbriefe still account for nearly 75% of all covered bond issuance. According to figures from the Association of German Mortgage Banks, gross Pfandbrief issuance increased by 14% between 2001 and 2002, from e174 billion to e198 billion.
But net of redemptions, both years were negative ? 2001 by a narrow e1.3 billion, 2002 by e16.8 billion. As Tim Skeet, head of European Bank DCM at ABN Amro, says: "It is vital that the Pfandbrief regains its premium cachet."
Says Christof Jütten, head of covered bond origination at ABN Amro: "Investors look at covered bonds as one asset class and they are traded as one asset class." Because German issuers traditionally saw the Pfandbrief as the best product available, it took them longer to see that a single European covered bond market was developing.
"You can only take the view that your market is separate when your product is trading at the tightest possible spreads," says Jütten. "But some Pfandbriefe have traded outside the covered bond curve."
That's because the German market is no longer homogenous. Investors now distinguish between issuers according to their underlying financial strength and their borrowing strategy. To stop the upheavals in the German banking sector being disproportionately reflected in the poor performance of their covered bonds, issuers have had to address a series of problems. These range from their own business models and structure, to relations with investors, to the legal framework for Pfandbriefe and the views of rating agencies.
Pfandbrief issuers are now more responsive to investors' demands. They are issuing in shorter maturities, for example.
"Looking back two or three years, issuers only looked at their own funding needs," says Clemens Schellenberg, head of funding and asset liability management at Hypo Real Estate Bank. "If you had strong new business projections for 10 years, you issued 10-year Pfandbriefe to match your liabilities. In the current interest rate environment, there's less demand for these maturities so issuers have to be more flexible to attract investors."
Pfandbrief issuers in particular have measured themselves against their Spanish competitors, whose cédulas have provided the chief competition for Pfandbriefe. By paying more attention to basics such as the maturity of their bonds, the Germans have successfully distinguished themselves.
"Pfandbrief issuers have learnt their lessons," says one banker. "In 2001 and 2002, if you were part of a primary Pfandbrief deal, you could be sure it would widen in the secondary market. These days are over in Germany. The cédulas market is still for people who are after a pick-up. Germany is for stable-for-life AAA bonds."
German issuers are using the pot system for their covered bonds, while cédulas are still generally sold through retention deals.
A key legal step in the Pfandbrief's comeback was on March 12, when Germany's federal legislature, the Bundesrat, passed the latest amendment to Germany's mortgage bank Act. It introduces mandatory 2% over-collateralization for Pfandbriefe. It also addresses Moody's concerns about their bankruptcy-remote status. Moody's had previously rated some covered bonds with reference to the credit quality of the issuer itself, not just the quality of the cover pools. In providing for the appointment of a dedicated trustee to monitor the cover pool in the event of insolvency, the German Act goes even further than Ireland's asset-covered securities (ACS) law in confirming the bonds' bankruptcy remoteness. Within days of the legislation being passed, Moody's had put some Pfandbriefe on positive watch, with a view to upgrading them once the law comes into force on April 1.
Alongside the mortgage bank legislation amendment, in December, Germany's federal financial supervisory authority, BaFin, published details of the regulatory requirements for the net present value calculation for cover pools. Issuers have until the end of April to adopt any new procedures and IT systems that they need to comply with the regulation.
While the mortgage bank legislation has hogged the headlines, Louis Hagen, general manager of the Association of German Mortgage Banks, says it really clarifies the theoretical relationship between a Pfandbrief issuer and its paper.
Stress testing
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Outstanding volume
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Source: WestLB research, Bloomberg
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"That was necessary for Moody's and for some investors," says Hagen. "Construing the law and legal procedures, we were always convinced that the segregation of the cover pools would be effective in the case of issuer insolvency. What brings much more quality to the Pfandbrief is the net present value regulation. This states the stress scenarios that the cover pools have to withstand. It is something new and it brings real transparency and quality."
The legislative changes were widely and accurately predicted and were largely priced into the market last year. But they have still had a positive impact on the market as a whole. The speed of its response suggests that Moody's is as relieved as everyone else that it can begin to change its ratings.
"Moody's was waiting for some kind of legal change to save face," says WestLB analyst Frank Will. "Everyone said that this didn't work and that for an organization like AHBR to have its mortgage Pfandbriefe rated A1 didn't make sense. But markets focus on the lowest rating."
Pfandbrief issuers that didn't get an AAA rating for their bonds from Moody's felt that they were being unduly penalized. "We saw spread widening to levels of 25 to 30 basis points over swaps," says Will. "Then people realized that this wasn't justified for a secured instrument, and spreads tightened."