Pfandbriefe: Germany's secret gamblers

The explosion of public (öffentliche) Pfandbrief issuance in the last two years is one of the most intriguing developments in the international capital markets. Investors get a spread to Bunds on paper that in many cases is effectively state-backed. The issuers make a positive spread between the assets that back the Pfandbriefe and the Pfandbriefe themselves: this is despite the fact that at the time they purchase the collateral it yields less than the yield that investors would demand in the Pfandbrief market. And the original borrowers are content to issue illiquid domestic instruments of no interest to foreign investors despite the obvious international demand for their credit.

The traditional explanation for the strange properties of Pfandbriefe relies on the idea of liquidity transformation. This is that Germany's 26 Hypotheken (mortgage) banks lend to home owners and public borrowers who can't easily get long-term finance from normal banks, or access the capital markets. These borrowers have to pay a premium for the illiquidity of the assets their borrowing creates. The Hypotheken institutes wrap up the illiquid mortgages - and in the case of öffentliche Pfandbriefe, the illiquid Schuldscheine - into liquid Pfandbrief.

This is pretty much how the Hypotheken Pfandbrief market still works. But international investors only buy the much larger öffentliche Pfandbrief issues. Here, the liquidity transformation argument breaks down.

The mortgage banks lend at ultra-low rates to state-backed entities by buying their Schuldscheine, Germany's traditional semi-tradable loans. So low is the yield on these Schuldscheine, that Hypotheken banks can't make a positive margin by selling Pfandbriefe to refinance their Schuldschein purchases. In theory, this securitization industry should make a negative return.

In practice, the more aggressive Hypotheken banks are too creative for that. Their piles of Länder Schuldscheine are fuel for arbitraging derivatives markets, gambling on credit spreads, playing yield curves, and - above all - betting on short-term interest-rate directions. One bank's head of treasury laments: "If you see a Hypotheken bank doing almost only public Pfandbriefe and making a big profit, you can assume it is taking a lot of interest-rate risk."

Why don't the banks simply take these bets directly, instead of using Pfandbrief issuance as a cover? Because they are forbidden by regulations to do that. So to keep playing the markets, the Hypotheken banks need to issue. To issue they need to buy Schuldschein, which drives Schuldscheine yields ever lower - keeping the borrowers out of the liquid, public markets. And the lower Schuldschein yields fall, the bigger the bets the banks need to make to make money.

The non-mortgage mortgage bank

So how does the scheme work in practice? Hypothekenbank in Essen is, as its name suggests, the city of Essen's mortgage bank. But mortgages are a small and shrinking portion of its business. At year-end 1998, its real-estate loans totalled Dm3.5 billion ($2 billion), compared to a Dm70 billion ($40 billion) portfolio of public credits.

The mortgage banking law which governs Essen Hyp and its peers was amended in April 1998. Since then, bonds can serve as Pfandbrief collateral in the same way as Schuldscheine. Since the reform, the Essen institution has invested in public-sector securities from all over western Europe. When head of trading Thomas Kaysh spoke to Euromoney, for instance, he was busy buying paper of the Austrian region of Burgenland from an investment bank, in the form of an asset swap paying Libor+2 basis points. At most times, between 10% and 20% of Essen Hyp's collateral pool for public Pfandbriefe is made up of bonds, most of them off-the-run foreign assets earning an arbitrage yield pick-up through swaps.

But the vast majority of the Essen bank's assets are Schuldscheine, predominantly issued by German Länder. Kaysh's team can't earn a spread by selling Pfandbriefe against these Schuldscheine. All Länder borrow more cheaply than a Hypotheken bank can. To repackage Bavarian Schuldscheine as Pfandbriefe, Kaysh estimates, would cost him about 12bp in negative carry.

So Essen Hyp creates its margin by betting on interest rate movements. It staggers its Schuldschein purchase and its Pfandbrief financing, according to which way it thinks rates will shift. For example, says Kaysh, the bank might buy 10-year Länder debt with short-term finance, and wait for two weeks while yields in the marketplace fall 20bp - below the running yield on the Schuldschein collateral. Then it would issue Pfandbriefe. Later, when market yields have fallen comfortably below the coupon on his Schuldschein assets, he might "hammer out a jumbo".

Essen Hyp chooses maturities that minimize yield-curve risk. Overall assets and liabilities are almost totally matched for duration. To a large extent, therefore, the firm is a betting house on interest-rate directions.

Only one full-time analyst studies interest movements, but says Kaysh: "All of us in the trading room, and also on the management board, have a view about rates." Risk-levels are managed with a value-at-risk (VAR) model. But VAR's limits were exposed in international financial markets during 1998. Isn't a bank strategy centred on placing directional bets bound to cause trouble? Kaysh thinks he can guess right: "We always get it wrong, every day, because we're all stupid. That's why we made Dm280 million last year."

He repeats the remark later in the conversation, showing the kind of confidence that caused Commerzbank, Essen Hyp's majority shareholder, such problems in the 1980s. Commerzbank took a hit when German short term rates rose sharply: it had a mismatched loan book.

Essen Hyp could lose heavily from, say, failing to foresee a shock that caused the European Central Bank to hike interest rates. It is also vulnerable to a stable economic environment. Its trades rely on a degree of volatility in rates. Otherwise, says Kaysh, "we can do no business". He is dismissive of the possibility that rates will stabilize. Interest rates will keep on moving, and he'll see it coming.