At a recent get-together of Munich's city bankers, Bayerische Handelsbank board member and new president of the Association of German Mortgage Banks Walter Dieck fell into conversation with a professor of economics at the University of Munich - a specialist in banking - about Germany's new "jumbo" Pfandbrief market which combines issuing activity into offerings of Dm500 million or more, and promises market-making. The market's profile is improving, they agreed. After all, remarked the professor, Pfandbrief had an accepted English translation - "mortgage bond".
Dieck smiles ironically when he recalls the depth of misunderstanding even at the very nerve centre of the Pfandbrief market's development. As Stephan Bub, treasury head at Bayerische Vereinsbank, says: "The idea of the jumbo Pfandbrief was born in Munich. The launch of the product demanded a highly concerted effort by the three big Munich banks."
Just how wildly misleading the translation "mortgage bond" has become is revealed by an analysis of the first six months of the jumbo Pfandbrief market. Between May or June 1995, when the first jumbo was issued by Frankfurter Hypothekenbank or Bayerische Vereinsbank (definitions differ) and the end of November, 31 Pfandbrief issues - with an average issue size of Dm1.285 billion and with maturities ranging from three to 10 years - raised a fraction less than Dm40 billion. But only three of these, raising Dm5 billion between them, were classified as Hypothekenpfandbriefe or debt securities backed by a pool of mortgages. The remainder were öffentliche Pfandbriefe, which are backed by public-sector loans financing a wide range of projects and buildings - but not mortgages. As a result, they theoretically offer exposure to German government risk and, in effect, are baby Bunds.
The reason for this is simple, but its longer-term implications are not. German law dictates that each and every new Pfandbrief issue must be matched by new lending. By definition, there is far more demand for large loans to the public sector - to finance libraries, schools, hospitals - than to individual mortgage borrowers. As Dieck says: "I know of no German house costing Dm100 million."
The result is that only a tiny handful of German mortgage banks - there are 28 in all - have the capacity to issue jumbo bonds backed by mortgages just once, let alone continuously. This means that the development of the jumbo market will depend on the flow of large-scale loans to the public sector. In other words, its growth will have almost nothing to do with the German mortgage market.
But international fund managers are neither stupid nor ill-informed. A promotional campaign by the Association of German Mortgage Banks, together with recently increased coverage of the market by international investment banks, has cleared up most of the long-held misunderstandings. The vast majority of investors now have a sophisticated understanding of the Pfandbrief market. They know that Pfandbriefe are not backed by individual mortgages, like the US mortgage-backed market; that no German mortgage bank has ever defaulted; that Pfandbriefe offer a generous yield pick-up over Bunds; that they can measure the performance of Pfandbriefe via the newly established PEX Index and that in the new jumbo market, bookrunners guarantee to quote continuous bid-offer spreads of between five and 10 basis points, depending on the maturity of the issue.
They know too that further important structural changes are imminent. Thorsten Neufeld, a researcher at Deutsche Bank in Frankfurt, points to the imminent launch of the new Pfandbrief trading system. The Rentenofferten- und Handelssystem der Deutschen Börse (ROHS) is yet another means through which the transparency of the market will be enhanced. "Everything that investors have had in BOSS [Germany's electronic trading system for equities] will be available through ROHS," says Neufeld.
In short, the Pfandbrief market is virtually unrecognizable when compared with what it was five years ago, when it was routinely dismissed by international investors as an illiquid, invisible, esoteric and poorly defined product suitable for German consumption only.
But these reforms fail to address a fundamental point. International fund managers need a more meaningful translation of Pfandbrief than "mortgage bonds" - the literal translation is pledge letters - so that they can tell trustees and unit holders what they are doing. And therein lies their difficulty. At Barclays de Zoete Wedd (BZW) in Frankfurt, fixed-income head Matthias Preller goes directly to the root of the problem when he says: "Nobody will ever blame fund managers who underperform in the German government bond market. But they will blame fund managers who underperform when they've bought Pfandbriefe."
This situation is ludicrous but true. And it clearly exasperates a number of issuers, such as Frankfurter Hypothekenbank. "One of the things which is still widely misunderstood is the issue of credit quality," says the bank's head of treasury, Henning Rasche. "If you look at our öffentliche Pfandbriefe, they are among the best you can get. They are fully collaterized by loans to the German public sector, mainly to the German federal and state governments. We have a very strong balance sheet and so far our Pfandbriefe are the only ones rated triple-A by Standard & Poor's. What more do people want? But we still don't get enough of a yield discount in return for this super credit quality."
With typical German tenacity, there is no hint of any plan to replace a name which has been used for about 200 years with something that trips easily off the international tongue. As Dieck says: "We want to export the name."
One or two Pfandbrief issuers in Germany are already looking forward to the possibility of issuing Pfandbriefe in currencies other than Deutschmarks - in the unlikely event that international investors begin viewing Deutschmark exposure as dicey. Bub reports that Bayerische Vereinsbank has been studying this option for "a good nine months" but adds that a non-Deutschmark Pfandbrief would act only as a "product to cater to very up-to-date niche interests of the market - by no means would it replace the jumbo market". Another bank clearly weighing up the possibility is the Frankfurt-based Commerzbank subsidiary, Rheinische Hypothekenbank (Rheinhyp). "If I want to, I can issue a Pfandbrief in sterling, French francs or anything else," explains Rüdiger Luchmann, head of treasury at Rheinhyp. "What I am not allowed to do is to take on currency risk. But that does not matter because we have an increasing flow of foreign currency assets. We have two offices in Spain, for example, and an office in the UK, and we're about to open one in Denmark."