With much being made of the split between "core" and "non-core" covered bond markets, and that between legislated and structured issues, it is a comforting thought that the European covered bond community is for once in harmonious agreement.
Unfortunately, the extent of that agreement is that something needs to be done, rather than what that something might be. Last month in Milan, the European Covered Bond Council met to discuss possible solutions to the problems in inter-dealer market making. One of the key selling points of covered bonds is the stringent market-making commitment to which underwriters commit themselves.
But volatility in the wider financial markets as well as specifically in covered bonds, culminating in the pulling of a three-year deal from AIB Mortgage Bank last November, caused the suspension of market-making in covered bonds on the advice of the ECBC’s "eight to eight" committee. Problems in the swap market as well as negative headlines, especially regarding Spanish, UK and US covered bond sectors, have meant that market-making problems have persisted through the first quarter of 2008.
The focus of the ECBC plenary meeting was the Packmohr plan, the proposed development, formulated by Ted Packmohr, head of covered bond research at Dresdner Kleinwort, of a hybrid trading platform to replace the flawed telephone system that allows market-makers a significant measure of deniability in quoting prices. The Packmohr plan has not received universal approval by any stretch. "The e-trading solution has created more questions than answers," said Ciaran O’Flynn, head of European agency and covered bond trading at Morgan Stanley. "This tells me it is still not a workable solution."
Multiple options
At the plenary meeting, Richard Kemmish, head of covered bond origination at Credit Suisse and chairman of the ECBC’s market issues working group, was obliged to run through 23 different proposals, delivered as responses to the Packmohr plan. It is this lack of consensus that caused some at the meeting to question whether any progress had been made at all, and Kemmish made it very clear where the difficulty lay. "If you tossed a coin and asked ‘heads or tails’, someone in this room would ask for a third option," he said.
The problem is that although most people now accept that covered bonds are essentially a credit product, not a rates product, they are unique among credit products in that their selling point is entirely their safety, and not in any part their relative value. "The relative cheapening of a number of covered bonds is not perceived as a buying opportunity but as an indication of lower quality," said Fritz Engelhard, covered bond analyst at Barclays Capital.
One concern about Packmohr’s proposal is that the extra transparency, seen as a good thing by many in the market, could allow dealers’ positions to be undermined by this sensitive information. One counter-proposal suggested only allowing core markets onto the platform; another proposed a distinction between on-the-run and off-the-run covered bonds. Both suggestions are designed to maximize the perception of safety more than anything else, and this theme pervaded the meeting.
One thing that everyone agreed upon was that the market had been hurt by coverage in the press, and that in order to find a solution the flow of negative sentiment had to stop. "We need to get this topic out of the headlines now," said one delegate.
Packmohr himself admitted that no plan could solve all the problems facing the covered bond market, and although his solution has the backing of many influential participants, such as the association of German Pfandbrief banks (VDP), he was quick to welcome any feedback. "No system should be beyond critique and improvement, so the solution is not set in stone," he said. "We will have these discussions again and again but we need to do something or we’ll look stupid."