European government guarantee packages: Guaranteed to confuse
The sincerest form of flattery
IT IS COMMONLY impressed on investors that in more than 200 years of existence, the German Pfandbrief, the benchmark of the modern covered bond world, has never experienced a single case of default. This is not just a fact that is trotted out for marketing purposes in the same way that, say, a hedge fund might boast that none of its investments had lost money. The Pfandbrief’s perfect record is, rather than merely an affirmation of its strict safety regulations, an integral part of its make-up. Protection from default is not so much a priority as a purpose. Measures to safeguard the Pfandbrief holders of an insolvent issuer are comprehensive, and as a result there has never been a case of failure. There has also never, in more than 200 years, been a case of the German government having to reassure the market that it is ready to step in and aid the Pfandbrief if the need arises, simply because that need was never foreseen. Until now.
On October 13, the German government introduced a draft bill for the financial market stabilization act, in which it made particular reference to the Pfandbrief. The wording of the accompanying statement is specific, as the Pfandbrief is not included in the rescue package. It is implied rather than confirmed that Pfandbriefe are now under government protection. "The bill shall cover financial sector corporations and financial instruments in a comprehensive manner. At present, however, it is not deemed necessary to include the Pfandbrief under its regulatory scope," the statement reads. After another nod to the asset class’s long and default-free history, however, it goes on to say that "if and when necessary for the proper functioning of the Pfandbrief market, the German government shall adopt further statutory measures on an ad hoc basis in order to safeguard the German Pfandbrief".
No precedent
The semantically non-committal nature of the statement does not, however, disguise what is in fact a substantial commitment on the part of the German government. Essentially there is now an implicit guarantee on all Pfandbriefe, a situation that would have been utterly unthinkable in any time other than the one in which the financial world now finds itself. "In principle, the Pfandbrief doesn’t need a guarantee; it would be a paradox to say that it’s safe and then need a guarantee put on it," says Louis Hagen, executive director of the association of German Pfandbrief banks (VDP). "But we must admit that since the Lehman collapse and the Hypo Real Estate difficulties the impact on the Pfandbrief market has been quite negative."
Although no one in the Pfandbrief market would argue that there is any real chance of a Pfandbrief issue defaulting even in this unprecedented environment, the fact that the product has been included in the government statement tells volumes about how the sentiment and policy of investors has changed across the markets. Investors want safety, not yield. Pfandbriefe have grown to account for fully 25% of the bonds outstanding in the German fixed-income market as investors welcomed a pick-up over government issuance while being perceived as having almost the same level of protection. Until now, the difference has been so negligible as to be dismissed by investors. But with investor confidence now at such low levels across the financial markets, any added protection is keenly sought after. With governments the world over putting guarantees on bank accounts and bond issues, any product without one will struggle to arouse investor interest – 200-year pedigree or not. "This implied guarantee has never been offered before, but there’s never been a crisis like this," says Franz Rudolf, senior covered bond analyst at UniCredit, which owns Pfandbrief issuer HypoVereinsbank. "There’s been trouble at single banks before but no need for a guarantee. It is an important signal to the market."
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"Whatever the government does, it must bear in mind that it has to take care of the Pfandbrief"
Louis Hagen, VDP |
And one that was sorely needed. The Pfandbrief market has been frozen solid since Hypo Real Estate (HRE) had to be rescued with a €50 billion bail-out package from both the financial sector and the government, the largest since the Second World War. Until then, the Pfandbrief had proven fairly resilient in the face of the credit crunch. Although spreads did widen, they did not do so as much as in other covered bond markets. Before the HRE rescue, the Pfandbriefe of Depfa, HRE’s public sector arm, were trading at 30 basis points over mid-swaps, while its Irish ACS issues were trading at about 75bp over. This differentiation between German issues and those from other markets has pervaded the financial crisis until now. But despite news of HRE’s bail-out, spreads moved to new wides. Depfa’s Pfandbriefe were quoted at about 125bp over following the rescue.
Described among Pfandbrief participants as "monumental" and "unbelievable", the HRE rescue brought investors face to face with the prospect of one of the largest banks in Europe’s largest economy going under. That the bail-out came not just from the government but from HRE’s peers in the financial sector shows just how seriously the news was taken – this liquidity offer bail-out was increased after an initial €35 billion offer was deemed inadequate. And it was not just financial help that other banks were prepared to offer but also human resources. When HRE’s chief executive, Georg Funke, stepped down, he was replaced by Deutsche Bank’s global head of investment, Axel Wiendt. Kai Wilhelm Franzmeyer, formerly group treasurer at Commerzbank, joined the board of HRE with responsibility for the treasury across the whole HRE group.
But problems at a Pfandbrief issuer should not be construed as problems with the Pfandbrief. HRE’s difficulties came about because of funding gaps at Depfa. The bank’s business model had become unsustainable. As is common with a public sector bank, Depfa’s model was to fund short and lend long. As the short-term markets dried up, so its problems became apparent. The Belgian/French bail-out of Dexia came about for similar reasons. There were no troubled assets, and certainly no troubled Pfandbrief. "This is not a Pfandbrief problem but a broad capital markets topic," says Bernd Volk, director of covered bond research at Deutsche Bank. "It is now very difficult to make this business model work, and it will have to be adjusted."