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.”
A good mix
Adding credibility to Luchmann’s observations about a possible non-Deutschmark Pfandbrief market is his bank’s initiative in appointing an overseas bank as a member of the consortium of bookrunners for its most recent jumbo Pfandbrief issue. Although BZW was officially the first non-German bank to lead a Pfandbrief issue (in a Dm250 million issue on behalf of a Berlin-based mortgage bank), UBS was the first to act as a joint bookrunner for a jumbo deal when it joined Commerzbank, DG Bank and Trinkaus & Burkhardt in running Rheinhyp’s Dm1.5 billion four-year issue of Hypothekenpfandbriefe in September. UBS has since followed suit in co-leading issues on behalf of Hypo-Bank and Allgemeine Hypothekenbank (AHB). “I’m looking for a good mix of international and domestic bookrunners,” says Luchmann, “because our target must be to make the Pfandbrief more international. Sure, all the German banks have good international contacts, but to be honest, you need more than a typical German bank to reach investors in the US or Asia.”
In 1996 and beyond, several other international banks are expected to join UBS in running Pfandbrief issues, with JP Morgan widely tipped as the most likely candidate to follow the UBS example. “JP Morgan has officially said that it will install a Pfandbrief desk, and that before it starts acting as a market-maker, it will invest in a dealing desk and look for qualified staff,” says Luchmann. “I think that is important because foreign banks in this market must demonstrate that they have a long-term commitment to its development. They must be prepared to play the market-maker game for years – right up until the maturity of a 10-year issue, for instance.” At JP Morgan in Frankfurt, treasury head Peter Schwicht confirms the report: “At the moment, we’re looking for the right people to trade Pfandbriefe but I guess that by the start of 1996, we’ll be all set,” he says. And once JP Morgan is in, suggests Schwicht, it will be there for the long term: “I think the Pfandbrief closes the missing link between the government market and the Euro-Deutschmark,” he adds, “so it’s a market we will need to have a presence in for a long time. We’re celebrating our 30th year in Germany this year and we have a very large trading outfit here. This speaks for itself.”
BZW is another foreign house with aspirations to play a more expansive role in the Pfandbrief market in particular and the German domestic fixed-income sector in general. As Preller points out, though, his department has only been up and running since the beginning of April 1994, when he joined BZW from Merck Finck. His team is now 12 strong and is looking to expand, but this is difficult because competition for top-quality Pfandbrief staff is intensifying in Germany.
Preller adds that although BZW is marketing the Pfandbrief actively in London, Amsterdam and elsewhere, he still finds it difficult to “work through prejudices” against the instrument, with overseas investors generally remaining “conservative” and “reluctant”. Overall, the jury appears to be out on the extent to which the speedy development of the jumbo Pfandbrief market has succeeded in attracting more international participation in it, and on the extent to which issuers have sought to promote the bonds internationally. Take, for example, a heavyweight issuer such as Bayerische Landesbank, which launched its first Dm1 billion jumbo at the end of July, a 10-year issue for which the bank acted as the sole bookrunner. “The biggest part of the issue was placed domestically,” says Karl-Heinz Kröll, senior vice-president of domestic fixed-income sales at Bayerische Landesbank’s Munich headquarters. “That was because, in the initial stages at least, we have to make sure that the product can cater to the needs of the investors which have been active in the market for the last 20 years. For 20 years, it’s been an illiquid product and the first priority is to show German investors that it can be a liquid instrument. But in the future, we may well bring in foreign bookrunners.”
Bayerische Vereinsbank also began by focusing on the domestic sector. “In our first 10-year issue, participation by foreign investors was about 15%,” says Bub, “but of that 15%, the main portion was probably investors in countries neighbouring Germany, such as Luxembourg, although we also had one or two Asian investors involved. In our second jumbo, which was a five-year issue, the ratio of foreign involvement improved to almost 40%.” Bub concedes that German funds domiciled in Luxembourg, for example, would have accounted for some of this 40%, adding that probably around 35% went – and stayed – overseas. Nevertheless, this represents an impressive improvement, given that over the last five years it has been estimated that foreign investors accounted for no more than 10% or 15% of the total volume of outstanding Pfandbriefe. “We organized numerous selective investor seminars in Austria, Italy, Switzerland, Belgium, the Netherlands and so forth,” says Bub, “and we are touring Asia right now. We are seeing tremendous interest from Asian central banks, for example, which are looking to invest their Deutschmark reserves in paper with a credit quality which is very close to Bunds.”
For the time being at least, a 35% overseas placement is clearly the exception and not the rule. At Dresdner Bank in Frankfurt, treasury department director Thomas Ludwig says: “There’s still not the volume I would hope to see from foreign investors. In rated issues, between 15% and 20% maximum is taken up by foreigners; for unrated issuers, I’d say it’s between 10% and 15%.”
A question of support
There is also some difference of opinion about the extent to which jumbo Pfandbriefe have been welcomed by domestic investors. Rasche at Frankfurter Hypothekenbank notes that since the launch of the jumbo issues, a number of heavyweight local corporate investors have returned to a market which they previously refused to touch on the grounds of illiquidity. Ludwig at Dresdner Bank agrees, adding that the jumbo issues have also bolstered German investors’ appetite for trading: “In the jumbo Pfandbriefe, about 70% or 80% of the buying has been trading-oriented,” he reckons.
Others are not so sure that this year’s burst of activity will ensure a noticeable increase in support for the jumbo Pfandbrief issues – either locally or from overseas. At Merck Finck Investment Management in Munich, managing director Josef Kaesmeier sounds two words of warning. First, it is important to recognize that so far the jumbo issues have enjoyed something of a honeymoon period during which investors have been able to exploit the natural inefficiencies of an immature market. All appear to agree that the spread between jumbo issues and government bonds remains artificially high and almost certainly will not be sustained.
“Jumbos are still attractive in comparison to Bunds,” says Deutsche’s Neufeld. “Although the spread has come in a little recently, they are still yielding 30 basis points over Bunds, which is a very considerable pick-up. I think the spread must narrow and at the end of the day will stabilize at around 10 basis points, which is why we are recommending that investors buy the jumbo Pfandbrief now.”
The test for the market, say Kaesmeier and others, will come when the spread has all but disappeared. At BZW, Preller reports that a number of clients are already asking why they should forgo even 2bp or 3bp to buy jumbo issues when they can buy illiquid issues with steady track records. However, Bub of Bayerische Vereinsbank says that this is missing the point: “One group that isn’t participating in the jumbo market at all are the buy-and-hold investors who don’t like giving up 7bp or 8bp and who claim they don’t need the liquidity,” he says. “But what they overlook is that, if they were more flexible in their investment behaviour – if, for example, we had much more activity in repos and securities lending in Germany – they could achieve a much higher total return on the jumbos than via the standard illiquid issues.” For this to happen, Bub agrees, German banks themselves need to be more active in developing efficient securities lending delivery and payment systems.
Kaesmeier’s second warning about the future of the jumbo Pfandbrief is related to the longer-term participation by domestic investors, who are the traditional lifeblood of the Pfandbrief market. For years, local institutional investors clamoured for increased liquidity in the German fixed-income market, Kaesmeier explains. In August 1994, he says, they were at last given it – not through the introduction of any new investment product but via a change in Germany’s KAGG (Capital Investment Act). This removed the requirement that Germany’s investment funds could invest no more than 20% of their assets in federal government paper and the same proportion in the paper of other public-sector issuers. In theory, therefore, the Act paved the way for local funds to hold up to 100% of their assets in liquid Bunds and did away with a clause which more or less forced any fixed-income fund to hold Pfandbriefe.
Pfandbriefe vs Bunds
In its Pfandbrief Quarterly of August 1994, Deutsche Bank alerted its clients to the possibility of a shift of asset allocation away from Pfandbriefe and towards Bunds. Over a year later, Deutsche’s Neufeld insists that this has not happened and that the jumbo issues have, on the contrary, made Pfandbriefe more popular than ever among German institutional investors.
Kaesmeier warns against complacency for two clear reasons. First, he says, government bonds had an “unfriendly” year in 1994, suggesting that few investors would have been grasping at the opportunity of jumping back into the market in the last quarter of that year. Second, he explains that the process through which Germany’s investment funds and their investment managers draw up and sign management contracts is a lengthy one: “We only changed our last agreement [dictating asset-allocation patterns] last week,” says Kaesmeier. As a result, the shift in assets away from Pfandbriefe and into Bunds could well be still to come, especially if spreads between the two products narrow. At Merck Finck – which has some Dm3 billion under management – Keismeier reports that the change is already visible: “Two years ago, Bunds accounted for 15% of our assets under management,” he says. “Today that share has doubled to about 30%.”
Aside from the longer-term buying intentions of international or domestic investors, there are a number of other imponderables which have been raised by the development of the jumbo Pfandbrief market. One of these concerns the prospects for a Pfandbrief future which, until very recently, was cited by international investors as a sine qua non upon which their future participation in the market depended. Today, most market participants argue that the emergence of the liquid jumbo market clearly paves the way for the introduction of the futures contract. As recent research published by Deutsche Bank notes: “An underlying volume of Dm20 billion to Dm30 billion of deliverable paper is seen as the pre-condition for a functioning Pfandbrief future.” This had led Neufeld at Deutsche Bank to insist: “I think a futures contract will go ahead, although I have no idea when.”
But the longer-term value of a Pfandbrief futures contract appears to be a subject on which German bankers and analysts are split. One camp argues that the introduction of liquid jumbos, which bear the same risk profile as German government securities, will lead first to a narrowing and then to a stabilization of spreads between Pfandbriefe and Bunds. As a result, they argue, a Pfandbrief future would be superfluous, given that investors could use the Bund future as a perfect hedge. Exhaustive research recently undertaken by Deutsche Bank found that, contrary to popular belief, there appears to be little correlation between the buying behaviour of foreign investors and the Pfandbrief/Bund yield spread.
Others argue that the assumption that the Bund future would work as an adequate hedge is at best hazardous and at worst downright foolish, given the historical relationship between Pfandbriefe and Bund spreads. According to Deutsche Bank, the average spread between Pfandbriefe and 10-year Bunds was 10bp in 1991, widening to 19bp in 1992, 26bp in 1993 and 1994, then retreating again to 19bp by May 1995. “Spreads never stay stable,” says Preller at BZW. “To hedge Pfandbrief positions with the Bund future may work but it is a very dangerous game to play. I am still convinced that a Pfandbrief future is necessary.”
What is jumbo?
An additional, and probably more important, imponderable resulting from the evolution of the jumbo market is the future of Germany’s smaller mortgage banks. Few believe that in 1996 and beyond the jumbo market will be able to continue to absorb the number of issuers it accommodated in its first six months. Between May and November, 18 banks tapped the new jumbo market: nine of those came to the market more than once. Ludwig at Dresdner Bank believes that this pattern will intensify in 1996: “I don’t think we will see many houses appearing as new issuers,” he says, “but that is not to say that there won’t be several more jumbos from existing issuers.”
This profusion of new-issue activity has led some local bankers to question the validity of the expression “jumbo”. Luchmann at Rheinhyp, for one, believes it has very rapidly become a misnomer. A jumbo issue is officially categorized as a Pfandbrief raising Dm500 million or more, in which a sole manager or consortium of bookrunners guarantees to quote a continuous bid-ask spread. Luchmann questions this definition: “We have to be absolutely clear about what a jumbo issue really is,” he argues. “It seems to me that every Hypo [mortgage] bank could tap the market for Dm1 billion or Dm1.5 billion at least once, and if that happens, we’re going to see 50 or 70 or 90 jumbo issues every year. The danger is that issues of Dm1 billion will become as illiquid as the old Pfandbriefe were.”
The reason for this, says Luchmann, is clear: several of Germany’s largest institutions, such as the giant insurance companies, remain buy-and-hold investors – or what German issuers and their bankers used to describe as “good” investors. As a result, says Luchmann, it is quite probable that of a 10-year issue of Dm1 billion, up to Dm800 million could very easily be immediately locked away in the coffers of monolithic institutions and not see the light of day for another decade. “What we need to do,” argues Luchmann, “is to increase the size of these issues step by step. It makes no sense to get to Dm1 billion or Dm1.5 billion and then stop. We need to get up to Dm3 million or Dm5 billion.”
If other issuers agree and the jumbo Pfandbrief market becomes more ambitious, setting a floor of say Dm3 billion, a very obvious problem – in the form of a very clear fragmentation among Germany’s mortgage banks – could arise, as the smaller mortgage banks will not be able to raise such large quantities. On the one hand, there will be a cluster of perhaps 10 banks – spearheaded by the likes of Depfa, Frankfurter Hypothekenbank, Westdeutsche Landesbank and the major Munich-based banks – which will be able to raise highly competitive funds and to attract liquidity-conscious international investors.
On the other hand, there will be a larger band of smaller mortgage banks – typically those based in locations outside the main German cities – which will suddenly find that their cost of funding rises dramatically, perhaps prohibitively. The fragmentation will become even more pronounced if and when a larger number of the issuing banks decide to apply for investment ratings to back individual Pfandbrief issues. As a senior representative of a mortgage bank puts it: “Moody’s, Standard & Poor’s, and IBCA have all announced that not all Pfandbrief issuers would automatically be AAA.”
A fragmentation of this kind among the issuing banks would be no bad thing for investors in the German fixed-income market. On the contrary, an element of diversification in Europe’s biggest bond market would be a positive development. As Kaesmeier at Merck Finck says: “Up to now, investors really only had the two big segments to play with in the market – Bunds and Pfandbriefe. Now we will have a third segment, with the Pfandbriefe being divided into two – low-yielding jumbos and high-yielding illiquid Pfandbriefe.”
But while more choice may be welcome to investors, the jury is out, for now, on the long-term effects of a division within the market of smaller mortgage banks in Germany.
It is precisely because these smaller institutions are almost certain to be confronted with higher refinancing costs that several bankers in Frankfurt and Munich referred to “overcoming resistance” or “breaking the ice” as a necessary part of introducing and developing the jumbo Pfandbrief market. Over the longer term, they suggest, the growth and sustainability of the jumbo Pfandbrief market seems likely to be a harbinger of mergers among Germany’s smaller mortgage banks. As one Munich banker asks rhetorically: “Why do Deutsche and Dresdner each need to have three mortgage banking subsidiaries, all issuing Pfandbriefe of Dm500 million or Dm1 billion, when they could combine their forces and issue blocks of Dm1.5 billion or Dm3 billion?” Why indeed?
The Asian dimension
Thomas Reh, managing director of investment banking at Düsseldorf-based Westdeutsche Landesbank (WestLB), spent much of November in Asia. As a representative of Germany’s largest issuer of Pfandbriefe – the bank typically issues between Dm40 billion and Dm50 billion each year – it was important for Reh to continue to drum up support for the instrument among investors in Japan, Singapore, Taiwan and Korea. “I found on my most recent trip that more and more investors are looking positively at the Pfandbrief market,” he reports. “We saw interest from central banks in Asia, but also from pension fund managers and from banks with asset management arms, especially in Japan.”
However, in spite of the good reception he enjoyed in Asia, Reh appears to be keeping his feet firmly on the ground about the potential of the Pfandbrief market, for a wide range of reasons. First, he acknowledges that, for the time being, investors are for the most part capitalizing on a window of opportunity which is unlikely to stay as widely open as it is now. “We have to be realistic,” he says. “We are now in a bull market and spreads are very attractive in comparison with Bunds and other currencies. Certainly, if we saw the spread come down to below 10 basis points, the interest would disappear.”
Over the longer term, more important than the spreads available between Pfandbriefe and Bunds, according to Reh, is the level of commitment to quoting prices market-makers will maintain if sentiment turns sour. He is unashamedly sceptical about this. It is one reason why WestLB acted as the sole bookrunner when it launched its first jumbo Pfandbrief – a five-year, Dm2 billion Oeffentliche Pfandbrief – in September. “One has to be sceptical,” he says, “that if and when we see higher interest rates, the promises that have been made by many of the smaller banks about market-making will be kept. I know that in the 1980s many investors had their fingers very badly burned by market-makers when the tide turned against the Pfandbrief market. I have very serious doubts about the smaller bookrunners.” In other words, Reh suggests that investors ought to look as carefully – if not more carefully – at the bookrunning consortium appointed by each Pfandbrief issuer, as they do at the issuer itself.
“I’m not saying that in the future I would exclude appointing consortia to lead-manage our deals,” Reh continues. “But if I did, I would be very, very choosy about who I’d appoint.” Nor is Reh attracted by the idea of encouraging foreign investment banks to join bookrunning consortia: “I can’t see that it would add any value,” he insists. “Euro-issues co-led by foreign investment banks have not lived up to their promises, and if we’re talking about placing perhaps 10% of a Pfandbrief issue internationally, we can do that efficiently ourselves.” From his experience quizzing investors in Asia, Reh believes that, for the larger German Pfandbrief issuers, it is realistic to place between 5% and 10% of an issue outside Europe, adding that “anybody who tells you that they’ve placed 25% or 30% of a Pfandbrief issue in Asia is, to put it bluntly, lying”.
