France, Spain, and most recently Luxembourg, now compete with the German Pfandbrief for the attention of international investors wishing to put funds into high-credit-quality collateralized bonds. These countries’ new covered bonds have successfully been launched in jumbo format, spreads have tightened to German Pfandbrief levels and volumes are set to grow further.
The three new markets hardly present
an immediate threat to the original Pfandbrief market, which is now worth e1 trillion ($840 billion) – e367 billion of which fall in the jumbo sector where liquidity is adequate to attract non-German investors. But if they care to worry, where should German mortgage banks expect the toughest competition to come from?
The French obligations foncières are definitely the best instruments, say the French. The Spanish cédulas hipotecarias are also much better than the Pfandbriefe, so the Spanish claim – and Luxembourg’s lettres de gage are so good they will conquer the market in no time, reckon bankers in the Grand Duchy. Considering that these new Pfandbrief versions show certain differences in detail, this battle could cause considerable short-term confusion among investors.
In the case of France and Luxembourg, new laws have been enacted – in June 1999 and May 2000 – that challenge the German Hypothekenbankgesetz (mortgage bank act) in security and sophistication. In fact, some of the features are so good that it is now being proposed that they be incorporated into the long-standing German law.
Banks outside Germany have long considered that the well-developed market in securitized state loans and mortgages has given German banks a competitive advantage in funding and capital management that they might one day use to compete successfully outside Germany. In order to copy the success of the Pfandbriefe, lawmakers elsewhere in Europe had to guarantee the quality of the new covered bond instruments.
Most important for their triple-A rating is the preferential status granted to investors in the case of bankruptcy. The success of Pfandbriefe also stems from other strong security measures. The business activities of the issuing entities – the mortgage banks – are restricted to low-risk-type public-sector and real-estate financing. This is enshrined in the “special bank principle”. There is special stringent supervision by an independent trustee and an authorized regulating body, as well as a loan-to-value limit that prevents mortgage loans from being fully refinanced through Pfandbriefe.
As with the German Pfandbriefe, the French, Luxembourgeois and Spanish versions are all constructed to be close to government bond credit quality. All are rated triple-A, have a 10% risk weighting, qualify as tier 1 category and are thus eligible to be used as repo collateral with the European Central Bank.
Proponents of the German system believe religiously in the purity of their market, pointing to the record of not a single default in more than 100 years. France and Luxembourg, though, have grabbed the attention of investors – and the German banks – by creating an even more secure instrument. (No new law was introduced in Spain.) Their jurisdictions grant preferential status not only to holders of the covered bonds, but also to counterparties to hedging instruments. By including derivatives in the privileged collateral pool of a covered bond, the likelihood of an interruption of payments in the case of insolvency is greatly reduced, as it avoids extra-pool netting by derivatives counterparties. Without this rule swaps might not produce the necessary cashflows to continue payment in a bankruptcy. Pfandbrief issuers cannot, however, confirm this, as none has gone into insolvency so far. Still, amendments to the German law – expected next summer – aim to include a similar ruling.
The French, for their part, are unimpressed. “The obligations foncières are more secure than the Pfandbriefe – not only because swaps benefit from the privilege [the preferential status], but also because of more frequent controls,” says Edouard Payen, head of bond origination at Crédit Agricole Indosuez. “These reduced risks were the reasons for investors accepting the obligations so quickly, and why we expect them to trade, in time, at the same level as the best Pfandbriefe.”
A unique feature of the French law is that mortgage lenders have to transfer their assets to specialist subsidiaries, the sociétés de crédit foncier (SCFs), unlike German mortgage banks, which hold collateral assets on their balance sheets. SCFs are not allowed to have other activities, or any employees, and cannot own equity interest. The separate balance sheet of an SCF adds to the transparency of obligations, says Olivier Delfour, senior director of European structural finance at credit rating agency Fitch, as “it is easier to look through the books of an entity that has no other activities”.
But importantly, any bankruptcy proceedings against a shareholder of a SCF cannot be extended to the SCF itself. Thus, the obligations promise greater security to investors, because any deterioration in the bank’s balance sheet that could trigger its bankruptcy would not affect the credit quality of the SCF. As such the French SCF comes closer to a special-purpose vehicle used in securitization than to other covered bonds.
But to Georg Grodzki, director of credit advisory at CSFB, a separate balance sheet is more of an “optical extra”. He says: “The Pfandbrief collateral is quasi off-balance sheet. The collateral’s legal status of ‘special assets’ means that in the event of bankruptcy the supervisory authorities take over the management of the collateral and the rights of Pfandbrief holder to the securities.” A change in the German mortgage law in 1998 prohibits the Hypothekenbanken from calling a moratorium over the ‘special assets’, a rule also implemented in Luxembourg.
“What does make obligations foncières more secure, though, is the fact that holders have absolute priority in their claims; they have to be paid even before tax can be collected,” says Jean-Claude Synave, managing director of Dexia. “In the hypothetical case of bankruptcy proceedings for a SCF, all obligations foncières will be paid at their contractual due date, in priority to all other debt. The acceleration of cash flows or liquidation of assets to anticipate reimbursement of the covered bonds is not allowed.”
The rule that maturities and interest-rate exposure of obligations and their collateral must match, aims to prevent the sort of mismatching that has become permanent in German issuing practice in the last few years. German mortgage banks began to pursue collateral acquisition and Pfandbrief refinancing as a means to take interest-rate – rather than credit – positions, through maturity mismatching. Also, the French law states that derivatives can only be used to offset interest rate and currency risk, and that the value of assets must at all times be higher than any liabilities with priority in case of bankruptcy. Independent auditors, who are appointed by the supervisory body (the Commission Bancaire), are responsible for checking the quality of the assets and compliance with these regulations. By contrast, Pfandbrief collateral is supervised by a pensioned trustee who may not have auditing qualifications.
These merits have delighted investors to the extent that obligations now trade flat to some Pfandbriefe – up from launch levels of 2 to 4 basis points over last year. So far, two SCFs have issued seven jumbo bonds worth e14.25 billion, and covering maturities ranging from two to 15 years. The two parent companies – Dexia Public Finance and Crédit de Foncier de France (CFF) – are also fairly big, standing up to comparison with the biggest German mortgage banks. Research by Depfa confirms an enormous potential for growth, estimated at e150 billion to e200 billion.
With these ingredients for a huge and liquid market already established, will it be only a matter of time until the obligations snatch away investors from the Pfandbriefe market? “Obligations foncières are certainly a very competitive product,” says Ted Packmohr, market strategist at Dresdner Kleinwort Benson. “At the 15-year range, for example, there are not that many issues. CFF’s e1.25 billion 2015 issue is very attractive.” Another CFF bond, the e4.2 billion 2010, is only outstripped by four German jumbo Pfandbriefe in terms of volume, and is traded at the EuroCreditMTS, the electronic trading platform for European spread products.
But Packmohr thinks that the success of the obligations foncières will not harm the German market – on the contrary. “The obligations complete the German market, and encourage the internationalization of the product,” he says. It’s an often-voiced argument. Indeed some German bankers believe that the established Pfandbrief players should have taken a more active role in encouraging more covered bond markets around Europe as a way of awakening much broader investor interest in the asset class. “The emergence of new markets broadens the appeal of the instrument, and more investors will come to the market. It’s not a zero-sum game,” says Marc Towner, vice president at Depfa.
For now, however, the obligations foncières remain a very French product. The longer maturities in particular are mainly placed with French institutional investors. Frank Jesse, head of covered bond trading at DG Bank, says that it is still more difficult to sell obligations than Pfandbriefe at the same spread. The obligations have yet to establish a reputation with international investors. There is a lot of work to do, a lot of explaining is needed and visits to investors outside France to be made. American investors in mortgage bonds might be attracted by some of the more familiar features of French obligations, though a sterner test might be overcoming their mistrust of the euro.
There are several other details that investors will have to examine carefully. The collateral for the obligations is, for example, not pooled into separate cover funds for mortgages and for public loans, as is the case in Germany and Luxembourg. Although there is a de facto separation in France, because issuers specialize in either business, they theoretically enjoy more flexibility. It may not turn out to be so great an issue: German public-sector and mortgage Pfandbriefe trade at the same levels. But in the short term, “investors have to be a bit more vigilant,” says Grodzki. “They have to undertake more effort in digesting the information, which means higher costs, which could well be reflected in higher spreads.”
Another variation from the Pfandbriefe is that “the range of public-sector borrowing is of much more variable quality. Consequently, other things being equal, a random portfolio of French public-sector debt will in total be of lower credit quality than an equivalent German portfolio,” states a report by Fitch. Synave at Dexia counters such arguments: “The local authorities in Germany have, in fact, more freedom to run a deficit. The federal government guarantees the Länderdebt to set off this risk. In France, local authorities cannot run a deficit by law, and if they do the local prefect imposes spending cuts or tax rises immediately. Every debt has to be reimbursed by law.”
It will take some time for the obligations foncières to become as well known as the Pfandbriefe, and it will take a longer still for them to be as respected as the Pfandbriefe which, in the 100 years since enactment of the Pfandbrief law in its present form, have not produced a single default.
Spain seeking recognition
The Spanish cédulas hypotecarias also suffer from a lack of international recognition. Of course a falling euro does not help attract investors. But even euroland’s own investors are a bit cautious. The cédula is the most basic type of covered bond. “The mortgage market law was modified in 1981, but was not designed – as in France and Luxembourg – for the international market,” says Maria José Lockerbie, managing director financial institutions at Fitch.
Holders of cédulas hypotecarias are also granted priority treatment in case of bankruptcy – though after claims from the state (taxes) and employees (salaries and wages for one month). But the cédulas are not as bankruptcy remote as the other Pfandbrief versions. Any financial institution recognized by the Bank of Spain can issue cédulas hypotecarias – in other words, the instrument is not secured by a separate collateral pool.
“But over-collateralization makes up for this,” says José Luis Dominguez de Posada, director of funding at BBVA. “The law effectively requires a surplus cover of a minimum of 11%, though our cédulas hipotecarias have an over-collateralization of approximately 600%.” The issuing bank’s whole mortgage portfolio provides cover for the cédulas, whether qualifying as collateral or not, so that at the current low issuing levels over-collateralization is high. “Because of this huge over-collateralization cédulas are better than the Pfandbriefe,” says Rafael Garcés Beramendi, director of credit products at Caja Madrid. “Although that is probably a very Spanish opinion.”
Losses are very unlikely in the long run. But payments might be delayed in an insolvency procedure, the duration of which can only be speculated about, as there has not yet been a default of cédulas hypotecarias since their creation in 1869. With the probability of default being directly related to the creditworthiness of the issuer, the cédulas trade 6bp to 10bp over Pfandbriefe. Spanish legislation is also less restrictive in that it permits a higher loan-to-value ratio – 80% for residential mortgages, 70% for commercial property, compared to 60% in Germany and Luxembourg and 60% to 80% in France.
The cédulas hypotecarias might also not quite make it into the jumbo super league of liquid internationally-traded bonds because the growth of the market is limited. Cédulas can only be backed by mortgage loans, and not public-sector loans. Spanish banks have so far focused on domestic mortgages. This market has grown substantially in the past five years but is still rather small at e175 million when compared with Germany’s e1,200 billion in 1998. (Depfa Research)
Posada says that a new law is proposed to allow covered bonds backed by local and regional government assets. This would create the cédulas locales, which could be a crucial impetus for further growth, considering that public-sector Pfandbriefe account for about 90% of the German jumbo market.
Luxembourg getting big
Luxembourg’s lettres de gage could find themselves best positioned to attract investors’ attention. But because of their tender age – the first was issued in May 2000 – it is hard to say for sure. The lettres de gage are most closely modelled on the Pfandbrief and have far less of a national identity than other European instruments. “The French, Spanish and German Pfandbriefe can rely very much on their national markets,” says Christof Schörnig, managing director of Pfandbrief Bank International (PBI). “But that’s impossible for Luxembourg. We can only follow a European strategy. Investors as well as issuers will be more international, which is why the Luxembourg market will grow very rapidly.”
Issuers don’t have such large volumes of assets on their books. Not only are assets hardly as abundant as in other, larger countries, but two out of the three issuers were only set up last year. At a closer look, this is not necessarily such a drawback. Subsidiaries were set up so quickly because the lettres de gage claim something no other instrument can offer. Eligible collateral includes mortgages and public loans from all OECD countries – a considerable advantage over the funding restrictions in Germany and France which can only include assets from European Economic Area (EEA – EU members plus Norway, Iceland and Liechtenstein) countries plus Switzerland, Poland, the Czech Republic and Hungary for mortgage loans in the case of Germany.
And the lettres de gage display all the other merits, too: investors are given preferential treatment, assets have special status (no moratorium can be called), derivatives can be included into the collateral pool and a trustee, who must be a qualified auditor and approved by the Commission de Surveillance du Secteur Financier, oversees the pool.
The lettres have another advantage over the Pfandbriefe in that substitute collateral (liquid and risk-free bonds) up to 20% may be included in the pool, compared with 10% in Germany.
Any bank can set up a subsidiary in Luxembourg and shop around for assets in OECD countries. For the German banks, which have dominated the Luxembourg market so far, it’s a gift of the gods. Their foreign assets in the Pfandbriefe to date are only eligible without restriction if they come from EEA countries whose jurisdictions provide preferential rights to Pfandbrief holders – France, Austria, Denmark and Luxembourg. Assets from other EEA countries are admitted up to 10%, though this regulation will lose its significance with the trend in many countries to update their insolvency regime.
So German mortgage banks are missing out on a promising growth segment of the market. Add to that higher interest rates, which make assets more expensive, as well as a flattening yield curve that leaves little room for taking advantage of interest rate differentials, and the relatively poor performance of Pfandbriefe comes as no surprise. This year new jumbo Pfandbrief issuance has, for the first time since their creation in 1995, failed to exceed the levels of the previous year.
Banks have been rather inactive this year, not because of an investor run to competing products, but because of poor market conditions. Credit spreads are now around 65bp above Bunds, and haven’t fallen below 50bp for several months, whereas a year ago they were at 40bp.
An extension of business opportunities into new markets is now such a priority that the German banks aim to incorporate it in their law. It might take some years to get through parliament, but one Hypothekenbanker expects the new law to be adopted in 2001. Then, he says, “the expenditure of having set up a new subsidiary in Luxembourg will have been for nothing.”
The growth of the market in lettres de gage crucially depends on more issuers seeking to take advantage. “If more banks come to the market, the lettres could become the second biggest segment in the European jumbo market,” says Schörnig at PBI. He expects three to five new issuers within one year, and the market share in the European covered bond market to increase from 4% to between 10% and 15%. Yet if the German mortgage law is changed along the lines of Luxembourg’s soon, the predicted growth potential might not materialize.
European Pfandbriefe
Is the coming change in the German mortgage law, which has until now been upheld as the strictest and most efficient legislation on covered bonds, a sign of the Europeanization of the Pfandbrief? Countries could, so the argument goes, adapt their laws until there is a common Pfandbrief. A European Pfandbrief was envisaged in the 1980s as a desirable development. Depfa, the biggest Pfandbrief issuer, has long campaigned for a truly European Pfandbrief under one legislation, and still believes it could materialize. “It should not be too difficult to align the laws along the German Pfandbrief, which is acknowledged as the most efficient,” says Depfa’s Towner. “The EU Investment Directive already acts as a minimum standard, and the euro will add to the development of a common instrument, as does the decline in government bonds.”
But as there are no concerted efforts to create such an instrument, the different national laws will prevail for some time. “Of course that means investors have more work to do in analyzing the various instruments, but the different products also offer more opportunities to investors,” says Schörnig at PBI. “It is very likely that this Pfandbrief asset class will achieve international status by going down this alternative route.”
A European market is already in the making in that there is no distinct visible obligations financières or Pfandbrief curve. Towner reckons that spreads will converge further, and Schörnig expects a differentiation of the European Pfandbrief-curve not along countries, but along individual names.
“As the European Pfandbrief market continues to grow, it will attract more investors,” says Schörnig. “It’s good news for everyone. The only losers in this increasingly competitive market for covered bonds will be the banks that fail to attract international investors, unless this is their strategy.” Banks that cannot offer triple-A instruments will find themselves left behind by their foreign peers. So to avoid losing the business of refinancing mortgages and public loans, most European countries – except the UK which favours US-type securitization – are hurrying to upgrade their laws. Ireland is expected to produce a new law in 2001, and Belgium, Austria and Switzerland are amidst discussions. (There are other European mortgage bond markets, such as in Sweden and Denmark, but they don’t produce jumbo issues.)
For now the Pfandbrief remains the most recognized and demanded spread product in Europe, with liquidity in all maturities and a repo market that is unrivalled in providing for complex hedging, trading and investment strategies. An extension of the German mortgage bank act will further strengthen the position of the Pfandbrief. Fears that any relaxation of the strict eligibility rules constitutes a danger to its security are unlikely to be founded, as the inclusion of G7 assets seems to be favoured over OECD countries.
The only cloud on the horizon comes in the form of Brussel’s annoyance with the privileges granted to the German Landesbanken by the German state. The Landesbanken issue about 40% of all Pfandbriefe, though considerably less jumbos. “If they would get privatized, they could lose their status as Pfandbrief issuer, because without special guarantees Landesbanken are like any other bank involved in a variety of higher-risk activities that violate the special bank principle,” says a source close to the market. But this is only one of several possible developments; the banks could also outsource their Pfandbrief business.
Warnings about the deteriorating quality of Pfandbrief collateral also continue to be heard. First, if the mortgage banks do have large open positions from mismatching assets, an inverted yield curve (that comes higher short-term rates and lower long-term rates) might inflict huge losses in a bank’s balance sheet.
Secondly, the risk in a mortgage pool could also mount as more commercial and industrial mortgages are taken on in proportion to less risky residential mortgages. At least this risk should be contained by the 60% loan-to-value limit, which means that only 60% of a property’s mortgageable value can be taken into the collateral pool. Pierre Menet, head of hybrid debt at Société Générale, also warns about a 51% increase of senior unsecured debt on the German Pfandbrief banks’ balance sheet between 1989 and 1999. “Although that does not in itself cause a lower quality in Pfandbrief collateral, this debt, which does not get refinanced at all, increases the general riskiness of German mortgage banks.”
But other emerging Pfandbrief markets will hardly be in a position to fill the gap, if there was one to be left by the German issuers. The European market will grow but not at the same rate at which the jumbo Pfandbrief market took off in 1995. At the heights of 1997 to 1999, an average of one jumbo a week was coming to market. “The potential for growth is seriously restricted in this environment of rising interest rates,” says Jesse. “The new markets did not catch the best moment for taking off.”
Spain: much untapped potential
Cédulas hipotecarias have been issued domestically for many years by most Spanish savings banks – the cajas. When the central banks of Spain, the supervisory bodies of Germany and France reduced the risk weighting for cédulas from 20% to 10% in May 1999 the conditions were set to attract the sort of bond investors that want to diversify their Pfandbrief portfolio. Argentaria sparked off the Spanish jumbo market in September 1999 with a e1.5 billion five-year deal. Banco Bilbao followed the same month with a e1 billion 10-year issue, and in September this year it issued a e1.5 billion 10-year cédula. Caja Madrid produced a e1.5 billion 2010 deal in October 1999, which was subsequently tapped with e500 million in May.
After Banco Bilbao’s merger with Argentaria to form Banco Bilbao Vizcaya Argentaria (BBVA), Moody’s upgraded Argentaria’s issue from double-A, so that all cédulas are now rated triple-A.
There are still plenty of mortgages on the banks’ books to be refinanced. “The amount of cédulas so far issued is only a minor fraction of the underlying potential assets,” says Maria Lockerbie, managing director financial institutions at Fitch.
But few banks have yet made use of this facility. The cédulas are not very well known internationally, and Spanish banks still get relatively cheap funding for unsecured transactions in the domestic market.
Secondly, says José Luis Dominguez de Posada, director of funding at BBVA, “the combination of equity market volatility, higher interest rates and a change in the law – granting the same tax benefits to deposits as to mutual funds – caused a shift away from mutual funds to deposits, which provided an even cheaper source of funding for banks.”
The market in cédulas will not exactly be bustling with activity, and BBVA as well as Caja Madrid have not planned another issue. They will come to the market “if the market conditions are right”.
Other candidates likely to issue jumbo cédulas in the future are the big Spanish savings banks Caja Galicia, La Caixa, Caixa Catalune, though it remains to be seen whether the amount a caja can issue will be large enough to compensate for the effort and cost that an international issue entails, says Lockerbie.
If the existing mortgage market law is extended to allow for public loans to back cédulas, BBVA will be active in that market through its subsidiary Banco de Credito Local.
Luxembourg: German style with a wider view
Luxembourg’s three special banks excited the markets with their brand-new jumbo lettres de gage this year, though they were all set up by the end of 1999 under the special banking law of 1997. Only with a change in the law on June 22 2000 could the lettres receive a triple-A rating. The new amendment ruled out any chances of default by exempting the mortgage banks from the existing bankruptcy law that allows a moratorium to be called over assets. It also clarified the rules over the inclusion of derivatives in the asset pool.
In view of this change Standard&Poor’s already gave a triple-A to Eurohypo’s first lettre de gage, a e1 billion five-year deal that was launched in May. By late October the market had grown to three jumbos – one from each of the three issuers – with a total volume of e2.2 billion.
Eurohypo was able to come out with the inaugural issue so quickly because it has been operating in Luxembourg since 1989 – until 1999 with a general banking business licence. It is 90%-owned by Eurohypo Frankfurt and 10% by Nürnberger Lebensversicherungen.
Eurohypo’s first jumbo was very successful. The joint-lead bookrunners, Barclays Capital and Deutsche Bank, said that they were sold out one day after launch. “The deal was mainly going to institutional investors,” says Reinolf Dibus, who is administering the lettres at Eurohypo. “We priced a few basis points above the Pfandbriefe issued by Eurohypo Frankfurt to attract investors. The deal’s spread has since tightened two basis points and now trades near the levels of our parent company.”
EEPK, the Erste Europäische Pfandbrief und Kommunalkredit-bank, issued a e500 million three-year bond in September. The Pfandbrief Bank International (PBI) also needed a little more time to build up its asset pool, following its foundation in July 1999. It came to the market with a e750 million five-year debut in October. Their levels, too, have tightened to the German Pfandbriefe curve.
Although it is difficult to base comments on one jumbo issue only, warns Christof Schörnig managing director at PBI, it seems that Eurohypo and PBI are the most expensive issuers, followed by EEPK. This does not surprise Dibus, who says these trading levels are determined by the affiliation of the subsidiaries, and in particular “reflect the conservative business strategy of Eurohypo”.
Eurohypo ultimately belongs to Deutsche Bank, PBI is majority-owned by Hypovereinsbank (and six other Munich-based banks), and EEPK’s shareholders are the Düsseldorfer Hypothekenbank and the Hypothekenbank Essen – both of which trade at the lower spectrum of the German Pfandbrief curve – as well as a holding company owned by the Dr Schuppli group. Multi-millionaire Wolfgang Schuppli first made his money by producing sewing machines, but then changed track and founded Hypothekenbank Essen and Berlin. He also owns the Düsseldorfer Hypothekenbank.
Investor interest in the new lettres has been lively – 40% of Eurohypo’s issue has been sold to Europeans outside Germany and, spectacularly, 41% was placed outside Europe by lead manager Barclays Capital. Banks were the main buyers at 41%, which could explain the view taken at Hypovereinsbank, which lead managed both Eurohypo’s and PBI’s deal. “We’ve found institutional investors outside Europe rather cautious due to the weakness of the euro.” says its head of covered bond syndicate Christian Reusch. “The main interest comes out of Europe.” Neither has PBI’s bond sold heavily outside Europe, although some notable demand came from Japan.
Eurohypo’s Dibus says the yield pick-up helped to attract investors, as did the exceptional transparency. All assets in the pool are broken down by country and rating. published on their website, and updated at least every three months. The periodic publication of such information may well help to make the lettres de gage an international success in the long-term. High standards of transparency are a great way for issuers to differentiate themselves. Not that Pfandbrief issuers are incurably secretive – in fact banks such as Depfa and Rheinhyp have led the way in giving more information to investors – but there is often a mentality in Germany that resists Anglo-Saxon openness, says Frank Jesse, head of covered bond trading at DG Bank.
The success of the lettres de gage will also depend on their credit-worthiness. Luxembourg’s law is the most flexible in that it allows assets stemming from all OECD countries to be eligible as collateral. As the OECD also includes less creditworthy countries such as Mexico, Hungary, Turkey and South Korea an extension into these markets will endanger the top credit quality that Pfandbrief investors demand. All three issuers have therefore voluntarily restricted their activities: Eurohypo will not make loans to Mexico, Turkey or South Korea. The PBI and EEPK exclude these countries, plus Greece, Iceland, Poland, the Czech Republic and Hungary. “We only invest in countries rated double-A or better,” says Schörnig. “In any case, this is where 98% of growth takes place. Only 1% comes from single-A and triple-B markets.”
More issuers are expected to come to the market soon – three to five is Schörnig’s guess for the next year, which, he says, will also include non-German banks. Mortgage banks are also likely to take up the business of issuing lettres de gage hypothécaires. The present market participants all specialize in public debt issues, the lettres de gage publiques. From this part of the market there will certainly be more jumbos this year.
France: designed with care to compete
The obligations foncières are widely regarded as the most carefully designed of the new covered bond instruments, trying to improve on the German system while building on an existing law that dates from 1852. The French market has developed rapidly since September 1999 when the new mortgage banking legislation came into force.
Obligations foncières with an outstanding value of e32 billion – of which e14.25 billion are jumbos – have been issued by two sociétés de crédit foncier (SCF): Compagnie de Financement Foncier (CFF), a subsidiary of Crédit Foncier de France, and Dexia Municipal Agency (Dexia MA), a subsidiary of Dexia Public Finance Bank (Crédit Local de France), which is itself wholly owned by Dexia. Crédit Local de France exclusively lends to the public sector, while Crédit Foncier is mainly active in the mortgage lending business.
Dexia Crédit Local de France was issuing bonds before 1999. But as the group is rated double-A, the new obligations foncières are a welcome source of cheaper funding at triple-A levels. Dexia MA has so far e9 billion outstanding, of which e7.5 billion are jumbos. A e2 billion five- or ten-year issue that will be fungible with an existing issue will be coming soon. To accelerate liquidity, Dexia MA has been acting as “category 1” issuer, which allows investors to merge the new taps immediately with the existing issue, and not after 40 days as is the rule under “category 2” status. Category 1 is required on the euromarket systems to have issues fungible from the first day, and will attract more investors whose priority is liquidity.
To enhance liquidity further, Dexia MA also aims to trade on the EuroCreditMTS platform, probably by the end of the year. This requires a sum of outstanding jumbo issues of e10 billion and a size of e3 billion for the specific issue. Many traders say that there is, so far, no visible liquidity premium for bonds on EuroCreditMTS, as those have been the most liquid issues anyway. But a study by Salomon Smith Barney detected a small premium of 1.6 to 2 basis points, and growing. The Compagnie de Crédit Foncier has already contributed one e4.2 billion issue – the first non-German – to the 18 Pfandbriefe traded at EuroCreditMTS. All in all CFF has issued e8.6 billion obligations foncières, of which e8.45 billion are jumbos.
Olivier Allard, head of debt capital markets at CDC Marchés, thinks “that there will be new issuers coming to the market, but certainly not before the end of the year. Creating a subsidiary – anyone can do that.” But given all the legal requirements, setting up an SCF is expensive.
Other structural oddities of the French market might hold back the growth of covered bonds. In the public loan sector, the biggest advantages of entering the market should, in theory, accrue to the savings and loan societies, the Caisses d’Epargne, which have a total market share of 20% to 30% – second after Dexia with 40%. But there are 34 of them throughout France, and putting their assets into a common pool is so complicated in terms of assessing the risks for each party, and the relative quality of the assets, that it is a project for the longer term.
But the savings societies have a 30% stake in Crédit Foncier de France, and might prefer to transfer some of their assets, thus benefiting from its reputation and the liquidity of its issues. In France the collateral pool’s assets do not have to be divided by mortgages and public-sector loans, making such a transfer from public lenders to a mortgage bank possible. Still, even this process is complicated. For now CFF is buying assets from the savings societies.
The other major player in the public and mortgage lending sector is Crédit Agricole Indosuez which leads the market in mortgage lending through its 53 regional banks, and ranks number three in the public sector. So far, Crédit Agricole has not made plans for setting up an SCF. Crédit Agricole can facilitate another instrument to refinance residential mortgages – the Caisse de Refinancement de l’Habitat (CRH). It is the leading shareholder of the CRH, with most other large French banks, including BNP and Crédit Lyonnais, having stakes as well.
“Many banks have looked into the possibility of setting up a SCF,” says Edouard Payen, head of bond origination at Crédit Agricole, “but for the moment, the CRH is a convenient way to refinance. It’s rated triple-A and has the advantage that assets remain on the bank’s balance sheet.”
CRH was set up in 1985, then called Caisse Refinancement Hypothécaire, to refinance residential mortgage loans of its shareholders, and is not seen as a profit-maximizing institution but rather as a service provider. Alongside the changes in the mortgage law in 1999, CRH was able to strengthen its position. The law added new eligible assets and extended their origin to European Economic Area countries. CRH bonds’ main difference compared with the obligations, according to credit rating agency Moody’s, lies in the fact that they “carry no interest or maturity mismatch risk and are enhanced by a higher level of over-collateralization.” But although the CRH bonds are also rated triple-A, they are a very French product in a small, closed market.
Several French banks are said to be discussing the creation of a SCF by putting their assets into one pool. But again, complications arise, starting from calculating the assets’ risks to getting approval by the banks’ shareholders to give up valuable assets.
According to Dexia, there might not be any other issuers for another two or three years. At first sight, this looks likely to restrict the growth of the French market. Compare that with the German Pfandbrief market of 33 Hypothekenbanken. Arguably, the advantage of more issuers lies in the greater likelihood of mutual help in case of a bankruptcy by one of them. But it may be good news for the jumbo market in obligations foncières, because two large issuers have more assets on their books – though most of them are in France – with which to collateralize larger, liquid bonds.
On Crédit Foncier’s balance sheet are e22 billion of mortgage loans, e1.6 billion of local authority and public loans, and some mortgage-backed securities, such as the fonds commun de créances. If Crédit Foncier does get assets transferred from the savings societies, and more foreign business is taken up, the potential for growth is substantial. Depfa estimates the French market’s potential at e150 billion to e200 billion.
Considering that the obligations financières have only been on the market for a year, the 22 market-making banks have done well in providing liquidity, though it is nowhere near the level of the German Pfandbriefe. One feature that is missing in the French market is the amount of intra-bank trade which accounts for an estimated 25% of all buying of Pfandbriefe. “Germany is different in that banks are taking large amounts of Pfandbriefe on their books, whereas there are no heavy positions yet on French books,” says Allard. Secondly, the repo market is not as well developed as in Germany, and market makers have to be encouraged to become more active in that area.
