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IFR: Are there specific areas of the insolvency law that you’re seeking to change or update?
Jens Tolckmitt: Luckily so far there has never been a case of an insolvency of a bank so we’re looking at it more from a theoretical point of view, concentrating on constantly improving the legal framework but also looking at what would actually happen if insolvency occurred and how we can ensure that what is written in law runs smoothly. I think that is very important. Who is the administrator? What can the administrator do? What are the instruments that he has at hand? How do we make sure that he can act immediately; things like that?
IFR: Mathias do you see interest in issues like this in the market?
Matthias Melms: Yes. From our discussions with investors, they always ask us about insolvency around German Pfandbriefe and what would happen after the theoretical default of an issuer. In Germany, the stakeholders have maybe worked a bit harder than in other jurisdictions, which is one of the reasons I think German issuers can fund a little bit cheaper than issuers from other jurisdictions.
Jens Tolckmitt: It’s sometimes been said - negatively - that the German law is always under construction. It is, but I’d put a different spin on it in that the dynamism of the German law is something that investors appreciate very highly because they know that whenever there is a concern from a rating agency, for instance, about liquidity in the pool after insolvency or something like that it will be dealt with immediately.
What you see, not only in Germany but in many other countries as well, is that they’re upgrading their laws, and people see that it’s worth looking even at some of the technical issues that seem quite difficult to explain but which are perceived to be important by investors.
Joerg Huber: There is another point. We Germans opened this Pandora’s Box of making the jumbo Pfandbriefe global. When other jurisdictions started to emerge we suddenly had, competition, which was quite good but led to this constant updating.
Nowadays, we have to keep up not to just make the law even better but also to explain to investors that there are already so many features in the law which make Pfandbriefe superior to other products.
I have discussions with investors and when I answer their questions, around for example how many non-performing loans are in the cover pool, I tell them there’s a minimal amount because they are booked out after 90 days maximum, so there is not even small element of non-performing loans. And they tell me: “I didn’t know that”. There are a bunch of small features that they know from other covered bond issuers but when they compare them with Pfandbriefe, it’s not even comparable.
IFR: That’s an interesting point. From a deal maker’s perspective, Stefan, what kind of conversations do you have with issuers? Are they focused on the transparency issue and on comparability between different covered bond classes?
Stephane Bataille: Well, the main takeaways from the last six months are not with regards to cover pool transparency. I think Pfandbrief are very, very sophisticated but you have to bear in mind that other countries or issuers outside Germany can also be very transparent. Some UK or Dutch issuers are good examples and they all have the relevant information on their web page. I think the theme of asset encumbrance is something which at least some issuers are nervous about, especially in France. But we have also these discussions in the Nordic region, for instance.
Torsten Elling: Maybe one reason we’re seeing such questions from investors is the amount of due diligence around investing in covered bonds has massively increased. Investors are demanding much more information and asking more questions then ever before, partly because of the different variety of covered bonds out there, or so-called covered bonds, but also because maybe in the past they had some negative experiences around spread widening so they really want to understand why it happened to make sure it doesn’t happen again.
A lot of the questions are coming from more credit-oriented investors who are looking at an ABS type of investment and focusing on deferred loans, which doesn’t make any sense for covered bonds. But it clearly shows me that we have much more education to do for new investors coming to the market, particularly those coming from the credit world who want to get more involved in covered bonds.
IFR: Do you think German covered bonds spreads make sense at these levels? We saw a little bit of push back on certain deals where investors just thought they were too tight for what they were getting. Can they tighten even further?
Stephane Bataille: From a relative value perspective Pfandbrief are probably trading where they should be trading, in very narrow ranges with the Bund as a floor and the Laender as a cap. There’s not much room and I wouldn’t expect a lot of standard deviation going into the next few months. The same is true for Nordic covered bonds. I think they’re also trading very tight to Pfandbriefe. But you know this is low beta stuff so I don’t think you will see significant changes.
Ralf Burmeister: You also have to look at the supply mechanisms. The Pfandbrief market has almost halved in the last decade. Just this year we have net outflows of €40bn-plus and this is major driver of spreads too. If your Pfandbrief matures you’re desperate to get another one if you want to keep your exposure to German covered bonds constant
Stephane Bataille: But that is not possible. If you look at the stock of outstanding Pfandbriefe, they peaked at €2trn in 2000 but are now around €550bn. I understand what you’re saying. Investors need to be benchmark neutral so they have to buy Pfandbriefe but there is simply a lack of paper.
Ralf Burmeister: I agree. Not every investor can keep his exposure. You have to wake up early!
Stephane Bataille: I understand there is a clear need to re-invest in Pfandbriefe but there is a lack of paper. So, what will happen? German investors will naturally look for alternatives so they’re looking around France, Benelux and the Nordic countries, and the UK to some extent. That is one of the reasons we are seeing such high German participation in international deals.
Before the crisis, German participation in international transactions was around 30%. Last year, it was 45% last year and now it’s 47%. We think it’s still going higher and will probably reach 50%. So, you have huge redemptions in the Pfandbrief market and not enough Pfandbrief supply. We have huge redemptions, too, of guaranteed Landesbank paper out to 2015. This money is looking for alternatives outside Germany.
Torsten Elling: But there is potential for German Pfandbriefe to tighten even further. If investors really want to keep a minimum basis in very safe and solid German Pfandbriefe, they just have to accept tighter spreads; it’s just a simple supply and demand pattern. You don’t have any supply, but demand is still up there so you will see that it’s going to be priced like that.
What we’re seeing currently is this magical Euribor flatline where people are really concerned about “can I really buy at sub-Euribor levels”? We’ve seen German transactions priced substantially sub-Euribor, with demand coming out of Asia. I think that might be the next step as well once this hurdle has been taken. German Pfandbriefe can trade tighter just because of the demand.
IFR: What are the expectations for Pfandbrief issuance in 2013?
Jens Tolckmitt: We estimate between €60bn and €65bn.
Matthias Melms: We’re predicting in the region €50bn in overall issuance but I think we only expect €20bn to €25bn in benchmark covered bonds. As for the Pfandbriefe demand issue, If you look at recent issues for the likes of Aareal, Deutsche Pfandbriefbank or for our subsidiary Deutsche Hypo, they issued at very tight levels but there wasn’t huge demand as reflected by high bid-to-cover ratios. I think investors have problems buying at a certain level. Not all issuers can price through Euribor.
Torsten Elling: But did we ever think that German Schatz would price with a negative yield?
Ralf Burmeister: That’s one thing and the other is swap spreads and whether Euribor flat is the right measure. I mean if you have five-year Pfandbrief new issues out of Germany with a coupon of zero point something and you assume inflation at a normal rate of, say 2%, if you buy and hold the paper, it’s clear you’re willing to lose capital. Why do you do that?
IFR: Good question. Is it down to capital preservation? Is that still a driver? When we were in the eye of the eurozone crisis, the focus was getting your money back. But we’re no longer in crisis mode.
Ralf Burmeister: It comes down to absolute yield. Slowly but surely, we’re reaching, a point where, say a 0.5% coupon for five years doesn’t make sense. That’s a Japanese style scenario. If you think: “well, within five years the world will change” then you might go for the Pfandbrief in terms of liquidity and maybe some kind of capital preservation in the short run but you’re not supposed to hold this paper for the whole five years. That’s the point. Within the Pfandbrief sector and the demand/supply patterns, it’s easy to get rid of paper.
Stephane Bataille: For me it’s also a function of swap spreads. If five year Bund-swap spreads were plus 70bp. why shouldn’t Pfandbriefe trade 20bp or 25bp back of swaps? But if we are at 35bp, there is not a lot of room.
Ralf Burmeister: Euribor is mainly driven by banks but if you look at order books, treasuries of banks aren’t necessarily the number one investor like they used to be in the past.
IFR: How important is the performance of these deals? Muenchener Hypo came at minus 14bp but didn’t perform particularly well after that. Is that something investors will look at and think: “well, I didn’t do very well out of that last time, I won’t buy now”? Or are they taking a longer-term view?
Ralf Burmeister: I don’t want to comment on any particular deal but when demand is there and syndicates do their job and allocate orders, it’s done. As I said there are natural limits in terms of absolute yields but you’ve seen a lot of new interest this year with tremendous over-subscription so it’s a lot of work for syndicates on allocation.
As I said, Euribor is not a natural limit or a barrier, as Stefan pointed out with his example of plus 70. So why not go for it? As to performance, yes it will be noted. So, if a particular issuer squeezes out the last couple of basis points out of the deal and leaves nothing on the table for the investors you will think twice or three times before subscribing to the next new issue.
I’m not saying it’ll shut out the investor for a long time but you take note and when you have one-on-ones, that’s one of the questions that you’ll be asking.
IFR: We touched on transparency so coming back to that for a second: is cover pool transparency generally better across core and peripheral jurisdictions? With regard to Spain, the government is going to great lengths to prevent the banks from foreclosing on defaulted mortgages. Could this affect cover pools? It’s one of those complex politics-meets-economics issues but from an investor point of view, how do you view that and more to the point: how do you price that kind of risk in?
Ralf Burmeister: When it comes to Spain, it’s just one element of the homework you have to do. You evaluate pool by pool and bank by bank. But there’s a systemic component to it. The introduction of a bad bank solution is positive for the overall banking sector; and you have support between the States with the ESM/EFSF etc, but you have to break it down to the particular issue and then to the specific cover pool.
On transparency, I would love to see more at the bank level instead of the pool level. As we have seen, for example, from the latest exercise on counterparty risk, it comes down to derivatives which are not in the pool. You need to see the bank book, the derivatives books and the derivative counterparties in order to get an idea of why the rating agencies are running amok and threatening issuers with six or seven notch downgrade.
You need to see the bank as an issuer. At the end of the day, you like to know what the risk is of the bank as issuer defaulting; only then can you move to the second step, to the cover pool and make an estimate of the recovery you might get on it. But your first line of defence is the issuer so you naturally want to have more information on that and there is much more room for improvement. I’d rather have 10% more transparency on the bank than 10% more on the cover pool.
Matthias Melms: I think Ralf is completely right. But we still have a lack of transparency in some peripheral countries. From our point of view and from our investors’ point of view it has been very difficult to get clear information about the cover pool as well as the bank books.
In Germany, you have Paragraph 28 [of the Pfandbrief Act covering transparency provisions] where issuers have to give information every three months. If you have a look at Norway or Sweden, you have banks that provide information every four weeks and give an online update about the cover pool.
For other countries, you have do to a lot of homework. The ECBC label initiative - which is not supported by all issuers - is a step in the right direction. If you look at the homepage, you can get information about some Spanish issuers that have joined the label initiative, which is more than I’ve seen in the past. Getting something done centrally by the ECBC is the way to go and improve the standards of transparency.
Jens Tolckmitt: I fully agree that transparency beyond the cover pools is becoming more important but the Pfrandbrief Act or any legislation across the covered bond universe is not the right place to regulate it. The question is who are you addressing? It’s not that issuers or banks are not transparent today, the question is: can I get the information I need as easily as I can get information on cover pools?
It’s obviously a job for banks to provide transparency but it’s also a job for investors to look at open sources of information where they can get transparency. It’s not the case that the only thing about a bank that is transparent is the cover pool. With the German law, we’re state-of-the-art. We are discussing now the introduction of LTV transparency into the German law as well, for example. But the specific covered bond laws are definitely not the right place to regulate transparency beyond the cover pool. That’s very important. Everybody would agree that transparency is becoming more important but it’s not the job primarily of our industry.
Ralf Burmeister: I wasn’t asking for more transparency on the bank level within the covered bond legislation. Don’t get me wrong.
Jens Tolckmitt: All of the different transparency initiatives out there are concentrated on covered bonds and the cover pool. I think it’s very good to concentrate on that, but if you look at how to develop transparency further, I think it would be the wrong way to go for those asking for transparency to address the covered bond industry with claims for more transparency on the overall bank. It’s not their job.
Joerg Huber: Transparency sounds very positive and it’s very important but a lot of people nowadays are just trying to get the figures into a spreadsheet and trying to compare. The problem is covered bond issuers in Europe have different business models and the figures that come out might not really reflect the quality [of the pools] because business models are different so investors or analysts unwilling to do additional homework to really understand the credit might find that information was misleading.
Jens Tolckmitt: If you look at this issue from a different perspective, with regard to asset encumbrance, my personal view is that one of the reasons the discussion around asset encumbrance has been concentrated so much around covered bonds is that it’s the only transparent type of encumbrance on the balance sheet of a bank.
Real problems for unsecured bank investors are likely to arise from those areas of asset encumbrance that are not as transparent as the covered bond. You’re just not aware of what is changing on a daily basis, in terms of assets that are reserved for specific kind of creditors.
IFR: Could better transparency across the covered bond universe actually be detrimental to Pfandbriefe, since the German market currently benefits so much from the fact that transparency elsewhere is lower?
Jens Tolckmitt: I don’t think so. I’m pretty convinced that what we have seen internationally and will see over the next few years is a move towards the kind of transparency that in many aspects is close to what we are now already providing for Pfandbriefe. But this is not something we’re jealous to share. If you perceive the covered bond as an asset class in general with a certain differentiation then you have to work towards uniform transparency or perhaps a harmonisation of what is perceived to be important.
You will not be able to make it totally uniform because conditions in different countries are different and definitions are different and likely to remain so. But a move towards more transparency as we saw in 2012 and will see in 2013 and the years ahead is something we value highly.
IFR: I was curious to go back to the periphery. When you look at the Portuguese banks, they’re focused mainly on senior unsecured while the Irish banks have done covered bonds. There is obviously a price differential there. It seems that the Portuguese banks were thinking when the market is there it makes more sense to access senior. Torsten, what would be your advice to issuers in the more troubled jurisdictions? Do you think covered bonds are the best tool to be using to get the most economical funding?
Torsten Elling: It all comes back to the all-in levels of the firm and that’s different in each jurisdiction and different for each company, given that you have different levels of where you generate your mortgages and how you run your bank books. From that perspective, both credit classes are very strong at the moment. We saw a lot of senior at the end of last year and I think it was quite important to see that again. Banks, besides covered bonds, need additional funding tools available to them and the levels of oversubscription we saw tells you a lot. I think the performance of the senior was partly driving the performance of covered bonds so in the end everybody benefited.
But, if it comes back to making a judgement as to what’s the better funding tool I think both avenues are open to the Portuguese as well as to the Irish and even the government markets are open again as we saw with the Ireland and Portugal taps. But it all comes back to what’s cheap on an all-in cost basis for each issuer.
IFR: But are covered bonds better for troubled markets?
Torsten Elling: We saw in the past specifically when funding was drying up in senior unsecured in 2009 and 2010 that the covered bond market was always open, so from that perspective, I’d say yes, to a certain extent. But on the other hand, covered bonds are different tools so you can’t really look at it like that. Senior and covered are two tools that need to be in the basket for all issuers and they should make use of them both.
Stephane Bataille: But we’ve seen covered bonds coming out of Portugal, too. At the end of last year, there were a few senior transactions but Caixa Geral de Depositos did a five-year covered bond. And if you look at dealflow out of Iberia this year, it’s been relatively balanced between senior and covered bonds, albeit we’ve seen a little more covered bond production.
If you want to extend your duration profile as a peripheral issuer, it’s still easier to do a covered bond than a senior. You saw the 10-year BBVA trade, which was first 10-year transaction from BBVA since 2007, I think. If you want to extend your ALM profile you’d opt for covered bonds. If you don’t want to give away your best assets at the moment, you should opt for a short-dated senior.
IFR: The duration question is an interesting one for peripheral issuers. At the beginning of the year, we saw Spanish banks going out to six years and 10 years as you mentioned. What has brought this about? Is it more economical for issuers to go out along the curve? Is the investor bid for duration stronger?
Stephane Bataille: I’m sure Ralph has an opinion on this but economically it makes zero sense. If I issue a 10-year covered bond at 250bp, economically it doesn’t make sense. But of course they are using LTRO money so are happy to extend the duration profile a little and are happy to have access to public markets and so on.
Ralf Burmeister: Torsten mentioned two-year Schatz at negative yields. That’s one consequence of the latest central bank actions. They’re flattening the curve at the front end so you need to go out the long end of the curve to get absolute coupons and certain levels of return. It’s that simple. If the central bank squeezes the front end there’s no place to go other than along the curve. This is one part of the explanation of the hunt for yield which is going on.
The other thing is we’ve hardly seen any long paper for a couple of years. So besides all the yield stuff and central bank actions, it’s the supply and demand pattern and the fact that we’ve seen very little issuance from very few jurisdictions so if a long-dated issue from another jurisdiction pops up, it immediately gains rarity value, notwithstanding the absolute levels. This is another part of the explanation and why we will see more diversification in 2013 across the curve when it comes to maturities.
IFR: As well as going out along the curve, you can go down the credit quality curve too. We’re seeing a lot of issuance from national champion type issuers such as BBVA, Bank of Ireland, Caixa Geral. Will the covered bond market accept issuance from second-tier peripheral banks or smaller banks with smaller balance sheets? Is there demand there?
Torsten Elling: I think clearly there’s demand there. It’s a question of price. They could even issue longer-dated paper if they were willing to pay the price. But as Stefan says, at a certain level it becomes uneconomic and for those smaller banks even more, given the fact that they have to pay a higher price.
What’s also important about choosing duration is not only the all-in cost between different funding tools. Due to the rating agencies, collateral management also becomes very important. The all-in level if you do proper collateral management looks totally different to the theoretical all-in. I think that’s something where some issuers have been quite surprised.
Covered Bonds Roundtable 2013: Part 3
