IFR Pfandbriefe Roundtable 2015: Part 1

IFR: Thank you for attending IFR’s latest Pfandbriefe Roundtable. The big topic of the moment, of course, revolves around the actions of the ECB and its latest covered bond purchase programme – CBPP3 – which has received a lot of negative sentiment from the covered bonds community. I suspect this will form a central theme of our discussion today.

Jens, let me come straight to you. While it may be difficult today to get beyond the purchase programme and its current impact, should we keep it in perspective? In other words, we may not necessarily agree with the programme or the way it’s being executed, but from your perspective at the VDP how does it fit in to the realm of wider issues you’re dealing with?

Jens Tolckmitt, VDP: What we are dealing with is the overall attractiveness of our product. Its long-term attractiveness – looking back but also looking forward – has always been the legal and regulatory framework.

But the current situation is not positive, especially for issuers, in that a functioning market is being severely hit by Central Bank action. In the long run, however, other topics will dominate. These will include all the regulatory issues we have on our plate, which are highly relevant and which are likely to be much more important in determining the future of the Pfandbriefe and the overall covered bond product than current interference by the Central Bank as a buyer in our market.

Obviously, continuing to make this product safe from a legal perspective in Germany with the Pfandbriefe Act and making sure that its attractiveness and safety are transformed to the European level in the regulatory harmonisation exercise is a major theme. And the unavoidable question – “is the overall concept appropriate to use for other purposes? If yes, in what way?” – is much more important if you look at it medium to long term.

IFR: In that context, are we assigning current ECB action more importance than it deserves, particularly as it’s a temporary phenomenon?

Jens Tolckmitt, VDP: It’s extremely important to state that this action is not welcomed by the industry, given that we had a market that was functioning and is now being seriously harmed by this action, which has broader goals in mind.

If you consider its political objective of facilitating the extension of loans into the real economy, I suspect if we go around the table we will all agree that this is not necessarily something you will achieve by providing an over-liquid market with more liquidity.

However, I’m pretty sure that once this external interference goes away and we return to normal market conditions in the overall capital market, there will be good reasons for real-money investors to invest in Pfandbriefe and there will be no long-term harm to the market.

IFR: Matthias, what’s your perspective?

Matthias Melms, Nord/LB: The way in which QE was carried out in its first stages by the ECB, focusing on covered bonds and ABS as a way to increase the balance sheet to €1trn, was not thought through. By the way, the clever guys at the ECB knew last summer that these instruments wouldn’t work and they wouldn’t be able to find sufficient assets to raise the balance sheet to that level, so it was no surprise that they introduced pure QE focusing on SSA.

From our perspective it isn’t clear [the roundtable took place on January 29] which assets they will buy from the SSA universe. We understand that way that they will focus on supras but specifically which type of SSA they will buy at the end it is uncertain. By the same token, it’s also uncertain if they will carry on with the current speed in the covered bond market, buying €10bn per month.

The €37bn they bought in the first 15 weeks of the programme was the easy stuff, but it’s getting more complicated every week to persuade investors to sell bonds to them. Obviously, the more aggressively they bid the more paper they’ll get, but I’ve spoken to a lot of investors and bank treasuries – the latter are also an important investor group in the covered bond market – and they told me they would never sell covered bonds because they rely on the coupon. And because they wouldn’t be able to invest the cash in an asset class as safe as covered bonds and earn a yield so it makes no sense.

In the end, I suspect we’ll see the ECB leaving the covered bond market more or less alone so they will reduce their purchasing volume through to the end of September. We calculate, incidentally, with regard to other instruments that it’ll also be really complicated for the ECB to source material enough from the SSA market, especially the supras.

The ECB wants to buy about 12% of the amount in government bonds, meaning around €6bn in the SSA market month by month. But just like in the covered bond market, we don’t think they’ll be sustain this buying power until the end of September 2016 because of the problem of getting enough paper, not only from investors but from issuers too because they have stricter criteria in the covered bond market.

They are allowed to buy up to 30% of the bonds of one issuer and they can buy up to 70% of each issue in the covered bond market. If they really want to buy until the end of September next year, maybe they’ll have to come up with other criteria; otherwise, we don’t think that they’ll get enough paper.

IFR: Ralf, why do you think the ECB targeted covered bonds again? The first purchase programme had a clear end-game because the markets at the time were frozen but I’m unclear as to what analysis the ECB conducted this time around in terms of how CBPP3 might skew the market. Can you help elucidate?

Ralf Burmeister, Deutsche Bank AWM: You should ask the ECB. I’m not sure to what extent they did any research but the point is, given we’re now at CBPP3, it’s clear that covered bonds have become a regular tool of monetary policy, The ECB started buying covered bonds in the first place because it didn’t cause any political trouble, and because they’ve now done it twice they’ve figured out that doing it a third time wouldn’t cause any major political resistance.

Pfandbriefe and other covered bonds are now part of the regular toolbox of central banks. This is here to stay. However, always thought it was just one element to get them where they wanted to get to. If you listen to ECB speeches, there are people in the governing council who would have loved to have done sovereign QE long before now.

But maybe it was also a ruse. Back in August, in Jackson Hole, Mario Draghi spoke of adding approximately €1trn to the ECB’s balance sheet. Everyone knew this could never be achieved by purely buying covered bonds, but now they have a good argument, saying: “we tried everything we could by buying private sector assets, so let’s try government bonds”. Maybe that’s one part of the explanation.

The other thing is we’re talking here about QE1 and we just got to know its conditionalities. But looking at the experience from the US and the UK, they did QE more than once, so this may not be the end-game. You can’t rule out that they might impose another programme if they don’t achieve their targets.

A very interesting aspect of this, which pertains to issuers is: with the current squeeze in the market, we are in an odd situation in that one party that is now buying and buying and buying with unlimited financing power has, coincidentally, also become your supervisor as of November 1. If you issue a new bond and you have your supervisor in the order book, can you ignore him? Some market participants see this as a moral hazard problem.

Coming back to your original question, the market – not necessarily the rating agencies – has accepted that there is limited credit risk in covered bonds. It’s also a very common perception within the European Central Bank. They have no problem whatsoever going down the credit curve and buying all the way down to Triple B minus or opting for split-rated bonds if they go for best rating.

The point is: no one is screaming; there are no protests on the streets, because Pfandbriefe and covered bonds generally functioned throughout the financial and sovereign debt crises and we didn’t see defaults like we saw in other parts of the structured finance universe. The ECB is still reluctant to buy pure credit risk: they could have opted to buy outright corporates but didn’t because they shied away from credit risk.

This still seems to be a hurdle, so maybe because of this covered bonds fitted in nicely because they could say: “we are pumping up the balance sheet, but we are in a position to manage the increase in terms of risk”. Maybe that’s another part of the explanation.

Coming back to what Jens said, I think – and again making a statement about Pfandbriefe – I absolutely support the VDP in its efforts to increase transparency, because right now we are seeing some movements. If you take a look at, for example, the Dutch legislation, you have to dig deeper and say: “OK they have a 180-day liquidity rule but this excludes soft bullet maturities”. That’s a new step. It’s a technicality, I know, but I don’t like it.

There used to be a common standard; first it was Germany introducing the 180 days, then the French took over, and now the Netherlands has it as well, but not for each and every maturity, so regulators have a big burden to take care of these days. It’s common sense; it’s a harmonisation of standards and definitions.

Hopefully, we’ll get a good way down this road, as the ECB is now the single supervisor for the majority of banks and sets common standards, but this doesn’t make my life as an investor easier if you have provisions in place but still there are national differences in terms of what this provision effectively means.

IFR: Bodo, this issue that Ralf brought up about how issuers manage their books when the biggest investor is their supervisor is an interesting one. Does that weigh on your mind when you’re looking at doing issues and how you allocate?

Bodo Winkler, Berlin Hyp: We have to make a distinction between the two functions of the ECB. They are not only based in two separate buildings; the ECB as an investor has nothing to do with the ECB as our supervisor so the supervision role of the ECB should have no impact on the allocation behaviour of issuers.

Berlin Hyp hasn’t issued any benchmark covered bonds since the programme was announced but we have our principles. We have already communicated to the ECB and the Bundesbank that we have a critical view on any investor who is active today but disappears at another time. In other words, should I harm my original investor base by over-allocating one investor who is in the market for a very limited time?

We were deeply worried when we heard about massive orders in books from banks that came to the market at the end of last year. The situation has improved for issuers [since the beginning of the programme] because the ECB decreased the size of their orders. But the question remains how to deal with an investor who is there once and then disappears. I have a clear preference for investors who are always there in every single transaction we launch.

IFR: Götz, can you comment on this? Bearing in mind what Bodo said about the ECB’s separate functions, the fact of the matter is the ECB is the biggest buyer in town and issuers have to manage investor relationships very carefully. How do you deal with that and how do you manage those relationships in a way that is satisfactory in an unusual market dynamic?

Götz Michl, Deutsche Pfandbriefebank: Obviously it is important to have orders in the book. However, if the book is considerably oversubscribed and we have, for example, a bond issue totalling €500m we run the risk of disappointing our ‘golden’ investor base when allocating the paper – there will always be core investors among those who don’t get their order or don’t get the whole order.

We’re in the same situation as Bodo as we have not issued yet. So the question is: are we already facing the problem? This is an interesting point because secondary market levels are very tight. For us, the question really is: at what levels can we really issue? How many ‘real money’ investors are in the book? How heavily will the issue be oversubscribed?

The second point in this context is: how certain is the whole transaction itself due to the interference of the central bank in the market? A year ago it was relatively easy to say: “this is the level; this will be the order book; this is what we expect if we launch a new transaction.”

The discussion now is on the one hand around whether issuers are pricing bonds too tightly. This of course is a bit of a problem internally because you end up paying too much if the order books get too big due to the central bank buying. On the other hand, if real money investors stay out of the book because they’re afraid of the central bank as a big buyer and the central bank doesn’t order, we’ve priced the issue too tight.

It has become more difficult – and maybe this is a question for syndicate as well – to find the right price for a new issue. What is the right price? We see a transaction launched today in the 10bp area that is finally priced at 6bp, and investors normally don’t like this kind of movement.

If real money investors are not really getting the bonds they want, we normally would tap a benchmark transactions outstanding to meet this demand

This does not really solve the real problem but it solves the problem of allocation. The investor gets the bonds and we get granular funding at the same time. If we just do €500m benchmarks, we end up with a massive negative carry due to negative interest rates and the fact that it will take time before we invest the funding we raise.

Considering this of course, there is not such a big problem with the central bank intruding on the market. The ECB could certainly be offered the bond as well by easily increasing the tap after we have satisfied the first investor who’s interested with amount they want (of €50m or €100m).

IFR: Jörg, can you also address this issue of issuer mind-set?

Jörg Huber, LBBW: Just to elaborate on this moral hazard issue that Ralf brought up. If my regulator is also the biggest order in the book, do I have a conflict in allocation? Definitely not. This regulator, on the one hand, is flooding the market with money because he has quantitative easing in place; on the other hand, other people in that regulatory body impose regulations that make it almost impossible for banks to lend money to push the economy forward. That is dubious so asking: “do I really have to allocate more to that investor higher?” No.

We have already issued twice since the covered bond purchase programme has been in place. The first transaction was an add-on, which was driven by investors who couldn’t get any German paper in the secondary market. About 80% of the paper the ECB has bought has been sourced from the secondary market.

But the driving force was definitely the central bank. Having said that, there were also other investors interested in the transaction so it wasn’t at 70%. We have definitely discussed how we put transactions into the market in the future. We have built up a traditional investor base, not just in Europe but worldwide, so how can we do transactions and allocate fairly in the market?

When I say “fairly”, the whole market is distorted because the ECB is buying secondary and bringing spreads down. Even with the add-on, where you can say: “yes, it’s investor driven” the market is already trading at a very artificial level but it’s investor-driven because they can’t get hold of any other paper.

When we did our transaction last week, it was definitely at a very tight level [€500m 0.100% due 2019] but levels were driven one to two basis points tighter by investors away from the regulator. Certainly if the regulator or if the ECB didn’t have its buying programme, levels would be much higher but this is a new market environment and investors have to participate because they have to invest. So they did participate in the transaction.

Partly because we’ve had lots of roundtables like this one involving the ECB, the Bundesbank, etc and articulating our doubts and our worries about its programme, what we found with the transaction is that, first of all, the ECB or the Bundesbank was not the frontrunner driving the issue. They had limits in the bid they put in so the transaction was really driven by traditional investors and then the ECB came in on top of that.

For us, it was clear that we wanted to have an allocation process where we didn’t cut them out completely but where we were also in a position to fulfil demand from real investors.

IFR: On that issue, you had 50 or so names in the book, both domestic and international. How did the allocation discussion go with your underwriters? Did you have to push back? I’m curious to understand the conversations you had.

Jörg Huber, LBBW: The allocation was definitely the result of a standard process where we sat with the syndicates and went through the list and I said: “These should be the allocations”. Of course, the syndicate managers know individual names much better so came back and told us the changes they’d suggested. But the first bit was really done by us, where we said: “These are our traditional investors, the ones we have constant contact with.” We steered the book and decided where the bonds went.

IFR: Rafael, so far we’ve discussed this from a rather negative perspective. But there are benefits to issuers; it’s not all bad news.

Rafael Scholz, Münchener Hyp: Thank you very much for that question, Keith. It’s quite interesting listening to my colleagues around the table because I have a completely different opinion and it’s great to be one of the last guys answering.

We’re talking about a luxury problem here. To be honest, there is always a bull market. Who are the winners? Not just the issuers. Issuers are not really the winners at the moment; the winners are investors who bought peripheral covered bonds two to three years ago, for example.

We also understand that more than 80% of the purchase activities of the ECB have been in the secondary market. The ECB is not chasing anyone to sell but the spread compression has happened, so Pfandbriefe have benefited a bit, but most of the other markets have benefited even more.

So now we’re having a discussion around the table about allocation. We’ve been in the market for many years now. I’d like to recall 2006. We had some huge investors with big pockets and big tickets in the market. Did we discuss that? Not at all. What happened then? Everyone wanted to visit these investors.

That was the story then and now we are complaining about the ECB. I’m not complaining because the ECB is not chasing me to issue and not chasing me to allocate as much as they want. The reason they are putting orders with a huge volume is because they are allowed to. Why did they start with covered bonds? It’s the second-biggest fixed-income market in Europe. It’s no miracle.

This whole discussion about the ECB is overdone in my view. We’re all benefiting from this situation. The primary market is functioning very well not just because of the ECB, and we have seen a lot of covered bonds coming into the market at very, very tight levels. Please remember the participation of the ECB has been less than 20%, so just one-fifth. There seems to be a lot of other investors still thinking that covered bonds are pretty good.

The one disappointment at the moment is that the traditional private placement market in Germany is shrinking. What’s the reason behind that? We have a combination of LCR discussion, as well as benchmarks for fancy products for investors like the ECB. This is maybe a bit disappointing for a lot of issuers, but that’s the market.