IFR Pfandbriefe Roundtable 2015: Part 3

IFR: Beyond ECB, one of the bigger issues I’d like to raise with you is the future of the Pfandbriefe as a product, because we’ve seen dwindling supply. In the medium to long term, where do you see this product? We’re not discussing its qualities, which I think are given, but negative net supply is a problem. It creates distortions for investors and for issuers as well. Is this a perennial problem? Is there a solution to this?

Jens Tolckmitt, VDP: I’m always, as I said before, as an association guy taking the long-term view. If you take the long-term view, then you see on the one hand that what we have seen over the last 12 to 13 years, especially in public sector Pfandbriefe, is the reversal of I would say an unhealthy development in the 1990s, exactly in the opposite direction.

The consolidation over the last 13 years has been the building up of the volume in the 1990s, based on business models that were simply not viable. Not only since the crisis but even before, it turned out that they are not viable, and so supply is reduced and what banks are returning to is what I call ‘value-added business’, which may not always have been the case in the 1990s, where this was basically buying Bunds in the market and refinancing them via Pfandbriefe. But again it was something that not only the issuers did but also something investors wanted so it was an overall market development.

If you look at the figures today, we are close to the levels of the early 1990s. That was when the Pfandbriefe had already existed for decades and I’m pretty sure that we will continue to see consolidation but consolidation is getting smaller, in public sector Pfandbriefe too. We have some issues ahead of us that will influence consolidation: regulatory issues that are quite relevant for some of the businesses refinanced via Pfandbriefe but I think the Pfandbriefe is returning to the original role that it had for a long time.

One other thing: there’s been a sea-change – more pointedly since the beginning of the financial crisis and since the enactment of the Pfandbriefe Act – that banks coming new to the market and issuing are normally universal banks.

Especially since the crisis, basically every bank is looking at whether they should put Pfandbriefe into their funding mix, which is positive so the number of issuers is increasing. However, the way they use the product is different and you have to accept that. It’s not the days of a larger number of specialised, wholesale-funded banks through the capital market and predominantly through Pfandbriefe but a typical universal bank using the Pfandbriefe as an addendum to an existing funding mix consisting of deposits unsecured bonds and Pfandbriefe, and maybe hopefully in the future again to a certain extent, securitisation so that we get rid of using the covered bond for everything that we want to use it for.

We are not there yet, but this use by new issuers simply translates into lower issuance volumes by specialised Pfandbriefe banks. That’s also answering your question: where is the future? Pfandbriefe is to a certain extent changing its role as a funding instrument and being used for different things.

IFR: I wanted to move on and ask our issuers about innovation. Is this an important aspect in today’s market?

Jörg Huber, LBBW: Definitely, as long as it makes sense. You have to be prepared for new developments. Investors are looking for new possibilities to get some yield enhancements but at the end of the day, you have to compare that with your traditional instruments. As a treasurer you have to choose the most efficient funding instrument.

We looked at the SME structured covered bond concept and we are certainly in a position to do something like that as we also have loans out to SME corporate. But it’s not cost-efficient for us at the moment. That might change, and with all the kinds of regulatory changes we have already seen we have other things which we can use when necessary.

We still issue ABS in the form of ABCP, but that is purely to refinance certain corporate assets such as factoring. We have a lot of possibilities. We’ve haven’t used some things and we probably won’t use others at all, but you have to be prepared for it.

Nord/LB for example, is on a roadshow for an issue of benchmark Luxembourg Lettres de Gage. If you had asked somebody six months or a year ago they would have said Lettres de Gage are dead. But there comes a time when you say for certain kinds of assets this is probably the most efficient way to refinance them at the moment.

Rafael Scholz, Münchener Hyp: Well I just issued the first SRI covered bond in the world [a €300m ESG bond that refinanced loans to co-operative home building associations in Germany that meet specific sustainability criteria]. I believe SRI will be the topic of the next decade, but the question is how it would be solved by a covered bond issuer. That’s still uncertain and unclear.

Financial products don’t give you any emotional feelings (maybe bad emotional feelings because of low or zero interest rates, but I’m not talking about that). What we have to try to do within the industry is to bring more emotion into our products, especially in the real estate market where investors and especially private investors are very keen on environmental topics.

So why not provide these borrowers with the same emotional product on the liabilities side so you can have a circle in the long term?

From that perspective, I guess that will be the main driver. Of course, we can talk about an easier way around mortgage lending to commercial properties; that’s maybe even easier and hopefully someone will follow the framework we designed because it is a simple but manageable framework and it doesn’t matter which assets you take but you have to negotiate with investors as well as the rating agencies. You might find a way, but creating an SRI covered bond which is different from agency-driven SRI bonds is possible. That was proven by our transaction last September.

Bodo Winkler, Berlin Hyp: We liked the SRI Pfandbriefe when it came to market and I think that social responsibility, sustainability, and environmental awareness are big topics for the future in the financial markets.

Coming to innovation, what can I offer Ralf as an investor who is desperately looking for yield? In this environment, probably not any Berlin Hyp Pfandbriefe. When Rafael issued his SRI Pfandbriefe, it priced – correct me if I’m wrong – like an ordinary mortgage Pfandbriefe of Munich Hypo. It didn’t offer any additional yield to investors or any additional profit to the issuer.

In the end, we are at a point right now where yield-driven investors, and not only in the Pfandbriefe environment, have problems. It’s an issue for the whole fixed-income market; a market where you can keep the word ‘fixed’, but ‘income’ has almost disappeared.

Götz Michl, Deutsche Pfandbriefebank: As Bodo already said, there’s not much we can do. We could probably look at foreign currencies such as Swedish krona and sterling, which the ECB isn’t buying. We offer higher spreads there compared to euro issues because we save the cross-currency derivative. Consequently, if the investor is able to take foreign currency, there may be opportunities in other currencies. That would provide higher spreads for the investor and the bank could save the cost of the derivative.

IFR: Last year, the European Banking Authority published an opinion on the preferential capital treatment of covered bonds, which is now with the European Commission. It made a series of recommendations on a range of areas including regulatory framework harmonisation. Jens: will this have an impact on the Pfandbriefe market? It doesn’t seem to be on the radar screen of most market professionals.

Jens Tolckmitt, VDP: I would recommend people look into it, but I know from past experience that it’s difficult to communicate that to the market because in the end, looking at the timeframes that markets normally look at, it’s a distant issue. But the main points have been made now and what we are now facing is their translation into regulation or law, a process currently under way.

A basic rule of lobbying is it’s always better to make your points before anything is written down and that is why it’s important to look at it now. We will see the outcome in maybe two years’ time but by then it’ll be fixed. The time to influence that outcome is now. There are a number of issues that can shape the product and the market quite significantly in the future.

IFR: Can you summarise your position on the key points of the EBA paper?

Jens Tolckmitt, VDP: We have been told that around 90+% of the paper is based on the German Pfandbriefe Act, which maybe is a summary answer to how we see the paper. It’s a good one. We have a number of issues where we also think that it’s not practical. For example, the range of assets that may be in a cover pool limited to EEA countries is certainly not realistic – not only for Germany but for others as well.

The question of the composition of the mortgage cover pool and how it should change over time is certainly something that we will address during ensuing talks, but overall it’s a very good paper. It’s driven by the understanding that you should set standards and principles rather than define very concrete rules which would mean maximum harmonisation with no leeway for national legislators. So that is positive.

Something that is not written in the paper and which we are looking at very cautiously is the question of innovation. I like innovation. The appealing thing about combining ecological or SRI issues and Pfandbriefe is that they fit together. But I have also heard about innovations for Pfandbriefe or for covered bonds that I don’t like. It’s important to make sure that innovation is kept within certain boundaries and we need to take care of this when discussing with the Commission what the takeaways from the paper are.

IFR: I wanted to give everyone a chance to make a summary closing comment. Let’s go round the table. What your priorities are for this year, your hopes or expectations?

Ralf Burmeister, Deutsche Bank AWM: I see the Pfandbriefe market in line with other European covered bond markets. It will be not an outlier in any direction; it will remain scarce and expensive. Looking at the German economy (which does not imply that all Pfandbriefe issuers are purely doing business in Germany with German-based assets), it’s going to be rather boring. There will be no surprises, because the economy in Europe is growing slowly and so there should be no major changes ahead.

There were and are a lot of reasons for regulation. But in the field of Pfandbriefe we are running the risk of over-regulating something that works and which is proven. One problem might be several sources of regulation. When it comes, for example, to TLAC I was speaking to a non-German issuer who said, “I have deposits and I have covered bonds. If because of regulation, I have to issue senior debt which becomes bail-inable, which I don’t like and which I haven’t done before, I would have to buy back my covered bonds in order to bring my balance sheet back into compliance with the new rules”.

I think that’s odd. We have to watch out that the market we have in place still works in two or three years’ time and that we still have room to manoeuvre.

Franz-Josef Kaufmann, Commerzbank: I think we have seen throughout the crisis that covered bonds, especially Pfandbriefe, have evolved to become an extremely important instrument recognised by regulators and by the markets. For issuers, having such an instrument in the portfolio holds a high degree of importance.

I can say, at least for Commerzbank, that it’s the most attractive capital markets funding instrument we have available. Especially when it comes to the shaping of the regulatory framework, regulatory requirements will define the instruments we need to issue; will define the quantity of instruments and type of instruments we have to issue. Having instruments in the portfolio with preferential treatment among regulators, like Pfandbriefe and covered bonds, is very helpful.

It gives you access to attractive funding; it provides as well an element of contingency in your internal liquidity modelling. You know that if you have collateral available that enables you to issue Pfandbriefe, you could issue in difficult times either directly to the market or even in the very worst case you could generate liquidity from the central bank.

It has also been proven that we have a concept in place for covered bonds that is well recognised and is more openly discussed to be used for other assets. Clearly, we need to make sure that going forward we maintain the high quality of the Pfandbriefe as it is recognised now.

Rafael Scholz, Münchener Hyp: It’s very difficult to answer after Franz-Josef, because I’m much in line with his answers and from a Münchener Hyp perspective the Pfandbriefe was always the most important source of funding and we remain strongly committed to the Pfandbriefe.

But please allow me a personal note: someone once taught me the expression ‘German angst’ and that was what I’ve felt during these 90 minutes. We have been market professionals for many, many years and I was missing the optimism. We have to create the market and if we are not creating a market, who is going to do it?

We have always seen ups and downs but we have to take it as it is and try to make the best of it. That was what I was missing during this roundtable.

Jörg Huber, LBBW: I wouldn’t call it ‘angst’; it was certainly more a feeling of frustration. We discussed that we have very low spreads, that we have a fantastic new-issue environment for covered bonds and specifically for Pfandbriefe borrowers.

Keeping up the work to promote Pfandbriefe as one of the safest instruments is certainly a big topic because with all of this ECB action, what we see is a socialisation of spreads, so to speak. Things are compressing and you don’t see this differentiation any more where investors like Ralf are sitting there and looking at different kinds of issuers and trying to find out what the difference should be. That’s more or less gone.

It’s important to keep investors informed and educated about quality, because the ECB won’t be there forever and we really need to have that kind of knowledge pushed out there again.

Götz Michl, Deutsche Pfandbriefebank: I’d like to bring up the currency topic again. The ECB is buying euros. For us I think it’s a good opportunity to push for foreign currencies, such as sterling or Swedish krona because you don’t need the derivative and beside this you can broaden your investor base into other markets.

German or Continental European investors may be interested in investing in non-euro denominated covered bonds or Pfandbriefe because they know the credit and they get a little pick-up. Therefore we might be able to provide an additional product, which helps both sides.

Bodo Winkler, Berlin Hyp: For mortgage lenders like us, there are good reasons to believe that 2015 will be a good year. We have a well-functioning mortgage market, competition has increased but you can still achieve solid margins. That is, of course, also thanks to the conditions that we find in the covered bond market when we issue Pfandbriefe, so that is quite a positive expectation.

On the other hand, what I’m a little worried about is the increasing regulation in every single field of banking. Looking at an ordinary bank today, the ratio between market staff on the one hand and back office and corporate centre staff on the other hand has changed dramatically.

It’s getting more and more difficult for markets staff to feed the rest of a bank which has increased in recent years due to more onerous regulation. Regulation is still a big topic and especially the interaction between the different pieces of regulation. I think there’s still a lot of work to be done to examine this and to be determined from a regulator’s point of view where we want to go with our banking industry in the end.

Friedrich Luithlen, DZ Bank: I agree the market is very good now. I also agree that there is no cause for German angst. I would, however, say that a certain apprehension is in order looking into the next couple of months because the ECB will be a very deciding – and political – factor.

On innovation, it may be instructive that so far it was private sector inventions. It was people getting together, there was supply and there was demand, and you invented a product putting the two together. Now the innovation we’re talking about – and also what we’ve alluded to already during the discussion – is driven by the official sector. It’s driven by the IMF; it’s driven by the European Union that want to replicate the macro-prudential use of the covered bond market as we have it now in other asset classes. This is to steer liquidity flows into certain areas of the economy where they are perceived to be lacking.

It is a very interesting development whether that sort of reverse type of innovation from the official sector to the market is going to work. I’m sure we’ll be smarter by the end of the year.

Then finally, I’d like to mirror what Bodo said about regulation and the way that it would be a shame to love this market to death for macro-prudential reasons. Let’s keep in mind that there are hundreds of investors in Europe, and indeed in Germany, still engaged in the asset class, some of them already sidelined. Some of the dealer banks have begun reducing headcount and infrastructure around the product. Let’s try and keep what we have at least.

Matthias Melms, Nord/LB: I want to mention two things. We touched on this earlier: we have negative net supply in the Pfandbriefe market. That’s true, but if you look at the different segments, something has happened under the surface. We have the problem of having been too optimistic with public sector Pfandbriefe in the 1990s and the early 2000s.

Now we are working on that and that’s why we have a negative net supply, but on the other hand I’m pretty optimistic for the mortgage Pfandbriefe. We expect an increase in outstanding volumes this year and in 2016, so I think under the surface we have some growing segments. Even in public sector Pfandbriefe, there are some banks rethinking this product.

Another comment I want to make is around the EBA and the idea of harmonisation. I like the idea of getting some kind of harmonised European-driven regulation for covered bonds on the one hand. On the other hand, I see it as a really big problem if we harmonise too much.

In the past, we’ve had competition among different jurisdictions, and I think a lot of other jurisdictions have benefited from the ideas coming out of the German Pfandbriefe market and the ideas that the VDP produces. In future we’re getting harmonised legislation for covered bonds maybe all over Europe, and I fear that we don’t have enough competition there to produce new ideas for this asset class.

Jens Tolckmitt, VDP: We have our challenges ahead. The most important thing from a lobbyist point of view is to make sure that nobody gets complacent about the quality of the product, having achieved what we have achieved over the past year. So we have to work on that. We’re doing that on a national level under our own law, and we need to make sure that this quality perception is also enshrined in the European harmonisation exercise.

If you look at the banks overall, their main challenges are coming from banking regulation not covered bond regulation. We have a number of huge issues there, including the new regulator/investor that we have seen in the market. By the way, I am pretty convinced that one is different from the other and there are proper guidelines to make sure that no-one perceives them in a double role.

Having said that, we have to create quality. I also see that there is a thin line between increasing quality and keeping the product economically sensible. It helps nobody if you have an over-regulated covered bond or Pfandbriefe nobody is using because it’s not economically sensible. That is something we have to communicate to regulators on a European level.

And coming back to innovation, it’s not German angst but I have seen so many financial products being hijacked that were originally a good idea but were killed because they were so successful. We want to avoid that for the Pfandbriefe and the covered bond. That is not angst; that is just sensible treatment of something that has survived for 250 years.

IFR: Gentlemen: thank you so much for your comments. It’s been, I think, a really insightful discussion. Thank you.