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Western EuropeJuly 3 2005

A cause for celebration

DEPFA has gone from strength to strength since it split from the Aareal mortgage bank and moved to Dublin. Jan Wagner reports from Frankfurt and Dublin on the most profitable bank active in Germany today.Germany’s mortgage banks have been partying recently. In May, Eurohypo held a bash to celebrate the 10th anniversary of the “Jumbo Pfandbrief”. Since its introduction, the high-volume Jumbo has spawned a €600bn European market.As the market leader, Eurohypo and its peers whooped it up. Attractions included plenty of champagne and an elephant installed in front of the Frankfurt stock exchange. Another Pfandbrief conference, replete with champagne, was hosted in June.
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The mood should become rather more sober this month. For one thing, the mortgage banks will face more competition after the July 19 enactment of Germany’s new Pfandbrief law. The law gives all banks active in Germany the right to issue Pfandbriefe.

All the celebrations cannot disguise the fact that, apart from the likes of Eurohypo and Hypo Real Estate, the mortgage banks are highly exposed to the weak German real estate market. This market has often undermined their profitability, even if their Pfandbriefe are among the world’s safest and most popular investment-grade bonds.

Cash cow

But for one of the group’s smaller peers, the party is still going on. This is DEPFA, which has emerged as a veritable cash cow since it split from German mortgage bank Aareal and relocated to Dublin in 2002.

In April, Gerhard Bruckermann, the DEPFA chief executive, said the bank would earn €600m after tax in 2006, up 20% from the amount expected in 2005. DEPFA’s return on equity of 25% also makes it by far the most profitable bank active in Germany right now.

DEPFA’s success is down to simple economics. It is a big player in the German state finance market, helping sub-sovereign governments and the German government itself fund budgets and infrastructure projects. Indeed, the high-quality government loans collected in Germany account for about a third of the pool for DEPFA’s own covered bonds. But, unlike its peers, state finance is all that DEPFA does – it is not saddled with real estate risk from Germany, or any other market for that matter. DEPFA’s profitability has been boosted further by its move to Dublin. There it faces a corporate tax rate of 12.5%, compared with an effective German tax rate in the low 30s.

International expansion

The tax rate is an important reason why the lion’s share of DEPFA’s covered bonds are in Irish Asset Covered Securities. The ACS is a Dublin-domiciled clone of the Pfandbrief. Pfandbriefe are still issued through DEPFA’s German arm, Deutsche Pfandbriefbank. Another key factor in DEPFA’s success has been its international expansion, which has opened up lucrative opportunities around the world. Mr Bruckermann says that beyond the crucial western European markets, DEPFA’s business is growing steadily in the emerging markets of Eastern Europe and Asia. The bank also has an office in Tokyo.

In the US, DEPFA has gained a foothold in the massive municipal finance market. However, it is not lending to these governments because it is not a business where, as Mr Bruckermann puts it, “we can add value”. The bank provides liquidity lines to ensure bond payments are made on time, and it will soon act as a financial guarantor for municipal bonds.

Even so, the DEPFA chief executive stresses that Germany will remain the bank’s main market for the foreseeable future. “Germany is still the biggest market in terms of new business. We have a lot of maturing assets there and there is a lot of replacement [lending] going on. Beyond the funding business, we also do derivative business, advisory work and structured finance there,” says Mr Bruckermann, who was interviewed by The Banker in Dublin.

Given that governments across Europe are strapped for cash, DEPFA also should profit from the trend toward public-private partnerships in infrastructure finance, he adds. But not everything has gone that swimmingly for DEPFA. The €500m in net profit expected for 2005 is, for example, below the €540m figure for 2004. And although DEPFA is predicting another 20% rise in net profit next year, the growth is below the stratospheric levels of recent years.

A bigger blow to the bank was the aborted sale of Deutsche Pfandbriefbank. DEPFA had put it up for sale in early 2004 as part of a strategy to concentrate its covered bond issuance in lower-cost Dublin. In April, however, Mr Bruckermann was forced to admit that DEPFA had failed to fetch an appropriate price for Deutsche Pfandbriefbank and the unit would be reintegrated into the group.

Funding targets

Naturally, Deutsche Pfandbriefbank’s loss of an exclusive right to issue Pfandbriefe had a negative impact on its value. DEPFA now plans to use Deutsche Pfandbriefbank on an opportunistic basis and Mr Bruckermann says the German arm must meet specific funding targets.

The hiccups this year have prompted criticism that DEPFA was overreaching. Andreas Weese, an analyst at HVB, the German bank merging with Italy’s UniCredit, comments: “There is no question that these are blows to the credibility of management. Gerhard Bruckermann has been too aggressive with his targets.”

The criticism has not dented DEPFA’s shares significantly. Following a stock split, shares are trading at around €13, near an all-time high of €14.

In any event, Mr Bruckermann defines DEPFA as a growth company, noting that because the bank only has a 2% to 4% share of the global state finance market, it has huge potential. “My feeling is that we should not change the business model. It locks in long-term margins and has a predictable revenue stream,” he says.

“When we don’t see this growth any more, we should become more of a dividend-paying institution. It sounds boring, but not everybody needs to be a financial powerhouse.”

While DEPFA was instrumental in creating Ireland’s ACS, Mr Bruckermann surprisingly backs the idea of a single European covered bond instead of the 22 currently in existence. He observes that since the launch of the euro, demand for fixed-income investments in the currency has been rising steadily, especially among US and Asian investors. If, therefore, European banks could create one unified bond issued with varying maturities, “the market potential for this would be enormous”, he says.

To achieve this, he believes a consensus between the German, UK and French banking associations is necessary, although it will be hard to obtain. The German banks are likely to argue that the Pfandbrief should serve as the basis for the European bond, he says.

The Association of German Mortgage Banks already took the first small step towards creating a European covered bond. In November 2004, the association organised the first meeting of the European Covered Bond Council, a forum where issuers discuss common standards for the security.

But Louis Hagen, the association’s executive managing director, emphasises that while the idea is very attractive from a simplification and liquidity standpoint, a single European covered bond will not emerge any time soon for several important reasons. First, he says, the international investors that his association has spoken to appreciate the multitude of covered bonds because of, among other things, the variety and possibilities for arbitrage.

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Louis Hagan, executive managing director of the Association of German Mortgage Banks

Political hurdles

There is also a strong economic argument for the status quo. “The proliferation of covered bonds in Europe makes for competition between the issuing countries. This, in turn, has further enhanced the quality of these investment-grade bonds,” Mr Hagen says.

Finally, he says, enormous political hurdles stand in the way of creating a single European bond. “Each issuing country is very proud of its covered bond legislation. The Danes and the French, for example, would not want to follow our lead and abandon the exclusive right among some of their banks to issue the bonds.”

It seems, for the time being, a European covered bond, along with further political integration in the European Union, will remain a dream.

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