There is much trumpeting, if that’s the word, in certain quarters as the jumbo pfandbrief market celebrates its 10th birthday. The team at Dresdner Kleinwort Wasserstein can trumpet louder than most because their bank has been ranked among the top three in this segment every year since the start. No-one else can claim as much.
With roots in the 18th century, the pfandbrief itself is nothing new. Over time it evolved into a specialised, highly regulated, covered bond issue backed by German mortgages and public sector loans. Until the mid-1990s, however, the market was very illiquid – easy to get into, not so easy to get out of. These were top quality assets trading at junk grade spreads.
“For the quality of assets to be reflected in accurate spreads, you had to get the liquidity right,” recalls Erich Pohl, global co-head of capital markets and chairman of DrKW Germany. A former head of fixed income who joined the bank in 1992, he led DrKW’s efforts to establish itself as a force in this business and, indeed, to keep the new market on the rails.
The solution to the liquidity problem was the jumbo – a minimum DM1bn (€511m) issue with guaranteed two-way prices. The market was inaugurated in May 1995 by Frankfurter Hypothekenbank Centralboden (a predecessor of today’s Eurohypo), when it issued the first pfandbrief with in-house market-making. Subsequent taps brought the paper to jumbo size.
Dresdner makes debut
Two months later, Dresdner made its debut, adding an important innovation. Its own mortgage bank subsidiary, Deutsche Hypothekenbank Frankfurt/ Hamburg (also now part of Eurohypo), issued the first jumbo pfandbrief with external market-making – provided by what was then Dresdner Kleinwort Benson.
DePfa issued the first syndicated jumbo pfandbrief, with three market-makers, in August of the same year, followed by the first global pfandbrief in February 1996. The credit quality with a yield pick-up over Bunds and the promise of liquid prices began to attract foreign investors and, even more so, international investment banks into the market.
“A little like the Wild West”, is how one German banker describes these early stages, and things got wilder before they settled down. Issues came out fast and furious and banks became stuffed with paper. Market-making was haphazard and often costly as spreads widened, and at least one foreign bank reneged on its commitments in order to flee the field. The primary market was not profitable for the first five years, according to one banker who was there, though the large German banks dug themselves in for the long haul.
Although the market was driven initially by issuers and investment banks, the participants realised that stability and growth depended on bringing investors closer to the process. “It was important that these were not just bought deals by market-makers, but that they should involve the investor base,” says Christian Haller, DrKW’s head of German and Austrian sales and a key figure in the bank’s success in this market.
Restoring order
In 1996, the big banks put their heads together and agreed on various measures to restore order. The most important was a fixed price re-offer system, introduced early in 1997. “The fixed price re-offer system was a clear break-through,” says Mr Pohl. “From then on there was much higher activity. Investors began to get credit lines for all the covered bonds and there was tremendous issuance in Germany.”
Outstanding volumes, which passed the DM100bn mark in 1996, doubled to more than DM200bn in 1997. Liquidity was enhanced further as an active repo market began to develop, with particular commitment from – not least – DrKW. “We are the leading repo market for jumbo covered bonds,” Mr Pohl says.
One of DrKW’s milestones was its involvement in the first Ecu issue, for Allgemeine Hypothekenbank (AHB), in 1998. “We were the leading capital market house in DM-denominated covered bonds,” notes Mr Pohl. “How could we become leaders in the euro market? We knew we had to be first with an Ecu issue.”
The market reached a peak, in one sense, in 1999 with a DrKW-led €5bn jumbo, the largest ever, once again for AHB. “Such big liquidity, together with repo facilities, effectively created a hedging instrument,” observes Mr Pohl. That size has rarely been seen since, but the market was beginning to broaden.
“Internationalisation took time,” Mr Pohl concedes. “But gradually issuers in other countries began to take an interest. They could see issue spreads tightening significantly, which held out the prospect of attractive funding for them.”
Pfandbrief issuance in (pre-euro) foreign currencies developed relatively early on. Then non-German issuers began to exploit this funding method as their countries passed new covered bond legislation or dusted off existing laws. Argentaria and BBV – as they were then – issued the first Spanish jumbo cédulas in 1999, followed swiftly by CCF and DexMa with the first French jumbo obligations foncières.
Cracks in the market
By then, however, new cracks were appearing in the German market. It emerged that the funding strategies of some issuers were less than cautious, effectively using jumbos to play the market. German property prices turned down, the credit ratings of a number of pfandbriefe were downgraded and outstandings fell. It was crisis time again.
Among the key responses then were consolidation among mortgage banks, a new code of conduct to promote transparency in the primary market and the late – for covered bonds – adoption of the pot system. “This allows the lead managers to collect all the orders in a joint effort and put them into the book-building pot,” says Kai Wolter, DrKW head of covered bond trading. “That visibility allows maximum possible feedback and gives the best momentum of flows for primary as well as secondary trading.”
New German legislation will allow more issuers into the pfandbrief market while maintaining its quality. At the same time, internationalisation has surged once again. “France, the UK, Ireland and Spain are all now large issuers,” says Ted Packmohr, DrKW’s highly rated covered bond and agency analyst. “Spain has a booming housing market and this year could become larger in new covered bond issuance than Germany – for the first time.”
A particularly influential deal, involving DrKW as joint bookrunner, was the first UK covered bond from HBOS in 2003. Since Britain has no appropriate legislation, HBOS structured the issue to provide equivalent safeguards. While other UK issues have followed, the deal quickened the pace of legislation in other countries.
“As soon as HBOS said it would do a covered bond issue without a law, all those markets that were thinking about creating or updating legislation had to move fast,” observes Richard Kemmish, DrKW’s London-based covered bond product manager.
International interest
DrKW is working on the first jumbo covered bond out of Finland, Mr Kemmish says, and expects to see the first deal from Sweden soon. “The potential in Italy is enormous, given the size of the underlying housing market and the cost-saving potential for major banks,” he adds.
The investor profile is becoming much more international as well. “Originally, it was largely a German client base,” says Mr Packmohr. “Now it’s a more mixed picture and, when a new jumbo comes to market, 60% to 70% of it will be sold outside Germany.”
“The market is going strong,” agrees Mr Pohl. “Will it continue to expand outside Europe? Australia has looked at it, though the regulator wasn’t comfortable with it. China and India will be looking for new ways of funding in the future. And UK developments will help to deliver other Anglo-Saxon countries.”
DrKW is ideally positioned for any such developments, he insists. “We have the dream team,” he says. “And we have provided consistency to both issuers and investors, which is why we have kept ourselves at the top of the pack.”
