Germany’s Pfandbriefe could be the ideal product for US investors but they remain hesitant, says Suzanne Miller.The German Pfandbriefe has been more reliable than a Duracell battery. First issued 230 years ago, the bonds have survived the Napoleonic wars, World War II and the collapse of the Berlin Wall with no known defaults, proponents say. Yet most US bond investors have scant interest in the Pfandbriefe, a covered bond collateralised by long-term assets that has traditionally been issued by German mortgage banks. Shouldn’t US investors reconsider, given that Pfandbriefe have toughed out one of the worst credit cycles since the Great Depression?

This was what senior German mortgage bankers and a handful of experts and traders were hoping when they met with US investors at a New York conference in May. The message was that the Pfandbriefe can survive just about anything – even Germany’s current banking crisis. “Don’t believe the German banking system sucks and the Pfandbriefe is part of it. The Jumbo market is the safest and most liquid you can find,” the US audience was advised by Christian Ganssmuller, head of German fixed income at Citigroup Global Markets Deutschland AG.

With more than E1100bn outstanding, the Pfandbriefe is the biggest segment of the euro-denominated private bond market in Europe, rivalling the size of individual European government bond markets. Jumbo loans are the biggest and most liquid issues, with about 300 loans outstanding and averaging E1.6bn in size. The Pfandbriefe is issued to fund loans secured by first-ranking mortgages or loans to the public sector and are typically rated triple-A. One of its big selling points is its reputation of being bullet-proof to all kinds of risk.

For instance, issuing mortgage banks are legally limited to the mortgage and pubic sector financing business – meaning they’re barred from jumping into riskier businesses. Moreover, German mortgage borrowers don’t have prepayment options for the first 10 years of their loan, so there’s little prepayment risk – unlike the US mortgage-backed securities market, where prepayment risk is a way of life.

The last bastion

“We’re still in the midst of a major change in a downward US credit cycle. If this is an asset class that’s held up for more than a century and people here are looking for a safe place of return, this is one of the last bastions in the world,” says a private US investor who attended the conference and, by his own admission, is one of the few US Pfandbriefe enthusiasts in America.

That’s because most US investors shun overseas fixed income instruments that carry a currency risk, either because fund managers are restricted from investing in euro-denominated assets or because it hardly seems worth the bother. But for those who are savvy currency hedgers, the Pfandbriefe – which typically carries a triple-A rating – can offer better returns than lower-rated BBB US corporate bonds. This investor said he bought a 10-year Pfandbriefe in 1998 and held it through 2001, netting around 80bp more than if he’d invested in a US triple-B corporate bond over the same period.

US holds back

Still, these kind of home runs are rare for US investors, given that few pick up the bat. Over the past four or five years, there have been about 15 new Pfandbriefe issues denominated in US dollars. Even so, the majority of buyers have been European investors based in the US or overseas.

Dan Markaity, managing director of the government securities agency desk at Merrill Lynch, says a big problem is that German mortgage banks tend to issue Pfandbriefe as private placements, or 144A filings, which doesn’t appeal to US buyers concerned about liquidity.

He says German issuers should use a global bond format if they want to win US investors, who like to track investments against public indexes and tend to shun illiquid foreign-currency assets with a currency risk. He also says issuers need to do some intensive, old-fashioned marketing to spread the word in the US. That would mean moving more trades to the electronic exchanges and freeing traders to hit the road.

Credit cracks

Still, it might prove a tough sell right now. The truth is that even the redoubtable German mortgage banks have had credit troubles. About a year ago Moody’s Investor Service cut the triple-A senior unsecured rating of the German mortgage bank AHBR to single-A, the first mortgage bank issuing Pfandbriefe to be downgraded by a rating agency. An investment bank analyst explained that the downgrade came after the holding company BHW extended a loan of E200m so AHBR wouldn’t take a loss. When that happened, something unheard-of also occurred: spreads for AHBR widened some 15bp – an enormous move for this asset class.

The downgrade prompted Moody’s to take a closer look at the industry. Karsten von Köller, president of the Association of German Mortgage Banks, says: “Moody’s has been concerned about alleged ‘substitution risks’ referring to the insolvency remoteness of overcollateralisation in the case of insolvency.” Those concerns prompted further downgrade and that put the brakes on new issuance.

That gave the industry a nasty shock. Anxious to prevent future downgrades, the industry is seeking an amendment to the German mortgage act that will make pools even more bankruptcy-remote than they currently are. The amendment is working its way through the upper and lower houses and is expected to be enacted by January 1, 2004.

Room for improvement

Banks have taken other measures to improve the instrument’s risk-remoteness. Thanks to a July 2002 amendment in the Mortgage Bank Act, banks now use derivatives to hedge against currency and interest rate risk. It works something like this: banks use derivatives to match cover pools, or the underlying assets for securitised issues. If an underlying institution goes bankrupt the derivatives aren’t going to blow up because of counter-party risk. While issuing banks used to be partners to a swap deal, now the respective cover pools hold the rights and obligations of these contracts. “The possibility of netting in the event of insolvency now only exists in respect of a mortgage bank’s general assets or of one of the cover pools,” Mr von Köller says. To ensure lenders don’t use derivatives to overcollateralise, the net present value of the derivatives can’t exceed 12% of the aggregate cover assets or of the Pfandbriefe outstanding.

Over the past two years, a few other countries have created legal frameworks that allow their banking sector to issue these bonds as well. France, Spain and Luxembourg have launched covered bond programmes while last year, Ireland introduced a covered bond law. More recently there’s been talk that the UK will be next, says Roger Kubarych, senior economic advisor at HVB Americas.

By now, the instrument has a deep foothold in most parts of Western Europe and even in Japan. The US investor is the last big hold out.

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