Following market swings during the crisis, traditional covered bond issuers have called for the market to be split in two to recognise that these bonds have performed better. Michael Marray looks at the problem.

One of the crucial tasks for the covered bond market in the coming months is to agree upon new interbank market making arrangements. As the subprime crisis rippled into other markets across the world last August and September, the system under which market makers quoted continuous screen-based bid-offer prices for jumbo covered bonds quickly ran into difficulties.

Wild swings in prices, particularly on bonds from countries such as Spain and the UK, left market makers risking big losses in the fast-moving market, and with fixed bid-offer spreads and the absence of effective hedging tools, many market makers withdrew from their continuous pricing obligations and provided prices only on request. So-called ‘hot potato’ trades, where positions were dumped from one market maker to another, were a common occurrence.

A new screen-based electronic trading platform is regarded as important by many market participants, who see liquidity as a key element to the covered bond market. But exactly what form it should take is a matter of much disagreement, and meetings between various investment banks have been fractious.

Split possibilities

Late last August, some market makers actually held discussions with one another about splitting the covered bond market into two, with more stable bonds from Germany, Austria, France, Luxembourg (plus Depfa deals done out of its Dublin vehicle under Irish-covered bond law) being classified as ‘core’ issues, and deals from other countries as ‘non-core.’

The European Covered Bond Council (ECBC) has since been engaged in a series of initiatives to stop such a split from taking place, and as of February 2008, was studying submissions to its covered bonds trading proposal.

Stop-gap solutions

In the meantime, temporary solutions have brought some order to the market. The so-called ‘8 to 8 Committee of Representatives of Market Makers and Issuers’ was put in place late last September, and came up with a politically acceptable rule. It states that bonds trading wide of 20bp over mid-swaps would be traded at triple the standard bid offer spreads set out in market making agreements, (and therefore give dealers a bigger commission to offset the greater risk they are taking in such volatile markets). Less volatile bonds trade at double bid offer spreads.

This avoided a split along geographical lines, which would have looked like a group led by German pfandbrief issuers effectively breaking away to form a premium market.

But the essential problem remains that relatively stable products such as the pfandbrief and obligations foncières have seen themselves tainted by the wild swings and associated secondary market disruption in other covered bonds such as UK contractual covered bonds and multi-cédulas.

“Between August and December of last year, German institutions sold €58.5bn worth of pfandbriefe, mostly in the private placement market, with some non-jumbo public offerings and a few jumbo deals,” says Louis Hagen, executive director of the Association of German Pfandbrief Banks. “So there was minimal interruption of the primary market, with the pfandbrief proving itself to be a source of liquidity even in very difficult market conditions.”

Mr Hagen adds: “When market making was suspended for three days in November we understood why this needed to happen, and we accepted it, but the Association of German Pfandbrief Banks and its members had many calls from investors who were disappointed that the pfandbrief was included in the suspension, so we began to look for more differentiation for products such as obligations foncières and pfandbrief which were performing better than other covered bonds.

“When market making rules were temporarily put in place, reducing the minimum ticket size to €5m and tripling bid-offer spreads, we made it very clear to other ECBC members that this was the last time that we would accept such treatment to apply to all covered bonds uniformly.”

New rule sets

What followed was the market being divided into two, with one set of market making arrangements for bonds trading inside 20bp, and another set of rules for those trading wide.

A new electronic trading platform for market making is now being discussed, although Mr Hagen views the 20bp dividing line as a useful standard which could be left in place, providing an automatic trigger in times of market turbulence.

Clearly, finding solutions to secondary market pricing mechanisms is important to the re-opening of the primary market for many issuers because investors want to see good liquidity and a transparent pricing mechanism.

“There is pent-up demand, and investors want to access the market but one problem is that they are wary of volatility in the secondary market and often don’t know at what level to mark their existing book, or if prices being quoted by market makers are meaningful,” says Richard Kemmish, director of debt capital markets at Credit Suisse, who chairs the ECBC’s market issues working group.

Like most market participants, Mr Kemmish views it as unlikely that there will be a return to the continuous screen-based pricing of bonds under the old interbank market making system.

“Recognising that there are disagreements between market participants on the form that a new trading system should take, there is a middle ground of enough reform to give investors confidence about where price levels really are, but not to compromise the commercial interests of major market makers,” says Mr Kemmish.

Access to data

One ECBC covered bond trading proposal currently being discussed does not envisage continuous live prices, but does involve a high level of transparency on the prices at which trades have been executed, including ‘close of day’ prices being disclosed, giving all market participants access to this data via Bloomberg, Reuters and other sites.

Patrick Amat, chief financial officer at Crédit Immobilier de France and current chairman of the ECBC, believes that a solution to the crucial secondary market problems will be found.

“The ECBC has been pleased with the market acceptance of the recommendations of the 8 to 8 Committee of Representatives of Market Makers and Issuers, set up to give guidance during times of market turbulence, as well as special situations. And now the ECBC is working on long-term improvements to the market making process,” he says.

“We have had a large number of high quality and diverse comments on the proposals put forward by the Market Related Issues working group, and all market participants are committed to improvements in market making arrangements,” adds Mr Amat.

Putting some order into the secondary market and persuading investors and issuers that the prices being quoted give a realistic view of the market will be very important in bringing investors back.

At the moment, spreads are erratic and uncertainty is making it difficult to price new deals. And if issuers do come wide in order to get deals away, this often has the effect of re-pricing existing issues in secondary.

“Investors are differentiating between top Spanish banks and smaller regional banks which access the multi-cédulas market and there is a big difference in secondary market spreads,” says Ted Packmohr, covered bond analyst at Dresdner Kleinwort in Frankfurt.

“But even for the top Spanish banks, the question is whether it is in their best interest to come at the short end offering investors a sizeable spread pick-up, because this would set a new benchmark and might pull out secondary spreads on their existing issues.”

In addition to more transparent pricing, investors are also now looking for more performance data on the covered bond loan pool.

Responding to this appetite for more detailed information on the part of investors, Fitch Ratings has taken quarterly (or sometimes monthly) data from issuers and has prepared a set of performance data for investors within its new Covered Bonds ‘Smart’ tool.

“Smart tracks not just the changing credit risk of assets in the cover pool, but also other risks such as the mismatch between assets and liabilities because the cover pool maturity profile never matches the redemption profile of the bonds,” says Helene Heberlein, managing director at Fitch Ratings.

“There are also interest rate and currency mismatches in some covered bond programmess, which may not be completely hedged out,” she adds.

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