Germany prepares to expand inclusion in Pfandbriefe

A phenomenon that has taken both the U.K. and continental Europe by storm, covered bonds are now routinely issued by many of the major mortgage lending institutions in the U.K., and are seen as an alternative to traditional RMBS. With the promise of more volume in the near term, market players - buyside and sellside alike - are increasingly comfortable with how the product functions.

But pundits anticipating the fall of the RMBS are likely to be proven wrong.

"People have predicted the demise of the RMBS market, but it won't happen," said one market participant. "On the one hand, the major U.K. mortgage lenders that have set up new covered bond programs have continued to issue from their respective master trust programs - and that's done little to quell RMBS activity in the market this year. RMBS will continue to tighten as people realize its value."

There is no covered bond legislation per se in the U.K., as it exists in more mature markets such as the German Pfandbriefe, but issuers have been able to structure the product around current laws. Because U.K. deals do not have a specific legislation, they do not comply with the European Union directive on undertakings for collective investments in transferable securities (UCITS). This means that U.K. banks issuing covered bonds must hold more capital on their balance sheets.

"There is some room for articulating [regulatory] methodology on covered bonds," said one market analyst. "The popularity of this product has prompted some jurisdictions to establish covered bond methodology. We can assume regulators in the U.K. have looked carefully at transactions, but the fact that there is no regulation might be a problem."

Because of this situation, investor interest from outside the U.K.

is limited, as some institutions are allowed only up to 5% of their funds to be invested in non-UCIT covered bonds. From a U.K. perspective, there are concerns that bondholders might not be adequately protected under the current insolvency legislation. At the Barcelona conference in June, there was talk that the U.K.

Financial Services Authority was considering placing a limit on structured covered bond issuance in an attempt to protect unsecured depositors.

The recent U.K. covered bond deals have been structured much like U.K. RMBS. A ring-fenced pool of assets is sold to an SPE via an equitable assignment. The covered bonds are issued by the parent and the SPE guarantees the payments on the bonds, explained analysts at Barclays Capital.

Recent continental development

Sweden, the third largest mortgage-bond market in Europe behind Germany and Denmark, has recently unveiled new legislation in this area that will take effect this month. The new rules will state that holders of covered bonds are entitled to a preferential claim in the event of bankruptcy of the issuer.

Germany is also amid a shift in legislation. At the moment, rule markers are working out new guidelines to be included in a pending Covered Bond Act, which should come into effect during the first quarter of 2005. The reworking of the Pfandbriefe, one of the oldest and more established covered bond markets, is in response to the abolition of the state guarantees for the Landesbanks. At the moment, only 45 of these specialized German banks can issue Pfandbriefe. Under the new rules, all credit institutions complying with the revised mortgage banks act will be eligible to enter Pfandbriefe.

Concerns exist, however, about deals from institutions that are not currently adhering, or do not plan to adhere to the stricter revised mortgage act. With the absence of specialized banking laws, there are no loan-to-vale lending limits. The new act does not assign a trustee to ensure that the necessary cover exists, and it does not set limits on Pfandbriefe outstanding.

"Until July 2005, these deficiencies will be mitigated by state guarantees," explained analysts at Commerzbank. "Therefore, if Landesbanks or public savings banks continue to issue Pfandbriefe under [the] current public Pfandbriefe act, rating deterioration seems inevitable, unless the issuing institution voluntarily adheres to the stricter stipulations of the mortgage banking act."

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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