The Pfandbrief Facts and Figures about Europe s Covered Bond Benchmark

Transcription

1 The Pfandbrief Facts and Figures about Europe s Covered Bond Benchmark

2 Member Institutions of the vdp

3 The Association of German Pfandbrief Banks (vdp) currently represents 34 members. As the representative of its member institutions the vdp looks after the interests of the Pfandbrief Banks vis-à-vis national and European decision-making bodies as well as a broad professional public. Moreover, the vdp in its capacity as the umbrella organization of the German Pfandbrief Banks supports its members with highly specialized business solutions. The expertise of the vdp is tailored to the specific requirements of Pfandbrief Banks the Pfandbrief and generation of eligible assets as cover. The vdp promotes the economic concerns of its member institutions focusing on lobbying activities in capital market and tax policy as well as in all other political areas relevant to Pfandbrief issuing activity. In addition, it assists its member institutions in regulatory issues and represents them vis-à-vis the national supervisory bodies. Information and experience from member institutions are exchanged, prepared and developed into market standards in the Association s bodies within the scope of group governance. In addition, the vdp provides its members with business solutions that benefit the specific lending and issuing business conducted by Pfandbrief Banks. The business activities of the vdp members profit from the vdp s recognized expertise, its extensive network and well-established communications instruments.

4 2 Content The Pfandbrief Background Information 4 Preface Henning Rasche President of the Association of German Pfandbrief Banks 6 The Legal Framework for Issuing Pfandbriefe Dr. Louis Hagen Association of German Pfandbrief Banks 16 The Pfandbrief Market 27/28 Bodo Winkler Association of German Pfandbrief Banks 28 Amendment of the Pfandbrief Act Dr. Otmar Stöcker Association of German Pfandbrief Banks 34 Market Making for Jumbo Pfandbriefe: Quo vadis? Franz-Josef Kaufmann Eurohypo AG 42 Pfandbriefe in periods of financial crisis Quality prevails Ernst-Albrecht Brockhaus, Horst Bertram BayernLB 48 The Pfandbrief and the ECBC s Essential Features of Covered Bonds Ralf Burmeister LBBW

5 Member Institutions of vdp 57 Deutsche Apotheker- und Ärztebank Düsseldorf 58 Aareal Bank Wiesbaden 6 Bayerische Hypo- und Vereinsbank Munich 62 BayernLB Munich 64 Berlin-Hannoversche Hypothekenbank Berlin 66 COREALCREDIT BANK Frankfurt am Main 68 DekaBank Frankfurt am Main 7 Deutsche Genossenschafts- Hypothekenbank Hamburg 72 Deutsche Hypothekenbank Hannover 74 Deutsche Kreditbank Berlin 76 Deutsche Postbank Bonn 78 Deutsche Schiffsbank Bremen 8 Dexia Kommunalbank Berlin 82 Düsseldorfer Hypothekenbank Düsseldorf 84 Eurohypo Eschborn 86 Hamburger Sparkasse Hamburg 88 Helaba Landesbank Hessen-Thüringen Frankfurt am Main 9 HSH Nordbank Hamburg 92 Hypo Real Estate Bank Munich 94 Hypo Real Estate Bank International Munich 96 Hypo Real Estate Holding Munich 97 IKB Deutsche Industriebank Düsseldorf 98 Kreissparkasse Köln Cologne 1 Landesbank Baden-Württemberg Stuttgart 12 M. M. Warburg & CO Hypothekenbank Hamburg 14 Münchener Hypothekenbank Munich 16 Nord/LB Norddeutsche Landesbank Girozentrale Hanover 18 SEB Bank Frankfurt am Main 11 Sparkasse KölnBonn Cologne 112 Valovisbank Essen 114 Westdeutsche ImmobilienBank Mainz 116 WestLB Düsseldorf 118 WL BANK AG Münster 12 Wüstenrot Bank AG Pfandbriefbank Ludwigsburg Further Information 122 The Methodologies of the Rating Agencies 125 Other Pfandbrief Issuers 126 Topics covered in

6 Preface Dear Reader, The strength of the Pfandbrief becomes most obvious in a difficult economic environment. When the shockwaves triggered by the US subprime crisis hit Europe s shores, the Pfandbrief proved its importance as a safe haven for fixed income investors and as a reliable and cheap source of liquidity for the issuers. Despite the persistently adverse conditions on the credit markets, the issuers sold almost as many Pfandbriefe as in the corresponding period one year before. Differentiation in terms of credit quality increased again appreciably on the Covered Bond markets. Previously, differences in quality were hardly reflected in swap spreads. Today, however, they signify that as the crisis continued, investors made a more differentiated assessment of the risks entailed in the different Covered Bond products. In absolute terms, Pfandbriefe nevertheless had to put up with an albeit slight markup versus swaps on the primary market. The financial market crisis was not without consequences for the Jumbo market. After several attempts were made through concerted action at European level to uphold market making, the realization finally won through that the one size fits all approach was unsuitable for the situation at the time. Yet although the market was divided in two, it proved impossible to guarantee the smooth functioning of interbank market making. During this difficult phase, Pfandbrief issuers worked especially hard to stay in touch with investors and market makers so as to take the right measures for the Pfandbrief at the right time. It may be seen as a result of these consultations that the quotation of prices for Jumbo Pfandbriefe among banks is to be resumed after the summer break at higher bid-offer spreads. It was with a view to ensuring that the Pfandbrief retained its benchmark position on the Covered Bond market that the vdp initiated the first amendment of the Pfandbrief Act. The draft bill for a law on the further development of Pfandbrief legislation was

7 Henning Rasche president presented at the end of June of this year. The indications are good that the amendment of the Pfandbrief Act the Act entered into effect in 25 will successfully complete the parliamentary procedure to be adopted and promulgated early in 29. In light of the uncertain market environment and the fading prospects for the global economy, considerable challenges lie ahead for the Pfandbrief banks and the other groups in the banking sector. The Pfandbrief banks realize it is highly important in this situation that the Pfandbrief continues to receive the market makers support, which gratefully the Pfandbrief was also given during the financial market crisis. The Pfandbrief banks strategy of focusing on quality and on engaging in an investor-friendly issuing policy proved yet again to be the right one and impressively so. The spectrum of Covered Bonds is growing constantly, as is the complexity of the market as a result. This makes the Pfandbrief banks all the more determined to continue the course they have embarked upon, and to consistently gear their activities to maintaining and enhancing the Pfandbrief s quality in order not to jeopardize the tremendous confidence investors place in the Pfandbrief. This edition of the vdp Pfandbrief Fact Book would not have been possible without the efforts and expertise of the authors. Our particular thanks go to them for contributing, also in these difficult times, toward the success of this the 13th issue. I hope our readers find it makes instructive reading. Henning Rasche President of the Association of German Pfandbrief Banks

8 The Legal Framework for Issuing Pfandbriefe Pfandbriefe are covered, interest-bearing bonds. They are issued by credit institutions with a license to engage in Pfandbrief business (Pfandbrief Banks) and placed on the capital market. These credit institutions use them to fund certain loans that are secured by real estate liens, ship mortgages or claims against public-sector bodies. Depending on the type of collateralization, these bonds are referred to as Mortgage Pfandbriefe, Ship Pfandbriefe or Public Pfandbriefe. Most Pfandbriefe are issued in the form of bearer bonds, registered bonds also play an important role. dr. Louis Hagen Association of German Pfandbrief Banks

9 7 The legal basis for issuing Pfandbriefe is the Pfandbrief Act (Pfandbriefgesetz, PfandBG), the purpose of which is to ensure the Pfandbrief s high standard of safety. On the one hand, this legislation serves to satisfy the demand by certain circles of investors for a secure investment. On the other, thanks to the low risk premiums to be paid, Pfandbriefe provide issuers with a very cheap and reliable source of funding. This in turn enables the issuers to supply the credit market with loans on a continuous basis at prices that take their bearings from the capital market. Structure of a Pfandbrief Bank General supervision on the basis of the German Banking Act (KWG) Lending Operations not eligible as cover Other Assets Other funding capital (Deposits, Uncovered Bonds etc.) Special supervision on the basis of the Pfandbrief Act (PfandBG) KWG Mortgage loans commercial residential 6% of the Mortgage Lending Value Mortgage Pfandbriefe KWG Public-sector lendings 1% of the Lendings Public Pfandbriefe PfandBG Ship financings 6% of the Mortgage Lending Value Cover Pool Monitor Examines the Cover Ship Pfandbriefe PfandBG The Pfandbrief Bank grants property finance, ship loans and public-sector lendings. These assets are taken onto the credit institution s balance sheet. The cover pool monitor enters loans or parts of loans that are eligible as cover under the Pfandbrief Act in cover registers, together with the collateral for them. A separate register is maintained for each loan type. In their entirety, the cover assets entered in a cover register are referred to as the cover pool. Pfandbriefe are issued on the basis of the cover assets. The Pfandbrief Bank undertakes to pay the Pfandbrief bearers the promised interest and, at maturity, to repay the principal amount of the Pfandbrief. In the event of the Pfandbrief Bank s insolvency, the Pfandbrief bearers have a preferential claim in respect of the assets entered in the cover registers. The cover pools are not included in the insolvency proceedings; instead they are administered separately.

10 8 The Legal Framework for Issuing Pfandbriefe The high standard of safety the Pfandbrief offers is owed to the provisions of the Pfandbrief Act and to the regulations issued pertaining to the Pfandbrief Act, the main elements of which are as follows. Supervision Granting of licenses Pfandbrief business, which is to say the issuing of Covered Bonds on the basis of mortgages, claims against public-sector bodies and ship mortgages acquired, is one part of banking business. To be awarded a license to engage in Pfandbrief business, a credit institution must fulfill special requirements. For example, it must have core capital of at least 25 million Euros and be licensed to conduct lending operations within the meaning of the German Banking Law (Kreditwesengesetz, KWG). Moreover, the credit institution must have at its disposal suitable procedures and instruments for managing the risk entailed in the cover pools on the one hand, and its issuing operations on the other, prove that it intends to engage in Pfandbrief business on a regular and sustained basis, and put the appropriate organizational structure and resources into place. In stipulating these special conditions for the granting of a license, legislators seek to ensure that each credit institution conducts its Pfandbrief business seriously and in a sustained manner by linking the assumption of Pfandbrief business with substantial effort on the bank s part. This is intended to make it more difficult to engage in opportunistic business strategies of a short-term nature. Because a Pfandbrief Bank needs an individual license for each of the Pfandbrief categories, it must prove it has the requisite expertise in the various operations eligible as Pfandbrief cover. Permanent supervision and cover audits In addition to the general banking supervision, a Pfandbrief Bank is subject to a special form of supervision by the Federal Financial Supervisory Authority (BaFin), the aim of which is to monitor observance of the Pfandbrief Act and the regulations issued in connection with it. The permanent supervision is conducted by the department at BaFin responsible for the respective credit institution. The prerequisite for the Pfandbrief market to function effectively is the highest and the most uniform standard of safety possible, across all issuers. For this reason, the special supervision of Pfandbrief Banks must be conducted according to uniform principles. The Pfandbrief Competence Center I Basic Issues was set up at BaFin to ensure the uniform application and interpretation of the Pfandbrief Act. Besides the ongoing supervision, a further feature are the cover audits, which are performed on a regular basis usually every two years. Their purpose is to examine the cover pool assets by way of random checks. These cover audits are conducted by Pfandbrief Competence Center II Examination of Cover Assets at BaFin to make sure that uniform standards and requirements are complied with. Cover pool monitors Moreover, cover pool monitors are to be appointed at every Pfandbrief Bank. Their task is to see to it that the statutory cover for the Pfandbriefe is given and that the cover assets are duly entered in the respective cover register. Appointed by BaFin, the cover pool monitors are not

11 answerable to the bank, the supervisory authority or the Pfandbrief creditors. The function they perform is shaped solely by law. BaFin may revoke the appointment for an objective reason. Thus, the cover pool monitor may be regarded as an independent monitoring body. Quality of the Cover Assets Not all the loans a Pfandbrief Bank extends are eligible as cover. The Pfandbrief Act expressly stipulates which loans and other claims may serve as cover assets. In this context a distinction is, as a rule, made between the individual Pfandbrief types. Mortgages as cover assets Only mortgages that meet certain requirements may be used as cover for Mortgage Pfandbriefe. Land charges and foreign security interests that offer comparable security rank equal with mortgages. The property charges may burden landed property or equivalent titles to land in Germany, in the Member States of the European Union or another Contracting State to the Agreement on the European Economic Area (EEA), in Switzerland, in the USA, in Canada or in Japan. Both commercial and residential properties may be lent against. Also eligible as cover for Pfandbriefe are assets in the case of which other credit institutions hold the land charges for the Pfandbrief Bank on a fiduciary basis, provided the Pfandbrief Bank is entitled to the separation of these assets from the trustee s assets in the event of the latter s insolvency. In order to promote securitization and Pfandbrief business, a law in 25 established the Funding Register (Refinanzierungsregister) under the German Banking Act, ensuring the insolvency remoteness of land charges held on a fiduciary basis. Of crucial importance in the case of the encumberable titles abroad is whether they are comparable to equivalent titles to land under German law (e.g. residential property and rights in relation to building leases/hereditary building rights). Financings that are secured by way of properties outside the States named above do not qualify as cover, and cannot therefore be funded through Pfandbriefe. For the Pfandbrief Banks foreign business that is eligible as cover, moreover, the share of the financings in respect of which the preferential right in insolvency is not ensured must not exceed 1 % of the mortgage cover assets. The EU States are not included in the Pfandbrief Bank s foreign business in this context, as the preferential right in the case of insolvency is ensured here. One of the central pillars of the safety of the Mortgage Pfandbrief is that property financings may be included in cover only up to the mortgage lending limit of 6% of the mortgage lending value (MLV). The way in which the MLV is to be determined, and the requirements in respect of the valuer s qualifications and the valuer s independence vis-à-vis the Pfandbrief Bank are regulated in detail by the Pfandbrief Act and the Regulation on the Determination of the Mortgage Lending Value (Beleihungswertermittlungsverordnung, BelWertV). The MLV reflects only the long-term sustainable aspects of a property, meaning that speculative aspects are disregarded. The aim here is that the MLV, in contrast to the market value, shows as little in the way of fluctuation as possible. The MLV must not exceed, and indeed is usually lower than, the market value. However, the difference between the two values does not remain the same, for which reason it is not possible to make a simple value deduction. Instead, the difference is determined by the expectations of the market with respect to the future price development of the property in question. Yet the mortgage lending limit of 6 % of the MLV does

12 1 The Legal Framework for Issuing Pfandbriefe Mortgage lending value vs. market value Value Market value Mortgage lending value 6 % mortgage lending limit Time Conservative valuation of real estate The mortgage lending value (MLV) is determined according to detailed statutory provisions Based on permanent features of the property Market value is the upper limit for the MLV Occasion-related review of the MLV Claims up to 6% of the MLV are eligible as cover not mean that a loan in order to be eligible as cover may only be equivalent to this 6 % limit. Only the part of the loan that is eligible as cover may not exceed this limit. This can be achieved by dividing the loan into two parts one up to the 6 % limit and the other above it. However, this is not necessary in practice as an ideal division is possible and is applied in most cases. Finally, the properties lent against must be insured against the risks relevant to the location and type of property. Claims against public-sector bodies as cover assets Under 2 Pfandbrief Act money claims resulting from the granting of loans, from bonds or from a comparable legal transaction may serve as cover for Public Pfandbriefe. Debtors in this respect may be EU Member States, Contracting States to the Agreement on the EEA, Switzerland, Japan, the USA as well as European Member States of the OECD; domestic regional and local authorities as well as local authorities and regional governments, in a EU Member State, in a Contracting State to the Agreement on the EEA as long as they have a risk weighting not exceeding 2 % pursuant to the EU Directive relating to the taking up and pursuit of the business of credit institutions; domestic regional and local authorities as well as public-sector authorities for which state support ( Anstaltslast ) or a legally founded obligation ( Gewährträgerhaftung ) or for which a state refinancing guarantee applies, or which are legally entitled to raise fees, rates and other levies; also non-profit administrative organizations in the afore-mentioned foreign States which are subordinate to the central governments, regional governments or local authorities and have received a 2 % risk weighting pursuant to the EU Directive relating to the taking up and pursuit of the business of credit institutions;

13 11 the European Investment Bank, the International Bank for Reconstruction and Development, the Council of Europe Development Bank or the European Bank for Reconstruction and Development as well as with a limit of 1 % of the cover pool the European Central Bank and the central banks of the Member States of the EU. Except in the case of the non-profit administrative organizations, it is sufficient if the other bodies mentioned assume an explicit guarantee in respect of a claim. No longer eligible as cover are claims against public-sector credit institutions for which no legally founded obligation or only a modified state support exists. In particular, this concerns savings banks and Landesbanken. However, they may be included in cover to a limited extent as claims against credit institutions. Claims against the above debtors remain eligible as cover if, under the agreement between the German Federal Government and the European Commission dated March 22, 22, they continue to have a state guarantee (grandfathering). In the case of claims against public-sector bodies and of mortgage claims, the 1 % limit likewise applies to claims against debtors from third States in which the Pfandbrief creditors preferential right in insolvency is not ensured. The claims against certain public-sector bodies may be used as cover not only for Public Pfandbriefe but also, up to 2 % of the respective amount outstanding, for Mortgage and Ship Pfandbriefe, and mainly serve the purpose of steering the liquidity of the cover pools. Ship mortgages as cover assets Certain ship mortgages may be included in cover for Ship Pfandbriefe ( 21 Pfandbrief Act). The ships and ships under construction that are lent against must be recorded in a public register. The ships must not be older than 2 years. Lendings against ships, like lendings against properties, may be included in cover only up to the equivalent of 6 % of the ship s MLV. The MLV, which is also a permanent value, must be determined according to the principles of the Regulation on the Determination of the Mortgage Lending Values of Ships and Ships under Construction ( Schiffsbeleihungswertermittlungsverordnung ). Special requirements apply to the eligibility of ship mortgages as cover, such as maximum lives for ship mortgages. The share of lendings in the case of which the preferential right in insolvency is not ensured may be a maximum of 2 % for Ship Pfandbriefe. This takes into consideration the fact that ships are often registered abroad, and a 1 % limit would unreasonably restrict the use of the Pfandbrief for credit institutions and with that, their competitiveness. Claims against credit institutions Claims against suitable credit institutions may serve as further cover assets for all three Pfandbrief types ( 19 par. 1 no. 2, 2 par. 2 no. 2 and 26 par. 1 no. 3 Pfandbrief Act). This serves the purpose of enhancing the cover pool liquidity. The cover pools are made up of a large number of assets with different maturities, interest rates and currencies. The maturities, coupons and currencies of the Pfandbriefe cannot match exactly those of the cover pools. Usually, for example, Pfandbrief issues are of a greater volume than the underlying assets. To balance out these mismatchings it is necessary to be able to include liquid and flexible assets such as claims against credit institutions in the cover pools. Since the basic features of the cover pools should not, however, be changed, claims against credit institutions may account for only up to 1 % of the total volume of the respective Pfandbrief type.

14 12 The Legal Framework for Issuing Pfandbriefe Claims resulting from derivative contracts Subject to certain conditions, claims resulting from standardized master agreements in respect of derivative transactions against suitable credit institutions, financial services institutions, insurers and central counterparties at a stock exchange, at the German Federal Government and with federal States ( Bundesländer ) may be eligible as cover for all Pfandbrief types ( 19 par. 1 no. 4, 2 par. 2 no. 3, 26 par. 1 no. 5 Pfandbrief Act). The natural mismatch (above) between cover pools and Pfandbriefe can give rise to interest rate and currency risks in the cover pools. These risks can be neutralized by offsetting assets, or by derivatives (interest rate and currency swaps) concluded between the Pfandbrief Bank and the derivative counterparty. Depending on how interest and exchange rates develop, the net present value of derivatives may change in the short term. A positive value from the Pfandbrief Bank s viewpoint gives rise to a claim on the part of the Pfandbrief Bank against the counterparty. A negative value means the Pfandbrief Bank has a liability towards the derivative counterparty which, however, is not payable until the derivative contract is terminated. Claims and liabilities are netted against each other on a daily basis. The standardized agreements used in practice for derivatives provide that, in the event of insolvency, either party may terminate the contract vis-à-vis the other with immediate effect. In consequence, the derivatives concluded under the master agreement are settled at their net present value and the resultant claims to which the parties are entitled are offset against each other to establish the net claim. Such a consequence would not, however, be consistent with the Pfandbrief safety concept, under which outstanding Pfandbriefe may not become payable prematurely even in the event of the Pfandbrief Bank s insolvency but are to be satisfied out of the payment flows from the cover assets when they mature (see preferential right in case of insolvency, p. 14). If it were possible, on the Pfandbrief Bank s becoming insolvent, for the counterparty to terminate the derivatives concluded in order to hedge against interest rate and currency risks, the cover pools would be exposed to these risks. For this reason it is both necessary and required by law that derivatives included in cover may not be terminated by the counterparty if the Pfandbrief Bank becomes insolvent. To achieve this in practice, individual agreements are concluded under a master agreement and derivatives are allocated to the respective individual agreements. For example, if a Pfandbrief Bank issues Mortgage Pfandbriefe and Public Pfandbriefe, three individual agreements can be concluded: one for the derivatives pertaining to each of the two cover pools, and one to which the remaining assets of the Pfandbrief Bank are allocated. Netting takes place only among the derivative claims that fall under the same individual agreement. In the event of the Pfandbrief Bank s insolvency, therefore, only the individual agreement concluded with the counterparty for the other assets of the Pfandbrief Bank can be terminated. The individual agreements for the cover pools, on the other hand, must remain in force, and could only be terminated if the cover pools also became insolvent. The individual derivatives are entered in the respective cover registers. Derivatives may have a negative value, giving rise to liabilities in respect of the cover pool. As a concession for the fact that the counterparties have to waive their right to terminate the derivative contracts, even if the Pfandbrief Bank becomes insolvent, their claims rank equal with those of Pfandbrief creditors. To prevent the cover pools from becoming inordinately volatile and in order not to undermine the principle behind the cover pools, the claim or the liability under the net derivative position in each cover pool may not exceed 12% of the cover assets or of the Pfandbriefe outstanding.

15 13 Cover Register The above-mentioned cover assets must be entered in cover registers ( 5 Pfandbrief Act). A separate register is to be maintained for each Pfandbrief type. The entry of derivatives is subject to approval by the derivative counterparty and the cover pool monitor. This requirement is due to the above-mentioned special aspects regarding derivatives as cover assets. The cover registers, which may also be kept electronically, must be passed on to BaFin at regular intervals, where they are stored. Cover registers are, of course, highly important. All the assets recorded in the cover register belong to the respective cover pool and are, in the event of the Pfandbrief Bank becoming insolvent, subject to the Pfandbrief creditors preferential right in the event of insolvency. Details on the maintenance of the cover registers are set forth in the Cover Register Statutory Order (Deckungsregisterverordnung). Active Management of the Cover Pools to Ensure Matching Cover The cornerstone of the safety of the Pfandbrief is the fact that the Pfandbrief creditors entitlement against the Pfandbrief Bank to payment is secured by the cover pools. Further, only the Pfandbrief creditors have a right to satisfaction of their claims out of the cover pool in the event of the Pfandbrief Bank s insolvency. Thus it is essential that, should insolvency occur, the cover pools contain sufficient cover assets to satisfy the Pfandbrief creditors claims to interest and principal. This is achieved, first of all, in that the nominal value and the net present value of the Pfandbriefe outstanding are covered at all times by matching principal and interest income in the cover pools, 4 pars. 1 and 2 Pfandbrief Act (matching cover). The Net Present Value Regulation (Barwertverordnung) stipulates in detail how the net present value is determined, and permits three methods for its calculation. These methods use different fictitious changes of interest rates and exchange rates which are to be taken into account when determining the net present value. The cover pools are subjected to defined stress scenarios, so that in effect a net present value cover surplus results. Moreover, excess cover must be maintained in net present value terms which amounts to 2 % of the Pfandbrief liabilities to be covered, and which must be invested in particularly liquid assets. The purpose of this mandatory overcollateralization is, in the event of the Pfandbrief Bank s insolvency, to cover risks that may arise as well as administrative expenses payable and to meet liquidity management costs. Over and above this, it is at the issuer s discretion to maintain further, voluntary excess cover. This is a precondition rating agencies generally stipulate to award top ratings to Pfandbriefe. Unlike those for Mortgage Backed Securities, cover pools for Pfandbriefe are dynamic. This means their composition changes over time, according to the maturities and to the cover assets that are newly registered. Loans are repaid or are removed from the cover for other reasons, to be replaced by new loans, and new business is included in cover to enable the Pfandbrief Bank to issue new Pfandbriefe. Thus, the cover pools have to be actively managed to ensure matching cover at all times. The Pfandbrief Act stipulates that risk management systems must be installed to identify, assess, control and monitor the relevant risks such as counterparty risks, interest rate, currency and other market price risks, operational risks and liquidity risks ( 27 Pfandbrief Act).

16 14 The Legal Framework for Issuing Pfandbriefe Transparency of the Cover Pools To give investors as exact and up-to-date a picture as possible of the composition of the cover pools and the Pfandbriefe outstanding, Pfandbrief Banks are required to publish certain information on a quarterly basis and additional data annually. Such information includes, for instance, the regional distribution of the cover assets, the type of properties lent against, the debtors of public-sector liabilities and the amount of claims that are at least 9 days in arrears. This allows Pfandbrief creditors to compare the cover pools of different Pfandbrief Banks. What is more, this disclosure requirement has the effect of demanding more discipline of the issuers. Preferential Right in the Event of Insolvency The safeguarding mechanisms enshrined in the Pfandbrief Act would be ineffectual without the Pfandbrief creditor s preferential right in the event of insolvency. Under this preferential right the cover pools are at the disposal solely of the Pfandbrief creditors and, under certain circumstances, of derivative creditors in the event of the Pfandbrief Bank becoming insolvent, Pfandbrief creditors preferential right in the event of insolvency Insolvency of the Issuer Insolvency Administrator Pfandbrief Bank Other assets Creditors Other Assets Other Creditors Mortgage Loans Cover Pool Administrator Mortgage Pfandbrief Holders Claims against Public-Sector- Debtors Ship Mortgages Mortgage loans Claims against Public-Sector- Debtors Ship Mortgages Holders of Public Pfandbriefe Holders of Ship Pfandbriefe What makes Pfandbriefe insolvency remote Pfandbriefe do not accelerate Segregation of cover pools Insolvency privilege of Pfandbrief creditors

17 15 to satisfy their claims. This means that the Pfandbrief Bank s insolvency does not affect them. To ensure this preferential right, the Pfandbrief Act provides for an emergency plan that is set forth in detail. Segregation of the cover pools The assets that make up the cover pools do not participate in the insolvency proceedings in respect of the bank s assets. They constitute, for each Pfandbrief type the credit institution issues, special assets out of which the Pfandbrief creditors claims are to be satisfied ( 3 par. 1 Pfandbrief Act). The bank s insolvency administrator therefore has no access to the cover pools and the Pfandbriefe do not accelerate. With regard to mortgage loans, which are in part included in the cover pools and are in part outside the cover pools, the Pfandbrief Act provides that the payment flows from these loans first pass in full to the cover pool administrator (see below). The insolvency administrator can demand that the payment flows be separated at his expense, and that the payments in respect of the parts of the lendings above the cover limit flow to him. Cover pool administrator When insolvency proceedings are initiated in respect of the bank s assets, the court at the Pfandbrief Bank s seat appoints one or more cover pool administrators at the request of the supervisory authority ( 3 par. 2 Pfandbrief Act). Cover pool administrators may also be appointed before insolvency proceedings are initiated if the bank s insolvency is to be feared and such action is necessary to protect the Pfandbrief creditors. The cover pool administrator is a natural person. He has the right to manage and dispose of the cover pools, and represents the Pfandbrief creditors interests. The creation of the office of cover pool administrator strengthens the protection of the Pfandbrief creditors. It would be inappropriate if the management board of the insolvent bank or bank at risk of insolvency were allowed to continue maintaining the cover pools. Given the conflicting interests of the Pfandbrief creditors and the Pfandbrief Bank s other creditors, the insolvency administrator would likewise be unable to safeguard the Pfandbrief creditors interests in the appropriate manner. The cover pool administrator has a number of alternatives for ensuring that the Pfandbrief creditors claims are satisfied in a timely fashion: He can collect the payment flows of the cover pools and service the outstanding liabilities in accordance with the terms of issue ( 3 par. 1 Pfandbrief Act). Further, he may sell individual assets in order, above all, to procure liquidity ( 3 par. 2 Pfandbrief Act). This form of settlement would be continued until all the Pfandbriefe were repaid. Any surplus would be passed to the insolvency administrator. He may transfer all or parts of the cover assets from one cover pool, and liabilities stemming from the Pfandbriefe as a whole, to another Pfandbrief Bank ( 32 Pfandbrief Act). To be able to do so he needs the supervisory authority s approval. With the supervisory authority s approval the cover pool administrator may agree with another Pfandbrief Bank to hold the cover pools in a fiduciary capacity for that bank ( 35 Pfandbrief Act). In such a case, that Pfandbrief Bank must assume liability for the Pfandbriefe outstanding. Because a transfer of cover pools can be carried out very quickly, work-intensive individual transfers can be avoided in this way. Insolvency or overindebtedness Where there is a reason for insolvency in respect of the cover pools, separate insolvency proceedings can be instituted in respect of them at the supervisory authority s request. If the Pfandbrief creditors are not fully satisfied under this procedure, they can assert their remaining claims within the scope of the insolvency proceedings of the Pfandbrief Bank s other assets.

18 16 The Pfandbrief Market 27/28 Not even the Pfandbrief was thouroughly immune to the large market disruptions that emanated from the subprime crisis. Yet it did prove a reliable funding instrument in the period under consideration given it afforded issuers access to liquidity at all times at only slightly increased yield levels. With the exception of prime government bonds no other asset class proved as resilient as the Pfandbrief. By now, the international Covered Bond market clearly differentiates individual products. This differentiation benefits the Pfandbrief and its clear and detailed legal basis, with the longest track record amongst all products in the Covered Bond market, its strong systemic footing in the German financial system, the fundamental role of public supervision and most of all its strong and loyal domestic investor base. Bodo Winkler Association of German Pfandbrief Banks

19 17 Pfandbrief Holds Its Own as a Premium Product During the Financial Crisis The period from the second half of 27 to the end of the first half of 28 was characterized by strong market upheavals. The trigger was the US subprime crisis, which assumed the proportions of a global financial crisis during the course of summer 27. Uncertainty still prevails as to which banks will have to make write-downs, and in what amount, on structured securities or property loans of inferior quality. This puts a considerable burden on banks lending operations with each other, and has made unsecured lendings appreciably dearer on the money market. On the capital market, too, even high-quality banks could only raise unsecured outside funds by accepting sizeable markups. Even for good quality borrowers, a rise in the cost of funds by 7 basis points or more versus swaps compared with the first half of 27 was not the exception. The market for securitizations ground to a complete standstill. Not even the Pfandbrief was able to completely shrug off the disruptions that shook the markets. The bid-offer spreads widened, and interbank market making for Jumbo Pfandbriefe and Jumbo Covered Bonds was temporarily suspended (see the article by Kaufmann p. 34 et seq.). And from Q2 28 onwards, issuers had to pay higher markups on their first-time issues. Yet the markups were extremely small compared with what other bond types were experiencing, whether unsecured bank bonds or industrials, foreign Covered Bonds or structured credit products such as MBS. This clearly illustrates that today, more than ever, the Pfandbrief is perceived on the markets to be a premium product. First-Time Issue Volumes and Volumes Outstanding Lower... Thus, Pfandbrief banks were able to issue Pfandbriefe at any time throughout 27 and the first half-year of 28. One point in their favor were the three different Pfandbrief segments at their disposal, namely Jumbo (bearer) Pfandbriefe, traditional bearer Pfandbriefe and registered Pfandbriefe. For the actual placement they have the choice between private placements and public offering, i.e. they can use different sales channels, thereby addressing different investor groups. With a volume outstanding of about EUR 889 bn, the Pfandbrief held a top place in the European bond markets in 27 as well. However, at EUR 135 bn, gross sales were down on the year 26. The decline in the volume outstanding from EUR 949 bn to EUR 889 bn was due to the drop in new issue activity as well as, above all, the high repayments that again characterized 27. There is no connection between the lower first-time sales figures and the financial crisis. Instead, other factors which in some cases varied depending on the respective Pfandbrief type were responsible for the negative new issue volumes in 27 (EUR 43 bn for Public Pfandbriefe, and EUR 17 bn for Mortgage and Ship Pfandbriefe together). For the Pfandbrief market as a whole, which had its record year in 1999 with a new issue volume of EUR 282 bn, as in the years before, many issues from the fat years also fell due in 27 and 28 without being replaced. Where Public Pfandbriefe are concerned, moreover, it has to be said that issues brought by public-sector credit institutions after July 19, 25 are no longer covered by state guarantees. This means they can no longer be included in cover. Because issues of this

20 18 The Pfandbrief Market 27/28 The Pfandbrief market 27/28 New issue volume/month ( billion) 18, Begin of Subprime Crises 16, 14, 12, 1, 8, 6, 4, 2, Registered Pfandbriefe Bearer Pfandbriefe Jumbo (Bearer) Pfandbriefe Source: Deutsche Bundesbank, UniCredit kind in the past accounted for a sizeable portion of the cover pools for Public Pfandbriefe, the decline in these bonds is explained by the drop in assets eligible as cover. In addition, narrow margins and the in the period under review initially very flat yield curve, which has even been inverse since the ECB meeting on June 5, 28, make it more difficult to engage in capital market driven public-sector lending. Where Mortgage Pfandbriefe are concerned, one must bear in mind that before the financial market crisis broke out, many banks shied away from the work involved in including mortgage loans in cover. This was because the yield gap separating uncovered bank bonds and Pfandbriefe was at historic lows until summer 27. However, the subsequent massive widening of the gap between the yield levels of Pfandbriefe on the one hand and uncovered bonds on the other caused many issuers to reconsider.... Yet a Positive Outlook for 28 and 29 Just as the reasons varied for the receding first-time sales and volumes outstanding of the different Pfandbrief categories, so the expectations for the current and next year vary. At the start of 28 the vdp conducted among its member banks, which account for approx. 97% of market volume in terms of Pfandbriefe outstanding, a survey on their plans for new issues in 28 and 29, and on the repayments due in both years. All the banks participated in the survey, with only four of them not yet in a position to report on planned new issue volumes for 29. The findings revealed that in 28 maturities totaling EUR 157 bn are to be expected. The corresponding figure for 29 is EUR 142 bn. According to the plans reported by the vdp member banks, new issues will clearly exceed maturities in the case both of Mortgage and of Ship

21 19 The Pfandbrief market Perspective 27/28 Maturities (in ) Mortgage Pfandbriefe 28 36, ,311 Public Pfandbriefe , ,27 Ship Pfandbriefe Total , ,991 2, 4, 6, 8, 1, 12, 14, New issues planned (in ) Mortgage Pfandbriefe 28 51, ,4 Public Pfandbriefe 28 75, ,7 Ship Pfandbriefe 28 2, ,12 Total , ,22 2, 4, 6, 8, 1, 12, 14, Netto new issues (in ) Mortgage Pfandbriefe 28 14, ,287 Public Pfandbriefe 28 44, ,55 Ship Pfandbriefe 28 1, ,71 Total 28 28, ,553 4, 3, 2, 1, 1, 2, *Four credit institutions were unable to report new issue plans for 29. Source: vdp banks, new issues will clearly exceed maturities in the case both of Mortgage and of Ship Pfandbriefe. Thus, net new issues are planned of EUR 15 and 22 bn respectively for Mortgage Pfandbriefe, and EUR 1.3 and 1.7 respectively for Ship Pfandbriefe. In contrast, negative net issue figures may be expected of EUR 44 and 41 bn for the Public Pfandbrief. There will therefore be a shift among the Pfandbrief types, with Mortgage and Ship Pfandbriefe accounting for a growing share compared with a declining share for Public Pfandbriefe.

22 2 The Pfandbrief Market 27/28 Spread Performance Uneven Whereas in previous years the spreads of Pfandbriefe versus swaps narrowed continuously, they began to widen from the start of Q2 28 at the latest. Initially, the outbreak of the financial crisis had scarcely any impact on the Pfandbrief spreads on the secondary market. Nor did the widenings of the bid-offer spreads for all Jumbo Covered Bonds, which led to the temporary cessation of market making, alter this position. Indeed, also during the crisis Jumbo Pfandbriefe outstanding yielded at accustomed low levels, or at even tighter spreads. On July 31, 27, the average spread of all Public Jumbo Pfandbriefe outstanding was about 1 basis points (BP) below swaps; for Mortgage Pfandbriefe it was 8 BP. On April 1, 28, the swap spreads of Public Jumbos outstanding had even narrowed to 14 BP, while mortgage Pfandbriefe remained constant at - 8 BP. At the end of June, Public Jumbo Pfandbrief yields were at 11 BP and Jumbo Mortgage Pfandbriefe at mid-swap flat. These figures are proof that investors are increasingly differentiating between Mortgage and Public Pfandbriefe. This trend can also be observed on the primary market, where funding through Mortgage Pfandbriefe is today 4 to 5 basis points dearer than through Public Pfandbriefe. In the past this difference, where it existed at all, was rarely more than one basis point. This development is to be explained on the one hand by the resentment towards real estate security as a result of the financial crisis and, on the other, by a clear trend of Public Pfandbriefe becoming scarcer. If one considers the spread development of Jumbo Pfandbriefe in the secondary market by residual time to maturity, it may be seen that the swap spread has widened most in the case of 1-year bonds. Whereas the yield differential as at mid 27 was still at a historic low of 4 BP, 1-year Jumbo Pfandbriefe were again quoted at 6 BP over swaps in June 28. This is mainly due to the fact that the yield markups for Jumbo new issues have risen, above all, since the beginning of Q2 28 and the new issues have led to a repricing of the market. Also Jumbo Pfandbriefe with a five-year residual maturity are again being quoted above the swap curve, their swap spread having widened from 6 BP since mid 27 to +2 BP in June of the current year. In light of the capital market turbulences in the period under review, however, the extremely small change is remarkable. No other securities segment apart from first-class sovereigns displayed such stability whether other Covered Bonds, senior unsecured bank bonds or sovereigns from Southern Europe.

23 21 Spread Jumbo Pfandbriefe versus Swaps (in bp) Jumbo-Swap 5 years Jumbo-Swap 1 years Source: WestLB Whereas the changes versus swaps were marginal given the turbulences on the financial market crisis, the widening of the spreads of Pfandbriefe versus Bunds was more pronounced. During the period under review they rose from 19 to 49 BP in the 5-year, and somewhat less strongly (from 23 to 41 BP) in the 1-year segment. For investors this means that when they buy an in most cases AAA-rated Pfandbrief, they can collect a pickup of close to 5 BP compared with a Bund. At no time in the last five years was it possible to pick up such a high premium. Spread Jumbo Pfandbriefe versus Bunds (in bp) Jumbo-Bund 5 years Jumbo-Bund 1 years Source: WestLB

24 22 The Pfandbrief Market 27/28 Two further developments compared with previous years warrant mention: 1. On the primary market, too, swap spreads rose again in recent months for the first time in years. The vdp Pfandbrief curve provides the best overview of funding conditions for Pfandbrief banks. The spreads at issue of Mortgage and Public Pfandbriefe as bearer, registered, Jumbo and traditional Pfandbriefe are included here. The markup versus swaps that the banks had to pay for covered funding was still at historic lows in July 27. The vdp Pfandbrief curve showed negative pickups even for 1-year maturities. At the end of June 28, by contrast, it was only possible to float 1-year Pfandbriefe with a yield pickup averaging about 5 BP versus swaps; the corresponding figure for 5-year Pfandbriefe was 3 BP. Spreads vdp-pfandbrief-curve (against Swap) Spread (bp) years 5 years 1 years 15 years Source: vdp 2. After investors had differentiated less and less between issuers over the last years, they recently began paying considerably more attention to the issuing banks, although Pfandbrief ratings have remained stable or have even improved. Here too, however, it has to be said that the Pfandbrief can still be regarded as very homogeneous compared with developments on other markets.

25 23 Covered Bond Market Grows Worldwide The European Covered Bond market also profited in the past years from the confidence placed in the Pfandbrief. For years now, an endless series of new issuers and new Covered Bond legislations have celebrated their debut on the market. This trend continued during the financial crisis, when first-time Jumbo Covered Bonds from Denmark and Hungary, and structured Covered Bonds from Canada were floated. In already established Covered Bond markets such as, for instance, Spain, Sweden, Norway and France, new issuers took to the stage last year and in the first half of this year. And in Germany, HSH Nordbank issued the first Jumbo Ship Pfandbrief and, at the same time, the first rated Ship Pfandbrief in January 28. After its inaugural issue in January of this year, Postbank returned to the market in May with its second Jumbo Mortgage Pfandbrief. In June 28, Deutsche Apotheker- und Ärztebank joined the Pfandbrief market for the first time with a Mortgage Pfandbrief of EUR 5 million. However, the repercussions of the financial crisis can also be clearly felt on the Jumbo Covered Bond market. After years of setting new records in sales of first-time issues, 27 produced the first decline in new issue volumes to EUR 161 bn (26: EUR 176 bn). Nevertheless, the volume outstanding was increased yet again, totaling around EUR 824 bn as at year s end. Between January and mid June 28, new issues totaled EUR 69 bn. This is remarkable in light of the ongoing market disruptions, all the more as issuers of UK Structured Covered Bonds did not place any Jumbo bonds during that period and the issuers of Cédulas, which were always among the largest issuers in previous years, fell back considerably. In 27 almost one quarter of all new Jumbo issues came from France (totaling EUR 4 bn), followed by Cédulas (EUR 36 bn) and Pfandbriefe (EUR 33 bn). So far in the current year, Germany and France together account for more than 55% of the new issue volume of Jumbo Covered Bonds worldwide, with the Pfandbrief leading the table with EUR 21 bn. Whereas in France not only the traditional Obligations Foncières but also structured Covered Bonds have been issued since 26, new issue volume from Germany still only comprises Pfandbriefe. Jumbo Covered Bonds from Scandinavia have likewise played a major part so far in 28, with Denmark, Finland, Norway and Sweden together bringing Jumbo Covered Bonds totaling EUR 13.5 bn.

26 24 The Pfandbrief Market 27/28 Jumbo Covered Bonds: gross new issuance 27 and 28 Jumbo Covered Bonds first-time sales 27: billion 14 1 Germany 2.5 % 2 Spain 22.3 % 3 France 24.7 % 4 Ireland 1.6 % 8 Netherlands 3.4 % 9 Finland.6 % 1 Sweden 3.9 % 11 Portugal 2.8 % UK 1.7 % 12 USA 4.7 % Luxembourg.2 % 7 Austria.6 % 13 Norway 2.8 % 14 Canada 1.2 % 3 Jumbo Covered Bonds first-time sales 28 (until 2. June): 69.3 billion 1 Germany 3 % 7 Sweden 7 % Spain 9 % 8 Portugal 5 % France 26 % 4 Austria 1 % 5 Netherlands 4 % 6 Finland 1 % 9 Norway 7 % 1 Canada 3 % 11 Hungary 1 % 12 Denmark 4 % Source: HVB/UniCredit On the secondary market too, the market shares taken by the individual Covered Bond segments shifted, after the swap spreads of Jumbo Covered Bonds outstanding had increasingly converged over a number of years. Whereas the Jumbo Pfandbriefe outstanding were still trading at roughly the same level as one year before and French Jumbo Covered Bonds, after 5 BP on average in June 27, were outstanding with slightly positive swap spreads, the yield levels for Covered Bonds from Spain and the UK in particular widened distinctly. In terms of the average of all bonds outstanding and of the average of all maturities, at end June 28 Jumbo Cédulas were yielding at swap +46 BP, and UK structured Covered Bonds as much as swap +62 BP. One year before, paper from both segments traded for the most part close to mid-swap.

27 25 Similar developments were seen on the primary market, which scarcely admitted issuers from Great Britain after the financial crisis broke out. Following a period of abstinence lasting months, Cédulas could be issued again in Q2 28, albeit at price levels hitherto unknown on the Jumbo Covered Bond market, ranging up to swap + 83 BP. Although the issuers of Jumbo Pfandbriefe have also paid higher markups recently, there has so far not been a single bond for which the issuer had to pay more than 13 BP versus swaps. Developments on the primary and secondary market for Jumbo Covered Bonds show clearly that Covered Bonds are, against the background of the financial crisis, a reliable funding source. However, the market has experienced an in part significant repricing, with distinct differences emerging between individual segments in the meantime. The main beneficiary of this development is the Pfandbrief with its clear-cut and extensive legal framework, the longest track record of all bonds on the Jumbo Covered Bond market, its firm, systemic anchoring within the German financial system, the important role played by the state supervisory authority and, above all, a loyal German investor base. Swapspreads Jumbo Pfandbriefe and Covered Bonds in bp Market as a whole Public Pfandbrief Mortgage Pfandbrief France Ireland Spain UK Source: LBBW, iboxx; as at June 23, 28 Only recently, the market saw the first Jumbo Covered Bond issue from a private Italian issuer and the debut of Covered Bonds in Greece. New Covered Bonds are, moreover, to be expected from countries such as Greece, Japan or Mexico in the near future, while the issuer base is set to expand further in already established Covered Bond countries.

28 26 The Pfandbrief Market 27/28 Private Placements Continue to Advance Trend Toward Longer Maturities Stopped The vdp examined the structure of the Pfandbrief market also in the current year, conducting a survey that went beyond merely establishing new issue volumes and volumes outstanding, and also took parameters such as type of placement, coupon structure, issue currency and average residual times to maturity into consideration. Whereas such data were previously not available in aggregated form, there is now a time series from 23 to 27, the data for which were requested from the issuers themselves. Information provided by the vdp member banks made up the foundation of this study, representing as they do a market share of some 97% as at end 27. The result is a detailed picture of the German Pfandbrief market that reflects interesting developments: The share of Jumbo Pfandbriefe of the total volume of Pfandbriefe outstanding diminished further in 27, coming to 35.2% at the end of the year compared with almost 4% as at end 23. Since then, the total volume has steadily declined. The development of the ratio of public offerings to private placements has a close bearing on this trend. In 23, only 34.3% of all Pfandbriefe were placed on a private basis compared with 57% well over half in 27. This demonstrates how investor interest in tailored products has grown. Issuers can normally obtain more favorably priced funding through such individual, small-volume Pfandbriefe, regardless of whether bearer or registered paper, than through the public offering of Jumbo Pfandbriefe. Thus, this development offers the Pfandbrief banks advantages. Pfandbrief new issues by placement type 7 % of Pfandbrief new issues public placement private placement Source: vdp

29 27 In 27, too, the greater part of Pfandbrief business was conducted in local currency. The share of Pfandbriefe denominated in a foreign currency rose slightly, from 2.6% to 2.8%, in terms of volume outstanding as at end 27. However, given the drop in new issues of foreigncurrency Pfandbriefe from 4.7% to 2.6% year on year, the volume outstanding of such paper cannot be expected to rise much in the foreseeable future. The trend of a growing share of Pfandbriefe bearing a fixed interest coupon also continued. In terms of securities outstanding, their share rose from 85.3% in 23 to 88.8% only recently. Meanwhile, Pfandbriefe structured as floaters saw their share in new issue business expand from 11.3% in 26 to 14.8% in 27. In contrast, the trend toward longer residual times to maturity seems to be weakening. Whereas the average residual time to maturity of newly issued Pfandbriefe increased from 6.4 years in 23 to 7.4 years in 26, it was 7.2 years in 27. Although the residual time to maturity of the volume outstanding rose from 4.6 to 5.6 years in the same period, the shortening of maturities will also impact the volume outstanding in the years to follow. This effect will be amplified by the fact that an unusually large number of Jumbo Pfandbriefe with a maturity of 3 years or less were issued in the first half-year of 28. A more detailed account of the findings of the survey may be found on the websites both of the vdp and of the European Covered Bond Council (ECBC), where comparable data for the Covered Bond markets of other countries are also available. maturity of Pfandbrief outstanding vs. New issues Maturity Pfandbrief outstanding Maturity new issues Source: vdp

30 28 Amendment of the Pfandbrief Act At the end of 26, just one and a half years after the Pfandbrief Act (PfandBG) entered into effect, work began on a first amendment. The aim was to safeguard the future of the Pfandbrief while keeping it attractive for issuers and investors, yet without compromising the quality standards of the Pfandbrief. One should bear in mind that at that point in time, the capital market was experiencing a growing neglect of risk sensitivity, the result of which was that the quality of the Pfandbrief yielded only very few basis points compared with other financial products. After intense debate, and against the backdrop of the subprime-driven jitters felt on the markets, all thoughts of expanding the business eligible as cover were abandoned. Published at the end of June, the draft bill focuses squarely on the quality of the Pfandbrief, on making technical improvements by implementing practical experience gathered in the application of the Pfandbrief Act since 25, and on the introduction of the Aircraft Pfandbrief. Dr. Otmar Stöcker Association of German Pfandbrief Banks

31 29 Liquidity risk addressed 27 Pfandbrief Act sets forth general rules on the handling of different risks in the cover pools. Whereas concrete limits apply to interest rate, currency and credit risks, liquidity risk has so far not been specifically addressed. In this context, liquidity risk is defined as the risk that, in the event of the Pfandbrief bank s insolvency, the bank is no longer able to provide sufficient liquidity to service Pfandbriefe falling due in the coming months, e.g. large-volume Jumbo Pfandbriefe, in a timely manner. Rating agencies and investors see this as a weakness of the Pfandbrief Act, which is why the rating agencies are calling for additional collateral to cover this liquidity risk. Against this background, under the draft bill on the further development of Pfandbrief legislation, a provision concerning the limitation of the short-term liquidity risk is to be included. As a result, the maximum cumulative liquidity needs of the next 9 days would be assured by assets that may be used as securing excess cover and by other liquid cover assets. All the financial instruments that are entered in the cover register and are classified by the European System of Central Banks (ESCB) as being eligible as collateral for central bank borrowings are deemed to be liquid for this purpose. Additional Collateral It is crucial for the safety of Mortgage Pfandbriefe that the real estate liens guarantee access to the economic substance of the properties. This has to be assured also in the event of unexpected developments, in particular damage to the building. To this end, 15 Pfandbrief Act explicitly calls for building insurance. Under German law the claim against the insurer is included in the real estate lien and consequently belongs to the cover pool. No doubt with this in mind, legislators have so far refrained from expressly requiring that such additional claims be included in the cover pool with the result that, in the event of insolvency, they are at the disposal of the Pfandbrief creditors only and not to the bank s creditors in general. However, the law as yet contains no clear and explicit provision that collateral not covered by the real estate lien belongs to the cover pool. The draft bill clearly states that this additional collateral (in particular assignments or pledges of rent and insurance claims) will be used to safeguard the claims of the Pfandbrief creditors. In order to make the provision easier to apply and not to overburden the cover register, the draft bill provides for an automatic registration, so that these additional assets which belong to the economic substance of the property do not have to be entered in the cover register individually. This applies in like manner to ship mortgages and liens in respect of aircraft. Public-Sector Lendings of Credit Quality Step 1 One declared objective of the draft bill is to ensure that Public Pfandbriefe conform to the Capital Requirements Directive (CRD) by amending 2 Pfandbrief Act. The implications here are that investors would not have to examine the actual status of the individual issuers cover assets in terms of their CRD conformity. What is more, the danger would be eliminated that a

32 3 Amendment of the Pfandbrief Act Pfandbrief bank could lose the privileged risk weight for its Public Pfandbriefe in the event of a change of its public-sector cover assets. Ultimately, the result is that the German Public Pfandbrief market would stay homogeneous inasmuch as a differentiation between CRD-conforming and non CRD-conforming Pfandbriefe would not be necessary. Where claims against third states (outside the EU/EEA) are concerned, CRD conformity is assured through a statutory link with credit quality step 1. In contrast to the CRD (Directive 26/48/EC), however, under 2 Pfandbrief Act not all third states of credit quality step 1 are to be considered eligible as cover, but only the third countries which are currently eligible as cover, i.e. USA, Canada, Switzerland and Japan. Aircraft Pfandbrief The main new feature with regard to business eligible as cover is the proposal that aircraft financings be permitted as cover assets for a new Pfandbrief category, the Aircraft Pfandbrief. During the legislative procedure for the Pfandbrief Act, the Finance Committee of the German Bundestag asked the Federal Government to look into whether statutory regulations should be created for an Aircraft Pfandbrief. In light of the continuing high funding needs of banks that extend aircraft financings, the legal prerequisites for the issuance of Aircraft Pfandbriefe are now to be incorporated into the Pfandbrief Act. As with Mortgage Pfandbriefe, Public Pfandbriefe and Ship Pfandbriefe, separate cover pools are to be set up for Aircraft Pfandbriefe. For the next five years the draft bill forecasts a new lending volume in aircraft financing of approx. 45 billion per year. Together with the financings already in these banks loan books, this should constitute an adequate basis for sustainable and sufficient volumes of Aircraft Pfandbriefe to be issued. Given the fierce competition among international market participants in the aircraft financing business, the possibility of funding through Pfandbriefe would boost the competitiveness of the credit institutions operating in Germany. In light, in particular, of the latest crisis on the international capital markets, which caused the securitization segment to dry up, the Aircraft Pfandbrief is likely to meet with strong interest from issuers and investors. Loan claims secured by liens in respect of aircraft would be a suitable means of forming a Pfandbrief cover pool in the same way as liens in respect of ships. Ships and aircraft are movable durables that are used to transport people and goods. Both have a long useful life. The security instruments legally required for a Pfandbrief exist both in the case of ships and of aircraft. The registered lien in respect of an aircraft is a security interest of a quality and reliability equal to those of the ship mortgage. Because the secondary markets for aircraft are liquid and efficient, the realization of aircraft is assured. The draft bill makes stringent demands with respect to the statutory collateralization of aircraft financings, so that the high level of safety that German Pfandbriefe afford creditors is also assured where the Aircraft Pfandbrief is concerned.

33 31 Administrative Easements The draft bill provides for a number of easements of a purely administrative nature, which have no impact on the quality of the Pfandbrief itself. One of the most important provisions has to do with the abolition of the practice of Treuhändermitverschluss (safekeeping by the cover pool monitor under dual control). This practice was once most significant in connection with certified mortgages in that it made it de facto impossible to dispose of the mortgage claim, because the cover pool monitor held the mortgage certificate in safekeeping in the bank s safe. Only the bank and the cover pool monitor together had (or have) access to the contents of the safe. Certified mortgages have not been used in Germany for many years. Instead, registered land charges and foreign registered mortgages have become the rule. Thus, there are no certificates that would need to be put into safekeeping, thereby preventing the claim from being disposed of. The same applies to ship mortgages. In securities, too, there has for years been a clear trend towards paperless business. Physical securities are rarely used nowadays as cover assets for Public Pfandbriefe. It is not surprising, therefore, that none of the new sets of rules governing Covered Bonds that have been introduced in many European countries in recent years have assumed the German practice of Treuhändermitverschluss something that cannot be said of many other rules. This is to say that Treuhändermitverschluss is legally obsolete and can be abolished without jeopardizing the quality of the Pfandbrief. Other, no less important, technical easements concern the abolition of the nominal interest matching principle and of the calculation of interest cover, and of the obligatory redemption of cover mortgages after not more than 1 years. Both are of doubtful effectiveness and unnecessary, besides being unclear and extremely complex to implement. Their elimination will not impair the Pfandbrief s quality. Ships The draft envisages changes, some of which are of a legal nature or serve clarification purposes, for the Ship Pfandbrief sector. These changes make it easier for issuers to include ship mortgages in cover and to fund lending activities through Ship Pfandbriefe without any negative impact on the quality of the Ship Pfandbrief. For instance, the permissible maturity of ship mortgage loans is raised from 15 to 2 years. However, the maximum permissible age of ships for lendings that serve as cover is unchanged at 2 years. This means that a loan can be granted for the entire 2-year useful life of a ship, as assumed in the Pfandbrief Act. In actual fact, the economic life of ships is usually at least 25 years, so that it is still more than long enough for the ship to serve as security for the Pfandbrief.

34 32 Amendment of the Pfandbrief Act Legal Clarifications A number of provisions contained in the draft bill seek to clarify questions that have arisen in connection with the funding register. For instance, when the Pfandbrief Act was drafted a number of passages were not at least in the opinion of the rating agencies legal advisors sufficiently clear. These primarily concern the use of the funding register for syndicated loans and pooling models. The draft bill resolves a conflict between the cover register and the funding register that has long been a moot point. Often, credit institutions have from the outset an economic interest in granting a large loan through a syndicate, or in transferring part of it to other credit institutions, thereby assigning part of the loan claim to other (syndicate) banks. To cut down on costs and administration caused by transferring the registered land charges, which have by far predominated in practice for years, the land charges are created directly for the syndicate leader. The syndicate leader then holds them in a fiduciary capacity for the other syndicate members. The maintenance on a fiduciary basis of registered land charges by the syndicate leader for the syndicate banks is problematic, however, when the syndicate leader is a Pfandbrief bank that has included a part of the claim in cover, and now uses the funding register to hold on a pro rata basis a registered land charge belonging to the cover part of the claim in a fiduciary capacity for another Pfand-brief bank (syndicate bank). In such a case, the view taken is namely that 6% of the mortgage lending value of mortgage loans is always included in cover, even if the syndicating Pfandbrief bank (syndicate leader) has entered a lower value in its cover register. The consequence is that, when the funding register is used, a conflict arises between the syndicate leader s cover register and the funding register (and also, therefore, the cover register of the syndicate bank). Thus, in the event of the syndicate leader s insolvency, the part of the land charge entered in the funding register would also be included in the syndicate leader s cover pool and, with that, belong to the special assets of the syndicate leader. The syndicate bank would therefore be unable to realize beyond any doubt its right to separation of the assets stemming from the entry in the funding register. In the absence of an insolvency-proof right, the syndicate bank would not be able to include the syndicated parts in cover. The draft bill clearly states that the asset parts made available to the syndicate banks in the cover register through the funding register may be classified as not belonging to the cover pool, i.e. they are not cover assets of the syndicating Pfandbrief bank (syndicate leader). Thus, the mortgage loans and real estate liens belong to the cover pool only in the amount in which they are entered in the cover register. Furthermore, the draft bill includes non-german EU Pfandbrief banks in the sphere of application of the funding register. In practice, interest is strong in also being able to use the funding register within the scope of syndicated financings with foreign EU institutions. The prerequisite for use of the funding register in cross-border syndicated loans is that non-german EU institutions may be beneficiaries under the funding register regime. Under Section 22a subsection 1 German Banking Act (KWG) the funding register may only be used in favor of a special purpose vehicle, a refinancing intermediary or a Pfandbrief bank.

35 33 The term Pfandbrief bank within the meaning of 22a subsection 1 German Banking Act also includes, in an interpretation conforming to EU law, non-german EU institutions which engage in Pfandbrief business. If the term Pfandbrief bank were restricted to the business of German institutions, only German institutions would be able to use the funding register. Excluding institutions of other EU states from being able to use the funding register would probably violate the freedom of capital movements of the non-german EU institutions. In order to concretize the term Pfandbrief business, reference is made to the eligibility criteria for Covered Bonds pursuant to Art UCITS Directive. Given the insolvency-law objective of the funding register, the main criterion in concretizing Pfandbrief business is: which foreign EU institutions have a cover pool that is protected under insolvency legislation and therefore investors who require protection under insolvency legislation. Moreover, the draft bill expressly rules out a forced sale by third parties. Under 22j subsection 1 sent. 1 German Banking Act, a claim becomes insolvency-proof when it is entered in the funding register. However, Section 22j German Banking Act does not explicitly give protection against forced sale by third parties in respect of the assets entered in the funding register, although such protection does result from general principles of law. Rating agencies and Pfandbrief analysts have, however, questioned the protection against forced sale. The draft bill explicitly states that this protection is given. Summary The proposals contained in the draft bill are to be warmly welcomed, as they heighten the safety of the Pfandbrief. Outdated and unwieldy procedures are eliminated, enhancing the efficiency of the provisions of the Pfandbrief Act. The introduction of the Aircraft Pfandbrief gives German Pfandbrief legislation an innovation that will strengthen the competitive position of the German Pfandbrief banks in international lending business.

36 34 Market Making for Jumbo Pfandbriefe: Quo vadis? When the first Jumbo Pfandbrief was brought to market in 1995 its success was driven by the issuing volume, pricing, and not least by the pledge to quote two-way prices. Today, this is known as market making. For the first time, Frankfurter Hypothekenbank created a Pfandbrief issue with real liquidity, quoting a fixed bid-offer spread of 1 pfennigs for single tickets up to DM 1 million. The concept of issuing Jumbo-format Pfandbriefe with a pledge to quote a bid-offer spread was quickly adopted by other institutions. Franz-Josef Kaufmann Eurohypo AG

37 35 35 Instead of individual banks placing large-volume issues, the next logical step was to commission an issuing syndicate with the job of marketing the Jumbo Pfandbrief issues and of subsequently assuring market making. Market making subsequently became a constituent component of the Minimum Standards for Jumbo Pfandbriefe. For an investment bank to have the status of market maker for a Pfandbrief is not necessarily dependent on its belonging to the placement syndicate. As a rule, however, all syndicate members are at the same time market makers for the issue they place. The market making commitment is formally set down in the agreements concluded between the Pfandbrief banks and investment banks (= underwriting syndicate). The Basic Understanding Part of the basic understanding both of the issuers and of the investment banks engaged in market making is that quoting two-way prices at all times is a central feature and, with that, a fundamental component of a Jumbo Pfandbrief issue and indeed of the Pfandbrief market as a whole (see Chart 1: Current market making standards). This gives Jumbo Pfandbrief investors the certainty that they can at any time place large buy and sell orders within tight bid-offer spreads. Thanks to its liquidity, then, the Jumbo Pfandbrief is classified as a rates product. The market making commitment refers both to the active quoting towards customers and to market making by investment banks among each other (interbank market making). Thus, in secondary market making activities towards investors, possible positions can be distributed among several investment banks, even though the investor has approached only one of these banks with a buy or sell order. It is generally understood among investors that a well-functioning interbank market making is the basic prerequisite for tight bid-offer spreads and corresponding volumes. Chart 1: Current market making standards Jumbo Pfandbrief Market making standards (as of August 26) Bid /offer spreads dependent upon maturity minimum 5 syndicate banks two-way prices for lots up to 15million suspension must immediately be communicated recommendations: separate lines for Pfandbriefe issuer credit related topics effecting market making must immediately be discussed within the MIC up to and incl. 4 years: 5 cents 4 years to 6 years: 6 cents 6 years to 8 years: 8 cents 8 years to 15 years: 1 cents 15 years to 2 years: 15 cents 2 years to 25 years: 25 cents

38 36 Market Making for Jumbo Pfandbriefe: Quo vadis? In principle, the contractual arrangements between issuers and market makers are sufficient to ensure market making. Yet in the history of market making there have been repeated crisis situations. These can occur due to general market upheavals and volatilities or may result from individual credit events. In 25, the problems suffered by Pfandbrief issuer AHBR led to the partial discontinuation of market making for that bank s Jumbo Pfandbriefe. Two main lessons were learned from that situation. First: the market s understanding of the high quality of the Pfandbrief and, in particular, of the uncoupling of unsecured risk vis-à-vis the issuer needed to be deepened. Second: all the parties involved had to admit that communication towards the market participants was not at its best, triggering uncertainty among investors in particular. vdp responded quickly to the crisis by forming a market making working group that comprised capital market experts from several Pfandbrief issuers. Modification of the Minimum Standards for Jumbo Pfandbriefe To prevent such occurrences from happening again as far as possible, the Pfandbrief issuers which together make up the Association of German Pfandbrief Banks (vdp) in 26 initiated a modification of the Minimum Standards for Jumbo Pfandbriefe. The main focus was placed on rules of communication between market makers and issuers, and towards investors. One major change was the Market Maker and Issuer Committee (MIC), which the vdp set up jointly with market makers. As its name suggests, this body consisting of representatives of the issuers (the a.m. working group) and the market makers concerns itself with topics relating to the Jumbo market, and in particular with any problems arising on the market or for individual issuers. Meetings are convened at short notice if critical situations become imminent, the aim being to find solutions. The modification of the Minimum Standards was also discussed with the market makers in this circle. An explicit recommendation was built into the Minimum Standards for Jumbo Pfandbriefe which permits the suspension of market making in compelling situations, whereby such action must be communicated without delay. The rules and measures set forth for the Pfandbrief proved a success until the Pfandbrief as the US subprime crisis went on was punished along with other Covered Bonds. By the end of July 27 the shockwaves caused by the US subprime crisis, which had been smoldering for several months, were palpable on the capital market. The markets were in a state of nervousness, volatilities took on dramatic proportions, and investors appetite for risk dwindled in just a very short time. When the troubles began, market making for Jumbo Pfandbriefe held up well. The investment banks shrugged off considerable uncertainty, high volatility and soaring yield gaps between Bunds and swap rates to continue market making for Jumbo Pfandbriefe, ensuring the basis for good liquidity on the secondary market. Pressure on market making grew more intense the more differentiated the prices for the different Covered Bonds became. At European level, market making for all Covered Bonds was looked upon and discussed as being for one product group, although significant differences in volatility were clearly discernible. The yield gaps separating Pfandbriefe and swap rates largely remained constant.

39 37 First Problems in the Second Half of 27 The situation changed for the Covered Bond segment early in September 27, when spreads for structured Covered Bonds and Spanish Cedulas in particular widened dramatically (see Chart 2: The Pfandbrief a premium product in the covered bond market). At the same time the hedge markets, notably the swap markets, dried up, making it increasingly difficult for market makers to hedge their positions. The risks on their books rose, and the pressure on market making to cut back positions grew. The Jumbo trading desk of an investment bank is usually responsible for the entire segment. As a result, a discontinuation of market making affects all Covered Bonds including Pfandbriefe. The discontinuation of quotations on the electronic trading platform MTS had repercussions not only for Jumbos Covered Bonds but also for a large number of government bonds and issues by supras and agencies. By contrast, market making via voice-based trading still functioned virtually hitch-free, ensuring that Pfandbrief investors were provided with adequate prices at all times. In early September 27 the market makers represented in the ACI responded to the mounting difficulties by doubling the bid-offer spreads (see Chart 3: Timeline). The volumes ( 15 million) were left unchanged. Interbank trading, in particular with Pfandbriefe, was maintained although not all market makers found it easy to honor their commitment. Chart 2: Covered bond market - swap-spreads in comparison Jun-7 Jul-7 Aug-7 Sep-7 Oct-7 Nov-7 Dec-7 Jan-8 Feb-8 Mar-8 Apr-8 May-8 Jun-8 Jul-8 France Covered German Mortgage Pfandbriefe German Public Pfandbriefe Spanish Covered Ireland Covered UK Covered Source: IBOXX

40 38 Market Making for Jumbo Pfandbriefe: Quo vadis? Chart 3: Time bar Early Sep 27: 21. Nov 27: 4. Jan 28: From Mid Mar 28: Widening bid/offer spreads to 2x Interbank market making for all Covered Bonds stops New Years begin, all CB s 2x spreads EUR 15mn Market makers topped asking prices each other Q3/7 Q4/7 Q1/8 Q2/8 18. Sep 27: ECBC plenary, 8-to-8 committee meets 26. Nov 27: Interbank market making begins again 3x bid offer spreads for EUR 5 mn 11. Jan 28: Tiering : 2x spreads for EUR 15mn if < E+2 max 3x for EUR 5mn if > E+2 At the end of September 27, the ECBC decided to create a committee at European level along the lines of the German MIC. Called the 8-to-8 Market Maker/Issuers Committee, its task was to deal with acute problems on the Covered Bond market. This committee comprises representatives of the largest market makers in terms of their market making commitments, and representatives of issuers of the largest Covered Bond markets (see Chart 4: Joint committees of issuers and market makers). The 8-to-8 Committee was designed as a platform for an open, yet confidential discussion of issues before passing a recommendation on to the ECBC Steering Committee. Each member may convene a meeting by conference call at short notice and at any time, particularly if requested by a third party. The aim is for the committee to be able to give the market a consistent recommendation that has been debated and agreed upon. Subsequently, the situation on the Covered Bond market at first calmed down. However, the increasingly serious upheavals witnessed on the markets as the financial crisis persisted meant that action was still necessary. In mid November 27, the market situation escalated to such an extent that the 8-to-8 Committee felt compelled to recommend to the ECBC that interbank market making be ceased for 3 banking days. The German Market Maker and Issuer Committee (MIC) followed suit in the interest of a uniform line of action for the Covered Bond market as a whole. Differentiation of the Covered Bond Market Interbank market making was resumed after three working days. In response to the volatile market environment the bid-offer spreads were widened three-fold and the ticket size was reduced from EUR 15 million to EUR 5 million. During this phase, too, the Pfandbrief market showed itself to be remarkably robust thanks to its depth and the Pfandbrief s firm anchor-

41 39 Chart 4: Common committees of issuers and market makers Pfandbrief Community MIC (Market Maker and Issuer Committee) Covered Bond Community (ECBC) 8-to-8 Market Maker and Issuer Committee founded June 26 supported by the vdp and ACI six issuer major Pfandbrief issuer (DG Hyp, Eurohypo AG, HRE, HVB, LBBW, Münchener Hyp) five Pfandbrief market maker (Barclays, Commerzbank, Deutsche Bank, DZ Bank and WestLB) founded September 27 supported through the ECBC eight largest market makers (Eurohypo AG, Caja Madrid, CFF, DEPFA Bank plc, ABN Amro, Caxia Geral, Nordea Bank and HBOS) eight issuers from major jurisdictions (ABN AMRO, Barclays Capital, Deutsche Bank, Dresdner Kleinwort, DZ Bank, HSBC Bank plc, Natixis and Unicredit Corporates & Markets) ing in the domestic market in particular. The spreads remained stable. This strong and highly effective domestic market, which is capable of accommodating smaller Pfandbrief issues at virtually any time, and the constant demand for registered Pfandbriefe made it possible to satisfy funding needs without Jumbos. Thus, Pfandbrief issuers were not forced to resort to highprofile, large-scale transactions in a troubled market environment, with pricing concessions that would automatically have put pressure on the secondary market. At this point, thought was also being given to the extent to which differentiation in the market making for the different products might help. It became obvious that the problems afflicting other markets were being socialized at the Pfandbrief s expense. The overall market situation still did not relax as had been hoped. The traditional Christmas break in market making brought some calm with it but it proved to be a deceptive calm. The ECBC and 8-to-8 Committee agreed at the beginning of January 28 to resume interbank market making at twice the bid-offer spreads and at ticket sizes of EUR 15 million. However, hopes that market making would return to normal were dashed. Different banks went about their market making activities in very different ways. Faced with these circumstances, a few days later the ECBC was forced to discuss splitting the market, and indeed subsequently recommended such a split. As a result, Covered Bonds with a swap spread of 2 basis points and more in secondary market trading were traded at three times the bid-offer prices and at ticket sizes not exceeding EUR 5 million among the investment banks. Covered Bonds with a swap spread below 2 basis points, which included the Pfandbrief, were traded at twice the bid-offer prices and at ticket sizes up to EUR 15 million. Fears that market participants might offload their Pfandbrief investments on a large scale because of the better liquidity, thereby depressing prices, proved unfounded. On the contrary, the market remained well-disposed towards the Pfandbrief. This was underscored by a number of successful Jumbo Pfandbriefe placements in the first four months of 28.

42 4 Market Making for Jumbo Pfandbriefe: Quo vadis? The financial market crisis came to a head in March 28 when the investment bank Bear Stearns, too, had to be taken over. Since then, interbank market making has come to something of a standstill. Market makers rarely ask each other for quotes, choosing instead to try and square the customer flows in-house. Nor did the takeover of Düsseldorfer Hypothekenbank by the deposit insurance fund of the private banking sector to prevent the bank s possible distress have a lasting effect on the Pfandbrief spreads on the secondary market. Even when there was no market making in Q2 28, Jumbo Pfandbriefe issuing activity was brisk. However, issuers have learned that without market making in a volatile market environment, the new issue premium (markup versus the secondary market curve) is higher than in normal times. It is noticeable, moreover, that the market is differentiating more strongly between Public Pfandbriefe and Mortgage Pfandbriefe. The resultant gap has widened from about 1 basis point at the beginning of the crisis to 5 to 6 basis points. As the situation on the hedge market became more stable, and given the robustness of the Pfandbrief market, more and more investors called for a return to regulated interbank market making. The issuers are taking these remarks seriously as they want the Pfandbrief to remain a liquid product, i.e. be seen as a rates product, also in future. Talks have since been started with the market makers to discuss what steps would have to be taken for market making to return to normal. The stability of the outcome takes priority over speed in this case, as nothing would harm the market more than hectic actionism with only short-term solutions. Greater Transparency Needed Notwithstanding contractual obligations, during the course of the financial market crisis of 27/28 the Pfandbrief issuers showed considerable understanding for the plight of the investment banks, which were no longer able to adequately hedge their risks in market making. At the same time, of course, issuers expect contracts to be fulfilled not only during fair weather conditions. This should also entail, in the Pfandbrief issuers view, that investment banks responsibly bring themselves into the dialog concerning a return to market making. At first glance, the advantages of market making appear to benefit only the issuers and investors. But upon closer inspection, it becomes clear that investment banks have built up an entire field of business around the Covered Bond business. The wish to preserve it ought to motivate market makers to actively seek solutions for rendering the market making system more robust and crisis-proof. The large majority of all the parties involved are convinced that interbank market making is an indispensable part of the Pfandbrief market. The crisis revealed weaknesses, some of which have been remedied in the meantime. For instance, in addition to the MIC at German level a crisis team has also been created at European level in the form of the 8-to-8 Committee. Taking a differentiated view of the different Covered Bond markets with respect to market making ensures that consideration is given to the different statutory frameworks and structures of Covered Bonds, which in turn are reflected in the appraisal of risk by the markets.

43 One flaw concerns the question of transparency in market making. At the latest when the trading of Covered Bonds on EuroCreditMTS was discontinued at the beginning of the financial market crisis, pricing lost some of its transparency. Only off-floor trading remained, which does not offer this transparency. Investors confidence in fair pricing by the market makers was subjected to a severe test. What is more, the withdrawal to off-floor trading meant issuers were unable to directly follow market making activities, to combat rumors at any early stage, or to provide an appropriate response to criticism from the market. Under such circumstances, the issues are scarcely in a position to control whether the market makers meet their obligations. Transparency is crucial to Pfandbrief issuers, and they are supportive of all efforts to enhance it. For this reason, the establishment of an efficient electronic trading system for Pfandbriefe is held to be of key importance to the quality of future interbank market making. The objectives in this respect are twofold. First, electronic trading is to be made more resistant to crisis. This can be achieved by changing to the request for quote system. Experience has shown that in times of crisis, market makers are not in a position to quote tradable prices on a permanent and direct basis for all Jumbo Covered Bonds. Moreover, crisis mechanisms can be incorporated into an electronic trading system that take pressure off market making depending on market volatilities, and apply in like manner for all concerned. Second, transparency is to be greatly improved for investors and issuers alike. Intensive talks with leading market makers have shown most of the community to be very receptive to these ideas. The vdp market making working group is actively involved in the ongoing dialog and is endeavoring to give the process a positive forward thrust. It is also noticeable that providers of electronic trading systems see this market development and are working on concrete solutions. The Pfandbrief banks are unable to exercise any direct influence on investment banks in this question. However, one should not overlook the often symbiotic relationship the parties involved share through the wide-ranging transactions market makers conduct. The investment banks who pledge to engage in market making for a Jumbo Pfandbrief usually belong to the syndicate that places the Jumbo on the market. For their work within the syndicate, and for market making, the investment banks receive management and underwriting fees which vary according to the life. For instance, these fees come to about EUR 1.6 million for a Jumbo Pfandbrief with a life of five years and a volume of EUR 2 billion. Apart from mandates in connection with the placement of a Jumbo, market makers maintain a great many other contacts to the various issuers. All in all, the business contacts are so numerous as to make both issuers and investment banks interested in a good working relationship. After all, it is in the interest of both sides that the success story of the Jumbo Pfandbrief continues. Against this background, the Pfandbrief banks which together make up the vdp are confident that together with the investment banks they can lay the foundations for a market making that will also function smoothly in more difficult times. Market making in interbank trading and towards investors is the basis for liquid secondary market trading and makes the Jumbo attractive for international, trading-oriented investors. Past months have made it unmistakably clear that we have much to learn in order to make an existing, successful market making more crisisresistant. All the players ought to seize this opportunity under the motto: Lessons learned. 41

44 42 Pfandbriefe in periods of financial crisis Quality prevails They are more valuable now than ever before. This is now, no doubt, an accurate description of the importance of Pfandbriefe to the Treasury and Refinancing departments of large banks. In the continuing global financial market and banking crisis, German Pfandbriefe have given an outstanding demonstration of their worth. Ernst-Albrecht Brockhaus, Horst Bertram BayernLB

45 43 They are more valuable now than ever before. Every treasurer with this product in their collection of refinancing instruments can endorse this assessment of German Pfandbriefe. German Pfandbriefe have performed impressively during the global financial market and banking crisis. The high quality standards demanded by law, the regulator and the issuing banks mean that demand from investors has never dried up. Even in the face of dramatic headlines in the media, Pfandbriefe were still in demand. The product is therefore also important for the refinancing of a large commercial bank. The advantage of Pfandbriefe lies above all in relatively cheap refinancing conditions and the possibility of maintaining long-term capital market funds, even during tough times. Since the financial market crisis broke out in summer 27, banks have generally received sufficient new unsecured funds from the capital markets. However, maturities are currently relatively short at between two and three years. Pfandbriefe offer the issuer the possibility of diversifying the investor base, maintaining relatively high volumes often with a relatively short preparation time and thus also of optimising asset/liability management. National and international investor confidence in German Pfandbriefe is not a given, but instead needs to be justified by all participants on a daily basis. The Pfandbrief Act (PfandBG) provides a sound, conservative legal framework. Its upcoming amendment will result in further measures to improve quality (e.g. by addressing short-term liquidity risk in cover pools). Supervision by the German Federal Financial Supervisory Authority (BaFin) and the German Bundesbank also contributes to confidence in Pfandbriefe. 1 Strict supervision is a good thing The German supervisory authorities see Pfandbriefe as being of fundamental importance to the financial system, and have already given clear proof that they pay more than just lip service to this idea. The positive performance of Pfandbriefe during the financial market crisis, particularly compared with most of the competition in European covered bonds, clearly shows that investors prefer products with a legal basis and an interested, proactive regulator. In other words, investors seem to attach greater importance to having a strong monitoring authority than to contractually fixing every detail just in case. But it is ultimately down to the issuers themselves to keep the national and international investor base balanced. Investors, whose capital the continuously growing number of issuers are chasing, expect more and more insight into the issuer s activities, its credit rating and regular, meaningful information on the quality and breakdown of the cover pools. In the past 12 months, investors have begun to demand significantly more information.

46 44 Pfandbriefe in periods of financial crisis Quality prevails You don t need to be clairvoyant to predict that wealthy investors will ask for information above and beyond the published transparency reports required by Section 28 PfandBG. However, as a legal minimum standard and for the purpose of comparison, the Section 28 data are unique in the covered bond universe and are to be welcomed. Investors are particularly interested in whether they will be serviced on time and without any problems with cash flow from the register of cover in the event of the issuer experiencing serious difficulties. Ratings of each of the types of Pfandbriefe used (public-sector and mortgage-backed, among others) by the three leading agencies, Fitch Ratings, Moody s and Standard&Poor s, can also contribute to transparency. In our view, initiatives from agencies, aside from regular studies, to make the most current data on cover pools available to investors should be welcomed as long as these occur to a sensible degree and take into account the specific features of the Pfandbrief system. This is also an area of opportunity for issuers who are prepared to offer more transparency. 2 Customised premium product German Pfandbriefe should exploit their benefits more than they have done to date particularly with regard to quality. According to the initiative of the Association of German Pfandbrief Banks (vdp), as a premium product, German Pfandbriefe should be further distinguished from international competitors. The parties involved are aware that this product needs to be actively maintained. Aside from the information and transparency offered and the legal framework, this depends in particular on issuers putting investors at the heart of their own activity and providing them with customised products that cater to their requirements. This is demonstrated in the domestic market in particular, where regular small-volume orders are executed with investors. If the investor wants a specific coupon, a specific maturity, a specific structure and does not get this, he will turn to the competition, who are only an inexpensive telephone call away. This also includes being prepared to execute small tickets. For example, at BayernLB in 27, placements of mortgage-backed Pfandbriefe with a total volume of EUR 2.2 bn were spread across around 5 different series and a variety of individual tickets. In the same period, public-sector Pfandbriefe of EUR bn were spread across 192 different series. However, it is also important to maintain an active market for own securities not to be confused with market making for Jumbo Pfandbriefe and also to show flags when trading on the stock market. Traditionally, a portion of the demand from German investors is for registered Pfandbriefe. During periods of low capital market yields in particular, these bonds enjoy enthusiastic demand from investors who do not have to carry out mark-to-market valuation for registered securities. These are almost exclusively long-term oriented investors who are also prepared to acquire registered Pfandbriefe with maturities of well over 1 years. Last year, the share of registered securities in sales at our Bank was over 1% for mortgage-backed Pfandbriefe and almost 15% for public-sector securities.

47 45 There are also national and international investors who favour the liquid version, Jumbo Pfandbriefe, with a volume of at least EUR 1 bn. These investors are far more trade-oriented, compare the yields from jumbos with those from agency bonds (for example, from development banks such as Bayern Labo, KfW, Rentenbank) and invest when relative price competitiveness is judged to be right. While there were phases during the years following the creation of the jumbo segment (1995) when Treasury departments could still aim for refinancing benefits regarding price, the situation has been reversed for several years and a jumbo which should give investors a big sum all at once often requires a certain yield premium compared with traditional Pfandbriefe. spread development vs. swaps (bp) Jul 7 Sep 7 Nov 7 Jan 8 Mar 8 May 8 Jul 8 Unsecured bonds of big banks Pfandbrief All Covered Bonds Source: IBOXX 3 Jumbos open doors The question of whether it is more sensible for issuers to issue jumbos or small volume traditional Pfandbriefe is not a straightforward one. The focus is naturally primarily on the requirements of the investors, whose demand can lead to significant shifts in volumes issued (jumbo/ non-jumbo issue). Even during periods of very high demand for small volume securities, it is still necessary to display a jumbo flag. This services the demand for liquid Pfandbriefe and also creates the possibility of being seen by international investors, who do not regularly acquire small volume Pfandbriefe. Even in difficult periods on the financial markets, when it is not easy to place unsecured bonds with international investors, jumbos play an important role in opening doors to maintain a dialogue with these investors, transmit the information necessary to keep credit lines open and hear about changes in investment preferences. Jumbo or not; this depends on the volume that the bank concerned can actually issue based on the available cover.

48 46 Pfandbriefe in periods of financial crisis Quality prevails If the total cover pool is relatively low, the concentration of the due date of a very high share of Pfandbriefe liabilities on a fixed date would not only put unnecessary stress on collateral and cash management, but potentially also on the desired AAA rating. Naturally, rating agencies do not view mismatches between the due dates of bonds and coverage favourably and this is supported by very high requirements for coverage and maintaining liquidity, which make reasonable cover pools difficult for a jumbo issue. It is therefore advisable for the issuer to hold off from issuing a jumbo with a low register of cover. Trends in public-sector and mortgage-backed Pfandbriefe will diverge in the next few years. To date, issuing jumbo public-sector Pfandbriefe has been relatively straightforward. However, in the next few years, it will become more difficult for issuers to provide investors with the desired volume of new public-sector Pfandbriefe. This is due to two factors in particular. With the cessation of the state-backed guarantee obligation and guarantor s liability support mechanisms, new securities issued by savings banks are no longer suitable for arranging cover. By contrast, public sector financing in general has become very difficult. As many state or sub-state entities often have a better credit rating than the financing banks and the budget situation has often become quite comfortable, it is currently a challenge for banks to generate sufficient lucrative business for the register of cover. In periods of falling risk appetite, it appears to be necessary for an increasing number of banks to only issue credit to this sector if the congruent maturity refinancing also provides a positive interest margin. As a result, in the next few years, the volume of public-sector Pfandbriefe falling due will be significantly higher than the volume of new issues; i.e. the dominance of public-sector Pfandbriefe will decrease and this class of Pfandbriefe will gain a certain scarcity value. By contrast, the mortgage-backed Pfandbriefe segment is likely to grow in the medium term, as evidenced by a number of factors in addition to the attractive refinancing costs. Landesbanks are looking for an efficient option to enable savings banks to refinance their real estate financing using Pfandbriefe without the savings banks themselves having to develop the very costly and time-consuming structure to issue their own Pfandbriefe. The Pfandbrief Act and the German Banking Act (KWG) offer an option to do this, using the refinancing register and pooling structures. For savings banks that don t have a definite need to refinance, there is also the option of making appropriate cover pools available to the Landesbank and achieving margins this way. By contrast, there is still generally no suitable, straightforward technical solution for processing this type of transaction for mortgage-backed Pfandbriefe and the corresponding cover pools. Solutions are anticipated here in the foreseeable future, and banks which can offer them will then as technology is key take over market leadership and be able to add a new and desirable feature to German Pfandbriefe. Similar structures are, of course, also conceivable for the relationship between locally-based cooperative banks and their controlling bodies. In order to meet the increased demand for information from investors, it will become necessary for issuers of mortgage-backed Pfandbriefe to give more insight into cover pools. In future, investors will have more opportunities to invest in focused cover pools, as some issuers are seeking to distinguish between residential and commercial loans. A clear and convincing model, professional management of real estate operations, comprehensive transparency regarding the quality of cover pools and active communication with investors will be the key to successfully placing this asset class and not only during difficult periods on the capital markets.

49 47 4 Technical aspects are important In addition to meeting investors requirements, Treasury interests and business-specific aspects also play a significant role in refinancing. The main issue, without a doubt, is how to hold sufficient volumes in the register of cover. In addition, management of the register of cover represents a demanding, labour-intensive and time-consuming activity. Only an optimised process will enable a bank to make effective use of Pfandbriefe when refinancing. Good collateral management not only manages the register of cover for the Pfandbriefe, but also ensures the collateralisation of alternative sources of refinancing, manages the cover for the liquidity facilities at the central banks, deposits collateral with stock exchanges, clearers and brokers and takes on operational margining for repos and OTC transactions and collateralisation of loan transactions. Using the refinancing register also offers the option of optimising registers of cover for Pfandbriefe, where these are also available at subsidiaries, with regard to structure, cash flows and ratings, etc. 5 Summary German Pfandbrief issuers will continue to foster and cultivate their premium product, focussing on further improving its quality; the upcoming amendments to the law will bring about further improvements in this area. German issuers could face the task of improving transparency for investors yet further, as the competition for investment funds will become even tougher, but this is a competition they will win.

50 48 The Pfandbrief and the ECBC s Essential Features of Covered Bonds The answer to the question What is a Covered Bond? is important to issuers and investors alike, given that the term is not legally protected. To this end the article explains the Essential Features of Covered Bonds agreed upon by the European Covered Bond Council (ECBC), and analyzes the extent to which the Pfandbrief complies with the essential features. The analysis shows that the Pfandbrief clearly exceeds requirements. Ralf Burmeister LBBW

51 The capital market can be quite simple at times. Look up, say, the definition of Covered Bonds in a relevant book of law. In Germany, if you were to translate the term Covered Bonds into German ( gedeckte Schuldverschreibungen ) you would quickly come across a definition in Section 2a German Banking Act (KWG), to the effect that gedeckte Schuldverschreibungen are Pfandbriefe as defined in 1 par. 3 Pfandbrief Act. The sentence ends there, to be followed not by a full stop but by a list of conditions under which bonds in addition to the German Pfandbrief can achieve the status of a gedeckte Schuldverschreibung or Covered Bond within the meaning of the German Banking Act. It would be inappropriate to deal with these conditions in depth here. Nevertheless, it is interesting to note that German legislators (like most of their counterparts in Europe) do not stipulate a list of individual Covered Bond products from countries A, B, C, etc. Instead, they define criteria the bond must meet to qualify for Covered Bond status. The reason for this is obvious. They want to be independent of legislations in other countries to which, in cases of doubt, they could not respond quickly enough in their own legislation in any case. Further, they want to avoid untransparent situations for investors bound by the provisions of the German Banking Act. In light of the above, it makes sense to take a closer look at the definition of Covered Bonds in European legislation. On a regulatory basis, the Capital Requirement Directive (CRD), with reference to par. 22 (4) of the EU Directive on UCITS Undertakings for Collective Investment in Transferable Securities sets forth the conditions under which securities may be considered Covered Bonds. However, the terms gedeckte Schuldverschreibungen and Covered Bonds are not legally defined, because the terms are not protected. Thus, they can also be applied to bonds that do not satisfy the criteria of the CRD. For instance, the Spanish multi-sellers bonds as well as DZ and DSL Briefe are referred to as Covered Bonds, although they fail to meet the conditions set out in the CRD or in Section 2a German Banking Act. One should, moreover, bear in mind here that the CRD has an expiry date. The criteria it contains are to be revised by the end of 21, with the result that they may be changed. We can therefore look forward to a gripping debate, as the EU has so far not issued a clear commitment to maintaining the present-day standards. Given the lack of a definition and solid criteria, it would be worthwhile examining what the industry itself has to say about the Covered Bonds topic with the Essential Features of Covered Bonds laid down by European Covered Bond Council (ECBC). To begin with, we are surprised to find that the ECBC makes no attempt to define Covered Bonds, choosing only to describe the essential features of these securities. This may be explained by the wide diversity of bond types that have made their way to the Covered Bond market in the meantime, and as a direct result by the wide-ranging interests the individual members of the ECBC pursue. 49

52 5 The Pfandbrief and the ECBC s Essential Features of Covered Bonds What are the minimum standards the ECBC has agreed on, and how does the German Pfandbrief fit into this scheme? Essential Features of Covered Bonds Covered bonds are characterised by the following common essential features that are achieved under special-law based frameworks or general-law based frameworks: 1. The bond is issued by or bondholders otherwise have full recourse to a credit institution which is subject to public supervision and regulation; 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; 3. The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times; 4. The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies. To explain these common features, which are reduced to a bare minimum, and to prevent possible misinterpretations of the Essential Features, they are accompanied by Explanatory Notes (see annex to this article, pp. 52 et seq.). These notes contain a more detailed explanation, for instance, of what the ECBC means by financial assets, prior claim, etc. However, even taking into consideration the Explanatory Notes, the statement made above does not change. Consequently, the following may be abstracted from them with regard to the Pfandbrief. The Pfandbrief fulfils the criteria set forth by the ECBC with ease. Pfandbriefe are issued in Germany by banks which, in addition to a banking license, must be in possession of a license to engage in Pfandbrief business. With that, the Pfandbrief satisfies Point 1. Besides a minimum requirement of core capital totaling EUR 25m, any potential Pfandbrief bank must prove during the licensing procedure above all that it has an appropriate risk management system in place capable of handling the dynamic nature of business within the cover limit. Because the bank is the issuer of the Pfandbriefe, an unconditional right exists against the credit institution towards the satisfaction of the obligation under the Pfandbrief. The Pfandbrief Act as a special law provides, in the event of the issuer s insolvency, not only for the Pfandbrief creditors preferential access to the cover pools but also for a corresponding right in respect of the remaining insolvency assets if the cover pools are not sufficient to fully satisfy the Pfandbrief investors claims. With that, the first part of the requirements of the Essential Features under Point 2 are also met. The claim in respect of a cover pool with financial assets is one of the core elements of German Pfandbrief law. For this reason, seen solely from the German viewpoint, this point in the ECBC s catalog may seem redundant. But given the great many formats that already exist or future Covered Bond formats currently under discussion, it certainly does make sense. The financial assets eligible as cover are set down in the Pfandbrief Act and the accompanying statutory regulations (Regulation on the Determination of the Mortgage Lending Value (BelWertV), Regulation on the Determination of the Mortgage Lending Values of Ships and Ships under Construction (SchiffsBelWertV), etc.), and so grant every investor transparency.

53 It is worth noting that the asset classes public-sector lendings, real estate loans and ship mortgages, which according to the Pfandbrief Act each make up separate cover pools, are also explicitly recognized in the CRD as asset classes which are eligible for Covered Bonds. What is more, the issuer s obligation to maintain the assets in the cover pool as per Point 3 of the above criteria is likewise anchored in the Pfandbrief Act and the Net Present Value Regulation (BarwertVO). The net present value overcollateralization which by law must be at least 2%, and the stress scenarios, required and controlled by the supervisory authority, within which the limit of 2% may not be breached provide comfortable protection for investors. In reality, the excess collateral maintained is usually considerably above the statutory minimum level due, not least, to the requirements rating agencies make. The German supervision of banks is an integral part of the Pfandbrief system, given that evidence of the management of asset pools is both a criterion when awarding licenses to engage in Pfandbrief business and a constituent part of the ongoing regulatory supervision of each issuer. In Germany, supervision as defined in Point 4 is performed by the Federal Financial Supervisory Authority (BaFin). Cover audits on the issuer s premises are carried out by the supervisory authority s own staff or the task is assigned to an external cover auditor. It should be pointed out here that BaFin not only carries out the supervisory duties stipulated in the fourth point of the ECBC minimum standards, but that it also has far-reaching possibilities to intervene as soon as signs of a Pfandbrief bank s insolvency become apparent. For example, under 3 (5) Pfandbrief Act, BaFin can have a cover pool monitor appointed to manage the cover pools before insolvency proceedings are opened in respect of the assets of a Pfandbrief bank, to prevent the rating of the Pfandbriefe from deteriorating. It becomes clear that the ECBC has done some valuable work to make it possible to identify and classify the wide variety of Covered Bonds, and above all to precisely categorize conceivable mixed forms of classic Covered Bonds and ABS securitizations. However, an ordinal scale in terms of the safety standards of individual Covered Bond products cannot and should not be derived from the Essential Features. The quality of Covered Bonds depends not least on the strength and the reliability of the underlying regulatory framework as well as on the rigorousness of the supervision carried out. Finally, neither the definitions of Covered Bonds found in legal texts and other sets of regulations nor the criteria of the ECBC with its minimum standards offer any basis for determining the actual quality and safety of a Covered Bond. As a whole, the ECBC Essential Features cannot be considered prohibitively high; in other words, they are no stamp of quality. For instance, there are no requirements with respect to the quality or the qualifications of the cover auditor, or about the extent of possible punitive sanctions should an issuer violate the requirements governing the cover assets. If one shares the opinion that the market is always right, the Pfandbrief comes out on top in terms of spread changes during the financial market crisis. The Pfandbrief has a very long and highly successful track record. What is more, besides the attributes already mentioned in this article, primarily its special degree of transparency as a result of statutory requirements is likely to have contributed to the investors, to date, unshakeable trust in the Pfandbrief. The Pfandbrief has proven itself in times of crisis, because when the going gets tough it offers issuers access to the capital market and, with that, the chance to engage in new business. This being so, there is no need to doubt that, in the process of the amendment of the Pfandbrief Act, the German issuers have every interest in ensuring that the quality standards achieved to date are not diluted. 51

54 52 The Pfandbrief and the ECBC s Essential Features of Covered Bonds Essential Features of Covered Bonds The ECBC sets out below what it considers to be the essential features of Covered Bonds, together with explanatory notes. It is intended that they are to be read independently from any other definition or interpretation of Covered Bonds such as those set out in the undertakings for collective investment in transferable securities (UCITS) and paragraph 68, Annex VI of the Banking Consolidation Directive (BCD, also known as Capital Requirements Directive, CRD. See 26/49/EC and 26/48/EC.) These common essential features should be understood as the ECBC s minimum standards for Covered Bonds. Essential Features Covered bonds are characterised by the following common essential features that are achieved under special-law based frameworks or general-law based frameworks: 1. The bond is issued by or bondholders otherwise have full recourse to a credit institution which is subject to public supervision and regulation; 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; 3. The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times; 4. The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies. Explanatory Notes Covered bonds are characterised by the following common essential features that are achieved under special-law based frameworks or general-law based frameworks Special-law based frameworks A special-law based framework is a legal framework based on a law and/or binding regulations of a public supervisory authority, specifically dedicated to regulate a covered bond system of a country. As of December 27, special-law based frameworks exist in 26 countries in Europe. Bonds issued in accordance with a special covered bond law may benefit from preferential risk weightings in the hands of certain regulated investors, depending on the jurisdiction of the investor and whether the bond otherwise meets the requirements of Article 22(4) of UCITS and paragraph 68, Annex VI of the BCD. General-law based frameworks A general-law based framework is a legal framework based on general law (such as contract law) or on law and/or regulations of a country not specifically dedicated to regulate a covered bonds system. As of December 27, covered bonds based on general law-based frameworks exist in five countries worldwide.

55 53 1. The bond is issued by or bondholders otherwise have full recourse to a credit institution which is subject to public supervision and regulation; Full recourse A full recourse right creates an unrestricted unconditional obligation on the credit institution to repay a debt. Generally, default on a full recourse obligation leads to the insolvency of the obligor, and the creditor will have a claim on the general insolvency estate of the obligor on an equal basis with the other general creditors of the obligor. In most covered bond structures, the bond is issued by a credit institution, giving investors direct full recourse to the credit institution s full resources. In some structures, however, the covered bond is issued by a special purpose entity (SPE), which on-lends the proceeds to a credit institution (whether by making a loan or buying a bond). This provides bondholders with full recourse to the underlying credit institution, albeit indirectly, through the SPE. For investors subject to the BCD, only covered bonds issued directly by a credit institution qualify for preferential risk weightings. Full recourse to a credit institution is a key difference between securitisation and covered bonds. In securitisations, bondholders only recourse is to the cashflows from a securitised portfolio of assets. The credit institution which originated the assets typically does not guarantee the performance of the securitisation. Therefore, if the cashflows from the securitized portfolio are insufficient to make payments on the securitisation units when expected, holders of the units would generally have no claim against the credit institution which originated the securitised assets. A credit institution which is subject to public supervision and regulation A credit institution is an entity licensed to carry on one on more banking activities, such as receiving deposits from the public, granting loans or providing payment services. Credit institutions are distinct from corporates in that owing to their importance to the financial system they are subject to public supervision and regulation which prescribes standards for the management of credit, liquidity, interest rate and operational risks. 2. Bondholders have a claim against a cover pool of financial assets in priority to the unsecured creditors of the credit institution; Financial assets Financial assets include loans, bonds and similar instruments, as well as derivatives designed to hedge interest and currency risks. Financial assets do not include equity securities, real property, commodities or tangible property. The most common cover assets are mortgage loans secured on residential or commercial property (or securitisation units backed by residential or commercial mortgage loans), mortgage loans secured on ships and loans to public sector entities. Most cover pools also include cash deposits. All covered bonds contain minimum cover pool asset quality standards. For covered bonds issued under a special law, these quality standards are set out in the law itself and/or binding regulations; however these may also be supplemented by contract. Where the covered bond is issued under general law, these quality standards are set out in the contracts which govern the covered bond issuance.

56 54 The Pfandbrief and the ECBC s Essential Features of Covered Bonds The BCD also imposes certain minimum standards for cover pool assets. For investors subject to the BCD, only covered bonds with BCD-compliant cover pools are eligible for preferential risk weightings. Cover pool; priority to unsecured creditors A cover pool is a clearly identified, ring-fenced pool of assets dedicated to secure the covered bonds. That is to say, in the event of the insolvency of the credit institution, the assets in the cover pool will be used to repay the covered bondholders before they are made available for the benefit of the credit institution s unsecured creditors. The method used to ring-fence the cover pool varies. In most jurisdictions, the special law either excludes the cover pool from the insolvency estate of the credit institution, or provides covered bondholders with a preferred claim within the insolvency estate itself. In some jurisdictions, the cover pool is preserved from the insolvency estate of the credit institution by being transferred to an SPE, which guarantees the credit institution s obligations under the covered bond. Finally, some structures use the implementation of European Collateral Directive in their jurisdiction to pledge the cover pool assets. 3. The credit institution has the ongoing obligation to maintain sufficient assets in the cover pool to satisfy the claims of covered bondholders at all times; Sufficient assets The value of the cover pool assets meeting the minimum quality criteria described above must be at least equal to the value of the covered bonds. In most jurisdictions, the value of the cover pool is required to exceed the value of the covered bonds by a prescribed amount, known as overcollateralisation. The minimum level of overcollateralisation is set by the special law or within the contracts governing the covered bond issuance. In some cases, the minimum level of overcollateralisation may be set by a combination of the two the covered bond law prescribing a minimum level of overcollateralisation, but the credit institution committing to a higher level through either voluntary, nonbinding commitments or contract. Ongoing obligation The credit institution has the obligation to ensure that the value of cover pool assets meeting the minimum quality criteria described above is equal to or higher than the value of the covered bonds at all times. The credit institution may therefore be required to add further assets to the cover pool to compensate for matured or defaulted assets. In securitisations, by contrast, the sponsoring credit institution is generally not compelled to replace assets which enter into default after they have been transferred into the securitisation portfolio. Therefore, if defaults in the securitised portfolio are higher than anticipated when the securitisation was issued, the resulting losses will be borne by the investors in the securitisation, rather than by the sponsoring credit institution.

57 55 4. The obligations of the credit institution in respect of the cover pool are supervised by public or other independent bodies. Supervision of the credit institution s obligations in respect of the cover pool ( special supervision) is supervision specifically for the benefit of covered bondholders, as opposed to supervision relating to the general stability of financial or other markets, general customer interest, deposit protection, and the like. Special supervision is therefore distinct from the general supervision of the credit institution referred to in paragraph 1 above. Each form of supervision is an essential feature common to Covered Bonds, as listed above. The content and the level of the special supervision in respect of the cover pool varies from one system to another. Typical features of special supervision include: a special cover pool monitor periodic audits of the cover pool by the cover pool monitor ongoing management and maintenance of the cover pool upon the credit institution s insolvency to ensure the timely payment of covered bondholders. In special-law based frameworks, the task of special supervision is usually assigned to public authorities and the issuer is required to obtain a licence to issue covered bonds. In many countries, this public authority is the banking supervision authority; in others, the capital market supervision authority; in some, both. These public authorities will also appoint or approve the cover pool monitor, and these authorities may also conduct their own audits of the cover pool from time to time. Special public supervision is a condition of Art. 22 (4) of the UCITS directive and of several other EC directives (including those regarding insurance companies and deposit insurance), making bonds which are subject to special public supervision eligible for favourable investment limits for certain investors. In addition, for investors subject to the BCD, only covered bonds subject to special public supervision are eligible for preferential risk weightings. In covered bonds issued under general law frameworks, the key features of special supervision are replicated by contract, to the extent possible. Therefore, for example, the issuing or sponsoring credit institution will appoint an external auditor to audit the cover pool, and an external trustee will be appointed to safeguard bondholders interests: changes to the contractual documents which set the terms of the programme may not be changed without the consent of the trustee, for example.

58 56 simply pfandbrief simply pfandbrief simply good vdp Member Institutions 57 Deutsche Apotheker- und Ärztebank Düsseldorf 58 Aareal Bank Wiesbaden 6 Bayerische Hypo- und Vereinsbank Munich 62 BayernLB München 64 Berlin-Hannoversche Hypothekenbank Berlin 66 COREALCREDIT BANK Frankfurt am Main 68 DekaBank Frankfurt am Main 7 Deutsche Genossenschafts-Hypothekenbank Hamburg 72 Deutsche Hypothekenbank Hanover 74 Deutsche Kreditbank Berlin 76 Deutsche Postbank Bonn 78 Deutsche Schiffsbank Bremen 8 Dexia Kommunalbank Berlin 82 Düsseldorfer Hypothekenbank Düsseldorf 84 Eurohypo Eschborn 86 Hamburger Sparkasse Hamburg 88 Helaba Landesbank Hessen-Thüringen Frankfurt am Main 9 HSH Nordbank Hamburg 92 Hypo Real Estate Bank Munich 94 Hypo Real Estate Bank International Munich 96 Hypo Real Estate Holding Munich 97 IKB Deutsche Industriebank Düsseldorf 98 Kreissparkasse Köln Cologne 1 Landesbank Baden-Württemberg Stuttgart 12 M. M. Warburg & CO Hypothekenbank Hamburg 14 Münchener Hypothekenbank Munich 16 Nord/LB Norddeutsche Landesbank Girozentrale Hannover 18 SEB Bank Frankfurt am Main 11 Sparkasse KölnBonn Cologne 112 Valovis Bank Essen 114 Westdeutsche ImmobilienBank Mainz 116 WestLB Düsseldorf 118 WL BANK Münster 12 Wüstenrot Bank AG Pfandbriefbank Ludwigsburg