Pfandbrief literally translates to “collateral letters” in German. We think. It always reminds us of Pfannkuchen (pancakes) though.
Regardless of its literal meaning, the word’s been in the news more than usual recently, thanks to the bailout of Hypo Real Estate.
The German bank was thrown a second lifeline last night after a first rescue package (involving a consortium of other banks pledging to provide liquidity support) fell through. That package broke down, reportedly, after the other banks found out Hypo needed more than the €35bn first discussed. That bring’s last night’s bailout to about €50bn and has left some analysts scratching their heads, with good reason.
This from Citigroup today:
Consortium & Government Appear Rattled – Press reports suggest that the consortium withdrew the liquidity line after HRE had identified a further funding gap. We wonder how did this gap suddenly appear? Did the consortium see other things that concerned them? Based on the reports, it would seem the government was also taken by surprise, and was reluctant to expose taxpayers further, so pressured the consortium to agree to the new package.
HRE Equity Could Be Worthless – While HRE once again has an emergency liquidity package in place, we think the events of the weekend will likely raise further big questions about the state of the company’s balance sheet and its management controls. Also the government and consortium appear to have no appetite for it, and we think are likely to prioritise a rapid wind-down. This may or may not yield value to equity holders. We are reviewing our target price.
There’s an irony here. Hypo was the uber-cheerleader (and issuer) of the ultra-safe German covered bond – the Pfandbrief. It’s funding, like its Pfandbriefe, should have been relatively safe.
Pfandbriefe are more highly regulated and require less leverage than similar commercial mortgage backed securities (CMBS). They also remain on banks’ balance sheets –allowing them to borrow against them.
Thus while CMBS pretty much died in recent credit-crunched months, research from Eurohypo shows that €58.5bn of Pfandbrief loans were issued in the past 12.
As FT Deutschland notes today, Pfandbriefe have also benefitted from an implicit government guarantee that Berlin would never let an issuer fail. We’ve seen that in action over the past week with Hypo.
Nevertheless, here’s what Deutsche Bank thinks would happen in the event of issuer insolvenecy:
In case of insolvency of the issuer, Pfandbrief holders have priority on the claims in the cover pool and rank pari passu with unsecured creditors for assets outside the cover pool. Pfandbriefe do not automatically accelerate when the issuer goes insolvent. Once the insolvency proceedings start, the assets recorded in the cover registers are by law automatically separated from the insolvency estate. The cover pool assets will not be affected by the insolvency proceedings, but form a separate legal estate without necessary further legal action. Hence, cover pool assets will not be part of insolvency proceedings. A special cover pool administrator (Sachwalter) who will be different from the insolvency administrator of the bank will be named by the insolvency court…
In short, if the issuer goes bust the lender can take possession of the underlying assets — the mortgages. (If the mortgages go bust, that’s a different, though potentially related problem, see here). The major difficulty is, as always, liquidity:
In case of Pfandbrief issuer insolvency, liquidity risk seems to be the biggest risk regarding timely payment of Pfandbriefe. Moreover, in case a lack of liquidity leads to cover pool insolvency, acceleration might threaten the 100% recovery value for Pfandbrief holders. However, liquidity risk is alleviated by the net present value matching principle and the limit on interest rate risk stipulated in the net present value regulation between the cover pool assets and the outstanding Pfandbriefe.
We’re guessing the liquidity issue was what sparked Germany’s intervention, considering the sacredness of the actual Pfandbrief payout.
There’s also the possibility of (ahem) passing the Pfandbriefe between banks, which would also lessen the impact on lenders:
Overall, we have a very high confidence that the formal procedure stipulated in the Pfandbrief Act to protect Pfandbrief holders will work in case of issuer insolvency. Hence, despite all kind of possible economic and political support scenarios to prevent a Pfandbrief issuer’s insolvency (which we would expect), if the last line of defense is breached, we are confident that Pfandbrief holders will benefit from the preferential claim on all cover pool assets. Also the cover assets and liabilities can be potentially transferred to another bank, which in such a crisis scenario may not necessarily be a Pfandbrief issuer as stipulated in the Pfandbrief Act. A non-Pfandbrief bank may be allowed to quickly apply for a Pfandbrief license to take over cover pool and Pfandbriefe.
Mmmmmm…Pfandbriefe.
For added covered bond kicks, Immobilienblasen points us to Hypo’s last risk report. It’s here, from page 27.