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The importance of the Pfandbrief on the international financial market

Table of Contents

List of abbreviations

List of figures

List of tables

1 Introduction
1.1 Preface and procedure
1.2 Definitions
1.2.1 History of origin
1.2.2 Model of the mortgage banks
1.2.3 Basic structure of the Pfandbrief

2 Basic mechanisms and main influencing factors of the Pfandbrief market
2.1 Legal framework for Pfandbrief issues
2.1.1 Specialized banking principle for a low-risk business area (§§1,5HBG)
2.1.2 Lending value and lending limit against price fluctuations (§§11-13HBG)
2.1.3 Coverage principle and circulation limit as additional pillars of security (§§6,7HBG)
2.1.4 Congruence principle in terms of solvency (§9HBG)
2.1.5 Pfandbrief creditors' preferential insolvency right (§35HBG)
2.2 Implied market segments
2.2.1 Money and capital markets determine the financial market
2.2.2 Primary and secondary market
2.2.3 Real estate market
2.2.4 The international financial market
2.3 Positioning of the respective market participants
2.3.1 Refinancing instrument for issuers
2.3.2 Safe and profitable form of investment for investors
2.3.3 Regulators' interests
2.3.4 Credit assessment by rating agencies
2.3.5 Competition between Pfandbriefe and their issuers in Switzerland and abroad
2.3.6 The intermediary role of the lobby
2.4 Summary

3 success factors of the Pfandbrief system
3.1 Fine-meshed safety net to protect against various risks
3.1.1 Dynamic legislation
3.1.2 Internal and external control bodies
3.1.3 Risk components and neutralization instruments used
3.1.4 Privileged risk weighting
3.1.5 Risk / return profile and portfolio management
3.2 High quality standards
3.2.1 Transparency
3.2.2 Liquidity
3.3 Sustainable and adapted product policy
3.3.1 Reputation of the Pfandbrief system
3.3.2 Innovations
3.3.3 Standardization and diversification
3.4 Summary

4 Development of the international dimension
4.1 Harmonization approach of the UCITS Directive
4.2 The Jumbo Pfandbrief, a benchmark
4.3 Continental European version of the Pfandbrief: Covered Bonds
4.4 Anglo-American securitization technique for mortgage-backed securities
4.5 Summary

5 Implications of the new Pfandbrief Act
5.1 Reason and objective
5.2 Reorganization of Pfandbrief Law
5.2.1 Loss of the special banking principle
5.2.2 Increased requirements for quality assurance measures
5.3 Increased competitive pressure versus new business models
5.4 Summary

6 Conclusion and outlook
6.1 Conclusion
6.2 Outlook


Statutory declaration

List of abbreviations

Figure not included in this excerpt

List of figures

Figure 1: The Pfandbrief refinancing system

Figure 2: Fixed-income securities on the German bond market

Figure 3: Refinancing methods in the EU

Figure 4: Capital investments of insurance companies in Germany: total of mortgage, land charge and pension debt claims

Figure 5: Security of the mortgage Pfandbrief

Figure 6: Success factors in value creation by a mortgage bank

Figure 7: Structure of financial assets in Germany

Figure 8: Covered bonds outstanding in the EU

Figure 9: Shares in the European jumbo market

Figure 10: Evaluation matrix of European Pfandbriefe

Figure 11: Simplified representation of an MBS transaction

List of tables

Table 1: Symbols of the rating agencies

Table 2: Overview of the covered bond markets

1 Introduction

1.1 Preface and procedure

Against the background of the dynamics of change in the financial services industry, the present work is dedicated to a traditional financial instrument, the Pfandbrief, and its sustainable success story. It concentrates on the Pfandbrief of private-law mortgage banks, which, in contrast to the public Pfandbrief, operates in free competition and, compared to the Ship Pfandbrief, covers a representative market share. In doing so, the success factors are examined which raised the Pfandbrief from the status of a stopgap measure in the 18th century to a European benchmark of the 21st century. Largely unnoticed by the public, the new Pfandbrief Act, which came into force on July 19, 2005, marked a turning point for the Pfandbrief market.

The work is divided into 6 chapters, all of which look at the Pfandbrief product alternately from the perspective of the issuer and the investor. In the introductory chapter, the term Pfandbrief is classified and the Pfandbrief system is presented. The second chapter then deals with its legal basis and macroeconomic relationships. The third chapter works out the key points of the Pfandbrief system that have led to its success, with particular emphasis on the safety factor. Building on this, the fourth chapter analyzes the determinants of the internationalization of the Pfandbrief and provides an overview of their extent. The penultimate chapter deals with the possible effects of the upcoming reform of Pfandbrief law on the position of the Pfandbrief in the context of international financial markets. Finally, Chapter 6 summarizes the knowledge gained in the course of the work and supplements it with an outlook.

1.2 Definitions

1.2.1 History of origin

The basic structure of the Pfandbrief has existed for more than 235 years. Its roots in Germany go back to the 18th century, when Frederick the Great introduced this security to meet the financial difficulties of the nobility and to finance the reconstruction of his country after the seven-year war between Prussia and Austria. The monetary system became a central concern of economic policy at the time. At the same time as the Pfandbrief was created, precious metals were replaced as the usual means of payment by banknotes. Friedrich II. Wrote in his famous Cabinets Ordre dated August 29, 1769 that the Pfandbriefe “will circulate like cash in hand”. In fact, there were more Pfandbriefe in circulation than banknotes at the beginning of the 19th century.

For financial policy it was important to win the trust of potential investors with a safe investment opportunity in order to stimulate the desolate economic situation at the time. High security standards were therefore of fundamental importance for the quality and acceptance of the Pfandbrief. In the oldest form, the security was based on the fact that the security holder himself obtained a lien on the borrower's property; Such securities were called “Pfandbriefe” from that time. This direct connection between obligation and security in rem was later broken when the first modern German mortgage bank based on the model of Crédit Foncier de France was founded in 1862[1].

The practice of financing mortgage loans by issuing Pfandbriefe also has a long tradition. The Pfandbrief system is based on the Mortgage Bank Act, a unique set of rules with the overriding aim of investor protection, which came into force on 01.01.1900 at the same time as the Civil Code[2]. It granted the mortgage banks the exclusive right to issue Pfandbriefe in the private banking sector. In addition to the 20 mortgage banks under private law, 18 Landesbanken and Sparkassen each are authorized to issue public Pfandbriefe and 2 ship banks are authorized to issue ship Pfandbriefe, whereby the public credit institutions are subject to the ÖPG of 1927 and the ship banks to the Ship Pfandbrief Bank Act of 1943.

1.2.2 Model of the mortgage banks

With the Pfandbrief system, the mortgage banks used the capital market as an intermediary between borrowers and Pfandbrief investors at an early stage[3]. The procurement of capital market funds through the issue of Pfandbriefe is a specialty within the framework of the entire securities business, in which the issuers are limited to a clearly defined credit area[4]. The private-law mortgage banks operate according to the restrictive regulations of the HBG in terms of creditor protection, without ever having recorded a single insolvency case. Within the German 3-pillar banking system, they are important representatives of the private banking sector; At the end of 2002 they had just under € 1.25 bill. generates a market share of approx. 20% of the total business volume of German banks[5]. For mortgage banks there are stricter capital requirements compared to other credit institutions: While a liable minimum equity of € 5million. is generally sufficient for banks, the regulatory equity capital when a mortgage bank commences business is at least € 50 million.

By issuing Pfandbriefe, mortgage banks raise funds to lend to borrowers, as shown in Figure 1. The latter have to pledge the loaned land and real estate to the mortgage banks as security for the loaned funds. In the balance sheet of these special credit institutions, the Pfandbrief liabilities to be booked on the liabilities side are offset by a mass of certain assets on the assets side, the so-called "land loans" or "real estate loans", i.e. receivables that are primarily due to real estate - and not due to the creditworthiness or balance sheet of the Borrower - are secured by mortgage.

Figure 1: The Pfandbrief refinancing system

Figure not included in this excerpt

Own illustration based on Stöcker (2004)

Since land is the most secure pledge that cannot be lost and cannot be destroyed even in wars, the loans granted by the mortgage bank for residential construction or commercial properties are secured by liens entered in the land register. This collective term includes both land charges and mortgages, according to which the encumbered property is liable for the payment of a certain sum of money (§§1191ff BGB) or a direct link is established between the property and the claim (§1113 (1) BGB). For mortgage financing according to the Pfandbrief concept, the land charge forms both a loan security and a product feature[6].

The German mortgage banks owe their favorable cost structure and refinancing advantage to the continuous issuance of Pfandbriefe, which enables them to activate funds at low cost in order to be able to grant mortgage loans for residential and commercial building purposes. Because of their low margins, they mainly use the liabilities side to increase their profitability[7]. Depending on whether the bank focuses on lending or deposit business, we speak of an active or passive bank.

Mortgage banks have comparatively lean structures and, unlike traditional commercial banks, because of their low-risk business, are long-term oriented. By providing long-term investment capital with low risks and insufficient margins, the mortgage banks fulfill a macroeconomic function and contribute to the stability of the German real estate market[8]. The long-term refinancing options offered by the Pfandbrief, in turn, characterize the German long-term culture, which is not as pronounced in other European countries[9].

1.2.3 Basic structure of the Pfandbrief

According to their legal nature, Pfandbriefe are bank bonds that are secured by first-rate mortgages. In this thesis, the terms bonds, bonds, securities, debt instruments and securities are used synonymously with the Pfandbrief. Under the name “Pfandbrief”, which is protected under Section 5aHBG, this special type of security may only be issued for bonds from German mortgage banks, ship pfandbrief banks and public-law issuers. The distinction between “Mortgage Pfandbrief” and “Public Pfandbrief” relates to the cover pool of the respective Pfandbrief type and not to the issuer group “private mortgage bank” or “public law bank”.

As a rule, the Pfandbriefe are bullet securities. Traditional Pfandbriefe are issued over the counter with a total volume of between € 5 and 500 million in the form of tap issues. Individual series are issued within an issue, the issue price of which varies depending on the applicable capital market interest rate at the time of issue[10]. Pfandbriefe are mainly issued with a fixed coupon (fixed interest rate). However, the variety of conceivable features is large and ranges from simple stepped interest rate bonds to highly complex structures[11]. The return on the capital employed is usually higher for the investor, the longer the term of the paper. Most of today's Pfandbriefe have terms of five to ten years and have fixed maturity dates without the possibility of prior notice[12].

Pfandbriefe have the status of a surrogate for the very safe Bunds. The return on the Pfandbrief is determined by the current key interest rate at the time of issue, as well as the interest rate on Bunds plus a risk premium. The return on a Pfandbrief denotes the interest claim of the investor or the interest liability of the issuer. When listing financial instruments, a distinction is made between the ask price, i.e. the price at which a seller is willing to sell the security, and the bid price, namely the price at which a buyer is willing to buy the security. Furthermore, the technical term for an interest rate or yield difference between two products on the capital market is "spread"[13].

Pfandbriefe can be designed as bearer and registered bonds, with around 75% of all Pfandbriefe nowadays being bearer papers, while the share of registered papers is around 25% for large nominal values. Since the individual certificate is becoming less and less important when investing in securities, the Pfandbriefe are issued in the form of a global certificate. Effective pieces (so-called mantle) are only issued in rare cases. Either the bank or the financial intermediary keeps the document in the custody account from the start, or the investor is not assigned a specific document from the outset, but only a participation in a collective portfolio of similar papers. For private and institutional investors, the Pfandbrief offers the advantage of a high-quality investment product with a high credit rating and interesting returns.

The HBG regulates the business activities of the mortgage banks down to the last detail and thus reliably protects Pfandbrief creditors from the risk of capital loss. Its key points are explained in detail in the following chapter, as they make a decisive contribution to the security of Pfandbriefe. In addition, the legislature expressly recognizes their special quality, as money administered in trust may be invested in these titles for a ward. As a result, the Pfandbrief plays a central role in the financial system because it contributes to a better allocation of capital, which in turn benefits economic growth[14].

2 Basic mechanisms and main influencing factors of the Pfandbrief market

In order to classify the importance of the Pfandbrief in its framework conditions, the first chapter examines its legal and economic policy principles as well as the group of stakeholders it affects.

2.1 Legal framework for Pfandbrief issues

The fate of the actors (German mortgage banks) is closely linked to that of their instrument (Pfandbriefe). This is expressed in a common law, the Mortgage Bank Act.

2.1.1 Specialized banking principle for a low-risk business area (§§1,5HBG)

As the first cornerstone of the previous Pfandbrief system, the specialty principle in Section 5 (1) HBG stipulates that German mortgage banks only enjoy the privilege of refinancing their lending business or parts of it by issuing Pfandbriefe as specialist banks with a narrowly defined, low-risk business area[15]. It is intended to ensure a concentration and specialization of know-how in the granting of mortgage loans[16]. The term “special bank principle” has only been used as a counterpart to the term “universal bank principle” that emerged in the 20s since the 1950s. The lending business of German special credit institutions abroad is limited to the countries of the EU and the European Economic Area as well as Switzerland, Canada, North America and Japan. The proportion of foreign transactions may not exceed 10% of the total cover pool.

In addition to their main business, since the revision of the HBG within the framework of the 4th Financial Market Promotion Act of July 1, 2002, the special credit institutions have been given the opportunity to provide additional services that are closely related to their core competencies, real estate and public finance[17]. As a side business are i.a.Real estate brokerage, the administration and brokerage of mortgage loans for third parties, the implementation of appraisals, asset and financing advice, the cross-border issuance of mortgage and municipal loans to defined foreign borrowers as well as the granting of subordinated loans are permitted.

In addition to issuers from the public sector (Landesbanken, Sparkassen and Deka-Bank), 17 “pure” private mortgage banks act as Pfandbrief issuers. For historical reasons, 3 “mixed” mortgage banks are also allowed to issue Pfandbriefe. They arose from the fact that over 100 years ago the legislature, with the HBG, left the universal banking business to the institutions that did not exclusively conduct this business, so to speak under "vested rights". The start-ups of mixed-use mortgage banks are excluded[18]. In contrast to pure credit institutions, which are subject to the limitations of the HBG, the mixed ones can concentrate on their core competencies and still use all the possibilities of a universal bank within the meaning of the German Banking Act[19]. With their much greater leeway on both the assets and liabilities side compared to pure mortgage banks, the mixed mortgage banks are among the largest special credit institutions. It should already be noted that specialization creates the special connection between securities and cover assets. The Pfandbrief issuers have developed a specialization advantage from their limited activities and have thus acquired a high level of competence and a strong market position.

2.1.2 Lending value and lending limit against price fluctuations (§§11-13HBG)

The HBG contains further protective measures, in particular in favor of Pfandbrief holders, in Sections 11–13 in unchanged form since its inception. They relate to the value of an asset (here, in particular, land and real estate are meant) with which it can be used as security for mortgage loans, namely its lending value. When determining the mortgage lending value of real estate, the principle of caution is to be followed. The aim is not to determine the market value at a specific point in time, but rather the hedging value that can be expected with sufficient certainty based on a long-term forecast. The focus is on long-term properties and the sustainably achievable yield of the property. According to a rule of thumb, the mortgage lending value is typically around 15% below the current market value of a property[20].

In addition, the HBG sets a lending limit of 60%, i.e. a maximum of this proportion of the lending value determined according to conservative standards may be used to secure the mortgage. Only mortgage loans of up to 60% of the lending value may be refinanced through Pfandbriefe. In addition, a so-called ranking ratio is determined for mortgage loans, i.e. a sequence according to which the rights of different creditors are satisfied. First-rate mortgages are entered first in the land register and repaid first in the event of liquidation. The 60% lending limit protects against price fluctuations and, as a result, limits the first-rate secured mortgage loan to around 50% to 55% of the market value of a property. There have not yet been any declines in prices on the property market in the amount of the unused 45% in Germany. In order to protect the Pfandbrief creditors, there is therefore a considerable safety cushion against depreciations that cannot be completely ruled out, even with the most careful valuation. The limit on the loan-to-value ratio also ensures that, in the event that its debtor becomes insolvent, the bank can obtain its money through the sale or auction of the property on which it is lent, even if cyclical fluctuations in the market value cause the assets included in the cover pool to decline in value[21].

Real loans in excess of the lending limit to borrowers who seek total financing from “one source” are permitted. However, they may not be refinanced through Pfandbriefe, but, for example, through uncovered bonds; these are limited to a maximum of 20% of the value of a bank's mortgage portfolio. Uncovered bonds make refinancing costs more expensive than Pfandbriefe by around 20 basis points (one basis point corresponds to one hundredth of a percentage point).

Mortgage banks generally only finance real estate that can be used by third parties and that are not tailored to the specific purpose of a borrower. This is intended to ensure that a sufficient number of potential buyers can be expected in the event of a forced sale. Real estate financing is therefore limited to all types of residential real estate and certain commercial properties, such as hotels, commercial buildings, and office buildings[22]. Thus, the valuation of properties and the lending limit of 60% guarantee the intrinsic value of the cover pools.

Every mortgage bank is obliged to issue an appraisal instruction that takes into account the relevant rules of the HBG and requires the approval of the supervisory authority. If the bank's own experts are used, the valuation and loan processing must be carried out separately. The appraisers are required to have proven long-term experience in the real estate and construction market; they are usually sworn in as building experts.

2.1.3 Coverage principle and circulation limit as additional pillars of security (§§6,7HBG)

The term “covered” bond and its security are based on the quality of its cover assets. The cover principle thus embodies a supporting pillar for the protection of Pfandbrief creditors. A distinction is made between regular coverage and substitute coverage as well as factual, securing and voluntary excess coverage. According to Section 6HBG, all Pfandbriefe in circulation must at all times be covered by mortgage or municipal loans that have at least the same scope and at least the same interest rate (ordinary cover)[23]. Mortgage loans and government loans that are refinanced through Pfandbriefe form two separate cover pools. The cover assets of covered bonds must be separated from other assets of an issuer as a special fund. A distinguishing feature between the mortgage stock and other assets is that assets that are not eligible for cover (e.g. those whose lending value is above the 60% lending limit) may not account for more than 20% of the total volume of mortgage loans. There is no direct allocation of specific cover assets to specific Pfandbriefe, rather the total amount of coverable mortgage or government loans and the total amount of mortgage or public Pfandbriefe are opposed to each other.

In order to clearly identify the assets belonging to the cover pool, the mortgage banks keep a cover register for each type of claim (mortgage and government loans). A trustee monitors their compliance and carries out the entry or deletion of the assets used for cover (§29HBG)[24]. The nominal and present value of outstanding mortgage Pfandbriefe must be secured at all times by first-class mortgage loans. If the assets provided for (ordinary) cover are not sufficient, so-called substitute cover can be provided in accordance with Section 6 (4) and 5HBG up to 10% of the total Pfandbrief in circulation.

The HBG only recognizes values ​​of first-class creditworthiness as substitute cover assets, which are finally listed in the law. These include federal government bonds, comparable papers from other EU member states and balances with suitable credit institutions. With regard to cover eligibility, a distinction is made between countries and the acceptance of the preferential bankruptcy law there[25]. In addition to the “actual excess cover”, the last amendment to the HBG on April 9, 2004 introduced a “securing excess cover”, which amounts to 2% of the cover pool. It is calculated - separately for the two cover pools - according to the present value. Analogous to the substitute cover values, it is to be invested in highly liquid values. This secure excess cover is a safety buffer against additional administrative costs of the fund in the event of bankruptcy of the mortgage bank as well as credit and liquidity risks (interest rate and currency risks are already taken into account in the present value cover calculation)[26]. In addition to the statutory excess cover, the mortgage banks are free to top up their cover values. This voluntary excess cover applies to some foreign variants of the Pfandbrief.

In order to secure the intrinsic value of the cover pool from the outset, high demands are placed on the quality of the objects of cover: State loans in the non-European G7 countries are permitted as cover values ​​for public Pfandbriefe in contrast to the local mortgage loan business, which is only permitted as non-cover business. Financing of unfinished buildings may not exceed 10% of the mortgage used to cover the mortgage and may not exceed twice the liable equity. As part of the regular coverage check, the Federal Financial Supervisory Authority (BaFin, formerly the Federal Banking Supervisory Office) checks compliance with the statutory valuation and lending provisions as well as compliance with the valuation instructions[27]. Finally, it should be noted that the quality of Pfandbrief cover is based on the fact that the issuer is a highly specialized Pfandbrief institute. This specialization means an additional risk minimization, since the mortgage bank is not only the legal entity of the cover assets, but mostly justifies and manages them at the same time[28].

In addition to the already mentioned safeguards for Pfandbrief owners, the legislature limits the volume of the Pfandbriefe in circulation to 60 times the equity capital for pure mortgage banks and 48 times for mixed mortgage banks, even if sufficient cover assets are available. Over the past ten years, the volume of mortgage Pfandbriefe and public Pfandbriefe in circulation has risen steadily, almost regardless of the economic situation. This is a clear indication of the high quality of this financial instrument[29].

2.1.4 Congruence principle in terms of solvency (§9HBG)

However, these regulations were not yet sufficient for the legislature either, which is why they also determined the permanent solvency of mortgage banks in accordance with Section 9HBG. The principle of congruence states that claims on the assets side with liabilities on the liabilities side (here: the Pfandbriefe) of a mortgage bank must match with regard to their term, the currencies in which they are denominated and their termination options. The aim of the congruence principle is to largely eliminate liquidity, interest rate, reinvestment and exchange rate risks for the special credit institutions[30]. Since 1991, mortgage banks have also been allowed to do business within the EU and EEA as well as in Switzerland. Loans in foreign currencies must be refinanced with Pfandbriefe in the same currency (currency congruence). Interest rate and currency risks that arise due to different maturities or different currencies between the Pfandbrief and the cover value must be hedged through appropriate measures, which Chapter 3 deals with in more detail[31].

2.1.5 Pfandbrief creditors' preferential insolvency right (§35HBG)

In the event of the insolvency of a German mortgage bank - an event that has never occurred since the HBG was enacted - the Pfandbrief creditors enjoy a preferential right to satisfaction over the assets recorded in the cover registers over all other creditors. The isolation of the cover pools in the event of an issuer going bankrupt reduces the probability of default of Pfandbriefe. As long as the values ​​in the cover pool comply with the regulatory requirements, the Pfandbriefe will not be settled early in the event of the issuer's insolvency. In this regard, §35Abs.1HBG explains that Pfandbrief creditors do not participate in the insolvency proceedings of the mortgage banks. In addition, a prohibition of execution and set-off protects the cover pool (§34aHBG) in advance.[32].

The separate cover pools for mortgage Pfandbriefe and public Pfandbriefe each have the status of a separate fund. In contrast to the general principle of insolvency law, the claims of Pfandbrief investors - in accordance with the terms of issue and on the basis of the income from the healthy cover pool - are satisfied without any compromises until repayment. Interest and redemption payments received after bankruptcy proceedings have been opened on the assets belonging to the cover pool are also covered by the bankruptcy privilege. Other creditors could only fall back on this if the claims of the Pfandbrief creditors have been met in full and the excess amount has been paid out to the bankruptcy estate. Conversely, the other assets of a mortgage bank would be equally available to the Pfandbrief holders alongside the other creditors.

On the other hand, separate insolvency proceedings are opened on a non-performing cover pool for which the coupon and capital can no longer be paid on time. As a result, the Pfandbriefe would become due in accordance with Section 41HBG[33]. In order to ensure that the Pfandbrief creditors are properly satisfied, the procedure is handled by a court-appointed trustee. The trustee can also be appointed via a mortgage bank before insolvency proceedings are opened, e.g. to prevent an existing excess cover from being deducted from the cover pools. He manages the special assets of the Pfandbrief creditors and even has access to payment flows that relate to so-called non-covered parts, i.e. those loan parts that are above the cover limit of 60% of the mortgage lending value of a property[34].

This prevents the cover pool liabilities from being serviced with a delay. In order to ensure that the cover pools to secure the Pfandbrief creditors are processed quickly, the law enables the entire transfer to another mortgage bank. The insolvency resistance also applies to the values ​​of the "factual", which result from the present value coverage calculation, the securing and usually the voluntary excess coverage[35].

2.2 Implied market segments

In order to classify the Pfandbrief in its macroeconomic environment, this section describes the sub-markets that are relevant for the Pfandbrief.

The German financial location benefits from the size of the German economy. When it comes to capital market products such as household savings or bonds in circulation, Germany holds the top position in Europe. While the market share of government bonds is the downside of the high government debt, the size of the market for bonds from financial institutions is due to the attractive instrument “Pfandbrief”.

In contrast, the total financial assets, i.e. the sum of bank deposits, insurance reserves, fund shares and securities, are relatively low in Germany: It amounts to 370% of GDP compared to an average of 500% in the euro area. This can be explained by the investment preferences of the German bank-based financial system that have evolved over time. There is talk of an underdeveloped capital market in Germany.

Numerous theoretical and empirical studies have shown a causal relationship between the level of development of the financial system and economic growth. The financial market mainly influences growth through the mobilization of savings capital (Pfandbrief), allocation of capital for investments (loans), monitoring of the use of funds and risk transformation (risk-free deposits against risky loans)[36].

2.2.1 Money and capital markets determine the financial market

On the financial market, a distinction is made between money and capital markets according to the maturity of monetary transactions. While short-term fundraising takes place in the money market, long-term financial operations are carried out on the capital market.

Pfandbriefe play a privileged role on the money market: As the only private debt instrument to date, the Pfandbrief has been placed on an equal footing with government bonds by being included in the ECB's category 1 directory[37]. The European Central Bank hereby recognizes its high security standard and enables it to be used as a discountable or bombardable security in money trading with the ECB throughout Europe[38]. This is why European banks hold significant amounts of Pfandbriefe as collateral for their liquidity-providing measures by way of sale or pledge to the ECB.

The ECB sets the key interest rate as part of its monetary policy.The interest rate structure has an important influence on the maturity transformation of banks. Borrowing funds on the money market is associated with high costs for banks with a flat or even inverse interest structure. An inverse interest rate structure is used when inflation is expected to regress if the interest rates resulting from the prices for government bonds are lower than in the normal case for longer-term commitments than for short-term maturities; the granting of longer-term loans (maturity transformation) is then hardly profitable[39].

In simplified terms, the lucrative maturity transformation of the mortgage banks runs according to the following scheme: They grant long-term loans that are usually subject to higher interest rates than the "short end" and - in addition to Pfandbrief issues on the capital market - refinance themselves on the money market with short-term loans at lower interest rates. The added value results from the interest rate difference. The consequence would have to be a widening spread due to a risk premium for holding Pfandbriefe. There is therefore a negative relationship between the interest rate structure and the yield spread. The market reacts to a Pfandbrief offer that significantly exceeds the demand for this investment with interest rate premiums and spread widening, which for issuers are synonymous with less favorable refinancing conditions[40].

The capital market is made up of the stock market (market for equity capital) and the bond market (market for debt securities). At the same time, both asset classes and real estate within a portfolio are in competition with one another. As the share market cools down, investors are increasingly taking refuge in safe investment havens, such as real estate or bonds (e.g. Pfandbriefe), which are more stable in value than shares[41]. The term bond market is derived from the former quality of the Pfandbrief as the preferred instrument for private old-age provision before the introduction of the state model.

Figure 2: Fixed-income securities on the German bond market

Figure not included in this excerpt

Source: VDH (2004)

With an outstanding volume of over € 1 trillion. and a share of 32% of all German fixed-income securities in circulation, the Pfandbrief is established as the leading segment on the German bond market (see Figure 2). The financing needs of the real estate industry and the public sector are covered to a large extent with the funds raised from the issuance of Pfandbriefe. The Pfandbrief thus makes a major contribution to Germany's economic stability. In Europe, too, the Pfandbrief market takes the top position on the bond market; it ranks sixth worldwide[42]. The rapid growth of the Pfandbrief market is due to the lively issuing activity between 1995 and 2003. This success is due in large part to the introduction of the Jumbo Pfandbrief, which is discussed in Chapter 4[43].

Despite the low nominal interest rates since 2003, investor demand continuously follows supply. The bond markets owe their robust condition to the low inflation rates in Europe and the USA combined with investors' distrust of a sustainable economic upturn. The Pfandbrief segment also benefits from this, with its approx. 19% annual growth in issue volume based on a consistently high level of interest in the German Pfandbrief and the progressive establishment of international covered bonds similar to Pfandbriefs[44].

2.2.2 Primary and secondary market

The primary market is used to place securities, while fungible bonds that are already in circulation are traded on the secondary market. The trading of Pfandbriefe on the primary market mainly focuses on telephone traffic, which is difficult to understand[45]. Issuers and investors operate on the primary market. Here banks are more likely to act as buyers of new Pfandbrief issues, but this relationship is reversed in the secondary market. Only investors negotiate among themselves on the secondary market. The central banks' share of primary market turnover is well above their secondary market quota, with their main focus usually being on the area of ​​short to medium maturities. More active trading houses such as funds are proportionally more represented in the secondary market turnover than in the primary market[46].

On the secondary market, stocks can be purchased at a price below par. This results in the advantage of achieving an additional redemption profit at the end of the term in addition to the ongoing interest. The difference between the lower purchase price and the guaranteed redemption price results in a profit that is not subject to income tax: Converted to each year of the term, this results in a higher return. Different purchase prices, terms and nominal interest rates lead to very different returns on fixed-income securities.

Since 1998, mortgage banks have been authorized in the public lending business not only to be active in the primary market, but also to buy government bonds on the secondary market in order to treat them as proper cover funds and to refinance them through Pfandbriefe[47]. In the repo business, the secondary market for Pfandbriefe is becoming increasingly important. In a repo transaction (repo is the abbreviation for repurchase agreement), also known as repurchase agreement, securities are sold for liquidity, with the simultaneous agreement to buy back securities of the same type and quantity at a future date and at a fixed price. The security backing serves as security. This liquid repo market segment, in which volumes of over € 10 billion are traded daily, contributed to the revitalization of the Pfandbrief market at the beginning of this millennium[48].

2.2.3 Real estate market

The multi-faceted real estate industry is one of the most important and top-selling German economic sectors. Around 10% of German employees work in the housing industry, banking, representatives of real estate funds, etc. According to an analysis by the ECB in 2003, a large part of the welfare effects depends on the prosperity of the real estate economy. An indispensable framework on the way to a professional European real estate industry is reliable legislation that encourages investment and, above all, enables long-term planning[49].

Weak to stagnating domestic demand, inadequate margins and a significant deterioration in asset quality are putting a strain on the earnings situation of the entire German banking industry. These circumstances have led to a structural change since the 1990s, which also affects the real estate market, which shapes the lending business of Pfandbrief issuers[50].

Compared to other forms of capital investment, the real estate investment sector has peculiarities that distinguish it significantly from other markets: its extended investment horizon, the amount of investment, the complex contractual obligations as well as the heterogeneity and lack of transparency of the real estate markets[51]. Factors such as the real estate crisis in East Germany, the misallocation of capital resulting in excess space and the state's continuous withdrawal from housing construction subsidies have created a market environment that, after decades of growth, has reached the limit of saturation[52]. These unfamiliar conditions for the traditional mortgage business are reflected in increased depreciation and the creation of loss provisions. For this reason, a high proportion of loans from the new federal states in the cover pool, for example, are assessed negatively.

There is a direct connection between the dynamics of the Pfandbrief market and the real estate market. The composition of the cover pool on which the Pfandbrief is based is made up of three sub-segments of real estate financing, the private, commercial and state segments. Private residential construction, which can be highly standardized, generates only small margins. Many households have invested much of their wealth in residential property, so consumer spending is more than twice as responsive to changes in property prices as it is to changes in share prices. Although property ownership is the most important asset component of German households, it is less pronounced than in other European countries and still has sales potential.

Commercial real estate that requires intensive advice and generates higher margins offers better opportunities in the international mortgage lending business. After all, the government deficits are keeping investment in the government infrastructure subdued, which is reflected in the reduced issuance of public Pfandbriefe. In general, Germany has bottomed out in the real estate cycle[53]. As a result, the domestic mortgage lending business is declining and justifying an increasing expansion in foreign markets.

In an international comparison, the German real estate market has a low return (mortgage rates have fallen to a historic low of less than 5% in recent years), but it is considered to be the most stable market in Europe. It owes this to its legal market value assessment, which focuses more on value continuity, in contrast to the point-in-time market value analysis customary abroad. The polycentric structure of the German real estate market is attractive for foreign investors, in which several metropolitan areas with different real estate cycles compete, whereas countries such as France or Great Britain each have only one important real estate location[54].

Although the single currency of the euro zone has already caused a stronger convergence of mortgage rates and a standardization of the European Pfandbrief market, we cannot yet speak of a European mortgage credit market. Country-specific regulations such as differently strict consumer protection laws are still delaying the establishment of a uniform internal market for real loans[55].

2.2.4 The international financial market

The liberalization and deregulation of the markets that emerged at the beginning of the 1990s raised doubts about the viability of the Pfandbrief market in the emerging competition between the individual financial markets. The Pfandbrief was not well known abroad. But as European integration and the networking of the markets progressed, international investors increasingly considered financial products such as the Pfandbrief as part of their portfolio diversification. This opened up a cross-border sales potential for him, as shown in Figure 3[56]:

As the largest economy and largest consumer market in Europe, Germany has some structural catching up to do by international standards. Experts criticize the German banking system with its anachronistically high state share in the banking industry. If one looks at the usual measure of competitiveness, namely the return on equity after taxes, the German banks achieve single-digit key figures on average and are thus below the European average.

Figure 3: Refinancing methods in the EU

Figure not included in this excerpt

Own illustration based on VDH (2001)

At the financial market level, too, the international orientation is a market-driven, competitive process that will take place over the next few years even without targeted support measures. However, by promoting the financial location through coordinating regulations and creating common standards, the goal of merging the traditional strengths of the German financial system with the financial innovations of future markets will be achieved faster and more efficiently[57]. The German banking landscape can not only achieve increased competitiveness compared to European competitors through consolidation measures, it also requires greater regulatory scope and more flexibility[58].

With the introduction of a single European currency, the ECB expected the spreads of European government bonds to shrink further. However, as long as different tax systems significantly hinder the European integration process, typical liquidity premiums and credit risks are expressed in slightly widened spreads[59].

Since the disenchantment on the Neuer Markt and the associated bursting of the stock bubble, leading representatives of the economy and central banks have been observing the real estate and bond markets, which are now preferred by investors as safer investments. It turns out that both markets are currently considered overvalued, but without posing a significant threat to the stability of the financial system. According to a study by the International Monetary Fund, the world financial system is well equipped to cope with the bursting of potential pension or real estate bubbles. The actors reacted to shocks such as the collapse in share prices after the turn of the century or the terrorist attacks of September 11, 2001 in the USA with strengthened balance sheets[60]. In this way, the markets can gradually absorb possible imbalances without massive distortions. This affects the Pfandbrief insofar as the question arises whether the image of a favorable market that has prevailed since 2003 is distorted.

According to an analysis by the Bundesbank, there is currently plenty of cheap capital available on the international financial markets. Against the background of expansionary monetary policy and general doubts about a sustained improvement in the economy, this capital is increasingly flowing into the bond and real estate markets. The capital market interest rates, which are decisive for mortgage banks, have fallen to a historic low of 4% in Europe, despite a key rate hike. As measured by the yields on 10-year government bonds, long-term interest rates on the international bond markets reached a seldom low level in relation to the average, which has been 5% over the past 20 years.

As early as 2001, the Bank for International Settlements observed that the real estate and capital markets were increasingly converging. Thus, not only is the risk spread over a larger number of different investors, new causes of volatility must also be expected. With increasing internationalization, the boundaries between the forms of financing are becoming more and more permeable: capital and real estate markets are growing closer together, which additionally increases the competitive pressure. In corporate finance, lending and capital markets are no longer a contradiction in terms, as demonstrated by investors, who tend to view covered bonds as a credit product rather than a traditional interest rate instrument. The company's financing base is broadened through complementary capital market products and alternative forms of financing. In order to hedge credit risks, for example, more and more loans are being securitized and thus made accessible to the capital market. Innovative securitization instruments form the bridge from the credit to the capital market business, which is discussed in more detail in Chapter 4[61].

2.3 Positioning of the respective market participants

Several players influence the Pfandbrief market. The following sections deal with their respective motivation and position in relation to the Pfandbrief.

2.3.1 Refinancing instrument for issuers

The group of Pfandbrief issuers comprises only 40 credit institutions, divided into mortgage banks, ship mortgage banks, state banks and savings banks. Its dimensions are inconspicuous in international comparison. This small group of regular issuers owes its long-term success only to the strictly regulated Pfandbrief issuance in terms of investor protection[62]. According to the figures published by the VDH, the mortgage banks have been particularly active in granting commercial and public loans for more than a decade. They are leaders in the market for outstanding Pfandbrief volumes[63].

Relative to Pfandbriefe, the spreads of uncovered bonds widened significantly more sharply as a result of the problems in the German banking system, which went hand in hand with higher costs for raising funds via unsecured securities[64]. The refinancing advantage of the Pfandbrief is not limited to the spread between covered and uncovered bonds; Its high liquidity makes it particularly interesting for foreign investors[65].

Compared to federal bonds, the creditworthiness of which is based on the state liability mechanisms, Pfandbrief issuers even have to calculate an interest surcharge when issuing first-class Pfandbriefe.

Within the Pfandbrief segment, the return varies depending on the issuer profile or the quality of the cover pools.Since issuers and investors are gaining greater room for maneuver due to the convergence of the financial and capital markets in Europe, it can be assumed that the Pfandbrief segment will become increasingly heterogeneous.


[1] Kern 2004, p. 10

[2] Fehr 1995, p. 12

[3] See Goedecke, Kerl, Scholz 1996, p. 22 and p. 210

[4] Leitgeb, Hauzinger, Veljic, Pascher, Schmidt 2004, p. 10

[5] Kullig, Walburg 2003, p. 19

[6] Zoller 2004, p. 1112

[7] Behr, Güttler, Kiehlborn 2003a, p. 7

[8] Nolting 2002, p. 724

[9] Hagen 2002a, p. 742

[10] Bettink 2002, p. 758

[11] Arndt, Tolckmitt 2001, p. 12

[12] Kern 2004, p. 443

[13] Gabler 1996

[14] See Spremann, Gantenbein 2002, p. 202

[15] See Hies 1996, p. 42

[16] See Hagen 2002a, p. 742

[17] Büchler, Stäuble 2003, p. 5

[18] Sauer 2002, p. 740

[19] Nolting 2002, p. 725

[20] See Stöcker 2004, p. 73

[21] visited on May 3rd, 2004

[22] Arndt, Tolckmitt 2001, p. 28

[23] Rasche, Hagen 2003, p. 4

[24] Arndt, Tolckmitt 2001, p. 22

[25] Kern 2004, p. 79

[26] Mirkes 1999, p 47

[27] Arndt, Tolckmitt 2001, p. 24 ff.

[28] Kern 2004, p. 486

[29] Deutsche Bundesbank 2004, p. 10

[30] Fehr 1995, p. 12

[31] Rasche, Hagen 2003, p. 4

[32] Kern 2004, p. 80

[33] Arndt, Tolckmitt 2001, p. 23

[34] See Stöcker 2004, p. 67

[35] Kullig 2004, p. 9

[36] See Heise, Kater 2004, p. 212ff.

[37] Leitgeb, Hauzinger, Veljic, Pascher, Schmidt 2004, p. 8

[38] See Stöcker 2004, p. 98

[39] Spremann, Gantenbein 2002, p. 72ff.

[40] Rees 2001, p. 59ff.

[41] Just 2003, p. 226

[42] VDH 2001, p. 1

[43] Rasche, Hagen 2003, p. 4

[44] WGZ 2004, p. 6

[45] See Hies 1996, p. 169

[46] Packmohr, Mächtlinger 2004, p. 10

[47] Behr, Güttler, Kiehlborn 2003a, p. 22

[48] See Kullig, Walburg 2003, p. 9

[49] Alda, Koppenhöfer 2003, p. 404

[50] See Nolting 2002, p. 724

[51] Room 2002, p. 134

[52] Nolting 2002, p. 724

[53] Breuer 2004, p. 924

[54] Real Estate & Financing 2003b, p. 438

[55] Hardt 2003, p. 745

[56] Köller 2000, p. 616ff.

[57] Heise, Kater 2004, p. 216

[58] Breuer 2004, p. 925

[59] ECB 2001, p. 31

[60] Engelen, Maisch, Landgraf 2004, p. 19

[61] Heise, Kater 2004, p. 214

[62] Arndt, Tolckmitt 2001, p. 16

[63] Behr, Güttler, Kiehlborn 2003b, p. 6

[64] Hagen 2002a, p. 742

[65] Journal for the entire credit system 2004, p. 1112

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