Mortgage bond and MBS market development in Germany.

• Author: Franscini, Mathilde
• Position: Mortgage backed securities

Funding mortgage loans through Pfandbriefe is constrained by a conservative loan-to-value limit of 60%. Therefore, there is an increasing need for MBS, particularly synthetic transaction. However, MBS are still subject to 100% risk weighting.

The international reforms, through the Basel Accord among other things, will affect German banks more than in any other European country because they will force them to change their less-stringent capital reserve requirements, which now give them a competitive advantage in pricing loans and holding them on their books. Furthermore, Landesbanks, the state-owned German banks required to lend on property law, enjoy "AAA" ratings because they are state supported. This gives them a funding advantage that has been recently challenged by the European Banking Federation to the European Union.

1. RESIDENTIAL PROPERTY MARKET STRUCTURE

   The German property market has historically been stable and conservative:

   * A relatively stable interest rate environment has led to a large proportion of fixed-interest mortgages with long maturities. The interest is mainly fixed for between five and ten years. However, high penalties make an early conversion of the loans in time of falling interest rates economically unattractive.

   * Lenders are generally conservative in their lending policy. As a rule, borrowers are expected to have a minimum equity cushion of about 20% of the value of the property. Down payment is typically 35 to 40%.

   The main mortgage lenders are the savings banks and private mortgage banks with a share of around 25% each. With a market share of about 15% cooperative banks are the third largest group of lenders. Universal banks have less than 10% of the property lending market.

   The mortgage banks are strongly specialized as a consequence of legal restrictions and mainly integrated within the scope of the major universal banks where they act as subsidiaries.

   These mortgage banks can only refinance a maximum of 60% of the mortgageable value through Pfandbriefe. The amount over and above this 60% cannot be included in the collateral for Pfandbriefe and must be refinanced elsewhere, creating an opportunity for MBS.

   Some characteristics of the German housing market can be highlighted. First, the level of home ownership has always been very low in Germany--40%, with 42% in Western Germany and 31% in Eastern Germany. This is due primarily to historical reasons (state housing policy), to the high land and property prices and to an unfavorable tax regime. However, home ownership is expected to rise in the long term. Second, there seems to be a certain geographical attachment in Germany, which means that there is little geographical mobility. Third, there are huge social and cultural barriers against defaulting on mortgage payments.

   In the traditional model category, there is a mix of the depository system (savings banks, cooperative banks) and of the mortgage bank system (mortgage banks). In the modern model category, the direct sale system is predominant.

2. SPECIALIZED FUNDING VEHICLES

   1. Mortgage Bonds--Pfandbriefe

      The German Pfandbrief market is the largest non-state segment in the European bond market with a volume outstanding of over EUR 1 tn at the end of 1999. Public Pfandbriefe account for around 80% of the volume outstanding, the rest being Mortgage Pfandbriefe.

      1. Types of mortgage bonds

         Traditional Pfandbriefe

         The bonds are usually with fixed interest rates and with maturities of 1 to 10 years (although the medium term maturities of 5 to 7 years predominate). On average the size of a classical Pfandbrief is some EUR 150 mn. Traditional Pfandbriefe are offered for sale in the open market in the form of tap issues. Within one issue, individual series are set up, the issuing price of which varies depending on the capital market rate applicable at the time of issue. This type of mortgage bond is flexible and can thus be tailored to investors' specific needs.

         Jumbo Pfandbriefe

         In order to be considered as a Jumbo, the issue volume has to be at least of EUR 500 mn. Other conditions need to be met: a) only fixed-interest, bullet instruments with annual interest payable in arrears (so-called straight-bond format); b) at least three market makers, two rates with a spread of a maximum of 5 to 10 pfennigs; c) standardization (which makes for transparency) of the Pfandbrief global certificate, the Pfandbrief terms and conditions and other documentation.

         The jumbo Pfandbrief market currently consists of over 280 Pfandbriefe with a maturity of up to 14 years and a combined volume of over EUR 325 bn. Here the Public Pfandbrief, which is covered by state loans is dominant. Recently however, Jumbo Mortgage Pfandbriefe have increasingly been issued too. For example, in 1999 a Global Mortgage Pfandbriefe in the amount of EUR 2 bn was launched. The successful placing of new issues with international investors, the listing of jumbo Pfandbriefe in various international bond market indices and the issue of Globals, which are offered in the leading financial centers, underline the attraction and outstanding role of the jumbo Pfandbrief among European spread products. The inclusion of large-volume Pfandbriefe in the electronic trading system EuroCreditMTS, which brings the jumbos involved closer to the liquid government bonds, reflects the success of this new instrument.

         Jumbo Pfandbriefe are placed through issuing syndicates consisting of national, and to an everincreasing extent, international banks. To guarantee the liquidity of Jumbo Pfandbriefe at all times, at least three syndicate banks must act as market-makers for each issue.

         There is apparently a trend towards larger issue volumes (EUR 2 bn or more). As a result of the EMU convergence process, the remaining yield difference between government bonds of the EMU countries have settled on a low level and jumbo Pfandbriefe might benefit from an increase in the demand for spread product. In this new environment, this new security is becoming a European...