In our view, favorable credit conditions, stable ratings and outlooks on most issuers, and a strong sovereign will continue to support ratings stability for German covered bonds in 2019. S&P Global Ratings is publishing a series of reports taking a closer look at specific covered bond markets. In our fourth report, we review the German covered bond market.

Overview: Germany, Home Of The Pfandbrief

The popularity of the Pfandbrief is unparalleled in Europe and supported by an indisputable track record dating back more than 200 years. The Pfandbrief has benefitted from constant investor demand throughout a period of significant changes, such as German reunification and the introduction of the euro. Despite the Pfandbrief's stellar reputation, the volume of outstanding covered bonds has decreased from €885 billion before the financial crisis in 2007. In 2007, the German covered bond market was the largest in the world, but the market has since been considerably affected by a decrease in eligible cover assets, in particular the ineligibility of claims against Germany's public sector credit institutions (savings banks and Landesbanks). Today, Germany has the second-largest covered bond market behind Denmark and the largest euro benchmark market, with outstanding issuances totaling €366 billion in 2018.

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Following the financial crisis and significant losses on investments, German Landesbanks' traditional business models faced challenges, resulting in the restructuring of some and years of subdued covered bond issuance. However, issuance was up again in 2018, and the primary market have seen strong starts to 2019. Issuance in the primary markets has been supported by the European Central Bank's quantitative easing program (the third covered bond purchase program [CBPP3]), while liquidity in the secondary market has suffered as some investors have withdrawn. The tapering and ultimate end of the ECB's program in December 2018 resulted in increasing spreads, which has brought back some investors previously crowded out by ECB demand. Finally, restructured issuers have returned to the market in time to take advantage of comparably attractive funding rates.

Types Of German Covered Bonds

The German covered bond market comprises covered bonds backed by different assets types: mortgage loans (Hypothekenpfandbriefe), public sector debt (Öffentlichepfandbriefe), ship mortgages (Ship Pfandbriefe), or aircraft mortgages (Aircraft Pfandbriefe). These asset types must be included in separate cover pools, but the majority of Pfandbrief issuances are backed by two different types of collateral: public sector loans and mortgage loan-backed covered bonds (approximately 98% of the market). This article will focus on the mortgage and public sector covered bonds. For each covered bond type, the German covered bond law defines the eligible assets, the loan characteristics, and eligible jurisdictions.

Issuance Momentum To Continue In 2019

German covered bond issuances may gain momentum this year as funding provided by the ECB's targeted longer-term refinancing operations (TLTRO II) will have a remaining maturity of less than a year and will no longer be eligible for inclusion in the calculation of banks' regulatory net stable funding ratio (NSFR). German banks took the fourth-highest amount of TLTRO (€94 billion) but mainly participated due to the operations' attractive conditions, and they mainly used the borrowed funds for lending. Overall, the participating banks' financial situation improved noticeably, although this had no impact on their credit standards, according to the German Bundesbank. As a consequence of the funding maturing, we expect additional covered bond issuance from Germany in 2019. Further, we estimate there will be about €10 billion of additional maturities in 2019 compared with 2018, which will further support increased issuance. Finally, the restructuring, mergers, and repositioning of a number of German banks have further improved the positive outlook for German covered bond issuance.

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Germany's Covered Bond Framework

Pfandbrief are issued on the basis of the German Pfandbrief Act (Pfandbriefgesetz, PfandBG) and The Regulation on the Determination of the Mortgage Lending Value. The Pfandbrief Act came into force in 2005 and has been amended on several occasions.

All issuing institutions must have a specific license to issue Pfandbrief, whereby the legislators seek to ensure that the Pfandbrief business is part of the long-term business model of the individual bank. In addition to general banking supervision, a Pfandbrief bank is subject to a special form of supervision by the Federal Financial Supervisory Authority (BaFin) to ensure compliance with the covered bond law. As the cover pool remains a part of the issuer's general balance, the BaFin appoints an independent cover pool monitor to ensure that the register for the cover pool is properly maintained at all times. Derivatives must be entered in the cover registers, and payments to counterparties rank equal to Pfandbrief creditors.

One of the central pillars supporting the strong credit story of the mortgage Pfandbrief is that eligible loans may be included in cover pools only up to the mortgage lending limit of 60% of the valuation of the property securing the loan.

The cover pool of a public sector Pfandbrief may consist of claims against government bodies such as EU member states, local authorities, and regional governments; export credit agencies; public sector entities of an EU or European Economic Area member state; and German public sector authorities. Claims against credit institutions may account for only up to 10% of the total volume of cover loans.

Chart 1

Compatibility With EU's Proposal To Harmonize Covered Bond Frameworks

Despite a number of amendments since its introduction, the German legal covered bond framework will likely need some further adjustments in preparation for the new EU harmonization directive. We do not foresee any issues with the framework adapting the new EU requirements for covered bonds. German covered bond issuers have a track record of implementing EU legislation in an effective manner as observed by their implementation of the Mortgage Credit Directive 2014/17/EU, legislation the EU introduced to protect mortgage borrowers. Although the overcollateralization requirements of the EU's final directive for covered bonds seem to be compatible with Germany's current law, adjustments are likely required for its current derivative limits and potentially the compostion of cover pools, in particular asset geography. Furthermore, it remains to be seen whether competitive pressure will prompt German issuers to begin adopting features of foreign issuers' covered bonds such as soft bullet structures (see "Soft Bullet Proposal For German Covered Bond Law Is Unlikely To Affect Ratings," published April 22, 2016, and higher loan-to-value (LTV) limits allowed in other juridstictions. In our opinion, the implementation of one or both features could enhance the attractiveness of the product as a funding instrument and boost covered bond issuance in Germany but could also jeopardize investors' risk perception of German covered bonds. Chart 5 shows the growth of German mortgages with little, but positive, effect on outstanding covered bonds so far.

Chart 5

Features Of Assets Securing German Covered Bonds

Residential mortgage loans:   The majority of German residential mortgage loans have a fixed interest rate for 10 to 20 years. The borrower agrees to the amount of regular installments and also decides whether to make additional down payments on the loan (Sondertilgung). Full prepayment before maturity requires the borrower to compensate the issuer. Installments are the same amount throughout the repayment period, and the interest portion is therefore high in the beginning, while repayment increases over the life of the loan. Not all loans are repaid in full at maturity, and such loans would need refinancing before maturity. Historically, mortgage loans have been funded been by savings banks using funds available due to Germany's high savings rates.

Building society loans (Bausparvertrag):  Since 2016, building societies (Bausparkassen) have been allowed to issue covered bonds, which has allowed the sector to expand into the commercial banks' residential mortgage business. As can be seen from chart 6, the potential for further covered bond issuance is significant but so far issuance volume have been subdued. The typical Bausparkassen product consists of an annuity loan linked to a building society savings program. Installments are paid into the program, which are used to pay off the mortgage at a later stage. The popularity of building society loans increased rapidly from the late 1970s until the mid-1990s because they guaranteed high interest rates on savings and security. The loans remain very secure; however, the low interest rate environment has caused a decline in demand of new contracts. Although we've observed a decline in the total number of outstanding contracts, the volume invested under the existing contracts has continued to rise. The reason for the increase is that owners of older contracts that guarantee higher interest rates continue using them as an investment alternative in the current low interest rate environment.

Chart 6

Commercial real estate loans:   Commercial properties eligible for German cover pools vary but consist mainly of office space, retail facilities, and to a lesser extent, industrial space. However, the largest segment is often multifamily housing, which from a regulatory standpoint is not necessarily considered commercial real estate expsoure. Mortgage loans to these segments reflect the nature of the borrowers. They are normally variable-rate linked to the euro interbank offered rate (Euribor) and have shorter maturities and interest-only characteristics. As chart 7 shows, although the percentage of commercial real estate mortgages is decreasing, the total percentage of commercial and multifamily housing properties included as security in the German cover pools remain above 50%. The percentage of collateral secured by all property types in Germany now make up almost 80% on average.

Chart 7

Public sector loans:   Public sector loans are relatively diverse, ranging from loans to German local and regional governments, public utility companies, export credit agancies, and supranationals. However, the market share of local and regional government funding has decreased, and banks have struggled to find other assets with attractive margins for covered bond funding. Funding cost for the public sector remains very low, and the funding demand is decreasing (see chart 9).

An important factor contributing to the decrease in public sector assets was the elimination of state guarantees on claims against public sector credit institutions in 2005, which made such debt ineligible as security in cover pools. A transitional period for debt issued by German savings banks and Landesbanken ended in 2015 after the EU encourgaged the removal of the guarantor's liability (Gewährträgerhaftung) to improve competition in financial markets. This, combined with the low interest rate environment, has made the business case for public sector Pfandbrief less attractive.

The Market's Changing Landscape

Since 2011, we've observed changes among the largest issuers of covered bond and the type of covered bonds issued (see table 1). Of the top 10 issuers, mortgage covered bonds (Hypotheken Pfandbrief) now make up the largest volume of outstanding covered bonds of seven issuers compared to only two in 2011. The total volume of covered bonds issued by the top 10 largest issuers has decreased considerably since 2011 (down 38%) but has increased as a percentage of the total market (up 3%) and now contain approximately 90% of the total market. Further, a number of the top 10 issuers in 2011 have since merged with other issuers such as Hypotheken Bank Frankfurt and Commerzbank AG, Dexia Kommunalbank Deutschland and Landesbank Hessen-Thüringen (announced), and Deutsche Genossenschafts-Hypothekenbank AG (DG Hyp) with Westfaelische Landschaft Bodenkreditbank AG (WL Bank).

Table 1

Available overcollateralization has increased

The restructuring of a number of German financial institutions starting in 2010 led to a number of mergers, which have resulted in increased available overcollateralization for the covered bond programs that we rate. In fact, by merging issuers with lower overcollateralization with issuers with higher overcollateralization, the available overcollateralization for some issuers in the market has more than doubled since 2012.

Additionally, the restructuring and de-risking of certain banks, stronger capitalization, and growth in the German economy since 2013 have led to positive rating actions on banks, in turn supporting the ratings on covered bond programs.

Currently, available credit enhancement is significantly higher than target credit enhancement for the majority of the programs that we rate (see chart 8). The target credit enhancement is the overcollateralization required to achieve the maximum potential collateral-based uplift, and it covers credit risk, and market value risk, which is the credit enhancement that we expect would be required to refinance the cover pool in a stressed environment.

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Chart 9

Traditional Pfandbrief issuance has dropped

While issuance of market-based Pfandbrief is markedly down, the traditionally smaller segment of the market--the so-called "Namenspfandbriefe" (N-bonds)--has increased as a percentage of the total market, representing a potential source of Pfandbrief issuance growth. An N-bond is a covered bond or debt security, which, unlike a typical Pfandbrief or security, is unregistered. No records are kept of the owner or the transactions involving ownership. The liquidity of such bonds is generally considered lower than typical Pfandbrief, and investors have traditionally been buy-to-hold investors, such as life insurance companies. However, recent data suggest that N-bond volumes are also in decline and mainly remain a source for public sector funding (see chart 10).

Chart 10

Green covered bonds emerge

Another source for new issuance has been green and social covered bonds. Berlin Hyp paved the way for green covered bonds, while Deutsche Hypo, Landesbank Baden Wuertemberg, and Munchner Hyp since followed with further issuances (see "What's Behind The Rise In Green Covered Bond Issuance?" published June 26, 2018). Issuers have claimed that there have been advantageous funding conditions for green and social covered bonds but more importantly interest from investors who normally do not invest in the covered bond market. The green and social market remains limited in size, but as one of the largest covered bond markets, we expect German covered bond issuers to be on the forefront of developments within this growing segment.

Mortgage Market Overview: A Stable Economy Supports The Sector

We expect Germany's real GDP to grow by 1.6% in 2019, a slowdown after last year's economic expansion and a downward revision from our last forecast of 1.8% for the year given the contraction in third-quarter 2018. However, we do not think this will change the economy's growth path, and we see it rebounding over the next two quarters. Household consumption should drive growth in 2019 amid wage increases and low unemployment. Investment will continue to spur growth over the next few years due to important capacity constraints in manufacturing and construction.

The unemployment rate is at its lowest level since German reunification in 1990, despite a large number of new entrants to the labor market, including from lower-income EU members and a large inflow of refugees in 2015-16. We expect the unemployment rate to decline further to 3.0% this year from 3.4% in 2018 and to remain at that level in the medium term. We also expect the German jobless rate to stay significantly below the average of the eurozone over the forecast horizon.

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Property market outlook

House prices increased in 2017 at a lower rate of 4.5% compared to the 2016 level of 6.8%. However, when comparing the seven biggest cities, prices increased by 9.4% last year, compared with 10.9% in 2016. Demand for homes remains solid, mainly due to the strong economic growth and a strong labor market, and resulting low unemployment.

We still expect house prices to increase, though by lower rates of 3.5% this year and 3.0% in 2020. The recenty introduced government funding program (Baukindergeld), which aims to help families with children and single parents finance a residential property, could further support house prices.

Government funding program

There are several state-supported programs that provide assistance for property purchases or to build your own. The most recent was in July 2018, when the German government launched a funding program (Baukindergeld) for families with children or single parents. The aim of this program is to help families finance a house or an apartment. The applicant receives €1,200 per child per year, for a maximum period of 10 years (in total €12,000).

The applicant's taxable household income must not exceed €90,000 with one child plus €15,000 for any additonal child. The property must be for the applicant's own use and not for rental purposes. The program currently runs to the end of 2020, and applications for the funding program are made directly at the KfW, which is a German government-owned development bank.

The below chart illustrates the high demand for the funding program. In the first month after introduction nearly 25,000 applications were registered, and after three months nearly 48,000 applications were received. The majority of applicants were registered in North-Rhine Westphalia, with 10,728, and Baden Wuerttemberg, with 6,407. Since January 2019, more than 64,000 applications have been registered. On average, 3,000 applications are registered per week.

Chart 11

Although the demand is high for the funding program, the size is limited. The government allocates €3 billion per year for the program. We will follow the performance of these loans, which may be at higher risk because the support ends after 10 years, normally before the end of the mortgage loan term. This could subject the borrower to a payment shock at the end of the support period similar to loans with initial interest-only periods.

Outlook And Comparison Of German Covered Bond Programs

The strong German economy and low interest rates have been very supportive of mortgage market performance. Further, a number of German covered bond issuers have finalized restructuring programs and now stand stronger than before the crisis. Due to the commercial component of German cover pools, credit risk in German pools is sligthly higher than cover pools in strictly residential-based jurisdictions. However, the very conservative mortgage lending values reduce expected loss when default occurs, which compares positively to other juridstictions with higher LTV ratios.

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Chart 15 shows the very high issuer credit ratings (ICRs) for most of the S&P Global Ratings-rated programs. This allows the issuer to reach the 'AAA' rating based on juridstictional support.

Chart 15

Chart 16 shows our average cash flow calculation across countries. German programs on average have slightly higher credit risk compared to peer countries, but lower market risk. Considering the lower market risk, the available credit enhancement is also lower relative to other countries.

Chart 16

Program Comparison

Even though German programs' performance is generally strong, some differences in characteristics of the cover pool and cash flow results are evident. Most German issuers provide stratified cover pool information rather than loan-by-loan data. Consequently, we assess the Pfandbrief's collateral credit quality relatively conservatively because we receive information on a weighted-average basis. For example, as part of our analysis we would make LTV ratio adjustments based on the higher end of the weighted-average LTV ratio bucket reported. This would generally lead to higher risk measure results for the weighted-average foreclosure frequency (WAFF) and our loss estimate measure, the weighted-average loss severity (WALS), than if we were to analyze the pool using loan-by-loan data. Below we present the key characteristics of the German covered bond programs that we rate.

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However, credit characteristics of German cover pools are not static as charts 19, 20, and 21 show, and individual issuers of German covered bonds frequently make changes to the asset composition, in terms of asset types and geography. Furthermore, programs are managed differently in terms of the level of available overcollateralization. These are all factors that can change the number of available notches of uplift and eventually the achievable rating under S&P Global Ratings' covered bond criteria.

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Scenario Analysis

Although we expect that annual nominal house price increases will slow in the future, we modelled a scenario analysis in which we forecast some large drops in house prices. For this scenario analysis, we tested a drop in house prices of 10% and 20%, similar to what occurred in Eastern Germany after the reunification when more than one million of the East German population emigrated to West Germany. In the mid-90s, house prices decreased within three years by about 15%, and shortly after the 2000s the accumulated price drop was roughly 20%.

The significant drop in house prices did not lead to any negative rating actions on our rated covered bonds directly related to the decline in the regions, which was also due to the fact that real estate assets in the regions are not common in cover pools rated by S&P Global Ratings.

Table 3 shows the effect of the house price decline on our WALS calculation. The overcollateralization in line with the current rating does not increase significantly. These hypothetical house price drops do not affect the achievable rating on any of the programs either.

Table 3

Related Criteria

• Methodology And Assumptions: Assessing Pools Of European Residential Loans, Aug. 4, 2017

Related Research

• European Economic Snapshots, Dec. 18, 2018
• Global Covered Bond Insights Q4 2018, Dec. 12, 2018
• Global Covered Bond Characteristics And Rating Summary Q4 2018, Dec. 12, 2018
• Credit Conditions EMEA: Bracing For Turbulence, Nov. 29, 2018
• European Economic Snapshots For Q4 Published, Oct. 11, 2018
• Europe's Housing Markets Are Staging A Soft Landing, Sept. 3, 2018
• Criteria Guidance: Covered Bonds Criteria, May 2, 2018
• Glossary Of Covered Bond Terms, April 27, 2018
• The German Pfandbrief Market: Ongoing Success Story Or Further Decline Ahead?, Sept. 12, 2017
• Is The Pfandbrief Still Important For German And International Capital Markets?, Sept. 12, 2016