In its Covered Bond Market Insights report, S&P Global Ratings presents the local covered bond market, explains how the relevant legal framework works, provides an overview on the local mortgage market, compares key characteristics of the existing programs, and presents the results of a scenario analysis.

In this report, we review the German covered bond market. In our view, relatively stable ratings and outlooks on issuers and a strong sovereign will continue to support ratings stability for German covered bonds in the medium term despite the COVID-19 pandemic.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The consensus among health experts is that the pandemic may now be at, or near, its peak in some regions, but will remain a threat until a vaccine or effective treatment is widely available, which may not occur until the second half of 2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Overview: Germany, Home Of The Pfandbrief

The popularity of the Pfandbrief is unparalleled in Europe, and the Pfandbrief is supported by an indisputable track record dating back more than 250 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, outstanding covered bond volume has reduced by over half from €885 billion before the financial crisis in 2007, when Germany had the largest volume in the world. Today, Germany has the second-largest covered bond market behind Denmark and the largest euro benchmark market, with outstanding issuances totaling €355 billion in 2020.

Although the size of the market has stabilized in recent years, it faces a number of challenges. Some are widely shared by the general covered bond market, while some more specific to the German economy.

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Eurozone monetary stimulus following COVID-19

Following the COVID-19 pandemic outbreak, the European Central Bank (ECB) announced a significant bond purchase facility, the Pandemic Emergency Purchase Programme (PEPP), on March 18, 2020. The ECB said the asset purchase program will last until at least June 2021, and at the beginning of June, it increased the program to €1,350 billion from the €750 billion. The program is designed to keep capital markets functioning, liquidity flowing, and to encourage banks to extend capital to stimulate the economy. We expect the ECB's monetary policy to remain loose at least until 2023. The PEPP comes on top of the €20 billion of monthly Asset Purchase Programme (APP) net purchases as well as the Corporate Sector Purchase Programme (CSPP), and we expect that covered bond yields will remain at historically low levels.

European covered bond framework under implementation

In September 2019, the European Parliament approved the final version of the directive and regulation on the harmonization of covered bonds. Following the publication of the directive and regulation in the Official Journal of the European Union, national authorities have 18 months to transpose it into their national legislation and an additional 12 months to apply the new rules. The alignment of the German legislative framework with the best practices of the European Banking Authority is medium (see "Harmonization Accomplished: A New European Covered Bond Framework," published April 18, 2019). However, the main required updates are to implement a nominal minimum for overcollateralization and liquidity coverage. The harmonization directive allows for potential revisions of current loan-to-value limits, use of derivatives, and overall asset eligibility. We expect all changes to be carried out with the highest respect to the tradition and reputation of the current framework. Making more significant changes to the framework has the potential to increase both the attractiveness as well as risk of the new Pfandbrief, in our opinion.

COVID-19 tightens its grip on Europe's mortgage markets

As a result of the COVID-19 pandemic and its impact on the economy, we expect house prices to decline in nearly all European markets this year. For Germany, we forecast a decline in prices by 1.2% this year and 0.4% in 2021. We believe that large-scale job support schemes deployed by governments across Europe, such as Germany's "Kurzarbeit" (reduced working hours), will contain the rise in unemployment rates and therefore the decline in house prices. By 2022 nearly all markets should return to relatively strong house-price growth (see "Government Job Support Will Stem European Housing Market Price Falls," published May 15, 2020).

The Covered Bond Framework: Detailed Regulation Limits Risk But With Little Space For Innovation

Legal framework

While the Pfandbrief has origins prior to the establishment of present-day Germany, the German Pfandbrief Act (Pfandbriefgesetz, PfandBG; The Regulation on the Determination of the Mortgage Lending Value) known today stems from 2005, and it has since been amended from time to time. In addition to the main legal framework, three issuer-specific frameworks allow for the issuance of covered bonds (DZ-Bank covered bonds, DSL covered bonds, and Landwirtschaftliche Rentenbank covered bonds).

The German covered bond law divides covered bonds into specific 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). For each covered bond type, the German covered bond law defines the eligible assets, the loan characteristics, and eligible jurisdictions.

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Table 1

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 are eligible for cover pools under certain conditions and are subject to certain limitations. Payments to counterparties rank equal to Pfandbrief creditors.

One of the central pillars supporting the strong history 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. Further, the valuation is a "Beleihungswert," a conservative valuation based on long-term considerations, and by definition, always lower than the current market price.

Commingling

Commingling risk refers to the risk that cash collected from the cover assets (mortgage loans, for example) could be trapped in the insolvent estate or temporarily restricted from servicing the covered bonds. If the insolvent issuer's estate can make a claim, such cash collections may be considered lost or frozen depending on its status under general insolvency law. The German cover register does not constitute a legal entity prior to the default of the issuer. Therefore, following the issuer's insolvency, cash is held in the issuer's name and some cash holdings are held on the cover pool's behalf, which creates a potential risk of commingling.

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Overcollateralization and liquidity tests

The covered bond law requires that the nominal value of the assets is higher than the value of the liabilities at all times. Additionally, issuers must include 2% overcollateralization on a net present value basis based on a weekly stress test. Finally, the issuer must cover the maximum liquidity need within the next 180 days.

These tests are designed to not only ensure a minimum ratio of cover pool assets for covered bonds, but they also serve to limit liquidity risk. The tests have been the source of animated debate in light of the introduction of net stable funding requirements and the EU's covered bond harmonization directive (see "Soft Bullet Proposal For German Covered Bond Law Is Unlikely To Affect Ratings," published April 22, 2016).

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Mortgage Market Overview: COVID-19 Brings GDP Down, Unemployment Up

Economic growth at risk

Due to the COVID-19 pandemic, we revised our expectations downward for the German economy. We anticipate that Germany's real GDP will decline by 6.2% in 2020 before recovering by 4.4% in 2021. The government has initiated fiscal stimulus of more than €1 trillion to support the economy, including cash transfers, credit, and guarantees to support corporates. It also initiated a partial unemployment scheme called "Kurzarbeit," which involves reduced working hours.

We revised our labor market forecasts for the next few years and expect an unemployment rate of 5.0% for 2021, up from 3.4% in 2018. Still, according to our forecasts, Germany would have a lower unemployment rate compared to peer countries like Belgium or the U.K.

It is likely that the German economy will drift into a recession in 2020, as a result of weak consumption due to the containment measures imposed by the government as well as weak exports.

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German cover pools

German cover pools are managed according to the German covered bond legislation, which allows for dynamic management of the cover pool. This may affect the asset composition, the geographical focus of the assets, and the level of overcollateralization (as long as it is above the legal minimum), while issuers may utilize covered bonds more or less depending on their funding needs. The following table depicts the development of the top 10 issuers in Germany's covered bond market. It shows the change in outstanding bonds over time as the market has moved from covered bonds backed by public sector assets to mortgage backed covered bonds. Further, the changes reflect consolidation in the market, with a number of mergers taking place since 2011.

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Since 2011, we have seen an increase in residential mortgage assets in the cover pool, while the percentage of commercial real-estate has decreased.

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Residential mortgage loans

Most 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, residential 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. The typical Bausparkassen product consists of an annuity loan linked to a building society savings program funding residential mortgages. Installments paid into the program 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. However, the low interest rate environment has reduced demand for new contracts. There is significant potential for further covered bond issuance, but recently issuance volume has been subdued.

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. The largest segment is often multifamily housing, which from a regulatory standpoint is not considered commercial real estate exposure. Mortgage loans 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 remains above 50%. The percentage of collateral secured by all property types in Germany now makes up almost 80% on average.

Public sector loans

Public sector loans are relatively diverse, ranging from loans to German local and regional governments, public utility companies, export credit agencies, and supranational organizations. However, local and regional government debt has decreased, and banks have struggled to find other assets with attractive margins for covered bond funding.

COVID-19 and the consequent increase in spending by local and regional governments may increase their need for funding, and in turn, this may support new issuance of public sector Pfandbriefe (see "How COVID-19 Will Change Covered Bonds," published July 8, 2020).

Cover pool management changes over time

As the charts below show, German cover pools rely on different levels of commercial assets. While most issuers focus on assets sourced in Germany, some are mainly using non-German assets to issue covered bonds. The impact of COVID-19 may therefore affect different programs to different degrees. Our credit analysis reflects the respective geography of the assets, while the remaining uplift reflects the issuer's jurisdiction.

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Given the change in the utilization of covered bonds and the risk composition of the cover pools, the overcollateralization levels evolve from time to time. Generally, we observe very high levels of available overcollateralization, but the below chart highlights notable differences and high levels of change over the period.

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Green covered bonds emerge

A 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 have since followed with further issuances. More recently, Deutsche Kredit Bank launched a so-called blue covered bond program backed by public utility funding (see "Are Covered Bonds Becoming More Sustainable?" published Sept. 6, 2019). Issuers have claimed that there have been advantageous funding conditions for green and social covered bonds, but more importantly, there has been interest from investors that 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. Since 2019, the Association of German Pfandbrief banks (VDP) has maintained the minimum standards for Green Pfandbriefe, and further product development is planned by the participating banks.

Table 5  |  View Expanded Table

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Ratings Outlook: Covered Bonds Are Well Insulated From The Risk Of Bank Downgrades

German covered bonds benefit from highly-rated issuers, which are the first recourse for bondholders. Moreover, programs with a highly-rated issuer can benefit from unused notches of uplift, offering some protection against downgrades of the issuing bank.

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Chart 12 shows the breakdown of the average target credit enhancement levels compared to available credit enhancement across countries. We define the target credit enhancement as the overcollateralization commensurate with the maximum collateral-based uplift.

German programs on average have comparable credit and market risk compared to peer countries. Consequently, the available credit enhancement is also comparable relative to other peer countries.

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Scenario Analysis: German Covered Bonds Can Withstand Substantial House-Price Corrections

In light of the current economic environment, we have carried out a scenario analysis with large drops in house prices to gauge whether these would affect the overcollateralization that is commensurate with our ratings. We have tested this scenario analysis for house-price drops of 10% and 20%, similar to what occurred in Eastern Germany after the reunification when more than one million of the East German population immigrated 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%.

Table 7 shows the impact of the house-price declines on our weighted-average loss severity calculation. The overcollateralization in line with the current rating does not increase significantly. These hypothetical price drops do not affect the achievable rating on any of the programs either.

Table 7

Transaction Updates

• Transaction Update: Deutsche Apotheker- und Aerztebank eG Mortgage Covered Bond Program, July 17, 2020
• Transaction Update: DZ HYP AG (Public Sector Covered Bond Program), April 3, 2020
• Transaction Update: DZ HYP AG (Mortgage Covered Bond Program), Feb. 28, 2020
• Transaction Update: DZ BANK AG Deutsche Zentral-Genossenschaftsbank (DZ Briefe), Jan. 27, 2020
• Transaction Update: Wuestenrot Bausparkasse AG (Mortgage Covered Bond Program), Jan. 21, 2020
• Transaction Update: NRW.BANK Public Sector Covered Bond Program, July 19, 2019

Related Criteria

• Methodology And Assumptions: Assessing Pools of European Residential Loans, Aug. 4, 2017
• Covered Bond Ratings Framework: Methodology and Assumptions, June 30, 2015
• Covered Bonds Criteria, Dec. 9, 2014
• Methodology For Assessing Mortgage Insurance And Similar Guarantees And Supports In Structured And Public Sector Finance And Covered Bonds, Dec. 7, 2014

Related Research

• How COVID-19 Will Change Covered Bonds, July 8, 2020
• Credit Conditions Europe: Curve Flattens, Recovery Unlocks, June 30, 2020
• Global Covered Bond Characteristics And Rating Summary Q2 2020, June 30, 2020
• Global Covered Bond Insights Q2 2020, June 30, 2020
• Government Job Support Will Stem European Housing Market Price Falls, May 15, 2020
• European Economic Snapshots: Larger Risks To Growth Loom Ahead, May 5, 2020
• Summary: Germany, April 3, 2020
• Are Covered Bonds Becoming More Sustainable?, Sept. 6, 2019
• Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019