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.

Overview: COVID-19 And ECB Affect The Pfandbrief

Similar to that of other European markets, 2020 continued to be a challenging year for covered bond issuance in Germany. Year-to-date German investor-placed benchmark covered bond issuance is about 37% lower than the total 2020 level. Today the German covered bond market is the second-largest after Denmark and the largest euro benchmark market, with outstanding issuances totaling €375 billion as of H1 2021.

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Overall, in 2021 we expect German investor-placed benchmark covered bond issuance to be lower than in 2020. This is due to issuers' continued access to competitively priced central bank funding--which steered some banks toward retained, rather than investor placed, covered bond issuances--and growth in bank deposits due to reduced consumer spending.

Transposition of EU's covered bond directive accomplished, but challenges remain

On April 15, 2021 the German Bundestag passed the Covered Bonds Directive Implementation Act (CBDUmsetzungsgesetz, CBDUmsG), aimed primarily at implementing the EU's Covered Bonds Directive into Germany´s Pfandbrief Act (Pfandbriefgesetz, PfandBG) and making adjustments to reflect changes to article 129 of the Capital Requirements Regulation (CRR). On May 7, 2021 the second reading in the Bundesrat took place, making Germany the first country to complete the parliamentary procedure for implementation of the EU's Covered Bonds Directive.

The main changes to the PfandBG include, amongst others: the introduction of an option for the cover pool administrator to extend the maturities of an insolvent issuer's covered bonds by up to one year; an additional nominal statutory overcollateralization (OC) requirement of 2% for mortgage and public sector covered bonds and 5% for ship and aircraft covered bonds; derivative eligibility amendments; amendments to provisions for the liquidity buffer and the cover pool monitor's reporting duty; and the expansion of transparency provisions.

Article 1 of the CBDUmsG, which includes the option to extend the maturities of covered bonds, entered into force on July 1, 2021. Article 2 CBDUmsG, including provisions on implementing the CBD, will enter into force on July 8, 2022.

We understand that the wording of the extension is currently being processed by German covered bond issuers. The deadline to include program documentation updates for new issuances is May 2022. The current documentation for outstanding bonds will not be amended.

We continue to view the German covered bond legal framework as very strong. These changes have no impact on our ratings on German covered bonds.

Concerns raised over valuations

The Association of German Pfandbrief banks (VDP) has expressed concerns regarding the Beleihungswertermittlungsverordnung (BelWertV)-–the German valuation regulation--which it considers too conservative and which may limit the use of covered bonds for funding of residential real estate. The BelWertV limits the valuations used for covered bond issuance and--combined with loan-to-value (LTV) limits of 60% (lower than the directive's 75%)--severely limits issuers' use of residential mortgage collateral in German covered bonds. In our opinion, stringent valuation limits are one reason for German covered bond issuers' higher percentage of commercial real estate as collateral for cover bonds compared to other countries.

COVID-19 has had a limited impact on loan performance and sustainable covered bonds support issuance

The German housing market strongly weathered the COVID-19 pandemic, partly due to pandemic policy measures in Europe, protecting workers' jobs and income, short-time work and furlough schemes which avoided a wide economic downturn. Germany has extended such measures until year end 2021. Despite lower issuance, green covered bonds continue to gain importance for German covered bond issuers.

Germany's Covered Bond Framework: Will Harmonization Bring Growth?

German covered bonds are issued on the basis of the PfandBG and The Regulation on the Determination of the Mortgage Lending Value. The PfandBG came into force in 2005 and has been amended on several occasions. In May 2021 Germany's Bundesrat approved amendments to the PfandBG, completing the parliamentary procedure for implementation of the EU's Covered Bonds Directive.

In addition to the main legal framework, we understand that three issuer-specific frameworks will continue to allow for the issuance of covered bonds: DZ-Bank covered bonds, DSL covered bonds, and Landwirtschaftliche Rentenbank covered bonds. We expect these frameworks to continue to align with the main legal framework

The PfandBG provides for covered bonds to be backed by: mortgage loans (Hypothekenpfandbriefe), public sector debt (Öffentliche Pfandbriefe), ship mortgages (Schiffspfandbriefe), or aircraft mortgages (Flugzeugpfandbriefe). These must each be included in separate cover pools. The majority of German covered bonds are backed by either public sector loans (about 34% of total outstanding covered bonds) or mortgage loans (approximately 66% of total outstanding covered bonds). For each of these collateral types, the German covered bond law defines the eligibility criteria, loan characteristics, and eligible jurisdictions.

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In addition to general banking supervision, covered bond issuers are subject to supervision by the Federal Financial Supervisory Authority (BaFin) to ensure compliance with the covered bond law. BaFin appoints an independent cover pool monitor to ensure the cover pool register is maintained at all times. Derivatives are eligible for inclusion in the cover pool under certain conditions and limitations. Payments to counterparties rank equal to payments due to covered bondholders.

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 based on the mortgage lending value ("Beleihungswert"), a conservative valuation based on long-term considerations, and which by definition cannot exceed the current market price. The new legislation will maintain the lending limits, which has raised some concern for limited growth in residential mortgage loans as security for covered bonds.

Overcollateralization, liquidity buffer, and maturity extension

The May 2021 amendments to the PfandBG introduced an additional nominal statutory OC requirement of 2% for mortgage and public sector covered bonds and 5% for ship and aircraft covered bonds effective July 8, 2022.

The PfandBG still also requires issuers to hold a liquidity buffer that covers maximum net liquidity outflow over the next 180 days.

One of the main amendments to the PfandBG is the introduction of an option for the cover pool administrator to extend the covered bonds' maturities of an insolvent issuer by up to one year. The maturity extension cannot affect the ranking of covered bond investors or invert the sequencing of the covered bond programs' original maturity. Maintaining the original payment sequence of outstanding covered bonds may be a challenging exercise in our opinion, and will likely lead to further extensions, since extending one bond may require extension of other bonds due within the extension period.

Our rating analysis will consider the extended maturity of the covered bonds, which could help improve the observed mismatch between assets and liabilities--particularly for residential mortgage programs with traditionally higher asset-liability mismatches. For public sector programs, which traditionally have lower asset liability mismatches, we expect the effect to be limited.

Accordingly, we anticipate that a maturity extension may affect the overcollateralization commensurate with the maximum collateral-based uplift (see also "Approach To Analyzing German Covered Bonds Clarified Following Changes To The German Covered Bond Law," published on Oct. 6, 2021).

Commingling risk

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 potential commingling risk.

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Mortgage Market Overview: German Housing Market Maintains Momentum

We anticipate Germany's economy will grow by 3.1% in 2021 and 5% in 2022, after a 4.9% contraction in 2020. Increasing vaccination rates will result in further lifting of restrictions, which leads to a boost in private consumption. Furthermore, the boost to investment across Europe from the Next Generation EU plan should lead to higher demand for German industrial products and exports. However, the main risks stem from the impact of COVID-19 variants and financing conditions when central banks reduce their bond purchases.

In line with the observed recovery, we expect unemployment to decline from the current level of around 4% to 3.5% in 2022 and 3.4% in 2023.

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Property market outlook: House prices should increase more slowly in 2021

House prices exceeded 6% in 2020 and are expected to growth 5% in 2021. The expected sustained economic and employment recovery will support the housing market beyond 2021, with house prices expected to grow by 4.9% in 2022 and by 4.5% in 2023. The search for yield will continue to generate investor demand in large cities and investor-based markets, especially in Germany, where housing prices are still catching up with the rest of Europe.

House prices in Germany are also supported by population growth, which, despite low birth rates and high death rates, continue to increase due to positive net migration (see chart 7). Growing immigration will continue to support German house prices, particularly in urban areas (see chart 8). The top 10 largest German cities have recorded positive growth in population from 2009-2020. Strongest growth is observed in Leipzig, Munich, and Frankfurt. In the same period, the total population increased at a much lower rate of 1.7%. We expect growing urbanization in Germany to continue to support demand for housing despite COVID-19, with stable house prices in the bigger cities at least.

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Features Of German Covered Bond Programs

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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Green Covered Bonds And ESG Considerations

As one of the largest covered bond markets, we expect German covered bond issuers to be on the forefront of the developments within this growing segment. Since 2019, the Association of German Pfandbrief banks (VDP) has maintained the minimum standards for Green Pfandbriefe. Furthermore, the VDP has established minimum standards for social covered bonds that build on existing green and social standards. Participating banks are planning further product development.

Environmental and social credit factors are typically credit neutral in our analysis of German mortgage covered bonds. While we typically consider social factors to be a credit positive in the assessments of the public sector entities included in public sector cover pools. The German Pfandbrief law requires the coverage of 180 days liquidity. Issuers are not committed to maintain a minimum level of OC in the program. While this does not affect our ratings on the bonds, it reduces the number of unused notches which provides protection in the event of an issuer downgrade.

Climate Risk Vulnerability

Extreme weather events such as heavy rainfall and heatwaves are becoming more frequent. In July 2021, severe weather conditions resulted in some of the worst flooding catastrophes seen in Germany. Heavy rain and flooding led to significant damages mainly in the German states of North Rhine-Westphalia, Rhineland-Palatinate, and Bavaria. The total damages are estimated to be about €7 billion. Of that sum, €6.5 billion alone is for residential buildings, households, and businesses.

Although most properties affected may have residential building insurance, natural risk insurance is not a common feature of household insurance in Germany. According to the Gesamtverband der Deutschen Versicherungswirtschaft (GDV), only 47% of properties in North Rhine-Westphalia and 37% of properties in Rhineland-Palatinate are secured against natural risk.

In response to severe damages, the German government has established a €30 billion reconstruction fund. From this sum, €2 billion will be used for infrastructure reconstruction, with the remaining €28 billion to be distributed amongst impacted states according to the damages caused (54.4% to Rhineland-Palatinate, 44.0% to North Rhine-Westphalia, 1% to Bavaria, and 0.48% to Saxony). Impacted homeowners, companies, and other facilities are expected to receive a compensation up to 80% of the total damage. In more severe cases it is possible to receive 100%.

We do not expect the damages linked to the current flooding to have any impact on the rating of our rated mortgage covered bonds. Although losses are significant, the affected regions make up a limited part of the diversified loan portfolios constituting the security for covered bonds. Compared to the overall size of the cover pool, we expect losses to be manageable also considering the strong government support for the borrowers.

Comparison Of German Covered Bond Programs

As shown in chart 10B, the share of German assets backing covered bonds varies across issuers. While most issuers focus on assets sourced in Germany, some include mainly non-German assets in their cover pools. Our collateral support analysis is performed using the respective criteria for the underlying asset type, while our resolution regime and jurisdictional support analysis reflects the issuer's jurisdiction.

As chart 10A shows, the share of commercial assets also varies significantly across issuers. While we believe that commercial real estate asset performance may deteriorate, we do not anticipate this significantly impairing the credit quality of the German mortgage covered bonds that we rate. This is because of the availability of credit enhancement to absorb losses.

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Ratings Outlook: Unused Notches Mitigate Bank Downgrade Risk

The German covered bonds which we rate are issued by highly-rated issuers, which are the first recourse for bondholders. As a result, most of our rated German covered bond programs benefit from multiple unused notches of ratings uplift, which protect the ratings on the covered bonds if the issuer is downgraded.

On June 24, 2021 we downgraded various German banks including the Cooperative Banking Sector (see "Various German Banks Downgraded On Persistent Profitability Challenges And Slow Digitalization Progress"). This rating action did not affect our ratings on the covered bonds issued by Deutsche Apotheker- und Aerztebank eG, the public sector and mortgage covered bonds issued by DZ Hyp AG, and DZ Briefe issued by DZ Bank AG (see "German Cooperative Banking Sector Downgrade Does Not Affect Ratings On Four Covered Bond Programs," published on June 28, 2021).

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Chart 14 shows the breakdown of the average target credit enhancement levels of mortgage and public sector covered bond programs compared to the available credit enhancement across countries. We define the target credit enhancement as the OC commensurate with the maximum collateral-based uplift.

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

Despite the currently strong housing market, we have carried out a scenario analysis with large drops in house prices to gauge their impact on the final rating outcome or the OC commensurate with the current ratings on the covered bonds. We have tested the impact for house-price drops of 10% and 20%, similar to what we observed in Eastern Germany after the reunification when more than one million of the East German population immigrated to West Germany. In the mid-1990s, 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 house-price declines on the weighted-average loss severity calculation for our rated mortgage programs. The OC in line with the current rating would not increase significantly. Additionally, these hypothetical price drops would not decrease the maximum achievable rating on any of the mortgage covered bond programs.

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Transaction Updates

• NRW.BANK Public Sector Covered Bond Program, July 28, 2021
• Deutsche Apotheker- und Aerztebank eG Mortgage Covered Bond Program, June 28, 2021
• DZ HYP AG (Public Sector Covered Bond Program), April 12, 2021
• DZ HYP AG (Mortgage Covered Bond Program), Feb. 23, 2021
• DZ BANK AG Deutsche Zentral-Genossenschaftsbank, Feb. 1, 2021
• Wuestenrot Bausparkasse AG (Mortgage Covered Bond Program), Jan. 29, 2021

Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
• Covered Bond Ratings Framework: Methodology and Assumptions, June 30, 2015
• Methodology And Assumptions: Analyzing European Commercial Real Estate Collateral In European Covered Bonds, March 31, 2015
• Covered Bonds Criteria, Dec. 9, 2014
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014

Related Research

• Approach To Analyzing German Covered Bonds Clarified Following Changes To The German Covered Bond Law, Oct. 6, 2021
• European Economic Snapshots: A Faster-Than-Expected Restart, Sept. 29, 2021
• Credit Conditions Europe Q4 2021: Rampant Recovery, New Risks, Sept. 28, 2021
• Economic Outlook Europe Q4 2021: A Faster-Than-Expected Liftoff, Sept. 23, 2021
• Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions, Aug. 2, 2021
• Covered Bonds Outlook Midyear 2021: Credit Stable Despite Waning Support, July 23, 2021
• Covered Bond Harmonization In The EU Remains A Work in Progress, July 13, 2021
• Commercial Real Estate In Covered Bonds: Is It Worth The Risk?, July 8, 2021
• German Cooperative Banking Sector Downgrade Does Not Affect Ratings On Four Covered Bond Programs, June 28, 2021
• Various German Banks Downgraded On Persistent Profitability Challenges And Slow Digitalization Progress, June 24, 2021
• Economic Research: How Long Can The ECB Yield Shield Last?, June 11, 2021
• Credit Trends: Global Financing Conditions: Bond Issuance Could Decline 2.25% In 2021 To $8.2 Trillion, April 28, 2021
• Europe’s Housing Market Will Chill In 2021 As Pent-Up Pandemic Demand Eases, Feb. 22, 2021
• ESG Industry Report Card: Covered Bonds, Nov. 9, 2020
• Glossary Of Covered Bond Terms, April 27, 2018