Sep 4, 2009

Will Aristote save the real estate finance?

In the last 12 months we had numerous questions of investors on what is the Pfandbrief market (the German cover bond market) and how does this market works. I happened to run into an academic study that is a good introduction to the instrument. It is published on the web site of the VdP (Association of German Pfandbrief Banks). The study is dated February 2009, and is called “Refinancing Real Estate Loans – Lessons to be Learned from the Subprime Crisis” (full study can be downloaded following this link).

This is a well documented document that on more than 100 pages summarizes (on 100 pages …) the mechanics of the Pfandbrief market compared to the Asset backed securitization market.
It basically tries to convince the reader that if you consider on one hand

a) a bond secured by a real estate loan of a maximum 50% Loan to Value, and the corporate credit of an investment grade financial institution (the cover bond)

or on the other hand

b) a bond secured by a real estate loan of a Loan to Value of up to 90% (the Mortgage Back Security, MBS)

then the cover bond is (i) a different instrument than the Mortgage Back Security, and (ii) is less risky than the Mortgage Backed Security. I thought that this should be as easy as convincing a skydiver that he is more secured with a reserve parachute than without, but I am probably wrong giving the length of the study. I also thought that whether one is more risky than the other is not really relevant as long as the risk is rightly priced.

Some of the arguments used to convince the reader of the superior quality of the Pfandbrief market are really overselling the Pfandbrief. My preferred example is the nice syllogism on page 94 which reads as follows: “the fact that not a single Pfandbrief issued by Hypo Real Estate defaulted because of a government bailout proves the safety of Pfandbrief even in extreme situations.” I thought that it essentially proves that the government saved the day (at tax payers costs), but what do I really know.

The Pfandbrief market is a major source of financing not only for German real estate, but for real estate across Europe. Whereby the CMBS market is still presenting absolutely no sign of life, the Pfandbrief market has shown lately some positive signs, but is still, as far as I can see from alstria’s point of view, not functioning normally.

Although I appreciate the need for the Vdp to differentiate itself from the MBS in investor’s minds, I am not sure that this kind of study is going to help reviving the market. If it is true that in order for the MBS market to come back to life you would need investors willing to underwrite the bonds again, this might not be the main problem with the Pfandbrief market. As the Vdp study rightly highlights, the main difference between the Pfandbrief and the MBS, is that the Pfandbrief is first secured by the balance sheet of the banks. Reviving the Pfandbrief markets would de facto need investors to trust banks balance sheets again. Unless, they can be convinced by page 94 and trust that in any circumstance ”a government bailout proves the safety of Pfandbrief even in extreme situations”. Who knows...


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