Pfandbriefe come to China

With foreign exchange reserves bulging with low-yielding US treasuries it is no secret that from Seoul to Singapore, Asia's central banks are casting around for something a little more exciting.

China, with over $400 billion stashed away, is a prime candidate for diversification and bankers at the forum organized by the Association of German Mortgages in Beijing on Thursday confirmed they had sold such products to the government - although they would not be drawn on how much.

"The attraction of Pfandbriefe - Germany's favourite financing instrument - is that they offer great security with a nice yield pick up over German government 'bunds' or treasury bonds," points out Dr Louis Hagen, general manager of Association of German Mortgage Banks.

Historically, that's been around 40bp, although it's shrunk to around 15bp this year as Germany's sovereign credit has dipped.

Hagen's pitch is aimed squarely at China's central government, since currency controls prevent local institutional and private investors from investing abroad.

Pfandbriefe are an unusual product, although they are rapidly being copied throughout the world as government wise up to their advantages.

"Pfandbriefe are an interesting instrument because they were created with a specific purpose in mind: to allow certain banks - the mortgage banks - to obtain long term financing, which they in turn lend out only to house buyers and the public sector," says Jens Schmidt-Buergel, general manager of Fitch Deutschland.

For the public sector, the Pfandbriefe market acts in a similar way to the US municipal bond market, with Germany's highly decentralized cities and regions tapping the mortgage banks for financing.

The mortgage banks, which had issued over €800 billion ($1.04 trillion) in total loans as of 2003, are the biggest issuers of such instruments, although the landesbanken (German regional banks) also take part in the business. Unlike the landesbanken, the mortgage banks are prohibited from engaging in any other kind of corporate or investment banking business.

Volume outstanding for the total German bond market was €2.92 billion euros as of October 2003, of which Pfandbriefe made up a whopping 37%.

The advantage of the set up is that the legal structure, based on the Mortgage Bank Act, facilitates transactions by imposing compulsory transparency and predictability criteria.

"The stringent legal provisions give the pfandbriefe a credit quality that comes close to that of sovereign borrowers," says Hagen.

Pfands are not mortgage backed securities, emphasized bankers speaking at the forum.

"MBSs are different to pfandbriefe for several reasons: they have a shorter tenor, usually three to four years, and the assets are organized in a special purpose vehicle, rather than having the strength of a strong credit institution behind them," argues Hagen, adding that supervision is a lot less rigorous in most MBS cases.

In addition, MBSs are usually off balance sheet, unlike the Pfandbriefe.

Halifax Bank of Scotland (HBOS) recently engineered a deal which reflects many issues, as well as the spreading popularity of the instrument.

The United Kingdom housing market is regarded as highly volatile, if not speculative in Germany, where buyers insist on long-term fixed rates in tune with their long-term aims for property.

In the UK, where the name of the game is to shift properties quickly in order to clamber up the housing ladder, buyers are much more willing to gamble on interest rates staying in their favour. Consequently, buyers frequently obtain mortgages at floating rates, or with fixed interest rates only for a short period.

Yet with the UK debating on whether to join the European currency union, the government is investigating the best process for avoiding a property market crash should interest rates leave the Bank of England's control, and worse, rise.

Hence the interest in, and success of, the HBOS deal.

"However, the HBOS deal is a one-off. The UK doesn't have the extensive safeguards enshrined in law which Germany has, " says Hagen.

Obvious parallels exist between the mortgage agencies in the US and the German mortgage banks, although they are not identical.

"Fanny Mae and Freddy Mac have more of a social role in helping people buy houses; mortgage banks in Germany are strictly commercial," says Fitch Deutschland's banking analyst Jens Schmidt-Buergel," and of course they are currently mired in controversy concerning their under-capitalized state, use of derivatives and possible privatization."

German mortgage banks are keen to expand their lending, given that their lending peaked in 2001 - hence their increasing forays abroad.

So far, Japan, which Hagen has visited almost every year for the last seven years, is the prime investor from Asia. But with this historic first visit to China, it's clear which new source of capital the German mortgage association has now got its eye on.