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Fire sale!

13 May 2014
Richard Kemmish

Moody’s last week announced that German covered bonds have on average the lowest asset-liability mismatches of any nation’s covered bonds. Which makes for a pretty boring headline. Calling ALM mismatches ’fire sale risk’ - that is the risk that a failed borrower has to sell a load of assets to make a bullet maturity repayment on a bond - makes it sound slightly less dull, but still.

Unless of course you have been around for a long time and you remember the infamous story in Borsen-Zeitung in 1998 (how old does that make me feel?): “Die Deutschen Hypo-Hedge-Funds” - you don’t need to speak much German to realise that this is not an article designed to make the journalist popular with the pfandbrief issuers.

One of the biggest shocks ever to hit the Pfandbrief market was the allegation that some issuers were running big maturity mismatches, and therefore rate risk in a product that was supposed to be totally risk free. Of course the shock of that article galvanised the pfandbrief establishment into action, regulations and laws followed rapidly to address the perceived problem and as a result, as Moody’s have< illustrated, Pfandbrief went from problem child to best in class.

But all of that remains a bit of a mystery to investors bought up in an environment of floating rate mortgages and (dare I say it) a securitisation market approach to analysing credit risk. Who cares about maturity mismatches when mortgages repay voluntarily as fast as they do in, for example, the UK? It’s safe to assume that in countries with mortgage markets like the British, there will always be enough principal flowing into a cover pool from mortgages that are repaid early to meet even the lumpiest of bond maturity profiles.

The best argument in favour of this approach was Northern Rock. When the Rock failed we all saw those shocking pictures of depositors queuing up to take out their life savings but no-one reported the number of their customers queuing up to repay their mortgages and take their business elsewhere. The reality in the Northern Rock cover pool is that in no time at all it was awash with far too much cash to know what to do with.

Which is all just another illustration of the problems that we will come up with if we really try to harmonise covered bond markets across Europe as Commission seem to want. First we have to harmonise the underlying mortgage cultures and I can’t see that happening any time soon.  In Germany it’s appropriate to look at ALM in the cover pool, in the UK at the loan to value of the mortgages. The covered bond regulations in each country focus on what they should focus on given the reality of the underlying assets.

One size does not fit all.

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