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: Strong Momentum Revives The German Covered Bond Market, As Outlook Darkens

Issuance has continued to rise in 2022 so far, with a record €39 billion of German benchmark covered bond issuance as of mid-October. The normalization of the ECB's monetary policy and resulting reduction of cheap central bank funding will support covered bond issuance, although rising interest rates and continued high household savings following the pandemic may taint issuers' funding needs.

As of year-end 2021, the outstanding volume of covered bonds exceeded year-end 2015 volumes for the first time. Germany maintains its spot as second-largest covered bond market after Denmark and the largest euro benchmark market, with outstanding volume totaling €391 billion as of end-2021.

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Implementation of the EU´s Covered Bond Directive

On April 15, 2021 and May 7, 2021 the German Bundestag and the Bundesrat, respectively, approved amendments to the Pfandbrief Act (Pfandbriefgesetz, PfandBG), implementing the EU's Covered Bonds Directive into German Pfandbrief law and adjusting it to reflect changes to article 129 of the Capital Requirements Regulation (CRR). The amendments finally came into force on July 8, 2022. Furthermore, the statutory orders--which are based on the PfandBG--were also adapted in 2022.

The main changes to the PfandBG include, amongst others: The introduction of an option for the cover pool administrator to extend the maturities of principal payments of an insolvent issuer's covered bonds by up to one year; the introduction of an option for the cover pool administrator to extend maturities of interest and principal within the first month after his appointment to the end a one-month period without further requirements; an additional nominal statutory overcollateralization 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.

Our rating analysis considers the extended maturity of the covered bonds, which could improve the observed mismatch between assets and liabilities--particularly for residential mortgage programs with traditionally higher asset-liability mismatches. For public sector programs, which typically have lower asset liability mismatches, the effect is limited.

German covered bond issuers have already updated their program documentation to include the wording for the extension. 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.

Updated valuation regulation may increase use of Pfandbrief

Recent amendments to the Beleihungswertermittlungsverordnung (BelWertV)--the German valuation regulation--will make it easier to include private residential loans in cover pools. For residential properties, the amendments increase the threshold for detailed valuation requirements, allow for increased use of automatic valuation models, and grant the use of online video inspections made popular during the COVID pandemic. We believe the amendments will make registering residential loans easier, which may increase their use in German cover pools.

For commercial properties, the amendments call for dynamic discount rates tied to the 30-year German Bund. Floors and ceilings are 3.5% and 5.5% for multifamily houses and 4.5% and 6.5% for commercial properties. Foreign commercial assets benefit from removing minimum discount rates, which may introduce more foreign assets in German cover pools. We understand that the Association of German Pfandbrief banks (VDP) has concerns about the link between the 30-year German Bund and the relative shorter tenors of commercial real estate lending.

High inflation is constraining the post-COVID-19 push

Since the beginning of the year the eurozone's economic focus has shifted from COVID-19 toward high inflation, driven by the conflict in Ukraine, supply chain issues, and rising interest rates.

Following solid GDP growth over the first half of this year, we expect eurozone GDP to moderately contract in fourth quarter 2022 and first quarter 2023, which increases the risk of a recession by 2023.

We forecast inflation will reach 8.2% this year and 5.2% in 2023. Given still strong economic conditions and inflation well above the ECB's target, the central bank raised all three key interest rates by 50 basis points (bps) in July and a further 75 bps in September. The ECB further has announced that the central bank will take further action in upcoming meetings.

Germany's Covered Bond Framework: Old Values Prevail

German covered bonds are issued based on the PfandBG. The PfandBG came into force in 2005 and has been amended several times. In May 2021 Germany's Bundesrat approved amendments to the PfandBG, implementing the EU's Covered Bonds Directive.

We understand that in addition to the main legal framework, three issuer-specific frameworks will continue to allow for the issuance of covered bonds: DZ-Bank, DSL, and Landwirtschaftliche Rentenbank. Newly issued bonds will not be designated European covered bonds, but we expect these frameworks to continue to align with the main legal framework.

Under the PfandBG issuers do not need to be specialized banks and can exercise all activities of credit institutions, although they require a special license for Pfandbrief issuance.

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. Most German covered bonds are backed by either public sector loans (about 32% of total outstanding covered bonds) or mortgage loans (approximately 67.5% 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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Table 1

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

Since July 8, 2022 the PfandBG has required a nominal statutory overcollateralization of a minimum 2% for mortgage and public sector covered bonds and minimum 5% for ship and aircraft covered bonds. Potential winding-down costs after issuer insolvency are considered through the requirement to maintain a minimum overcollateralization coverage of 2% on a net present value (NPV) basis. Cover pool assets used for the NPV overcollateralization cannot be considered in the nominal overcollateralization calculation. Furthermore, covered bond issuers must calculate the maximum liquidity gap within the next 180 days, which must be covered by liquid assets.

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. We size for this risk in our overcollateralization calculation.

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Mortgage Market Overview: Rising Interest Rates And Inflation Challenges Housing Market

We expect the German economy to grow by 1.5% this year and to shrink by -0.3% in 2023, driven by a rapid increase in energy costs and inflation. We expect consumer price inflation to reach 8.4% this year and 7.0% in 2023 on the back of higher energy and food prices resulting from the current geopolitical context.

The unemployment rate is at an all-time low. We expect it to remain at 3.1% this year, but to increase to 3.5% in 2023.

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Property market outlook: House price growth could slow

We expect price growth in Europe's major housing markets to cool over the next few years on the back of declining affordability, as prices exceed incomes and mounting interest rates.

We anticipate German house prices to grow by 8.0% this year and 6.5% in 2023, see ("European Housing Markets: Soft Landing Ahead," published on July 13, 2022). Nonetheless, we expect sustained house-price growth, given our forecast of supply not catching up with demand. Continued immigration has exacerbated demand pressures (see charts 7 and 8) and recently nearly one million refugees from the Ukraine were registered in Germany. Although a high portion will likely return to Ukraine once the conflict has ended, some will remain in Germany, which may support housing demand.

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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

Green and sustainable covered bonds are a growing segment in Germany, with €8.4 billion of issuance registered until September 2022 (approximately 86% of this comprises green covered bonds). We expect this market to continue to grow as alignment with EU taxonomy and the European Green Bond Standard brings additional clarity and strong investor demand supports further growth.

Since 2019, the Association of German Pfandbrief banks (VDP) has introduced minimum standards for Green Pfandbriefe. Recently the VDP outlined minimum standards for the issuance of public green covered bonds. This is the third sustainability framework created by the VDP, which provides guidance to issuers and investors.

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

Comparison Of German Covered Bond Programs

As shown in chart 10B, most German covered bond issuers prefer a higher share of 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 varies significantly across issuers, but there is not a shift away from commercial mortgages, which could be due to COVID-19's impact on commercial real estate assets. If commercial real estate asset performance deteriorates, 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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Chart 10B

Given the change in the utilization of covered bonds and the risk composition of the cover pools, the overcollateralization levels evolve. Generally, we observe significant available overcollateralization, but the chart 11 highlights notable differences and much change over the period. Compared to last year, the available overcollateralization increased on average. This is because covered bonds in some programs were redeemed, while the asset balance increased or reduced proportionally less than the redeemed covered bonds.

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Table 5  |  View Expanded Table

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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. These allow most of our rated issuers' covered bonds to reach the 'AAA' rating based on jurisdictional support alone.

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.

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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 overcollateralization 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 carried out a scenario analysis with large drops in house prices to gauge their impact on the final rating outcome or the overcollateralization commensurate with the current ratings on the covered bonds. We tested the effect of house price drops of 15% and 25%, more conservative assumptions than the 10%-20% drop that occurred in Eastern Germany after reunification, when more than one million of the East German population immigrated to West Germany. While testing the impact of these scenarios on the credit risk, we removed our additional adjustment reflecting current overvaluation in the German residential housing market.

Table 7 shows the impact of house-price declines on the weighted-average loss severity calculation for our rated mortgage programs. The overcollateralization in line with the current rating would not increase significantly. Additionally, these hypothetical price drops would not decrease the maximum achievable rating nor the number of unused notches 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 27, 2022
• DZ HYP AG (Public Sector Covered Bond Program), April 14, 2022
• DZ HYP AG (Mortgage Covered Bond Program), March 22, 2022
• DZ BANK AG Deutsche Zentral-Genossenschaftsbank, Jan. 26, 2022
• Wuestenrot Bausparkasse AG (Mortgage Covered Bond Program), Jan. 21, 2022

Related Criteria

• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• 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

• Recession Risks Deepen, Oct. 12, 2022
• Economic Outlook Eurozone Q4 2022: Crunch Time, Sept. 26, 2022
• Global Covered Bond Insights Q3 2022, Sept. 8, 2022
• Covered Bonds Outlook Midyear 2022: The Meaning Of Higher Interest Rates, July 18, 2022
• European Housing Markets: Soft Landing Ahead, July 13, 2022
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Economic Outlook Eurozone Q3 2022: Inflation Dulls The Post-COVID Bounce, June 27, 2022
• Approach To Analyzing German Covered Bonds Clarified Following Changes To The German Covered Bond Law, Oct. 6, 2021
• Climate Risk Vulnerability: Europe's Regulators Turn Up The Heat On Financial Institutions, Aug. 2, 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
• ESG Industry Report Card: Covered Bonds, Nov. 9, 2020
• Glossary Of Covered Bond Terms, April 27, 2018