A draft second financial market stabilisation law released by Germany’s finance ministry on Wednesday appears to provide for government backed covered bonds, in contrast to the first such framework, and some bankers said any guaranteed Pfandbriefe could hit the overall primary covered bond market in January.

The draft law lays the foundation for a reactivation of SoFFin, Germany’s bank rescue fund, as part of the implementation of a European Council action plan agreed at the end of October, which requires financial institutions to temporarily increase core capital ratios in 2012, with member states providing support if the capital cannot be raised on the market, and also called for state guarantees to improve longer term funding.

The law would be effective until up to the end of 2012. The draft was approved by the government on Wednesday, and has entered the parliamentary legislative process.

In the context of the provision of guarantees, the draft law refers to guarantees for a period of up to five years, and up to seven years for covered bonds. The text of the draft law, including the introduction, does not refer to Pfandbriefe, a term protected by law in Germany, instead referring to “gedeckte Schuldverschreibungen”, a generic term for covered bonds.

RBS analysts said the move was surprising and contrasted it with the last SoFFin legislation, under which banks could not issue guaranteed covered bonds. They nevertheless noted that the draft law only mentions covered bonds but not explicitly Pfandbriefe.

“There is, however, a reference to Art 20a Kreditwesengesetz (KWG),” they added. “To our understanding, this would limit the guaranteed issuance to Pfandbriefe and CRD compliant bonds and would exclude structured covered bonds which have been discussed in Germany for a while now.”

Market participants are understood to be seeking clarification on the exact motivation behind the legislation’s language and any potential implications, while enquiries from The Covered Bond Report were not answered by press time.

The Association of German Pfandbrief Banks (vdp) successfully lobbied against government guarantees of Pfandbriefe when the first SoFFin package was introduced, arguing that they were superfluous and that Pfandbriefe could get by without them.

The RBS analysts highlight a crowding out of existing covered bonds as a harmful side effect of the guarantee measures, which will depend on issuance volumes and new issue spreads, with wider implications for the supranational and agency sector also possible.

They noted that it is difficult to forecast to what extent banks will use the guarantee scheme, with two longer term repo operations (LTROs), of 36 months, announced by the European Central Bank on 8 December likely to help offset some of the imminent funding pressure on banks. In addition, the split between any issuance of government guaranteed covered bonds and senior unsecured issuance is relevant, they said, listing several disadvantages of opting for guaranteed covered bond issuance, including the respective fees. New issue spreads of government guaranteed unsecured bank debt and a possible downgrade of Germany to AA+ by Standard & Poor’s would also influence the take-up of guarantees for covered bonds and Pfandbrief spreads.

“Taking all these points into account, we are concerned about the risk of another crowding out,” they said. “If German banks once again begin to heavily rely on state guarantees for their issuance, then non-guaranteed Pfandbriefe as well as other state-guaranteed debt will likely suffer.

“The extent of any spread widening will depend on the actual new issue spread levels and the volumes that are issued with SoFFin guarantees.”

RBS’s analysts noted that seven year government backed KfW paper trades at 9bp-10bp over mid-swaps and FMS Wertmanagement at 23bp-25bp over, while Deutsche Bank’s April 2018 Pfandbriefe trade at 28bp and Eurohypo’s at 70bp. They said that were guaranteed Pfandbriefe or senior unsecured new issues to come at 25bp over, spreads on outstanding Pfandbriefe would widen and the liquidity of non-guaranteed covered bonds could dry up.

A DCM banker agreed and said that this could have serious knock-on effects for the wider covered bond market. He said that some market participants had been hoping that German or Nordic names would reopen the market in January, allowing French, UK and others to follow, but that any uncertainty surrounding potential SoFFin backed Pfandbriefe at cheaper levels would put a hold on German issuance and also hit the potential for Nordic supply.