Germany’s Pfandbrief issuers are moving to address concerns about debt from countries such as Greece backing covered bonds by introducing a new model for the valuation of such assets in cover pools whereby haircuts will be applied to assets from sub-investment grade sovereigns.

The Association of German Pfandbrief Banks (vdp) announced the move yesterday (Thursday) after an AGM, during which two new board members were elected.

The model foresees haircuts being applied to the nominal value of sovereign debt included in Pfandbrief cover pools if the sovereign features a sub-investment grade rating, said the vdp, with the size of the haircut informed by ratings of sovereigns provided by Moody’s, Fitch, and Standard & Poor’s, and the expected losses that these ratings reflect. The haircuts will be independent of the maturity of the debt.

The new model is being adopted voluntarily by vdp members and The Covered Bond Report understands that although an amendment to the Pfandbrief Act is being worked on the model is not set to be included in legislation for the time being. A market participant suggested that such a move in relation to sovereign debt at this time could be politically tricky.

Jens Tolckmitt, chief executive of the vdp, said that the association developed the model to respond to a significant increase in differences in creditworthiness between European sovereign debtors over the course of the debt crisis, and that the treatment of cover pool collateral will therefore mirror banks’ approaches under internal risk models.

He said that the crisis has shaken investors’ confidence in the creditworthiness of certain sovereigns, and that unrestricted cover pool eligibility of claims on EU and EEA sovereigns and sub-sovereign entities without differentiation on the basis of creditworthiness has recently therefore increasingly come in for criticism.

By dealing with this via haircuts to be applied under the model, Pfandbrief issuers are providing for improved transparency and thereby enhancing the security of the Pfandbrief, added Tolckmitt.

Issuers will carry out a separate cover pool valuation according to the new vdp standard and publish the results on their websites in addition to transparency information required by section 28 of the Pfandbrief legislation, as well as on the vdp website. The appropriateness of the haircuts applied under the model are intended to be reviewed yearly and adapted if necessary.

Moody’s in April noted that asset selection risk had increased for public sector Pfandbriefe as a result of sovereign downgrades, with sub-investment grade rated assets remaining eligible for cover pools. However, the rating agency said that most issuers have been prudent, with Greek assets having been almost completely remove from cover pools, for example.

According to Johannes Rudolph, head of covered bond research at HSBC Trinkaus, with the exception of Poland, European covered bond legislations split public sector assets into those that are eligible and those that are not, rather than incorporating a mechanism for marking down public sector loans. Under Polish covered bond legislation, assets from a country that has undergone a debt restructuring are ineligible for a cover pool for the next five years.

In HSBC research published in February Rudolph proposed that banks apply the same haircut to loans in cover pools as any provisioning they had done for such loans on their balance sheet, and that where a sovereign had obtained IMF support a 20% haircut be applied, with the greater haircut of the two applied if both are relevant.

Today, he welcomed the model being introduced by the vdp.

“It’s a good thing,” said Rudolph. “It’s a first step that maybe other countries can follow”.

Torsten Temp, HSH Nordbank

The use of ratings as the basis for valuations comes despite the vdp and several of its members having been critical of rating agencies in the past, and the association has worked on making Pfandbriefe more transparent to enable investors to analyse their cover pools without recourse to ratings. A covered bond investor said that he understood the vdp to have sought ways it could have come up with a valuation model that did not include reference to ratings, but, he said, the association had clearly ultimately found this too difficult and, like regulators and others facing similar situations – had to settle for using ratings.

The composition of the board of directors of the vdp was also on the AGM agenda, with incumbent president Jan Bettink re-elected for another two years and Torsten Temp of HSH Nordbank and Georg Reutter of DG Hyp voted in as new members.

Temp is a member of the board of directors at HSH Nordbank and replaces Hubert Beckmann, deputy chief executive at WestLB, while Reutter succeeds Thomas Sommer, member of the board of WL Bank.