“Pfandbriefe”, or “It Wasn’t Me!”: Why Nobody Realizes That Germany Is the Biggest Systemic Risk in the EU

I grew up in a small town in Long Island with some very funny people, Howard Stern and Eddie Murphy. Eddie had a skit in his stand-up comedy “Raw” which is a reminiscent of the macro scene of the modern day EU. Let me know if you get it…

“This is a quote from myriad analyst, “It is hard to believe that while banks in Euro area are plagued with asset write downs and massive losses, while the German banks are untouched. If any of the German banks fail, it would cause wide spread tumbling down of the entire banking sector in the Euro Area.” You see, Germany is that dude that Eddie Murphy is talking about. Their major trading partners are either in recession, or entering recession. Their real estate is super duper, uber bubbly (but of course will go much higher, so now is the time to buy), and their banks have highly leveraged assets that literally dwarf the economy that their domiclied in – thus making a cash bailout arithmetically impossible. Despite all of this, when investors look over there and say “Hey, you look like your in some pretty hot water and the ECB is obviously acting to protect somebody in troube!”, what do the Germans say? “Hey, it wasn’t me!”

Yep, it’s not them. Right…. Some background first.

The ECB started buying Covered bonds issued by commercial banks at the end of 2014. Covered bonds, which generally have high credit ratings, are bonds where the payments of principal and interest are backed by both the bank’s balance sheet and a pool of assets, such as mortgages and public-sector loans.

Covered bonds are known as “Pfandbriefe” in Germany, where an early form of the bonds were introduced by Frederick the Great of Prussia – in 1769 to make it easier for owners of large agricultural estates to get cheap credit. Groups of land-owners guaranteed individual members’ loans against the risk of individual default. As part of its asset purchase program, the ECB has bought covered bonds worth about 158 billion euros. The consistent purchase of covered bonds by the ECB sent the yield of these bonds into negative territory during the past 18 months, with Germany having the highest share. A city research report states that 97% of German Pfandbriefe with a maturity of five years or less have a negative yield. That’s practically all of it.

In this context, German lender Berlin Hyp issued €500m of euro-denominated zero-coupon covered bonds, yielding a return of negative 0.162% on March, 2016 marking it the first time a non-government bond offering a negative yield. The issue came ahead of European Central Bank’s policy meeting that authorized the purchase of corporate securities via the QE program – what a coincidence, no? Dig a little deeper and you’ll find it also happened when Berlin Hyp became significantly more risky…

They’re betting the house on German real estate, and why not? This is the time to buy. Prices have went up likely more than anytime on record, and if prices soar more than anytime in history, then first thing anyone should do is pile on after the fact, right?

Data from globalpropertyguide.com

Notably, Berlin Hyp’s new covered bond yields around 40 basis points more than equivalent three-year German government debt. Given the crowding of negative yield bond in the market and ECB’s obligation to hit its monthly target of Euro 80 billion, Berlin Hyp’s covered bonds hold a buying appeal from a purely yield perspective if one really insists on buying German debt. From a fundamental investor’s perspective, this makes very little practical sense, given the significantly higher risk profile of Berlin Hyp and its cover relative to the German government…

In the same week when Berlin Hyp launched its negative yield bond, ECB announced the inclusion of non-banking corporate bond in its buying program (again, one hell of a coincidence). Although the details of CSPP are still not known (but I’ll betcha Berlin Hy executives know it), the announcement of ECB entering in the non-state corporate bond market has been cheered by the investors. European corporate bond indices rallied, driven by the new stimulus measure. The Markit iTraxx Europe Index of credit-default swaps on investment-grade companies posted what looks to be a record decline – including the biggest single day drop in more than three years.

This begs the question, is Berlin Hyp truly (a bank that had to be bailed out of the last financial crisis) more credit worthy than nearly all of the sovereign states in Europe and nearly as credit worthy as Germany itself. Is this bank worthy of paying for the privilege of lending them money – essentially “Return Free Risk”? Can you still say that knowing they have bet the from on what looks very seriously to be a real estate bubble in their local markets with negative rates everywhere (in other words the direction of least resistance for rates is up, meaning cap rate direction of least resistance is down)?

Part two of the Veritaseum Macro Research introduction is out, and available for purchase here. I believe it should open some eyes. Every report after this point will be about identifying those banks, brokers and entities that we believe are at risk of going bust, and attempting to narrow a timeframe as to when. We will also elavorate heaving on the Peer-to-Peer economy and how embracing it can do more to isolate you from the coming crisis than nearly anything else. We’re not playing here. For those that don’t know my track record…