5 questions for Casper Andersen, Standard & Poor's Global Ratings

Rapidly rising mortgage rates and the increased cost of living are putting downward pressure on the European housing markets. We now expect interest rates to be higher for a longer period of time. House prices are likely to continue to fall in most European countries over 2023 and 2024, with a limited prospect of a recovery in 2025. As higher interest rates intensify across Europe, we continue to forecast a sustained correction, but not a crash, of house prices for most countries. Higher mortgange rates are the main factor behind weakening demand and declining prices, while potential demand and housing needs in Europe remain high. The German residential housing market will likely experience an above average correction compared to other European countries. The decrease in construction cost inflation might itself contribute, to some degree, to falling home prices even if output remains constrained. This downward cost push might be at play in particular in Germany. We expect prices will reach the average low point by the end of 2024. Decreasing construction inflation may contribute to falling house prices even if output remains constrained. This downward cost push might be at play, particularly in Germany, where underlying housing demand appears to be more robust than elsewhere.

German covered bonds have the highest average commercial real estate exposure out of all European covered bond markets. Commercial real estate prices are currently adjusting lower which is likely to continue as long as interest rates are moving higher. More remote work and sluggish economic growth could weaken tenant demand in Europe this year and lead to more vancancy and/or rent pressure. Combined with low yields, this could also result in further revaluation losses. We expect a widening gap between grade-A assets, located in central districts, and grade-B assets, located in peripheral locations.

Sustainability standards regulations are also likely to tighten in Europe, with the U.K. now requiring a minimum energy performance rating for commercial properties.

Conservative underwriting (which include strict LTV limits), limited exposure to the office sector, and the level of available credit enhancement, should limit the risk of credit quality deterioration of the covered bonds that we rate.

While we believe that CRE assets and even residential asset performance may deteriorate, we do not anticipate it to significantly impair the credit quality of the covered bonds we rate. This is due to the availability of credit enhancement to absorb losses and the limited exposure to sectors that we consider to be more at risk. While we generally observe manageable CRE exposure in our rated cover pools due to high levels of unused overcollateralization (OC), we believe the repricing of CRE assets and requirements to frequently update valuations may lead issuers to change their cover pool composition and, hence, some cover pools’ risk profiles. We generally believe that covered bond ratings are well positioned to withstand a housing market correction and are a potential source of stable funding for such assets.

In our view, the main challenge for the Pfandbrief banks is to match the cover pool (asset side) to the increasing cost of covered bond funding (liability side) to ensure the attractiveness of the covered bonds in a higher for longer interest rate environment. This may be particularly challenging for residential mortgages with comparably longer fixed interest period as in Germany, although seasoned cover pools may help soften the impact. Higher interest rates can negatively affect our collateral analysis results for programs exposed to unhedged interest rate risks. Further, shorter covered bonds’ maturities can increase refinancing risk when they widen a program’s asset-liability maturity mismatch (ALMM).

If credit performance remains stable, commercial real estate may offer an attractive collateral alternative, as margins are comparably attractive to residential mortgage assets. In cover pools slow to adapt their earnings, the OC commensurate with the current rating may increase due to the higher cost of funding as outstanding covered bonds are refinanced. Additionally, issuers have been focusing on issuance in the lower maturity segment of three to five years. If the shorter maturity covered bond issuance lowers the weighted-average maturity of the outstanding covered bonds, ALLM risk may increase, which in turn may increase the level of required OC for the current rating, all else being equal.

The German “Beleihungswert” remains a very conservative assessment of the collateral value, in our opinion. Combined with very low LTV ratios, and a focus on high-quality collateral in grade-A central locations, it may shelter the Pfandbrief collateral from the worst valuation adjustments. That said, some of the valuation adjustments may require cover pool adjustments, such as replacing existing collateral or adding new eligible collateral, so it may become increasingly important that Pfandbrief banks stay vigilant and actively manage the credit exposure of the cover pool. This may require substituting assets from outside the cover pool or adding additional collateral to mitigate increasing risks. Generally, we observe that the available credit enhancement for our rated programs significantly exceeds the level required to maintain their current ratings. We believe that the available credit enhancement should mitigate any deterioration in collateral performance arrising from inflationary and interest rate pressures.