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Speaker Series Part 4

As part of our Schuldschein speaker series Ralf Garrn, Managing Director of Euler Hermes Rating GmbH, discusses the topic of asset-backed Schuldschein.


Asset-Covered Schuldschein Financing – An alternative to an existing financing need

The German Schuldschein has been used to provide lending for established creditworthy businesses in developing new sources of lending independent of the traditional banking market. The paralysis of the banking system after the financial crisis in 2008 meant that it would be decades before banks were able to effectively service the financing needs of corporate borrowers again.  Securitisation of commercial mortgage backed loans had been the way banks offloaded credit risk to other investors. Securitisation had indeed enabled banks to provide large volumes of loans to their customers but the market closed because of the Lehman Brothers’ collapse.  Without the opportunity to transfer loans, liquidity in banks was no longer available.  In addition, the need for banks to write off bad debts meant that banks no longer had enough capital even for their core businesses.  New capital was needed to enable banks to survive, but this has been insufficient in allowing them to increase lending.  The situation was worsened as regulators insisted that banks held higher levels of capital as insurance against further bank failures of the sort that had led to the economic recession in 2008.  The end result was a severe credit squeeze.

This position has eased a little in some countries such as Germany, although recovery has been patchy, with a continuing shortage of lending in the real estate sector or renewable energy and infrastructure sector. It has, however, shown no improvement, or has actually got worse, in other countries such as Italy and Greece where public deficits and sovereign debt have joined together to create a perfect storm. The private sector has been forced to respond by cutting costs and reducing dividend payments in order to increase capital. Secondly, there was the adverse market facing institutional investors.  Since 2008, there has been a period of unprecedented low interest rates as central banks including the ECB increased the supply of money in order to provide life support for their endangered economies. This has made it very difficult for insurance companies and pension funds to find suitable investments for their cash.

Today real assets such as real estate or infrastructure debt are a preferred asset class for Schuldschein financing. Investors look for credit quality and yield. The credit quality of assets is expressed by a project rating. The rating expresses an opinion regarding the probability of default and expected loss of the financing instruments- the default risk. The analysis is largely based on the assessment of project and financial risks where the project risk profile expresses the certainty of the cash flow forecast by assessing market and technical risks while the financial risk profile is a quantitative evaluation of project cash flows particularly with regard to the project's debt service coverage. Every rating reflects the project's unique structure and is based on conservative assumptions. Some structural safety characteristics can be favourable for the project finance transaction rating, such as cash reserves that can compensate for payment problems. Lastly, the recovery rate is calculated to assign the rating of the Schuldschein note.

While high credit quality is required for regulated investors such as insurance companies and pension funds under their respective regulatory regime, the yield is a fundamental basis for their success and the sustainability of their obligations towards all beneficiaries from insurance products and pension claims.  Solvency II and Basle have already made clear that asset-backed claims are treated with some preference when it comes to capital adequacy or the investment of premium reserves.  Furthermore, at least German regulators have treated claims for example those secured by real estate as a preferred asset class to their supervised entities.  In addition, the Schuldschein available in the German market has some built-in safety mechanisms: (a) Senior tranches come only with investment grade rating, (b) overall LTV vary rarely exceed 75 % of the actual market value and (c) the amortisation profile aims at an LTV close or below 50 % of the then market value at maturity.  Market rates for senior tranches currently stand between 2.75 % to 3.25 % p.a. for senior tranches which show a distinct bettering against investment grade corporate or sovereign bonds.  In addition, there are still quite good quality assets available which can justify the alternative investment rationale.

To hear more from Ralf and his views on the Schuldschein market, he will be speaking at this year’s International Schuldschein Forum on the 13th and 14th of June in Frankfurt.

This content is provided by Euromoney Seminars for informational purposes only, and it reflects the market and industry conditions and presenter’s opinions and affiliations available at the time of the presentation.