Q&A: pbb Deutsche Pfandbriefbank on lending to local authorities
0Jean Christophe, head of public investment finance, talks to Room151 about forward starting loans and the market for specialised lenders.
Jean Christophe
Q: Tell us about your recent activity as a lender to UK local authorities?
JC: pbb Deutsche Pfandbriefbank is a leading European commercial real estate and public investment lender. The bank is the largest issuer of Pfandbriefe and an important issuer of covered bonds in Europe. pbb has been observing and researching the UK as a market for Public Investment Finance over two years. In February 2016, pbb entered the local authority market closing two
£10m forward starting loans with Midlothian Council. The Bank has developed a pipeline of potential loans with other local authorities in England and Scotland.
Q: Why does pbb believe there is growth in the UK market for specialised lenders in the public investment space?
JC: pbb´s focus is on delivering added value to UK local authorities. It has become clear that forward starting loans were of particular interest to local authorities in the UK. Councils approve capital plans which stretch out to five years; many have accumulated significant short term borrowing and “internal borrowing” to fund such capital plans. At some point, many local authorities may wish to refinance with long term borrowing fixing interest rates.
The bank is well placed to support local authorities in this process. In addition, pbb has the specificity of being able to finance public investments whether the investment is conducted by the public sector, realised through a PFI or many other structured approaches that could suit public sector clients.
Q: At £20m, the Mid-Lothian loan is relatively small. How do you make that work for you and for the council?
JC: pbb is interested in developing long-term relationships with councils. £10m is about the minimum ticket that pbb would consider for financing public investments. Although the loan ticket size might be relatively small, our aim is to build up a portfolio over time. Given the long-term maturities, total loans outstanding are expected to add up to a more significant sum.
Q: Tell us about ‘forward starting’ loans. How do they work and is the major benefit the interest rate hedge?
JC: A forward starting loan is simply a fixed rate loan with a future and predetermined start date. A council might be investing in large capital projects such as new schools and roads that will be carried on budget, it may wish to use its cash reserves or short-term borrowing to fund the capital expenditure and subsequently refinance using long term borrowing.
If the council wishes to fix the interest rate applicable to the long-term borrowing in advance, it saves interest cost during the construction period and minimises the interest rate risk that would exist if it did not enter into the forward loan. The same applies if a local authority has loan maturing over the next couple of years: securing the liquidity and the interest rate for the upcoming refinancing helps the council to bring security into its financial prospective.
Q: In the last year we’ve seen Warrington’s local authority private placement, increased activity from the EIB and the municipal bond agency project rumbles on. How big an opportunity do you think there is for lenders other than the PWLB? Do enough authorities want to borrow enough money?
JC: We have seen an increased interest in the UK local authority market. Each of the new entrants seem to provide solutions to local authorities, which differ in “shape” and “size”. We have structured a product that fulfils a specific market need currently not offered to local authorities in a market wide scale.
In terms of the size of the market, the bank has been discussing some opportunities and we think these will materialise into signed loans. However, the product needs to be explained and this takes time. We are also discussing other financing schemes with clients, for instance in relation to financing larger housing projects, which would be at the crossroad of our two strategic businesses.
Q: What’s the smallest/largest amount you would lend in the UK?
JC: The bank is interested in £10m to £100m tickets. However, our main focus is on client relationships so that the total credit exposure the bank might build over time to one authority could be higher than £100m.
Q: How do you assess the risk of lending to UK councils?
JC: The bank has an independent and experienced Credit Risk team which assesses the risk assumed from each transaction with local authorities across Europe. pbb makes use of internal credit risk models regulated and approved by the German financial regulator (BaFin) to assess and effectively score the credit risk assumed by each loan. “Total debt to cash flow from operations”, “total debt to total revenues” and “net liability from pension obligations” are just a few examples of quantitative measures that are used as yard sticks to measure debt capacity.
The analysis will, in addition, include qualitative factors such as the local and national economic environment, demographics, and much more. Together these elements provide a “full picture” that is the basis for the bank’s credit decision. Altogether we consider that most of the UK councils are likely to fulfil our investment criteria.
Q: Do you envisage any scenario by which a UK local authority might default on a loan?
JC: During our internal assessment, all scenarios are considered, including the worst case. Part of this assessment allocates a probability of default to the local authority. In general, the expectation is that the probability of default is low, which is reflected in the tight margins offered to local authorities in the UK but the probability of default is not zero. Furthermore, local authorities are becoming less homogeneous from a credit risk perspective as a consequence of the devolution of powers process.
We seek to understand the current administrative framework and the main changes to be expected in all our key markets. In addition, we‘d like to get insight into the financial prospective of our clients as we want to make sure that borrowers have and will retain the capacity to fulfil all their obligations out of the loan contracts.
Jean Christophe is head of public investment finance at pbb Deutsche Pfandbriefbank.
*pbb Deutsche Pfandbriefbank is a supporter of Room151
