Some UK issuers had set up programmes solely to access the SLS, but covered bonds used as collateral in the scheme must have two triple-A ratings.
Moody’s downgraded Chelsea Building Society’s covered bonds from Aaa to Aaa3 on April 16 and left them on review for downgrade after earlier last week downgrading its issuer rating from A2 to Baa3 as part of a group of negative actions on UK mortgage lenders.
Its covered bonds are no longer eligible for the SLS, only having one triple-A rating now from Fitch, and the building society has said that it is in talks with the Bank.
Moody’s also put on negative review the triple-A rated covered bond programmes of Standard Life Bank and six UK building societies: Coventry, Newcastle, Norwich & Peterborough, Principality, Skipton and Yorkshire.
These issuers are now in discussions with the rating agency about how they can maintain top ratings for their covered bonds.
"We are currently talking to Moody’s about the rating action," said Guy Thomas, finance director at Principality Building Society. "They have made some suggestions about enhancing the cover pool, for example by increasing overcollateralisation or introducing a standby service provider.
"The difficulty is not knowing categorically what steps would avert a downgrade."
Time for pass-throughs?
One possibility that has been suggested is for issuers to restructure their programmes to try to achieve a higher Timely Payment Indicator (TPI) from Moody’s. This is a measure assigned by the rating agency that determines how closely an issuer’s rating is linked to its covered bond rating.
The programmes of Newcastle, Norwich & Peterborough and Principality have TPIs of "probable-high" because they have partial pass-through structures. The other issuers’ have TPIs of "probable" and one way in which they might be able to stave off a downgrade of their covered bonds would be to restructure their covered bonds and adopt a pass-through structure.
A change from probable to probable-high would, for example, be enough to raise the ceiling rating for the covered bonds of Skipton and Yorkshire from Aa1 to Aaa at their current rating levels.
And Britannia Building Society this week finalised a £3bn covered bond programmes that has been assigned a TPI of "very high" by Moody’s, meaning that its issuer rating could fall as low as Baa2 without its covered bond rating being constrained below Aaa.
Britannia said its covered bond programme is structured on a pass-through basis, "specifically to seek to de-link it from the business generally and thereby avoid the issues that the Moody’s review has posed for other societies."
Britannia executed a £1.4bn debut transaction this week. "The timing is entirely accidental," it said. "Like any sensible organisation, we are looking at diversifying our funding sources. Covered bonds may not have been necessary in the past given our activity in the securitisation market, but that market is not what it was. Covered bonds have an important part to play in our wholesale funding mix, which accounts for around one-third of our overall funding."
Britannia is rated A2 by Moody’s. The rating was placed on review for downgrade last week, but its programme was rated triple-A by Moody’s and also Fitch.
"We’re comfortable that the issues that Moody’s has with the other building societies won’t apply to our covered bonds," said Britannia. "There is clear water between Britannia and the other building societies in the sector."
Britannia members are set to vote on a proposed merger with The Co-Operative Bank at the annual general meeting next week.
BNP Paribas, HSBC, JPMorgan and Royal Bank of Scotland arranged Britannia’s programme.
However, although pass-throughs hold out the prospect of more stable ratings for UK covered bonds, one banker suggested that restructuring programmes was an unenviable task within the timeframe before Moody’s could take further action — 30 days — and given that the Bank of England might anyway relax the SLS criteria by, for instance, making them the same as for the Discount Window.
Those issuers that have only issued for the purpose of accessing the SLS could find it easier to restructure their programmes that have sold bonds publicly.
"It’s fair to say that it’s a lot easier to restructure those programmes where only a single series of covered bonds has been issued because then you are just dealing with one noteholder," said Sally Onions, a senior associate at Allen & Overy. "Obviously it is a lot harder to get approval to restructure a programme when you have a disparate group of noteholders that must agree."
Yorkshire Building Society was the first of the institutions affected to issue covered bonds, first tapping the public markets in October 2006. It has sold several covered bonds publicly and could therefore face the most difficulty materially changing the terms of its programme.
Market participants have also pointed out that European investors that had bought bullet bonds would be unlikely to want to be left holding pass-through securities.
Contingency planning
The issuers are also looking beyond maintaining their ratings at alternative measures.
"There are a wide range of options available to us, including taking steps to maintain the triple-A rating of our covered bonds. We are looking at the relative cost and appropriateness of those options," said Jonathan Westhoff, finance director at Newcastle Building Society. "All these things are about choices."
Indeed the institutions have played down talk of the possible downgrades of their covered bonds causing a "crisis", stressing that they have other options open to them, even if their covered bond ratings are cut.
"Ninety-five percent of our mortgages are funded through retail funds," said Principality’s Thomas. "We have one of the lowest wholesale funding ratios against our peers, and have a good level of liquidity.
"Clearly this issue is a challenge, but not an overbearing one. We have a number of options at our disposal, and will work through this."
One option for the issuers, if their covered bonds no longer have two triple-A ratings, is to use them to access the Bank of England’s Discount Window. Covered bonds are eligible for this facility as long as they were triple-A rated at launch and are rated A3 equivalent or higher.
Richard Wells, finance director at Norwich & Peterborough, outlined several possible outcomes, which are dependent on what actions Moody’s and the Bank of England take.
"It’s early days yet, and we have a certain amount of time to review the different options that are available to us," he said. "There are several features of the bonds that we can work with, for example by bringing in a third party swap provider.
"If a rating reduction is confirmed, we would then most likely have to repay any element of the covered bond that we have with the Bank of England, for which we have adequate liquidity. What we are waiting for, however, is a response from the authorities."
Wells highlighted another two options that are available should it no longer have access to the SLS.
"We are eligible for the government guarantee scheme, which was extended to the end of this year, and could therefore do a guaranteed deal instead," he said. "It could be slightly larger than the funding received from the covered bond, and so that would be fine from a liquidity point of view.
"Another option that we have if the covered bond rating is reduced would be to see if there are more investors on the public market that may be interested in taking our covered bonds."
One banker pointed out that government-guaranteed bonds can only be issued up to 7% of sterling eligible assets and said that in Chelsea’s case, at least, the amount it could raise would be lower than the amount it appears to have raised from the SLS.
