A more relaxed attitude from the FSA is allowing innovation in the UK covered bond market to flourish. Abbey is eyeing the market, the pioneering HBOS has added social housing loans to the asset class, and Northern Rock has given the market a synthetic twist.
When the Financial Services Authority (FSA) published its first guidance on the use of covered bonds by banks in the UK in a letter to the British Bankers Association those looking to profit from the market, whether issuers or intermediaries, were rightly alarmed by the regulator's hawkish stance.
The FSA suggested that it might limit covered bond issuance to just 4% of a bank's total assets to protect depositors from being put in a subordinated position to covered bondholders in respect of mortgages placed in the cover pool.
Banks exceeding this guidance, said the regulator, could have the additional perceived risk to depositors reflected in their individual capital ratio.
Although HBOS, which had opened the market, was well within this ratio, the market's only two other issuers, Bradford & Bingley and Northern Rock, were already uncomfortably close to this level.
"These banks are only just starting their programmes so I can't understand why the FSA is making these negative noises so early on," said one banker in London.
Although the letter was an interim response to an issue that the FSA had yet to tackle head on and the regulator said that the exact levels permitted would be dealt with on a case by case basis, the guidance had to be taken seriously given the regulator's authority and the lack of other direction on the subject.
Since then, banks have therefore been lobbying the FSA to come up with revised and more flexible guidance.
The investment banking arms of ABN Amro, Citigroup and HSBC have been involved in talks with the regulator alongside current and potential issuers, whether declared or undeclared, the latter group including both UK clearers and former building societies.
Alongside the 4% issue, the industry is also pushing for the FSA to bring covered bond issuance explicitly under its regulatory remit so that the UK's instrument can become UCITS eligible and benefit from the 10% risk weighting of its continental counterparts rather than its current 20% weighting.
The most recent meeting took place in mid-March.
Bankers involved in the initiative have described the FSA's stance as positive on both fronts.
"The FSA embraces the benefits of covered bonds," says Mauricio Noé, head of covered bonds and ABS capital markets at ABN Amro. "It recognises the importance of the product as a tool for providing liquidity, which is clearly advantageous given that the loss of the provision of liquidity is such a serious matter for banks."
Noé says that the regulator is therefore leaning in the right direction. "We are moving towards some kind of recognition of the product under UCITS for covered bonds, so hopefully the risk weighting will come down to 10%."
But given that UCITS is a European Union-level framework, it is not only the FSA that needs to be involved and turning the goal of a 10% risk weighting into reality could take time. There is therefore the possibility that rather than on the basis of a standalone measure any time soon, the issue will have to be dealt with as part of the lengthy CAD 3 project that will transpose Basle II into a capital adequacy directive for the European Union.
Covered bonds become habitual
The 4% matter can, however, be dealt with on a separate and strictly domestic basis.
While the regulator has indicated that there is no hard 4% limit and that banks will be given individual guidance by their respective FSA counterparts, market participants nevertheless feel that a public statement regarding the way in which covered bonds will affect capital assessments must be forthcoming.
"Banks need some sort of a framework under which they can work out the impact of covered bond issuance," says one DCM official in London. "And even though it is apparent that the FSA's stance is not as restrictive as that suggested by its original letter, it now needs to come out and say something clear because it created so much confusion with its only public comment."
Those involved in the initiative say that unlike UCITS, guidance on how covered bond issuance will be treated for solvency purposes could be forthcoming as soon as the next six months.
That the FSA has not been overbearing in its stance towards covered bonds in its one-to-one discussions with banks was made clear in January when the market received a fillip from Abbey.
Since the market was opened in July 2003, Abbey had long been seen as a leading candidate for issuance, but internal challenges and then the takeover by Banco Santander Central Hispano meant there were distractions.
But in January the bank announced that it was mandating Barclays Capital, Citigroup and Deutsche Bank to explore the feasibility of a covered bond programme.
Barclays and Deutsche, meanwhile, are still working on structuring Nationwide's planned programme. The inaugural issue has not appeared as early as expected, but Nationwide is still on track to launch a deal later this year.
"The UK covered bond market is going to mature and it is going to take off and be as strong as other mature covered bond markets," says Arjan Verbeek, director in securitisation at Barclays Capital in London. "It just needs time for everybody to get comfortable with exactly what the instrument looks like and trades like, and with the amount of support that the FSA will give it. But it will happen and the momentum is definitely there."
Northern plans ahead
If confirmation that the 4% level cited by the FSA is not a hard and fast rule were still necessary, Northern Rock is preparing to take its issuance above that ratio. Dresdner Kleinwort Wasserstein, HSBC and Ixis have the mandate for a long dated benchmark.
Latest figures from the bank show total assets of £43bn, 4% of which is £1.72bn. At current exchange rates this is equivalent to Eu2.5bn, so with Eu2bn outstanding only Eu500m more of covered bonds is necessary to push Northern Rock over 4%.
But since its inaugural covered bond, Northern Rock has in another transaction hinted at how issuers might deal with the FSA in future.
In February the bank became the first of the trio of UK covered bond issuers to launch a synthetic securitisation of its cover pool.
The deal, Graphite Mortgages plc — Provide Graphite Series 2005-1, was launched off the Provide programme sponsored by zero risk weighted swap counterparty KfW, the German development bank.
Graphite comprised six tranches of funded notes secured on KfW Schuldscheine (a domestic German market for private placements), totalling £182.25m, while Northern Rock retains the first £20m of risk. The remainder is transferred through a credit default swap. All tranches have a one-off call option in December 2009.
After HBOS had opened the market, many observers suggested that funding provided by covered bonds when combined with a synthetic transaction could provide a more efficient way for UK banks to both fund themselves and manage their capital than RMBS.
Since then, the funding cost of covered bonds, RMBS and synthetics have all come in, and an exact cost-benefit analysis will depend on the quality of the mortgage pool, the issuer's cost of capital and the precise trading levels of all three instruments.
But those issuers wishing to take advantage of having access to the liquidity and investor diversification provided by having in place parallel covered bond and RMBS programmes might still find the covered bond/synthetic combination useful.
The FSA has pointed out that the subordination of depositors' claims to the cover pool would mean that they would, in most cases, have access to a lower quality asset pool, and banks are under normal solvency regulations required to hold higher capital levels against lower quality assets. This explains the FSA's statement in its letter that banks issuing a high level of covered bonds relative to their assets might be required to hold more capital.
However, a synthetic transaction in isolation would free up capital and leave a covered bond issuer with a stronger capital base.
"The Northern Rock deal was not directly linked to any capital implications for the bank of its covered bond issuance," says one UK bank coverage official. "But the combination of the two does provide a clever argument to go to the FSA with."
HBOS finds sterling sociable
The market's leader, HBOS, has meanwhile been pushing ahead at full steam.
In December the bank launched the first deal off a new £3bn covered bond programme backed by social housing loans that now runs alongside its regular issuance backed by residential mortgages.
The first transaction was a £500m 20 year issue led by DrKW and UBS, who teamed up again to launch the second deal off the programme, a similarly sized five year transaction, in early February.
As well as establishing a new asset class, the debut was also the most high profile covered bond in the sterling market to date. However, HBOS found little difficulty in persuading investors of the instrument's merits.
"We have really opened up a new market segment," Steve Lorimer, director of debt capital markets at HBOS in London, told EuroWeek. "Before this there had been very little take-up of covered bond product in sterling, but we have managed to get a lot of investors involved."
In particular, HBOS had hoped to ensure that investors would, as continental European investors typically do, delink their exposure to the covered bond from that of HBOS itself, and it successfully did so.
"The majority of investors did not count this as exposure against the HBOS credit but against the collateral, which is like how continental investors treat covered bonds," said a UBS syndicate official. "By being able to delink this programme from HBOS credit exposure, the issuer has avoided constraining lines on its name."
The success of the programme could encourage other issuers into the market. "The nature of the product does mean that it is ideally suited as collateral for banks to put behind covered bonds, for two reasons," says Richard Kemmish, covered bonds product manager at DrKW in London. "Firstly, the credit quality is fantastic."
Standard & Poor's agreed with this when awarding the programme a triple-A rating. "The sector has a strong credit quality as a result of a long history of government support and pre-emptive regulation," said the agency.
"Secondly," says Kemmish, "margins are thin in the lending business so it is important for issuers to achieve as low a cost of funding as possible."
Nationwide is the biggest lender to the sector, while Bradford & Bingley is also a leading player. Of banks that have not yet announced plans to issue covered bonds, Barclays, Britannia and Royal Bank of Scotland all have more than £1bn of exposure to the sector.
And while HBOS has potentially opened the sterling market up for other covered bond issuers, Kemmish sees no reason why social housing covered bonds should not be readily accepted by euro buyers.
"Many countries in Europe have some form of social housing that is financed to some extent by the private sector," he says, "and the details of any particular country's framework are not that difficult to grasp. You don't have to look at the UK social housing sector for very long to realise that it is a heavily regulated and government protected sector that is also backed by bricks and mortar, so to some extend it combines the strong elements of both public sector and mortgage covered bonds."