The regulator suggested 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.
Even if the 4% ratio is later raised, a limit of this order of magnitude would dash the hopes of Britain's second tier banks that structured covered bonds could radically broaden their range of funding options.
HBOS has already issued covered bonds equivalent at yesterday's exchange rate to 2.2% of its total assets at the end of June this year, while Bradford & Bingley has issued 3.8% and Northern Rock 3.8%.
Bankers speculated this week that the closeness of the 4% level to the ratios for the two mortgage lenders was no coincidence.
The FSA's views were greeted with disbelief in some quarters of the market. ?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 who has worked on structuring UK covered bonds.
One UK financial institutions origination banker said the FSA's view could restrict the issuer base in the UK. ?Any of the smaller mortgage lenders will not be able to issue in enough size to make covered bonds economic,? he said.
The biggest banks, which have plenty of non-mortgage assets, like Barclays or HSBC, would be able to finance a larger percentage of their UK mortgages with covered bonds before breaching 4% of total assets ? but they have the least need for covered bonds, since they have so many other cheap funding options.
The FSA has been approving covered bond issues on a deal-by-deal basis since HBOS opened the UK market in July 2003, but it gave its first public guidance on the product in a letter to the British Bankers' Association last week.
Responding to enquiries from issuers and other interested parties that had demanded more clarity, the FSA highlighted the detrimental effect that ringfencing mortgage assets on balance sheet to back covered bonds could have on depositors, by giving covered bond investors a preferential claim on the assets.
?A smaller, and potentially lower quality, pool of assets would be available than would otherwise be the case to meet the claims of depositors,? the FSA wrote. ?There is also a gearing effect, in terms of the arrears rate of the remainder of the mortgage portfolio.?
Here, the authority is apparently referring to the practice of ?cherry-picking' better loans to include in covered bond pools.
All the UK banks that have so far issued covered bonds have selected loans with low loan-to-value ratios, to make them comparable with German Pfandbriefe and other covered bonds. They can also remove mortgages in arrears from cover pools under certain conditions, and check the collateral regularly, replenishing it if necessary.
By implication, the collateral left to meet unsecured claims is weakened.
Capital penalties mooted
Although the FSA's letter lacked detail and said banks would be dealt with on a case-by-case basis, it hinted at a restrictive policy.
This was made clear by the FSA's statement that while it had been content for current issuers to launch covered bonds amounting to 4% of total assets, even this ratio could not be relied on as being considered as immaterial to depositors' interests.
Banks exceeding the FSA's guidance will have the additional perceived risk to depositors reflected in their individual capital ratio (ICR). This is the capital ratio the FSA requires for each bank.
In a further, and baffling, blow to the keenest issuers, the FSA also said that ?the greater the proportion of mortgage assets as a percentage of total assets, the greater the weight we would place on covered bond issuance as a factor in the ICR assessment?.
Both Bradford & Bingley and Northern Rock have stated that they intend to issue covered bonds regularly, with similarly sized transactions to their Eu2bn debut deals.
But with Eu35bn and Eu37bn of total assets, respectively, even to issue one more Eu2bn deal next year, they would have to grow their total assets to Eu67bn to stay within a 4% limit.
Nationwide Building Society, which is preparing its covered bond programme, had £101bn of total assets in April, of which some £70bn were mortgages.
UK banks ?disadvantaged?
Protecting retail depositors is a key part of the FSA's role, but bankers said the authority was being ultra-conservative and harming potential issuers' interests.
?I feel very strongly that the FSA is disadvantaging the UK banking sector versus its European peers,? said one debt capital markets banker.
However, there are few countries where banks do enjoy both covered bond and retail deposit funding.
In Denmark, France and Germany the issuers of mortgage backed covered bonds are specialised institutions that do not traditionally take deposits ? though in Germany the issue of subordination of senior unsecured bondholders did arise when mortgage banks used overcollateralisation to boost their ratings.
In Spain and Ireland, where commercial banks that take deposits can also issue covered bonds, regulators have been more relaxed than the FSA position.
Bank of Ireland, which is preparing the first Irish asset covered security backed by mortgages, has transferred Eu9bn of mortgages into its Bank of Ireland Mortgage Bank subsidiary, compared to Eu83bn of total assets at the end of March.
The bank plans to issue Eu10bn of covered bonds and has so far cleared all the regulatory hurdles to do so.
UK issuers and investment banks had been delighted to have opened a structured covered bond market without having to wait for an enabling statute ? but they are now feeling the drawbacks of this fast track, private sector-led approach.
As one observer pointed out, Bank of Ireland has been able to embark on its programme in full knowledge of the framework in which it is operating, but UK banks are facing moving targets.
Bankers said Australian banks were facing similar obstacles to those in the UK in their early discussions about introducing structured covered bonds.
The country has a highly developed mortgage securitisation market and Australian banks are investigating the attractions of adding covered bonds to their funding arsenal, but the Australian Prudential Regulation Authority is said to have similar concerns to the FSA regarding their effect on depositors.
Move could protect MBS
The FSA's tough stance towards covered bonds could be a fillip to the UK's residential mortgage securitisation market.
The opening of a UK covered bond market, combined with the lower risk weightings for residential mortgages planned under Basel II, prompted talk of the demise of the MBS market, but its health has been underscored this year by record issuance.
HBOS reaffirmed its belief in MBS by launching Europe's largest ever securitisation, a £6.1bn issue from its Permanent Financing master trust in March. Bradford & Bingley is establishing its own master trust, Aire Valley, from which it intends to launch £3bn-£4bn of deals a year.
While the FSA has not issued public rules on the amount of mortgage assets banks may securitise, bankers say its private guidance to issuers has been clearer than that for covered bonds.
Northern Rock has £20.3bn of MBS outstanding, making up 38.4% of its funding.
But securitised assets are in fact sold and cleanly removed from the balance sheet ? they do not subordinate other liabilites. And cherry-picking assets has long been forbidden.
Despite the unwelcome import of the covered bond guidance for would-be issuers, one investment banker said the mere fact that the FSA had made a public statement was a sign that it was taking covered bonds more seriously.
But another observer called the letter a delaying tactic.
The FSA called the guidance ?an interim response? and said it planned to give further consideration to the matter.
