On a crisp December morning in 2002, Bill Young and Angela Clist walked into HBOS Treasury Services in the City of London wondering whether they would be making a quick exit. Though Young, the head of European securitization at Goldman Sachs International, and Clist, a partner in the international capital markets practice at law firm Allen & Overy, knew their counterparts at the U.K.'s biggest mortgage lender well, they were bringing a bold proposal. The pair wanted HBOS to become the lead participant in Project Connery, their code name for the U.K.'s first covered-bond offering (Sean being the first bond -- James Bond, that is). “We didn’t know what reception to expect,” says Clist.
When Young and Clist emerged from HBOS’s offices on Old Broad Street hours later, they had accomplished their mission: The firm had agreed to the foray into covered bonds. “It helped immeasurably that we knew the people so well, having worked with them on previous innovative transactions,” recalls Gavin Parker, an associate director at HBOS, which was created from Bank of Scotland’s 2001 acquisition of the Halifax Building Society. The group had crafted the first U.K. residential-mortgage-backed securities master trust, for Bank of Scotland in 2000, and a similar vehicle for Halifax in 2001. The latter had raised £3.5 billion ($5 billion), which was then Europe’s largest RMBS issue. “There was a huge amount of accumulated knowledge in the team,” says Parker.
Covered bonds, which are debt obligations backed by mortgages or public debt that remains on the balance sheet of the issuer, weren’t new. Continental markets in these instruments -- first authorized by law in Germany in 1772 -- expanded rapidly once German banks started issuing huge offerings, so-called jumbo Pfandbriefe, that typically exceeded Dm1 billion ($720 million), in 1995. Jumbo Pfandbriefe proved so popular with big international investors that France began issuing its version, obligations foncières, and Spain its rendition, cedulas hipotecarias, in 1999. Total issuance last year alone reached E115 billion ($102 billion), up 53 percent from E75 billion in 2002.
But HBOS would be traveling a different course than banks in Germany, France and Spain. Governments in those countries had passed legislation designed to spell out which creditors would be repaid and in what order in case of a bankruptcy; they also set disclosure requirements and asset-quality guidelines. Germany’s Federal Financial Supervisory Authority and France’s Commission Bancaire are charged with ensuring that the rules are followed in their countries. In contrast, the U.K. has no specific legislation and no special regulator. Instead, it is relying on existing common-law precedents for bankruptcy and asset protection.
“Realizing that the Pfandbriefe market is very well established, it was important for us to structure a transaction that was both robust and recognizable to existing Pfandbriefe investors,” says Parker.
Apart from the legal framework, the HBOS transaction would in most aspects closely resemble other covered-bond offerings. It would be backed by residential mortgages, and these assets would remain on its balance sheet. The asset pool can be overcollateralized, giving the bonds a credit rating superior to that of the issuer. The appeal to investors would also remain the same: They could buy an asset typically rated triple-A at a spread of between 7 and 10 basis points above government bonds. HBOS, in turn, could save quite a few basis points over other, less-secure types of financing.
Seven months after the meeting at HBOS, Project Connery hit the screens, with the big bank selling E3 billion of seven-year bonds due 2010. Goldman Sachs, Citigroup and Dresdner Kleinwort Wasserstein led the offering, which was oversubscribed by more than 50 percent and traded up in the secondary market. In October, HBOS followed up on this success with a E2 billion ten-year issue. Mortgage banks Northern Rock and Bradford & Bingley each raised E2 billion in five-year bonds that were priced this April and May, respectively.
This year Citigroup expects the U.K. covered-bond market to grow to a robust E25 billion. If that estimate is correct, the U.K. market will represent 15.6 percent of an expected E160 billion of European covered-bond issuance in 2004.
The success of HBOS and other issuers raises questions about whether legislation is necessary. “The U.K. covered-bond market has challenged the perceived need for the market to operate with country-specific legislation,” says Ted Lord, head of European covered bonds at Barclays Capital in Frankfurt. “That is an interesting development for the European market as a whole, because it begs the question whether banks in markets such as Italy [where consideration of authorizing legislation has dragged on] will wait or follow the example of HBOS and the U.K.”
Whatever the broader implications for Europe, treasurers at U.K. mortgage banks are pleased to have a new financing tool. Peter Green, director of treasury at Bradford & Bingley in London, is delighted by how well his bank’s E2 billion, five-year covered-bond deal went last month. Green turned to the technique to lower his cost of funding. Bradford & Bingley’s unsecured debt trades at a 20-basis-point spread to midswaps, the benchmark for corporate issuers, but the covered-bond deal was priced at a 9-basis-point spread and has since tightened a point in the secondary market. Green is so satisfied with his deal that he is planning to make covered-bond issuance a cornerstone of Bradford & Bingley’s funding strategy.
“We plan to do a deal a year,” he says. “Our overall funding requirement is £4.5 billion annually, and I would expect one quarter of that to come from covered bonds.”
A further advantage for an issuer is that the instrument adds variety to its investor base. Whereas 70 percent of a typical bond issue from a U.K. mortgage bank is distributed to local investors, more than 80 percent of the euro-denominated covered-bond issues have been sold outside the U.K. The biggest investors, typically buying 35 percent of the issues, have been German, says Marcus Guddat, head of the covered-bond syndicate at Citigroup in Frankfurt.
Not only do they pick up some yield over government bonds, but investors also like the fact that covered bonds offer an alternative to the securities of U.S. mortgage agencies Fannie Mae and Freddie Mac at a time when their borrowing status is under review. Covered bonds also provide ample liquidity because lead managers offer a market-making commitment. As Roger Webb, fixed-income manager at £110 billion-in-assets Morley Fund Management in London, notes, “If you are happy with the structure of the bond and the quality of the asset pool, then these are attractively priced triple-A-rated assets.”
German investors, who are comfortable with the bond structure after long experience with their own E1 trillion Pfandbriefe market, also get a yield advantage over their home market. For example, HBOS’s inaugural July offering was priced at a 3.5-basis-point spread to benchmark issuer Depfa Bank’s equivalent Pfandbriefe deal. (The spread has since narrowed to 2 basis points.)
Although investors take some comfort in seeing HBOS’s name connected to a deal, the issues themselves are structured so that the credit rating of the securities is divorced from the credit rating of the issuer. “It is the pool of assets backing the covered bond that ultimately decides the rating, not the issuer,” explains Brian Kane, a European structured-finance analyst at Standard & Poor’s in London.
The spread of U.K. covered-bond issues above that of equivalent Pfandbriefe issues results from the lack of specific covered-bond legislation in the U.K. But the fact that HBOS has to pay only a slim 2 basis points more than Pfandbriefe is a tribute to the structure devised by lawyers at Allen & Overy and the bankers at Goldman Sachs, Citigroup and Dresdner.
“The most important thing is to ring fence the assets from the sponsor,” lawyer Clist explains. “HBOS acts as a guarantor, but a separate company holds the assets.”
This company, known as HBOS Covered Bonds LLP, acts as guarantor in the case of a default by HBOS, paying the interest due and the principal amount at maturity. In Continental deals specific laws mandate these procedures, obviating the need for a separate partnership to act as guarantor.
Stuart Jennings, senior director of the structured-finance group at Fitch Ratings, says, “The triple-A rating of the bonds reflects the robustness of the legal structure and relies upon monetizing the cover portfolio in the worst-case scenario of an issuer default.” In that instance the assets are protected in the limited liability partnership. The LLP has no assets other than those designed to pay the bondholders, and those investors have a claim on the assets ahead of any administrator or creditor. Another protective element that has given the rating agencies comfort is the overcollateralization of the asset pool, typically 108 percent of the value of the bond. All of the U.K. issues have used the same legal structure, and all have been triple-A rated.
The fact that U.K. covered bonds are issued according to legal principles rather than an explicit law actually affords greater flexibility by some measures. For its inaugural deal HBOS used assets in the collateral pool that exactly matched Pfandbriefe rules. No mortgages with a loan-to-value ratio of greater than 60 percent were included, nor were mortgages in arrears or nonperforming loans. However, as Bob Liao, director of securitization at Citigroup, notes, some issuers have since varied the makeup of the asset pools. For instance, the loan-to-value ratio of mortgages for the Bradford & Bingley and Northern Rock bonds was increased to 75 percent. Also, mortgages in arrears were included at 40 percent of their value.
“Because HBOS was the first bond, we wanted the deal to look as much like Pfandbriefe as possible. We were conservative,” Liao explains. “But mortgages in arrears do have a value and, so long as an appropriate weighting is applied, can be included in the asset pool.”
As attractive as these deals are for U.K. issuers, there is one downside: The absence of covered-bond laws means that U.K. bonds have a 20 percent risk weighting under current international bank capital guidelines, known as the Basel accord, whereas European covered bonds such as Pfandbriefe have a 10 percent risk weighting. That means banks, which are big buyers of triple-A-rated bonds, have to put aside twice as much regulatory capital to buy a U.K. cover bond as they do for the equivalent Pfandbrief, obligation foncière or cedula. As a result, they have bought small amounts of these new securities.
However, bankers, issuers and lawyers hope to get international banking regulators to lower the U.K. weighting so the deals can compete on an even footing with European alternatives. “The industry has been lobbying hard to get it changed,” says Liao.
Covered bonds should also benefit from the Basel II accord, to be published at the end of this month, which will update the original capital requirements, set in 1988. The key difference between covered bonds and the mortgage-backed securities first popularized in the U.S. is that the American invention allows issuers to move assets off their balance sheets. Under Basel II the risk weighting for residential mortgages is expected to decline from 50 percent to at most 20 percent. As a result, the impetus to get mortgages off balance sheets will decrease, making covered bonds more attractive to issuers. Basel II will take effect at the end of 2006.
Capital weightings notwithstanding, the U.K. covered-bond boom looks like it will continue for a while. In the next few months, HBOS is planning to come to market with the first 15-year bond. And the Nationwide Building Society, the U.K.'s fourth-biggest mortgage lender, has announced that it will launch a covered-bond program later this year.
But just how big the market becomes may still depend on whether the U.K. ever decides to take up its own legislation governing the area, according to some participants. They say that investors and issuers may not want too much exposure to a market with an untested legal support system. “I don’t think this is a problem for 2004 or 2005; this market could easily grow to E40 billion,” says Barclays Capital’s Lord. “Whether it can grow to E200 billion without legislation is another issue. In Spain there were E8 billion of bonds outstanding in 2001, and there are now E75 billion. The U.K. could grow that fast, but in Spain the growth has been accompanied by tightening and clarification of the cedulas legislation.” No such legislation is under discussion in the U.K.
Although most European countries are adopting covered-bond legislation, Citigroup’s Liao disagrees with the notion that the U.K. needs to follow suit. An Italian mortgage lender is reportedly looking at issuing a U.K.-style covered bond rather than waiting for local legislation. And Clist says she has discussed the U.K. structure with lawyers in Australia interested in adapting it to local needs.
In the meantime, U.K. borrowers like HBOS are enjoying their splendid isolation.
