HBOS Treasury Services issued the inaugural UK covered bond in July 2003. This was followed by first issues by Northern Rock and Bradford & Bingley in 2004 and recently by a first issue by Abbey National Treasury Services. All these issues have adopted a similar structure, involving the sale of high-quality collateral to a bankruptcy-remote special purpose vehicle (SPV), giving the covered bondholders recourse both to the issuer and to the underlying assets in the event of default. The resulting market offers UK banks a simple means of raising funds and provides investors with a structural alternative to covered bonds such as the German Pfandbrief, the Spanish Cédulas Hipotecarias and the French Obligations foncières created by specific legislation enacted in those EU member states. However, there are some key issues to be resolved to ensure the continuing success of the UK covered bonds market.

Structure

A typical UK covered bond structure involves the following elements:

• Programme: A UK bank, directly or through a subsidiary (which must be a public limited company), issues the covered bonds under a medium-term note-style programme. The covered bonds are direct, unsecured and unconditional obligations of the issuer.
• Intercompany loan agreement: The issuer lends the proceeds of each issue of covered bonds to a bankruptcy-remote SPV incorporated as a limited liability partnership (the LLP). The loans will not be repaid by the LLP until the issuer has repaid all amounts payable under the corresponding series of covered bonds.
• Covered bond guarantee: The LLP provides a covered bond guarantee as to payments of interest and principal under the covered bonds. The covered bond guarantee constitutes direct, unconditional and unsubordinated obligations of the LLP. The recourse of the covered bondholders against the LLP under the covered bond guarantee is limited to the assets of the LLP from time to time.
• The proceeds of the inter-company loans: The LLP uses the proceeds of the loans from the issuer, among others, to: (i) purchase mortgage loans from the UK bank; and/or (ii) refinance an existing series of covered bonds.
• Security: The LLP grants security in favour of a security trustee under a deed of charge to secure its obligations under the covered bond guarantee. The security consists principally of the LLP's interests in the mortgage loans.
• Notice to pay without acceleration against the LLP: If the issuer defaults in respect of its obligations under the covered bonds, a notice to pay will be served on the LLP under the covered bond guarantee and the LLP will then be required to pay the amounts due and payable in respect of the covered bonds in accordance with their original terms (that is, as far as the LLP is concerned, the obligations under the covered bonds are not accelerated). However, the covered bondholders will also have an unsecured claim against the issuer for the full amount payable on the covered bonds (that is, on an accelerated basis).
• Acceleration against the LLP: If the LLP itself defaults in respect of its obligations to pay guaranteed amounts, the bond trustee will be entitled to declare the covered bonds immediately due and payable under the covered bond guarantee and the security trustee will be entitled to enforce the security under the deed of charge.
• Asset coverage test: The LLP is required to ensure that at all times the adjusted value of the mortgage loans (taking into account set-off risks, defaulted loans, loans in arrears and the loan-to-value, or LTV, of the loans) will be at least equal to the aggregate principal amount outstanding of the covered bonds. Any breach will entitle the bond trustee to accelerate against the issuer under the covered bonds and to serve a notice to pay on the LLP under the covered bonds guarantee.
• Amortization test: The LLP is also required to ensure that, at all times after the service of a notice to pay on the LLP under the covered bond guarantee, the value of the mortgage loans (on an unadjusted basis, except for loans in arrears) is at least equal to the aggregate principal amount outstanding of the covered bonds. Any breach will entitle the bond trustee to declare the covered bonds immediately due and payable under the covered bond guarantee and the security trustee to enforce the security under the deed of charge.
• Servicing: The UK bank will enter into a servicing agreement with the LLP and the security trustee, agreeing to provide administrative services in respect of the portfolio of mortgage loans.
• Members: The members of the LLP will be the UK bank and certain designated members, to ensure that the LLP will continue to be a going concern, even if the UK bank ceases to be a member (because, for example, it has gone into administration or liquidation).

FSA approval

The UK's Financial Services Authority (FSA) issued an interim policy response on August 17 2004 on its approach towards the prudential regulation of the issuance of covered bonds (available at www.bba.org.uk). This interim policy recognizes that covered bonds offer potential funding advantages for issuing banks, but have the potential to pose additional risk to depositors because of the preferential claims of the covered bondholders on the mortgage loans securing the covered bonds.

The FSA indicated that it will focus on the materiality of a particular bank's covered bond issuance and, if the particular bank's covered bond issuance becomes material, it would reflect the additional risk in the FSA's assessment of its individual capital ratio. The FSA will, for the time being, continue to consider each issue on a case-by-case basis. Although not a hard limit, the FSA indicated that it was content for current issuers to issue covered bonds amounting to around 4% of their total assets.

The UK issuing banks have indicated that they are not happy with this guideline limit. In particular, the benefits of issuing covered bonds include investor diversification, more efficient management of funding maturity, an increase in the liquidity and stability of funding sources and cheaper funding. Further, the existence of the guideline differentiates UK covered bonds from those issued in other EU member states, which is unhelpful from a marketing perspective. The FSA is considering its position on the 4% guideline and it is expected that it will issue a further paper on this matter in the next few months.

EU regulation

Article 22 of the EU's Co-ordination Directive on Undertakings for Collective Investment in Transferable Securities (UCITS) restricts the exposures of regulated funds to certain types of assets. The general rule, as set out in Article 22(1), is that no more than 5% of any regulated fund should be exposed to any given individual asset. Article 22 then contains various derogations from this limit, which recognize the lower risk characteristics of certain types of bonds.

Article 22(4) is relevant, and says:

"Member states may [increase the permitted exposure of UCITS to certain bonds where] these are issued by a credit institution which has its registered office in a member state and is subject by law to special public supervision designed to protect bond-holders. In particular, sums deriving from the issue of these bonds must be invested in conformity with the law in assets which, during the whole period of validity of the bonds, are capable of covering claims attaching to the bonds and which, in the event of failure of the issuer, would be used on a priority basis for the reimbursement of the principal and payment of the accrued interest."

The purpose of Article 22(4) is to derogate the limit on exposure of regulated funds to covered bonds. It is also important because, by Article 63(2) of the EU Banking Co-ordination Directive, member states are permitted to ascribe a 10% risk weighting to bonds that fall within Article 22(4). Consequently, bonds that qualify under Article 22(4) are more easily placed in large size and the issuer is able to enjoy a competitive advantage in the bank funding market.

Article 22(4) requires a "special public supervision" designed to protect covered bondholders. In most EU member states, compliance with the requirements of Article 22(4) can only be achieved by specific legislation due to the ease with which liquidators and other office holders in such debtor-friendly jurisdictions can recharacterize transfers of assets and annul transactions; for example the German Pfandbrief, the Spanish Cédulas Hipotecarias and the French Obligations foncières legislative regimes.

It is possible under English law to achieve robust collateral coverage for holders of covered bonds through the true-sale mechanism. Provided that the sale of the collateral to the bankruptcy-remote SPV as described above has been made on arm's length terms and is not a sham, the collateral will not be available to a liquidator or administrator of the selling bank. The issue, however, is that UK covered bonds are not subject to special public supervision and so do not fall within Article 22(4). Accordingly, UK covered bonds suffer from a competitive disadvantage to their European counterparts.

The Miles Report

In 2003, the UK Treasury commissioned David Miles to prepare a report on the UK mortgage market as part of a series of studies on matters affecting long-term fiscal policy, with the aim of maintaining stability in the UK economy. The report was published in March 2004. Among his recommendations, Miles noted that the lack of specific covered bond legislation in the UK could affect the development of a UK covered bond market. In particular, the lack of such legislation: (i) could lead to a cost premium on UK covered bonds; and (ii) could hamper the recognition of covered bonds by the UK authorities under the UCITS Directive.

The Miles Report also notes that the relevant recognition of UK covered bonds under the UCITS Directive could be achieved through an amendment to the FSA rules, rather than through primary legislation. Lastly, the Miles Report recommends that the FSA provide a definitive view on whether or not UK insolvency law is enough to allow for the recognition of covered bonds under the UCITS Directive.

The UK issuing banks have asked the FSA to take action to implement such a supervisory regime to enable UK covered bonds to fall within Article 22(4). A key issue for the FSA will be the degree to which it is required to monitor compliance with the terms of the regime and the effects of non-compliance.

Capital Requirements Directive

A further issue facing the UK covered bonds market is the impact of Basel II and the draft Capital Requirements Directive (CRD). The FSA has reserved its position on this matter, but it is expected that it will issue a statement in relation to this issue in the next few months. The draft CRD, published by the European Commission on July 14 2004, has revisited the definition of covered bonds as part of its more general review of the capital treatment of these bonds. The draft definition states that covered bonds are bonds which fall within the terms of Article 22(4) and which are collateralized by any of the listed categories of eligible assets. In essence, these eligible assets are:

• exposures to or guaranteed by central governments, central banks, multilateral development banks and international organizations that have ratings of AA- or better;
• exposures to or guaranteed by public sector entities, regional governments and local authorities that are risk-weighted the same as the above exposures that have ratings of AA- or better;
• exposures to institutions that have ratings of AA- or better, but not exceeding 10% of the nominal amount of outstanding covered bonds of the issuing credit institution (other than where exposures are caused by the transmission of payments from the obligors of loans secured by real estate);
• loans secured by residential real estate or shares in certain Finnish residential housing companies where only liens that are combined with any prior liens within 80% of the value of the pledged property; and
• loans secured by commercial real estate or shares in certain Finnish housing companies where only liens that are combined with any prior liens within 60% of the value of the pledged property (although the competent authorities may recognize loans secured by commercial real estate as eligible where the LTV of 60% is exceeded up to a maximum level of 70% if the value of the total assets pledged as collateral for the covered bonds exceed the nominal amount outstanding on the covered bond by at least 10% and the bondholders' claim meets the legal certainty requirements and takes priority over all other claims on the collateral).

The proposed list of definitions raised some issues. In particular, it was not clear whether the proceeds of the sale of mortgage loans (for example, after a default by the issuing bank) or the proceeds of payments on the mortgage loans would be included in the list of eligible assets. Further, it was not clear that AAA-rated residential and commercial mortgage-backed securities could be included in the list of eligible assets. Mortgage lenders and arrangers have been active in proposing amendments to this part of the CRD to ensure maximum flexibility for the development of new covered bond structures. Amendments to the proposed definitions were tabled with the European Parliament on May 25 2005, but whether the amendments will be agreed remains an open question at the time of writing.

Author biography

Vanessa Hardman Allen & Overy LLP Vanessa Hardman is a senior associate at Allen & Overy LLP in London, practising within the securitization group. Vanessa specializes in whole-business transactions, but has also advised on restructurings, such as the high-profile Welcome Break deal, and on residential mortgage-backed master trust issuances.