An audacious deal by HBOS last month signalled the birth of a UK market in covered bonds. Now all eyes are on regulators to clear up confusion about the amount of capital that bank investors should hold against investments in these deals.
The €3 billion ($3.45 billion) issue is the first time an English bank has accessed institutional demand in Europe for covered bonds, where investors have been buying German covered bonds (Pfandbriefe) for years. But the HBOS deal is risk-weighted at 20%, meaning banks that buy it must hold $1.6 million in reserve for every $100 million they invest. This is twice the figure for an equivalent German deal.
The lawyers that put the HBOS issue together say regulators should have granted the deal the same risk weighting as covered bonds elsewhere in Europe. But even they admit there is no legal basis for this because of widespread uncertainty over the European Commission's rules on the subject. Meanwhile, the UK's Financial Services Authority (FSA) says it stands by its weighting, but might change it for future deals.
"If more banks start to use this structure and it becomes effectively a UK Pfandbriefe it is possible we'll look at the risk weightings. But we'd have to do so in the context of the new Basel Accord," says David Eacott, a spokesman at the FSA.
At stake is the extent to which UK issuers will be able to access one of Europe's must abundant sources of cheap funding. The market is worth more than €1 trillion, and the bonds are popular with investors for good reason. Since Frederick the Great of Prussia created the product by decree in 1769, there has never been a single default.
Modern German covered bonds, known as Pfandbriefes, are asset-backed but remain on the issuer's balance sheet. Issuers originate very specific assets only, usually mortgages. And if they default, bondholders have direct access to the assets. Should the collateral run out, bondholders are first in queue for the rest of the issuer's assets.
Demand from investors is beginning to outstrip supply. The instrument has been so successful that countries such as Ireland have introduced covered bond laws to copy the technique.
Just like Pfandbriefe
Now HBOS has chosen also to access the market, but using structured finance techniques to compensate for the lack of a specific law on covered bonds in the UK. "We tried to structure the deal so that other issuers could come into the market, so it was undertaken with future transactions in mind," says Gavin Parker of HBOS Treasury Services.
Lawyers equalled the security provided to investors by Germany's longstanding Pfandbriefe rules by transferring the assets to an on-balance sheet limited liability partnership and over collateralizing by 60%, the same degree as a German deal.
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Angela Clist: "The law is in limbo" |
As well as the partnership having guaranteed obligations to repay the bondholders, HBOS's rights to the assets are subordinated in the event of the bank becoming insolvent. The guarantee works similarly to a wrap, pledging payment of scheduled interest and principal to avoid risk of acceleration in the event of HBOS going bust. The bond trustee has not only a claim against the limited liability partnership, but also an unsecured claim against the administrators of HBOS. This matches a Pfandbriefe investor's claim to both the specific assets behind a deal and the rest of the bank's balance sheet.
Using a medium-term note programme to issue the bonds allows the bank to issue further securities on short notice with no lengthy documentation.
Yet lawyers for HBOS were unable to make their case for a lower risk weighting stick with UK regulators. The lawyers' argument hinged on Article 63 of Europe's Banking Coordination Directive, which says member states may fix a risk weighting of 10% for covered bonds to avoid "grave disturbances in their markets".
This was established as a temporary measure in 1988 and was supposed to expire in 1998. Since then, there has been no formal clarification of what risk weightings on covered bonds should be, but the European Commission allowed Ireland to apply the 10% weighting in its recent covered bond law.
"The law is in limbo," says Angela Clist at Allen & Overy, who acted for HBOS on the deal. "People think you can still get access to this weighting but the legal platform for it doesn't really exist anymore."
If Article 63 does in fact still apply, then it is possible that the HBOS deal and future transactions based on the same template should indeed qualify for a lower weighting. Although there is no special law for covered bonds in the UK, the HBOS deal should still qualify under the EU's definition of covered bonds as contained in the Undertakings for Collective Investment in Transferable Securities (Ucits) Directive.
Ucits defines covered bonds as those "subject by law to special public supervision designed to protect bondholders". And the directive describes this supervision as follows: "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."
Says Clist: "It isarguable that theUK's creditor-friendly insolvency regime falls within the Ucits requirements even without a specific law. And ifit does it would be unfair that the HBOS bond did not get the attendant right to a 10% risk weighting."
But the Financial Services Association is unmoved. "The FSA doesn't recognize a 10% risk weighting on any covered bond," says Parker at HBOS.
This is partly because regulators feel their hands are tied by the constraints of the Basel Accord on Capital Adequacy. "Basel more or less dictates which products go into which risk weighting category," says David Eacott of the FSA press office.
In Europe though, the Commission seems to have informally extended the 10% allowance indefinitely. There is no legal confirmation of this, meaning that although some governments may have the confidence to pass legislation allowing 10% weightings, a single deal such as HBOS alone will not change the situation in the UK.
With the success of HBOS at attracting German investors, and rumours that UK banks Bradford & Bingley and Northern Rock are looking to issue similar bonds, the first English law deal has clearly succeeded in winning acceptance as a real covered bond.
But, until either the FSA or the European Commission clarifies the law on risk weightings, UK issuers will find themselves at a competitive disadvantage compared with their continental peers.
This means they will miss out on a benefit provided to some by a quirk of European law that seems no longer to exist.