Why the sun hasn’t set on RMBS

THE FUTURE LOOKS bright for covered bond issuance in the UK. “The market will develop to become one of the most important term financing instruments for UK banks,” says Dominic Swan, managing director at HSBC, one of a group of UK houses now actively considering the launch of a structured covered bond programme. If this is the case, the UK Financial Services Authority’s decision in February to embrace full Ucits compliance for UK covered bonds will only accelerate this process [see UK banks gain parity, Euromoney March 2006].

The FSA decision was made because “expectations are that the regime will facilitate innovation and promote competition. It is also consistent with the findings of the Miles Report [on the future of the UK mortgage market],” according to the regulator. The long-term impact of this decision could be far-reaching, given the UK’s longstanding love affair with funding mortgage origination in the securitization market.

Total residential mortgage-backed securitization (RMBS) issuance in Europe stood at the equivalent of about $175.2 billion in 2005 (boosted by some huge regulatory capital trades that hit the market in early December). Of this, $83.8 billion (47%) came from UK issuers. By comparison, total public covered bond issuance from UK issuers stood at €25.25 billion and £1.5 billion ($33 billion equivalent overall). Northern Rock’s fourth issue of €2 billion was additionally in the works by mid-March and there have been a number of private placements but the sector has a long way to go before it represents real competition. And the dilution of the capital arbitrage potential offered by RMBS under Basle II (the presumed trump card of the covered bond market) might not turn out to have the impact that many had expected.

The fact that five UK issuers decided to set up covered bond programmes without the jurisdiction having an EU-compliant covered bond regime illustrates the demand from mortgage originators for this kind of funding diversification. The proposed legislation will make very little difference to the day-to-day working of the UK market: as long as audit and legal opinions are in place that will be the basis for FSA supervision (due to come into effect in January 2007). All five covered bond issuers (HBOS, Abbey, Nationwide, Northern Rock and Bradford & Bingley) are among the top 10 mortgage lenders in the UK (see table). And four of the remaining five in the top 10 are known to be evaluating the use of a master trust or covered bond programme, or both.

In many ways it is surprising to see this flurry of activity on the master trust front given the rapidly closing regulatory capital arbitrage window. Basle II is very favourable to residential mortgages from a risk-weighting perspective: In absolute terms at the triple-A level the capital weighting for RMBS falls from 50% to 7% under the internal ratings based (IRB) approach. The equivalent triple-A rated covered bond will have a weighting of 4%. “By reducing the capital requirement for mortgages held on-balance sheet, Basle II will level the playing field between RMBS and covered bonds,” says Rob Thomas, senior policy advisor at the UK’s Council of Mortgage Lenders. “The point of the IRB approach is to accurately reflect the level of risk in the portfolio.” The impact of the new Basle Accord will be felt most keenly in the double-A rated bank universe – which includes many of the big mortgage originators.

The capital arbitrage argument became something of a moot point a year ago when Northern Rock’s £2 billion ($3.5 billion) Provide Graphite synthetic securitization effectively transferred the risk of its covered bond collateral pool off the balance sheet. The transaction used the KfW Provide programme to achieve the trade, by which the zero-weighted counterparty wrote a credit default swap against the cover pool, combining the covered bond and synthetic structures to replicate a cash transaction. But an RMBS structure would always be a cheaper way to achieve this.

The logical outcome of the FSA’s decision should be a surge in covered bond deals from traditional RMBS issuers as they tap into a new, cheaper investor base, safe in the knowledge that they are not sacrificing any regulatory arbitrage opportunity offered via securitization. “The issuance of UK covered bonds did not really fulfil expectations last year,” says Ted Pakmohr, covered bond analyst at Dresdner Kleinwort Wasserstein in Frankfurt. “The FSA decision encourages banks to come to the covered bond market and we expect several new issuers over the next few years.” Heiko Langer, senior covered bond analyst at BNP Paribas, predicted last November that UK covered bond issuance would hit €18 billion to €22 billion this year and has not revised his estimate in the light of the FSA’s decision.

However, this is still a small amount when even individual master trusts deals have reached £6 billion. “Our covered bond programme continues to grow in importance for us. It gives us great access to long-term liquidity,” observes Chris Fielding, head of securitization at Abbey. But he points out that the depth of the market is comparatively limited. “The covered bond market is not as liquid as the master trust market, with multi-tranche and multi-currency issues, at any one point in time. I suspect that you won’t see the scale of issuance in covered bonds that you have seen in master trusts in a single transaction.”