A 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 capital that bank investors should hold against investments in these deals.
The €3 billion issue is the first time a UK bank has tapped demand for covered bonds from institutional investors in Europe that have been buying German Pfandbriefe for years. But the bond is risk weighted at 20% – twice the figure for an equivalent German deal – so banks that buy it must hold $1.6 million in reserve for every $100 million invested.
The lawyers that put the HBOS issue together say regulators should have granted it the same risk weighting used elsewhere in Europe. But even they admit there is no legal basis for this because of uncertainty about European Commission rules.
The UK’s Financial Services Authority says it stands by its weighting, but might change it in future. “If more banks start to use this structure and it becomes effectively a UK Pfandbrief, it is possible we’ll look at the risk weightings. But we’d have to do so in the context of the new Basle Accord,” says FSA spokesman David Eacott.
At stake is the extent to which UK issuers will be able to access one of Europe’s most abundant sources of cheap funding.
German covered bonds, Pfandbriefe, are asset-backed but remain on the issuer’s balance sheet. Issuers originate 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 line for the rest of the issuer’s assets.
In its issue HBOS has used 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 devised a structure that provides security equivalent to that offered to investors by Germany’s Pfandbriefe rules by transferring the assets to an on-balance-sheet limited liability partnership (LLP) and overcollateralizing by 60%, the same degree as a German deal.
A wrap-like guarantee As well as the partnership having guaranteed obligations to repay 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 LLP, 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 a bank’s balance sheet.
Using an MTN programme to issue enables HBOS to issue further securities at short notice with no lengthy documentation.
Nevertheless, lawyers for HBOS were unable to make their case for a lower risk weighting stick with UK regulators. Their argument hinges 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”. But 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.
“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 any more.”
If Article 63 does still apply, it is possible that the HBOS deal and future transactions based on the same template should indeed qualify under the EC’s definition of covered bonds in the Undertakings for Collective Investment in Transferable Securities directive.
Ucits defines covered bonds as those “subject by law to special public supervision designed to protect bondholders”. The directive says: “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.”
Clist says: “It is arguable that the UK’s creditor-friendly insolvency regime falls within the Ucits requirements even without a specific law – and if it does it would be unfair that the HBOS bond did not get the attendant right to a 10% risk weighting.”
The FSA 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 Basle Accord on capital adequacy. “This is a very restricted process. Basle more or less dictates which products go into which risk-weighting category,” says the FSA’s Eacott.
In Europe, though, the EC 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’s will not change the UK situation.
With the success of HBOS at attracting German investors, and rumours that other UK banks might issue, the first English-law deal has clearly succeeded in winning acceptance.
But until either the FSA or the EC clarifies the law, UK issuers will be at a competitive disadvantage.
