Edward Russell-Walling examines the move by HBOS to create a social housing covered bond and its attractiveness to European investors.Any half-decent treasury textbook warns of the need for diversification of funding sources. Few advise the creation of a new asset class, although that has not discouraged HBOS. Last December, the bank carved out new territory in the sterling debt market with a £3bn programme of covered bonds secured on loans to housing associations. Enter stage left the “social housing covered bond”, a hitherto unknown species of debt.
HBOS, with its powerful presence in UK mortgage lending, is a respected name in both equity and debt markets – so much so that many sterling bond investors have sated their appetite for its unsecured paper.
“Most of our assets are denominated in sterling. Pricing being equal, we prefer to take funding from sterling investors to keep assets and liabilities matched,” comments Robert Plehn, HBOS head of securitisation. “But the sterling investor base is not big enough to support all our needs, so we have diversified into different currencies.”
Diversification
In this quest to diversify, HBOS has also become a big securitiser in one form or another. It has issued some £30bn of residential mortgage-backed securities (RMBS), as well as a further £2bn in securitised corporate loans. In 2003, it launched what is now a €25bn covered bond programme, secured on residential mortgages. “The RMBS programme has raised our profile and investor base in the US enormously, as well as in Europe,” says Mr Plehn. While HBOS covered bonds have helped to increase distribution in Europe, as a class they have only achieved minimal penetration among US investors. “So we don’t see them as a route into the US right now, though that could change,” he adds.
In both cases, the aim has been to de-link the credit quality of the assets from HBOS risk. The difference between a straight securitisation and a covered bond is that in the latter case the investor looks to the originator as well as to the assets for repayment. Moreover, the asset pool has a stand-alone rating that can be higher than that of the originator.
New investors
The consequent decoupling allows the bank to sell more debt to existing investors, who don’t need to allocate the investment to their HBOS limits. It also opens up access to new investors. In the case of covered bonds, these new investors are principally European institutions that have long been comfortable with covered bonds, but which might not be familiar with the HBOS name. The hope is that once they have bought the structured debt, they might then look more favourably on unsecured debt.
The social housing covered bond merely extends this strategy, albeit rather boldly, and exploits the appetite for long-dated AAA paper in the sterling market. “The challenge was to educate investors about a product that was relatively unknown in the UK, as well as to convince them that the risk was de-linked from HBOS risk,” explains Mr Plehn.
A safer bet
The quality of a covered bond is largely determined by the quality of the collateral, and loans to housing associations are claimed to be a safer bet than residential mortgages. Housing associations (‘registered social landlords’ in official parlance) are non-governmental organisations – government does not want this debt on its balance sheet – but they are supported by government grants and subsidies. Housing Associations are regulated by the Housing Corporation. To date there has never been a housing association default. “It is unlikely that the UK government would ever let any of these landlords go down,” says Mr Plehn. UK investors understand this in a way that continental investors might not, which was one reason why HBOS chose not to denominate the issue in euros.
Unlike pfandbriefe, obligations foncieres and certain other European varieties of the covered bond, the UK instruments are not governed by legislation. Some view that as a weakness. “Using contract law and securities technology, we have recreated what exists under the legislation for pfandbriefe,” counters Mr Plehn. “In fact, we had to structure it so carefully, with the ratings agencies examining every aspect, that we believe our product is stronger than the legislated product.”
Framework
The Financial Services Authority (FSA) is now evaluating a regulatory framework that will put the UK regime on a more legalistic footing. In turn, this should reduce the risk weighting of UK covered bonds from their present 20% to the 10% enjoyed by legislated products. Moreover, this should attract more UK issuers to the market, although the FSA is threatening to limit covered bond issuance as a proportion of assets.
Bookrunners Dresdner Kleinwort Wasserstein and UBS placed an initial £500m of the AAA/Aaa, 20-year paper at 42bps over gilts. Mr Plehn doesn’t expect issuance in the near term to be any more than 50% of the £3bn programme. “But to be able to issue 20-year debt at an effective 13 to 14bps over Libor? That’s a very attractive programme.”
