It would be difficult to talk about European securitization without discussing the rise of the covered bond structure. The HBOS covered bond program best represents the development of this new asset class. As an alternative to traditional securitization, the covered bond addresses the need - especially under the pending Basle II - for issuers to tap a broader investor base. HBOS is the parent company of Halifax Plc, and is the largest mortgage originator in the U.K.

Although players admit that, in terms of structural innovation, the features were less than exciting - as it was modeled after a straightforward Pfandbriefe-type structure - it provided the U.K. mortgage lending industry a tool for expansion.

HBOS E3 billion (US$3.3 billion) inaugural issue launched in June this year through Citigroup Global Markets, Goldman Sachs and Dresdner Kleinwort Wasserstein. The deal was followed up by a E2 billion (US$2.36 billion) 10-year, second round of financing in October. The inaugural seven-year structure was launched under HBOS Treasury Services E14 billion (US$16.5 billion) covered bond program. The triple-A rated bond priced at 10 basis points over mid-swaps, what amounted to almost seven basis points cheaper than a prior unsecured deal with the same average life earlier in the year, said market sources.

One of the biggest hurdles was adapting a structure that would function without a specific covered bond legal framework, such as that in Germany. HBOS adopted a hybrid product issued under the existing U.K. common law, possible because of the strength of the U.K. insolvency regulation. This allowed the lender to issue debt at the triple-A level.

The covered bonds are backed by a guarantee from the newly created HBOS Covered Bonds LLP. HBOS on its own is rated at Aa2', by Moody's Investors Service. The guarantee is secured by a portfolio of mortgages, each with a maximum LTV of 60%. Under U.K. law, the structured covered bonds will carry 20% risk weighting, whereas the neighboring European framework only requires 10% risk weighting. Still, the bonds are similar enough to German Pfandbriefe to appeal to the traditional investor base of that paper.

The reception was appealing enough: Other U.K. lenders are talking covered bonds going forward. While similar deals will undoubtedly follow, the HBOS program is tailored specifically to issuer needs.

"Before the market sees an explosion, a simpler, more repeatable structure needs to be tested," said one market source.

Mortgage lenders are not expected to abandon the traditional securitization structure, but open up an alternative base of funding.

Still, covered bonds, combined with lower origination, may end the exponential growth of the European RMBS market seen over the years. On the other hand, covered bonds limit a bank's ability to gain capital relief, and securitization investors prefer product with more yield. These factors will continue to draw U.K. lenders to securitize.

"On the investor side, appetite for RMBS paper will not disappear, and traditional securitization investors depend on this sector to achieve critical mass in their holdings," said one market source. "So while we may see less U.K. paper, it leaves room for diversification from other jurisdictions and it could mean that next year we'll start seeing more attractive spread levels."

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