HBOS unveiled its E14 billion (US$16.4 billion) synthetic covered bond program last week, expecting to deliver its first issue by the end of July. Market analysts are certain that the HBOS program will open the door for other U.K. mortgage lenders wishing to follow suit.

One of the biggest hurdles the U.K. mortgage lender faced was adapting a structure that would function without a covered bond legal framework (see ASR 6/23). What they've come up with is a hybrid product issued under the existing U.K. common law that was possible because of the strength of the U.K. insolvency legislation. In fact, under U.K. law, the triple-A rated HBOS issue was able to achieve one of the highest ratings yet for a covered bond issue.

"They have come up with a structure that virtually takes out all the weakness in other covered bond markets in Europe," said one market analyst.

The covered bonds achieved a triple-A rating backed by a guarantee that is provided by the newly created HBOS Covered Bonds LLP - HBOS on its own is rated at Aa2', by Moody's Investors Service. The guarantee is secured upon a portfolio of mortgages, each with a maximum LTV of 60%. The structured covered bond functions in much the same way as a securitization. It's the securitization techniques adapted that allow the covered assets to be delinked from the rating of the originator and also make this issue less volatile compared to past unstructured covered bonds issued in Europe.

How the guarantee works...

According to Moody's, the major difference between structured covered bonds and ABS is that investors continue to have either direct or indirect recourse to the originator. The underlying collateral would repay the bonds only if the originator defaults. In a securitization, the cash flows from the assets serve to repay the bonds.

The bond guarantee is in place as a mean to deter administrators from gaining immediate access to the asset-covered pool in the event of default. "At the moment Halifax is issuing approximately E2 billion (US$2.3 billion) over five years and one of the concerns was whether the guarantor would be able to cover the full amount as is required in a covered bond," explained one analyst. "The risk has been mitigated by implementing repayment over periods of time'."

If, for example, the bonds were to lose the single-A rating, the guarantor would deposit enough cash to redeem the next maturing covered bond six months before they are due. In the event the bonds lose the short-term P1' rating, that repayment period would extend to 12 months. According to Moody's, this arrangement mitigates the risk that the covered bond guarantor does not have the funds available to redeem the covered bonds when they fall due.

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 likely to provide a cheaper funding alternative compared to securitization.

As to whether the advent of a U.K. covered bond market might obscure securitization, sources said it's unlikely since the products seem to complement one another at this point. Covered bonds do not achieve the capital relief securitizations provide to balance sheets.

"Originators are likely to do both because of the added funding flexibility, and the different market dynamics between the two also opens up a wider investor base," said one source working on the deal. But if new capital requirements expected in Basle II (see ASR 5/26) narrow risk weightings between covered bonds and securitizations, market sources speculate that mortgage lenders might not be able to make the case for using the more expensive securitization instrument in the future.

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