FOCUS: UK Banks Tap Covered Bonds, But RMBS Buyers Still Missed

14th Jun 2010 17:18

By Mark Brown Of DOW JONES NEWSWIRES LONDON (Dow Jones)--U.K. lenders are increasingly turning to covered bonds to finance their lending activities, but some market participants caution that the instruments cannot fill the gap left by the collapse of the market for securities backed by residential mortgages. Covered bonds are high-quality securities issued by banks to refinance mortgages or public-sector loans. Banks maintain the credit quality of the loans, sometimes in accordance with specific legislation, and investors have a claim both on the issuing bank and the loans in the cover pool. That makes them safer in some investors' eyes than the residential mortgage-backed securities, or RMBS--which are issued by special-purpose vehicles and serviced with repayments on mortgages that are taken off the issuing bank's balance sheet--that were at the heart of the financial crisis. Covered bonds are also viewed as less risky than senior, unsecured bank bonds. Before the financial crisis, U.K. banks were big users of RMBS to support their mortgage lending. Issuance in the first half of 2007 totaled EUR96.2 billion. But the collapse of investor appetite for RMBS following the U.S. subprime mortgage crisis, and the near-collapse of the global banking system caused that followed, left U.K. banks heavily reliant on government support programs. The Council of Mortgage Lenders warned earlier this year that winding down these programs would leave U.K. lenders facing a GBP300 billion funding gap. So it isn't surprising that they are turning to the covered bond market to fill this gap. In contrast to RMBS, the U.K. has historically lagged behind the "core" European covered bond markets like Germany. But U.K. issuance is increasing. Royal Bank of Scotland Group PLC (RBS) sold its first covered bond last week, following earlier deals from Barclays PLC (BCS), Lloyds Banking Group PLC (LYG) and Spanish-owned Abbey PLC (DOY.DB) this year. RBS can issue up to EUR15 billion under its covered bond program, so the bank is likely to return to the market. "RBS will want to build its curve, so we should see further issuance from the program, as and when market conditions are suitable," said Jeremy Walsh, a syndicate banker at RBS who worked on last week's transaction. RBS raised EUR1.25 billion in its three-year deal, which priced at 125 basis points over the benchmark mid-swaps level. Covered bond bankers not involved in the transaction said this was in line with the spread on existing U.K. covered bonds. Although wider than for recent new issues from Germany and France, the spread shows that covered bonds represent an attractive funding source for U.K. banks. RBS' debut is arguably good value for the bank considering its five-year senior credit default swaps--a form of insurance against default--were trading above 200 basis points at one point last week. Of covered bonds, RMBS and senior debt, "covered bonds are cheapest [way to borrow]," said a funding official at a large U.K. bank. "That shows the importance of this product." And while the U.K. RMBS market has reopened in recent months, issuance remains well below pre-crisis levels. But there are caveats to the idea that U.K. banks can simply switch their funding from RMBS to covered bonds. Firstly, the investor base for covered bonds mightn't be big enough. "There's only a finite universe of demand for covered bonds," according to the head of securitization at one bank. This banker also points out that regulators will worry if banks pledge too high a proportion of their assets as security to investors in covered bonds. Indeed, rating agency requirements mean that covered-bond issuance needs more mortgages than would be the case if a bank opted to issue the same amount of RMBS. "Covered bonds provide cheaper funding than RMBS, but are not as collaterally efficient, meaning a covered-bond program needs more mortgages allocated to it to achieve triple-A ratings," Robert Plehn, head of structured securitization at Lloyds, told Dow Jones Newswires earlier this year. Lloyds has sold both RMBS and covered bonds this year. "The two instruments also attract almost totally different investor bases." And because investors are buying bonds issued by a bank rather than a special-purpose vehicle, they have a limit on the number of bonds from any single institution that they can buy. "Issuing covered bonds might just cannibalize the existing investor base for U.K. bank bonds," the funding official said. -By Mark Brown, Dow Jones Newswires; + 44 (0)207 842 9485, [email protected] (END) Dow Jones Newswires June 14, 2010 12:18 ET (16:18 GMT)