RMBS Returns Alongside UK Covered Bonds

Renewed master trust RMBS issuance in the UK, as the era of cheap central bank funding comes to an end, has raised expectations that this mainstay of the UK securitisation market will close out the year with a flourish. At the same time, mortgage lenders continue to explore the benefits of complementary funding via the rapidly growing UK covered bond market. 

Following several extensions to the Bank of England’s Term Funding Scheme (TFS) - the most recent iteration of which expired on 31 October 2021 - the funding landscape has now shifted back to private capital markets issuance to refinance this central bank funding, which has until now been the backbone of medium term institutional funding for UK banks since its introduction in August 2016.

ABS and RMBS continue to provide important sources of funding and have long been key components of the overall capital markets landscape in the UK. The preferred structure varies depending on an institution’s overall size, retail deposit base and credit rating. Consumer finance warehouses which are later utilised in public ABS or RMBS transactions are the typical route for startups, smaller banks and building societies. Large banks and building societies typically prefer master trusts where they can leverage their sizeable balance sheet to enhance the diversification of their funding base, or regulated covered bond programmes, if their ratings are sufficient for this source of funding to be competitive.

The success this summer of two headline RMBS deals by Lloyds Bank from its Permanent UK RMBS master trust programme, after a four-year lull, alongside a deal on the Lanark master rust which contains mortgages from Virgin Money’s Clydesdale Bank, demonstrated the pent-up demand from investors after limited supply in recent years. Lloyds also successfully tapped the UK covered bond market in-between its two Permanent deals, as did Coventry Building Society, which also operates its Economic Master Issuer RMBS programme. In this article we examine some of the key features of RMBS master trust and standalone issuance, as well as covered bonds.

Master Trusts

In the most active years for UK securitisation, prior to the financial crisis, familiar master trust platforms such as Northern Rock’s Granite, Barclays’ Gracechurch and Santander’s Holmes featured strongly, typically used for prime mortgage securitisation, with some £160 billion outstanding in 2008. The subprime crash in the US mortgage market which preceded the Northern Rock collapse and the subsequent freeze in UK structured finance markets highlighted the structural deficiencies within master trusts, which had minimum asset triggers and other features that assumed a model of continuous issuance and expansion.

Despite these structural deficiencies, master trust platforms still have many advantages, such as branding and recognition, size and scale, which lends to a more liquid secondary market for the notes in issue, as well as speed of issuance. Rather than using a static pool of assets, master trusts have monthly top-ups and substitutions which allows the pool to be constantly refreshed. Conversely, disadvantages within a master trust include complexities when amending the legal documentation and obtaining approval from noteholders. There is also more scope for conflict between different classes of noteholders in these structures.

The recent activity of banks, using new technology to structure master trust issuing vehicles as master issuers, has gone some way to address the problems that emerged during the aftermath of the financial crisis. When swap providers and banks were being downgraded during this period, it was often a complex exercise to work through the transaction documents to understand the impact and to determine what needed to be done. Today, however, there is greater clarity and less ambiguity in the underlying documentation.

Stand-alone RMBS

With a simpler and more flexible structure, new emerging lenders such as smaller fintech companies and challenger banks have joined traditional bank and building society issuers and now comprise a growing proportion of the RMBS market. Individual warehouse lines are usually established and termed out with smaller stand-alone issuances in the region of £150 million to £200 million. Well established banks and building societies outside of the Big Four will tend to bring larger deals of around £400 million to £500 million plus. With a broad collective of lenders utilising the UK RMBS market as an attractive source of funding, deals feature a wide range of collateral with more non-conforming portfolios, near prime and buy-to-let mortgages making up for softer issuance in prime residential mortgages. For stand-alone RMBS issuance, it can take at least a month to six weeks to bring a deal to market, which is longer than the two or three weeks which can be achieved for a tap issuance from a master trust.

The impact of the new Securitisation Regulations in the UK, which mirror the 2019 legislation introduced in the EU, brought in new requirements related to risk retention, investor due diligence and disclosure, along with other measures. It also introduced the concept of Simple Transparent and Standardised (STS) securitisations to promote greater confidence in a European securitisation market, which, in the eyes of EU officials, was still tainted by the issues that arose from the global financial crisis.

While there is a significant degree of additional work for issuers to attain the STS designation, the rules also put a considerable onus on investors in terms of the due diligence required, perhaps acting as a slight drag on the overall pool of potential investors. Some investors, notably insurance companies, have been effectively priced out of the securitisation market in the UK and Europe for non-STS deals, due to the high cost of capital required to hold these investments under Solvency II. This may go some way to explaining why US securitisation levels have rebounded strongly towards pre-crisis levels whereas EU and UK issuance has remained subdued.

Standalone issuances have been very prominent in the UK securitisation industry for the past decade or more and the basic structures have remained constant. There have been some tweaks, however, such as the use of liquidity reserve funds rather than external liquidity facility providers, as well as the introduction of revolving periods on some transactions. UK issuers have also adopted SONIA pricing over the past couple of years and have made the necessary amendments to historical transactions to accommodate the switch from sterling LIBOR which ceased at the end of 2021.

Covered Bonds

For UK banks with the requisite scale and external ratings from recognised rating agencies, covered bonds can be an attractive funding tool. Loosely based on the 250-year-old, €250 billon plus, German pfandbrief market, the UK introduced a regulated covered bond framework in 2008. The "cover pool" is managed dynamically, based on set overcollateralisation levels with a dual-recourse to the issuing bank by way of a guarantee.

Much of the attraction with a covered bond issue lies in its simplicity. With a straightforward structure, a covered bond is not tranched like a securitisation and usually only AAA investors are targeted. Regulated covered bonds have become attractive to investors, due to the increased investment limits. UCITS and non UCITS retail schemes allow up to 25% of assets in regulated covered bonds from a single issuer, compared to only 5% in other bonds from a single issuer. Investments in regulated covered bonds also benefit from up to a 60% lower risk weighting than unsecured senior debt. One of the primary principles of the regulations is that the cover pool must be capable of covering all claims from noteholders at all times. The Financial Conduct Authority, which regulates the UK covered bond market, utilises robust stress testing scenarios to determine overcollateralisation requirements, determined on a post-insolvency basis and based on the underlying credit quality of the cover pool of each individual programme.

It is still relatively early days for the UK covered bond market, certainly compared to its more storied German counterpart and others across Europe. What it does provide for UK originators is a regulated market and increased diversity in wholesale funding, with banks and building societies such as TSB and Coventry Building Society setting up covered bond programmes alongside traditional RMBS programmes. For example, Coventry Building Society set up a second covered bond programme at the end of 2020, on which Maples Fiduciary Services UK acts as corporate services provider.

The attractiveness of covered bond issuance for banks and building societies is heavily influenced by external credit ratings. The lower the issuer’s credit rating, the more overcollateralisation would be required and on falling below a certain rating, RMBS begins to look more attractive in comparison. An additional factor is the Financial Conduct Authority, which regulates the UK covered bond market, places a limit on the volume of covered bonds that each bank is permitted to issue, in line with its overall assets.

The Bank of England, through its regulatory arm The Prudential Regulation Authority, notes that firms will differ significantly in terms of the proportion of their assets which are encumbered in normal times and as a result it does not take a ‘one size fits all’ approach. Limits on covered bond issuance volumes as a percentage of a bank’s overall balance sheet will therefore vary widely between different banks, however, the volume of covered bonds a bank would be permitted to issue will be significantly below that of RMBS, due to the overcollateralised nature of the cover pool. Similarly, the rating agencies will not issue a Triple-A rating to covered bond notes if the underlying bank is below a certain threshold, in contrast to RMBS where a Triple-A tranche can be achieved by adjusting the subordination levels and other credit and liquidity enhancements.