Doing the right thing

The celebrated consultant, Peter Drucker, said management is doing things right but leadership is doing the right things. The past months have seen the UK's biggest mortgage lender, HBOS, revise its funding plans like many others. But its actions during the subprime crisis have demonstrated a readiness to help the market back to its feet that would have met Drucker's approval.

In mid-October, HBOS sought to reopen the UK covered bond market with a EUR2 billion seven-year deal priced at 16 basis points over mid-swaps. It was the second time this year the bank had sought to re-establish a pricing level for UK covered bonds, the previous attempt having failed to stabilise the market after rival Nationwide issued at much wider spreads while HBOS's deal was still pricing.

"Often it is difficult to be out in front, but there is a need for people to do that," says Tim Skeet, head of covered bonds at Merrill Lynch in London. "What they have succeeded in doing is bringing investors back and restoring a sense of confidence around the product, which is exactly what we needed." At the time of writing, market participants were hopeful that HBOS might provide similar leadership with another deal, this time in the securitisation market.

The face of the bank on transactions such as these is Robert Plehn, head of securitisation and covered bonds at Bank of Scotland Treasury (part of the HBOS group), who says he has found the past few months fascinating, despite being challenging.

At Bank of Scotland Treasury he leads a team responsible for structuring and negotiating deals under the bank's own securitisation and covered bond programmes, and securitisations for external clients of Bank of Scotland Corporate, relying on external investment banks primarily to distribute the bank's bonds to investors. It is a set-up unique in the UK industry and shows the depth of commitment at the bank to securitisation as a funding tool.

Visibility crucial

HBOS has suffered some negative press in recent months and its share price has been one of the weaker among its UK peers this year, hitting an annual low of £8.13 in September from a peak of £11.67 in February. But Plehn knows that becoming invisible during the tough times sends the wrong signal to investors.

Conversely, there is a value in providing leadership in adversity for those willing to take the risks that go with the role.

The bank's own interest in helping revive markets is clear. HBOS came into the liquidity crunch with 11 active securitisation programmes and it has over £90 billion in asset-backed issuance outstanding. This includes programmes relating to every element of its mortgage book except its Irish mortgage portfolio, including deals in Australia and a programme backed by Dutch assets originated through the bank's arm in the Netherlands.

Its reliance on asset-backed funding is far lower than that of peer Northern Rock, with securitisation at HBOS accounting for only 9% of funding, and covered bonds a further 4%. (Retail deposits by comparison provide 48% of the bank's financing.) But the securitisation and covered bonds have been essential in enabling the bank to diversify its investor base, lengthen its maturity profile and raise incremental funding.

Meanwhile, HBOS has placed itself at the forefront of innovation in the asset-backed markets. The bank was the first to apply US credit card securitisation techniques to the UK market, creating bonds with bullet maturities that helped it to attract US investors. And, in 2003, HBOS launched the first structured covered bond programme, replicating deals in countries with specific covered bond legislation despite the absence of a covered bond law in the UK.

Plehn continued this pioneering approach when he joined the bank from ING in the same year, extending the HBOS covered bond programme to tap the US market in 2006 and becoming the first issuer to do so. As recently as February this year, HBOS again successfully tapped the US market with a second issue, this time for $3 billion, with more than 70% of the bonds placed with US investors.

A hint of danger

At that stage, the full extent of the damage from the US subprime crisis was yet to become fully clear. Plehn says his team first sensed worsening conditions in Europe while marketing the bank's Prominent 2 CMBS Conduit transaction in late June. The deal priced just outside guidance - although at the time the continuing strength of mortgage sector fundamentals in Europe made the issue seem one of pricing and of competing supply rather than a more fundamental change in the market, he says.

The crisis at IKB Deutsche Industriebank changed that - after other banks were forced to step in to support the German lender following losses against US subprime holdings in its conduit. The asset-backed commercial paper (ABCP) market stopped in its tracks. Structured investment vehicles and conduits were left unable to roll over their paper.

According to research from Deutsche Bank in London, by September the US and Euro ABCP markets had shrunk by 25% and 35% on the preceding quarter. Meanwhile, US banks were also out of the market as buyers, owing to their own direct holdings of US subprime mortgage paper. "In a relatively short period of time, you had a massive investor base stop buying," says Plehn.

For HBOS the difficulties in the ABCP market led to some negative publicity in August relating to the bank's Grampian commercial paper unit, reportedly the biggest seller of commercial paper in Europe. On August 21, the bank announced the intention to fund from its own balance sheet the redemption of about $35 billion in commercial paper issuance from Grampian. It emphasised at the time that this would not adversely affect its business and that it had ceased funding through Grampian by choice.

"We just said we were not going to pay the kinds of rates investors were demanding," says Plehn. Buyers did not appear to be distinguishing between ABCP issued by A-1+/P-1 bank-sponsored conduits that only held high quality AAA-rated assets and other lesser quality ABCP, he adds.

However, the bank did acknowledge that the markets had repriced for financial institution term debt, and was willing to pay a higher margin than it would have six months earlier if that was fair pricing from a market perspective. With that in mind, in early September the bank tried to reopen the UK covered bond market with a EUR2 billion issuance of three year bonds.

"Nobody had issued a jumbo residential-mortgage-backed covered bond for a number of weeks and we had heard from a few investment banks that there were a number of investors that would like to see us come to market," says Plehn. "So we decided to cautiously test the market and when we received positive feedback, we launched a deal."

Skeet says the decision matched Plehn's previous strategy and the bank's sense of responsibility to lead the market. "They are a bank that uses a lot of wholesale funding. They are conservatively funded, but they know this is an important sector that is part of their future," he says.

At the same time, Plehn believes the benefits accruing to a regular issuer outweigh the cost of breaking open a frozen market. Opening the market repays an issuer with tighter spreads on future deals and a premium that goes with being perceived as a strong name in the market, he says.

Bookbuilding on a covered bond deal would normally take a day or two but in this instance, while bookbuilding occurred within the same day of the deal's announcement, this was preceded by two days of informal discussions with key investors. This extended market discovery was mainly owed to the difficulty of pricing in what Plehn describes as a new market. The transaction was planned at EUR1 billion but upped to EUR2 billion on the back of strong demand, pricing at 5bps over mid swaps compared to an estimated price of about 10bps tighter had the bank issued a similar tenor covered bond prior to the liquidity squeeze.

The bonds tightened slightly in the grey market, says Plehn. But spreads subsequently widened substantially as rival UK lender Nationwide Building Society sought to tap the market with a five-year deal at wider spreads while HBOS was still pricing its deal.

Says Skeet: "Everyone knew that somebody had to come out and reprice the curve, and HBOS stepped up to the plate. We all saw it as being a highly responsible and intelligent thing for them to do."

During the course of the following month, however, tightening secondary spreads for the September deal and more orderly issuance from continental Europe convinced the bank to try opening the market once more.

Market reaction to the subsequent EUR2 billion seven-year deal in October was positive, with the book for the second deal broader than that of the first, according to bankers close to the transaction. Meanwhile, secondary spreads in the covered bond market remained stable throughout the period of marketing on the deal, demonstrating the extent to which the market has normalised.

First in

Next, the bank faces the decision whether or when to replicate these efforts in the residential mortgage-backed securities (RMBS) market. Plehn is comfortable in principle with the idea of being one of the first European residential mortgage names to issue in that sector, although funding is still too expensive at current prices, he says. "If you are the first issuer to try and reopen a disrupted market, even if you are a benchmark issuer you may pay a bit of a premium to do so, but you would also expect to see comparative tiering as other weaker and more infrequent issuers come to the market. That tiering disappeared from the market when there was so much liquidity."

In October, Dutch issuer GMAC-RFC Nederland became the first issuer to complete a publicly placed deal in Europe with a EUR700 million transaction. As activity revives, market participants would also like to see a deal from HBOS's Permanent RMBS programme, which with £36.8 billion of issuance outstanding is one of the most liquid in the market. Hans Vrensen, head of European securitisation research at Barclays Capital says investors would welcome a deal from any of the bigger repeat issuers, although he cautions that a steady flow of primary market deals could still be some way off. Investors remain wary about continuing downward pressure on bond prices for fear of further forced selling of asset-backed bonds by structured investment vehicles, he says.

Meanwhile, developments in the US credit card asset-backed securities (ABS) market provide possibly the best indication of where a Permanent deal might price. Spreads on US credit card deals had tightened to around 25bps to 30bps over swaps at the time of writing, with issuance volumes growing - suggesting that liquidity is returning to this part of the market. Historically the bank's deals have priced 3bps to 5bps wider than US card deals, although the premium in the near term is likely to be higher.

Given investors' concerns about the lack of liquidity in the secondary markets and the uncertainty as to the amount of potential supply both on a primary and secondary basis, pricing any RMBS deal is difficult at present, says Plehn.

Nevertheless, market conditions are increasingly encouraging, and Plehn expects that spreads will stabilise at levels much tighter than those indicated at the moment, although he acknowledges that it may be quite a while before levels return to the tights seen in 2006 and 2007. On the asset side, this is likely to mean higher rates for some customers over the medium term.

For HBOS, this widening of spreads and increased cost of funding has led to a renewed focus on the quality of assets that the bank writes. It has also made the bank's falling share of mortgage lending earlier in 2007 look less of a problem than it seemed at the time. Its share of new UK mortgage origination dropped from about 17% to around 8% in the first half of this year, largely owing to pricing changes on loans to existing customers. At the time, this looked like a costly mistake.

Going for value

The emphasis now, however, is on relative value rather than market share. "If we pay 15bps more on the liability side that is fine, if we get an appropriate risk-adjusted return on the asset side that compensates us for the increased funding and capital cost," says Plehn. The bank can issue from any number of its funding programmes, he says. Some are more costly than others but the real question becomes what the bank plans to do with the money. With credit constrained, decisions about which markets to compete in are heightened.

HBOS chief executive Andy Hornby has also flagged up this shift in approach. At a Merrill Lynch conference in October, he said 2007 had not been the year to grow the mortgage book aggressively. The bank has changed its policy in response to the credit crunch, he said, and will not set market-share targets for lending next year as it has done in the past. Instead, said Hornby, the bank will make judgments on a trade-off between volume and margins on a month by month basis.

Plehn strikes a positive tone as he explains how this changed environment could work in the bank's favour, forcing weaker retail lending banks, investment banks and non-bank financial institutions that have driven down margins to exit the UK mortgage business. Several investment banks, for example, have acquired mortgage-lending subsidiaries over the past two years and some (such as Lehman Brothers) are already beginning to scale back those operations.

"With competition reduced, traditional lenders should be able to undertake more lending at pricing that generates a more attractive risk-adjusted return," says Plehn.

Investor's recognition of the bank's funding strength, as exhibited during recent troubles, should prove a valuable advantage and perhaps one that will outlast current market turmoil.

At Merrill Lynch, Skeet says: "There is a benefit to leadership in that you are perceived to be a responsible borrower that takes proper account of investor concerns. If you are seen to be in tune with what a lot of investors want, you are always going to benefit over the long term from their support."

Meanwhile, Plehn will be looking to investors for reciprocal understanding. "We are not going to pay an unreasonable amount if a deal doesn't represent good relative value for us," he says. If he can help restore that sort of reasoning to current markets, other issuers will be lining up to thank him.