The UK could see its first Danish-style covered bonds this year if Perenna’s application for a banking licence is successful. The company sees Denmark’s match-funding model and sale of long-dated covered bonds as the means to offering fixed for life mortgages. The CBR’s Neil Day spoke to Perenna co-founder and CEO Arjan Verbeek — formerly of Barclays, BNP Paribas and Moody’s — about the challenges facing the start-up and how the Danish model might address issues facing the UK mortgage market.

Neil Day, The Covered Bond Report: How easy is it for you to recreate a Danish-style covered bond bank in the UK? Has there been anything that needs to be changed in legislation or regulation or law for you to proceed? I ask that while acknowledging that the first UK covered bond was created without any dedicated framework being in place.

Arjan Verbeek, Perenna (pictured): I was at Moody’s back in 2002, 2003 when the first contractual covered bond was done in the UK and rated that transaction as part of the Moody’s team, so I’m very familiar with the journey the UK covered bond market has taken. UK law is contractual and contract law is obviously very flexible, you can structure any instrument from a risk point of view that you think is the right one to put into the market.

The UK covered bond legislation and regulation was put in place at a later stage, mainly because of the European investors. Covered bonds in the UK are generally either the floating rate sterling ones that end up going to the bank treasury books, or the euro-denominated ones that all go into the European investor base. There are very few long dated fixed rate sterling bonds in the UK market — just a few that were issued after the financial crisis. The UK framework was never designed with this in mind, but the regulations work for us — and all the EU regulations with respect to the Danish model will be moved across into UK regulation and still apply in the UK. So there isn’t really anything in UK law or regulation that prevents setting up this bank. We also don’t need any change to the covered bond side of the regulations at all — we need to have some different monitoring and reporting, yes, but not the rules and regulations themselves.

Day, The CBR: But what about in terms of bank regulation? For example, in Denmark there are specific rules for mortgage credit institutions when it comes to MREL. Do any issues like that come up?

Verbeek, Perenna: Encumbrance is not going to be a concern for us, because we won’t be having a deposit-led funding strategy. The whole deposit protection issue that the regulators worry about because of the subordination you get through the issuance of covered bonds doesn’t apply to us. So we have no such concerns.

Day, The CBR: There has been talk for years in the US and elsewhere about the Danish model being something that is attractive and benefits many stakeholders. However, it hasn’t really taken off anywhere outside Denmark. What is it that kind of makes you think that this is the time, and maybe you are the people, to make this happen?

Verbeek, Perenna: Firstly, we don’t need to have any change in rules or regulations. The moment you have to rely on a framework being set up or anything like that, it’s a major roadblock.

Secondly, you need the right types of skill-set together. The team that we assembled all have a mortgage finance background, and then we have added the other skill-sets to it. And in our system, you have to look at the origination and the financing sides and blend them together, so you need securitisation professionals who understand how both sides of the equation work.

Thirdly, the economic environment is perfect. Before the financial crisis you basically had asset-based underwriting in the UK and everybody could get whatever mortgage they wanted. When the responsible lending rules came in with the stresses, that capped how much people could borrow, and in an unfair way, because with interest rates having gone down, they should be able to take advantage of lower funding costs, but they couldn’t because of these rules — even if the rules are completely fair because the risk of rates going up could destroy lives. Fixed for life mortgages would really allow consumers to take advantage of these low rates and be able to afford the high prices that have resulted from them.

And with the economy suffering from the pandemic and the housing market being locked up, this is the perfect time for a product like ours — it solves a lot of issues, including systemic UK issues. We connect domestic supply of funds with domestic demand for funds, and that creates systemic stability, as we’ve seen in Denmark for 200 years.

Finally, setting up a bank has been a barrier to entry. Setting up a regulated entity and particularly a type of entity that is new to this jurisdiction is obviously a huge and complex task. We started with the securitisation, covered bond structuring aspects, and then we added all the expertise that we need to set up a bank, which includes the mortgage origination side, but it also includes legal, compliance and everything else necessary from a governance point of view. And then we need the systems. It’s been expensive, a lot of work and taken us a long time to get to this point. But we’re very pleased that we’re here now.

Day, The CBR: The government has pledged to introduce fixed for life mortgage loans to help first time buyers. Is there anything that they’ve done that is in favour of your initiative?

Verbeek, Perenna: As I said, the government doesn’t have to do anything for us to come to market. We were very happy to see that commitment being mentioned in the government’s manifesto, because it created greater awareness and shows the benefit that fixed for life mortgages have to consumers, which has been very important for us. But it’s also focused on first time buyers; what the government hasn’t focused on is the benefit of this product on all the other consumer segments that you have: second time buyers, last time buyers, people that need to borrow well into retirement, and even borrow a bit more to pay for their care costs or pension top-ups. All these borrower segments are helped by fixed for life mortgages. So it’s a hugely important product for the entire UK market, and it’s bigger than first time buyers — that’s the first point.

The second point is what they actually are doing. I’ve read in the press that they’re looking at the US agency model, and commentators saying the government needs to put a different type of “help to buy” in place, all other such things. Frankly, we are the proof that all of that is not necessary; you can facilitate that in the market without using the public sector balance sheet. It’s actually much better not to use the public sector balance sheet, because the public sector balance sheet generally distorts the market, and you need to have a normal market develop to create a liquid and stable system. The US agencies are a good example. They were set up during the Great Depression in order for mortgage lending to continue, but over time they have morphed into something where it’s all now on the government’s balance sheet and the government is the majority lender in the US mortgage market — that is not a healthy state of affairs, they need to change that, and they know that, but nobody knows how. How do you change something that big? The Federal Reserve together with a Danish bank have authored a report that basically said the US should look at Denmark, that’s a good way of doing it.

The strength of this model is recognised and I am convinced that the moment we’re up and running we’ll see at least four or five clones being set up in the industry. And that’s absolutely fine — the potential market is huge. If we believe Boris Johnson, the first time buyer market is two million customers, which at £200k per mortgage is £400bn. Later life markets are put at another £600bn, so we’re already talking about a trillion of new debt coming through. It’s massive, so there is enough for the entire market to make this work. And if the entire market works with us to make this happen, everybody wins, because the entire UK economy and system becomes more stable.

Day, The CBR: You mentioned barriers to entry — as well as the time and complexity, you need the capital. What can you say about your backers?

Verbeek, Perenna: When we started we financed ourselves from our savings, and then we had a smaller seed round that got us through the first stages of the of the bank set-up process. We recently closed a larger seed round that should get us to the banking licence stage. At the moment, what we have is venture capital, high net worth individuals who have invested, including some professional City people, ones who know the securitisation market and the capital markets. When we get the go-ahead from the regulator we will need to raise a lot more equity in the series A round to start lending, and we are obviously talking to a lot of parties about investing in that.

It’s a very safe proposition. It’s equity, obviously, but the market is so big and the opportunity is huge. And the investment is backed by bricks and mortar in the end — we’re not burning cash to generate customer demand; we basically have a profitable asset the moment it comes on the books. So it’s a different proposition than other challenger banks.

We’ve seen already very strong interest, particularly for the series A round, because that’s when all the regulatory risk is gone. And with the demand and indications of interest for our mortgages that have already been registered, we will already know how much we can lend, so there will be most likely a huge volume there ready for us to tap into. So that makes it a relatively low risk, but very attractive investment proposition.

Day, The CBR: You talked about connecting domestic demand and supply of funds. The long dated fixed rate callable bonds you would be issuing are something that isn’t particularly common in the sterling market, and I assume sterling would be your currency. What makes you confident about the investor base being there for this?

Verbeek, Perenna: We’re obviously talking to a lot of the investors. We’ve talked to the real end investors, the suppliers of money, which are pension funds, insurance companies and asset managers, but we’re also talking to the banks. And it is very clear that there is a price for this bond: if you ask anyone whether there is a demand for long dated fixed rate sterling, they’ll say, it’s a black hole. The question is, what is the price?

On the other hand, we are different, we take the price of the funding, and that results in the price of the mortgage. We are not looking at a product in the market and saying, oh, we need to beat that mortgage rate. We just offer a product that has a certain rate and then people can take it or leave it. But there’s not much out there to compete with our product, so it’s more a question of, do you buy a house with our product and borrow this much money? Or do you not buy the house? We have a huge target market by selecting the niches that the current products are not really fit for.

Day, The CBR: Until you actually start, is it not difficult to give potential borrowers a good indication what the actual rate will be?

Verbeek, Perenna: Until we sell the bonds, the borrowers will have a floating rate mortgage, like if they borrow at the bank base rate. But we will have a good indication by then what the price is, what margin over the benchmark Gilt it will be, even if it may vary a little bit.

Day, The CBR: Will it be all in sterling?

Verbeek, Perenna: We are definitely starting with sterling. I don’t see us going cross-border. In Denmark the banks do issue a few bonds in euros to match euro assets when their customers take out loans in euros, but they don’t take currency risk on the balance sheet, and we don’t want to either.

But you also see investors in Denmark, particularly the Japanese life insurance companies, buying Danish krone-denominated covered bonds and swapping them into yen. The investors, the asset managers, etc, they will be able to buy our bonds and repackaged into the right type of currency for potential investors. I have no doubt that the investment banking, capital markets, fixed income industry will start working with these assets and use them in different transactions.

Day, The CBR: Will you be hiring investment banks to sell the bonds? Or will this be via auctions as in Denmark?

Verbeek, Perenna: It’s true that the market in the UK will at first will be less efficient than it is in Denmark — it’s hard to beat their efficiency: the bonds are very liquid, very well traded, people understand it, it’s efficiently priced, etc — and in the beginning we will involve the banks to do a benchmark transaction.

But I have no doubt that over time, the UK market will become very efficient and we definitely want to get to the auction stage eventually, which will also involve the banks, of course. And given how much bigger the UK is than Denmark, we should be able to create a really liquid market over time with all the stakeholders involved.

Day, The CBR: Any final thoughts?

Verbeek, Perenna: It’s the perfect storm out there in the market. I think everyone is beginning to realise that it is necessary to have a product like this come to the market. Housing is one of the key drivers of growth in GDP.

And when it comes to getting houses green and getting people on the housing ladder, we’ve got the E and we’ve got the S. Obviously as a bank we’ve got a lot of governance, so we cover the E, the S, and the G.

It’s really the right time and era to now structurally change the way the UK mortgage market works. That’s what we’re going to do.

This article originally appeared in the November-December 2020 edition of The Covered Bond Report magazine.