Although the rest of the Budget measures will provide some relief for the new-build housing market and help reduce some of the uncertainties about the potential impact of withdrawing too soon concessions on stamp duty and income support for mortgage interest, they will have little impact on market activity in the short term.
Of course, the chancellor had little room overall for more substantive intervention. So, if the new ABS scheme was perhaps the most important measure in the Budget, what impact will it have?
Background
We have been putting the case to the tripartite authorities for a policy to re-open the moribund residential mortgage backed securities (RMBS) market since autumn 2007. An ABS guarantee scheme was first flagged in a Treasury announcement on 19 January. That announcement, in turn, followed the Crosby review to examine ways of re-establishing the RMBS market, commissioned by the Treasury in the 2008 Budget.
We have been actively involved in discussions on the ABS guarantee scheme with the Crosby review team and latterly the Treasury. As a result, we have been able to argue for the features we believed would make the scheme a success.
We have emphasised the need to ensure that the scheme is not overly prescriptive. In particular, we argued against excluding existing ‘master trust’ structures (the dominant model for securitising prime UK mortgages), a move we believe would have risked stigmatising these structures and denting investor confidence in UK RMBS.
We also argued against loan-to-value (LTV) limits that risked locking first-time buyer loans out of the scheme. And we argued for including a version of the scheme in which investors would receive a liquidity, rather than a credit, guarantee. We were heartened to see that the Treasury listened to our views and took on board all of these points.
The case for re-opening capital markets to fund mortgages stems from the inadequacy of retail deposits, which currently fund only around 60% of outstanding residential mortgage debt. The Crosby review recognised that retail deposits alone could not support the mortgage market at its current size, let alone allow for any growth.
How will the new scheme work?
Details of the scheme, including the full rules and application forms, are on the UK Debt Management Office website. The scheme will be open from now until October, and may be extended. It is open to any bank or building society that meet the terms of the credit guarantee scheme (CGS) announced last October. It will apply to both stand-alone pass-through structures (where investors are re-paid capital in line with the repayment of capital by mortgage borrowers) and revolving structures, such as master trust (where re-payment of capital to investors does not mirror exactly the profile of redemptions on the underlying mortgages).
Lenders will have the choice of using either a government credit guarantee, which is an unconditional guarantee to investors on all payments due to them, or a liquidity guarantee, where investors are ensured repayment of principal and interest, less any credit losses attributable to their bonds.
To protect taxpayers, the Treasury has stipulated that only the highest rated bonds (those with an AAA rating) will qualify. The government has also insisted that it must have recourse to the participating lender to make good credit losses or demand repayment of funds at maturity (despite the fact that securitisation was designed to be based on recourse is to the securitised assets, not the lender).
To be eligible for inclusion, mortgage loans must have been originated since the beginning of 2008 and have an LTV of no more than 90%. There is also a requirement that the mortgage pool in aggregate must have a weighted average LTV of no more than 75%. Mortgages to borrowers with adverse credit histories are excluded, although adverse credit is not defined specifically. But the Treasury informs us that this is meant to exclude only serious adverse credit cases, such as bankrupts and borrowers with serious county court judgments against them. Self-certified loans are also excluded. The scheme fees are 25 basis points per annum, plus the credit default swap (CDS) spread for the participating institution from 2 July 2007 to 1 July 2008. This is 25 basis points lower than the CGS fees.
What else is available?
Since October, the government has launched a range of different schemes to support the banking sector and maintain the flow of credit to firms and households. The October announcement included bank recapitalisation, the CGS and enhanced liquidity provision by the Bank of England. These were designed to provide a comprehensive answer to investors’ concerns about, in turn, bank capital, funding and liquidity.
As the financial environment deteriorated further, the January announcement contained the asset protection scheme (APS), under which the government offered to protect banks against potential future losses on their assets of uncertain value, and the Bank of England asset purchase facility. The latter is a fund the Bank could use to buy securities in the market with the potential to use newly-created money (creating a mechanism by which the Bank could undertake so-called quantitative easing).
A toolkit of measures
Although it may feel at times as though it is difficult to keep up with all these initiatives, you could think of these as different pieces in a toolkit – each performing a complementary function to the others. Collectively, they are a powerful array of tools able to address the multi-faceted nature of the crisis of confidence afflicting the banking system.
Within this toolkit, the role of the ABS guarantee scheme is to support funding through the capital markets. It can thus be thought of as sitting alongside the CGS. But why have two schemes to support lenders’ capital market funding?
When the CGS was launched, the Treasury explained that it was designed to allow banks to re-finance their maturing wholesale funding. At the same time, the Crosby review team explained that its proposal for a RMBS guarantee was designed to provide additional funding to support the growth of new mortgage lending.
This made the two schemes appear complementary: the CGS to stabilise bank balance sheets and re-assure investors that banks could meet maturing commitments; the Crosby proposal to stabilise the housing market by ensuring the continue flow of new mortgage funds to ordinary borrowers.
In practice, however, this difference of emphasis may be illusory for two reasons. First, although government has not made detailed figures available on the volume of bond issuance undertaken through the CGS, it seems that it has not held rigidly to the line that all CGS issues must re-finance maturing funding. This means that banks and building societies may already be able to fund new mortgage lending with funds raised through the CGS.
Second, while the Crosby review argued that guarantees on RMBS should be open to all lenders – including non-deposit takers – who have not benefited from the CGS or other government schemes, the ABS guarantee scheme is explicitly closed to them. This is one important aspect of our advice that the Treasury has not taken on board, as we had argued forcefully for non-deposit taking institutions to be included and for the scheme to be designed in a way that ensured they could use it. Non-deposit takers would have been able to resume new mortgage lending had they been able to access the scheme on appropriate terms but, without it, they remain unable to offer new loans.
What impact will the scheme have?
In practice, unless the ABS guarantee scheme is broadened out to include non-deposit takers, it will, in effect, just be an alternative to the CGS for participating banks and building societies seeking to raise wholesale funding. Use of it will depend on the comparative attractiveness of the two schemes to issuers and investors and on the government’s preference for issuance under one scheme or the other, since it is the government that decides the limits placed on volumes of issuance under both schemes.
So can we say whether issuers and investors will favour the ABS guarantee scheme or whether the government will have any preference for issuance under one scheme or the other?
Investors have been quite comfortable with the CGS, purchasing some £100 billion of bonds to date. These are straightforward bonds with bullet repayments (that is, where investors receive all their capital back on a fixed future date) and recourse to the issuing bank or building society and to the government. Under the ABS guarantee scheme ‘credit version,’ the claim on the lender is substituted by a claim on the pool or mortgage assets.
As the investor will take by far the greatest comfort from the government guarantee, any other claim is likely to be viewed as being of limited importance but a secondary claim on a pool of mortgages may be seen as inferior to one on a major UK bank or building society.
The ‘liquidity guarantee’ version leaves the credit risk with the investor. No doubt, they will demand a premium for the extra risk but given that the bonds in question will be AAA-rated, this premium may be quite modest. Investors who understand mortgage credit risk ought to gravitate to this version.
Costs for lenders
For issuers, the fee payable to the government for using the guarantee is 25 basis points lower under the ABS guarantee scheme. But set against this is the cost of undertaking a securitisation (including, for example, fees to credit rating agencies for rating the bonds and the cost of marketing the bonds to investors). A securitisation will also absorb mortgage assets, shrinking the pool of assets available for other purposes (for example, to access Bank of England liquidity support). The Financial Services Authority (FSA) may also demand that lenders hold more capital since fewer assets would be available to support depositors.
The liquidity guarantee version would cost lenders more, as investors would undoubtedly demand a premium for buying these bonds. But strategically this version of the ABS guarantee scheme may prove more attractive because it will attract investors who want to take mortgage credit risk and could therefore be a key step to re-opening an RMBS market not supported by the government.
Notwithstanding the strategic attraction of liquidity-guaranteed RMBS, it seems likely that, left to themselves, investors and issuing banks and building societies would probably opt for the simpler CGS, given the choice.
On the other hand, the government may prefer issuance under the ABS guarantee scheme because it offers more protection to taxpayers (because the government has recourse both to the lender and to a pool of mortgage assets while, under the CGS, it can only claim against the lender). This may encourage the government to steer lenders in the direction of issuing under the ABS guarantee scheme, perhaps through the imposition of a more generous ceiling on issuance under this scheme.
The government’s view?
The liquidity guarantee version offers particular attractions for government as it not only insulates taxpayers from direct exposure to mortgage credit risk but it also protects them from the indirect exposure that would come from the lender retaining all the credit risk. The government would be one of the main winners from the re-emergence of a non-guaranteed RMBS market and successful issuance of liquidity-guaranteed bonds would be a key step in that direction.
While the ABS guarantee scheme offers clear advantages to government, it must be mindful of the burden imposed on lenders by schemes that tie up their assets, given the other calls on those assets (not least the Bank of England special liquidity scheme, where, in return for £185 billion of funding, lenders have pledged £287 billion of securities, mostly backed by residential mortgages).
The ring-fencing of mortgage assets that the ABS guarantee scheme involves leaves fewer unencumbered assets for unsecured creditors such as depositors, which is likely to be a cause for concern at the FSA, possibly leading it to impose higher capital requirements.
The noises coming out of the Treasury suggest that it does not expect heavy usage of the ABS guarantee scheme in its early months, but rather sees its potential to gain gradually in popularity thereafter. The Budget announcement included no figures on expected usage, while the Crosby review recommended that issuance should total £100 billion spread over two years.
It was probably wise of Treasury not to provide a figure given the uncertainty over potential investor demand, issuer appetite and indeed ultimately over consumer demand for mortgage borrowing. The government may have a preference for ABS guaranteed issuance over the CGS but, if it does, it has not yet chosen to reveal it.
Conclusion
We welcomed the Budget announcement of the ABS guarantee scheme, particularly the liquidity guarantee option, which could be an important step back to capital markets functioning without government support. But we still cannot be sure about its possible impact. This is one more scheme in a toolkit designed to support the financial system and maintain lending. Even though it is a powerful kit of measures, it is fighting against strong contractionary forces and will take time to take effect.
We will continue our discussions with the Treasury, arguing that the scheme should be extended to non-deposit takers and altered to allow them to use of it. Our view of the UK mortgage market is that it can only benefit from the government embracing the need for diversity and competition.
