Paul Marland, AGM, Intermediary Sales at West Brom for Intermediaries
Mortgage lending is a key part of the UK economy and, each month, mortgage lenders deal with truly astronomical amounts of money. For example, in June this year, the Council of Mortgage Lenders (CML) announced record gross mortgage lending of £32.2billion. That follows the previous monthly record of £29.1 billion in May, which is up from £25.7 billion in June last year.
To put these numbers in perspective, £32 billion is about the amount that all UK charities raise in a year; supermarket giant Tesco’s turnover in the UK is about £32 billion each year; and £32 billion is the amount of money that the world’s richest men, Bill Gates and Warren Buffett, recently allocated to fight global poverty and disease. Whichever way you look at mortgage lending statistics, they are truly eye watering.
Consider, for a moment, the implication of those statistics. Each working day about £1.5 billion is paid out to borrowers. That money has to be raised, either from investors or the capital markets, and someone in each lending organisation has to ensure there are sufficient funds to satisfy the needs of borrowers, while at the same time ensuring there is neither a funding shortfall or surplus. This is the task facing finance directors and treasury teams and it is one of those ‘backroom’ roles we hear little about, but which is vital to the well-being of the lending industry.
A constant balance
There is a popular misconception that lenders have access to limitless supplies of funds which, regrettably, is not true. Lenders constantly have to balance their supply of funds against the demands of borrowers and, for many lenders, that means managing retail savings inflows, raising capital on the wholesale markets, or ‘reprocessing’ capital, via either whole loan sales or securitisation.
In days gone by, the formula was easy – lenders took money from investors and lent it out to borrowers. This was all well and good as long as retail investments were in plentiful supply and at the right price, which wasn’t always the case. Lenders therefore supplement their retail deposits by borrowing wholesale funds from the financial markets. Financial institutions usually borrow funds linked to London InterBank Offered Rate (LIBOR) and for relatively short periods, typically three months.
If all lending was based on variable rates, life would be pretty straightforward. Standard variable rates (SVR’s) mean lenders’ margins remain constant and, at the moment, we are seeing tracker rates and discounts, which are directly linked to a standard rate, (usually Bank Base Rate) increase in popularity. This is because the pricing of fixed rate mortgages has risen over recent months and the pay rate of many discount and tracker deals are now more competitive than some fixed rate mortgages over a similar term.
However, as we all know, the pricing of fixed rate offers varies over a period of time and we have just been through a couple of years in which fixed rate deals have been extremely popular and they continue to be a favourite with borrowers. Lenders, therefore, also need to be able to fund fixed rate mortgages.
Funding a fixed rate
When funding fixed rate mortgages, lenders use a mechanism known as swaps. A swap is an agreement between two financial institutions where, for a specific amount and period of time, one organisation agrees to pay the other a fixed rate of interest in exchange for a floating interest rate, which is usually LIBOR.
When financial institutions enter into a swap, they only exchange the interest flows and not the actual principal amounts involved, which significantly reduces the potential large credit exposures. Swap rates can be obtained for almost any period and, unlike Bank Base Rate, are not set by a central organisation and will therefore move up and down based on supply and demand. Yield curves, which reflect prevailing swap rates, are regularly poured over by treasury teams to identify where the best deals are to be had.
A swap is therefore a type of hedge, which protects lenders against a mismatch between their funding costs and the rate at which they lend money.
Reprocessing
Borrowing money, either from depositors or the money markets, is only one way for mortgage companies to fund their lending activities. Another way is for lenders to ‘reprocess’ the money they have already lent, either via whole loan sales or securitisation. For a number of lenders, especially those who do not have access to capital of their own or who find it difficult to raise sufficiently large quantities of capital to fund a growing volume of lending, whole loan sales and securitisation may be their only options. However, these funding techniques are also used by lenders such as building societies, particularly if they provide access to cheaper funding than money markets or retail deposits.
Lenders who are involved in whole loan sales will usually agree a form of funding called a warehouse line with a financial institution. In concept, this is similar to a large overdraft and enables lenders to accumulate a pool of mortgages (in a mythical ‘warehouse’) before they are bundled together and sold on to another financial institution at a premium. The warehouse line is usually for a short period, usually less than a year and for a pre-agreed amount, and a lender will keep filling and emptying the warehouse facility on a cyclical basis. Lenders will often have several warehouse facilities agreed, so that they do not have to stop lending if finding a buyer takes longer than expected.
Securitisation is another way of reprocessing funds. The key difference between whole loan sales and securitisation is that with securitisation mortgages are bundled together in what is known as a special purpose vehicle (SPV), which is a company established specifically for the purpose of securitisation. The revenue generated by the mortgages held in the SPV is then sold on to investors in the form of interest yielding bonds – or residential mortgage-backed securities as they are sometimes called. In most instances the mortgages themselves remain with the originator, who then continues to administer the loans on behalf of the bondholders.
The process of securitisation is therefore invisible to borrowers who, in most instances, don’t even know that their mortgage forms part of a securitised pool. Terms and conditions will remain the same and borrowers will usually continue to deal with the same organisation which initially granted the loan.
The mortgages that are securitised are rated by a specialist agency and are given an investment grade, ranging from AAA which denotes high quality low risk assets to C, which are higher risk assets but which generate a higher return. Rating agencies such as Standard & Poors, Moody’s and Fitch may be familiar names to you.
Lessening dependency
In order to sell the securities, a lead manager is appointed to look after the transaction. These are typically large investment banks such as Merrill Lynch, Lehman Bothers and Goldman Sachs. They effectively act as salesmen and their clients include pension funds, insurance companies and other institutional investors.
As with whole loan sales, the lender receives cash from the sale of the bonds and this cash is used to repay the loans which funded the mortgages initially. The SPV then takes on the risk relating to the mortgages it holds and makes its money from the difference between the income generated by the mortgages and the money it has to pay out to bondholders.
One of the appeals of securitisation for lenders is that it provides long-term funding and thus lessens their dependency on short-term funds. For brokers, the key benefit is that securitisation enables more money to be lent and the boom in lending and the profusion of products launched during recent years has a lot to do with funding techniques such as securitisation.
Funding mortgages is, without a doubt, a job for the ‘back-room boys’. But it pays for intermediaries to have a basic understanding of what is happening behind the scenes.
