When first commissioned to write this feature, the task seemed pretty straightforward, if a little mundane. After all, just how excited can – or should – one get about wholesale funding lines and covered bonds? But that was before the financial tsunami we’ve come to call the ‘credit crunch’ struck, and made the previously little-understood subject of lenders’ funding the hot topic at every dinner party.
Much of the credit for this is due to Northern Rock. There’s nothing like a well-known brand getting into a mess to stir up the headline writers and ensure we’re force-fed a diet of bad news for days on end. And when the mess directly involves the ‘little people’, Christmas has arrived early for the glass-half-empty scribblers.
We know by now that the real cause of ‘the mess’ was neither Northern Rock nor the media. It lies across the Atlantic where irresponsible lenders created a mountain of high-yield, but high-risk, non-conforming debt that was syndicated around the world in a way that has proved to be horribly opaque – hence the accusatory fingers now pointing at the rating agencies and its buyers.
Hit by a devastating triple whammy of rising rates, falling house prices and increasing job losses, exposed borrowers in the US started defaulting on their obligations on a massive scale. The result was as predictable as it was savage – plummeting valuations on the associated debt and a liquidity crisis that has closed the money markets to all but the highest quality transactions.
The impact has since spread to embrace the UK on a scale that was completely unforeseen, but particularly in the specialist lending sector. The result is a battered marketplace that only two months ago appeared glowingly confident of its continued success and even invulnerability. The question now is how quickly we can expect a return to normality.
Funding options
Pre-credit crunch, lenders had access to a number of funding options. These included retail deposits, wholesale loans, covered bonds, whole loan sales and securitisation. The particular method by which a lender chose to fund its activities depended on a number of factors, such as its business model and credit rating.
Traditional lenders with a retail-based distribution, such as high-street banks and building societies, have historically relied on a mix of customer deposits and loans from the money markets. Indeed, being mutual organisations, building societies are required by law to ensure that at least 50 per cent of their funding derives from their savers.
Retail deposits are the simplest way to fund lending. An upward adjustment between the rate of interest paid to savers and that charged to borrowers provides the all-important margin. But it works best when there is a plentiful supply of funds at an acceptable price.
This has become more difficult to achieve in a highly competitive retail savings sector, and is one reason why banks and building societies also use wholesale loans from the financial markets to bolster their funding. These are usually short-term loans linked to the London Inter-Bank Offered Rate.
Lenders who do not have access to a reliable or established retail deposit source, or who cannot access funds from the money markets at an appropriate cost, have been forced to look elsewhere. From this, a number of alternative methods of funding have become increasingly mainstream.
Whole loan sales are simply the packaging of loans for sale to a third party. The purchaser acquires assets and the attendant risk, while the seller receives upfront cash and a freeing-up of its balance sheet. The latter often retains responsibility for servicing the portfolio post-sale.
A relatively new method of funding is that offered by covered bonds. The process involves bundling together a tranche of mortgage assets as collateral for raising funds via a bond sale.
However, the assets remain on the lender’s balance sheet and only become transferable to the bondholders in the event the lender defaults on its contractual obligations. This has been thought unlikely given that covered bond issuances have been most popular with providers of prime mortgages achieving AAA ratings. But recent events have cast doubt over the reliability of such ratings.
The appeal of securitisation
Perhaps more familiar is securitisation which originated in the US non-conforming market in the1960s as part of a public policy initiative to increase the funds available for residential mortgages. It was adopted in the UK in the mid-1990s by the new generation of specialist lenders, and has since proved instrumental in fuelling the growth of the non-conforming market. It has been widely used by most specialist and many mainstream lenders.
Securitisation is the commoditising of revenues or assets so they can be sold as interest-yielding structured investment bonds. Put simply, assets are bundled together and sold to a special purpose vehicle (SPV), a company set up for this purpose. The bundle of assets within the SPV is rated by specialist rating agencies to assess their quality and the expected cash flow over time. The bonds are then sold to investors on which they receive interest.
Securitisation is suitable for many different types of asset but particularly mortgages. Once bundled together in an special purpose vehicle (SPV), they are repackaged as tradable securities in the form of bonds known as residential mortgage-backed securities. The SPV takes on the risk attached to the mortgages, and the lender receives cash from the sale of the bonds.
The benefit to the lender is that the cash can be used to pay off the loans from its bankers that funded the mortgages in the first place. Coupled with the transfer of risk to the SPV, this injection of cash puts the lender in a better position to negotiate new funding lines and to develop new products. In most cases, the lender continues to earn benefit from the mortgages as the interest paid to investors is lower than that charged to the mortgage borrowers.
Securitisation also provides lenders with long-term funding by matching the term of the mortgages in the SPV. By contrast, funding lines negotiated through banks are short-term and are more expensive, and difficult to obtain and keep.
Future prospects
Some experts have been concerned for a while that securitisation had yet to be tested in a recessionary environment, particularly in light of current high levels of consumer indebtedness. But none had foreseen the dramatic impact of the credit crunch that has left investors eschewing perceived higher risk transactions, regardless of their underlying quality. This includes non-conforming mortgage lending and secured loans.
The current position is that lenders who rely on the money markets for their funding have become effectively disenfranchised. But many so-called balance sheet lenders are similarly affected. While they may carry their assets on balance sheet, many also rely on the money markets for a significant part of their funding. Moreover, their appetite to fill the gap created by the crunch is likely to remain limited.
The result is product rationalisation, a tightening of criteria, price hikes and deeply frustrated lenders, brokers and customers. More seriously, people are losing their jobs and businesses going to the wall.
The position will only improve once the markets crystallise the extent of their exposure to US non-conforming debt and regain their nerve for investing in fundamentally sound markets.
The market that emerges from this nervous breakdown will be a better one. While painful now, we will look back on these events as a necessary correction.
get the daily news delivered to your inbox
find the latest industry jobs
download our news ticker
