The success of the specialist, or non-conforming, lending sector is evident to anyone with an understanding of the UK mortgage market. It is rooted in a number of factors, but chief among these is evolving social and economic demographics married to a continuing appetite for homeownership. The specialists have been quick to recognise this, and have responded by developing innovative products that appeal to changing consumer needs. As a result, the sector has matured into an important and vibrant part of the overall market, and one increasingly in competition with traditional lenders.
Despite this, the two groups continue to exhibit marked differences. But it is in the area of mortgage funding that the real difference exists.
Lenders need constant access to funds. Traditional, or mainstream, lenders have in the past relied on retail deposits to fund their mortgage lending. In simple terms, this involves customers investing their cash through current, savings and investment accounts. In turn, this cash is lent to borrowers at a higher rate of interest than that paid to depositors. The difference, or margin, less the lender’s operating costs provides the profit.
Many traditional lenders continue to fund their lending in this way, supplanted by inter-bank loans. However, lenders who do not have access to a reliable or established retail deposit source, or who cannot access funds from the money markets at reasonable cost, have been forced to look elsewhere. From this, a number of alternative methods of funding have become popular. The most significant of these is, arguably, securitisation.
Origins and development
Securitisation originated in the US non-conforming market in the 1960s as part of a public policy initiative to increase the funds available for residential mortgages. It first came to Europe in the 1980s, and was adopted in the UK in the mid 1990s by the new generation of pioneering specialist lenders, including Kensington. It has since proved instrumental in fuelling the growth of the non-conforming market, and is now widely used by most specialist and, increasingly, mainstream lenders. So what exactly is securitisation?
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.
Many different types of asset are suitable for securitisation. Some rock stars, for instance, have securitised future earnings from their early recordings. In the context of mortgage securitisation, a quantity of mortgages are grouped together in a SPV and repackaged as tradable securities in the form of bonds. These are known as residential mortgage-backed securities (RMBS). 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 – an essential activity in the current highly competitive market. In most cases, it also continues to earn benefit from the mortgages in the SPV 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 – less than 365 days in most cases – and are considerably more expensive, difficult to obtain and keep. Securitisation has, by contrast, developed into a large and truly international market with all the advantages that brings.
The securitisation process
The term ‘securitisation’ derives from the fact that the investors in the SPV are doing so against secured assets – the RMBS. The process begins with the pooling of the mortgage assets and the creation of the SPV.
The next step is the appointment of the parties to bring the transaction to the market. These usually comprise:
issuer – i.e. the SPV
lead manager to manage the transaction – i.e. usually one or more investment banks
rating agencies – i.e. one or more from Standard & Poors, Moody’s and Fitch
lawyers
auditors
In addition, parties are appointed to look after the interests of the investors. These include:
trustees
paying agents
A third party loan servicing company may be appointed to manage the mortgage portfolio if the lender out-sources this process.
Next in the process is the identification of the pool of assets which are brought together and analysed by defined characteristics, including interest rate margins, product type, loan-to-values, credit profile and geographical distribution. This is followed by the rating agencies’ assessment using sophisticated financial modelling to simulate the performance of the mortgages, create cash flow projections and make assumptions about arrears, losses and other risks. Once completed, the bonds are rated.
The bonds are usually issued in a range of denominations from AAA notes, which give the lowest return but also the lowest risk, through to BB and even C notes that offer higher levels of risk and return. The returns are usually long-term in nature, reflecting the way in which borrowers repay their mortgages. However, investors in A bonds receive their payments from the SPV before those investing in the higher risk notes.
Prior to the selling of the bonds to investors, the transaction’s auditors perform file audits to prove the quality of the assets and that of the underwriting process that created the mortgages.
The bond sale comes next. This involves the lead manager’s sales force presenting potential investors with information about the assets in the SPV and the lender’s underwriting and servicing processes, business strategy and objectives. This frequently happens through investor ‘roadshows’ that may not necessarily be restricted to the UK. The investors themselves usually comprise institutional investors such as insurance companies, pension firms and other specialists in this market.
The extent of investor interest and demand determines the final size of the offering. Using Money Partners’ recent third securitisation as an example, this saw its planned size of £500 million rise to £600 million – a sure sign that the transaction was well planned and marketed. The launch date is then set along with the final price of the bonds. On completion, the lender receives its cash and the process starts all over.
Future prospects
Some commentators are concerned that securitisation has yet to be tested in a recessionary environment, and have begun to speculate on the consequences for the model in the event of falling house prices and a rise in Base Rates and unemployment – particularly in light of current high levels of consumer indebtedness. There is also concern over the impact of Basel II regulation that will link capital adequacy requirements more directly to risk. This will cause the rating agencies to play a more important role, and will almost certainly require greater allocation of resources by securitising lenders.
Securitisation also faces a challenge from the whole loan sales market which has enjoyed impressive growth in recent years. This process is particularly attractive to lenders who choose not to use securitisation as their only method of maintaining funding liquidity.
For all this, the success of securitisation in the UK mortgage market is clear from the growth in RMBS issues. These have risen from less than £5 billion in 1977 to over £77 billion in 2005, and have been driven by the continuing rise in house prices coupled with stable and low interest rate levels. The development of the specialist lending market has made securitisation a popular and common funding method, and there is little sign that demand is waning. If anything, the reverse is true.
Lenders considering using securitisation would be wise to take note of what analyst Datamonitor said in its 2005 report on the sector: ‘to be a viable business solution, securitisation should not just amount to a one-off deal but should be embedded as a key part of the company’s strategy and business rationale. The company must embrace all aspects fully and integrate securitisation into its philosophy’.
