Securitisation has been around for years in the US, but it only recently made an appearance in the UK mortgage market. Essentially, securitisation is the process by which securities are created to fund an underlying pool of loans. And it is set to become a much more prevalent way of raising capital in UK mortgage lending.
The usual method of securitising mortgage loans is to package a group of them together and sell to a ‘special purpose vehicle’ (SPV) company, which in turn, issues securities that back the loans: therefore mortgage-backed securities (MBS). These securities are then sold on to investors, generally in the public bond markets, and the cash-flow from the mortgage loans is used to pay returns to the investors.
In the beginning…
The technique of securitisation originates in the US where, in the early 1970s, the government established the initiative by creating housing agencies to finance US residential mortgages. This occurred because the demand for housing was in the west, whereas all of the available finance was in the money centres in the east of the country. With cross-border money transfers not allowed, a number of government agencies were established to act as a conduit. Mortgage loans were made where the demand existed and were then converted into securities and sold to those who had the finance.
Loans originated by a mortgage lender (the primary market) were sold to the agencies who in turn were able to fund the mortgages through the securities markets (secondary market) ‘ with the added advantage of government sponsorship.
In the late 1970s, the government agencies became the main players in the secondary mortgage market in the US, and non-depository institutions became the main players in the primary market. Standardisation of loan documentation and cheaper loans driven by the efficiency of the agency securitisation programme revolutionised the market.
For the originators of mortgage loans, selling by way of securitisation is a very efficient use of capital. For those acquiring the securities, a profitable market-linked variable rate of return is enjoyed. It was inevitable that securitisation would be imported to Europe, with the largest share being in the UK.
Big bang theory
In the UK, the concept of mortgage securitisation has its origins in the evolution of the specialist mortgage lenders. In the 1980s, as a result of the big bang in the financial services industry, a new form of mortgage lender appeared alongside the traditional building society. Institutions, including foreign banks, looked to enter the burgeoning UK residential mortgage market and securitisation was at the core of their business models.
These institutions funded their mortgage originations, in the first instance through wholesale funding from banks. However, this effectively meant they were borrowing short to lend long. Re-financing the mortgage loans through securitisation solved the resultant mismatch. Among the institutions using this technique were National Home Loans (now Paragon), The Mortgage Corporation, First Mortgage Securities and Household Mortgage Corporation. In the early stages the technique was less attractive to the building societies that relied in the main on their deposit base to fund their mortgage originations.
The first bond was issued in 1987 and a total volume of £1bn mortgage-backed securities was placed in that year. In 1988 there was an incredible increase in issuance, fuelled by the growth of the specialist mortgage lenders, with over £3bn of mortgage-backed securities. This volume was not surpassed again until 2000, which saw the peak of the early UK mortgage-backed securities market.
The early 1990s brought spiralling interest rates ‘ climbing from 8% to 15% in the space of 12 months. Coupled with poor general economic conditions, this led to a downturn in the mortgage lending market. It is interesting to note that there were no defaults on the highest quality rated (AAA) securities issued before the downturn and securitisation has since proved to be a safe haven for investors compared with the more volatile corporate bond market. The securitisation market was still active, but stagnated for a time and was mainly tapped by institutions which were financing the acquisition of large mortgage portfolios through securitisation.
The mortgage securitisation market re-emerged during the mid to late 1990s with the advent of a new form of specialist mortgage lender, known as the non-conforming or sub-prime lender. Kensington Mortgage Company and GMAC-RFC have become the market leaders in this arena, but others such as Mortgages plc and Southern Pacific Mortgages Limited (SPML) also use securitisation to finance their mortgage portfolios. To date, GMAC-RFC through its RMAC programme and Kensington through its RMS programme have securitised over £6bn.
In 1998, total issuance in the UK mortgage-backed securities market was over £3bn for the first time in 10 years, but nearly 90% of issuance was from the non-conforming sector.
However, in 1999 the market grew dramatically with the entrance of Abbey National whose total issuance of over £5bn was split more or less evenly between prime and non-conforming. Abbey National’s entry was followed by Northern Rock and Bank of Scotland (subsequently HBOS). This activity indicated the growing acceptance from the large prime originators of the securitisation technique as both a source of funding and a tool for the efficient management of capital.
The market grew to a staggering total of nearly £13bn in 2000 and £16bn in 2001. In the UK, the leading issuers of prime mortgage-backed securities are Abbey National through its Holmes financing programme; Northern Rock with Granite; and now HBOS with its Permanent Financing Programme. GMAC-RFC is the UK’s fourth largest mortgage-backed securities issuer in 2002, with £1.1bn of securities issued.
Securitisation of UK mortgages, both prime and non-conforming, represented over 25% of total issuance in the european securitisation market in 2001 and is expected to record a similar percentage for 2002.
So while it has become an increasingly important method of funding for mortgage lenders, what does it mean for the intermediary market?
The growth of the UK mortgage-backed securitisation market has been good for intermediaries. The broker/packager proposition works well as a distribution channel for the specialist mortgage lenders who do not normally have a branch network. Given that they rely in the main on securitisation, it follows that origination will flow from the intermediary market.
Securitisation is a flexible funding tool that has helped in the area of product development. The mortgage pool is usually analysed by two of the three main rating agencies, (Standard & Poor’s, Fitches and Moody’s). New product ideas can be assessed using the rating agency criteria and credit rating model, giving the opportunity to bring new products to market quickly.
Ultimately, the borrower benefits because the originator is looking to fund competitive products, which can be input into securitisation deals. The ability to securitise on a regular basis gives the lender the chance to originate more products through the intermediary channel. From the borrower’s perspective, there is no change to the key terms of his mortgage loan if it forms part of a securitisation deal.
In the future, securitisation has the potential to make the biggest impact on the UK mortgage market for years. As a funding technique, it will grow rapidly and has benefits for all types of lenders. For the sub-prime lender, the main driver is a better use of limited capital and for the prime lenders, the motivation is mainly a cheaper source of funding.
With competition in the retail savings market so fierce, and with other investment options so limited, the asset-backed securities (ABS) market is changing investor opportunity, fulfilling a real need by providing positive margins above the London Interbank Offered Rate (Libor). The investor-driven demand will fuel the price competition that securitisation ‘ as an alternative funding technique ‘ presents.
This more keenly-priced funding for mortgage lenders should filter through to borrowers ‘ giving them more choice, as well as more competitive and cheaper products.