Almost every week a story appears in the mortgage trade press about another lender announcing its latest securitisation deal. The story usually provides details about the value of the securitisation, the rating it was given by the rating agencies and sometimes the investors involved. But, despite the regularity of these announcements, it is fairly safe to assume that most mortgage intermediaries will not study these in much detail as the news does not appear relevant to them and they may believe securitisation has no impact on the products and services offered by the lender involved.
However, this is not true and as a growing number of lenders look to raise funds and clear their back-books through securitisation deals, their importance to the future of mortgage lending in the UK will only increase.
So what exactly is securitisation? Essentially, it is the ‘bundling’ together of a collection of financial receivables – such as mortgages – which are then ‘sold’ to investors in order to raise money without the need to raise additional capital. Securitisation usually involves the creation of a security, or a publicly traded bond, as opposed to funding from a bank loan or deposits. It also results in the transfer of some or all of the credit risk to the investors.
Mortgage securitisation deals allow lenders to raise finance to fund new deals. Because the deals are not subject to the vagaries of the international money markets to the same extent as other finance-raising deals, the mortgage rates on offer can be competitive at times when other lenders’ deals are being constrained.
The end result of a securitisation is the raising of capital to fund future business activities. The decision to securitise or not for a lender can be compared to the decision made by most life assurance intermediaries as to whether to choose between non-indemnity/drip commission or indemnity commission. With non-indemnity, once the policy is sold a percentage of the premium is paid to the intermediary every time the client pays their premium until either the policy lapses, the term expires or it matures. However, with indemnity commission, the intermediary receives a one-off up-front sum once the policy is sold. In the long term, non-indemnity commission will pay the intermediary more, but to maintain cashflow and ensure liquidity many will take the lump sum option.
If a lender does not securitise, it will receive its profits on each mortgage over the lifetime of the loan, as long as the borrower pays their monthly repayment and until the borrower either remortgages to another lender or the mortgage reaches the end of the term, and so is comparable to non-indemnity commission. However, if a lender securitises, it can decide to take a one-off lump sum, based on the predicted value of a group of loans to enable them to raise money for additional lending. The loans may make more money in the long term, but cashflow is constantly needed to ensure new products can be developed and funded. Therefore, securitising is more akin to indemnity commission from the lenders’ perspective.
So just what can be securitised? In theory, any future cashflow can be securitised. For example, David Bowie famously packaged his future royalties on his back catalogue as asset-backed securities in 1997 and sold them to investors for $55m. The buyers of the bond (known as Ziggybonds) were lending against record masters, publishing rights and copyrights on past work that would entitle Bowie to future regular income streams. In 2007 the bond will mature and will pay 7.9% interest. In return, Bowie received cash then, rather than in the future and over a period of time.
Many other things, other than mortgages and music royalties, have been securitised such as credit card loans, car loans, train leases and pub revenues. However, the most likely assets to be securitisable are those which have a predictable future cash flow and were originated by a lender whose policies and procedures were put in place with securitisation in mind.
Most lenders who regularly securitise will have a planned securitisation programme and will have developed procedures to ensure that certain guidelines are followed to meet any potential investor needs and requirements. Also, they are used to providing accurate data about the loans and are able to provide all the legal documentation used in the process.
Platform is fortunate in that it is able to call on the services of Britannia Treasury Services (BTS) who work closely with it on the planning of its securitisations and on its behalf deal with solicitors, audit accountants, rating agencies and investment bankers to enable our securitisations to take place.
A rating is a crucial element in any securitisation transaction and will ultimately determine the price the investors are willing to pay. The rating provides information on the likelihood of an issuer being in a position to meet all the payments relating to an issue (interest and repayment). The analysis to obtain a rating concentrates on three areas:
• The credit quality/credit risk of the mortgage-backed claims.
• The mechanism for transmitting and allocating the payment flows.
• The legal framework of the transaction.
The bundle (usually referred to as a pool) of loans is also submitted to a stress test which has been developed by FitchIBCA called the Mortgage Default Model in which the repayment of the loan must be guaranteed. The better the rating, the worse the scenarios are applied in the simulation. The first variable – likelihood of defaulting – is determined by the loan to value (LTV) and by the debtor’s solvency, measured on the basis of loan commitments to income – commonly called the debt to income ratio (DTI). Lower LTV and DTI ratios lead to the assumption of a smaller likelihood of defaulting on the mortgage loan. The second variable – loss severity – is the difference between the loan balance and the recovery value of the property, divided by the loan balance (expressed as a percentage). This variable takes into account all costs in the event of a borrower’s default.
So is securitisation a good thing? Well, the Treasury believes so as, after careful investigation, many aspects of securitisation have been excluded from statutory regulation. In the end, it can offer many potential benefits to intermediaries and their clients, not just lenders and the investors. The main benefit for investors is that they gain a steady income stream on assets they cannot originate themselves. Also, as the lender still services the loans, they have no administrative burden either. The main benefit for lenders is that they have an alternative to deposits and bank loans for the funding of their mortgages.
Also, with traditional banks there are regulatory requirements to have enough capital on their balance sheets to cover the risks of lending (capital adequacy). As the risk has been transferred to the investor(s) on a securitisation, the capital backing required is considerably less. All this gives the lender greater flexibility and releases capital enabling them to grow its business quicker than would be possible using traditional funding sources. Finally, lenders are able to adapt to sudden increases in demand by raising additional funds via securitisation.
Impact on borrowers
In terms of borrowers, securitisation has little direct impact, as the loan is still serviced by the lender and their relationship with that lender remains unchanged. However, as securitisation lowers the cost of funds for lenders, it will reduce the cost of their mortgage. Also, it does create more competition as lenders without retail deposits can enter the market and provide products such as non-conforming mortgages, that would otherwise be unavailable. In fact, without securitisation, it is unlikely that there would be a non-conforming market either in the US or in the UK.
In essence, securitisation provides more competition and better-priced products giving an intermediary’s clients greater choice and better value. In addition, securitisation has given birth to more complex products such as non-conforming products and so heightened the need for quality mortgage advice. Finally, the investment mix of large fund managers will now almost certainly include a portion of Mortgage Backed Securities to take advantage of the higher returns on offer compared to other investments, especially in the market today.
Securitisation is here to stay and with lenders as large as Abbey National now using this method to fund its various activities, we can safely assume its future is secure.
Mortgage securitisation involves ‘selling’ a bundle of loans to investors in order to raise capital.
Bundles of loans are externally rated and decisions are based on factors such as the difference between the balance and the recovery value of properties.
Borrowers should feel little impact but as securitisation grows it may help to reduce rates.