To the casual observer, the mortgage industry seems to have undergone a century’s worth of change in the last few years. This is not just about legislation and regulation. It has also been impacted by the changing mix of funding techniques for mortgages as former building societies have converted to plcs, not to mention the entrance of new players and the re-emergence of securitisation as a tool for many lenders.
Retail funding has always been the traditional method of funding mortgages and has been linked to the need to balance interest rates charged with those paid to savers. This can mean thin margins when rates are high and savers prosper. Conversely, however, this can mean that borrowers pay wide margins when rates are low as savers will not accept rates which offer almost no yield, once inflation and tax are taken into account.
During the last couple of years, as the bank base rate maintained a downward trend, mortgage lenders stopped passing on the full amount of the reduction to their borrowers. As a consequence, we saw the emergence of tracker mortgages which were designed to take the guesswork out of mortgage selection as they ensure the mortgage rate stays in line with bank base rate.
While retail funding has massively shaped the way borrowers are charged on their mortgages, things are now changing.
The other main type of funding for mortgages is wholesale funding. This is where financial institutions borrow money from the money markets and re-lend it. Here, banks have advantages over building societies in that they are free to borrow as much as they like on a wholesale basis, which can be cheaper than retail. Building societies, conversely, are usually limited to 50% of their overall borrowing on wholesale terms. In the past, when rates have been low, this has given a significant advantage to wholesale-funded lenders. Without savers to consider they can follow rates right down.
Recently HSBC, Nationwide and Halifax have all introduced programmes for existing customers that link them, or give them the option to be linked to bank base rate, and typically at a margin of 1% over. At the same time, we have seen a lot of pressure on extended redemption charges and a consequent move to reduce the overall up-front giveaway to borrowers, which used to be recouped via these overhanging charges. A number of commentators believe this trend will continue marking a return to the situation we were in the 1980s, when only two types of product were available ‘ standard variable rate for new and existing customers and fixed or capped rates. Such a drastic change is unlikely, but the latest moves by a number of lenders to reduce ‘ or stop altogether ‘ remortgage products which do not allow the lender enough time to recover their giveaway, only reinforces the possibility of this happening.
More recently, we have seen the emergence of another type of lender known as the correspondent lender. This is a method of funding widely used in the US, and is being introduced in the UK. Simply put, it means the initial lender the customer deals with, sells the mortgage at or after completion to another lender. The advantage for the initial lender is that it frees up its balance sheet, enabling it to re-lend the money. In this way, correspondent lenders do not need to have balance sheets the size of traditional lenders.
Taking this one stage further, a programme called ‘through lending’ has been introduced. This is similar to correspondent lending except that the loans are originated in the initial lender’s name and brand, but are underwritten and priced to a mutually agreed criteria. The loans are passed after completion to the acquiring lender who will retain the servicing. This is a cost-effective means of lending for the acquiring lenders as the cost of acquisition, processing and marketing costs are all borne by the initial lender.
This process also works in reverse. For example, lenders who do not offer non-conforming products end up rejecting many thousands of customers each year. This can harm their brand as these customers may be savers or have other financial products with these providers. By embarking on a ‘through lending acquisition’ programme they can continue to lend to these customers in their own brand, but using the acquiring lender’s non-conforming criteria and rate structure. This way, they keep their customer, retain brand loyalty and after completion the loan is sold immediately to the acquiring lender.
Of course, the other driver for funding is whether or not assets are held on the balance sheet. If lenders have to provide sufficient capital against all of the mortgage assets that they hold, it makes sense for these lenders to move these assets off the balance sheet to free up capital. This is where securitisation comes in. This first appeared in the UK market in the late 1980s, and is emerging again as a sophisticated way of giving lenders flexibility around their balance sheets. This is no longer the preserve of American companies who have a developed market in mortgage backed securities. Large UK players such as Abbey National, Northern Rock, Bank of Scotland and Bradford & Bingley have all recently issued bonds and it is estimated that the overall size of the securitisation market could grow to £25bn a year.
Securitisation used to mean that products had to conform to tight criteria which meant that lenders were unable to be as flexible as the market would like. Things have come a long way since then and it is no longer the case that a securitising lender has to have stricter criteria.
All the above funding methods provide products across all sectors of the market. For example, it is possible to securitise buy-to-let alongside non-conforming mortgages alongside mainstream products.
The biggest impact predicted, however, is that of the move to an ‘interest rate equilibrium.’ This will mean that most borrowers will receive less of an incentive at the outset, but will mean that existing customers are no longer paying over the odds to subsidise the new ones. This is not exactly rocket science and is often referred to as customer relationship management. In other words, lenders are saying that it is high time they started to look after their existing customers and the only way of doing that is to focus on the rates they are paying.
What this means for brokers is that they will need to become more familiar with the funding opportunities that are now available and practised in the UK market. They will increasingly need to know and understand how a lender funds its mortgage products, as this may well be translated into how competitive the products may be over time. Also, in the case of mortgages that are securitised or sold to other lenders, transparency is key, so the customer needs to be aware at outset.
There is a wide range and large number of lenders in an over-supplied market and it is increasingly difficult for brokers to keep track with the pace of change. It has been suggested that regulation will reduce the number of lenders by up to 25%, but even so, that still leaves a diverse range of lenders all with different funding techniques. The transparency insisted upon by the draft legislation proposed will undoubtedly make the broker’s life easier if key features of the product, which are affected by funding are disclosed and easily available for the broker to obtain.
Industry players give their views on the new mortgage funding techniques
Richard Verdin, director of mortgage and protection markets at Legal & General
‘One of the most important things to high street lenders is their brand, and so I cannot see many advantages of correspondent lending for prime lenders. It might be alright for sub-prime lenders however, and it might take their relationships with their key packagers to another level. However, I can see securitisations growing as a funding method. Many of the major lenders have done them already and it enables them to free up capital so that they can create more opportunities for their customers.’
Tony Armstrong, director of corporate relations at Northern Rock
‘Securitisations have become much more popular among lenders over the last few years. It allows lenders to get mortgages off their balance books and they can then use the capital to fund new mortgage products and this looks set to continue over the next few years.’
Brian Pitt, sales and marketing director at Future Mortgages
‘Our way of trading in the mortgage book has been slightly different to other sub-prime lenders. We have raised funds by selling portions of our book to financial institutions such as banks and building societies through ~whole loan selling.’ But both this and securitisations are still options that we can explore. The recent consolidations in the sub-prime market has meant that one of the key factors to development is to push down the costs of funding, and this has often been done through securitisations, but it requires a good number of mortgages to do it well. In the future, there will be more of both whole loan selling and securitisations.’
Kieran Hartigan, group marketing manager at Abbey National
‘A number of lenders are now active in the securitisations market as the financial services industry looks for more capital efficiency, but this is still in its infancy over here and we do not expect a big explosion over the next 12 months.’