The credit dislocation, which began in the US sub-prime mortgage market early last year, now affects large parts of the market in the UK, despite the fact that the quality of a mortgage-backed securitisation depends on the risk-profile of the underlying assets, and the lack of significant issues with UK non-conforming lending.
Despite concerns about weakness in the UK housing market and a worrying upsurge in arrears at the beginning of this year, the risk profile of UK non-conforming mortgages remains good. For those lenders already well-capitalised or able to access affordable funding, it remains a good business to be in. In fact, with consumer demand continuing and lending capacity having gone out of the market, non-conforming lending is now more profitable than it has been for some years.
Lenders are able to properly price their loans for risk, and with higher margins, volumes do not need to be as high as in the past for lenders to be profitable. Reduced volumes will also lessen the liquidity issues going forward with the role of some intermediaries, such as mortgage packagers, likely to be greatly reduced. This market correction and the return of power to the lender is leading to a reduction in the fees intermediaries are likely to receive.
More opportunities
Less competition also brings the opportunity for major high street banks to capture market share. These new entrants, as traditional balance sheet lenders who have not felt the full impact of the liquidity squeeze nor increased cost of accessing funds, are able to take advantage of the opportunity to expand safely and profitably into the non-conforming market.
However, success hinges on the availability of funding, with the ability to create balance sheet capacity a key feature of a lender’s business model.
The obvious first port of call is the lender’s incumbent fund providers. However, at present, they are generally focusing on existing clients rather than seeking new business.
Those fund providers willing to lend are controlling their exposure by offering funding on tighter terms, with advance rates reduced to the region of 75% loan-to-value – well below the levels seen at the height of the market. Thinly capitalised lenders need to fill this gap with longer-term funding. A historic source of such funding has been mezzanine finance, but it is relatively expensive.
Lenders might also seek to sell a stake in their business to help bridge the funding gap. There is no shortage of private equity funds looking to invest in such enterprises. Sovereign wealth funds are looking for high yielding opportunities to invest in, also possibly through private equity vehicles.
For example, funds such as the China Investment Corporation, the Chinese sovereign wealth fund, been in talks with US private equity group JC Flowers to put about $4bn into a new fund to invest in ailing financial institutions. The move follows the groundbreaking transactions of Asian and the Middle Eastern sovereign wealth funds investing directly in big investment banks to shore them up after poor collateralised debt obligation investments and US sub-prime writedowns.
There is also the possibility of raising funds through the sale of non-conforming loan portfolios. Building societies – once leading acquirers in the whole loan market to obtain better margin business – are maintaining high liquidity positions and have become more cautious. However, they will return as significant buyers, as this stance is both costly and unsustainable.
More opportunistic bidders, such as hedge funds, are keen to buy portfolios at knock-down prices, even though it is the sellers who are distressed rather than the assets. They will incubate the portfolios and sell them on, probably at a big profit. Another option for lenders is an outright sale to a larger financial institution with a more varied funding structure.
Securing a share
Bidders are still looking to invest in the non-conforming sector to secure market share and establish a platform for growth once the securitisation markets re-open. But this pool of prospective buyers is small and centres on the investment and retail banks relatively unaffected by the US sub-prime issues. Investment banks understand the risks of being a lender, but there is a strategic difference between being the owner of an operational business rather than purely a finance provider and/or asset trader. This might inhibit further uptake, especially in today’s environment, where every new mortgage written and retained on their balance sheets will be loss-making, as the market price for these mortgages is currently below par. This phenomenon is unlikely to last indefinitely.
The UK’s non-conforming mortgage market is in a state of flux. Some participants have been forced to withdraw, others are selling their loan portfolios – often at a discount – and some are selling out altogether. Others, meanwhile, are seeking partnerships with private equity houses or tapping into mezzanine finance to tide them over until the markets return to normal.
For those participants who are able to find a palatable solution to their funding problems and remain in the market, there is everything to play for. Demand for non-conforming mortgages has not gone away, and the mortgage-backed bond market will recover eventually.
There is no quick fix solution but lenders do have a range of options available to them. It will ultimately be possible to escape the effects of the US problems and profitably fight back. n
Graeme Johnston and Salv Nigrelli are in the financial services corporate finance team of PricewaterhouseCoopers LLP.
