Securitisation

Securitisation – the lender’s perspective from HML

November 2007

The securitisation markets had been seeing upward pressure on pricing for some time. Concerns over the quality of (particularly) US sub-prime mortgage lending led to a tightening of investor appetite for mortgage-backed paper not just in the US but also in global markets – the old adage that when America sneezes, the rest of the world catches cold. Nervous risk managers in banks around the world then began to cast their eye at lending institutions and concluded that it might be safer to cut inter-bank credit lines to firms that (they feared) could potentially be affected by this reluctance among investors to buy mortgage-backed securities.

What started off as an actual problem with risky lending in the US, started to affect the UK market because people (investors and credit managers) jumped onto the bandwagon in thinking the same thing could happen here. Based on sentiment rather than fact, credit lines were cut, liquidity was squeezed, and the Northern Rock crisis played out in front of television cameras as savers queued around the block to withdraw their cash.

The quality of a mortgage-backed securitisation obviously depends on the risk profile of the underlying assets.

Irresponsible lending

In the US there has clearly been a significant rise in sub-prime delinquencies. There the problem was exacerbated by the ready availability in the past of heavy adverse credit. Indeed the boundaries in some cases have been pushed too far, stepping over the borderline into what one would have to describe as irresponsible lending. To highlight this, up to 50 per cent of US lending is above 95 per cent loan-to-value, in a market where house prices are falling, compared to the UK where lending above 95 per cent LTV accounts for less than 10 per cent of loans, in relatively stable market conditions.

With underwriting that left little or no cushion if borrowing costs rose, it didn’t take much for a significant number of these US loans to become non-performing. The result was that some of the securitisations into which they were bundled became impaired, in turn leading to the crisis of investor confidence.

Problem of sentiment

The situation here is different. It was not initiated by a significant pick-up in arrears on the mortgages themselves, but rather by concerns over the threat of one in the future. In one sense, sentiment is everything in the financial markets, and this evaporation of sentiment, which adversely hit the securitisation markets and raised lenders’ funding costs, has a knock-on effect on borrowers who will inevitably end up paying more.

So what is the fix?

If people come to realise that this is more a problem of sentiment than of fact, if lenders’ portfolios remain broadly clean (and are shown to do so), and if the financial markets return to some kind of normality sooner rather than later, one can expect normal service to resume over time. However, it would be unwise to count on that happening this side of Christmas.

Are UK mortgage portfolios clean?

Published data to the first half of 2007 would so far suggest that arrears and possessions have remained steady, but we must work on the assumption that there will be some deterioration going forward, not least as the sharp rise in LIBOR has pushed up the cost of variable rate products, creating a ‘payment shock’ for some borrowers on loans that are periodically reset. This also applies to a large number of borrowers reaching the end of fixed rate periods who, even when switching lenders and/or products, still face significant increases in monthly mortgage payments.

One-off cases of malpractice in the self-certification and sub-prime sectors attract a lot of media attention, but the number of cases where borrowers will face genuine financial pressure is likely to be small, especially given the favourable economic backdrop. The precise magnitude of any possible deterioration, and the possible knock-on effect on securitisations, are hard to judge, however.

What is clear from our discussions with administration agents in securitisations and the rating agencies is that day-to-day servicing of mortgages remains crucial. While an originator should, on the face of it, be apathetic as to the credit quality of mortgage assets once they have been sold, it is not as simple as that. Buyers do have some protections, and may be able to pass back loans that become non-performing unduly rapidly. In short, while the securitisation represents a ‘true sale’ and enables lenders to get the loans off their balance sheet, they don’t wash their hands of them completely. And, of course, a poor track record in generating good quality assets will make future securitisations nigh on impossible.

So what is the conclusion?

Now, more than ever, it is imperative that lenders handle the day-to-day cash collections and arrears management part of their activity as tightly as possible. This will help the ongoing performance of existing securitisations and help facilitate the successful completion of future transactions.

Whether servicing is handled in-house or via a third-party outsourced provider such as HML or one of our competitors, over the past year significant extra resources have been channelled into tightening of servicing procedures. This will help reassure existing note holders as well as new investors who will, in time, once again have confidence in the quality of UK mortgage-backed paper.

Paul Fenn is development director at Homeloan Management Limited