Mortgages & housing

Moving mortgage books around the market

July 2007

The UK secondary mortgage market, of which whole loan sales now form a substantial part, is the most complex and mature in the EU zone and has grown exponentially over the last decade from its early roots within the UK building society sector.

In 1997 the market was around £1 billion in size, in 2006 it was in excess of £10 billion, and 2007 is likely to be larger still. So why has the whole loan trading market grown?

The 1970s, 80s and early 90s

Traditionally whole loan sales took place between UK building societies, which previously dominated the mortgage sector (pre-demutualisation) and in whom most of the UK mortgage expertise was held. They were almost the only 'traders' of mortgage pools during the 1970s, 80s and early 90s.

Trading of mortgage books often formed part of mergers and acquisitions between similar mutual organisations or as a result of an organisation needing to divest itself of a portion of its balance sheet which no longer met its risk appetite or where asset/liability ratios were squeezed by too much or too little lending. Occasional books also came on to the market as a result of 'fire sales' where organisations pulled out of the UK mortgage sector altogether and sold their books on through either auction or direct sale.

Big changes in the 1990s and 2000s

By the late 1990s major changes had started to take place within the whole loan sales market, which was now being transformed by originators such as Amber Home Loans and, via their subsidiary mortgage companies, building societies such as the Stroud & Swindon, Britannia and Derbyshire.

This 'new and improved' breed of mortgage book traders were able to transform both the availability and acceptability of trading mortgage loans within the UK. First of all on a relatively small scale by number and volume but, crucially for the future development of the market, by starting to originate specifically to sell on through their subsidiary (non-member) lending companies.

As the number of buyers prepared to consider and invest in the whole loan purchase market grew, so did the number of portfolios available for sale. This increased demand, coupled with attractive premiums (price), enabled the nascent whole loan sale market to break out of its early shackles into mainstream market consciousness. The whole loan trading market started to come of age in the UK.

As more sellers and buyers continued to enter the market and liquidity grew, whole loan sales became a viable funding and profit-generation strategy for the new breed of direct lenders, such as Kensington, and the more sophisticated building societies, who still dominated the mortgage trading sector in the late 1990s.

Enter GMAC-RFC

In May 1998 GMAC-RFC entered the UK mortgage market, bringing with it a brand-new business model - 'create and trade', to take advantage of the now maturing secondary mortgage market, ultimately dominating and completing the maturation of it.

GMAC-RFC's new strategy, similar to but on a different scale from the building society traders, was simple: create the mortgages and sell all of them in the secondary market, starting by selling to the very building societies who had helped kick-start the new trading environment. The ideal partners were there and willing to trade.

As a consequence, by the end of the 1990s and into the early 2000s, whole loan sales (and securitisation) had helped many UK mortgage originators diversify away from their traditional sources of funding, which had been predominantly retail deposits and the issuance of senior unsecured debt for funding. Now they had access to different and often more cost-effective funds.

If the first big stage in the evolution of the secondary mortgage market in the 1990s was the increasing implementation of securitisation as a source of funding and risk transference, then by the early 2000s whole loan sales were becoming a true alternative or complementary route to the same goal. Whole loan sales now offered the seller the chance to sell mortgage risk, for a price, always backed by warranties to protect the buyer and the borrower, to reputable and willing partners.

What are the risks?

A whole loan sale is a risk-adjusted asset transfer (transaction) between two counterparties; both will seek a profitable and risk-weighted outcome. The seller is transferring the risks associated with the underlying loans - mainly credit, economic and legal - for a price at a given moment in time. The buyer is buying these risks for a price that should deliver an acceptable return for the risks transferred to it. In simple terms there is a risk reward transfer that matches both parties' return thresholds for the most effective use of their capital.

As with any arrangement to transfer a large economic value and legal ownership of multiple numbers of assets between two parties, there is a sale contract to govern the transaction. This contract, the Mortgage Sale Agreement (MSA), sets out the mechanics of the transfer, the characteristics of the assets to be sold, the protections that each side will be afforded from the transaction and of course the price to be paid.

The protection each party is offered by the MSA is governed by a set of 'warranties' that describe, and protect the buyer from, the legal and economic risks associated with the sellers' origination procedures, policies and actions. The seller is likewise protected from the legal and economic implications of the buyer's not adhering to the appropriate FSA regulations or CML guidelines (for loans pre-Oct 2004) on conducting mortgage lending, and reneging on the specific conditions of the MSA in relation to the administration of the loans and the treatment of the borrower and the introducer/broker.

The rights of the borrower are protected to the same extent as if they had remained with the originating lender. This protection is also set out in the Mortgage Sale Agreement. For example, the obligations contained in the terms and conditions of the original mortgage offer are passed on to the acquiring lender, and provided nothing changes in the credit or legal profile of the borrower or the related security, once sold, they are adhered to by the acquirer.

All buyers and sellers of mortgage loans in the UK have to be regulated by the FSA to conduct mortgage business or mortgage administration. Therefore all acquirers of mortgage loans have to adhere to the Treating Customers Fairly (TCF) principles and responsible lending guidelines as laid down by the FSA. Again these are stipulated in the MSA.

The market today

The whole loan trading market is now populated by a diverse mix of financial institutions, which encompasses investment banks, building societies, mortgage and retail banks and direct lenders. Whole loan sale transactions are likely to reach near to £15 billion, and perhaps as high as £17 billion (my estimates for this year).

The biggest players by trading volume, who are in the public domain, and in no particular order, are - GMAC-RFC, Mortgage Express, Credit Suisse Oakwood, Britannia Treasury Services, Kensington Mortgages, North Yorkshire Mortgages Ltd, Morgan Stanley and Amber Homeloans.

There are at least another 20 or so participants actively trading mortgage portfolios in the secondary market at this time. There are also numerous institutions ready to trade but which have not yet dipped their toe into the market, mainly due to the supply-side constraints of this rapidly growing, demand-dominated market.

In Q1 2007 the number of portfolios traded was probably already in the region of 25 or so, with an estimated value of perhaps £6 billion, and as demand for mortgage portfolio purchases continues to outstrip supply by perhaps three to five times, this upward trend is likely to continue.

Approximately £4 billion of the loans that have been traded this year have been or are being refinanced using securitisation. Securitising the mortgages following purchase allows buyers of the mortgage books to reduce the costs of funding the loans, transfer the risk off balance sheet and generate income. This cycle of whole loan selling to securitisers who then package the loans into securities is increasing the liquidity of the whole loan trading market, increasing demand and further commoditising both the transaction processes and the types of pool available for sale.

The net effect of this increasing liquidity in the secondary market has provided lenders who participate in it with an indispensable tool to drive market leading innovation in their product offerings to consumers, increase distribution and origination volumes, lower funding costs and better manage the risks, and has ultimately spawned several big new names in the mortgage market.

Whole loan sales have helped fundamentally transform the UK mortgage market - and long may it continue.

Craig Beresford is director of asset sales at GMAC-RFC