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A rough guide to securitisation
Lloyd Cochrane looks at the issue of securitisation in the market and how it affects lenders, brokers and borrowers
Securitisation has moved into the mainstream. While intermediaries are naturally focused on servicing their clients and finding them the most competitive deals, understanding how this crucial element of funding works is useful for anyone wanting to gain insight into the mortgage market.
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Securitisation began in the US in the early 1970s but in recent years is becoming far more commonplace throughout Europe and in particular, the UK, with its mature and dynamic mortgage sector.
What is securitisation?
In its simplest terms, securitisation means bundling up many mortgages and selling them as a single investment. Large numbers are involved – £500,000,000 could be a typical transaction.
The company doing the securitising would be paid by the investor who then receives regular payments as the mortgages are repaid.
Securitisation has to date been more common in the specialist lending market, but most high-street lenders have now used securitisation to fund an element of their mortgage originations.
While these lenders would, in the past, entirely fund their mortgages from the cash that they raised via retail deposits, the issue of corporate debt or additional share capital, securitisation offers an alternative way of bringing in funding and managing capital.
This capital management element to the banks’ use of securitisation is currently evolving with the the introduction of the Basel II solvency requirements. This will, in most cases, reduce the capital benefit of securitisation but the funding liquidity and diversity of the market is likely to see it remain an important part of the UK mortgage funding landscape.
A few technicalities
Once they are pooled together, the mortgage portfolio is sold to a so-called Special Purpose Vehicle (SPV).
The SPV funds the purchase of the portfolio by issuing debt in the form of bonds to capital markets investors, known as residential mortgage backed securities (RMBS). The debt issued by the SPV is split into risk-based tranches so that it will appeal to a range of investors. These will be given a rating by a ratings agency.
Investments suit a range of risk profiles and portfolios may be mixed. For example, a portfolio could contain prime buy-to-let mortgages which are lower risk with some that are non-conforming and higher risk, although the mortgage margins on each element of the portfolio will reflect the risk that the mortgages represent.
Why securitise?
One of the appeals of securitisation for lenders is that it provides a diversity to other forms of funding and matches the long-term funding against the long-term mortgages, and so lessens dependency on short-term funds. Securitisation can also transfer risk and potentially reduce the capital that a lender needs to hold against the mortgage assets while enabling them to maintain a revenue stream – depending upon how the mortgages perform – from the mortgages once all the other investors in the SPV are paid
Once the cash comes in, and any capital is released, from selling the RMBS, it is available to fund more mortgages which can themselves be sold, in a second securitisation.
Scope of securitisation
The vast majority of securitisation deals involve residential mortgages, but as the process has become more established and the market more liquid, it is now also being used for commercial loans and other financial transactions, such as credit card payments, student loans and utility bills as well as other more esoteric assets that exhibit stable cashflows over time including football gate receipts, music royalties, pub rental incomes and car rentals to name but a few.
Whole loan sales are another area well established in the US and developing fast in Europe as an alternative to securitisation. Indeed increasing numbers of lenders will conduct whole loan sales as well as securitisations.
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Whole loan sales also involve the sale of a pool of loans from a mortgage lender to another institution. But, the main difference between whole loan sales and securitisation is that with securitisation, mortgages are bundled together in the SPV and in many cases, the mortgages remain legally with the originator who then continues to administer the loans on behalf of the investors and may retain a junior ranking slice of income from the loans once the SPV has paid all other expenses and covered losses on a mortgage portfolio.
In whole loan sales, the risks and rewards are fully sold whereas securitisation can often be seen as a way of reprocessing funds.
Experience matters
There are a range of investment and commercial banks securitising mortgages that they may have originated via wholly owned mortgage subsidiaries or bought via trading desks, as well as underwriting and managing securitisations on behalf of their clients – such as high-street banks and building societies – who do not have in-house expertise. Competition in providing securitisation services is good news for the market because this means providers of these services need to continually demonstrate value and high levels of service.
In addition the maturing of the securitisation and whole loan sale markets has given start-up mortgage originators the confidence to establish ‘virtual’ mortgage lenders, relying on securitisation for funding, a third party for servicing and concentrating their expertise on the design and production of mortgages – ensuring ever greater diversity in product design and ever more competitive pricing for intermediary and consumer.
Experience matters. It means having access to best funding to keep the cost of the investment as competitive as possible. Offering high quality servicing in-house is also a strong selling point. If the management of the loans is outsourced to a third party control of service standards, levels of investment and the management of the arrears process may slip, particularly in a downturn when many clients of a third party servicer may be experiencing the same arrears problems.
How does securitisation affect borrowers?
Securitisation has no impact on the mortgage borrower’s position and there is no need for intermediaries to let their client know that their mortgage is likely to be securitised – the legal, origination, compliance and regulatory risk are retained by the lender and for the borrower, it is an invisible process.
In a whole loan sale, however, the borrower will almost always be informed that their loan is to be securitised.
US repercussions?
There have been many references in the press to the issues in the US particularly linked to non-conforming lending. The market developed differently there, with, on average, higher loan-to-value (LTV) ratios and a number of product designs resetting to very high levels within a different regulatory environment. The effect of more frequent interest rate rises on this market has led to rising repossessions and a fall in house prices in certain areas.
A number of states in the US have announced mortgage regulatory moves to tighten up home lending procedures and more are expected to follow shortly.
In the case of some securitised US mortgages, there will be some fallout for investors, but no one knows how effective measures currently being taken will be.
This is not the case in the UK where interest rates, although rising remain historically low, while property remains in short supply and high LTVs are not the norm across the market. The boom in specialist lending and the well regulated market also mean that the majority of people find their mortgage affordable – and so securitisation is continuing to provide an investment which is in demand.
Securitisation is likely to expand and lead to further product innovation. Meanwhile, securitisation has been positive for the market because it has lowered barriers to entry meaning more entrants and hence better deals. If we look back 10 or even five years at the range of specialist loans on offer, it is apparent that today’s products are far more appealing in their terms and conditions and cost.
Intermediaries may not need to know all the ‘ins and outs’ but securitisation looks set to continue to play a significant part in the current vibrant UK mortgage sector.
The views expressed in this article are those of Bill Dudgeon, Managing Director of db mortgages.
Securitisation has become a funding source of choice for many lenders, particularly those in niche markets. But what exactly is it?
The process usually works like this: Lender A launches a business with an initial funding line from a bank. That line will have an agreed ceiling. So, if Lender A is successful in growing completions then that initial source of funding will run out. Without more cash, growth stops.
For many lenders, securitisation is the answer. Lender A puts together the mortgages it has already completed into a portfolio and sells to a company specially created to acquire mortgages – a legal entity known as a Special Purpose Vehicle, or SPV.
The SPV is entirely independent and so the portfolio of mortgages within it is ring-fenced. Should Lender A go out of business, its creditors can’t touch the mortgage asset within the SPV. This level of safety is fundamental to the principle of securitisation.
The SPV has no staff. The funds to re-finance Lender A’s mortgage book comes from institutional investors such as banks, building societies, pension funds, insurance companies and hedge funds.
Another key player in the securitisation process is the Rating Agency such as Standard & Poors, Moody’s or Fitch. The agency will scrutinise the portfolio within the SPV and then rate the notes it issues as to its strength and reliability as an investment opportunity. Lender A will be looking to maximise the triple –A portion of the notes. The larger the portion of this rating, the SPV will attract strong interest from major investors, at the lowest cost.
The investor’s cash is then passed through the SPV to Lender A, in payment for the portfolio who can then use these funds to originate new mortgages. The SPV also remits value back to the lender reflected as margin on the portfolio of mortgages – the ‘profit on the deal’ for the lender. Meanwhile the investor receives interest from the SPV through its holding of mortgage-backed notes.
Because the SPV has no employees, it clearly can’t carry out day-to-day administration for the mortgages held within it. This is handled by the appointed administrator for the SPV – often the lender who first generated the mortgages. The lender will be bound by the stringent controls of an Administration Agreement. This agreement ensures that the lender can’t interfere with the way the mortgage portfolio is managed, so protecting the interests of the SPV, treating the customers fairly and protecting investor capital.
Why does our Lender A go to the considerable trouble and cost of setting up an SPV when they could go to other banks for further cash? The main answer is funding costs. An SPV with an AAA rating will be seen by investors as low risk, and so they will normally accept a correspondingly lower return than a bank might when financing Lender A directly in the conventional way.
This, in very simple terms, is what securitisation is all about – and why lenders are now using it on a regular basis, often more than once a year if they’re growing rapidly.
Tony ward, Basinghall
Along with Regulation, it is fair to say that securitization has provided one of the biggest and impactful supply side changes to the UK mortgage industry in the last five to ten years. Sub prime mortgages now account for over 6% of the whole mortgage market. What has prompted this growth is in part the demand from investors who see these loans understandably as good performers.
Securitisation has allowed lenders to develop ever more complex product models as they understand what pricing can be applied to multi levels of risk within a securitisation issue. Some lenders are effectively middlemen between the lending and the investment community and it is no great secret that the fortunes of the stock market and the housing market are perilously linked.
This state of affairs has come about because sub prime offers good reliable margins especially in the UK for investors.In essence, a lender finances the loans it provides to the market by selling on the loans it makes to the bond market through a structured mortgage backed security. This sale provides the necessary ongoing capital to operate. These loans are sold as portfolios comprising of various tiers of risk and offering varying rates of return, all of which as far as investors are concerned more than compensate for the risk. The money to be made from these deals has provided the motivation for so many investment banks to be operative in the UK market.
The significant cloud on the horizon has been the contagion from the United States which has it seems reached the UK market. Regardless of the reality in the UK of lower risk (lower LTVs etc) there are many stories about issues that have failed to launch successfully in recent weeks. Consequently the prospect of sub prime bond issues failing to provide funding for UK lenders is a more real one than ever before. This is serious news as demands for these loans from investors have underpinned the explosion of new lenders providing high proc fee heavy sub prime loans. In short,there may be a flight to quality. More investors will chase portfolios that are perceived as having less risk, namely prime and prime Buy-to-Let.
As if more evidence were needed, we have already seen many lenders who rely on securitisation move up the credit chain. This is interesting as there are already too many lenders chasing too little real new business across the whole market so a squeeze on near prime will surely mean bad news for some. The rule of thumb is that you cannot grow market share by tightening credit criteria but that is exactly what securitisation issues will demand.
Of course this has ramifications for brokers as well as lenders, as the biggest commissions are paid for the more adverse loans. If the market turns its back on these loans then expect to see the few lenders left standing paying less for the business. There is much talk about the proc fee time bomb but in my opinion it is market changes like these that will address this in the future.
What is certain is that if this continues expect to hear more about sub prime lenders feeling the pain. Balance sheet lending is starting to look appealing again.
