Time to feel confident about the mortgage market

Investor interest could spell more funding for lenders and therefore more competitive mortgage deals for you.

At the start of the month, Lloyds Banking Group launched a massive residential mortgage-backed securitisation (RMBS) deal, and investor interest was very strong indeed. So strong that the size of the original issue was extended to cope with the increased demand.

This bodes well for UK mortgage borrowers because it marks a further move towards the reopening of the securitisation markets, and that could open up billions of pounds of funding to UK mortgage lenders.

How does it work?

Lenders fund their mortgages in two ways -- either by using the money they get in as retail deposits (our savings), or by packaging up the mortgages they sell and selling them on to investors around the world. These investors provide further funds for lenders to lend, allowing them to sell more mortgages to package up to sell to investors.

It was considered a virtuous circle up to mid-2007, but became more of a vicious one when investors started getting the jitters about the value of the packaged mortgages they had bought. Once they noticed that US borrowers had been lent money they could never have afforded to repay, and were defaulting in their droves, investors decided that buying mortgages was perhaps not such a safe bet after all.

The house of cards well and truly collapsed as has been well documented, and the flow of funding to lenders dried up pretty quickly -- the credit crunch.

Farewell to funding

This was a massive problem because many UK lenders had become overly dependent on this wholesale funding market. Indeed, since some lenders didn’t have a deposit-taking arm they were 100% reliant on selling their mortgages on.

Even the banks that did attract retail deposits still got into the situation where the majority of their funding was coming from wholesale investors, so the credit crunch clearly had an enormous impact on their capacity to lend -- Northern Rock was the most high profile example.

One interesting point is that, because of their legal structure, building societies have to fund at least 50% of their lending from deposits, so they were never as exposed to the credit markets as other lenders. In practice, around 70% of building society mortgages were funded from deposits not the secondary funding markets pre-crunch, leaving them less exposed than banks. They have still been indirectly battered by the impact of the credit crunch and many are, perhaps justifiably, pretty miffed about a crisis they believe was caused by other institutions.

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Light at the end of the tunnel

It is now widely believed that we will never get back to the heady days of 2006 and 2007 when investors were keen to snap up any packages of mortgages, no matter how risky. And most people think that’s a good thing.

Recent question on this topic

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But there have been increased signs of life in the securitisation market since last September, and the pace of new deals has stepped up a gear in 2010.

In September 2009 Lloyds Banking Group launched a large securitisation deal worth £4bn and backed by HBOS mortgages. It was followed in October by a £3.5bn deal from Nationwide.

And this year alone we have already seen four securitisations launched by UK lenders. Lloyds Banking Group launched another HBOS issue worth £2.5bn in January. In February Santander launched a £1.4bn RMBS issue backed by Alliance & Leicester mortgages, and The Co-operative Bank launched a £2.5bn deal.

The latest deal by Lloyds this month is worth £3.4bn and is the first deal it has launched backed by Cheltenham & Gloucester and Lloyds TSB mortgages since 2007.

It’s great to see more deals of this kind being done, but it is the level of investor interest in UK RMBS issues that is really encouraging.

Confidence in UK mortgages

The Lloyds deal in September, for example, was oversubscribed by investors more than twice over, and investor demand pushed the Santander deal in February up by 40% from £1bn to in excess of £1.4bn.

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The most recent RMBS deal by Lloyds Banking Group this month attracted similarly strong interest. Indeed investor demand was so strong that the deal was increased by a massive £1bn to £3.4bn.

This high demand is positive, as it is great news that foreign investors feel optimistic about the UK housing market. Indeed, if they feel so confident about the market that they are prepared to put their money where their mouth is, maybe we should feel confident too. Remember, if the mortgages that investors purchase default and the lender cannot recoup its money by repossessing and selling the property, the investors have effectively purchased duds. They clearly don’t expect that to happen.

But let’s look at this latest deal a little more closely. The mortgages sold in the recent Lloyds Banking Group securitisation were whiter-than-white low-risk prime deals -- an investors dream with an average loan-to-value ratio of just 65%.

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Only the best

So perhaps they are not taking a massive risk on our housing market after all. Even if the borrower does default, there is a 35% equity buffer in the deals being sold.

All the deals done since the credit crunch started have been AAA-rated and from a very small number of large banks. For a real reopening of the market we need to see other lenders issuing RMBS deals and a wider variety of assets being sold on.

I’m not suggesting that we need to return to the days of packaging up risky mortgages willy-nilly, but the deals currently being done are not enough on their own to provide the funding needed to sustain the overall UK mortgage market or to promote competition.

Plus with Government funding through the Special Liquidity Scheme due to start being repaid by lenders from 2011, something needs to change to help fill the enormous funding gap that will be left, if lenders are to maintain the availability of mortgages. Deposit-taking alone is not enough, so it benefits the entire mortgage and housing industry, including borrowers, if the securitisation markets do reopen.

Some experts believe we have a long way to go until smaller lenders can access this wholesale funding, but others think we may see a breakthrough later this year. One thing is for sure -- every large bank that gets away an RMBS deal, no matter how squeaky-clean, moves us one step in the right direction.

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