Pooled finance – a new wholesale funding instrument?

The idea of smaller financial institutions pooling their resources together to access the capital markets is not new, but has so far evaded the UK. Philippe Tapernoux of KPMG discusses the pros and cons of pooled funding

Unsecured funding remains unavailable to most mortgage lenders. This has led to some resurgence of secured wholesale funding through covered bonds or securitisation. For smaller institutions, however, this route is difficult on a standalone basis. Pooled funding offers a means of market entry for smaller players but how does it apply to the mortgage lending sector in the UK and what are the issues a mortgage lender should consider before entering the fray?

With unsecured capital markets remaining unavailable to all but the biggest and best known mortgage lenders, a number of players have moved along the route of secured funding to access wholesale funding. This has usually taken the form of covered bonds and securitisations.

For example, in recent months, institutions such as Principality, Skipton or West Bromwich Building Societies have all embraced these instruments, while buy-to-let lender Paragon has secured warehouse funding which will ultimately lead to a new securitisation issue.

For smaller mortgage lenders wishing to access this market, the main challenge is one of size rather than capability or willingness: capital markets issues below the £150 million to £200 million mark are challenging not only because of the fixed costs involved, but also because of the lack of liquidity that deters institutional investors. This has led advisors and issuers to consider whether pooling the funding needs of several originators would allow them access to the capital markets.

Pooled funding – the concept

As its name indicates, pooled funding consists in putting together discrete small pieces of funding into one larger piece of debt issued to the market. The key is to balance the needs of investors and the cost and operational hurdles borne by participating originators. Investors will need an issue large enough to gain (some) liquidity, as well as homogeneity and minimal expected volatility in the underlying assets; the latter requirement enables analysis of the debt issue from a sector or asset class perspective rather than as a fixed income fund, containing an array of potentially volatile credits.

In the secured funding sector, the norm is to issue debt rated to a AAA rating level. This implies, unless originators cross collateralise each other, that each participant’s contribution to the pooling vehicle needs to be rated AAA as well. This can be achieved through a mini-covered bond or a mini-securitisation structured at the originator’s level, of which the AAA tranche only is used in the pooled transaction.

Whether a covered bond or a securitisation structure is ultimately selected, the basic concept is similar: a selected pool of mortgage loans is sold to a bankruptcy remote entity (special purpose vehicle or ‘SPV’). For covered bonds, the SPV acts as guarantor to debt issued directly by the mortgage originator. The dual credit of the issuer and of the guarantor - together with the fact the amount issued is lower than the amount of mortgages sold to the SPV (also called ‘overcollateralisation’) - results in the higher rating sought.

For a securitisation, the mortgage pool is split into tranches with different priorities of payments, the more senior ones being repaid in priority to the more junior ones. The junior tranches are sized so that the most senior achieves a AAA rating. Unlike covered bonds, the securitisation SPV then issues debt directly in the market.

The concept of pooled funding for mortgages is not new: smaller Spanish savings institutions (‘cajas’) have used pooled covered bonds for the best part of decade – and these instruments have not been particularly affected by the economic crisis in terms of performance. The development of a similar instrument in the UK has been slower.

Pooled funding in the UK

While unsecured pooled funding would be relatively simple to structure, it however, presents difficulties for investors and issuers alike. Investors are not keen to invest in unsecured paper from financial institutions; their view being that a pooled transaction does not bring obvious benefits to them. On the flip side of the coin, issuers would face pricing subsidies negotiations with those benefiting from decent credit ratings unwilling to pay the same spread as those with lower or no rating. Accordingly pooled funding for mortgage originators has focused on secured transactions to date.

Some initiatives to kick-start pooled covered bond programmes were started in the UK around 2007 and then again last year. The pre-crisis initiative was based on the success of similar programmes in Spain, while the more recent initiative relied on the relative stability of the covered bond sector during the crisis.

Rating agencies however have united to slow down these initiatives by making the coveted AAA ratings more difficult to achieve on covered bonds – through closer links between the covered bond rating and the unsecured rating of the issuer, together with higher overcollateralisation levels. While these changes obviously affect all covered bond issuers, they particularly hit the smaller ones, which typically have weaker unsecured rating (or no rating but a weak shadow credit assessment) or simply do not have a balance sheet large enough to be able pledge the amount of collateral required by the rating agencies.

As a result, pooled covered bond initiatives have mostly been put on hold. It could however remain an interesting instrument for existing mid-sized covered bond issuers, for whom there may be some benefits in respect of refinancing risk reduction when issuing smaller tranches at a time through a pooling vehicle.

The market focus has therefore, for the time being, shifted to securitisation. A vilified instrument during the credit crunch, securitisation is slowly making a return in the UK, as the market realises this instrument was not the cause of the crisis but rather a vector, when applied to lower quality collateral. While securitisation investors remain fewer than covered bond ones, resulting in higher issuance spreads, issuers realise that it provides a near-perfect asset and liability match to the underlying mortgages and carries a much weaker link to the originator’s rating than covered bonds. Combined with lower overcollateralisation requirements, it can become a more user-friendly instrument for smaller originators.

A potential alternative to securitisation or covered bonds could be a softer version of secured funding, where originators provide security over some of their mortgage assets, but in a less structured or rated fashion than for securitisation or covered bonds. This could appeal to investors that historically had credit appetite for the mortgage lending sector, but got deterred by the financial crisis.

Suitability for large or small institutions

Most larger UK institutions have already embraced secured funding for their mortgage origination. It would generally not make sense for them to consider participating in pooled funding programmes.

For mid-sized institutions that have or are in the process of setting up secured funding programmes, a dual approach of standalone issuance and participation in a pooled transaction can be interesting, as the issuance of smaller tranches will reduce the refinancing risk – besides the fact that costs of setting up a programme have already been incurred.

For smaller institutions which do not normally have the required size to access capital markets, considerations such as the fixed costs involved (including rating agencies or legal counsel) as well as operational changes (sale of the mortgage loans, information technology) are part of a number of questions they should ask themselves when considering their funding options.

Some questions to ask in respect of pooled funding

• Is this the right tool for us? At first thought the answer would seem to merely depend on the all-in price (spreads, fixed costs amortised over the life of the deal and variable annual costs versus amount raised), but in fact other factors also come into consideration, such as IT capabilities or the political willingness of entering in a transaction together with potential competitors. Timing can also be an issue, with the issuance date of a pooled bond tending to move at the pace of the slowest participant.
• What is the best structure? There are pros and cons in issuing covered bonds or mortgage backed securities, which will differ on an issuer by issuer basis. The structure of the pooled transaction may also have many different features. While the diagram above represents a classic structure, e.g. mini-funding issue with a master issuer, there are alternatives such as commingled assets, or pooling more than just the AAA notes issued by each sub-issuer.
• What are the costs (and benefits)? A number of the costs, such as legal and rating, are fairly inelastic. This will typically floor the minimum amount a mortgage funder should initially issue, in order to keep the all-in price to economic levels. In current markets we estimate that below an initial issue size of £40 million, the costs are likely to outweigh the benefits. Some of the benefits, including ability to access a new wholesale market, have been discussed above. Others include the relatively long term of that funding or the ability to repo the assets with banks or central bank programmes.
• How do we implement such a program? There are a number of topics to be addressed such as legal (pledgeability of the assets), IT (tagging receivables and reporting), commercial structure, rating or backup servicer requirements. A small internal project team should be put together, with the assistance of experienced external advisors
• Should I wait for competitors to pave the way and then join or will it be too late?

As we have seen, pooled funding can be an interesting wholesale funding alternative but its implications need to be carefully analysed.

Philippe Tapernoux is head of financial institutions debt advisory at KPMG Corporate Finance