The changing shape of securitisation
The future of securitisation in European mortgage funding is uncertain, says Andrew South and Scott Bugie of Standard & Poor’s Ratings Services. But they believe RMBS will continue to play a role in helping European banks to fund their mortgage portfolios
The recent global financial crisis and recession have weakened Europe's housing market, in Standard & Poor's Ratings Services' view. Property prices in most European countries are only now beginning to stabilise after a one to two year slump, and the volume of house sales is still close to record lows. We believe the state of the housing market is in turn linked to funding conditions for residential mortgage lenders.
Securitisation - in the form of residential mortgage-backed securities (RMBS) - underpins a material portion of home ownership in some European countries, such as the UK. However, for the past few years, the RMBS market has completely changed shape. Traditional RMBS investors have shunned the asset class, and central banks have instead stepped in on a large scale, accepting RMBS as collateral for loans to the banking system.
Consequently, while outstanding European RMBS almost doubled since 2007, much of it now resides as security with central banks, or is retained on lenders' balance sheets for potential future use in central bank schemes. RMBS placed with private-sector investors have been the exception, rather than the rule, since 2008.
We believe the issue that looms over the European housing market is what will happen to residential mortgage funding as and when government and central bank support programs wind down. In our opinion, in some countries this could reduce the availability and raise the price of mortgage credit in the absence of other funding sources, such as a viable market for RMBS placed with private investors.
In some countries RMBS has been a significant source of funding
The European Mortgage Federation estimates there was about €5.5 trillion in residential mortgages outstanding across the eurozone and the UK at the end of 2009. Together, five countries - the UK, Germany, France, Spain and The Netherlands - accounted for more than 80 per cent of this total (see chart 1).
Chart 1
Before the financial crisis that started in mid-2007, outstanding RMBS totaled about 12 per cent of combined eurozone and UK mortgage loans, although RMBS usage varies significantly by country. RMBS had grown to become a significant funding tool in the UK, Spain, Italy and The Netherlands, where it accounted for 15 per cent to 20 per cent of mortgage funding by the end of 2007 (see chart 2).
Chart 2
When the European financial turmoil erupted in 2008, investors turned away from RMBS. At times all wholesale funding markets for European banks effectively froze. To compensate for the closure of the RMBS market, significant government actions to inject liquidity in the banking system provided a new channel for securitisation. Highly-rated RMBS and other asset-backed securities became widely used as collateral in various government and central bank-sponsored funding and liquidity programs, such as the Bank of England's Special Liquidity Scheme.
By the end of 2009, the presence of these schemes had spurred an increase in outstanding European RMBS to about €1.1 trillion, or about 20 per cent of mortgage loan balances (see chart 2). In our observations, little of the increase in RMBS outstanding since the end of 2007 has been used to secure funding from private-sector investors. Instead, new RMBS since 2008 generally has been used to back borrowing from central banks or has been retained by the originating lenders.
New central bank and government programs set up at the height of the European financial crisis, and the expansion of existing schemes, in our view greatly helped the banking sector cope with the dearth of long-term funding brought on by the financial crisis. Over coming periods, when financial markets normalise and government-supported funding of this type gradually winds down, we believe long-term mortgage funding could be headed for difficult times. Although private-sector funding channels have reopened to some extent, the return to favour of RMBS with private investors remains tentative.
The injection of central bank funding increased the maturity mismatch of banks
The existing stock of European RMBS held by private-sector investors—our rough estimate is about €500 billion—is self-amortising, meaning that the paydown of the RMBS matches the run-off of the mortgage loans that they fund.
However, the scale of central bank funding is significant, in our view. We believe that the total outstanding RMBS used to collateralise borrowing from central banks now exceeds European RMBS held by private investors.
In our view, the substitution of central banks and governments for private-sector investors has exacerbated the funding maturity mismatch of the European banking sector. RMBS-backed borrowings from central banks are relatively short-term, while the assets they finance - the mortgage loans - are long-term. If central banks were to close down their RMBS-backed lending built up over the past two years, we think European banks would be hard-pressed to find an equivalent volume of long-term funding to replace it.
Uncertainty over how central bank funding could be replaced
European mortgage lenders that face funding redemptions of central bank programs will, we believe, have to raise corresponding new funds and/or shrink their assets in order to compensate. Without investor-placed RMBS, any new funding would have to come from other sources, such as customer deposits or capital market borrowing via unsecured debt or covered bonds.
The major source of European bank funding remains customer deposits, which have been flat since June 2009 due to the weak economy (see chart 3). Households' deposits have grown moderately, while corporate deposits have declined. Customer deposit growth for European banks moderately outpaced loan growth in 2009, and appears to be on track to do so again in 2010, due to continued deleveraging of corporate debt in the form of bank loans and only moderate growth of loans to households. While we believe the moderate deposit surplus with respect to loans in recent periods is positive for banks, in our view it has not been large enough to compensate for the potential shortfall that would result from the winding-down of central bank lending.
Chart 3
Covered bond issuance has been relatively robust in recent times. However, the likely ongoing scale of covered bond funding varies by country. The covered bond investor base in some countries—such as the UK—is likely to remain relatively limited, in our opinion. Countries with less history of covered bond issuance and a shallower domestic investor base may be the same countries in which lenders previously relied more on securitisation, and where the funding burden will therefore be largest.
We observe that unsecured, unguaranteed debt markets remain volatile, and significantly more expensive a funding proposition than before the crisis, given heightened investor risk aversion (see chart 4).
Chart 4
Funding pressures could limit net lending
With funding channels under pressure, some institutions could look to the alternative of shrinking the balance sheet, likely meaning negative net lending in one or more segments.
While net lending has fallen in most European countries, it generally remains positive (see chart 5).
Chart 5
Some lenders with greater funding constraints could, in our view, shrink their balance sheets to manage the withdrawal of central bank funding backed by RMBS, rather than pay high rates to fund in the wholesale markets. In practice, banks could also wind down other lending segments in order to maintain volumes in residential mortgage lending. For example, the sharp pullback in commercial real estate lending could prove to be a long-term strategic decision for some institutions, given their recent high loss experience. Lending to large corporates has in some cases already fallen as these borrowers meet their own funding needs via bond issuance rather than bank loans.
A rebound in European RMBS is ultimately a question of investor demand
We believe lenders will take individual approaches to meet their funding needs. Despite its current relatively high costs and uncertainties, securitisation is most likely to return as a funding tool among institutions that made the greatest use of it before the crisis began, and which therefore continue to be best positioned, in terms of infrastructure and investor relations, to use this funding channel in the post-crisis environment. Similarly, at the country level, we think it is no coincidence that the UK and The Netherlands are experiencing a small-scale return of RMBS issuance in early 2010; they were the top two countries in terms of RMBS issuance outstanding at the end of 2009, and therefore likely have the largest structural funding requirements to fill.
In our opinion, over the medium term, European RMBS appears to be headed for a decline from the unusually high current levels outstanding. If this is indeed the outcome, it may result in pressure on the availability of mortgage credit over the medium term and/or higher borrowing costs, more muted European mortgage-lending volumes, and potential downward pressure on the housing market in countries whose consumers have the greatest housing debt.
However, we believe the current funding squeeze also presents an opportunity for market participants to rebuild RMBS in a new form. Institutions that had previously not securitised have, in some cases, constructed RMBS infrastructure to access central bank liquidity lines, and therefore may have opened up the possibility of selling RMBS to private investors over the longer term. We believe the credit performance of European RMBS throughout the recent recession has been robust overall, and the asset class may therefore begin to appeal to certain investors once again.
We believe that RMBS will continue to play a role in helping European banks to fund their mortgage portfolios. Whether it's a leading role or a walk-on cameo will likely depend on how central banks, investors, lenders, and financial regulators respond to the ongoing tightness in funding.
Andrew South is senior director and Scott Bugie is managing director of Standard & Poor's Ratings Services
