UK RMBS issuance falls in the face of macroeconomic deterioration
Mark Boyce and Andrew South from Standard & Poor’s assess the state of the residential mortgage-backed securities market. Although it is way down on peak levels pre-credit crisis, the sector has been showing tentative signs of picking up
Bank deleveraging and cheap central bank funding schemes are constraining European securitisation volumes, and Standard & Poor's Ratings Services believes that UK residential mortgage-backed securities (RMBS) issuance could fall again this year. That said, some specialised mortgage market segments - such as buy-to-let - have begun to slowly re-emerge, which could be mildly positive for the UK RMBS market.
The UK's renewed economic contraction since late 2011 and the tough lending environment are continuing credit negatives for mortgage loan performance, in our view. Indeed, we expect that the proportion of loans more than six months in arrears could rise by about 25 per cent by the end of 2013 under our baseline forecast.
Securitisation returns as a key funding source for UK lenders
European securitisation issuance has fallen every year since 2008, as investors have withdrawn from the market and underlying bank lending has remained sluggish.
Since the beginning of the downturn, issuers have retained most transactions for potential use as collateral in central bank liquidity operations, rather than placing them with investors (see chart 1). Investors bought barely 20 per cent of overall European securitisation volumes in 2011.
Chart 1: European Structured Finance Issuance
Placed versus retained
Source: JP Morgan
However, the UK is one of a few European countries where securitisation remains a substantial wholesale funding source for lenders - in particular, for mortgage originators.
Investor-placed UK RMBS issuance reached about €37 billion-equivalent in 2011, representing more than half of publicly-placed European securitisation issuance (see chart 2). Moreover, while UK mortgage lending volumes have fallen by more than half since 2007, securitisation issuance is again funding more than a fifth of loan originations, on average - a return to the pre-crisis trend (see chart 3).
Chart 2: Investor-Placed European Structured Finance Issuance In 2011 (Bil. €)
By asset class and country
Source: JP Morgan
Chart 3: Monthly UK Gross Mortgage Lending Vs. Placed RMBS Issuance
12-month moving averages
Source: JP Morgan, Council of Mortgage Lenders, Standard & Poor's
The variety of UK lenders turning to RMBS placements post-crisis also suggests that issuance volumes could eventually pick up again. In 2011 and in the first half of 2012, five building societies debuted RMBS transactions.
Last year, Northern Rock sold RMBS to investors for the first time in almost two years and Virgin Money has since taken up the baton, launching its first transaction in June 2012.
Meanwhile, some of the largest UK banks and building societies that actively used securitisation pre-crisis - including Santander UK, Royal Bank of Scotland, Barclays, and Nationwide Building Society - have all tapped the RMBS market since 2010.
The emergence of US investors as significant buyers of European securitisation paper has also provided a boost to issuance volumes, in our view. US dollar-denominated tranches accounted for more than half of 2011 UK RMBS issuance, and about one-third of first-half 2012 placements. The scarcity of US private-label RMBS, along with the relatively higher spreads on offer in Europe, help to explain this trend.
The Prime Collateralised Securities (PCS) labelling initiative, launched in the first half of 2012, may also increase UK securitisation issuance. The scheme aims to identify securitisations which conform to certain standards of quality and transparency, and some UK prime RMBS transactions are likely to qualify for the label.
However, the ultimate impact of the scheme will depend on the as-yet undefined universe of eligible securities and the extent to which they attract favourable regulatory treatment for the banks and insurers that invest in them.
Cheap government funding alternatives could contain issuance growth
However, renewed weakness in the UK economy and lenders' high funding costs continue to constrain mortgage lending volumes. Economic output fell for the third consecutive quarter in Q2, and remains well below its peak in 2007.
Residential property prices have remained broadly flat year-to-date and have yet to show signs of a sustained recovery whilst consumer confidence indicators are at 2009 lows.
Gross mortgage lending volumes have barely budged over the past three years, and mortgage approvals for home purchase recently touched a three-year low, according to the British Bankers' Association.
Whilst UK government measures may help to support the housing market, they are unlikely to push up RMBS issuance in the short term, in our view. The FirstBuy scheme, which provides borrowers with equity loans, will only serve 10,000 first-time buyers over two years, compared with about 180,000 first-time buyer house purchases in 2011.
The NewBuy plan to provide partial mortgage indemnity guarantees to borrowers will serve 100,000 home buyers, but is only just getting into swing: By July 2012, would-be borrowers had made only 600 reservations under the scheme since its launch in March.
The Bank of England's Funding for Lending scheme (FLS), launched in mid-July, may further depress investor-placed RMBS volumes, in our opinion. Between August 2012 and January 2014, lenders will be able to borrow from the central bank for up to four years against collateral - including securitisations - for a fee as low as 25 basis points per year. This fee rises if net bank and building society lending falls over the coming quarters, so we believe the plan could push up lending volumes in second-half 2012 - an overall positive for the UK economy.
However, we expect that this funding could undercut typical wholesale borrowing costs, potentially replacing some securitisation issuance that lenders might otherwise have placed with investors.
In August, Leeds Building Society retained its debut RMBS deal, citing the compelling relative cost of the FLS, and tighter spreads on recent new deals suggest that investors are already worried about a dearth of issuance in the next couple of quarters.
That said, the volume of transactions that lenders retain could rise if lenders want to create collateral for use in the FLS. Likewise, lenders may also retain more securitisations to exchange for six-month liquidity in the Bank of England's new Extended Term Repo Facility.
Prime mortgage loans dominate issuance, but other sectors show signs of life
What might be described as "prime" mortgages - those made by mainstream lenders to borrowers with clean credit histories who live in the securing property - have collateralised the vast majority of post-crisis UK RMBS transactions. However, there are signs that other mortgage market sectors are slowly starting to re-emerge, potentially boosting RMBS issuance in the process.
Specialist mortgage lenders advancing loans to borrowers with limited or adverse credit histories have traditionally relied mainly on securitisation to fund loan originations. We characterise such loans as "non-conforming". The reliance of non-conforming lenders on wholesale funding sources left them particularly vulnerable when these markets effectively shut in 2008 and 2009. Several lenders sharply reduced their activity while others withdrew from lending altogether.
The non-conforming mortgage market is unlikely to return in its previous form, in our view, and as a result, RMBS issuance from the sector remains extremely limited. Regulatory requirements in Europe may hinder issuance volumes further.
Under rules introduced last year, European banks can only invest in securitisations where the issuer retains at least a 5 per cent stake in the transaction - a requirement that is potentially more onerous for specialist lenders lacking a deposit base.
Still, issuers have placed a handful of non-conforming deals with investors since 2010, and the primary market may see a few more in the rest of 2012 and next year, in our opinion.
The buy-to-let mortgage market has rebounded more substantially. Since 2009, many mainstream mortgage lenders have significantly tightened underwriting criteria - notably, by raising down-payment requirements.
At the same time, falling real wages, high unemployment, and sluggish house prices have weighed on consumer confidence. As a result, many would-be mortgage borrowers have deferred house purchases, pushing up demand for and yield on private rental accommodation.
This in turn has helped increase buy-to-let mortgage loan demand. Buy-to-let gross mortgage advances increased by 30 per cent in first-quarter 2012 compared with a year earlier, against less than 10 per cent for the overall UK mortgage market, according to the Council of Mortgage Lenders.
Meanwhile, tenant demand continues to outstrip new landlord instructions, and more surveyors reported rent rises than falls in first-quarter 2012, according to the Royal Institution of Chartered Surveyors.
Longer-term trends are also supportive of private rental demand, in our opinion. While surveys suggest that most British people still aspire to home ownership, the proportion of UK owner-occupiers has been steadily declining since the early 2000s. Over the same period, the percentage of private renters increased to 16 per cent from about 10 per cent of all households.
These trends bode well for buy-to-let RMBS issuance in the coming quarters, in our view, although volumes have yet to pick up significantly. Paragon Mortgages placed the only post-crisis buy-to-let deal with investors in November 2011.
RMBS credit performance remains robust, but renewed economic deterioration could push up arrears
UK RMBS credit performance has generally remained resilient over the course of the recent downturn, despite tough economic conditions. The credit quality of transactions backed by prime mortgage loans - which account for about 80 per cent by collateral balance outstanding of UK RMBS transactions that Standard & Poor's rates - has deteriorated since 2007, but loans that are more than 90 days in arrears still represent only about 2 per cent of balances outstanding (see chart 4).
Largely as a result, we lowered the ratings on tranches in only about 11 per cent of UK prime RMBS deals between 2007 and 2010, and virtually all of these downgrades were in a handful of transactions from a single mortgage originator. No UK prime RMBS transaction that Standard & Poor's rates has ever defaulted.
Chart 4: Average UK Prime RMBS Arrears*
* Among transactions that Standard & Poor's rates
** Includes repossessions
Source: Standard & Poor's
Collateral quality has deteriorated more sharply in the much smaller non-conforming sector. About 20 per cent of non-conforming mortgage loan balances that we rate are more than three months in arrears (see chart 5). The UK non-conforming RMBS sector accounted for more than half of our European RMBS downgrades in 2008 and 2009. However, non-conforming transactions account for only about 7 per cent by collateral balance of UK RMBS transactions that we rate.
Chart 5: Average UK Non-conforming RMBS Arrears*
* Among transactions that Standard & Poor's rates
** Includes repossessions
Source: Standard & Poor's
Meanwhile, buy-to-let arrears proved to be more volatile over the downturn. However, since peaking at about 4 per cent in 2009 - almost twice the peak for owner-occupied loans - the proportion of buy-to-let mortgages in severe arrears has declined for 12 consecutive quarters (see chart 6). This relatively robust performance is largely due to low interest rates, in our view.
Chart 6: Average UK Buy-To-Let Mortgage 90+ Days Arrears*
* Includes cases where a receiver of rent has been appointed
Source: Council of Mortgage Lenders
Chart 7: UK Mortgage Loan Severe Arrears Rate*
* Over six months arrears. Scenario projections from March 2012.
Source: Council of Mortgage Lenders, Standard & Poor's
Despite the relatively robust credit performance of UK mortgage borrowers, the weak economy remains a key risk, in our opinion. If contracting economic growth keeps the unemployment rate elevated, house price growth remains sluggish, and real disposable incomes grow only slowly - our baseline forecast - we expect severe arrears to rise by about a quarter between first-quarter 2012 and fourth-quarter 2013 (see chart 7).
Even if the economy rebounds more strongly, we forecast that severe arrears could still increase if monetary policy tightens and mortgage interest rates rise in tandem. Under more pessimistic assumptions, where the economy falls deeper into recession, we expect that severe arrears could rise by about two-thirds. However, even in this case, the absolute level of severe arrears would likely remain low, suggesting that RMBS performance should remain broadly resilient.