CML news & views

The closure of the wholesale funding markets – and the knock-on impact on housing and mortgage markets – have been widely reported. Recently, there have been encouraging signs of improvement. But questions remain over the future funding of UK mortgage lending. Many of these were scrutinised at our recent annual conference in a presentation by Tony Ward, the chief executive of Home Funding Ltd.

Tony Ward outlined how, in the years leading up to the credit crunch, wholesale markets provided an increasing share of the funding for the UK mortgage market. The UK, in fact, has issued more residential mortgage-backed securities (RMBS) than any country other than the US. The £78 billion of RMBS and covered bonds issued in 2006 represented 27% of gross mortgage lending and 71% of the net increase in the outstanding loan book.

Between 2000 and 2007, outstanding RMBS and covered bonds rose in value from £13 billion to £257 billion, compared to a total outstanding UK mortgage book currently totalling around £1,200 billion. The sudden disappearance of this funding option left a big hole in the mortgage market.

How the market developed

UK securitisation began in the mid-1980s, mainly through the activities of a number of specialist non deposit-taking firms looking to break into the mortgage market. Its success led to its adoption by many mainstream mortgage market players as they looked to maintain or build market share. It became part of the fabric of the industry.

Since the onset of the credit crunch, securitising mortgages has had a bad press. But much of this coverage fails to acknowledge some of its undoubted benefits: it matches the timescales of investors and mortgage terms; mortgages backing the assets undergo independent stress testing by ratings agencies; and the process is subject to continuing oversight. And despite public perception, prime RMBS performance has been very good during the recession and no investor in AAA- or AA-rated UK prime mortgage assets has lost a penny.

The UK and the US

Global developments have hit the sector hard. Despite the solid performance of the majority of UK mortgage-backed securities, the securitisation market has been damaged by the perception of being in a “bad neighbourhood” – associated by many with the US sub-prime market and the slicing and re-packaging of these often badly performing loans.

Although US sub-prime practices bear no resemblance to mainstream UK mortgage market activity, it has been unfairly tarred with the same brush. Since the onset of the credit crunch until very recently, it has been virtually impossible to issue new assets backed by UK mortgages

As the International Monetary Fund has pointed out, this lack of credit has created acute and specific problems for the UK economy and is a significant threat to recovery. It is estimated that borrowing demand will outpace supply by £280 billion this year and £150 billion in 2010.

Different types of lender

Funding difficulties have been particularly acute for smaller players in the UK market. This has led to a further concentration of lending activity among the seven largest lenders, who can access funding. As well as markets being less willing to lend to the smaller firms, it has been harder for many of them to access the authorities’ support schemes. The Bank of England’s special liquidity scheme (SLS), for example, is not open to non-deposit takers.

There was further evidence recently of the divergence of experience for UK lenders, with some of the big players successfully re-entering wholesale markets. These are still only tentative signs of recovery in wholesale funding – the most recent securitisation issuances were backed only by prime mortgages, were attractively priced, and gave investors the security of an option to sell the asset back in seven years’ time.  New covered bonds have also been successfully issued by some large lenders.

While it has been encouraging to see this restoration of activity, it is only tentative at this stage.  It is difficult to see enough wholesale funding becoming available soon enough to re-finance the assets currently parked with the Bank of England under the SLS – due to expire in early 2011.

The same is true of other government schemes and those of the European Central Bank, which have provided assistance to UK banks. More than £300 billion of debt requires re-financing in the near term and, unless these facilities are re-scheduled, the only option is funding through the wholesale markets.   

Looking ahead, the smaller players are likely to face further constraints. Regulatory requirements will see banks and building societies having to hold considerably more liquid assets. They currently hold around £280 billion mostly in cash and gilts, and FSA wants to increase this by around one-third. At the same time, the regulator wants to reduce reliance on wholesale funding.

Crunching the numbers

	£78 billion - how much lenders raised through now barely functioning securitisation markets at their peak in 2006
	Around £100 billion - how much the FSA wants lenders to increase cash holdings, taking the total to around £380 billion
	£280 billion - the IMF's estimate of the gap between demand for borrowing in the UK and supply in 2009

Retail deposits are unlikely to fill the funding gap. There are a number of factors likely to drag on the future supply of savings. Low rates for savers may reduce the incentive to save. In any case, households may be looking to pay down debt, rather than save. And higher unemployment, and a likely fall in disposable income as taxes rise, could reduce the capacity of households to save.

In any case, retail savings are not necessarily the magic solution to funding difficulties. There is an inherent pricing and maturity mismatch between savings and mortgages. And the cost of holding retail deposits will inevitably rise with tighter regulation and a possible decline in saving by households.

The drying-up of the remortgaging market is also serving to restrict retail funding by reducing the number of redemptions of outstanding mortgages. The effect of low interest rates and tighter qualifying criteria on remortgaging business means lenders are seeing far fewer repayments of loans and a lengthening of the average mortgage term. Even when loans are redeemed, the proceeds may be required to re-pay debt, rather than recycled back into the mortgage market as new lending.

Attitudes to risk

Increased regulatory intervention also raises some fundamental questions about the role of the financial industry within the wider economy. As in other industries, there is a need for some risk. Part of the sector’s role is to manage mis-matches on balance sheets to provide credit to the wider economy. While no-one advocates unwise or excessive risk-taking, a completely risk-free system is not conducive to a dynamic and innovative economy.

Tentative recent signs of recovery in wholesale funding markets are encouraging. But questions remain about what will happen when the authorities remove the support mechanisms currently in place. As Tony Ward concluded, we need a clear plan to foster competition – and a healthily functioning market – before this can happen.