CML news & views

Reports last week of another successful issue of mortgage-backed securities by the Lloyds Banking Group raised fresh hopes that the market is slowly continuing to re-emerge. The recent securitisation, worth £2.5 billion, is the most recent of several similar deals since last September, indicating a gradual thawing of the wholesale mortgage debt market, which froze at the onset of the credit crunch in 2007.

But while the recent deals are encouraging, progress towards the restoration of a healthy securitisation market remains slow. Meanwhile, the collapse of wholesale funding markets has left a £300 billion gap in mortgage funding. 

That gap has been filled temporarily by government funds through the special liquidity scheme (SLS) and the credit guarantee scheme (CGS). By 2014, however, both of these schemes will have expired. Hanging over the mortgage market therefore is a major uncertainty about how lenders will be able to re-finance this £300 billion over time. 

Sources of funding

The funding gap cannot be filled by retail deposits alone. The best outcome would be for funding to emerge from the restoration of a private sector wholesale debt market. But if investors are to return, they will need to feel confident that the issues left by the fallout from the financial crisis have been addressed, and that mortgage lenders and financial services markets will be profitable on a sustainable basis in the future.

Even if wholesale markets do start functioning again on the scale we saw before 2007 – which seems unlikely at this stage – there is considerable uncertainty over whether lenders would be able to re-pay government funding in full to the timetable currently envisaged for the SLS and the CGS. It is likely therefore that an extension of the period of government support will be needed.

One of the consequences of the closure of wholesale debt markets since 2007 – and the ensuing funding gap – has been a dramatic reduction in competition in the UK mortgage market. Emergency government action to fill the gap has been welcome. But government support has focused almost exclusively on larger deposit-takers, reinforcing the lack of overall competitiveness in the mortgage market.

The impact of regulation

The problem is exacerbated by the scale of proposed regulatory reform – and its impact on firms. While lenders accept the need for reform in response to the financial crisis, there is a danger that the way it is implemented will create additional problems for firms. 

The range of regulatory initiatives that we have already seen, both internationally and in the UK, risks creating a patchwork of changes that do not necessarily add up to a coherent whole, and do not create an environment in which firms can plan confidently for the future. The cumulative effect of a range of disparate measures raises the risk of a series of damaging, unintended consequences.

Like the rest of the world, the UK has been affected by a global financial crisis, but the vulnerability of bank funding structures was a specific issue in this country. Despite this, much of the regulatory reaction in the UK has focused on bank capital and liquidity, and the operation of the mortgage market. 

What UK regulators have done so far reinforces a concern that securitisation, wholesale-funded lenders and non-conforming mortgage credit are viewed essentially as problematic, largely because of experience in the US.

In the UK, however, residential mortgage-backed securities (RMBS) and wholesale-funded lenders have performed comparatively well, despite the collapse of confidence in them triggered by the onset of the global credit crunch, and a lack of support from the government. 

The need for a new approach

Unless there is a policy approach intended to encourage the development of wholesale funding, we are likely to see a long-term decline in choice for UK mortgage customers. What we need ideally is for policy-makers to identify and develop a sustainable funding model for the mortgage market of the future.

One of the most alarming features of the financial crisis was the run on Northern Rock, triggered by panic among depositors. The government has therefore been determined to reinforce consumer confidence by strengthening guarantees for retail deposits. 

But the government’s support for retail deposits, and senior unsecured bonds from banks and larger building societies – while failing to provide any meaningful assistance to the markets for RMBS and covered bonds – has distorted competition in the mortgage market, and this is affecting consumers. The playing field is now tilted in favour of firms that are funded by retail deposits and senior unsecured bonds and against those that rely on RMBS and covered bonds.

Moral hazard

Government policy is also creating a potential moral hazard. Depositors and holders of senior unsecured bonds may now feel they have less need to understand the risks associated with their actions because they are guaranteed support by the government.

Despite the government’s continuing lack of support for RMBS and covered bonds, these funding instruments have already proved their effectiveness during the financial crisis. One of their clear benefits is that they allow institutions that are not AAA-rated to issue the AAA-rated securities needed to access the SLS. 

It is difficult to reconcile the Bank of England’s negative attitude to RMBS with its demand for AAA-rated securities in exchange for loans under the SLS, given that banks can only satisfy this requirement by creating retained RMBS or covered bonds.

There is also a sharp contrast between UK policy and policy in both the US and Europe. In both of these large economic zones, there has been active support for markets in RMBS and covered bonds because it is accepted that they play a vital role. 

And with strong support for these markets in the US and Europe, the UK is in danger of losing out in competition for global investors. There is a real risk that even UK-based institutional investors will decide that it is safer to fund mortgages abroad because markets there have more tangible government support.

Conclusion

The government needs to develop and pursue a clear strategy for putting UK mortgage funding markets back on a sustainable footing. This will be an important priority after the general election. At the same time, it is important that government intervention should create the least possible market distortion. 

The government should seek to ensure that the support it offers, and the regulatory system it oversees, are much more balanced in their impact on retail deposits, senior unsecured bonds, RMBS and covered bonds and more even-handed in supporting different types of financial institution – whether they are banks, building societies and non-deposit taking lenders.

We believe that to develop and implement a clear strategy to revive UK funding markets, the Treasury should launch a collaborative exercise, drawing on industry knowledge in an expert group. With the SLS and CGS due to end in the next few years, the Treasury has a strong incentive to show that there is a robust, long-term solution to replace them. 

Without policy support, it may be difficult to re-establish a sustainable, long-term RMBS and covered bond market in the UK on the scale needed to plug the funding gap. That would leave firms continuing to rely on government funding, and the UK at risk of a chronic under-supply of credit – and the rationing of mortgages for customers – for many years to come.