Published: 4 September 2012 | Author: Bernard Clarke
Talk to anyone in the pub about mortgages, and most people have always had a view. Talk to them about mortgage funding, and it used to be blank faces all round. But the world has changed. These days, far more people have heard of securitisation, if not of other sources of wholesale funding such as covered bonds. They might not be able to define it, but plenty have heard enough in the wake of the financial crisis to express the view that it’s "a bad thing" – a view that seemed to be reflected among the authorities for a while, although that is now easing.
There isn’t a great deal of it happening, in any case. Investors who previously had a voracious securitisation habit went cold turkey in 2008, and have so far regained little of their previous appetite for mortgage-backed securities. After an optimistic start in the first quarter of 2012, when the wholesale markets, including securitisations, began to show encouraging signs of life, the renewed Eurozone crisis saw markets battening down the hatches again in the second quarter, and at the time of writing wholesale markets remain stubbornly stuck in the doldrums.
Retail Rules OK?
This, together with the wider problems in the interbank lending markets, has meant that many financial institutions - whether by accident or design - have been increasingly funding mortgages to a very large extent through retail deposits, a trend we have witnessed for several years now. And although savers themselves might not see it this way, this means that savers are currently able to get an inflation-busting good deal. They are currently able to obtain term deposit rates of over 3% - not bad, with the Bank of England rate at 0.5% and inflation running at 2.6%. With retail savings the main game in town for funding mortgages, competition for savings is strong, and shows no sign of abating.
But is this a healthy funding market for mortgages? Retail savings may be politically popular and seen as less risky than fickle institutional investment and wholesale funding, but is this perception accurate?
Why we need mixed funding
We would argue that there are good reasons why the mortgage market needs a wider funding base than retail savings alone. There are several reasons for this:
- The "putting all your eggs in one basket" argument. While retail savings may be the flavour of the month now, they are not immune from external influences. There have been plenty of examples in recent years when building societies, for example, have suffered outflows due to particularly aggressive rates on offer from National Savings products. In this situation, lenders risk having to pay savers such high rates that their mortgage rates become uncompetitive, or risk a shortfall in their funding needs as savers choose other more lucrative homes for their cash. We have also seen that at times of crisis, retail funding is not as stable and "sticky" as some people thought.
- The "borrowing short and lending long" argument. In an ideal world, lenders would match the term of their borrowing to the term of their lending. This would give them a perfect – and perfectly foreseeable – knowledge of what their rate of return would be over the full life of the loan. In reality, life is a lot less perfect than this. While a mortgage may be notionally a 25-year contract, in reality many mortgages will last nowhere near this long, as people choose to remortgage. Similarly, few savers would be prepared to tie up their savings for such long periods. This is also true in the wholesale funding markets. However, securitisation is one example of how lenders can offset the risk of mismatches between funding and lending maturities – when priced properly and undertaken transparently, it can significantly reduce the risk of lenders having to price in a generous margin to the consumer to offset the balance sheet risks of mismatched (or unknown) funding and lending maturities.
- The "market size" argument. The general consensus is that retail savings are insufficient to fund lending requirements, even in the current environment where consumers are cautious, lenders are risk averse, and lending is relatively subdued. If and when consumer confidence increases and lending appetite becomes more liberal, the "funding gap" would become even more obvious and could act as a significant constraint on legitimate lending and borrowing aspirations.
- The "price" argument. From the consumer’s perspective, the source of the funding is likely to be of less interest than the price that it results in them paying on their mortgage. Too much concentration on a single source of funds – for example, retail savings – may increase competition among lenders for that funding, and ultimately result in a higher price being charged to mortgage borrowers than would apply if lenders could pick and mix their funding from a variety of sources. It is likely to be in the consumer interest for lenders to have access to different funding channels that can compete on price.
So, the CML’s preference would be for a mixed funding environment, where retail savings probably form a majority of the lending industry’s aggregate funding base, but where a significant minority contribution is obtained from the wholesale markets, and where covered bonds and securitisation have a role to play too. While most lenders would wish to use a mix of funding, depending on their institutional type and the type of lending they wish to undertake, some may have a single funding channel and, for those that are not systemically important, this seems entirely reasonable – as long as they are able to match their lending and funding profile appropriately.
Does Funding for Lending help?
While the new Funding for Lending Scheme (FLS) – which enables lenders to access cheap funds from the Bank of England, at rates that get more attractive the more they increase their net lending – is a useful stopgap, it is already suffering from expectations that are too high about what it can deliver. Yes, it is cheap – but institutions can only use it to refinance 5% of their overall balance sheet in the first instance, plus any additional net lending that they undertake. So it is by no means a wholesale substitute for existing funding lines, as some commentators so far seem to be forgetting! That is not to undermine its usefulness, however – it should provide significant comfort to those lenders who are able to use it and should, other things being equal, exert downward pressure on mortgage pricing relative to what would otherwise have occurred. Furthermore, the FLS has also a limited life and can only be seen as a stop-gap solution. Ultimately firms will need the wholesale markets to provide the balance of funding for mortgage books.
A sustainable future
The biggest issue, in practical terms, is how the lending market can actually achieve a sustainable source of mixed funding for the long term. As the financial crisis showed us, markets can react extremely quickly. In 2008, the wholesale markets closed very suddenly, and lenders found themselves unable to rely on a funding channel that they had assumed would be available to them in perpetuity. Given the need to repay loans and refinance them regularly (and this is a feature of the retail savings market too, as some consumers withdraw their cash while others invest it, every single day), this caused lenders significant problems. The inability to refinance borrowing, rather than any fundamental deficiency in the majority of the underlying lending quality, was the trigger of the problems that Northern Rock experienced that forced its abrupt State rescue, and that subsequently fanned the flames of the financial crisis.
Lenders need to be able to rely on sustainable funding channels, and this is a significant challenge. Given that there is no single funding channel that can be seen as 100% reliable and guaranteed to be available for future business, this is another good reason why we favour a mixed funding model.