Funding - the future is certain, just give us time to work it out!
Published: 13 August 2013 | Author: Bernard Clarke
While the talking heads continue to debate prospects in the eurozone and the global economy that affect UK lenders' funding outlook, it has become a little easier to look backwards at least and make sense of funding market conditions over the last 18 months.
Broadly it's been good news - and better than we expected. In this article, we take a layman's look at prevailing and recent conditions in the mortgage funding markets. Overall, despite continuing capital pressure, we conclude that other factors (such as demand, and conduct of business regulation) may be more significant influences than funding on the flow of mortgage lending.
How is mortgage lending funded?
UK mortgage lenders raise the funds to lend out on mortgages through a mix of borrowing from retail depositors and wholesale funding markets.
Retail funding - that is, the money deposited in savings accounts with banks and building societies - has increased by nearly 6% over the past year. According to the Bank of England bank liabilities survey, a net balance of over a third of the banking industry said that the volume of retail funding had increased in the second quarter of the year, while a similar net proportion said that other funding had declined. This continues the trend seen in previous quarters.
Aside from retail deposits, lenders can also obtain equity funding (where the investors gets a share in the business and its future profits in return for their equity stake) and debt funding (where the investor simply gets a cash return or "coupon") from corporate investors. Like all sources of funding, cost is a key issue for the lender, but both equity and debt funding can be used to acquire assets (such as mortgages or corporate loans). Naturally, different types of lenders may use a different mix of funding sources.
Wholesale funding can take a number of forms:
- Senior unsecured debt. This is, effectively, when an institution borrows money that is not "secured" by underlying collateral (such as mortgages). It is "senior" because, in the event of default, it is repaid before some other forms of liabilities, such as subordinated debt. This type of borrowing is used relatively commonly by mortgage lenders to raise funds to make available for lending on mortgage. Over the past 18 months, investors in the senior unsecured market have been looking for strong credit ratings (single A or higher), with a focus on "national champions" - that is, the larger institutions within a country's financial system. UK lenders have continued to benefit from relatively strong and stable credit ratings compared with their European and US counterparts, and so have seen relatively strong appetite from investors. Combined with lenders' relatively low levels of demand for funding, not least because of the support provided by the FLS, this has resulted in cheaper borrowing costs for UK lenders, especially the larger lenders.
- Covered bonds. With this form of borrowing, the investor's return is derived from a pool of mortgages (and the interest that their holders pay to the lender), providing a "secured" form of borrowing. In addition, if for any reason the mortgages default, the investor also has additional protection because the lender issuing the covered bond promises to pay the investor the agreed coupon even if the mortgages do not perform as expected. The lender retains "ownership" of the mortgages that stand as collateral for the borrowing - and no risk arising from the performance of the mortgages passes to the investor. In the UK, the volume of covered bonds issued in 2012 was £20bn down from nearly £30bn in 2011.
- Securitisation. Unlike a covered bond, where the pool of mortgages providing the cashflow to pay the investor remains on the lender's balance sheet, securitisation involves the pool of mortgages being sold to a special purpose vehicle (SPV) which in turn issues notes to investors. The investors' returns are based purely on the performance of this pool of mortgages. With this form of funding (essentially a sale of assets), the risk that arises from the possibility of the loans defaulting passes from the lender to the investor. Securitisation markets effectively closed in the wake of the financial crisis, which revealed the complexity of some of the structures that underpinned US securitisations (although it is worth noting that no large lender prime UK mortgage securitisations ever defaulted). The market has now recovered, but investors remain primarily focused on the senior and therefore least risky (AAA tranche) of an issue. Over the past couple of months some element of investor appetite for the lower-rated (mezzanine) tranches of securitisation transactions, and for non-prime portfolios, has begun to emerge, suggesting some evolution in risk appetite may be under way among investors. However, the volume of assets securitised remains modest and well below the level of activity in the market before 2008.
Overall, conditions in all of the relevant funding markets have improved, over a series of quarters. What was different in the second quarter, however, was that total funding volumes nevertheless declined, rather than rose, and lender sentiment suggested that this would continue in the third quarter. However, this does not seem to be as a result of any particular difficulty for the lending industry in aggregate to access funds, and is more likely to be a reflection of lack of demand and the continuing pressure to shrink the balance sheet of lenders and focus on core activities.
What are the main current issues?
After the financial crisis, funding remained a problem for a considerable time, and throughout 2011. Not only was it difficult for lenders to raise the volume of funding that they required, on reasonable terms (one of the reasons why deposit rates were relatively high, despite the low level of UK interest rates set as part of monetary policy), but it was also imperative for lenders to increase the levels of capital and liquidity that they held.
Capital - which is essentially the "rainy day" fund set aside to cover and absorb potential losses that lenders might incur from running their business - saw a step change in terms of regulators' requirements. This remains the case - the Bank of England's liabilities survey asks lenders which factors have had an influence on increased demand for capital, and in the second quarter of the year the only positive reason cited by lenders in aggregate was regulatory drivers. Other potential reasons - such as changes in the economic outlook, in the riskiness of assets, in strategic decisions to increase risk, or changes in the size of the balance sheet, had not influenced lenders' capital position. The way in which most institutions have bolstered their capital has been through balance sheet shrinkage - including selling off non-core businesses - and also through capital generated in the process of buybacks of existing liabilities (for example, Santander recently announced a tender offer for some outstanding subordinated bonds). Of course, banks also have the potential to raise capital via the markets (either debt or equity or both) as Barclays has indicated it will do during 2013.
Liquidity - which is essentially the amount of money invested in short-term holdings that lenders can access quickly and convert to cash if they need to, to ensure they don't face cashflow problems in the course of running their business - also saw a similar step change. Over the year, we saw the ability of lenders to access liquidity increased by a number of Government initiatives, whether the operation of the discount window facility, access to long term repo facilities or the funding for lending scheme (FLS).
The combined effect was that lenders were constrained from undertaking as much mortgage lending as they might otherwise have done. Mortgages are long-term (illiquid) assets, so do not help lenders to improve their liquidity levels. And high loan-to-value – or other higher risk – mortgages require significant amounts of capital to be set aside in case of default - perhaps as much as four to seven times as much capital against a 90% mortgage as against a 60% mortgage of the same value - thus forcing lenders to make difficult choices about where to focus their limited lending capacity, at the same time as being required to bolster their overall capital holdings significantly.
However, during 2012 conditions began to improve, with significant support and a positive effect on sentiment created by the FLS. Lenders also began to complete their necessary balance sheet restructuring, and access to wholesale markets improved (for those lenders with an attractive credit rating). These more positive conditions have continued through the first six months of 2013.
Capital remains a challenge for lenders - and the Prudential Regulatory Authority's unexpected early introduction of the 3% equity/assets leverage ratio exacerbates this challenge for some lenders, and could potentially limit their ability to continue to grow their balance sheets. But, overall, the lending industry now faces far fewer constraints on its ability to lend arising from funding-related issues than it did even a year ago.
What do more positive funding conditions mean for the mortgage market?
Overall, one of the main effects is that the relative cost of mortgage borrowing for households has improved. The Bank of England Credit Conditions Survey for the second quarter of 2013 showed a significant net balance of lenders, for the third consecutive quarter, reporting that spreads (that is, the differential over Bank rate for variable mortgages, and the differential over the relevant swap rate for fixed-rate mortgages) had reduced.
Chart 1: mortgage spreads
The fact that lenders now have wider access to more diverse funding sources is therefore good news for mortgage borrowers. It will naturally be less welcome to savers, who have seen the rates paid on deposits fall, as competition among lenders to raise funds from these sources has diminished, even as lending volumes have risen. One effect has been to concentrate retail deposits at relatively short maturities - either instant access, or for fixed periods but generally less than two years, reflecting savers' reluctance to lock in to longer maturities at prevailing rates. This is interesting at a time when more mortgage business is being written at fixed rates - if unchecked, the phenomenon of "borrowing short, lending long" could be a concern. But of course the situation will not be allowed to go unchecked by regulators - and, in practice, the ability to access longer-dated funds via the FLS (to which 41 lenders have signed up) helps to mitigate the mismatch.
What does the future hold?
From being a major reason for the lack of balance sheet growth in 2011, the spectre of lack of liquidity causing another liquidity crunch has receded. Looking ahead, the conditions that have been prevailing over the past year should continue and, in the absence of shocks, should allow lenders to meet anticipated mortgage demand.
Having said that, wider economic concerns - in particular weak growth in the UK and the euro-zone - continue to over-shadow funding markets, and could prove destabilising. Volatility in the markets may also lead to temporary disruption. The suggestion that the Federal Reserve may end quantitative easing in the US was enough to send the market lower and restrict the ability of lenders to access the wholesale markets.
Aside from this risk, the debate about and future direction of UK monetary policy - aka "when will interest rates rise?" - may begin to change the mood music, particularly in the light of last week’s introduction by the Bank of England of its new forward guidance. However, any effects of the general funding position of UK mortgage lenders may only become clearer over time.