Real Estate Finance: More risks, fewer rewards
Lehman Brothers, and to a lesser extent Merrill Lynch, stole a march on other investment banks by originating their own non-conforming European RMBS product. Morgan Stanley, Deutsche Bank and JPMorgan have followed them, but at a time when the sector has lost some of its lustre and investors see more the risks than the rewards, are they right? Jean-Marc Poilpre reports.
The trendsetter in the UK non-conforming (NC) RMBS sector has undoubtedly been Lehman Brothers. Its ownership of three originators – Southern Pacific Mortgages, Preferred Mortgages and the London Mortgage Company – provides the firm with extraordinary origination and securitisation capabilities. To date Lehman's three UK mortgage companies have securitised about £15bn of loans in 39 transactions.
Despite its dominant position, Lehman has worked to secure fresh origination capabilities by sealing partnerships with Northern Rock and Alliance & Leicester, which both now originate non-conforming and near prime loans on its behalf. It is also active in the whole loan market, and the firm is poised to bring its first Dutch non-conforming deal this year.
Merrill Lynch has followed a similar model. It controls two mortgage originators in the UK –Mortgages Plc (2004) and Freedom Funding Ltd (2006) – whose loans are securitised via the Newgate platform and Ludgate Funding programme, respectively. And at the beginning of this year Merrill and Irish Life & Permanent Plc formed a joint venture for the origination of specialist residential mortgage loans in the Republic of Ireland.
Inspired by these leaders, other investment banks have decided to enter the market through origination and/or via the purchase of whole loans. Some banks are aggressively looking to gain market share and seem ready to sacrifice profitability for the sake of volume. The pressure to churn out mortgages is the strongest when the bank is the originator, but the whole loan market is also a major battleground.
"Competition in the whole loan market is stiff as some players are trying to gain market share and underbid the other banks," said Cecile Houlot, managing director at JPMorgan, responsible for Northern European FIG securitised products.
Analysts find it unlikely that all the participants will meet their lending targets for 2007 and 2008. Fitch senior director and head of UK RMBS, Gregg Kohansky, cautions that many new lenders have ambitious growth plans, and: "There is a risk that, in order to achieve such targets, these lenders will attract business by diluting lending criteria".
There is another argument in favour of investment banks' acquisition of mortgage originators, that by merging with banks, independent lenders can reduce their cost of funding as they no longer need warehousing facilities or certain credit lines.
The business model on both sides of the Atlantic is based on fast portfolio turnover, via EMTN issuance, which means fees are registered in quick measure while little risk is left on the banks' books. The creditworthiness of borrowers (and old-fashioned client relations) are rather less important.
The weak point in this scenario is if the banks find themselves getting squeezed. In the US, investment banks have found themselves warehousing large volumes of sub-prime loans, then suffering losses as the loans become delinquent or default before the banks could transfer the risk to investors.
New wave entrants
Let's look at the new entrants. Deutsche Bank's Eurohome, one of the latest entrants to the European NC market, could soon become the largest issuer. DB expects to issue three to four UK-backed deals and the same number of Continental European deals annually when the programme reaches full steam. The UK loans are originated by the bank's db mortgages unit, the European ones by its retail network.
JPMorgan is following a different route. Last year it established Great Hall Mortgages, a proprietary securitisation programme for non-conforming mortgages acquired in the UK whole-loan market. Its first two transactions securitised loans originated by Britannia unit Platform Funding Ltd.
"JPMorgan decided to form a partnership with Britannia to gain exposure to the non-conforming sector as principal, rather than solely through agency work. JPMorgan has a long-standing relation with Britannia via the Leek programme and was comfortable with its origination policy, its products and pricing," said JPM's Houleau.
JPM does not cherry pick loans from Britannia's portfolio, retaining only the best. "We purchase and securitise a cross-section of their portfolio, which represents Britannia's origination," said Houleau.
Relations between the two groups go beyond the transfer of loans. A subsidiary of Britannia – WMS – services Great Hall Mortgages' securitised portfolios. Britannia also participates in GHM's roadshows.
Morgan Stanley, another new entrant, brought its inaugural UK deal in April. Some of the loans securitised had been originated by its Advantage unit, and others were purchased from independent originators (Amber, GMAC and Victoria Mortgage Funding).
Morgan Stanley has been trying for a few years to build a global, vertically-integrated residential mortgage business. In December 2005 it acquired Advantage Home Loans, a mortgage packager, and is reportedly one of the bidders for Kensington Mortgages, a pioneer in the UK non-conforming sector that has been finding it increasingly difficult to operate outside a banking group.
But Bank of America's plans remain less clear. A source at BofA said earlier this year that the firm, which had hired senior bankers from Bear Stearns, was not looking to follow exactly the same route as Bear, and would not necessarily get involved in origination. The same source stressed that other approaches to the non-conforming sector were possible, such as the purchase of loans from NC originators or teaming up with other players.
Safe as houses
On paper, the most recent European NC transactions look quite safe, with often less aggressive structures than a few months or years ago and strong positioning in the near-prime segment. But some vintages are more at risk. Lehman Brothers analysts warned that vintages from late 2005 and early 2006 would see sharp increases in defaults, mainly as a result of a rate shock.
A research report by analyst William Howard Davies of Merrill Lynch compared the average pool quality of UK non-conforming transactions launched in 2006 and the first quarter of 2007 with the average of the 2002-2005 vintages. He suggested that underwriting standards in the UK NC mortgage market had not slipped.
The report showed a general shift within the NC sector towards near prime, with correspondingly higher WA current LTVs (LTV limits imposed by lenders are higher for near-prime mortgages than for heavy adverse or unlimited adverse loans) and a 7% fall in loans to borrowers with Country Court Judgements. The combination of better credit quality and higher LTVs offsets somewhat, hence the weighted-average foreclosure frequencies (as calculated by Fitch) have remained relatively constant, with the exception of a clear improvement in the case of Bear's Mansard. (See table.)
JPMorgan clearly looks at the upper bracket within this market. Houleau notes that the Great Hall programme could in theory securitise loans originated by any player and of any quality. However, "The GHM programme has now a well-established brand associated with the high end of the non-conforming market, similar to Leek, and we obviously want to preserve that strong positioning."
Bear Stearns prefers to describe itself as a "non-prime" player in Europe. Its Mansard programme securitises loans originated by its Rooftop unit. The firm is also active in the wholesale market, but those loans, if securitised, would not be included in Mansard. According to Fitch, 30.47% of the loans in Mansard 2007-1's pool were near prime, compared with none in Mansard 2006-1 and Farringdon Mortgages 2.
"Our first two Mansard transactions had under 10% heavy adverse loans, which is a reflection of our origination, which has moved towards near prime and away from heavy adverse borrowers rather than a conscious decision to remove them from our securitisations," said Martin Migliara, head of financial analysis and structured transactions at Bear Stearns.
"Our programme is market-oriented, and we offer an array of products across the credit curve. We do not deliberately focus on any single product and do not manage the Mansard pool in that way. But we do take advantage of the option to sell whole loan portfolios if we can achieve better execution that way for certain product types," said Bear Stearns' Khedouri, head of European residential mortgage and consumer loan origination.
Although a few investors believe that it is only a matter of time before the European NC market is hit in the same way as the US, many market participants are convinced that Europe is fully shielded from a systemic crisis.
"There are no signs currently that liquidity will dry out in Europe," said JPM's Houleau. "Fundamentals in Europe are different, and arrears levels remain good for high quality mortgage portfolios. There has been talk for years of a possible housing crash or a crash in the mortgage market, but nothing has happened up to now."
Lehman Brothers analysts have looked at the two markets and drawn the conclusion that the near-term risk of spreads widening in Europe on the scale of what has happened in the US is low. However, they add that after 2007 spread widening could occur if several key factors showed a deterioration.
In the short term, such relative optimism is based on significant differences between the two markets. For example, LTVs are less aggressive in the UK than in recent US home equity vintages; delinquencies in the UK have stabilised for 18 months while in the US they are still rising; and loss severities in the UK are just a fraction of what has been seen in the US.
But the sector is likely to remain on a tightrope. And as the credit cycle turns some bankers are already looking forward to the business opportunities that will arise from the expected sharp increase in credit-impaired borrowers.