Securitisation 2007: A tale of two markets
Initial fears of contagion from the US sub-prime turmoil affecting the UK non-conforming sector proved unfounded. But while some players view both markets are structurally different, others believe it is only a matter of time before the UK gets hit, like the US. Jean-Marc Poilpre reports.
European bankers are always keen to reject the term sub-prime to describe their non-conforming deals. But as in the US, banks operating in the UK have been quick to embrace a business model based on quick upfront profits and fast portfolio turnover.
In its Financial Stability Report of April this year, the Bank of England cited among various sources of vulnerability for the UK financial system the reliance of banks and other lenders on sustained market liquidity, both to allow them to distribute the risks they originate or securitise, and to allow them to adjust their portfolio and hedges in the face of movements in market prices.
"If it becomes impossible or expensive to find counterparties, financial institutions could be left holding unplanned credit risk exposures in their ‘warehouses’ awaiting distribution, or find it difficult to close out positions, as was apparent in synthetic US sub-prime mortgage markets in February," said the report.
As the Bank of England, and many other market watchers, point out, lenders may be less inclined to assess credit quality at origination if they bear little of the ultimate risk. Some investors and rating agencies are even plainer in their words: banks are ready to loosen their underwriting criteria to gain market share.
Barbara Rismondo, a senior analyst at Moody's, commented: "We see an overall relaxation in underwriting criteria. For instance, we now see buy-to-let loans to adverse credit borrowers. In the BTL sector, the rental coverage ratio is decreasing, while in other sectors, the income multiples are increasing."
This deterioration in pool quality should require higher credit enhancement. "However, Moody’s ratings are sometimes lower than the ratings from other rating agencies on the most junior tranches, so we are in some cases only retained to rate the most senior portions,” Rismondo noted.
Investors are clearly unsettled. "The situation in the UK non-conforming sector is nothing like the US sub-prime market now, but in two years' time we may well be in the same situation," one investor commented. "The US sub-prime market looked very healthy two years ago, then gradually underwriting criteria got relaxed and LTVs started to go up."
Others also see trouble ahead, but further – maybe five years – off. The key requirement for that scenario is a sharp house price correction in the UK, however according to many observers that is unlikely.
In a report titled "Lessons From the US for UK non-conforming Mortgages", S&P argued that UK borrowers were currently in a better position than US ones.
"Although stalling briefly in mid-2005, UK house price growth has since strengthened significantly. In the US on the other hand, it has been declining consistently since the end of 2004, with a sharper drop-off since the end of 2005," Andrew South, primary credit analyst at S&P wrote in the report.
The rating agency expects US average prices to be down 5% year-on-year by the end of the 2007, exacerbating potential problems from payment shock or other financial stress.
Barclays analysts expect house price inflation to remain high in the first half of 2007. "And if recent trends in fundamentals persist, real house prices should continue to rise steadily," they add. BarCap expects UK house prices to rise by 8.6% in 2007 as a whole and by 3%–4% in 2008.
Moreover, the interest environment in the UK remains more benign. US borrowers were hit by a so-called dual shock as some borrowers who had been offered deeply discounted initial interest rates were reaching the end of their discounted period at just the time when the US Federal Reserve was raising its interest rates sharply. In the UK, rate discounting has not been so large and the central bank’s rates have been less volatile in the recent past.
Bankers also draw comfort from other factors, such as that UK non-conforming lenders are not as reliant on warehouse lines as their US counterparts, so a liquidity crisis is much less likely.
"In the UK, most non-conforming lenders are now part of investment banks. Some five years ago, several of them needed warehouse lines, but this is not the case any more," said Jeff Stolz, managing director and head of Deutsche Bank's securitised products group.
Most UK players are also targeting a different market segment. "The UK non-conforming market is predominantly an Alt A market right now, rather than a sub-prime market. The large majority of the loans are buy-to-let and self-certified, and the majority of these loans don't have a CCJ," said DB's Stolz.
This could change if lenders were to loosen their underwriting criteria and bring riskier products, but Stolz does not see that happening now.
"The example of the US sub-prime sector suggests that a dramatic relaxation of underwriting criteria over here is unlikely," he said, noting that historically, European lenders have been more conservative and risk-adverse than their US counterparts.
In its comparative analysis of the US and the UK S&P emphasised that loan characteristics were quite different either side of the Atlantic. "UK non-conforming borrowers are probably better credit prospects than their US sub-prime counterparts," S&P's South said. "[This is] partly because the UK sector is usually defined to include 'near-prime' loans made to borrowers toward the top of the credit quality spectrum, while loan products in the more mature US market have instead extended further down that spectrum."
And besides lending to more heavily adverse borrowers, US lenders typically grant loans with higher LTVs. "Based on LTV ratios alone, recent US sub-prime lending has been riskier than UK non-conforming. Loans originated in 2006 had an average combined LTV ratio of 85% in the US, compared with only 76% in the UK," South noted.
He also stressed that in the 2006 vintage, more than 70% of US sub-prime loans had an LTV ratio greater than 80%, compared with only 54% of UK non-conforming loans. Piggyback loans (where borrowers are offered a first mortgage with an 80% LTV ratio and simultaneously a second loan for the remaining 20% of the property's value) accounted for 29% of 2006 US lending. But almost no loans in the UK non-conforming sector had an LTV ratio of 100%.
For loans securitised in 2006, S&P estimates that the average assessments of likely cumulative losses in a so-called "BBB economic environment" are 9.8% for US sub-prime loans, compared with only 3.0% for UK non-conforming loans (see table).
Moody's agrees that a combination of factors in the US led to the current sub-prime market turmoil.
"We may never see some of those factors in the UK," said Kruti Muni, a senior analyst at the agency, but added that her agency was mindful of other problems. One of these is "risk-layering", whereby a borrower with adverse credit can obtain a high LTV or cumulative LTV loan with little or no income documentation. According to Muni, Moody's constantly reviews originators' practices and tracks any changes in their underwriting procedures that might increase risk within each securitisation.
Most banks see themselves as "near-prime" players, and the quest for a suitable euphemism is an amusement to investors. In fact, the term "sub-prime" has effectively been banned from the European RMBS vocabulary, and "non-conforming" is also under threat, with most transactions being described as "near-prime". Lehman likes to use the term "niche-prime", while Merrill Lynch has brought "near-prime plus" deals.
Amid this confusing terminology, the rating agencies have tried to bring some clarity by setting out the criteria to define a near-prime borrower. It is still too early to say whether European bankers are right, but until now the UK non-conforming sector has remained extremely stable and resilient. The only indications of concerns have come in the form of reserve-fund draws.
In the past three years, several Residential Mortgage Securities transactions drew their reserves (they were issues number 15, 16 and 17); Bear Stearns' Farringdon Mortgages 1 and 2 as well as some of Lehman's SPS deals, most recently SPS 2005-2, in March.
As Citi analysts noted in a report, all these transactions had a common feature
– detachable coupons that depress excess spread. But these DACs are on the way out; only Kensington and HVB's Bluestone seem to be sticking to these coupons.
Bear Stearns also chose not to include DAC and MERCs in its Mansard programme, a revamped and improved version of Farringdon.
"We are always looking for the best execution, and we are mindful of what rating agencies and investors say," said Fred Khedouri, head of European residential mortgage and consumer loan origination at Bear. He noted that feedback about the new structures from even Triple A investors – in theory very unlikely to be affected by these coupons and certificates – was positive.
However theoretically robust these non-conforming RMBS structures may be, the success of a transaction ultimately lays with investors.
Until the beginning of May, investor unease was only reflected in the CDS market, while cash prices remained stable. But following the pricing of ResLoC, Morgan Stanley's inaugural NC RMBS deal, the synthetic market pushed the cash market wider. As a result, the second issuer in the market (Alba 2007-1), had no their choice than accept the new floor set for Triple Bs by ResLoC.
The real lesson from the US sub-prime turmoil is that when the market gets nervous, investors favour transactions with a clear track record over structure, however clever.