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Sunday is a terrible day for withdrawing money from the cash machine. With no staff working to refill the ATMs after the Saturday party crowd, any visit to the cash machine is invariably unsuccessful. But I am always confident that this is only a temporary “liquidity crisis,” and I will have full access to my “assets” come Monday morning. Many British mortgage lenders are probably wishing the same could be said for their “cash machine,” the European securitisation market.

The Freeze
The European securitisation market shuddered to a halt in August. Total issuance fell from €50 bn a month up until July to a paltry €15 bn after August. I don’t want to dwell on why this happened—the deepening US sub-prime problems, mortgage asset write-downs, a collapse in investors’ risk and liquidity appetite, and a loss of funding for key buyers like asset-back commercial paper (ABCP) conduits, structured investment vehicles (SIVs) and banks—these topics have been well documented elsewhere. But why is the Euro securitised market relevant to the UK?

Residential mortgage-backed securities (RMBS) accounted for over 50% of Euro asset-backed issuance, and the UK accounted for about 50% of total Euro RMBS issuance.  In short, the Euro securitisation market has been crucial in making credit cheaper and easier to obtain for UK households. That’s why the post-August turmoil in these markets is so important to the British economy.

My last Perspectives in September highlighted how economic growth was set to slow in the UK due to the lags of restrictive monetary policy. Since September, weaker housing and business survey data has confirmed that growth is slowing sharply enough to elicit a cut in rates from the Monetary Policy Committee (MPC) of the Bank of England (BoE). The market anticipates further interest rate cuts, with two- and five-year government and interest rate swap rates trading below base rates of the BoE.

But it is important to distinguish between this “risk-free” interest rate and the actual cost of credit. Lower base interest rates only work if they lower the cost of credit for the people that matter: consumers and businesses. And the turmoil in wholesale credit markets, particularly the freezing up in the securitisation market, has tightened credit conditions rather than eased them. To offset this tightening, the MPC will likely have to cut rates to well below their historical neutral range.

The British ATM: The Euro Securitisation Market
Chart 1 shows total UK RMBS¹ issuance on a 12-month rolling basis broken down by type: prime, non-conforming & buy-to-let. Issuance has exploded since 2006 as new issuers came to the market; with some of the prime RMBS pools containing 30-50% buy-to-let mortgage loans.

The growth of the non-conforming and buy-to-let RMBS segments has been especially important for widening the availability of credit in the UK by increasing the funding base for specialist mortgage lenders who have no access to retail deposits. The data in chart 1 shows that specialist mortgage lenders have been the marginal mortgage lender over the past few years. According to the BoE they have tripled the value of annual net mortgage lending and increased their market share of mortgage approvals for house purchase from 5% to 22% since 2001. Much of this specialist mortgage lending has been in buy-to-let mortgages which, according to the Council of Mortgage Lenders, accounted for 10% of outstanding mortgages in the third quarter of 2007, up from 2% in 2001. To give an idea of how the RMBS market facilitated this lending expansion it is worth noting that between 2001 and 2007 annual non-conforming and buy-to-let RMBS rose 500% with total issuance of almost £100 bn. This is equivalent to one third of specialist mortgage lenders’ net mortgage lending over the same period. 

Supply of Credit Falls And The Price Goes Up
But this securitisation cash machine has broken down. Non-conforming UK RMBS issuance totalled €2.4 bn since August, down 80% on comparable 2006 levels. The lack of credit has already fed through to the High Street. The Council of Mortgage Lenders reported that gross mortgage lending fell 8% in November, the first monthly fall since July 2005. A Moneyfacts.co.uk survey showed that the number of adverse credit mortgage products on offer had fallen 54% in the three months to October. A whole range of lenders have lowered maximum loan-to-value (LTV) levels, removed self-certified income mortgages and increased rental coverage requirements for buy-to-let loans. Some have withdrawn completely from the market. Kensington Finance—the UK’s first dedicated “sub-prime” lender—has “temporarily” withdrawn from the adverse credit market. Victoria Mortgages entered into administration in September while Paragon finance, the dedicated buy-to-let lender, announced it won’t be able to fund new loans beyond February. The fall in credit availability is particularly significant as we re-enter a heavy refinancing period for fixed-rate mortgages. Indeed, a few households may find that they are unable to refinance their fixed-rate mortgages and therefore move onto lenders’ punitive standard variable mortgages.

In my September issue, I also highlighted how much fixed mortgage rates have risen since 2005. But tighter credit conditions mean that borrowers have benefited little from falling interest rates since September. Chart 2 shows that the estimated funding cost² of a repackaged non-conforming mortgage loan on the RMBS market has jumped around 135 basis points (bps) to 3-month Libor + 160 bps in early January, while the cost of a prime mortgage loan has increased 70 bps to 3-month Euribor + 85 bps. These spreads may well come down in 2008 but it is unlikely that they will quickly return to the levels seen 12 months ago. The widening in the spread between the base rate and 3-month Libor rates will have also increased the cost of funding for floating rate mortgages, which tend to be priced off BoE base rates. As such it is no surprise that BoE data show that quoted fixed mortgage rates³ have increased slightly since the summer, despite a 100 bps fall in 2-year swap rates on the wholesale interest rate market.

Mortgage fees have also increased.  Moneyfacts.com reported a doubling in average arrangement fees since 2005. These tighter credit conditions will remove a key support for the consumer’s already over-valued primary asset: houses. The derivatives market currently prices an 8% decline in residential property prices in 2008. With a lower value for the consumer’s chief collateral and less willing lenders, the MPC will need to lower rates substantially if they want to materially reduce the cost of finance for consumers.

The Sucker Punch Comes From Commercial Property
The commercial property market is facing similar stress. According to the Investment Management Association, the top 32 on-shore commercial property retail investment funds generated average net monthly inflows of just under £400 million in the 12 months to July, attracted by annualised returns of 10-15%. But the lack of credit has seen the number of transactions collapse. According to the IPD, a real estate data provider, commercial property prices have fallen 8% from June to November. Investment inflows have turned to outflows, pressuring funds to sell properties to raise cash. Property funds have adopted defensive tactics, such as imposing 12-month notice periods for withdrawals and reducing retail unit prices around 8% by switching to an outflow rather than inflow pricing model. But a vicious circle of further fund withdrawals leading to forced asset sales looks likely. The derivatives market is currently pricing a 14% fall in commercial property prices in 2008.

Why does this matter from a macro perspective? Firstly, real estate accounts for around one third of business investment. So a weaker commercial property market has a direct macroeconomic impact. Secondly, real estate accounts for almost 40% of banks’ corporate lending and has been the only sector experiencing double digit annual growth over the last 12 months. Therefore, negative commercial property prices threaten to exacerbate a vicious circle by causing impairment of banks’ balance sheets and in turn reduce willingness to lend. An ongoing fall in available finance for commercial property would undermine prices further.

Can Central Bank Liquidity Injections Save The Day?
Central banks have stepped in by providing term liquidity to the banking system in return for collateral—in the BoE’s case down to AAA RMBS for a £10 bn 3-month tender. By providing term finance to banks, these measures should help to alleviate the supply-demand imbalance in wholesale inter-bank money markets and allow 3-month Libor rates to fall. Improving the functioning of the wholesale interbank market will at the margin improve the transmission mechanism between a lower base rate (risk-free interest rate) and the cost of credit (mortgage rates). But while this might make it easier for banks to finance their involuntary balance sheet expansion it will do little to address the reluctance of investors to finance Britain’s mortgage market. Unless the central banks are willing to fund the assets of the entire financial system (both bank and non-bank institutions) these measures will not in themselves solve the credit crisis. 

New Banking Regulations Offer Some Crumbs of Hope
I don’t like ending on a gloomy note so where are the chinks of light? Firstly, the introduction of Basel II in January and the UK Covered Bond Law in March 2008 might mitigate some of the credit tightening.

Under Basel II banks only need to put up 10-20% of risk capital against mortgage loans compared to 50% today. This means that a bank targeting a tier 1 ratio of 10% would now need £1-£2 of risk capital as opposed to £5 of risk capital under Basel I per £100 of mortgage loans. By lowering the regulatory capital requirements, Basel II effectively lowers the required hurdle rate for new mortgage businesses (other things equal). The only draw-back is that other things are not equal, and faced with declining rather than increasing values for property collateral, banks may choose to run with higher economic capital than prescribed by regulators.

The introduction of a UK Covered Bond Law in March may also help at the margin. Unlike with RMBS, mortgages backed by covered bonds remain on banks’ balance sheets. The issuing bank also takes the first hit on mortgage defaults and the pool of mortgage loans provides additional security in the event of the issuing bank defaulting—that’s why covered bonds yield some 60 bps less than RMBS. 

Currently, UK banks issue structured covered bonds that are not covered by legislation and are not UCITS 22(4) eligible. Regulations constrain EU banks to holding a maximum 10% of assets against any one counterparty unless the assets are UCITS eligible, in which case the limit is 25%. By making covered bonds UCITS 22(4) eligible, the UK Covered Bond Law might therefore increase demand for UK covered bonds from other European banks and in turn increase the supply of credit for UK banks. There are three draw-backs here, though. Firstly, the covered bond market is currently as shut to new UK issuance as the RMBS market. Secondly, specialist lenders will not be able to use this source of funding. Thirdly, the rules governing mortgage loans eligible for covered bonds are more restrictive than for RMBS.⁴

More Rate Cuts Are Required
Credit conditions for the whole economy can be eased by lower interest rates from the MPC. Policy is still on the restrictive side of neutral,⁵ so the MPC has plenty of room to cut. Historically, 2.25% real rates⁶ have been sufficient in this decade to restart the consumer’s animal spirits and spending, but this cycle will require lower rates to counter the market induced credit tightening. To make investing into housing attractive again, mortgage rates will need to fall below the current gross rental yield of about 5% (assuming house prices are unchanged). The market is currently expecting the BoE to end its rate cut cycle at a base rate of around 4.5%. This does not look low enough.

Myles Bradshaw
Vice President

¹ RMBS definitions: The UK equivalent of sub-prime is “adverse credit.” It is part of the “non-conforming” segment and includes people who have an impaired credit history, have been bankrupt, had country court judgements (CCJs) or Individual Voluntary Arrangements (IVAs) within the last 3 years, or had 1 month of mortgage or rental arrears within the past 12 months.  Non-conforming also includes self-certified income applications, people with no credit history, and right-to-buy (former council tenants living in social housing). A complete data set is unavailable but non-conforming is estimated to account for 5-8% of the UK mortgage market. Although dedicated buy-to-let RMBS pools exist, both prime and non-conforming RMBS may also contain some buy-to-let mortgages. For example, buy-to-let loans account for 48% of Birmingham Midshires’ Prime RMBS Trust, Pendeford.
² Using weighted issuance volumes by rating for AAA, A and BBB RMBS spreads.
³ BoE data show December weighted average quoted standard variable rates of 7.55%, 2-year fixed 75% loan-to-value (LTV) rates at 6.09%, base rate tracker 75% LTV rates at 6.23%.
⁴ For example, to qualify for UK structured covered bonds, all mortgages must have a maximum 75% LTV ratio whereas on average 35% of the UK prime RMBS mortgages have an LTV in excess of 80%. 
⁵ The November MPC minutes described a 5.75% base rate as mildly restrictive.
⁶ Real rates calculated as nominal interest rates less HICP inflation (the November HICP reading was at 2.1%).