mortgage securitisation looks in great shape.Issuance soared to new heights in 2006, helped by huge new deals from UK high street banks. For the moment, that impetus for growth continues
despite higher interest rates and worries about consumer debt.But, Darius Sokolov asks, could this just be one last blow-out before Basle II rings the bell on prime RMBS?
They came late, but they came in style. Nearly 20 years after US investment banks first brought mortgage securitisation to Europe, 2006 was the year when the technique spread along the UK high street like fire, as bank after bank brought big deals.
For years the big five British banks, HBOS the notable exception, had sat twirling their fans as building societies and specialist lenders took the floor. Now only HSBC has yet to securitise its mortgages and an issue is expected before the year is out.
Rick Watson, European Securitisation Forum: "there is certainly potential for further growth"
On October 26 Lloyds TSB sold the worlds largest ever securitisation, in terms of cash bonds sold, with its inaugural issue, Arkle Master Issuer Series 2006-1.
The £7.02bn ($13bn) deal was a classic exemplar of the UK MBS master trust, first introduced by Bank of Scotland in 2000, and since refined to a fine polish with delinking technology, enabling different layers of the capital structure to be sold independently. It was sold by Citigroup and Lehman Brothers.
A pool of prime mortgages initially worth £19.75bn from Lloyds subsidiary Cheltenham & Gloucester will be used to back this and further issuance as the programme rolls out.
Within days Lloyds was joined by Barclays Bank, unveiling its Gracechurch Mortgage Financing master trust programme with a £6bn issue.
Barclays had sold a £4.5bn standalone MBS deal in December 2005, parcelling its book of non-flexible mortgages. That was its first mortgage securitisation for 12 years; a second Gracechurch master trust issue of £6bn is now being roadshowed.
Next to arrive was Alliance & Leicester with an initial £2.5bn to launch its Fosse Master Issuer programme on November 10.
The three new master trusts had been preceded in May by a big standalone issue from Royal Bank of Scotland. The £4.7bn deal, Arran Residential Mortgages Funding No 1, was the banks first mortgage backed issue since NatWest Bank, bought by RBS in 2000, had issued the £300m Lothbury Funding securitisation in 1993.
This cascade of issuance from the UK banks powered another record year in European RMBS. Total issuance reached Eu256bn, up 60% on 2005, according to figures from the European Securitisation Forum.
Outside the UK, new issues from Spains largest savings bank, Caja Madrid, as well as smaller regional and savings banks such as Banco Gallego, Caja de Ahorros y Monte de Piedad de Gipuzkoa y San Sebastián (Kutxa), Caja Laboral Popular and Caixa Penedès helped Europes second largest RMBS market grow 38% in 2006.
Even these issues were dwarfed in February and March 2007 by the first two mortgage securitisations of Eu2.5bn and Eu5bn from Banco Bilbao Vizcaya Argentaria.
The Dutch market, too, grew by 30%, propelled by issuance backed by state-guaranteed Nationale Hypotheek Garantie mortgages.
In contrast to the UK and Spain, however, there was no move from the remaining big bank
Allen Appen, Barclays
Of the five big Dutch banks with the origination volume to run master trust-style programmes only two, Fortis Bank and SNS, are mortgage securitisers. ING, ABN Amro and Rabobank keep aloof.
"A highly rated bank like Rabobank can fund at very attractive levels through senior unsecured debt," says Bjorn Alink, director, debt capital markets origination, at Rabobank in Utrecht. "While there is still a capital advantage for securitisation, the spread of around 12bp-13bp over covered bonds is considerable and makes securitisation unattractive on many banks models. Indeed, for a triple-A rated institution the spread between senior unsecured bonds and covered bonds means that there is no real need to use covered bonds to chase funding."
At Aa2/AA-, ABN Amro is not rated quite as highly as triple-A Rabobank, but it runs a large covered bond programme. ING has launched sporadic deals backed by NHG mortgages, but not since 2004.
Fortis renewed its commitment to securitisation with its master trust-like vehicle Beluga Master Issuer. But the structure is unlikely to be imitated by others, says one Dutch banker. "It was very much tailored to Fortis needs," he says.
Set for more growth in 2007
With or without the Dutch banks, European RMBS issuance should keep growing this year. Aprils output was a mere Eu6bn, but the total of Eu99bn for the first four months of the year was nearly double that for the corresponding period last year, according to research from Deutsche Bank.
"We see increasing volumes coming through and there is certainly potential for further growth," says Rick Watson, managing director of the European Securitisation Forum in London. "There are Eu5tr of outstanding mortgages in Europe today, and around 20% of that whole market is funded through a combination of securitisation and covered bonds. That compares with more than 50% of mortgages funded by securitisation in the United States."
A survey by the Forum gives a consensus prediction of total issuance for this year of Eu282bn (out of a total securitisation flow of Eu531bn).
Not quite the same acceleration as last year, but nothing to sniff at. RMBS remains far and away the biggest securitisation asset class. And though non-conforming stories often grab the headlines, prime mortgage-backed bonds still account for around 80% of the market.
Gregg Kohansky, head of UK and Irish RMBS at Fitch Ratings in London, points out that last years big entrants would not have gone to the expense of establishing master trust programmes just to sell one-off issues.
"The fact that these major banks have all launched new master trust programmes, which have relatively high set-up costs, signals their intention to come to market regularly," he says. "This year we have only seen one or two issues out of each of those programmes. But once they begin using their programmes as we expect them to, that should contribute to a steady rate of growth in the market."
Macroeconomic and credit trends are likely to have a moderating influence on RMBS growth. Both the UK and the euro zone are moving towards higher interest rates. In research published on May 1, Duetsche Bank analysts wrote that the UK MBS market was already discounting an expected 50bp rise in rates this year. The first 25bp of that came when the Bank of England raised its base rate on May 10 to 5.5%, the highest level since 2001.
Credit concerns in UK
According to a February study by Fitch Ratings, there are two main areas of concern for the UK mortgage market.
House price growth slowed in 2005 to a trough of 3.2%, as against 13.9% in 2004, or the 14 year peak of 25.3% in 2002. But growth picked up again in 2006, leading Fitchs analysts to peg the house price to earnings ratio as a high risk factor for the next three to five years.
The analysts other main concern is household indebtedness relative to earnings, which they label a medium/high risk in the medium term.
"Fundamentals such as low unemployment, strong GDP growth, lower supply than demand and improved underwriting and pricing techniques continue to support the market," concludes the report, "but UK consumers have now assumed a far more worrying level of debt, and affordability for both mortgage and unsecured debt is now very stretched. Inflation has also suddenly become a greater threat, after reaching its highest point since 1991 last month. This leaves borrowers more vulnerable to unexpected further interest rate rises."
Another talking point in the UK industry is the fear of a repeat of the troubles in the US subprime mortgage market, where defaults and delinquencies have suddenly spiked, pushing many lenders out of business.
"People are obviously looking at what has been happening in the US, there is talk of contagion," says Kohansky. "Yet the natures of the markets are quite different. There is a greater emphasis on borrower-based rather than asset-based lending in the UK; and the two markets have markedly different supply-demand asymmetries. And subprime, which is where the problems in the US have been focused, is a much larger part of the market in the US than it is here."
Market participants are also keeping an eye on the recent trend of prime lenders relaxing their criteria, for example allowing higher loan-to-value ratios.
There is a possibility this could increase, says Kohansky, as newer lenders in the highly competitive non-conforming market try to encroach on the fringes of prime territory with specialist prime products such as high value mortgages or loans to borrowers with clean but short credit histories.
That might prompt the mainstream lenders to relax their criteria further, to protect their market share.
These same trends of higher personal gearing, banks relaxing their criteria, and the risk of higher interest rates are playing out across Europe.
But they have been felt most acutely in Spain, where the housing market has been hottest and potentially most explosive.
Spains property boom there are some who would use the word bubble has pushed house prices up 270% in 10 years. This inflation has kept up despite incredible supply growth 800,000 new homes were built last year.
When the chairman of Valencian property company Astroc was reported to have been buying his own firms properties the stockmarket jumped clear and the its shares collapsed by 60% in six days. The crash spread from construction stocks to hit mortgage banks as well.
But securitisation professionals are unperturbed. Juan Garcia, a structured finance analyst at Fitch Ratings in Madrid, says deceleration in the housing market has not yet filtered through into MBS.
"Over the last year the market has been characterised by increasing LTVs of the underlying mortgages," he says, "as house prices continue to increase. There is considerable competition between banks to make mortgages more affordable. As the traditional house price to income measure widens, delinquency rates might begin to increase slightly, but they are still very low compared to other countries."
Basle II: the big threat
Market participants, then, are cautiously optimistic about the credit outlook for European RMBS,and in the short term, expect more temperate but stable growth.
Looking a little further ahead, a considerably more serious threat to the RMBS market than LTVs or interest rates lies on the horizon.
In 2010 the Basle II capital accord comes into force.
From the issuers perspective, the basic change wrought by Basle II is that the risk weighting for mortgages held on balance sheet declines from 50% under the old Basle I regime to 35% in the standardised approach, and perhaps much less for banks adopting the Internal Ratings-Based (IRB) approach. The risk weights for advanced IRB banks could range from 20% down to as low as 10% in some cases.
"From 2010 the capital benefits of securitising residential mortgages will be much diminished for IRB banks," says Allen Appen, head of financial institutions securitisation at Barclays Capital in London. "As all the implications of Basle II come to be fully appreciated it may be that there are still some niche areas where mortgage securitisation brings efficient capital relief. But it is likely that securitisation will be utilised primarily as a source of liquidity and funding from 2010 onward."
This means that with the capital incentive gone issuers will weigh prime securitisation against alternative funding sources primarily on the basis of cost of funds.
On market spreads alone senior unsecured debt is typically the cheapest option for the highest rated banks. And for banks across the rating spectrum the swiftly developing covered bond market is calling.
The rise of covered bonds
When securitisation was first taking hold among European banks in the late 1990s, covered bonds may have seemed to some ABS zealots like an anachronism: an eighteenth century German version of securitisation that investors would soon come to discount as offering inferior bankruptcy remoteness. Furthermore, it was not tranched and offered no capital relief to the issuer.
But thanks partly to the Basle Committee, covered bonds have enjoyed a new lease of life since then.
Investors have shown a stubborn liking for covered bonds belt-and-braces offering of asset backing and an IOU from the bank.
Even though MBS can now be fashioned with bullet maturities, covered bonds still trade tighter.
First France, Luxembourg and Spain, and then almost every country in Europe has introduced or updated legislation enshrining covered bonds special status.
The mother market, Germany, refreshed its law in 2005 to allow any institution with a German banking licence not just the traditional Hypothekenbanks to issue Pfandbriefe.
And by 2006, Spain had far surpassed Germany in covered bond issuance.
In the UK, HBOS demonstrated in 2003 that there was no need for special legislation to launch a successful covered bond. Structuring techniques borrowed from MBS could be used to create a structured covered bond with the same essential property: double recourse for the investor to the mortgage collateral in the structured pool and to the issuer itself. This structured model was introduced to the Netherlands by ABN Amro in 2005.
The UK Treasury announced in June 2006 that it plans to introduce secondary legislation to convert these structured instruments into covered bonds proper, allowing UK covered bonds to move from 20% to 10% risk weightings under EU regulations. The Dutch government also plans legislation by the end of 2008."Having a specific covered bond law in the UK will have a positive effect on pricing," says Neil Sankoff, associate director, covered bond issuance, at HSBC in London, "primarily because it will give UK covered bonds the same 10% risk weighting that Pfandbriefe have. I wouldnt want to overstate it, though. UK covered bonds already trade very closely to mortgage-backed Pfandbriefe and obligations foncieres, so the effect will likely be more incremental than
Sankoff maintains that regulation will not make much difference to the quality of UK covered bonds from a structural perspective. The best UK covered bonds are already comparable to their counterparts on the continent. The issuers have very high ratings on an unsecured basis; the mortgages have to meet strict eligibility criteria to qualify for the collateral pools; and the levels of mandatory minimum over-collateralisation are in some cases several times higher than those required on the continent.
In November HSBC set up its first covered bond platform with an unusual structure. The bank initially assigned Eu15bn of mortgages to a new limited liability partnership, called HSBC Mortgages LLP, which can use its collateral either to back covered bonds issued directly by the bank or to secure MBS issuance from a separate SPV.
The first covered bond from the programme, a Eu1.5bn five year issue, was priced in November at 1bp through mid-swaps, a record tight for a UK covered bond.
Smaller institutions were also getting into covered bonds. Yorkshire Building Society sold a Eu1.5bn five year bond in October at 1 bp over mid-swaps.
"We are a single-A rated issuer on the senior unsecured side," commented Andy Caton, Yorkshires corporate development director in Bradford, of that issue, "and as the institution is growing we have got increased wholesale funding requirements. The covered bond is a way of tapping a brand new investor base and raising medium term funding at triple-A levels."
In Holland too, structured covered bonds were shown to be an option for lower rated banks when Achmea Hypotheekbank (a mortgage bank now owned by insurance group Eureko) released a triple-A structured bond in January. Achmea had brought an earlier covered bond-style secured debt issue in 2005, but only achieved an A+ rating.
Now investors were ready for the idea. To achieve triple-A, Achmeas bond gives investors more structural comfort than ABN Amros issue. Its notes allow a one year maturity extension as against ABN Amros hard bullets, and minimum overcollateralisation of 10.5% as against 8.1%.
The spread gap
Whether its 1bp through mid-swaps or 1bp over, this is pricing undreamed of in the RMBS market.
For example, a 4.5 year tranche of Lloyds TSBs debut was priced at 9bp over Libor, days before the HSBC covered bond debut.
Barclays Gracechurch Mortgage Financing sold its 5.86 year dollar paper at 10bp, and 6.53 year sterling notes at 11bp.
Purely on pricing terms, covered bonds have a strong advantage. What can RMBS offer to make up the difference?
"RMBS caters to a deeper investor base and offers more flexibility," says Kohansky at Fitch. "Issuers can issue bullet notes, similar to a covered bond; but also passthroughs and scheduled amortisation notes; and issue in a range of currencies, while covered bonds remain essentially euro-denominated."
Rick Watson points out that securitisation can get a much higher percentage of funding for your mortgage than the 60%-70% common in covered bonds.
Perhaps the biggest advantage of MBS, though, is to target a very deep investor base that can fund in super-size chunks.
"The market can absorb £6bn to £7bn of triple-A RMBS at a time," says one UK banker. "So far we havent seen anything like that in covered bonds."
This is because covered bonds reach a different, and in some senses less developed, investor base. One obvious distinction is geographical. Covered bonds typically tap a continental European market weaned on Pfandbriefe and French obligations foncières.
HSBCs euro-denominated inaugural issue, for example, went 29% to Germany and Austria, 25% to the Nordic region, 24% France, 9% the UK, 6% the Netherlands, with other Europe 4% and others 3%.
In comparison, Lloyds roadshowed Arkle across Europe and the UK and on both coasts of the US. Like most such major RMBS deals, it included tranches in sterling, dollars and euros.
Since then, securitisers have been expanding their international reach still further. HBOS issued the first European MBS tranche in Canadian dollars in an October deal from its Permanent Master Issuer programme, with other issuers quickly following suit.
At the moment this means that there is a rough border between the two markets predominantly European investors looking for sovereign-equivalent paper, against a more globalised investor base familiar with the extra analytics needed to assess RMBS collateral. Issuers looking for funding diversity will want a foot in both camps.
However, the covered bond market is spreading fast, and probably catching up with the reach of securitisation.
"Covered bonds are now being placed in Asia," says an official at one UK originator," which is potentially a huge source of demand. The foreign currency reserves that Asian central banks are sitting on represent an enormous possibility if they decide to diversify away from the dollar, and to approach triple-A covered bonds as equivalents to euro-denominated sovereign bonds."
A still greater opportunity is the opening up of a US market for covered bonds.
In September, Seattle-based bank Washington Mutual became the first US covered bond issuer with a Eu4bn structured issue.
Then, helped in part by the publicity WaMu had generated, HBOS issued a $2bn covered bond in November, and sold an unprecedented 76% of it to US investors.
The end of March then saw a second US heavyweight enter the market, as Bank of America sold a Eu4bn deal, announcing a programme worth Eu30bn.
"The announcement from Bank of America could be the tipping point people have been waiting for," says the UK issuing official. "If it demonstrates that there is a true domestic US market for covered bonds, that would lead to a great increase in liquidity in the global market. A US covered bond market would be truly revolutionary, and it could be happening a lot sooner than anyone had expected."
Spain: happy coexistence
In this context, the Spanish banks rush to issue more MBS is particularly notable, because it runs alongside the countrys thriving cédulas market.
Indeed, RMBS issuance has risen partly because the sheer volume of cédulas output was straining demand.
Does recent Spanish history prove that MBS and covered bonds can coexist happily together as complementary instruments?
"There was a degree of banks switching from cédulas to RMBS," says Pablo Llado, managing director, capital markets, Spain and Portugal at Calyon in Madrid. "On the one hand people saw that they had used a lot of cédulas capacity. And at the same time the spreads on RMBS had become more attractive."
Three years ago, five year Spanish RMBS traded at around 25bp over Euribor, according to Llado, with comparable cédulas at 5bp-7bp over. Those spreads are now typically 12bp-plus for securitisation and 2bp for cédulas.
But in its turn the securitisation push threatened to stretch demand for that product, with spreads widening to 15bp above Euribor, their highest levels for the last two or three years.
At the same time, investors jitters about the Spanish housing market also cooled appetite for securitisation, as some buyers worried about the quality of some of the new deals.
RMBS cope with higher LTVs
The rising loan-to-value ratios of Spanish mortgages have influenced the shape of recent transactions.
Spanish covered bond regulation limits the LTVs on loans in cédulas pools to 80%, so lenders have turned to securitisation to fund mortgages with higher gearings.
For example, BBVAs two giant deals funded mortgages with LTVs of over 80%.
BBVAs name did a lot to assuage any investor doubts about those LTV levels. But investors may become more selective with such high volumes on offer.
"The market is more cautious now than it was in January," says Ignacio Sastriques, head of funding at Bancaja in Valencia. "Investors are starting to really check the credentials underlying transactions, and will start to differentiate between deals backed by high quality collateral and those with lower quality collateral, such as high LTV transactions."
That would be in Bancajas interest, as a bank that uses securitisation as its primary funding tool, rather than to supplement cédulas. Bancaja is a long time securitisation issuer it does not currently have a cédulas programme and briefly held the Spanish MBS record with its February Eu2.6bn issue. But Sastriques says he isnt worried about oversupply in the market.
"Volumes have increased very rapidly," he says, "but we think the market can take these levels, which are due to continuing growth in the economy and the underlying mortgage market. One common development this year has been that large issuers like ourselves and BBVA have preplaced sizeable parts of our issuance."
But with Basle II approaching, how long can this Spanish boom continue?
"There will be a decline in RMBS under Basle II," says Llado, "in Spain as elsewhere. We may have seen the peak of the market in the last year, as the housing market begins to decelerate and banks turn to securitise other assets such as consumer loans. Not in the next year, but perhaps in two years time we will start to see the effect of Basle II."
The closing window
Some cite the recent vigorous activity in RMBS as proof that the market will endure.
But there is another interpretation, in which the debutants were arriving just in time for one last waltz.
"Inevitably a range of factors account for the material increase in UK RMBS issuance in 2006," says Allen Appen at Barclays Capital. "Primary among these was a realisation on the part of many highly rated banks that transactions completed in 2006 would remain capital efficient until 2010, given the functioning of Basle II implementation floors, at which time the window for securitisation as a capital relief instrument would effectively fully close."
Banks are still getting those capital benefits, and still finding an investor base that can give massive and liquid funding of a kind not yet available for covered bonds. But when the window closes it will come down to that spread gap. If there is still a 10bp differential between covered bonds and prime RMBS in 2010, securitisation is unlikely to prosper at least at its current levels. The hope is that MBS pricing will improve.
"The spread differential is the big question," says Rick Watson at the ESF. "I am optimistic for the future of RMBS in Europe. Prime RMBS spreads continue to be stable, and we anticipate that when Basle II is phased in through 2010 they will tighten. This is due to the fact that many of the biggest investors in MBS are advanced IRB banks, who will have reduced capital weightings for securitisation holdings under Basle II."
For bank investors, Basle II makes the relative risk weightings of securitisation tranches much more distinct. Bank investors following the IRB approach will hold 7% capital against triple-A securitised bonds less than the 10% weighting on covered bonds, and considerably less than the 50% required under Basle I.
Risk weightings will also decrease to a varying degree for notes between double-A and triple-B. The window will close most firmly on bonds rated below investment grade, where investors risk weightings go up.
Three years ahead of implementation, this trend is already emerging issuers such as HBOS and Abbey have sold transactions without paper rated below triple-A.
Views differ about whether sub-triple-A MBS will disappear altogether."The case for issuing below triple-A will depend on the originator and the asset
class," says Neil Sankoff at HSBC. "Whether its capital-efficient from a regulatory perspective will come down to the risk weighting of the assets on balance sheet, the originators own cost of capital and the strength of market demand at the attachment point where capital is actually released."
As these forces play out, the market will move towards a new equilibrium. Supply will almost certainly decrease as the risk weightings for mortgage lenders are cut, making securitisation unattractive at current prices.
The shift in demand is perhaps less obvious: a lot depends on the interest of non-bank investors outside the Basle system in buying paper rated BBB and below.
Investors to the rescue
And for triple-A bonds? Will those spreads come in enough?
For Allen Appen, hope lies in another feature that distinguishes covered bond and MBS investors.
"International MBS investors are by and large floating rate investors," he says, "while covered bond investors generally operate under a fixed rate mandate. The former have come to rely on MBS to a large extent as a major source of liquidity for their floating rate funds. It does not seem likely that this very large group of investors will simply watch their market be absorbed by a competing market without a response."
In that picture, there will come a time when investors have to accept that they must accept RMBS at tighter spreads.
However, issuers, too, may have to look carefully at how they value securitisation and meet buyers some of the way.
"There is one basic structural difference between a covered bond and a securitisation," says one banker. "A covered bond gives investors recourse to the issuer as well as to the mortgage collateral. When everything else is stripped out, that distinction should still account for some spread differential. Investors pay more for that recourse to the issuer, and issuers need to recognise that they will get less in its absence."
Eight years after Basle II was first mooted, the fog obscuring the future of securitisation is beginning to clear.
At least in an idealised future, a market equilibrium is likely to emerge, in which the price that clears covered bonds against RMBS reflects what investors will pay for recourse to the issuer.
The real world, of course, is not a case study in an economics textbook. Real markets can move rather slowly, and the invisible hand tends to reveal itself post hoc, if at all.
In fact, say bankers, the new reality may not be fully clear even in 2010, and it may be clearer in some places than in others.
"The same issues are at play in all jurisdictions," says Appen, "although related changes in issuer behaviour may occur more slowly than is likely to be the case in the UK. In the UK, most banks will adopt the advanced IRB approach from the outset of Basle II. In countries where a number of mortgage lenders may, at least initially, adopt the standardised approach, the relatively higher risk weightings applicable to residential mortgages, relative to IRB weightings, may mean that securitisation retains some utility as a capital management tool."
So the debate on the future of prime RMBS is likely to continue for some time yet. Meanwhile, the issuance party keeps on swinging.