What do you do with a problem like encumbrance?

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What do you do with a problem like encumbrance?

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Mortgage funding is being squeezed by a pincer movement of covered bond encumbrance and overzealous ABS regulation. But what about whole loan sales? They offer a viable alternative to covered bonds and securitisation — and one that looks increasingly attractive.

It's easy to see why tying up balance sheet assets can be a hard habit to break. Once you start spewing out secured funding, encumbrance of the balance sheet pushes up the cost of unsecured funding as investors demand greater returns.

That makes secured funding progressively more attractive to issuers — and to investors who worry they will end up without a claim to anything if the worst happens.

This is the self-fulfilling spiral described last week by Andrew Haldane, a member of the Bank of England's financial policy committee, when he warned of an encumbrance “arms race”.

At some point, a regulator will decide that Something Must Be Done. Encumbrance ceilings are surely a matter of time, although they will have to be tailored to each institution, making them devilishly complicated.

In normal circumstances, securitisation would be the most likely alternative for funding mortgage portfolios — but these are not normal circumstances. Issuers have had to dump ABS with the European Central Bank because they have not been able to sell it. And they have not been able to sell it because regulators have stubbornly refused to take a risk-based approach to the asset class.

Under the latest Solvency II proposals for the regulation of insurers, triple-A securitisations attract a capital charge that is 10 times the charge for similarly rated covered bonds. For double-A securitisations the multiple is almost 18 times more than double-A covereds. This is in spite of tiny expected losses for outstanding EMEA ABS — just 0.8%, according to Fitch.

Insurers hold 40% of total European invested assets, making them a fairly crucial source of real money demand for ABS. That will not continue under Solvency II. And as ABS is ineligible for liquidity buffers under Basel III, regulators have also managed to choke off demand from banks — the only other major buyer of the asset class.

Enter whole loan sales, a relatively unexplored area but one that could be a lucrative opportunity for issuers and investors.

There is about £20bn of legacy prime UK mortgages sitting uncomfortably on the balance sheets of an assortment of originators. Irish Permanent has £6.5bn, AIB has £2bn, the Lehman estate has £3bn and a few French banks hold portfolios of up to £2bn.

Bank of Ireland still has a whopping £25bn, but it has been getting in on the whole loan sale act. Last week it sold £600m to Coventry Building Society, having offloaded some £1.4bn to Nationwide in December.

Over time, insurers and pension funds will be attracted too. They want long dated secure investments, of course, but many will have noticed that regulators have set the capital charge incurred on holding whole loans at a lower level than for securitisations — even though liquidity and protection are also lower.

This will mean work for others. The big lenders may well develop their own distribution networks with insurers and pension funds. But smaller originators will need third parties to help value and auction their portfolios.

For the moment, the action is likely to be centred in the UK and the Netherlands. In most other European countries, mortgage pool data isn't up to scratch. That will change in time. When it does, banks across the region could find that the whole loan market is the missing link they have been searching for.

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