The UK RMBS market has made a flying start to 2024. On all fronts spreads have tightened, activity has picked up and there are hopes for more of the same to finish the year.
It’s a stark contrast to the mood at Global ABS a year ago, when lenders were grappling with the consequences of sharp rate rises. Although rates are yet to fall materially, a more stable picture is making life easier.
“It wasn’t so much that interest rates going up was a problem, it was the volatility,” says Kevin Ingram, partner at Clifford Chance.
“The UK mortgage market for new origination is now predominantly a fixed rate market, which makes the hedging essential. The volatility made it incredibly difficult, if not impossible, to price the hedging.”
Lenders, especially specialists, have had to prove that their business models are viable through the rates cycle.
“People were very used to a low interest rate, benign environment,” says Steve Harrison, director in debt capital markets at Together. “I think now people will be a lot more focused on their interest rate risk. Lenders are in the business of making informed lending and credit decisions, not making interest rate calls.”
Rates settling down, however, is cause for optimism.
“Lending volumes have bounced off rock bottom,” says Douglas Charleston, partner and portfolio manager at TwentyFour Asset Management. “That’s better than it was. It’s still not great, but enough to keep people ticking over for now. Profitability is also ok, and there’s just about enough to go round.”
An increase in specialist lending, combined with more banks needing to come to market, means that overall issuance is starting to tick up.
“The amount of paper outstanding […] was falling last year, but recent issuance has brought it back to flat,” says Gordon Kerr, head of European research at KBRA. “It’s not quite growing yet, but we’re getting there.”
Deterioration ‘priced in’
The levelling off of rates has also brought more confidence on collateral performance, and this has been reflected in investors’ attitudes. When Belmont Green returned to the market in April to issue from its Tower Bridge Funding shelf, it found the buyside in a different place to its previous visits in January and May 2023.
“The questions we got on 23-1 and 23-2 were around payment shocks and how borrowers would adjust,” says Belmont Green treasurer Giles Parker. “That wasn’t really the flavour of the conversation on 24-2. No one thinks we’re completely out of the woods, but it feels like swap rates are on a broadly downward trajectory now.”
That’s not to say that higher rates won’t continue to affect fundamentals, but people have a better idea of what to expect.
“Most people expect there will be some choppy water from here, but I think people can grasp what the impact of that will be now,” says Alastair Bigley, sector lead for European RMBS at S&P.
Cas Bonsema, senior ABS and covered bond analyst at Rabobank, says that he is anticipating “a little more deterioration”, but that it should be quite moderate and is “priced in”.
Moreover, with the market having withstood such a volatile time, some feel that certain types of collateral deserve a better reputation.
“People have said buy-to-let is untested and might not weather a downturn as well as prime resi [does],” says Paul Wilde, treasurer at Shawbrook Bank. “I think it’s time to drop that narrative, because we have been through some severe periods and buy-to-let has proved resilient.”
The easing of investors’ worries is reflected in tighter spreads. The senior notes of Belmont Green’s Tower Bridge Funding 2023-1 landed at 150bp over Sonia in January. The equivalent tranche of the April deal this year tightened to 88bp.
“In 2022 and 2023, rates went up so quickly that investor sentiment had a sharp pullback,” Wilde says. “We seem to have seen a reversal this year. Funds seem to have a lot of money to put to work.”
That can only be good thing for lenders.
“A positive is on the funding cost side,” says Charleston. “For non-banks especially, or deals with specialist collateral, that’s a big advantage. More peripheral issuers are considering doing deals and that tells you that funding side is pretty good.”
There could also be more chances for specialists to cater to people who fall outside the criteria of banks.
“If anything, [a higher rate] environment should be positive for specialist lenders,” says Harrison. “There should be more opportunity [to lend] outside of the mainstream. Regardless of whether RMBS spreads are 90bp or 110bp it shouldn’t move the needle unless you’re running super skinny margins. It’s more about whether the market is open or not.”
Others think tighter spreads would mean issuers would choose to join in.
“It’s a good time to do a debut deal,” says Bonsema. “In general, securitization funding looks attractive and I think that could push some people to come to market.”
Bigley at S&P also believes that more issuance from challenger banks could follow, either towards the end of this year, or in 2025.
Consolidation to continue
The evolution of the issuer base is also something to keep a close eye on. In recent years a number of mortgage lenders have been bought up or merged, while others have made forward flow agreements.
“We still see quite a lot of forward flow opportunities around and we could see a bit of M&A,” says Charleston at TwentyFour.
Indeed, the recent turbulence showed how lenders can benefit from diversification.
“It might be too early to call but there seems to be a trend towards consolidation,” says Simi Arora-Lalani, partner at Clifford Chance. “Rather than having smaller platforms doing narrow, more bespoke products, we’re starting to see lenders diversify and acquire additional portfolios or platforms.”
Together is one example of an issuer that can show off several products.
“Having a broad range of products is beneficial for a lender to be able to maintain origination volumes,” Harrison says. “For example, buy-to-let volumes are lower across the market, but bridging volumes are strong as we see investors wanting to move quickly to realise opportunities in a changing environment.”
Slimming down
Living through the turbulent times of 2022 and 2023 led many specialist lenders to give themselves extra warehouse capacity and thus gain the flexibility to delay deals. With market conditions looking more constructive, there could now be a temptation to scale back on that headroom and save on fees. But it is a temptation that should not be overindulged.
“Mortgage businesses will remove excess capacity, but most will conclude they need to have a decent amount of warehouse capacity in place,” says Ingram at Clifford Chance. “Recent crises have proved that if you don’t have capacity available and you can’t obtain more, then you’ve got to sell the assets you can’t finance yourself.”
There is, after all, no shortage of potential risks in the second half of the year, with the US election coming in November and continued tension in the Middle East.
“Putting on additional warehouse funding lines was necessary after the mini budget but, whilst it is looking like a more conservative approach now, I think with the potential volatility through the back end of this year it’s not a bad idea to have that back-up option,” says Arora-Lalani.
The challenge for lenders is to balance prudence with avoiding over caution.
“I don’t think you should assume the world will stay positive forever, and I’d expect most people to ensure that they have contingency funding options,” says John Rowan of Belmont Green. “But people are probably looking for more nimble and flexible facilities.”
Fixing a hole
One important unknown is how mortgage borrowers, many of whom are experiencing a period of elevated rates for the first time, will react in the new normal of higher rates.
“There might be a higher proportion of people that start to look at longer fixes, as rates come down,” Kerr says. “The UK mortgage market was relatively savvy, as a high proportion migrated to fixed rates as rates were signalled to rise.”
It could be timely for new lender Perenna Bank, which is offering fixed rate mortgages for up to 40 years. Such deals are widespread in several countries, including the US and Denmark. There are other reasons, beyond stability, that the products could catch on with borrowers.
“[Long term fixes] are a lot more attractive for first time buyers because you don’t have to stress for affordability beyond the fixed period, which means borrowers are eligible for a bigger loan,” says Kali Sirugudi, managing director at KBRA in London.
Perenna started lending early this year and has signed a warehouse with ABN Amro. It plans to issue covered bonds as soon as this year.
“Our solution makes the entire market healthier,” says Perenna CEO Arjan Verbeek. “It’s not so much disruption as fixing. Securitization is a great tool and I think it will grow, but it needs to be in the right way. Our bank is like a securitization master trust with governance on top.”
That means Perenna’s equity takes the credit risk in its originations, and for now it will also take on the prepayment risk.
“We need to manage prepayment risk,” Verbeek says. “In Denmark and the US, the market prices that option and gets paid a higher spread. The other option is we manage it ourselves and capture that option premium. We are establishing the market and that takes time. Maybe later investors will say [they’d] like that risk.”
Perenna also has to find a willing investor base. The natural solution is insurers and pension funds, for whom the steady cashflows are a good match with liabilities.
“I think most people would say, ‘interest rates are elevated, I’ll take the short-term fix and hope for declining rates in a couple of years’,” says Charleston. “But long-term fixed is a good product for insurers and they could gradually push down the cost if it becomes a scalable enough to catch their attention.”
It looks set to be one to watch in the years ahead.