In the first of a series of articles, we assess how vulnerable securities backed by residential mortgages secured on owner-occupied homes are to a downturn in the UK housing market.
5 minute read
In many investors’ minds, asset-backed securities (ABS), and in particular those backed by residential mortgages (RMBS), still elicit raw associations with the Global Financial Crisis (GFC) of 2008 or – more specifically – the US sub-prime RMBS implosion of that year, which for many serves as a marker for the start of the GFC. That non-US sub-prime RMBS transactions (including European RMBS transactions across the UK and the Continent) demonstrated highly resilient credit performance throughout the subsequent credit crunch and Eurozone debt crisis remains a fact lost on many observers; the reputation of the asset class has never fully recovered.
This image problem has meant that, despite annual new issuance of European RMBS being in the dozens of billions of euros for many years now, volumes are but a shadow of their former selves. Public placement volumes of RMBS bonds in the UK have also been depressed by the Bank of England (BoE) offering UK lenders the opportunity to fund residential mortgages via its Term Funding Scheme (TFS), which offered lenders a lower cost of funds than the bond market. A decade on, however, and the tide may slowly be starting to turn. With the BoE not offering any further funding via the TFS, UK RMBS should start enjoying a soft revival as lenders return to non-BoE sources of cheap funding. The EU’s upcoming Securitisation Regulation, coming into effect at the beginning of 2019, should provide the long sought-after regulatory certainty. Moreover, detailed quantitative proof of the resilience of UK RMBS to crises has been accumulating for a full decade across thousands of investor reports (publicly placed UK RMBS transactions typically update noteholders on their performance on a monthly or quarterly basis).
The question now is, with interest rates on the way back up and uncertainty overhanging the UK economy, can investors still rely on RMBS securities if the UK housing market, as some predict, were to suffer a crash?
Need for perspective
We need to put the current negativity towards the property market – some might say alarmism – into context. Housing slumps are a rare phenomenon. In the UK mortgage market, the most serious disruption in recent times was in the 1990s. However, with a severe recession just starting to bite and unemployment surging, that deep and painful downturn was predicated on a very different set of circumstances than we are seeing today.
At the time, the BoE did not have the power to pursue an independent monetary policy and interest rates were kept high to “defend” the British pound, which at the time was embedded in the European Exchange Rate Mechanism (ERM), the precursor to the euro. The resulting high interest rates proved devastating to the British economy and catastrophic for the affordability of homes as mortgage rates followed BoE policy rates higher. House prices fell precipitously as affordability constraints choked off demand. The economic dislocation only eased when the pound was finally allowed to drop out of the ERM. Nowadays, the UK economy and housing market enjoy the benefits of central bank independence and a free-floating currency.
The GFC proved challenging for the UK housing market as well, but mortgage repossession rates remained more contained than around the time of Black Wednesday (the day the UK government was forced to withdraw the pound from the ERM); and in the wake of the GFC, the UK’s regulatory regime for mortgage lending has been strengthened to guard again future such crises.
The chart below shows how UK house price growth turned negative around the pound’s exit from ERM and during the GFC. In the former event, high interest rates contributed to the house price decline and high inflation rates masked the severity of the decline in real terms. In the latter event, the decline in GDP was more prominent and the drop in real house prices more immediately apparent due to low inflation rates.
Figure 1: BoE Interest Rates, UK GDP Growth (YoY), UK House Price Growth (YoY) and RPI
Do higher interest rates matter?
So, if rapidly rising interest rates were the cause of the last severe slump in the UK mortgage market, could the same thing happen again today? The commonly accepted wisdom is that interest rates are only heading in one direction as central banks around the world reset their monetary policy after their resorting to unconventional measures, such as quantitative easing (QE), in response to the GFC.
Nervous home owners and buyers should take some comfort, however, in the fact that central banks world-wide, including the BoE, have repeatedly stressed that interest rates will be raised only gradually. Even if the UK economy were to accelerate sharply on the back of a benign Brexit, all the policy rhetoric still insists that any tightening will be measured.
In fact, as an independent central bank the BoE’s policy response can be expected to be rational. Should economic growth falter, interest rates can be expected to remain low, with correspondingly stable mortgage rates facilitating mortgage affordability. However, should economic growth accelerate and corresponding wage growth result in inflationary pressures, while interest rates can be expected to rise, the correspondingly higher mortgage rate should remain affordable as a result of rising incomes.
The balance of supply and demand dictates house prices and, as the popular press so regularly reminds us, demand has been outstripping supply ever more markedly for years now. The villains of the piece have been tough planning restrictions and decades of chronic underinvestment, which together have contributed to an unprecedented shortage of new housing.
While some efforts are made to free up more green-belt land for development, it remains the case that most government initiatives to increase the supply of new homes have failed. Indeed, in some cases, they have driven up demand instead of supply, thereby exacerbating the imbalance and pushing up prices even further.
Hence, with the political will to tear up planning restrictions evidently lacking and the UK population expected to continue to grow, UK house prices are buttressed by a seemingly intractable mismatch between supply and demand.
A further important aspect that has made the UK housing market more resilient to crises is mortgage market regulation under the Financial Conduct Authority (FCA). Today, the regulatory environment incorporates all the harsh lessons learned from previous crises. The days of risky mortgage lending are largely over, with restrictions now capping most loans at an income multiple set by regulators and requiring most borrowers to fully validate their income.
The FCA has also presided over a huge shift away from allegedly high-risk interest-only mortgages to repayment mortgages, while the BoE, in turn, has brought in strict interest rates stress test for lenders.
This strict regulatory regime may make it especially difficult for would-be first-time borrowers to get a foot on the housing ladder, as recognised by the government in its help-to-buy initiative. But the FCA appears to have opted for banking system stability over mortgage availability – hence the current very low default rates, which benefit RMBS investors.
The GFC caused a spike in UK mortgage arrears, but arrears have declined since and are near the lowest they have been for two decades.
Figure 2: Arrears > 3M for RMBS
RMBS market on a different footing
So how would UK owner-occupied RMBS transactions perform under the outlook we have described above?
The first point to note is that the GFC and the subsequent Eurozone crisis have resulted in RMBS transactions both on the Continent and in the UK to be even more conservatively rated by the rating agencies. As a result, rating agencies are insisting on high levels of credit enhancement (CE) for senior RMBS bonds for these to be able to achieve the coveted triple-A rating.
Additionally, UK RMBS structures now typically use sequential principal cashflow waterfalls (meaning that the senior notes are paid off first), which in turn means that the CE of the senior notes, which are already rated triple-A at inception, can continue to rise steadily after issue.
Furthermore, prepayment speeds have increased, resulting in faster repayment for these notes, leading to an acceleration in the build-up of senior CE post issuance. Hence, we expect senior CE to continue to build from initial levels in UK RMBS transactions, contributing to the strength and resilience of senior RMBS bond credit quality.
A quick example calculation to illustrate this point: The CE of the senior notes in a sequential RMBS transaction with an initial CE of 15% reaches nearly 25% after three years with mortgages repaying at a rate of 15% per year. Even if we assume a loss severity of 50%, 50% of the mortgage pool would have to default at the end of the third year before the senior notes would start to suffer losses. According to the Council of Mortgage Lenders (CML), the year with the highest repossession rate since 1975 was 1991, when the annual repossession rate peaked at 0.77%; and the year with the highest repossession rate in the 21st century (so far) was 2009, when the rate reached 0.41%. Neither figure comes anywhere near the 50% we calculate in our example.
We can see in the chart below that repossession rates (“default rates”) in the UK mortgage market peaked around the pound’s exit from the ERM and during the GFC, when declines in house prices were most pronounced. However, the repossession rate was substantially higher in the first than the second event.
Therefore, with the RMBS market in rude health and the TFS being wound down, how will pricing develop as traditional issuers return? “Although this could have the short-term effect of increasing securitisation costs for everyone as the supply and demand dynamic cut in,” says Tony Ward, chief executive of Home Funding, “medium to long term this can only be good news as we finally get these markets back on track and focus investors on buying them.”
Figure 3: Repossession Rates for Whole Market
Perception vs. reality
Much has changed since the early nineties; the UK economy now enjoys the benefits of an independent central bank and a free-floating currency, as well as a more flexible labour market; the latter resulting in high employment rates, albeit at the cost of lower wages during times of economic downturns. The UK’s residential property market is underpinned by strong structural factors, most notably a large and persistent imbalance between supply and demand. An updated regulatory landscape has, as intended, created a more resilient mortgage market. And the rating agencies’ tightened rating criteria have resulted in senior triple-A rated RMBS bonds of even higher credit quality.
In this context, RMBS bonds should profit from investors’ perhaps overdone concerns about a UK housing market crash. Indeed, the potential for attractive risk-adjusted returns can enhance this alternative asset class’ existing advantage as an effective diversifier within a fixed income portfolio.