Banks and buyers alike see prospects in the multi-billion pound industry of residential mortgage backed securities, which feature a lifetime loss rate of just 0.7%. However, investors need to be aware of where to access this asset class and understand the opportunities in US and European RMBSs vary.
In the late 1980s UK banks were exploring their funding options, which traditionally had been limited to deposits from individuals and corporations as well as issuance of senior debt through the capital markets.
The latter involves the issuer pledging the whole of its balance sheet against the aggregate of its senior debt, meaning the bond holder is exposed to the vagaries of the bank’s business risk and performance until the debt matures. The banks considered whether by pledging specific, high quality collateral against specific borrowing the rate of interest paid on the borrowing might be lower than on their standard senior debt. The collateral for this borrowing was pools of prime mortgage loans and the banks achieved their aim through the issuance of Residential Mortgage-Backed Securities (RMBS).
The product appealed to a specific set of investors, primarily treasury teams and structured vehicles who liked the high quality nature of the credit risk and the LIBOR based return. This investor base grew strongly through the 1990s and exponentially through the 2000s, allowing the market to develop, becoming deep, liquid and international.
Throughout 2008 and until late 2009 the European and Australian markets were re-pricing and attracting new investors for the existing RMBSs in issue. The major purchasers of newly-originated RMBS deals during this period were the European Central Bank (ECB) and the Bank of England (BoE) who took hundreds of billions of the securities as collateral for the substantial amount of liquidity they pumped into the financial markets throughout the period.
Clearly to build such a position illustrated the fundamental strength of these securities, as the central banks were not looking to add risk by taking on highly unpredictable collateral.
The public markets for new issues of RMBS reopened in late 2009 and since then they have been accessed by both established and new sponsors, including some of the smaller originators of prime mortgages and the better known originators of speciality mortgages (for example Kensington Mortgages for non-prime mortgages and Paragon Group for buy-to-let mortgages).
The investor base for European and Australian RMBS has developed now to include the more long-term buy and hold institutional investors such as pension funds and insurance companies, but increasingly global banks are starting to add considerable amounts of RMBS securities to their balance sheets due to the attractive yield and continuing excellent performance.
The strength of these deals was not only based on the quality of the mortgages, but also on the clearly defined operating structures that surrounded the mortgage pools. The bonds are issued from purpose-built vehicles that immunise the investor from the performance of the sponsoring bank by ring-fencing the collateral pool from the sponsor. This means that not only is the credit quality of the mortgage borrowers pre-defined but also that, should the sponsoring bank exhibit weakening strength, the RMBS note holders are immunised from this deterioration and the bank can be replaced in any of its roles.
The acronym RMBS was shared across markets, despite fundamental differences between mortgages in different countries, the business model of lenders across those geographies and the RMBS structures used as well. These differences have led to a significant divergence in performance and have often meant that the significant underperformance exhibited by US RMBS for example has tainted European RMBS simply due to the shared acronym. In a recent study of European deals from 2007, the rating agency Fitch estimated a lifetime loss rate of only 0.7%. When compared to other sectors in Fixed Income, not only Subprime RMBS from the United States, but also European High Yield or even European Sovereigns, this would be the strongest performance seen.
When considered in detail, the differences between Europe and the US explain the substantial performance variances experienced to date. Prime mortgages in the US are ultimately financed by government-sponsored entities such as Fannie Mae, meaning the US RMBS market is a ‘non-prime’ market. By comparison, in the UK of the £375 billion RMBS market, just
£25 billion is classified as being ‘non-conforming’ and the quality of these mortgages is significantly higher than that of US subprime.
Jurisdiction also plays an important part in judging the quality of an RMBS transaction, as differences in consumer credit laws vary widely. A borrower in the UK mortgage market should expect to have his house repossessed should he continuously default on the loan. Beyond this the lender can pursue the outstanding claim through the courts and recover its losses for a further 12 years. By contrast, a borrower in the US who defaults is not pursued for further recoveries once the property has been sold. This has significant implications for all borrowers once their property is worth less than the outstanding balance on the mortgage and provides no incentive for a borrower to continue to service his mortgage debt when there is a collapse in house prices.
Indeed, a US homeowner with negative equity could quite rationally conclude that in the current, prolonged housing recession their best option may well be to walk away from their mortgage, with a view to rebuilding their credit history and re-entering the housing market before house prices recover – even where the low mortgage rates make servicing the loan affordable.
The final key difference between the US market and the European and Australian markets involves the reason for doing it in the first place. In the UK the reason for the creation of the RMBS market was mainly an attempt to source cheaper levels of financing. In doing so the sponsoring bank retains the ‘first loss piece’, meaning that they lose money on a deteriorating transaction before the RMBS investors do.
In the US market the standard approach was to pass all the risk onto investors and for the originator of the mortgages to retain no exposure to their performance. This ‘originate-to-distribute’ model does not align the interests of the borrowers, the lenders and the RMBS investors, in stark contrast to the European model.
Residential mortgages are one form of borrowing that has been securitised and thereby funded by investors. While this has the advantage of the debt being secured on property, there are also liquid markets in Asset Backed Securities (ABS) sectors, financing unsecured lending such as credit cards, student loans and auto loans amongst others. The common nature of these deals is that the assets (the underlying consumer loans) pay interest and principal that pays the coupons and funds the maturity on the ABS bond. Like RMBSs, ABS bonds are typically issued in tranches, each offering a different level of risk; the least risky tending to have first recourse to cashflows and being the last to take any losses.
As banks and other financial institutions struggle to cope with the regulatory demands of raising new capital, de-levering their balance sheets and accessing funding in a meaningful and long-term manner, they continue to consider RMBS as a key component of their armoury. The appeal to investors is based around the fundamental strength of the structures and the collateral that allows them to take measured exposure to the credit risk of a high quality asset class, while receiving an excellent return for the inherent risk.
