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Clare Bettelley analyses the growing business of mortgage securitisation and what can happen when things go wrong

Securitisation is an increasingly popular source of wholesale funding which can help lenders to offer cheaper products and services but this depends on business from mortgage intermed-iaries being compliant.

Residential mortgage-backed securities (RMS) transactions are similar to a bond where institutional investors receive income payments based on the level of their invested capital.

Typically, lenders have to set up a special purpose vehicle which is a legal structure where lenders pool what they consider to be credit-worthy residential mortgages. Investors are then paid from the mortgage repayments of the pooled loans.

Creditors have a right to the repayments, usually in a predetermined order depending on the credit status of the mortgages in which they invest. This tends to be AAA or AA-rated within an RMS deal.

Any shortfall in borrower repayments has to be met by the originator of the securitised assets, that is, the lender, through reserves.

Recently, Kensington Mortgages was forced to make drawings on the cash reserves on two of its RMS transactions due to higher than anticipated loan losses.

The firm attributed the losses to a number of third parties, including mortgage brokers, packagers, solicitors and valuers that it used in 2003 and 2004. It ousted 6the firms from its panels.

In an investor note, Kensington said: “As part of our ongoing, regular review of counter-party performance, we have identified counter-parties which are correlated to some of the higher-loss severity cases. Where these counter-parties were determined to be performing outside of Kensington standards, action has been taken to remove counter-parties from our panels. We continue to monitor counter-party performance closely.”

The impact of the sub-standard applications resulted in Kensington Mortgages, one of four businesses within the Kensington Group, having to draw 710,000 out of a reserve of 17.6m for a transaction last month. It also drew 510,000 of the total reserve of 26.6m for RMS16.

RMS reserves are designed to be used by lenders experiencing difficulty meeting their debt obligations to investors of their RMS transactions. But it is in lenders’ interests to minimise the need to do so to avoid the cost of any future transactions escalating or in the worst-case scenario where defaults became a regular occurrence, prompting investors to look elsewhere for more secure investments. Mortgage intermediaries have a key role in enabling lenders to minimise reserve drawings and their obligation to do so is of growing importance given the evolution of the limited panel driven world. After all, the fight for business is hard enough without inadvertently getting ousted from lenders’ panels.

Kensington group finance director Steve Colsell says: “Clearly, we would expect the performance of loans introduced by some intermediaries to be better than others around our expected norm. This can be due to a number of factors such as business mix, region, or simply statistical variation. All of this is perfectly acceptable.

“However, material or consistent under-performance can be indicative of short cuts in processes or loose controls which are not always immediately apparent if the quality of the end product at the point of application is high.”

One mortgage adviser agreed but is confident that things are changing.

“I have never said we have got a squeaky clean industry and it is not a shock that there might be mortgage brokers out there who might not be completely honest but there are a lot of us trying to change things.

“The mortgage industry has gone through a lot of change over the last 10 months since Mortgage Day and a lot of this has been focused on further improving mortgage application processes.”

Lenders have got to take some of the responsibility of loan defaults, particularly where their own internal processes are concerned. Applications are only as good as the underwriting processes lenders create and manage.

Kensington group treasurer Mark Wilten says the company randomly spot-checks the standard of underwriting on a minimum of between 5 per cent and 10 per cent of all mortgage applications.

He says there are no plans to revisit this level, an attitude that may be surprising given the company’s recent experience, although the company does claim to scrutinise any significant loss cases.

Such scrutiny will be key given the growing popularity of securitisation. Northern Rock, HBOS, Paragon and Bradford & Bingley are but a few of the UK lenders now fully immersed in the world of securitisation.

And it will be key to supporting the future diversification of products.

David Shearer, a partner with law firm Allen & Overy, says: “As the securitisation market continues to innovate and as potential investors become more sophisticated in their understanding of the UK mortgage market, we are likely to see continued innovation in the range of products that mortgage lenders are able to offer and opportunities for IFAs.”

Northern Rock has been able to develop products such as its Together mortgage range while simultaneously offering one of the most competitively priced (5.6 per cent APR) personal loans on the high street today.

It has developed a highly successful securitisation programme, with assets under management subject to securitisation of 22.3bn, representing 40 per cent of its lending book as at December 31 2004.

But such innovation is reliant on a two-way process between lenders and intermediaries which will be tested in the second half of the year if predictions about a continued slowdown in new mortgage applications is correct.

Lenders are unlikely to forgive any third parties failing to meet their compliance standards so mortgage intermediaries should be doing everything in their power to address any shortcomings in the quality of their business processes before the decision is made for them.

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