Total outstanding mortgage balances in the UK stand at just over £500bn, with the industry projecting net lending of £40bn to £50bn a year for the next three years.
These massive figures, with mortgages comprising more than 80 per cent of all household debt, mean lenders are faced with developing new sources of funding to meet this demand while maintaining a competitive edge.
Traditionally, lenders have relied heavily on retail savings deposits as the primary source of funding. However, we have seen the wholesale markets increase in importance and we are seeing the development of securitisation and other new techniques as lenders strive to find the most cost-efficient funding methods while controlling their market risk. Retail funding still dominates but the wholesale markets and securitisation are now significant constituents of the overall funding base.
What are the key factors driving this change in mortgage funding and what does it mean for the market in future? We need to consider the key criteria for lenders in accessing the various sources of funding – costs, control, diversification, matching and capital.
Cost of funding
The developing trend towards wholesale funding has accelerated with the impact of the direct new entrants in the deposit market such as Egg and Standard Life Bank giving traditional players headaches in costs and volumes of new retail deposits. The traditional defence of using existing depositors to subsidise new accounts has come under fire from the consumer lobby and Cruickshank alike.
The decreasing flows of deposits and the increases in rates to levels that are less attractive relative to wholesale funding have brought lenders to tap new sources.
But the ability to take advantage of this depends on the credit-worthiness of the mortgage lender. A highly rated AA institution can command a smaller borrowing cost from the markets than a more lowly rated A institution.
Control over funding costs and diversification
Retail deposits not only provide lenders with a stable source of funding but also one over which, in theory at least, gives them complete contro
l over the rates.
In the UK, this has meant that a strong retail base has been essential to maintain competitiveness throughout the interest-rate cycle.
This was illustrated in the early 1990s when the retail-driven lenders were able to shield mortgage borrowers from high money market rates by holding down deposit rates to maintain margins. This resulted in the original centralised lenders, which were reliant entirely on wholesale funding, being squeezed out of the market.
A lender will also seek to avoid concentration of funding risk so that if the price or availability of one source is impaired, they still have the ability to continue to fund from other sources.
Wholesale markets offer a wide range of deep markets. At its simplest, there is straightforward bank funding,a bespoke loan from a syndicate of banks for a specified term. A lender looking for regular access to wholesale markets will set up re-usable debt programmes – commercial paper for short-term funding up to 12 months and a mediumor long-term note programme allowing fixed or floating-rate notes to be issued, commonly for three to seven years.
These capital markets,particularly in the US, are very deep and allow funding requirements to be met even in relatively adverse economic conditions.
As longer-term notes command a higher price, it is important for the bank to balance its sources of longand short-term funding, allowing for both price and liquidity considerations. A highly rated bank can rely more on cheaper short-term funding, with confidence that its rating will command sufficient demand to ensure refinancing without a problem.
A less well rated bank may, however, be forced to have a bias to longer term funds, as demand for its paper may be limited at certain times and it will want to avoid facing a period of heavy refinancing in adverse market conditions.
Matching and liquidity
There are a number of risks that the lender needs to control here.
First, rate reset risk, namely how closely correlated the timing is of changes in mortgage rates linked to changes in funding costs. This is straightforward for deposit funding but less so on the wholesale side.
Second, the lender needs to match the form of the interest rate to offer fixed and capped-rate mortgages with similarly structured funding.
Finally, the lender needs to consider overall duration and liquidity.
Under a mortgage, the lender is making a facility available for up to 30 years with no option to demand repayment if the loan is being appropriately serviced.
However, if the underlying funding can disappear overnight (for example, because it is all instant deposits) then the lender could be faced with a major liquidity crunch. The use of retail bonds and notice accounts can lengthen the duration of funding but the wholesale markets give access to more liquidity and longer-term sources of funding in volume.
Under securitisation, a pool of mortgages is “sold” to investors and removed from the balance sheet of the lender.
This reduces the capital requirements for the lender and can thus boost the return on capital employed.
However, as the lender commonly continues to service the mortgage, he can still maintain the customer relationship and has further cross-selling opportunities.
International changes in banks' capital requirements could accelerate this trend if the proposal to give mort-gage-backed securities with a lower risk weighting and, therefore, more favourable capital treatment than direct mortgage assets is implemented.
Securitisation offers further advantages in terms of more diversification of funding source and allowing lenders to reduce their exposure to certain types of lending, such as sub-prime. Securitisation has been widely predicted to be the funding tool that will lead to the rise of very long term fixed-rate mortgages along US lines in the UK.
But the US securitisation market, which accounts for 60 per cent of mortgage funding, has developed due to the implicit government guaranteed status of Freddie Mac and Fannie Mae as the dominant forces in the market. This lack of guarantee and cost considerations in the UK mean that we are only likely to see the UK follow the US model to a limited extent.
But, one new entrant has demonstrated further funding innovation. Standard Life Bank's Futureperfect mortgage currently offers a 25-year capped rate at 6.49 per cent.
The primary funding source for this is annuities from the insurance side of the group. This takes advantage of the low yields on long-term interest rates that are used to price annuities by matching the long-term annuity liabilities with long-term mortgage assets.
It is likely that we will see other diversified financial services groups bring together different parts of their balance sheet profile to extend the range of matching available.
For the mortgage borrower, the continuing innovations in funding are, in general, good news as these should drive wider product choice and competitive rates.
As far as the lenders are concerned, we are seeing the first steps towards the separation of origination, separation and funding capabilities.
The traditional competitive advantage of strong retail funding is being eroded and there are increasing opportunities to utilise wholesale funding or effectively “outsource” funding entirely by passing mortgage assets straight through to the investment markets.
The lenders which harness these funding trends will be best placed to take the lead in the mortgage products delivered to borrowers.