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Lenders play on a new pitch

For as long as those of us who are in the mortgage business can remember, the “no frills” variable-rate mortgage was funded by no-frills variable-rate savings. Not so today. New funding techniques are emerging in the UK mortgage market with the potential to change the way that homeloans are delivered and processed.

Let us start with securitisation. In the US alone, total outstanding mortgage-backed securities account for around $2.8 trillion.

Put simply, securitisation is the process under which a pool of assets is converted into marketable and tradeable off-balance sheet securities – then sold on to institutional investors.

The investors do not own the assets but they do own the securities (the “notes”), which offer returns dependent upon the performance of the underlying assets.

The US government&#39s securitisation programme radically changed the mortgage market there and it has the potential to have a positive impact here now that household name organisations such as HBoS, Abbey National, Northern Rock and Bradford & Bingley Group are using the technique.

For loan originators, selling them by way of securitisation can be a very efficient use of capital. For those acquiring the securities, a profitable market-linked variable rate of return can be enjoyed.

With such attractive benefits, it was inevitable that securitisation would reach Europe. For 2002, total estimates for European asset-backed securities issuances would be the equivalent of $140-$150bn, the biggest share being the UK.

Securitisation can be applied to anything with cashflow – Greek lottery receipts are said to be under review and UK Premiership Football clubs such as Leeds and Newcastle are not averse to it. Southampton FC&#39s new St Mary&#39s stadium was financed by securitisation. A deal of this type would involve future revenues (for example, season ticket sales) being pledged as security against loans.

With retail savings a costly way to fund mortgages, many prime lenders see the ABS market as a cheaper source of funding.

For sub-prime lenders, this is a better use of limited capital and for investors it presents a viable alternative to the limited investment options currently open to them.

As more investors turn to this technique, their needs will drive changes to the whole mortgage process, which is good news for customers. They are fuelling the price competition – which will lead to cheaper and more transparent products – and are steering the mortgage industry towards commonality of documentation, making it easier for customers to shop around.

Another new technique for the mortgage industry is through lending. This is a partnership between two lenders.

The “marketing lender” wants to sell products for which there is a demand via its existing distribution channels but is unable or unwilling to fund them. Products are sold under the lender&#39s own brand.

The “acquiring lender” has the appetite to fund these products – and acquires borrowers and assets cost-effectively in a pre-completed for- mat with no processing or distribution costs.

At mortgage completion stage, the funds are released by the marketing lender. The marketing lender then draws down funds from the acquiring lender and the loan passes through from the marketing to the acquiring lender on a loan-by-loan basis.

To the customer, the process is transparent because the arrangement is typically disclosed in advance and the key terms of the mortgage loan are guaranteed by the acquiring lender so the customer experiences no change.

The marketing lender receives a fee and the benefit of having expanded its product range. The acquirer receives a completed mortgage of a pre-specified type without diverting any resources away from its core business.

Apart from changing delivery modes and making the market more fluid and rich with choice, through lending is a way forward for some UK banks and building societies to compete in the sub-prime market.

Many lenders opt out of the sub-prime market altogether, leaving open the question of what to do with “rejected” applicants. Up until three years ago, they were picked up by the specialist sub-prime lenders.

Now, with companies such as HBOS and Abbey National entering the sub-prime market via their subsidiaries, rejected applicants are being passed by mainstream lenders to their competitors.

For many companies, through lending presents the opportunity to earn good fee income and retain these customers by offering own-branded sub-prime products, using their own application forms.

After three years of a transparent Libor-linked loan, redemption penalties fall away and the customer can be refinanced on to the original lender&#39s books, representing a steady stream of demand from rehabilitated customers in the future.

Correspondent lending is part of the same through lending family and there are organisations (such as packagers) of sufficient size and distribution to warrant offering mortgage products in their own brand.

As part of the process, the correspondent lender has control of the front-end administration.

At the point of completion, the lender steps in and advances the money, taking a post offer transfer to the customer.

Branded lending is an alternative method which is beginning to emerge in the run-up to regulation. The difference being that the packager promotes the lender&#39s products “in association” with the lender, with dual-branded literature so the customer is aware at the point of sale who the funding lender is.

Another funding technique – warehouse lending – could be a major breakthrough in the funding of UK mortgages in the next few years. It is usually employed by banks which want to be the lead underwriter in a securitisation of the same loans. Here, the bank advances money to a virtual lender, or large packager, without requiring any significant capital backing. When a lending tranche of sufficient size is established, the bank securitises that production.

The warehouse facility is then released to finance the next batch of loans, and so on. Like a warehouse, production is temporarily stored and soon moved on to be replaced by the next delivery.

Portfolio sales have been around for a few years but are now becoming a significant source of new business for many UK lenders.

When an organisation is unable to meet its lending targets for a particular year,a bulk purchase can be made via a portfolio sale to top up any shortfall.

Other techniques under review include a bespoke portfolio creation service, where one lender specifies the profile of assets it wants and another creates that portfolio to order.

Balance sheet rental, where assets are “parked” on one lender&#39s balance sheet by another, creating a guaranteed positive margin is yet another idea being looked at.

The market, of course, must be as sophisticated in its processing as it is with its funding.

Accompanying these new techniques must be an acceptance by investors and acquiring lenders that the old fashioned reference paper-chase has had its day.

It is time for the industry to accept that new funding techniques will change the way the market operates, start believing in its credit-scoring and search systems, so that customers can be offered what they really want – more choice, more competitive and transparent products and a decision at point of sale.

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