UK RMBS master trusts: Northern Rock – From hero to zero

by Louise Bowman

Northern Rock’s inability to tap the wholesale funding market is a body blow for the whole sector.

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Sub- prime special focus

Future business school lecturers looking to illustrate the importance of diversifying your sources of funding will probably have a well-thumbed case study at their disposal entitled “Northern Rock”. The UK mortgage lender has gone from hero to zero in a matter of weeks thanks to market dynamics over which it has no control. But as more than 40% of its funding comes from RMBS it faced the prospect in early September of being a forced issuer in a market where the relationship between fundamentals and pricing has completely broken down.

The precipitous slump in Northern Rock’s share price (it has fallen more than 45% year to date), together with fevered speculation in the financial press that it was now ripe for takeover by a larger rival such as HSBC, suggest that its wholesale-funded business model is fundamentally flawed. Indeed, this view was sealed on September 14 when news broke that the bank had been forced to approach the Bank of England as lender of Last Resort because it had been unable to tap the wholesale funding market at all.

For years, UK lenders Northern Rock and Kensington Mortgages were seen as shining examples of how a monoline mortgage business model funded in the wholesale capital markets could be successful. But with Kensington sold to Investec in June (at a fraction of its market capitalization of a year before), and Northern Rock facing a significant funding challenge, the fragility of this proposition has now been exposed.

Northern Rock's funding crisis has left the UK RMBS market reeling in shock. Players had been confident that the bank would be able to raise funds - albeit at a significant premium. “This model is not flawed,” said a securitization expert in early September. “What is flawed is the model of the sub-prime lender that relies on securitization 100% with no skin in the game. That is a very different proposition.”

The main disadvantage that Northern Rock faces is that it cannot compete on price with competitors that have cheaper funding alternatives, such as large retail deposits, to draw on. It also borrows against Libor and lends against the base rate and so faces a widening basis mismatch there. Northern Rock’s current funding mix is 23% retail, 25% wholesale, 44% MBS and 8% covered bonds. It placed £5.6 billion into the RMBS market in the first half of this year, and, according to James Hutson at Keefe Bruyette & Woods, if it had done the same again in the second half this would have cost it (assuming that its costs had increased from around 10 to 15 basis points to 25bp) £14 million ($28 million) over Libor as opposed to £8.4 million over Libor – a differential that he describes as “modest and lost in the roundings”. But now that the lender does not seem to be able to borrow wholesale at any price, estimating the impact of increased funding costs to the bottom line is largely academic.

Crippling cost

The Libor/base rate gap was at 85bp at the end of August, which could result in a gap cost of £35 million for the second half of the year. Figures such as this underscore the problems the bank faces, but the speed of its cash crisis is baffling. The pools of mortgages backing Northern Rock securitizations are of very high quality, and while retail deposits are a cushion, marginal mortgage growth at most of the big lenders has been funded in the wholesale markets – growing the retail deposit base is just too slow to cover this. Northern Rock was not the only lender expected to be forced to attempt to tap the RMBS market, and the big problem they face is one that affects them all – the fallout from the ABCP liquidity crisis.

ABCP conduits have traditionally been reliable buyers of huge volumes of UK prime RMBS paper (see chart), and as long as problems in that sector remain, the investor base for RMBS will be seriously curtailed – which will keep spreads high. “The impact of the ABCP liquidity crisis on the master trusts will be very substantial as these are eminently “SIV-able” assets – they are liquid and high grade,” says a UK portfolio manager. “The market will only normalize when it can be confident that the SIV/ABCP issue is behind it.” Lehman analysts estimate that conduits account for around 10% of European ABS buyers (around €50 billion) but that they pale in comparison to banks and asset managers. So although their impact is substantial, it is not overwhelming. But Ganesh Rajendra, head of European securitization research at Deutsche Bank, says that SIVs and ABCP conduits make up 35% to 40% of all buyers in the market so the impact will be severe.

Where did everybody go?

European ABS investor base

Source: DB Global Markets Research

But for some master trust issuers, the conduit issue is something they face as a sponsor as well.

Four UK prime RMBS issuers –HBOS, HSBC, Lloyds TSB and RBS – sponsor ABCP conduits with total outstandings between them of $110 billion. HSBC has additional exposure in this sector thanks to its two SIVs, Cullinan Finance and Asscher Finance, which have total outstandings of $42 billion. In the short term, if the additional cost that sponsors have faced in rolling CP for these programmes persists, these banks face the prospect of having to provide liquidity themselves. By late August, HBOS had announced that it was to fund its Grampian conduit (which has $35.4 billion outstanding) itself until such time as market pricing had improved to a level that is more acceptable to it.

The decision was presumably taken in the belief that the CP markets would return to normal within too long a time frame. According to Standard & Poor’s, the risk-weighted assets on the bank’s balance sheet would rise by nearly £14 billion if HBOS were to fund the conduit in its entirety.

The looming prospect of ABCP and SIV vehicles having to be brought on balance sheet must be a concern for HBOS, HSBC, Lloyds TSB and RBS: it would have a significant impact on their future lending volumes.

Forced issuance

But it is how to fund their current business that is the most immediate concern. September is traditionally characterized by a series of jumbo UK RMBS master trust deals: last year, there were deals from Northern Rock (£4.74 billion), HBOS (£4.4 billion), RBS (£6.5 billion – a standalone issue: RBS does not issue through a master trust) Alliance & Leicester (£2.5 billion) and Lloyds TSB (£7 billion) all come within weeks of the end of the summer break. Things will be very different this year.

“Northern Rock is traditionally the first cab off the rank so everyone was watching what price it cames at very closely,” says one investor. Only it didn't come at all. Issuing into a market as volatile as the ABS one has become is not for the faint-hearted. “Anyone that has to tap the wholesale, unsecured or short-term markets has been massively affected,” says a banker. “How do you possibly justify 40bp over Libor from a credit perspective for triple-A prime UK RMBS?”

Despite the very attractive jump in spreads on offer, many investors in UK RMBS were also frustrated as the September pipeline hoved into view. “I would love to see a deal done just to see some sign that there is a market out there,” said one. “Then we could go to our credit committee to untie our hands – we cannot do anything until they are convinced the market has turned. If we could just have a week without any bad news it would be great.” With, for example, Spanish triple-A RMBS trading wider in late August (50bp) than triple-Bs were in the first quarter, the desire to pile back in must be great indeed. However, in recent years the structures of the jumbo RMBS trades have been skewed in favour of US dollar buyers, with very large short-term 2a7 tranches which are sold to tax-exempt money market funds, an investor base that has been particularly adversely affected by the summer’s volatility.

Despite the fact that they have the cheaper covered bond option also available to them, it is probable that lenders such as HBOS and Abbey will also return to the RMBS market in the third quarter – but at far smaller volume. Insiders were hoping that Granite (Northern Rock’s master trust) would come at around £3 billion – far short of the nearly £5 billion of last year but still a sizeable deal – something now seen as hopelessly optimistic.

If conditions in the market do not improve dramatically, analysts reckon that the European ABS market will shrink by 60% year on year in the third quarter. “This is going to last a while and there is going to be enormous value destruction,” muses one.

Conventional wisdom has always been that it would be a slowdown in mortgage origination itself (triggered by a house price slump) that would check the growth of the UK RMBS master trust machine. The way things stand in mid September, it looks as if the process will be the reverse.

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UK RMBS master trusts: Northern Rock – From hero to zero

Northern Rock’s inability to tap the wholesale funding market is a body blow for the whole sector.

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