How effective is central bank help?
When securitization markets for residential and commercial mortgage loans froze last summer, a key funding source was removed at a stroke. Before the crisis, up to 40% of home loans and 20% of commercial loans were funded through securitization. In Europe lenders had to adjust quickly, tapping other funding sources and reining in the number of new loans. However, questions remain about how long the straitened environment will persist, and whether there is enough funding supply to meet borrowers’ demands.
"This is a market we’ve never seen before," says Peter Charles, chief economist for UK mortgage lender Bradford & Bingley. "All previous credit crunches in the post-war period came about because the authorities were raising base rates to choke off demand. That kind of decline is comparatively easy to cope with because it can be anticipated and it’s quite structured. This is the first time a crunch has been caused by a shortage in funding capacity, and what we’ve been trying to do is adjust the level of demand to fit supply. This has not been an easy task."
In order to avoid over-extending themselves, lenders have taken products off the market and have raised the rates on others. Loans such as Northern Rock’s now-infamous Together range, which allowed customers to borrow up to 125% of the value of a home, have vanished, and it’s now standard practice to tack on special charges for any loans with a high loan-to-value ratio. Gregg Kohansky, senior director in the European structured finance team with Fitch Ratings in London, says: "Things have really tightened up at the riskier end of the prime mortgage spectrum. Many lenders are basically trying to price themselves out of the market because it’s difficult to exit these loans via securitization."
If nothing else, says one market participant, the past nine months will have settled a perennial topic of debate that used to arise at the annual funding conferences organized by the UK’s Council of Mortgage Lenders: "The question was always ‘to what degree does funding drive lending?’ There’s no need to ask that any more." As silver linings to clouds go, that’s not very shiny.
Bradford & Bingley’s Charles says that mortgage demand was waning before the credit crunch began. At its peak in the fourth quarter of 2006, the UK mortgage market was seeing about 125,000 new loans for house purchases each month – a figure that dropped to about 105,000 by the middle of 2007 as affordability issues and interest rate increases took their toll on demand. Since the crunch, though, the decline in approvals has been precipitous, with the latest figures showing a record low of 64,000 in March and further declines expected. "Affordability had an impact on loan volumes – but nowhere near as great an impact as the drying-up of the securitization market. It’s pretty hard to adjust when approvals halve in the space of one year," says Charles.
Residential lenders have had to cut their cloth according to the remaining funding supply, and commercial lenders have done much the same, says Richard Curtis, head of bond syndicate with WestLB in London: "The investment bank conduits who moved into this space a few years ago have been squeezed out because their model was to lend and then recycle the risk into the capital markets via securitization, and that’s just not possible at the moment. But even other lenders are lending less, and when they do lend they’re charging a higher price and insisting on stricter terms – which some people simply can’t afford. Deals that would have been done a year ago are not getting done now."
Before the crisis, it was fairly common to make loans at 85% to 90% LTV, while today the upper reach for LTVs is more likely to be 70% to 80%, Curtis says. The cost of borrowing, meanwhile, has gone in the opposite direction – last summer, a typical commercial mortgage rate would have been around 80 to 90 basis points over Libor. Earlier this year, Eurohypo claimed to be originating senior loans at 125 basis points, he says.
One of the CMBS market’s blessings is the small volume of loans that are coming up for refinancing this year, says Hans Vrensen, head of European securitization research with Barclays Capital in London. There are about €150 billion in outstanding bonds, with loans that have outstanding balances worth less than €10 billion in total due to refinance in 2008 and 2009, he says. Many borrowers with loans of a similar vintage took the opportunity presented by low interest rates and rising property values to refinance or pre-pay their loans in recent years, removing much of the demand that would otherwise have materialized over the next three years. However, Vrensen warns that the focus on refinancings could extend into 2010 and possibly even 2011 if current property value declines continue beyond next year.
The picture is similar in the US. Julia Tcherkassova, CMBS strategist with Merrill Lynch in New York, says that only $17 billion of the total $730 billion fixed rate market needs to refinance this year – down from $25 billion last October. So far, insurance companies and regional lenders have been happy to step up and provide the funds. "If you go back 15 years, prior to the advent of the CMBS market, most commercial mortgage lending was done by insurance companies. With CMBS out of the picture, this is a sweet spot for insurers and commercial banks right now – they can pretty much pick the best loans, the best properties and the best borrowers and provide refinancing. It’s become the first and most important source of financing for the market," she says.
There will be a heavier refinancing burden next year in the US – and from 2011 onwards in Europe – so eventually, the absence of the CMBS market might start to pinch more severely. Tcherkassova has no doubt that there’s enough funding available to cover the needs of borrowers with performing loans who will be refinancing this year, with some capacity left to cover part of 2009. "Hopefully, by the middle of 2009 we’ll see CMBS back in action. If not, then we’re definitely going to have an increase in non-refinanced CMBS loans entering default – the other funding sources have their limits and by the middle of next year I think they’ll be exhausted," she says.