Mortgage finance: Have sub prime lenders missed the boat?
Rising personal bankruptcy levels and an uncertain economic outlook in the UK might suggest that non-conforming and sub-prime mortgage lending is not the smartest business line to jump into at the moment. Try telling that to the succession of new entrants now preparing to try their luck in this sector – one in which veterans might suggest that they are already 10 years too late.
Kensington Mortgages established the blueprint for securitization-funded sub-prime mortgage origination when it was established in 1995. The market has remained the preserve of specialist players, some of which have been sufficiently profitable to be snapped up by investment banks including Lehman Brothers (Southern Pacific Mortgages – SPML – and Preferred Mortgages) and Merrill Lynch (Mortgages plc). Both of these banks are expected to increase their involvement in the sector through further acquisition. Investor acceptance of sub-prime RMBS mortgage risk has meant that the cost of funding for these lenders has dropped significantly in recent years.
One new entrant is Basinghall Finance, a joint venture between Home Funding and WestLB. “We will target sectors of the more value-added areas of the market, which may include components of non-conforming, sub-prime and buy to let,” says Tony Ward, chief executive officer of Home Funding. “We are not trying to reach everyone and will have very targeted distribution, which is key,” says Ward. “Our food chain is shorter as it does not involve a centralized lender.”
Deutsche Bank has begun originating mortgages from its new originator, DB Mortgage Finance, and Morgan Stanley completed its acquisition of Advantage Home Loans in December. Investec is in on the act through its Unity Homeloans subsidiary (a joint venture with the Professional Mortgage Packagers Alliance) as is Oakwood Home Loans. Both firms were launched in November last year. HVB is active in sub-prime mortgage funding via a tie-up with Beacon Home Loans and its Bluestone Securities funding vehicle, which pools portfolios from different originators to reach critical mass. Dresdner Kleinwort Wasserstein is also participating in the sub-prime market, funding near-prime mortgages originated by Victoria Mortgages, a sub-prime lender. The mortgages have been placed in a special purpose vehicle called Livingstone Mortgages, which is funded via Beethoven Funding Corporation, a Dresdner-sponsored ABCP conduit.
Mortgage rates have steadily fallen in the UK throughout the decade since Kensington launched. “Spreads on securitizable assets are pretty tight so new entrants will probably be looking for more credit-intensive assets to get spread,” says Simon Potter, director in asset securitization at HVB in London. This might involve them targeting higher-risk borrowers or more aggressive mortgage structures – a risky proposition at this stage in the cycle. Kensington itself dipped into reserve funds on two of its RMS securitizations in June last year, and Lehman subsidiary SPML recently had to tap the reserve fund on its SPS 2004-2 deal.
The sub-prime RMBS market in the UK has yet to be tested in a downturn but structurers always emphasize the protection that is built into the deals. “Credit enhancement is several percentage points while historical losses have been basis points,” says Potter. But he adds that “the key is not the securitization technology [which is well tested], it is the ability to originate the right assets. Connecting up with the right broker/packager community will be crucial.”
Back office first
With so much interest in the sector, new entrants will need to find their niche as it will be difficult to compete with the many well-established lenders in the sector. “If you steam in as an investment bank without real world know-how you could come unstuck very quickly,” says Potter. “That is why banks need to invest in back office first.”