We are paying a 9% coupon on our lower tier 2 debt so why would we sell our equity pieces for 10% to 12%?
Established by ex-Goldman Sachs securitization supremo Martin Finegold in 1995, Kensington (now under the stewardship of its ex-Abbey CEO, John Maltby) grew its assets under management by 38% to £5.7 billion ($10.2 billion) in 2005. In November 2000 it was the first non-conforming lender to be listed and wrote the blueprint for non-conforming and sub-prime mortgage origination in the UK. And Kensington is still regarded as the blue-chip lender in this market a full decade later.
Securitization is the foundation of Kensingtons capital markets activity: the firm now has three active securitization programmes and issued £2.55 billion of bonds via four deals in 2005. The Residential Mortgage Securities (RMS) platform is now on its 21st issue and has been going since the companys inception. The Money Partners Securities (MPS) programme was launched in July last year with a 400 million issue. Money Partners is a joint venture between Kensington and a group of former igroup executives. The third securitization platform funds Kensingtons first foray into non-UK lending. Known as Lansdown Mortgage Securities (LMS), it was launched in April, backed by Irish mortgages written by Kensington subsidiary Start Mortgages.
Investor acceptance of non-conforming mortgage risk has broadened significantly in recent years (the result of a combination of the search for yield and a benign economic environment) and originators in this space have seen their funding costs plummet. In September 2000 Kensington was paying 37.5 basis points over Libor for 3.5-year triple-A sterling RMS paper; in October 2005 it paid 20bp even though it had recently drawn on the reserve funds of two previous RMS deals. It paid 120bp for single-As in 2000 and 58bp in 2005. The investor base continues to be deep and growing in diversity and demand, and we are spending a lot of time from an investor relations standpoint in making sure that we understand the key drivers for investors how their demand is changing, how their portfolios may be changing and therefore their availability for different maturities, rating levels down and up the credit spectrum, says group treasurer Mark Wilten.
Wilten joined Kensington in October 2004, having previously been the warehouse lender and securitization transactor for the company during his six years at WestLB. He is responsible for cash management, funding, securitization strategy and whole-loan sales. Wilten notes that changing demand has meant that investors are increasingly prepared to buy below triple-A, and Kensington itself has now issued down to double-B. But it is unlikely to issue below that for the time being, or explore selling equity risk. We have priced up what the market is demanding at the moment for equity returns and we do not believe it is an economic transaction for us, he says. The IRRs are high we know that investors are looking for 12% to 15% and we have heard of some even more aggressive bids of 10% to 12%. For us that still doesnt make any sense. We are paying a 9% coupon on our lower tier 2 debt so why would we sell our equity pieces for 10% to 12%? Kensington floated a £75 million lower tier 2 subordinated bond in November 2005. The cashflow assumptions that first-loss investors are running are also deemed too conservative. It is something that we will always continue to look at but the market dynamics are not right at the moment, he says.
But as funding costs have dropped, so have margins on mortgage lending. This is because the nature of Kensingtons client base has changed. Its business was founded on lending to people that traditional lenders would not accept and in 1995, just after the UKs 1990/91 house price correction, there was no shortage of them. But more than two-thirds of Kensingtons business is now classified as near prime or at the lower end of its adversity scale. Wilten explains that this is simply a by-product of economic circumstance. Near prime accounts for a significant proportion of new business [15%]. It didnt even feature before it is new to the market in the last 12 to 18 months, he explains. This is our price-to-risk strategy the price we get from that asset mix is lower but the risk we get is correlated. We havent moved away from higher-adversity products, it is the economic environment in which we find ourselves. If we are getting it right, we should be happy with a pricing and risk profile under which we have to take 100% of our business high adverse, or 100% of our business near prime, or anything in between.
Kensingtons average gross margin fell by 20bp last year but it still makes 3.3% over Libor on net lending, which itself grew by 88% to £2.29 billion. This sector is, however, undergoing a fundamental change, with more and more new mortgage lenders moving into Kensingtons territory [see Have sub prime lenders missed the boat? Euromoney, April 2006] and aggressively trying to build market share. Investment banks (particularly Lehman Brothers and Merrill Lynch) have also bought up many of the independents, and Kensington is now an obvious target for takeover speculation.
Wilten emphasizes the benefits to the company of its independence and quashes any buyout rumours. We are the only independent in the sector and we are not for sale, he says. From time to time we do receive approaches they have always been informal and they have never led to further conversations.
Competitive pressure among new originators to build market share has led to the emergence of a thriving whole-loan trading market in the UK into which Kensington has sold just over £1.2 billion of loans. There are now a lot more buyers, says Wilten. This market started with building societies that were flush with capital and didnt really have the ability to put that capital to work. We have now seen some of these players start to get interested in originating these types of assets themselves. Whole-loan sales will remain around 15% to 20% of overall completions.
It has taken 10 years for non-prime mortgage lending to become the bandwagon that it is today, but those merrily leaping on board (both in the UK and continental Europe) have been given pause for thought by the succession of reserve draws that have taken place in RMBS deals backed by these assets. Kensingtons draws on the reserve funds of two deals last year were small (4% for RMS 15 and 1.9% for RMS 16) but were met with considerable shock in the market, given the originators otherwise stellar reputation. The precise structure of Kensingtons securitizations can be held partly responsible: the deals incorporate detachable coupons and interest-only strips, which suck out most of the excess spread and necessitate larger reserve funds.
Keeping the market informed
The credit enhancement in our deals is the same as it would be if our capital structure was different, emphasizes Wilten. There is a perception in the marketplace that a transaction with excess spread structured out is more risky from a credit perspective than a transaction that does not have any excess spread structured out of it. This is not the case. He explains that Kensington devoted a lot of time and energy to managing the fallout from the reserve fund draws. We took a lot of advice as to how we managed the dissemination of information and told the market about what was happening, he says. We met with more investors for the subsequent transaction [RMS 21] than we have ever met with before for a securitization and we spent an awful lot of time answering questions. The deal was subsequently upsized by 20% and came at or inside price guidance for all tranches, which Wilten sees as vindication of this policy.
Kensington emerged from the episode unscathed but the risks inherent in this type of lending are now under intense scrutiny. The latest transaction to be hit by a reserve fund draw (Farringdon Mortgages 1, in April) involved an inexperienced originator in Rooftop Mortgages, which only began operations in 2003 just as base rates began to rise. The deal itself is only a year old.If more and more new UK lenders experience growing delinquencies, reputational risk will arise for this sector as a whole. But Kensington should be able to remain above the fray if there is any widespread blowout and indeed could benefit if there is a flight to quality within the non-conforming sector itself. And if the firm continues to expand its lending into continental Europe, this will mitigate its exposure to UK consumer credit. Wilten confirms that Kensington is actively considering other markets in Europe, but declines to go into specifics. What we look for is a viable market in terms of a natural specialist customer that needs our product offering, he says. We need to have the right opportunity. We become aware of things from time to time we didnt necessarily have a desire to go into Ireland, it wasnt at the top of our list. We just became aware of the opportunity and everything in terms of the assessment looked good. And that business has been very successful.
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