Running dry

The UK has seen an old-style bank run like those of the nineteenth century. German lenders have struggled to prop up failing conduits. Contagion from the US has reached Europe but not in the way anyone expected. Subprime lenders, in particular, have been quick to increase their rates and tighten lending criteria. By Dippy Singh

Victoria Mortgages, just a few months ago, was enjoying a subprime mortgage boom in the UK. But this September the company went into administration, a turn of fortunes that few European lenders were expecting.

Victoria's fate was determined by the capital markets. The current US mortgage crisis sent the global capital markets into a spin this summer, resulting in investors effectively shutting their doors to those that depend on their funding, regardless of how safe the collateral might be.

Victoria, owned by US private equity firm Venturion Capital, withdrew its entire product range on August 3, planning to re-launch with higher product rates when the markets settled.

Victoria confirmed soon after that it no longer had a funding line with Barclays Capital, although the lender's chief executive officer, Kevin Hilgren, said this funding had been cut at least a year before. The London-based lender also received funding from Swiss investment bank UBS, which itself had announced a profit warning due to the turbulent markets. UBS has now cancelled that credit line too.

As a result, Victoria became the first European victim of contagion even though bankers had been adamant that US problems would not spread. The European and US mortgage markets are still markedly different. In the UK, where delinquency rates are among the highest in Europe, only 1% of all mortgages were in arrears in the first half of 2007, according to the Council of Mortgage Lenders (CML). This compares to 5.12% of mortgages in the US for the same period, data from the Mortgage Bankers Association (MBA) shows.

Despite this, spreads on European residential mortgages-backed securities (RMBS) are witnessing unprecedented widening as investors view deals with mistrust and fear. In mid-September, spreads on UK prime triple-A tranches reached 60 basis points (bps) above Libor, according to Merrill Lynch, compared to 10bps in July. On triple-B tranches of UK subprime deals, if you could find a buyer, spreads stood at an eye-watering 350bps above Libor. The cost of funding through securitisation for mortgage lenders in Spain and the Netherlands had reached equally unappealing extremes (see Figure 1).

Asset-backed commercial paper (ABCP), a favoured funding tool of German banks in particular, also saw spread widening of around 50bps to 60bps over Libor during August, according to Fitch Ratings, up from normal levels of around 1bp under Libor.

Meanwhile, data from the Council of Mortgage Lenders (CML) shows that three-month borrowing in the London money markets increased to around 0.9% above the Bank of England base rate at the start of September, compared with the normal 0.2%.

On September 5, this led the Bank of England to break with protocol by raising its aggregate reserves target for the next month by 6% to £17.6 billion in an attempt to ease the pressure. This effectively allowed banks to borrow at the repo rate of 5.7% rather than market rates.

Later the same month, Northern Rock, the UK's fifth largest mortgage lender, was forced to obtain emergency funding from the Bank of England as liquidity ran dangerously short.

Though the fundamentals of the European mortgage and housing markets are essentially unchanged, there is little certainty over when investor appetite will return. Stuart Jennings, managing director of European RMBS at Fitch Ratings, says the RMBS sector could remain subdued for the remainder of 2007.

"These are unprecedented times. Those with the least diverse funding bases will be the most exposed," he says.

Deutsche Bank analysts predict primary securitisation volumes will fall by as much as 70% to 80% in the final four months of 2007 compared to the same period last year.

The effects of this global markets fallout have been felt most in the UK, especially among subprime lenders who have seen the cost of funding increase almost on a daily basis.

Within a period of days during August most lenders re-priced products to match increased funding costs (see Figure 2). Many revised their product criteria by lowering loan-to-value ratios (LTVs) and the amount of previous borrower arrears they would accept.

Mortgages plc, for example, will no longer accept buy-to-let loans (where the borrower obtains the property to rent it out) on its heavier adverse deals. Likewise, Platform, owned by Britannia Building Society, has removed its buy-to-let products from its light and medium adverse ranges. These are examples of revisions being made across the UK subprime sector and show which areas are now seen as too risky and uneconomical to fund.

Many lenders have also either withdrawn or limited their first-time buyer products. Meanwhile, unlimited adverse (where the lender accepts an unlimited number of previous arrears and county court judgements (CCJs) accumulated by the borrower) could be the first products to disappear from the UK landscape entirely. Platform has removed its unlimited CCJ policy from its heavy adverse range, as has Deutsche Bank's UK lender, db mortgages.

Platform, which relies on securitisations and portfolio sales as well as Britannia's balance sheet for funding, has also lowered the maximum LTVs allowed on new build properties. It is the only lender so far to announce such changes.

Those that are not owned by investment banks but depend on them for funding lines have been hardest hit by the capital markets downturn. Infinity Mortgages and Unity Homeloans, which had been funded by South African investment bank Investec, withdrew all their mortgage products at the beginning of August.

Like Victoria, they said they hoped to launch new products once the capital markets stabilised. However, Investec, which has recently bought Kensington Group, including Kensington Mortgages, says it is no longer able to guarantee funding for the two lenders.

Infinity said in September that it was planning to make a number of redundancies, while in the same month it launched a new mortgage packaging company. Packagers act as the broker's broker, helping intermediaries source subprime deals and carry out elements of administrative work. But Infinity insists this is not a back-up plan or diversion, and says it will return to the market as a lender.

At the time of writing neither Infinity nor Unity had secured alternative funding.

Going forward, investors' newfound risk-aversion will mean changes to the way funding deals are structured and sold. Gary Styles, strategy, risk and economics director at Hometrack, the UK's biggest housing data provider, says investors will want more information about the assets they invest in.

"Traditionally, lenders have focused on the borrower credit profile and the loans, rather than the actual properties they are lending on," he says. "Investors will be expecting more detailed analysis of individual loans on all counts, including the property risk."

This could include providing bondholders with asset scores for each individual property and more information on what will happen if lenders have to take repossession of a home.

Meanwhile, regular borrowers in the capital markets and established lenders are likely to fare better with investors than newer lenders. This has been reflected by the pace with which newer market entrants are dropping higher-risk products.

For example, while most lenders have increased rates on their self-certification mortgages, db mortgages, which has only issued two securitisations (both this year), has temporarily removed all self-certified products from its subprime range.

This is despite self-certified mortgages making up three-quarters of the portfolio for the lender's most recent RMBS deal, the £500 million Eurohome UK Mortgages 2007-2 in August. Jennings at Fitch says: "db mortgages is not alone in withdrawing products. But not as many lenders have gone as far as it has. Investors may pose the question, 'Why have they withdrawn these products?'"

The amount of light to heavy adverse lending in the pool also increased to 40.61%, compared with 9.1% in db mortgages' first securitisation in April 2007. The amount of unlimited adverse also rose - making up 17.4% of the pool, compared with 3.6% in Eurohome UK Mortgages 2007-1.

The triple-A tranche on db's second deal priced inside the triple-A notes on its first, but spreads on lower tranches were substantially wider (see Figure 3).

Jennings says the ambitious lending targets of the newer lenders, which served to create fierce competition among subprime lenders, have caused concern that credit standards were being eroded.

Derek Lloyd, group treasurer and head of capital markets at Kensington Mortgages, which is recognised as the pioneer of UK subprime mortgage lending, says money is still available but investors are becoming increasingly careful about where to invest it. "That decision will be made easier by securitising portfolios that were constructed by experienced lenders, who have priced for risk," he says.

Deal structures are likely to be less complex when the market recovers, too. "I think it's entirely possible that issuers and arrangers may choose to structure securitisations in a more plain vanilla way to attract investors," says Jennings. "They may, for example, choose to minimise features that strip out excess spread in deals and allow for more excess spread to flow through as credit support."

Features of this type include detachable coupons and interest-only strips attached to particular note levels that strip out the excess spread available to cover credit losses.

These have been especially popular in Spain. Many Spanish RMBS transactions include asset swaps that extract some of the credit enhancement provided by excess spread. Other features popular in the Spanish market include setting up a principal-amortization mechanism that becomes more conservative as defaults increase, or using interest-only tranches to fund the reserve fund. These affect the final capital structure on deals, necessitating higher subordination.

At the same time, European mortgage lenders are turning to other channels for funding. GMAC-RFC, one of the biggest UK issuers of RMBS, has switched from securitisation to trading heavily in the whole loan market.

Last year, GMAC-RFC completed four securitisations worth a total of £3.9 billion. This year, it has completed just one, valued at £525 million. Meanwhile, at the time of writing, GMAC-RFC had already executed 18 portfolio sales worth £7 billion this year compared with 25 deals in the whole of 2006 at a total value of £6.8 billion.

In April 2007, GMAC-RFC sold three mortgage portfolios to Oakwood Homeloans in a deal worth £923 million, the lender's largest portfolio to that point. But in late August, GMAC broke that record again by selling a £1.1 billion portfolio to Bradford & Bingley.

Some of the apparent liquidity in the whole loan market is the result of bargain-hunting investors, and some portfolios are being sold at a loss, according to traders. One UK lender is understood to have recently sold a £1 billion-plus portfolio at a 1.5% loss to face value, generating a potential loss of tens of millions of pounds.

Jeff Knight, director of marketing at GMAC-RFC, says the lender has not experienced any losses from its portfolio sales and expects healthy demand from whole loan trading partners going forward, despite some recent buyers being affected when they securitised the bought assets.

Three UK mortgage securitisations issued this May and June had triple-B spreads priced at levels up to 30bps wider than expected. And all three (ResLoC 07-1, ALBA 07-1 and Clavis 07-1) contained loans bought from GMAC-RFC.

According to Standard & Poor's, the three deals were marketed with price talk around 90bps for their triple-B tranches, but priced with spreads between 115bps and 120bps. This suggests lenders seeking funding in the whole loan market will still find themselves vulnerable to fluctuations in securitisation spreads.

Meanwhile, the implementation of Basel II capital adequacy requirements at the smaller building societies, who have traditionally formed the backbone of the whole loan market, could also curb their appetite for buying loans. Styles, at Hometrack, says: "Basel requires you to provide a lot more information on individual loans such as default probabilities. Buying in new books will only complicate the matter.

"Lenders should also prepare for the fact that building societies will be expecting much more detailed analysis of individual loans within the portfolios."

One last option for European lenders seeking funds might be the covered bond market where spread widening has been much less extreme than in RMBS (see Figure 4). Louis Hagen, executive director of the Association of German Pfandbrief Banks, says usual spreads on German covered bonds (Pfandbrief) versus swaps are between -2bps and -7bps, while Pfandbrief are now trading at spreads flat to swaps or down to about -5bps.

"In general, covered bonds are behaving very calmly in relation to the rest of the financial markets," he says. "While longer-term bonds, such as those above 10 years' maturity, are still difficult to gauge, medium-maturity covered bonds are doing well. There is liquidity there. Spanish and UK covered bonds spreads aren't fairing as well as other European programmes, but they are still doing better compared to other markets, like RMBS."

Analysts expect securitisation issuers to tap the covered bond market in the near term. With about EUR27 billion of European covered bonds issuance expected in the remainder of this year, net supply is likely to top about EUR65 billion in the month ahead, says Sabine Winkler, covered bonds analyst at Merrill Lynch.

The bulk of supply should come from Spain, she says, with roughly EUR30 billion in new issuance, followed by Germany and the UK with about EUR15 billion each. Some inaugural deals out of Norway, Portugal, Italy and Canada are also due to come to market.

But Tim Skeet, head of covered bond origination at Merrill Lynch, says: "We are asking: 'Does the covered bonds market have the capacity to pick up the slack?' The initial signs are that this sector can absorb a certain amount. And it is reassuring that HBOS and Nationwide introduced new bonds at the beginning of September."

But the pricing of Nationwide's covered bond sparked new concern, pricing wider than hoped and possibly making it harder for other new issuers to access funding. While HBOS priced its bond at 5bps above mid-swaps, Nationwide came in at 15bps above Euribor.

One source close to Nationwide says: "It was known that a Spanish bank was about to come with a bond too, so that forced Nationwide's hand."

Hagen says some lenders will have to re-evaluate the types of loans they originate if they want to fund through covered bonds. "Some of the mortgage business German banks had planned to securitise might not be eligible for covered bonds. For example, loans of high LTV would not be allowed. Generally, maximum LTVs for covered bonds are between 60% and 80%," he says.

High LTV mortgages in Germany are rare but not unknown. The alternative is to wait for the RMBS market to recover, or fund the assets through senior unsecured debt, Hagen says. But doing so is much more expensive.

Hagen believes German banks might also follow their UK counterparts and increase mortgage product rates. "No German lenders have opted to do this yet. But it is possible some will seek higher margins this way," he says.

In the UK, the covered bond structure is less rigid, says Skeet: "There is an LTV issue, but it depends on how you put the loans in the pool and at what level. Traditionally, in the UK, covered bonds were structured by the RMBS teams, and draw on RMBS technology."

Smaller lenders might also find ways to access the covered bonds sector. "Some can go through other parties," Skeet says. "Nationwide Building Society has said to smaller societies that if they want to access the market, they could go through its programme. There was also some talk a while back of some smaller UK lenders clubbing together to create a conduit whereby they could issue covered bonds."

Whether mortgage lenders decide to wait for the market to stabilise or take decisive action and change their funding models, they can no longer hide behind the comforting thought that they are immune from US troubles. When fear is driving the markets, the fundamentals really don't seem to matter.

ABCP NOT ROLLING ON

As subprime contagion spread to Europe in August, lenders that were reliant on funding via short-term commercial paper conduits backed by mortgage assets suffered especially.

Commercial paper (CP) is issued on a rolling basis ('rolled over') through conduits, in order for borrowers to fund longer-term assets like mortgages.

Commercial paper spreads widened by as much as 50bps to 60bps above Libor in August, and were still as wide as 40bps to 50bps in September. Spreads are normally around 1bp under Libor.

Towards the end of August, European issuers of ABCP failed to find investors for $3.5 billion out of the $6 billion of debt maturing on one day.

A teleconference held by Fitch Ratings on August 23 put bank exposure to ABCP at around $891 billion in Europe, the Middle East and Africa. This is just 3% of the assets of the 44 banks examined. As such, analysts agree that most banks should meet any funding calls arising from conduits.

However, Deutsche Bank says CP investors are among the most conservative in the world. Anthony Thompson, research analyst at Deutsche Bank, says: "To the extent that market volatility continues, we cannot ignore the fact that ABCP investors hold the keys to determining what issuers can fund in this market and at what price."

German banks, rated as one of the biggest issuers of ABCP, are most vulnerable, although a number of UK institutions including HBOS, Lloyds TSB, Barclays Bank and HSBC are frequent users of this market.

Two German banks, IKB and Landesbank Sachen, had to seek financial help after their ABCP conduits hit trouble as liquidity dried up in August.

Another risk is that large amounts of the conduits' securities will end up on the balance sheets of sponsor banks that provide their liquidity facilities. That would force banks to absorb any mark-to-market fluctuations and set aside necessary regulatory capital against those securities.

During the market turmoil HBOS announced it would use its own liquidity to repay the maturing debt of its Grampian conduit, where the assets now sit on the lender's balance sheet.

Mark Elliott, a spokesman at HBOS, says the bank has the financial strength to cover the whole £35 billion programme if necessary. "Financing the conduit ourselves at more preferential prices rather than issuing more CP makes sense, and we expect more lenders to do this. We have only funded a proportion of it, but if we funded more and more, there would be absolute minimal impact on our capital ratios."

Standard & Poor's estimates that if HBOS were to fund Grampian's entire asset base, the lender's risk-weighted assets would rise by almost £14 billion and its Tier 1 ratio, which was 8% at June 2007, would fall by 40bps, which it believes HBOS would be able to comfortably absorb.

The reduced investment activity of ABCP conduits could also affect RMBS spreads. ABCP conduits are large investors in triple-A tranches of securities including ABS, RMBS and CDOs. Any limitations in their efforts to address maturing CP needs are bound to have a further negative impact on the wider market, reducing demand for triple-A paper, says Merrill Lynch.

FIGURE 2. UK LENDERS' PRODUCT CHANGES SINCE CAPITAL MARKETS MELTDOWN

LENDER: PRODUCT RE-PRICING

Alliance & Leicester: Subprime fixed rates increased by 1.16%, self-certified fixed rates increased by 0.79%, variable rates withdrawn

Advantage (owned by Morgan Stanley): Subprime rates up 1%, self-cert up 0.85%, buy-to-let up 0.85%

Amber Homeloans: Self-cert fixed rates up 0.10%, self-cert up 0.50%

BM Solutions (owned by HBOS): Selected subprime full status rates up 0.70%, subprime self-cert increased by 0.50%

Cheltenham & Gloucester: Subprime fixed and tracker rates increased by 1%

db mortgages (owned by Deutsche Bank): Subprime rates increased by 1%, self-cert products withdrawn from subprime range, unlimited adverse pulled

edeus (part-funded by Merrill Lynch): Subprime rates increased by average of 0.65%

First National and igroup (part of GE Capital group): First National rates up by 0.62%, igroup rates up by 0.33%

GMAC-RFC: Unlimited adverse range withdrawn. Prime mortgages increased by 0.50%, subprime up 0.75%. LTVs lowered to 90% from 95%

Infinity Mortgages: Withdrawn entire products, yet to re-enter

Kensington Mortgages: Medium and heavy adverse subprime rates up by 1.5%, maximum LTVs lowered to 75% across range

Lehman Brothers (Preferred Mortgages and SPML): Increased all subprime rates. Shut down UK secured loans businesses. Will 'rescale' US and UK mortgage operations

Money Partners: Prime rates up 0.35%, subprime rates up 0.75%. LTVs lowered on medium to heavy adverse products

Mortgages PLC (owned by Merrill Lynch): Subprime fixed rates increased by 1%, then again by between 0.05% and 0.90%, withdrawn certain buy-to-let adverse deals

Northern Rock: Subprime fixed rates up 1.25%, subprime tracker rates withdrawn

Platform: Prime rates up 0.40%, subprime rates up 1%, maximum LTVs lowered to 90% from 95%, unlimited adverse withdrawn

Rooftop Mortgages (owned by Bear Stearns): Subprime rates increased by 0.65%

Salt: No longer accepts applications with arrears in last three months

Unity Homeloans: Withdrawn entire range, yet to re-enter

Victoria Mortgages: Withdrew entire range. Gone into administration

Source: Mortgage Risk/Moneyfacts.