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CONTENTS
Overview .............................................................................................................. 3 The Retail Market ................................................................................................ 3 The Securitised Market ........................................................................................ 7 The Mortgages ..................................................................................................... 8 Types of Mortgages ...................................................................................... 8 The Terms of the Mortgage ........................................................................ 10 Underwriting Criteria .................................................................................. 11 Non-Conforming Mortgages ...................................................................... 12 Prepayment and Credit ....................................................................................... 12 Factors Affecting Prepayment and Credit .................................................. 13 Recent Prepayment Performance ................................................................ 16 Recent Credit Performance ......................................................................... 16 Institutional Infrastructure ................................................................................. 18 Distribution Channels ................................................................................. 18 Appraisal and Approval Process ................................................................. 18 Foreclosure Procedures ............................................................................... 18 Structures ............................................................................................................ 19 Abbey National (Homes Funding) Structure.............................................. 19 Northern Rock (Granite) Structure ............................................................. 22 Bank of Scotland (Mound) Structure ......................................................... 23 Relative Value .................................................................................................... 24 Conclusions ........................................................................................................ 24 Appendix ............................................................................................................ 26
The author would like to express his appreciation to Milind Chaukar, John Dziadzio, and Ron Miao for contributing significantly to the content of this report. Jerome Bire, Rob Collins of Abbey National, Colin Hector, Nur Khan, David Johnson of Northern Rock, Prafulla Nabar, Brett Olson, Chris Patrick and Nick Turnor also provided comments on earlier drafts.
Publications: L. Pindyck, A. DiTizio, B. Davenport, W. Lee, D. Kramer, S. Bryant, J. Threadgill, R. Madison, A. Acevedo This document is for information purposes only. No part of this document may be reproduced in any manner without the written permission of Lehman Brothers Inc. Under no circumstances should it be used or considered as an offer to sell or a solicitation of any offer to buy the securities or other instruments mentioned in it. We do not represent that this information is accurate or complete and it should not be relied upon as such. Opinions expressed herein are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors. Lehman Brothers Inc. and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, Lehman Brothers Inc., its affiliated companies, shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of Lehman Brothers Inc. or its affiliated companies may be a director of the issuer of the securities mentioned in this document. Lehman Brothers Inc. or its predecessors and/or its affiliated companies may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities of any issuer mentioned in this document within the last three years, or may, from time to time perform investment banking or other services for, or solicit investment banking or other business from any company mentioned in this document. This document has also been prepared on behalf of Lehman Brothers International (Europe), which is regulated by the SFA. 2001 Lehman Brothers Inc. All rights reserved. Member SIPC.
OVERVIEW
The mortgage market in the United Kingdom is among the most promising assetbacked markets to emerge in the last few years. Due to high home ownership rates, significant home price appreciation, attractive interest rates, and intense competition among mortgage originators, the retail market has grown at an impressive rate since 1995. Meanwhile, changes in the UK banking industry have made it more attractive for lenders to tap the securitised market for funding. The securitised mortgage market has grown from virtually zero in 1995 to about 12 billion in 2000. This paper is an introduction to the mortgage market in the United Kingdom (England, Northern Ireland, Scotland, and Wales). We start with an overview of the retail market, including a discussion of the major types of lenders. We then discuss the securitised market and its potential. Since the underlying mortgages represent the collateral for securitisation, we devote a section to discussing the types of mortgages and the common terms and conditions, including underwriting criteria. We also discuss the data available and the factors that affect prepayments and credit performance of UK mortgages, and the institutional infrastructure in the UK. Finally, we close with a description of the structures most commonly used in UK mortgage securitisations and our view of relative value in the sector. The primary focus of this paper is prime mortgages, but we briefly discuss the nonconforming market as well. A note about currencies: since the collateral is in pound sterling, we will show all numbers in . When the data were available in euros or in dollars, they have been converted to pounds on the basis of $1.5 = 1 and 1.58 = 1, which are the prevailing rates as of writing.
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period, and home ownership has remained at a very high level of 67%. On a per capita basis, outstanding mortgages are about 9,111, which is comparable to the amount outstanding in the US, and higher than in Germany and France. Only Sweden and Holland have higher per capita mortgage balances. Most analysts now project that the markets growth will slow, but will continue at a lower rate of about 5%-6% for the next two years and 3%-5% over the longer term. While there are a large number of originators in the UK mortgage market, the top five lenders account for about 50% of the entire market. There have been several developments in the mortgage banking industry over the past few years that have increased the concentration in the sector. Figure 2 shows the 15 largest originators of mortgages at year end 1999, which have already consolidated to 13. The total
Figure 1.
Retail Mortgages Outstanding ( billion)* Retail Mortgages Advanced ( billion)** Mortgages Outstanding per capita ()*
* Source: Datamonitor and Bank of England statistics. ** Source: Council of Mortgage Lenders.
Figure 2.
Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
* Now part of Barclays Bank. ** Now part of Royal Bank of Scotland. Source: Council of Mortgage Lenders.
assets shown include assets that have been securitised. To understand the retail market, it is useful to group lenders into three major categories: building societies, banks, and specialty finance companies. Until recently, mortgage lending was dominated by building societies. These are mutual entities which are owned by depositors and borrowers, who are collectively known as members. Over time, some building societies have demutualized and converted to stock corporations initially owned by their former members. Many other building societies have retained their mutual status, e.g., Nationwide and Britannia are the bigger of these. Building societies, which accounted for over 60% of outstanding balance as recently as 1993, accounted for less than 20% of all mortgage lending by 2000. Building societies are regulated by the Building Societies Commission and are subject to a number of restrictions in addition to capital and reserve requirements, in accordance with the Building Societies Act. While they have become gradually less onerous over the years, some restrictions remain. For example, they must hold at least 75% of their business assets in residential mortgages. Further, they must raise at least 50% of their funds from individual members. Finally, since securitisation usually involves the transfer of ownership of the loan to a trust, it could cause a borrower to lose mutual membership. These factors limit the degree to which building societies can securitise their assets. Since they are mutual companies, building societies in effect distribute their profits by offering lower mortgage ratesbuilding society rates have typically been 45-65 bp lower than bank rates, but the differences are rapidly disappearing as banks have become more competitive. The bank category consists of converted building societies, as well as high street banks. Some of the former building societies that have converted to stock corporations are Abbey National and Halifax. Both of these have further developed their branch networks, deposit base, and other investments and are now almost indistinguishable from other banks, except perhaps for their business mix. Since Abbey National has been a stock entity for much longer, they have a more diversified mix of both lending and funding, with mortgages accounting for 36% of their assets, compared with about 53% for Halifax. There are a number of high street banks that are active in the mortgage market as well. These include Lloyds TSB, The Royal Bank of Scotland, Barclays, HSBC, and Bank of Scotland. Banks, including high street banks and building societies which have converted to banks, now account for over 70% of all mortgage lending. The other class of lenders is finance companies. These typically lend to nonconforming borrowers, a broad category which includes borrowers with imperfect credit or borrowers who are unable to document their income. The largest lenders in this segment include I Group, Kensington, RFC, Mortgages PLC, and SPML. This has traditionally been an under-served market, and we expect this to grow quite substantially over the next few years.
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Select Lenders
Abbey National plc: Abbey National started as a building society and converted to a stock company in 1988. It now has diversified retail banking and insurance operations with 765 branches and over 15,000 employees. Abbey National has total assets of 180 billion, of which mortgage assets account for 64.9 billion. They have been active in the securitisation market with two transactions in 1999 and two securitisations totaling about 5.0 billion under the Holmes Financing Master Trust in 2000. Halifax plc: Founded in 1853 as a building society, it has since converted to a stock company. It offers a wide range of consumer financial services, including mortgage and auto loans, credit cards, home and auto insurance, retail banking, and stock trading. The Halifax has total assets of 173 billion, of which mortgages account for 93 billion. 68% of the new mortgage business is variable rate. Halifax generates 48% of their new loans through retail channels. The three-month arrears amount to 1.39% of the total portfolio, which is slightly lower than the average for Council of Mortgage Lenders. Northern Rock plc: Founded in 1965 as a result of the merger of two smaller building societies, Northern Rock acquired over fifty more societies, before converting to a public limited company in 1997. It is primarily engaged in the mortgage and personal finance business. It has smaller businesses in general insurance through AXA and life insurance through a relationship with Legal & General. It also accepts deposits through a small branch network of 89 branches and a postal and telephone based operation. About 60% of the mortgage business is originated through intermediaries. Northern Rock has completed three securitisations (one in 1999 and two in 2000) totaling 2.6 billion. Assets under management totaled 20 billion, of which mortgages accounted for 79%. The historical performance of the Northern Rock portfolio has been very good, with arrears of three months or more being only about 0.9% of the total portfolio. Nationwide Building Society : Nationwide is now the largest of the building societies. It was formed as the result of a series of mergers of over a hundred building societies and has retained its mutual status. At the end of 2000, Nationwide had mortgage assets of 48 billion out of total assets of 64 billion. Mortgage assets grew almost 17% compared with 1999. They transact through a network of 681 building society branches. Nationwide is also active in personal lending, life insurance, mortgages for self-employed and commercial lending through subsidiaries. Bank of Scotland: Founded in 1695 by an act of Scottish Parliament, the Bank of Scotland is the UKs oldest bank. It has a history that is inextricably interwoven with that of Scotland. It now operates through a network of 325 branches, mainly in Scotland. The Bank of Scotland is a diversified consumer and commercial bank. The total mortgage portfolio stood at 15.9 billion at YE2000, an increase of more than 2 billion over 1999. The total lending portfolio is 55.5 billion, and total assets amount to 71.8 billion. The bank is also active in motor vehicle finance and in unsecured consumer finance. Bank of Scotland has completed two securitisations to date, one in 2000 amounting to 765 million and another in January 2001 amounting to 740 million.
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floating rate mortgages have virtually no duration or convexity, banks have not found it necessary to transfer any interest rate risk. However, we see increasing demand at the retail level for fixed-rate products of different kinds. Fixed-rate mortgages have option costs embedded in them due to the prepayment option, causing them to have negative convexity. In the long run, it is economically optimal for this convexity to be sold into the capital markets, and securitisation represents the most efficient way to do this. 6) Securitisation also requires changes in the internal systems of many lenders, which has taken some time, but are now mostly complete for the larger lenders. As a result of the changes in these factors, we believe that the UK securitised mortgage market is on the cusp of dramatic growth. We expect about 15 billion of newly securitised product in the market in 2001, growing to 20 billion a year over the next three years.
THE MORTGAGES
The mortgage market is competitive, and lenders have responded by developing a wide range of products to serve the differing needs of borrowers. Rates have not only become competitive, but may also have dropped to the level where many question the profitability of mortgage lending. Our analysis to date indicates that there are several collateral factors that affect the prepayment and credit behavior of mortgages. These include the type of mortgage, the rate the borrower is currently paying, the best remortgaging rate available, and the credit quality of the borrower. We discuss how each of these is treated in the market. To alleviate confusion regarding the terms and conditions of a mortgage, the UK government has set certain guidelines. The standard mortgages are often referred to as CAT mortgages (Charges, Access and Terms). The standards are not binding in that lenders are not required to offer CAT mortgages, and, in fact, they are not the most widely popular mortgages, precisely because the terms are somewhat rigidly defined. Each lender has historically published a rate called the Standard Variable Rate (SVR), to which the interest rates on its various programs are linked. However, developments over the recent past indicate that the market is moving away from SVRs towards using rates tied directly to the Bank of England repo rate.
Types of Mortgages
There are two ways to classify the mortgages made: by rate type and by product type. When classified by rate type, there are typically fixed rate and variable rate mortgages. Fixed-rate mortgages are somewhat misnamed, since the rates are generally fixed only for a period of 2-5 years irrespective of the repayment period of the loan. Variable-0rate mortgages are typically linked to the SVR of the lender. There are many variations on these two basic rate types, including discount mortgages, cash-back mortgages, and capped rate mortgages, which typically
come with attached conditions such as redemption periods. As of 1998, about 41% of all mortgages were fixed rate, 37% were variable rate, and the remaining 22% were capped or other types of mortgages. In terms of payment, there are several types of mortgages: repayment mortgages, interest only mortgages, endowment mortgages, and flexible mortgages. Repayment mortgages amortize fully over the life of the mortgage. The term of the loan, as with all types of mortgages, can be as long as 35 years, but is more commonly 20 or 25 years. Interest only (IO) mortgages require the payment of only the interest portion of the loan, while the principal balance remains unchanged. Borrowers typically make a parallel investment in a savings plan (such as an Individual Savings Plan, a Personal Investment Plan, etc.) which has a similar maturity to the mortgage. When the mortgage and the plan both mature, the proceeds of the investment may be used to pay off the principal balance of the mortgage. These mortgages appeal to borrowers who have shorter horizons or are planning to downsize their housing in the near future. Endowment mortgages are similar to IO mortgages except that the investment is made in the form of an insurance policy. Endowment mortgages do offer the advantage of giving the borrower the potential upside of alternative investments (e.g., equity), as well, and offer the borrower a wide choice funds in which to invest. However, when the endowment does not perform to expectations, the borrower is liable for the difference. Over the past few years, some adverse publicity about the adequacy of the endowment accounts has led to a drop in the popularity of IO and endowment policies to back mortgages. Flexible mortgages are the other major category of mortgages and have grown greatly in popularity over the past 3-5 years. These are mortgages which allow a borrower to draw more from a mortgage account or pay more into an account without additional transaction costs, paperwork, or penalties, subject to maintaining the conditions of the loan, such as the loan to value ratio. There are many variations on the terms of the mortgages, but in general, there are typically three elements of the loan: the initial loan, the drawdown facility, and the reserve account, which are all defined at the time the mortgage is made. Borrowers may draw additional amounts from the drawdown facility at any time. The reserve facility can be used to cover an underpayment, fund a drawdown, or repay principal. Underpayments, including missed payments, are typically allowed if there is sufficient balance in the reserve account. Overpayments are credited to the account in a predefined order, starting with overdue payments. This allows borrowers flexibility in managing their finances and has caused flexible mortgages to grow rapidly in popularity.
The rate types and payment types that we have discussed above apply to the prime quality loans made by the large building societies and the larger banks. In addition, there are a number of finance companies that offer alternative products for
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borrowers who do not meet the credit or documentation needs of the mainstream lenders. These include borrowers with mortgage arrears, the unemployed or selfemployed, as well as those with County Court Judgements against them. By some estimates, there are as many as 8 million people who fall into one of these categories.
Figure 3.
Rate (%/year)
8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5
Average Variable Rate Average Fixed Rate Bank of England Repo Rate
1Q97 2Q97 3Q97 4Q97 1Q98 2Q98 3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00
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discount mortgages. If this happens, remortgaging will be of value only to fixedrate borrowers. There are also differences in rates offered by different institutions. In particular, building societies have typically set their SVRs about 50 bp below those of banks to demonstrate the benefits of mutuality. Mortgages are also available over any term to a maximum of 30 years and occasionally longer. This is because IO and endowment mortgages usually have an accompanying investment that vests at a fixed time. Hence, if the borrower starts with a 20-year mortgage and remortgages four years into the mortgage, it would be unduly cumbersome to replan the investment. Hence, lenders usually set the term of the mortgage to match the existing investment. Most fixed-rate mortgages have a redemption penalty that applies for the fixed period. Penalties also typically apply to discount mortgages and cashback mortgages.
Underwriting Criteria
While the specific criteria used by the major lenders vary, the measures used are very similar. They can be broadly thought of as borrower credit measures, affordability measures (usually measured by the salary multiple), and the value of the property (which is measured by loan to value ratio). Credit Measures: The most widely used indicator of the credit quality of an individual borrower is the existence of County Court Judgements (CCJ) against the person. Creditors typically sue delinquent borrowers in a magistrates court, which issues a County Court Judgement. A debt repaid within 28 days of the judgement is cancelled and is removed from the record. A debt repaid after 28 days is satisfied and remains on the borrowers record for six years. A CCJ that is neither cancelled nor satisfied is considered outstanding. There are currently about 5.8 million CCJs on record against a total of 3.3 million persons. As the total population of the UK is about 55 million, the number of people with CCJs against them is about 8% of the population. Since CCJs represent actual missed payments that have been confirmed by the courts, they are a logical and very effective measure of credit quality. Some lenders also pay attention to the amount of the judgement, choosing to ignore judgements that are for only a few hundred pounds. Credit bureau scoring has also become common over the past few years. Several credit bureaus, including Experian and Equifax, collect data on borrowers, including payment history and credit inquiries. Fair, Isaac and Company recently announced a credit scoring system for UK borrowers similar to the widely used FICO scores in the US. Many lenders have also developed scoring systems using such data that allow them objectively to value a borrowers creditworthiness. It is
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likely that credit scoring will become more common and standardised within the next few years. Salary Multiple: Another criterion commonly used by lenders is the salary multiple. This is the multiple of the salary that lenders are willing to lend. This measure is somewhat different from the one used in the US, where the monthly debt payments as a fraction of the monthly income (called debt to income) is used. The two measures may be different if the interest rates are considerably different. Some lenders also have programs in which they lend to borrowers who are unable or unwilling to disclose their income, sometimes referred to as special status borrowers. Loan-to-Value Ratio: Most banks and larger building societies lend to a maximum loan-to-value ratio of 75%. A borrower who requires a higher loan to value is usually required to pay a Mortgage Guarantee Insurance fee. Other Factors: Other factors may also be factored into underwriting a loan as well. For example, there may also be exclusions, i.e., a lender may perceive some types of property as being too risky and refuse to lend on it even if the borrower satisfies all other conditions. The loan characteristics of the conforming lenders are generally similar, as Figure 4a shows. Generally, these lenders do not lend to borrowers with CCJs.
Non-Conforming Mortgages
The high street banks and larger building societies have strict conditions based on the borrower and loan characteristics discussed above. Borrowers who do not meet the requirements generally borrow in the alternative or non-standard market. While the alternative population has actually fallen in the past few years with the improvement in economic conditions, the market continues to be under-served and fairly lucrative from the lenders point of view, and we expect that the securitised market is likely to continue to grow over the next few years. The biggest lenders in this market are I Group, Kensington, Mortgages plc, and SPML. Going forward, some prime lenders are likely to develop non-conforming programs, as well. This so-called non-standard market charges rates which currently average about 10%/year, which is 200-250 bp above the SVRs for most mainstream lenders. A typical pool of alternative mortgages is also likely to have a higher proportion of loans in arrears and a higher percent of re-mortgagers. Figure 4b shows some characteristics for recently originated non-conforming mortgage pools.
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factors that typically affect mortgages. There are several reasons why a borrower would prepay a mortgage. These include mobility, remortgaging for rate-related reasons, and remortgaging to move to a bigger or better house. The factors that affect credit performance can broadly be classified as borrower ability and willingness to pay and the economic environment. We start by discussing the factors that affect prepayment and credit performance and then discuss some aggregate prepayment and credit trends over the past few years.
Originator Transaction Date LTV: Average LTV Highest LTV Loan Purpose: Purchase Remortgage Buy to Let Others Arrears: Current (< 1 month) Geographical Spread: London South East (excl. London) Property Type: Detached Semi-Detached Mid-Terrace Purpose Built Flat Other Wtd Average Seasoning Rate Type: Fixed Variable Other Factors
99.67%* 16.97% 27.86% 27.50% 29.99% 29.97% 8.12% 4.42% 35.3 months 52.50% 47.50% -
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Transaction Originator Transaction Date Wt. Avg. LTV Maximum LTV Avg. Seasoning Avg. spread over Libor Arrears > 2 months Loan Purpose Purchase Remortgage Right to Buy Consolidation Home Improvements Others Second Mortgages Average term to maturity Repayment Vehicle Capital Repayment Interest Only Part Rep./Part IO Endowment Pension Rate Type Variable Fixed Capped Discount Geographical Dist South East Greater London Self Certification
0% 256 months 48.44% 51.56% 16.52% 0.12% 16.52% 0.12% 83.36% 43.41% 16.78% 51.35%
economic times. Home price appreciation, which we discuss more below, has also tended to increase mobility. Another important driver of mortgage prepayments is rate incentive. Borrowers who currently have mortgages at rates higher than the rates available in the market have an incentive to remortgage and reduce their payments. However, this has to be balanced against the costs of remortgaging. On the other hand, borrowers who have mortgages at or below the current market rate are likely to prepay only when they change their residence. In fact, borrowers who are sufficiently out-of-themoney will likely have a disincentive to move, a phenomenon known as lock-in. Figure 3 showed the history of mortgage rates in the UK. For example, a borrower who took out a fixed rate loan in mid-1997 at 7% could have reduced his/her
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interest rate by as much as 1.5% by remortgaging in mid-1999. Borrowers with fixed-rate loans are much more likely to be affected by rate changes than borrowers with adjustable rate loans. Remortgaging Costs: The economics of mortgage lending in the UK are such that lenders make most of their profits from the margin between lending rates and funding costs. The revenue that the lender gets from the origination process is relatively small. Further, the third party costs associated with remortgaging are 1,000-2,000, including costs of appraisal, credit checking, etc. Even these costs are often borne by lenders. This implies that we would expect borrowers to be quite responsive to rate declines. Home Price Appreciation: An important driver of mortgage volume is home prices. Strong home price appreciation typically drives purchase activity by giving the owner greater mobility and freedom to upgrade to better housing. It also allows an existing owner to remortgage to take advantage of the increased equity in the home, either to take cash out or to obtain more favorable interest rates. After a period of relative stagnation in the early 1990s, home prices rose appreciably throughout the UK in the second half of the 1990s. However, one of the characteristics of this home price appreciation is the sharp difference in home price appreciation between the more prosperous areas in and around London and the North. Figure 5 shows average home prices for each region. Lenders differ quite substantially in their geographical mix. This may have implications for the default and prepayment rates for mortgages generated over the past few years.
Figure 5.
000 Pounts
160
120
North Yorks & Humber East Midlands East Anglia Greater London Sth East (excl GL) UK
80
40
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Credit Quality of Borrower: Borrowers with poorer credit histories generally prepay at higher rates than those with better credit in the absence of any rate incentives. This is generally because borrowers with poorer credit are more likely to have a need for additional cash, and remortgaging with a higher loan amount is one way to get additional cash. Further, borrowers with poorer credit may also be able to take advantage of better conforming rates if they improve their credit histories.
Figure 6.
CPR (%)
25%
15%
10%
5%
0% 1/94 7/94 1/95 7/95 1/96 7/96 1/97 7/97 1/98 7/98 1/99 7/99 1/00
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the UK. The repossession rate (which is roughly comparable to the default rate) has never exceeded 0.5% of outstanding balance, while the total 6+ month arrears peaked at only about 3.5%. It is also interesting to note that both the arrears rate and the repossession rate increased quite sharply during the economic downturn of the early 1990s. Subsequent to that, a strong economy, along with substantial home price appreciation in most of the country (as discussed earlier), has ensured that both the arrears rate and the repossession rate have remained very low. Many of the best quality lenders, including Abbey National, Halifax, and Northern Rock, actually have arrears rates significantly below the national average.
Figure 7.
% All Mortgages
35 30 25 20 15 10 5 0 2Q97 3Q97 4Q97 1Q98 2Q98 3Q98 4Q98 1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00 4Q00
Figure 8.
% Outstanding Balance 4
Repossession Rate Total 6+-Month Arrears 3
0 1H86 1H87 1H88 1H89 1H90 1H91 1H92 1H93 1H94 1H95 1H96 1H97 1H98 1H99 1H00
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INSTITUTIONAL INFRASTRUCTURE
The impact of institutional details on the performance of mortgage-backed pools is very significant, although it is sometimes difficult to quantify. We discuss three aspects in particular: distribution channels, the appraisal process, and foreclosure procedures.
Distribution Channels
Mortgages are distributed through a number of channels. The most common among these are branch networks and brokers, although new-economy channels such as telephone and the Internet are growing rapidly. The largest lenders, including the high street banks and the large building societies, use branch networks for most of their lendingseveral of them have hundreds of branches. However, some other lenders also make extensive use of intermediaries, which typically work with several lenders, and offer the initial contact with the borrower. Underwriting and appraisals are still typically done by the lender. As of now, about half of all lending is done through branch networks, and the other half is done through intermediaries.
Foreclosure Procedures
The UK has well-established procedures that govern repossession in the event of borrower default. The timelines and procedures are generally considered more lender friendly than many European countries and most states in the US. We describe the process below and also show a typical time-line in Figure 9. There are
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some differences between Scottish and English law, but they are too small to affect these timelines significantly. Assuming the mortgage is properly issued so that the lender owns the mortgage, the lender brings possession proceedings against the borrower in the County Court, which has exclusive jurisdiction over repossession cases. At the County Court hearing, the lender is expected to establish the validity of his claim. If the plea is successful, the Court issues an order for repossession. However, such orders are usually suspended, pending compliance by the borrower with terms imposed by the court. The suspensions are common and are intended to prevent peremptory repossession. This allows time for the borrower to sell the property or find other ways to pay the mortgage. After the suspension has expired, or if the borrower is unable to comply, the Court issues a repossession order, which then has to be executed.
STRUCTURES
There are essentially two types of structures that have been used in the UK mortgage market: the master trust structure and the stand-alone structure. Bank of Scotland was the first to introduce the master trust structure to the UK mortgage market. This structure is also now being used in the Abbey National transactions and is very similar to the credit card master trust structures used in the US. The stand-alone structures (e.g., the Northern Rock structure discussed below) are similar to the structures used in home equity loan transactions in the US. We describe the structures used in some of the largest transactions.
Figure 9.
Procedure Notice to Borrower County Court Hearings scheduled and held Suspension of Judgement Issue and Execute Repossession Order Total Time
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issuer to balance issuance to better match the principal payment profile of the underlying mortgages and, thus, improve collateral efficiency. Under this structure, which is depicted in Figure 10, Holmes Trustees Limited holds the portfolio under trust for the benefit of Abbey National and Holmes Funding. Abbey National continues to own a Sellers Interest in the mortgages,
Initial Portfolio
L
Funding GIC and Liquidity Facility (inc. Reserve Fund) Principal and Interest
HFC-2
Noteholders
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(required to be at least 4% of the mortgage pool) to protect against non-asset performance risks, including potential set-off risks associated with both borrower deposits held at Abbey National and Abbeys failure to fund redraws under flexible mortgage loans. The remaining interest in the portfolio is owned by Holmes Funding Limited, which pays for them through an inter-company loan from the Issuer, which in turn raises funds by selling securities into the capital markets. As with other master trusts (e.g., credit card trusts in the US), losses in the trust are allocated pro rata between the investors interest and the sellers interest. A new issuer is created for each transaction, with each issuer entering into the same arrangement with Holmes Funding and ranking pari passu in payment priority and loss allocation. Credit enhancement for each senior note is provided through a combination of excess spread, a reserve account, and the subordinated notes of all series. For each transaction, there is a revolving period and an accumulation period. During the revolving period, all notes receive interest only, and the principal payments on the mortgages will be reinvested into new mortgages meeting certain eligibility criteria. The senior notes (Class A) receive payments from the cash flows of the trust, while the subordinate notes (Class B and Class C) have scheduled maturity dates at which time they are repaid subject to certain portfolio performance criteria, which include no debit to the reserve fund to cover credit losses; arrears are less than 5% of the outstanding principal in the Trust; and the total Trust Size is above 5 billion. During the accumulation period, the proceeds are normally paid to Holmes Funding Limited so as to enable the payment of the note balance on the due date. If certain trigger events occur during the revolving period, an early amortisation occurs and the proceeds go to Holmes Funding until the Funding Share is paid down. The revolving period will end, and principal payments will be used to amortise the securities upon the occurrence of certain trigger events. An asset trigger event occurs when an amount is debited to the AAA principal deficiency sub-ledger. Upon occurrence of an asset trigger event, principal receipts on the loans will be allocated to Funding and the Seller proportionately based upon their percentage shares of the trust property. The payments to Funding will be allocated pro rata amongst each Issuer. Each Issuer will in turn make payments sequentially to the notes, beginning with the highest rated outstanding securities, regardless of scheduled maturity. Following the occurrence of a non-asset trigger event, all principal receipts will be distributed to investors until the Funding Share of the Trust Property is zero. Each Issuer will make payments sequentially to the notes, beginning with the highest rated outstanding securities, with the triple-A rated notes allocated payments sequentially to the Series with the earliest scheduled maturity. A non-asset trigger
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event occurs when one of the following events occurs: there is an insolvency event in relation to Abbey; Abbeys role as servicer is terminated and a suitable replacement is not appointed; the seller share less than the minimum required seller share; or the outstanding balance of mortgages in the trust falls below certain prespecified levels. When prepayments occur, Abbey National PLC maintains the trust size by substituting loans into the portfolio. The notes are sized so that with substitutions of prepaid loans, a payment rate of at least 4.5% is required to pay down the notes. If there is no substitution, a payment rate of about 7.0% is required. Since payment rates have historically been about 20.0%, this provides a reasonable cushion to ensure that the notes are paid on schedule. There are restrictions on the loans that can be substituted into the pool, e.g., no substituted loan can be in arrears of more than one month, the principal balance of loans in the trust which are in arrears of more than three months is less than 5%, certain LTV restrictions are met, etc. Various swap agreements are also part of the structure. This is because the mortgages are variable rate based on Abbey Nationals SVR, or fixed rate for some period. The notes, by contrast, are tied to 3-month LIBOR rates. Further, some of the transactions were denominated in dollars or euros, so that a currency swap agreement is necessary as well.
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Since the loans are typically based on the SVR of the lender, Northern Rock also provides a basis swap which converts the SVR into a 3-month LIBOR-based return. In addition, since a significant portion of each of the pools consists of fixed rate loans, the trust has also entered into a swap with Northern Rock to swap these fixed-rate loans into 3-month LIBOR-based rates. Since Northern Rock is the swap counterparty in each of these swaps, the swaps are conditional on Northern Rocks maintaining a P-1 rating, failing which it must find a suitably rated replacement. Some other features of the transaction deserve mention. If prepayments on the pool exceed 20% CPR, Northern Rock is allowed to substitute loans into the pool to maintain prepayments at a 20% level. The substitutions are subject to certain conditions about the quality of the loans and the performance of the pools. This gives Northern Rock the ability to ensure that the pool does not hit balance triggers.
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RELATIVE VALUE
The market is relatively young, but liquidity is expected to improve quite rapidly over the next few months as the volume of new originations increase. New issue spreads have been quite stable over the past year. In addition to the factors that usually affect spreads on fixed income products, such as credit rating and average life, a number of factors should be considered that are specific to this market. These include: Currency of issuance: dollar bonds tend to trade to 2-4 bp tighter than sterling or euro denominated bonds. This is primarily because of the deeper investor base in the dollar market. Soft bullet versus controlled amortisation: The controlled amortisation period in a master trust structure is usually about 6 months. The market generally trades bonds with controlled amortisation features 1-2 bp wider than soft bullets, which is more than the valuation difference justifies. Quality of issuer: The market is currently tiered into three parts: prime, non-conforming, and buy-to-let. The non-conforming market typically trades about 15 bp wider than the prime market, while buy-to-let trades about 8 bp wider.
In general, UK mortgages have been trading significantly wider than US ABS sectors such as credit cards. However, as the number of issuers in the market increase and liquidity improves further, we expect these spreads to tighten. Mortgage lenders face pressure on a number of different fronts, including pressure on their deposit base and increasing competition leading to lower rates. However, on a fundamental basis, UK mortgages offer the asset-backed investor diversification away from the U.S. consumer market in a high-growth, prime-quality sector with rapidly improving liquidity. Bonds from prime quality issuers such as Abbey National typically trade 5 -8 bp wider than US credit card securities. We do not believe that the credit quality of the issuers and the enhancement levels in these transactions justify these differences in spreads. It is also useful to compare UK mortgages with other European mortgagebacked securities. UK mortgages have tended to trade tighter due to better information about the products, as well as better liquidity. German mortgages that are available in the asset-backed market are effectively second liens since most amounts below 60% loan-to-value are absorbed by the Pfandbriefe market. Denmark and Holland both have well-developed mortgages markets, but they are both relatively small and, therefore, will never be as liquid as the UK prime market.
CONCLUSIONS
The UK mortgage market represents one of the largest growth areas in the mortgage backed market over the next few years. We project that industry and
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regulatory changes will cause huge growth in securitisation. The presence of large well-capitalized issuers, the well-established underwriting procedures, a strong institutional infrastructure, and strong economic growth make for a potentially liquid market. Spreads have been stable over the past year.
GLOSSARY OF TERMS
Although the US and UK mortgage markets have much in common, they often use different terms. We list some commonly used equivalent terms. UK Arrears Buy to let Conveyancing Endowment Insurance Flexible Mortgage Intermediary Legal Charge Mortgage Guarantee Insurance Portable loan Remortgage Repayment Loan Redemption US Delinquencies Investment Property Transfer of title Term-life insurance Home Equity Line of Credit Broker Lien Private Mortgage Insurance Assumable loan Refinance Amortizing Mortgage Prepayment
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Transaction Name RMAC 2000 - NS1 plc RMAC 2000 - NS1 plc RMAC 2000 - NS1 plc RMAC 2000 - NS1 plc Residential Mtg Securities No 8 plc Residential Mtg Securities No 8 plc Residential Mtg Securities No 8 plc Originated Mortgage Loans 6 plc Originated Mortgage Loans 6 plc Originated Mortgage Loans 6 plc Originated Mortgage Loans 4 plc Originated Mortgage Loans 4 plc Originated Mortgage Loans 5 plc Originated Mortgage Loans 5 plc Originated Mortgage Loans 5 plc Mortgages No 1 plc Mortgages No 1 plc Mortgages No 1 plc RMAC 2000 - NS2 plc RMAC 2000 - NS2 plc RMAC 2000 - NS2 plc RMAC 2000 - NS2 plc Kensington Mortgage Co - RMS9 Kensington Mortgage Co - RMS9 Kensington Mortgage Co - RMS9 Kensington Mortgage Co - RMS9 Kensington Mortgage Co - RMS9 Mortgages No 2 plc Mortgages No 2 plc Mortgages No 2 plc Originated Mortgage Loans 7 plc Originated Mortgage Loans 7 plc Originated Mortgage Loans 7 plc RMAC 2000 - NS3 plc RMAC 2000 - NS3 plc
Originator Tranche Residential Mortgage Securities plc Class A1 Residential Mortgage Securities plc Class A1 Residential Mortgage Securities plc Class A1 Residential Mortgage Securities plc Class A1 Kensington Mortgage Co Class A Kensington Mortgage Co Class M Kensington Mortgage Co Class B Igroup limited Class A Igroup limited Class A Igroup limited Class A Ocwen UK Ltd Class A Ocwen UK Ltd Class B OSWEN UK Class A OSWEN UK Class A OSWEN UK Class A Mortgages plc Class A Mortgages plc Class M Mortgages plc Class B RFC Mortgage Services Ltd Class A1 RFC Mortgage Services Ltd Class A2 RFC Mortgage Services Ltd Class M RFC Mortgage Services Ltd Class B Kensington Mortgage Class A1 Kensington Mortgage Class A2a Kensington Mortgage Class A2b Kensington Mortgage Class M Kensington Mortgage Class B Mortgages plc Class A Mortgages plc Class M Mortgages plc Class B I Group Class A I Group Class M I Group Class B RFC Mortgages Services Class A1 RFC Mortgages Services Class A2
Tranche Description Currency Amount Step Up/Call 12 Jun 07 GBP 99 Step Up/Call 12 Jun 07 GBP 104 Step Up/Call 12 Jun 07 GBP 15.2 Step Up/Call 12 Jun 07 GBP 6.8 USD 452.2 GBP 31.3 GBP 11.6 GBP 264 GBP 24 GBP 12 Step Up/Call 15 Jan 07 EUR 335 Step Up/Call 15 Jan 07 EUR 40 Step/Call 15 Apr 07 GBP 198 Step/Call 15 Apr 07 GBP 18 Soft Bullet 15 Apr 07 GBP 9 Step/Call 12 Apr 07 GBP 154 Step/Call 12 Apr 07 GBP 10.5 Step/Call 12 Apr 07 GBP 13.5 GBP 89.5 Step/Call 12 Jun 07 GBP 90 Step/Call 12 Jun 07 GBP 11.5 Step/Call 12 Jun 07 GBP 4 Step/Call 9 Feb 08 USD 142.4 Step/Call 9 Feb 08 USD 260.3 Step/Call 9 Feb 08 GBP 50 Step/Call 9 Feb 08 GBP 31.9 Step/Call 9 Feb 08 GBP 13.1 GBP 190 GBP 11.5 GBP 18.5 GBP 220 GBP 22.5 GBP 7.5 GBP 80 GBP 100
Flexible Mortgages 23-May-00 First Flexible No 2 plc 23-May-00 First Flexible No 2 plc Buy-To-Let Mortgages 23-Feb-00 Paragon Mortgages (No 2) plc 23-Feb-00 Paragon Mortgages (No 2) plc
Class A Class A
Call Jun 06, step Jun 07 Soft Bullet, Call Jun 06, Step Jun 07 Step Up/Call 15 Mar 06 Step Up/Call 15 Mar 06
GBP GBP
276 24
0.6 0.6
460 40
Aaa A2
5.3 7.03
29 80
Class A Class B
GBP GBP
166.5 18.5
0.6 0.6
278 31
Aaa A2
4.1 6
30 87.5
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