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ArchiveNovember 7 2005

Innovative techniques for funding

European lending institutions are increasingly using securitisation and the covered bond market in tandem as a means of reaping the advantages of the different tools. Natasha de Teran explains.
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Not long ago, European mortgage originators relied almost entirely on retail deposits and the issuance of senior unsecured debt for funding their mortgage loans. The increasing adoption of securitisation techniques since the 1990s, however, has gradually changed that.

Today, only 60% of mortgage debt in the region is financed through retail deposits and rating agency Standard & Poor’s (S&P) expects issuance of European residential mortgage-backed securities (RMBS) this year to reach a new record. The agency estimates that in the first six months of the year, volumes had already reached €102.65bn, well in excess of the €88.93bn for the same period in 2004.

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Banks that securitise their mortgages do so for risk transfer, funding and regulatory capital purposes. These are all valid and useful reasons yet some banks still do not securitise. William Cumming, co-head of securitisation at Citigroup in London, explains: “Those banks that still don’t actively pursue these routes, typically have deep deposit bases. They use this surplus capital to subsidise the mortgages funding themselves sub-Libor, where covered bonds or securitisations would be executed at Libor+ levels. In a sense, the abundance of capital is precluding these banks from being efficient.”

Immature markets

Although Mr Cumming stops short of giving examples, there are plenty. In Greece, for instance, where competition in the mortgage market is a relatively recent phenomenon, banks still typically finance their mortgage assets through their customer deposits, inter-bank borrowing and European medium-term note (EMTN) issuance.

S&P analyst Ioanna-Victoria Kyritsi says that may change with the advent of Basel II and as competitive pressure rises in the market. “Until now, Greek banks have been able to fund the increasing number of mortgages with their low-cost deposits. But this might not always be attainable, especially in cases when deposits are not growing as fast as loans,” she says.

“Securitisation becomes an attractive funding source given the increasing need of Greek banks to tap available wholesale sources. It may well be the solution for Greek banks, especially when faced with slowing deposit ratios and regulatory and competitive pressures.”

Securitisation is, however, far from the only option open to banks seeking to optimise return on equity, return on assets and return on economic capital. Jeff Stolz, managing director in the mortgage-backed securities origination team at Deutsche Bank in London, says: “There are various routes that can be followed to achieve these aims, including straightforward securitisations, synthetic securitisations or the issuance of covered bonds.

“The extent of their uptake has been dependent on the amount of competition in the individual markets, and the treatment of the various routes in the different jurisdictions.”

David Basra, Mr Cumming’s co-head at Citigroup, adds: “Banks that engage in these techniques appreciate the relatively low funding that can be achieved, the fact that they can tap into new investor bases and the ability to better match their funding requirements. Deposits are more volatile and offer little to no ability to duration match.”

New trajectories

The longstanding major funding source in Germany and Spain has been the covered bond market, while in the UK lenders have more often used securitisation. According to bankers there is now a trend in these and other European countries to combine the use of both tools.

The reasons behind this are the relative advantages and disadvantages of the two different routes. With covered bonds, banks do not get capital relief but, as Mr Basra points out, they have the advantage of offering lower and longer-duration funding than securitisations, and they also enable banks to tap into another type of investor base.

Mr Stolz says: “We are seeing issuers in these countries follow both routes, reaping the advantages of the different tools. Through securitisations, the issuers transfer the assets/risk off balance sheet and therefore achieve regulatory capital relief, while through the covered bond market they utilise secured on-balance sheet financing (no risk transfer) that typically taps into a new investor base that provides lower-cost longer-term funding.”

Mr Stolz says that lenders are also engaging in synthetic securitisations to hedge out their risks to obtain regulatory or economic capital relief. In these transactions the lenders buy credit protection on a pool of mortgage assets, through a series of credit default swaps. They then make regular coupon payments to the protection seller during the tenure of the collateralised debt obligations, in return for being made whole in the event of future losses. “These synthetic securitisations can also be used in conjunction with covered bonds – a combination that is particularly attractive because it secures long-term fixed funding as well as capital relief.”

Another alternative, according to Mr Stolz, is for banks to issue credit-linked notes tied to their mortgage pools. In these transactions, the mortgage assets remain on balance sheet but the banks achieve regulatory or economic capital relief.

Despite the strong headline growth in securitisation and other related techniques in European mortgage markets, their use in the region is less widespread than in the US. There the majority of outstanding mortgage debt is financed through securitisation and agency debt.

Bankers attribute the speed of adoption in the US to the arrival of dedicated mortgage companies – firms that originate, repackage and sell on mortgages into the capital markets in a systematic manner. These firms compete head on with the US banks, which have had to respond in similar kind to remain competitive.

In the US, mortgage companies already dominate the mortgage lending landscape, and though they have a larger market share than the banks, they have made banks more efficient mortgage originators,” says Mr Basra. “For instance, US banks have smaller asset bases than their European peers but higher profitability. The mortgage companies have contributed to this, forcing them to use less capital to run their business.”

Some US mortgage companies, like GMAC-RFC, have recently begun originating mortgages in Europe, which Mr Cumming says has already spurred banks there into the market. “Mortgage companies are still a relatively recent phenomenon in Europe but their presence here will increase and banks will have to adapt to meet that challenge.”

Business dissection

These are not the only changes afoot in the European landscape. European banks that are already familiar with the securitisation route are now apparently moving on and re-examining whether they should continue to hold the equity or riskier portion of the mortgage risk.

The majority of European RMBS issuers are well-capitalised banks so the incremental funding and regulatory capital relief gained by issuing sub-investment grade tranches has historically been relatively unattractive for them. Instead, these banks have primarily focused on the regulatory capital relief of the investment grade notes and the diversified funding they can achieve through securitisation, while retaining most residual securitisation risks.

Mr Cumming believes that this will change as more of them seek to achieve true risk transfer by selling off the equity or residual risk. The sale of this so-called “residual mortgage risk” is still a niche market in Europe. JPMorgan estimates that issuance in Europe has totalled only €680m in 64 deals since 2000.

Yet, like Mr Cumming, JPMorgan head of structured product research Ed Reardon anticipates further growth as a result of recent and incoming changes that are affecting the regulatory treatment of retained risks as well as the tighter pricing banks can now achieve for the tranches.

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