What is Mortgage Securitisation anyway, and does it matter? It did to Northern Rock
Posted by markharrison on November 26, 2007
One of the industry buzzwords being thrown around at the moment is “mortgage securitisation”. This is, it would appear, being blamed for everything from the collapse of Northern Rock to the decline of the NHS.
So, what is Mortgage Securitisation anyway?
Time for another history lesson.
Once upon a time, there were things called Building Societies. Building societies took in money from those who had it (called depositors) and loaned money to those who 1: needed it and 2: could convince the building society that they’d be able to pay it back (called borrowers.)
They would pay interest (at a low rate) to depositors, and charge interest (at a higher rate) to borrowers. The difference was used for three things:
- To pay the running costs of the building society (rent, heating, wages and salaries)
- To take into account the fact that some people wouldn’t pay the money back
- To pay out even more to the depositors, because it was they who owned the building society
There were other places from which it was possible to borrow money, including family, banks, and mob bosses.
The Building Societies, however, had some huge advantages over these:
- They had a lot more money than most families. While you might borrow a few quid from your mum to nip down the shops, most mothers didn’t have enough cash to lend each of their children enough to buy a house. The building societies did have enough money to do this, and hence far more people were, through borrowing, able to buy their own homes rather than rent.
- They had rather less aggressive collection policies than mob bosses. At the worst, they’d take your furniture and your house back, and 99 times out of 100, they’d bother to ask permission from the courts to do so.
- They charged lower interest rates for mortgages than banks did.
Then, about 10 years ago, this all changed. Most of largest building societies, and many of the smaller ones, decided that they’d be better off as banks. As banks, they’d have shareholders, and a bunch of owners who were different from the depositors. They managed to raise a lot of money by selling shares (and “gave away” some shares to the depositors as a sweetener.)
Once they were banks, there were more things they could choose to do (the laws are tighter in some respects for building societies), and they started getting “creative”.
The first thing they could do was borrow money (from people who weren’t depositors) in order to issue more loans. So, a bank wants to lend you £150,000 for your new Buy To Let, they don’t need to worry about getting 100 new customers, each with £1,500 on deposit, in order to cover that.
What some of them started doing was lending out at a Buy To Let rate, say, 6.5%, and assume that they’d be able to borrow the money on the open markets at a lower rate, say, 5.5%… and that the 1% difference would be enough to cover their costs and make a profit. There’s a rate called LIBOR, which is broadly the rate at which banks will lend money to each other.
This approach worked fine with customers who wanted floating rate mortgages – indeed, lenders tried to get customers to accept mortgages tied to LIBOR, so if the rate THEY had to pay went up, customers would pay them more. It wasn’t perfect, because LIBOR changes all the time, but mortgage customers ended up having their interest calculated monthly, so if the rate went up at the start of the month, the bank might have to carry the extra cost until the end of the month. (Of course, if the rate went down, the bank got the benefit straight away, but customers didn’t see the reduction.)
There was a problem with this, though – many customers wanted fixed-rate mortgages… so the banks got more creative. Some took the risk, and hoped that they could forecast the changes in interest rates well enough over a medium-term period (2-3 years) that they could peg their fixed rates at a level that would make them money.
Others decided to “hedge” that risk, basically by buying what was effectively an insurance policy. This insurance policy (called a swaption) was a deal in which they would pay a small amount, and if interest rates moved heavily in a certain period, they’d get a bigger amount back.
However, even this still left one big risk – what if customers didn’t pay their mortgages. Now, up to a certain point, the cost of this is already build in – you and I pay slightly higher rates, effectively to cover the bank against the possibility that our neighbours won’t pay up. (And, of course, the bank has the aforementioned right to ask the courts to take our houses off us if we don’t pay up.)
What the banks then worked out was that the skills of “selling people mortgages”, “processing mortgages” and “taking the risk that some people won’t pay” were fundamentally quite different.
Some decided to outsource the sales process, and offered commissions to “independent financial advisers” would would sell their products. Others kept sales in-house. Many did both.
Some decided to outsource their processing departments, either to India, or to “packaging companies” who’d do all the paperwork handling (many of whom also ended up in India.)
Some decided to outsource the “taking the risk”, and this is what securitisation does:
Say a lender has 1,000 mortgages owed to it. Each of these mortgages is for (on average) £150,000. Some are less, some are more – but the bottom line is that overall, the customers owe the mortgage company £150 million quid.
What the mortgage company would then typically do was register a NEW company. This new company would be sold to external investors… and would BUY the mortgages from the original lender. Typically, that meant that the lender would carry on doing the administration (and, of course, charging the new company a fee for doing so), but the income each month from the different customers would belong to the NEW company, not the original lender.
How much did the new company pay for these mortgages? Typically a bit more than what was owed.
The original lender got several benefits from doing this:
- They made a small (relatively) profit up-front
- They got an ongoing contract to do the processing
- They got someone else to take on the risk of borrowers not paying
- Oh, and as a more technical matter, because the mortgages weren’t on THEIR books, they needed to keep less cash around to comply with the “capital adequacy” rules for lenders.
The new investors got some benefits too – they got to be mortgage lenders without all the administrative overhead of setting up processing departments, and sales departments, and so on… and historically, most people ended up paying their mortgages, so it was fairly easy to predict how much money they’d make… (And some people, say pension funds who know how much they’re going to have to pay out each year, like PREDICTABILITY in their income very much indeed.)
The new investors also had a “liquid” asset – they could sell their shares in this new company rather more quickly than they could ask for repayment of a mortgage if they needed to get their cash back out.
Why is this called “securitisation” – because “securities” are (in the US) another name for “shares”… and the investors were buying shares in the new companies.
OK, that’s what securitisation is – so, what does it mean for us property investors?
By 2000, about 6% of UK mortgages were “securitised” in this way… and the numbers kept on going up.
However, all is not well… last week, Bradford and Bingley sold off a bunch of mortgages in this way – approximately £4 billion pounds worth – but rather than making “a small profit”, they made a loss of somewhere between £15m and £40m in the process (depending on who you ask, and how you count.) So far this year, B&B have securitised about £9 billion.
Northern Rock, on the other hand, have securitised almost £70 billion of mortgages so far this year.
At the next level down, we have Abbey and HBOS, who have done about £50 billion each… but in the context of MUCH bigger financial groups.
In fourth place, though, there’s a massive drop to GMAC at about £15 billion.
What’s changed is that the mortgage lenders (lke B&B) are finding it much harder to do this – so there’s bound to be a “credit squeeze”.
On the bright side, though, Northern Rock was “the big one” – there isn’t another such mortgage lender about to have the same problems (or rather, about to have problems on anything like the same scale.) Even if Abbey or HBOS had problems, they’d be a smaller drop in their overall accounts… and let’s be honest, if, for example, Clydesdale (who have done about £2bn this year) had problems, that wouldn’t have the same impact as NR.