Increasing defaults in the US sub-prime mortgage market and the ensuing global mortgage-backed securities (MBS) market freeze have triggered a credit crunch, which now risks putting the US into recession and is already being felt in the UK through a slower economy and declining house prices.
While traditionally UK mortgage lenders have relied upon retail deposits for funding, raising funding through the wholesale markets has become increasingly popular in recent years. Indeed, this method of funding accounted for a median of 27.8% of all funding in December 2000 but grew to 47.8% in the first half of 2007. Securitization in particular has become much more common because of its benefits to lenders.
UK mortgage lender Northern Rock's heavy dependence on the wholesale markets forced it to seek emergency funding from the Bank of England in September 2007, as the global MBS market froze. With the bank run and ensuing events, debate has been triggered on lenders' funding models in the UK.
Specialists are now exposed to liquidity shortages
Not all lenders are being impacted to the same degree by the liquidity shortage and securitization freeze - indeed, it is lenders in the specialist sectors (sub-prime, self-certification, and buy-to-let) which have felt more of the impact as these lenders tend to rely on wholesale markets and securitization to a greater extent. Because diversified banks fund around half or more of their mortgages through retail deposits, and building societies have to follow legislation that dictates wholesale funds to fund mortgage lending that can total no more than 50% of its total balances, these lenders are at less risk. Indeed, a number of examples serve to show this trend in the specialist sector: GMAC-RFC is making redundancies, while there has been discussion that Paragon Mortgages could be forced to run its business down if no new funding appears by Q2 2008.
The wholesale markets and securitization funding models are strong
Following Northern Rock's tumble, many are now questioning those UK lenders' funding models that rely upon wholesale funding and securitization in particular. Yet this type of funding will continue being relied upon as it is a strong model.
Funding by the wholesale markets has been in place for decades and has never really been an issue. Moreover, securitization has, up until recently, been a strong model for many years. Indeed, MBS have been used in the US for decades, and more recently, MBS have been expanding in Europe and other financial markets around the world. In fact, over the last decade - and specifically in the last five years - the UK mortgage market has developed into one of the most innovative in the world, with the ability to cater to all types of customers. Such a development has been largely due to the development in non-retail funding, particularly securitization.
Restoration of confidence in wholesale markets and securitization is necessary
There can be no turning back on funding models developed over the last decade in the UK. Many lenders would simply be unable to cope and the mortgage market would see a severe reversal in its development and sophistication. Indeed, the restoration in confidence in wholesale markets and securitization is necessary in maintaining the UK mortgage market that investors, lenders and consumers have become used to and benefited from.
While the wholesale markets are currently more expensive and illiquid, and the market for MBS has come to a virtual stop, eventually, lending based on wholesale funding and securitization will return. Once the markets understand and admit the extent of exposure to US sub-prime mortgage debt, it will then take some time for them to start investing once again in sound markets and securities.
However, before that can happen, all stakeholders involved in the financial markets and mortgage funding should look to put safeguards in place so that the unfortunate events that have transpired do not occur again. The Chancellor Alistair Darling's recently announced plans for primary legislation to be introduced in May 2008, which would include giving the Financial Services Authority greater powers to monitor banks' liquidity as well as their capital requirements, can only be a good thing in order to look to avoid other possible funding crises in the future. With preventative measures being implemented, funding via the wholesale markets and securitization will be a safer and healthier option than before. 'End Intelliext
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