Mortgage bond and MBS market development in the UK and France.

• Author: Franscini, Mathilde
• Position: Mortgage backed securities

The UK mortgage market has been dominated by variable-rate mortgages. It is therefore not appropriate to the development of mortgage bonds as a source of funding these mortgages and banks have turned towards securitisation instead. France has modernized its financial markets to enable the development of both mortgage bonds and mortgage-backed securities.

1. UNITED KINGDOM

   1. Mortgage Market

      The typical UK mortgage market looks nothing like the US market. The UK has one of the most varied mortgage markets around. This market is driven by variable rate and flexible mortgages.

      A relatively recent product is the flexible mortgage which is proving popular with borrowers. Flexible mortgages have developed largely in response to changes in the demographics of the UK, with less job stability, more temporary workers and increased mobility meaning income and circumstances can be changeable. The key feature of this type of loan is flexibility of payments: borrowers can pay more or less than their regular monthly payment and even take payment holidays for a few months. To the extent that the borrower has paid more than his scheduled amortization, he is often permitted to redraw (or borrow back) overpayments up to scheduled outstanding, or original advanced, amount, subject to certain conditions.

   2. Motivations for RMBS

      Compared to the rest of Europe, UK has a large and established market for mortgage-backed securities-but no market for mortgage bonds. Even so, only a small proportion of UK mortgages are securitised. The main reason is that UK banks have long been able to raise cheaper funding from customer deposits than asset-backed bonds would give them. This has left smaller financial institutions that specialize in non-conforming mortgages as the main source of mortgage-backed issuance. But as customers become more selective in the "destination" of their deposits, UK banks are losing fast their source of cheap money and now start looking at securitisation. High housing prices and low rates are driving RMBS growth. The securitisation process is now well understood by UK banks that are looking to diversify their funding sources. Moreover, innovative mortgage products, such as the country's new flexible mortgages, continue to foster and create a favorable borrowing climate. (1) UK MBS issuance to date has been almost exclusively at floating rates, but this trend could change.

   3. Tax Treatment

      Mortgage Interest Relief" Act Source (MIRAS) has been one of the most powerful tax incentive in UK. Indeed, home ownership increased tremendously throughout the UK in the 80s. In April 2000, this tax break has been abolished. The reason is that, since it was deducted at the source, it made it impossible for eligible mortgage to be securitised.

   4. Legal Framework

      By now, different types of securitisation structures have been able to evolve relatively free of legal restrictions, as long as they are not expressly prohibited by existing statutes.

      The UK mortgage industry is facing the prospect of government regulation. In January 2001, the government announced that mortgage sales would be brought under the jurisdiction of the Financial Services Authority (FSA). It also would set benchmark CAT (Cost, Access and Terms) standards for mortgages.

      This is part of the legal framework provided by the Financial Services and Markets Act, under which the FSA is the unique regulator. This Act is not implemented yet.

      In June 2001, the FSA issued its draft Interim Prudential Sourcebooks (IPSBs) for building societies (CP51) and banks (CP52). These set out the prudential framework until the end of 2002 when the new Final Prudential Sourcebook will be introduced. One of the consequences of the FSA's securitisation rules will be the establishment of new obligations for any building society involved in securitisation.

   5. Risk Assessment

      1. Credit risk

         In the case of MBS, the credit risk depends only on the quality of the collateral (asset cover) and on the transaction structure.

         FitchIBCA believes that the primary indicators of potential for future delinquency and default are a combination of the following factors: the affordability of a loan for a borrower (ability to pay) and the LTV ratio (incentive to pay).

      2. Prepayment risk

         With the growing popularity of flexible mortgage products and a review by the Office of Fair Trading, prepayment penalties are increasingly being dropped from mortgage products. However, many mortgage lenders, having dropped penalties, offer teaser rates encouraging the borrower not to prepay. In effect, the borrower will still be penalized for early redemption. In addition, prepayment penalties remain applicable to many of the fixed and capped-rate mortgages currently available during the fixed or capped period. Levels of prepayment are therefore difficult to predict and will not necessarily follow a historical trend.

         In the case of flexible mortgages, assessing this risk depends upon the specific features of the mortgage product. FitchIBCA has found that there is little uniformity to flexible mortgage products with regard to such factors as restrictions on redrawing (e.g. some lenders may impose fees above a certain redraw amount, others may not) and the extent to which a borrower may redraw. Note that there are no redemption penalties in the case of flexible mortgages.

         The "master trust" technique (2) is a structure to eliminate prepayment risk. An example is the "Holmes Financing" issue. The vehicle-Holmes Financing-issued the equivalent of USD...