Just over 10 years ago, second charge securitisations were commonplace and there was a healthy appetite to fund such loans.
Today’s second charge market may be in a strong position regarding volumes and demand but have investors re-gained the appetite they once had for the market?
The implementation of the Mortgage Credit Directive and full Financial Conduct Authority regulation next March, could be a spark to ignite investors’ hunger once again for the market.
Get Out Clause
Under the Consumer Credit Act, second charge lenders have not been able to apply significant Early Repayment Charges, with some borrowers paying nothing and others being charged no more than one to two months interest.
Alan Cleary, managing director of Precise Mortgages, believes this has hindered the securitisation market for second-charges.
He says: “At the moment because of the way regulation is, lenders can’t put ERCs on second charge mortgages.
You can’t securitise them because you don’t know whether that loan is going to be there by the time you have finished the transaction, let alone for any time after that, so investor won’t buy that.”
He says once the second charge market falls under MCOB next March, lenders will be able to put ERCs on second charge loans, which may result in the securitisation market opening up once again.
“Securitisations did occur before the crisis so there will be investors out there who have appetite for second charges,” he says. “As long as they are getting paid appropriately on the bonds that they buy then I think the securitisation market will come back but not for the next year or so.”
Michael Childress, chief executive officer of Step One Finance, says historically there were very few public stand-alone second charge loan securitisations completed in the UK.
But he says: “When you consider the relative quality of the loans originated post crisis combined with the product’s risk taming granularity, it would not be surprising to see some of the loans securitised either in private or public transactions in the next couple of years. The key issue to securitise will be size, and with 20 plus lenders jostling for a share in a market that produces less than £1bn per annum it may be hard in the near term to aggregate sufficient collateral for a traditional securitisation that would be widely distributed.”
Jon Sturgess, head of sales and secured lending at Masthaven Secured Loans, says it still remains to be seen as to whether the uptake will return for second-charge securitisations.
“With the securitisation market continuing to recover its appetite, it would be logical to assume that there would be greater interest in this format,” he says. “Next year particularly will see whether second charge sustains its growth trajectory; as by then we will see the full effect of regulatory integration.”
The second–charge market is set to more than double in size in the next five years. With around £1bn of lending expected in 2015 and annual growth projected to be around 30 per cent. This will naturally create the opportunity for increased securitisation.
Andrew Freeley, proposition director at HML and managing direction of HML subsidiary Specialist Mortgage Services, believes there will be considerably more funding injected into the market in the coming months and years.
“The inclusion of secured loans under the FCA’s mortgage rules will provide confidence to consumers and investors that lending is affordable, suitable and sold within an advice framework,” he says. “This will deliver greater certainty in investment returns, which will make the second-charge market appealing to investors and stimulate appetite by lenders to securitise.”
Richard Pike, sales and marketing director at Phoebus Software, says it will be interesting to see how this pans out adjacent to the implementation of MCD.
“Some standardising of processes across firsts and secured loans may amalgamate some funding requirements in terms of originations and therefore make it easier to fund into the sector, but in terms of securitisation this will usually be based on underwriting versus asset versus performance across a pool of assets and therefore standardisation could potentially make it easier and more cost effective to carry our securitisations moving forward.
“High lending margins compared with normal first charge residential with escalating house prices has been the foundation of secured loans for many years. The secret at the moment seems to be in slight product differentiators and also to have secured loans as part of a more diverse product set including, say, bridging, development finance and perhaps some niche firsts. This way if you pool the portfolio the risk profile gives a good ROI and also if performing, a good potential for using the assets to securitise.”
Other forms of investment
Second charges are currently funded either by retail deposits or some other warehouse or funding line.
Cleary says: “The capital markets are shaky. The whole reason we became a bank is because being a non-bank is strategically not a good thing to be. Seconds are reliant mainly on retail deposits and 95 per cent of the market uses retails deposits. Second charges carry a bit more risk because they are preferenced behind the first charge lender, so the chance of making a loss is greater,”
So what will this mean for any new lenders coming into the market?
Cleary says any new lenders will have to be small-scale as funding will limit their capability.
He says: “Their costs of funds will be much higher so they will probably go down the high LTV route in order to find margin, or sub-prime, but the FCA will obviously have a view on that.”
Cleary moves on to say the market is still a dynamic one which is well funded by the banks that are in the space.
“That market is about £600m a year,” he says. “There is plenty of funding for second-charges but the demand is not there. The size of the market is not being constrained by funding but by consumer demand.”
He believes demand will increase when the Bank of England increases the base rate.
“Once we get that, borrowers will suddenly realise that mortgages can go up and it will encourage borrowers and mortgage prisoners to go and look at their financial arrangements.”
Gary Bailey, director at Blemain Finance, believes it will be a positive year for secured loans and the coming months will present a number of opportunities for brokers.
“As the lending market becomes more complex, and second mortgages will become a ‘regulated mortgage contract’, it’s an arena intermediaries simply cannot ignore,” he says.
“Second charge mortgage products will continue to be key growth areas this year – in fact they’re likely to be some of the main sources of business for brokers throughout the rest of 2015. The Mortgage Credit Directive, post its initial challenges, will provide consumers with the opportunity to achieve an even better outcome on the appropriate circumstances.”
Childress believes more funding will come into the market as it continues to increase in size, as long as the overalleconomic fundamentals remain sound.
“The market remains a shadow of its former self with volumes well below the 2006 peak of circa £7bn per annum but with it now rapidly recovering and approaching the key milestone of £1bn per annum we expect that more investors will take note.
“Second charge loans offer a relatively long dated and high yield profile to investors, with the added benefit of second ranking security over real estate property. The favourable return profile coupled with the rapidly increasing size of the market has also caught the attention of a number of larger institutional investors. For investors interested in larger single transactions there have also been a number of large legacy portfolios that have been recently sold or are in the process of being sold.”
Sturgess believes the latest changes to the regulatory regime will open up its appeal to investors.
“They have provided the final piece of legitimacy that the industry needed to overcome the last of the negative prejudice that many in the intermediary market still felt,” he says. “Latest completion figures only highlight the upward movement of the industry and it will no doubt encourage investors of all kinds, corporate and private, to seriously examine our industry as a vehicle for investment.”
The regulatory changes will not change would-be funders’ outlay overnight but it will be a step in the right direction. It will be interesting to see whether lenders start to impose ERCs from next year and if this will indeed lead to the first upturn in securitisations the market has seen in ten years. Appetite from funders however is nothing without demand; and once the Base Rate does rise, the market will need to be ready to respond in order to make sure the supply of funding does not outstrip demand.