Where There’s a Will, There’s a Way
10 September 2018 by Douglas Charleston
When I first encountered ABS I was told, “ABS is about cash flow, if the asset has a regular cash flow then you can securitise it”. ABS bonds have regular coupons, and as long as the underlying pool of assets pay enough and on time – be it car loans, commercial loans or residential mortgages – then bond holders are happy. Simple.
Since that first encounter the market has remained a core financing option for banks’ consumer and corporate lending books, but there has always been a degree of innovation around the fringes. Some innovations have made sense, some less so, but there is no reason that loans that have been well underwritten cannot fit into a securitisation structure, so long as any specific loan features can be offset by the structure of the ABS deal.
One such fringe asset is the equity release mortgage (ERM), a product extended by a small number of lenders, often insurance companies, to older borrowers who want to use large amounts of equity held in their main property to fund their retirement but continue to live in the property. Shifting demographics have increased demand for secured borrowing by older people, a trend likely to continue as the population ages.
Greater still is the demand on the lending side. ERMs have thus far been an excellent complement to long dated longevity linked liabilities – the bread and butter of life insurers and pension providers. ERMs start with low loan-to-value ratios (LTV) and interest is capitalised so the LTV increases over time, while the borrower does not have to make any payments. The loans become payable in full when a borrower downsizes, moves into long term care, prepays or passes away. So the risk to the lender is tied to when these events occur (the later the better). Unlike traditional mortgages, the house value is also an important part of the credit risk.
Since 1991, over 400,000 borrowers have borrowed over £20bn through ERMs, according to figures from the Equity Release Council. A number of mainstream lenders, notably Nationwide Building Society, have started to offer a new style of ERM mortgage to borrowers who at maturity will be well into their retirement years.
Clearly this market is a potential source of future ABS supply, if the product’s quirks can be addressed in the structuring of the transaction. So how can you securitise a pool of UK ERMs, the interest on which accumulates over time as capital, instead of paying interest? In legacy equity release RMBS transactions, a large senior liquidity fund was used to pay bond coupons in the early years where cash flow is small. Over time ERM pools throw off more cash flow, and this senior facility is paid down followed by the bonds. One example is Aviva’s Equity Release Funding No.5 RMBS deal, where the most senior bond just received its first principal payment, 13 years after the deal closed!
Despite both the supply and demand drivers for ERM ABS looking healthy, the future growth of this market may be about to hit a speedbump. The UK’s Prudential Regulation Authority recently began a consultation on ERMs and will issue new guidance to life insurers at the end of this month.
The PRA’s chief concern is the assumptions life insurers make about how the value of the assets will behave over time, particularly in periods of housing market stress. ERMs are sold with a no negative equity guarantee – borrowers cannot be left with a loan balance greater than the value of their house. The PRA wants insurers to book this on their balance sheets as a put option on house prices. When combined with insurers’ long dated liabilities, this change would lower their “matching adjustment” benefits. This in turn would lower the Solvency II ratio (the industry’s primary measure of financial health) of insurers with significant ERM holdings, making the assets less attractive at the margin.
We eagerly await the PRA’s final guidance and note that while the result may set back the growth of the ERM market slightly, the problems the product solves still remain. Namely the gradually swelling ranks of retirees with large residential property wealth in need of liquidity, and a regulatory desire to reduce the risks associated with institutions taking on this long dated longevity risk. These problems demand a solution, and ultimately that could well prove to be the force that drives the ERM market to become more prevalent in European securitisation markets in years to come.
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