The Bank of England is fretting. Its latest report raises concerns that heightened risk appetite has prompted the development of techniques to repackage and spread risk around the financial markets. That kind of distribution that has been tested and found lacking in the US subprime mortgage market, where the high levels of arrears in recent vintages of lending has raised questions about the perverse incentives created for the originators by such on-passing of risk.
As a Standard and Poor’s report this week notes, “much of the concern in the US has surrounded loans that were originated in 2006. These loans are demonstrating early arrears around 40 per cent higher than recent averages.”
That report goes on to argue that in fact the UK remains less susceptible to the kind of subprime shock that has affected the US market. Riskier products became more popular stateside, with higher loan to value ratios, lower standards of income verification and adjustable-rate mortgages, which start at a fixed, discounted rate and ratchet up after two or three years, accounting for more than 80 per cent of lending, up from 60 per cent in 2000.
The UK remains more conservative – with LTVs of 76 per cent on average last year, compared to the US at 85 per cent, where “piggyback” loans on top of that, at 29 per cent of last year’s lending in the US, take overall LTVs much higher.
The lower credit quality of the US sector left it more sensitive to economic pressures, such as interest rate rises and slowing house price appreciation. Some estimates suggest US subprime ARMs taken out between 2004 and 2006 could suffer an average increase of about 30 per cent on the first reset date, says S&P.
Lower average risk in the UK should mean better protection against an unfavourable environment, according to S&P. But while the UK sector has weathered a brief dip in house price appreciation and some moderate rises in interest rates, the test has been much less severe than in the US.
Not enough for the Bank to sleep easy, in other words. But the Bank’s concern isn’t really with the lower rungs of the mortgage lending ladder per se. “The rapid growth of structured credit markets over the recent past has largely taken place in benign conditions. The recent problems in the US sub-prime market are an important test of the structure of this market and its performance in response to stress,” the report reads.
Their concern is that, with default rates at historically low levels and the market anticipating some increase in credit spreads over the coming years, a sharp weakening in corporate credit exposing a growing tranche of risky corporate debt could make the US subprime mortgage market a potentially illuminating example for leveraged corporate markets.
Notwithstanding some important differences laid out between the markets – such as the prevalence of ‘put back’ features in the subprime market and the greater likelihood of a rating on the underlying in corporate lending – the reports notes:
- Strong investor demand for securitised assets, combined with benign market conditions, has sustained a heavy issuance of both residential (RMBS) and commercial mortgage-backed securities (CMBS). In turn, this seems to have led to an easing in underwriting standards, such as increasing ‘covenant-lite’ deals in the leveraged lending arena and weaker documentation requirements for
CRE [commercial real estate] lending - [Those] sponsoring securitisations face the same types of warehouse risk in securitising corporate and CRE loans as for residential mortgages. Indeed, some of these collateral pools will be subject to longer warehouse accumulation periods than retail mortgages as it takes time to accumulate a stock of comparable loans.
- Given that risk is transferred to other market participants, there are concerns that the ‘originate and distribute’ model might dilute incentives for the effective screening and monitoring of loans in the corporate market
- The structured corporate credit market is characterised by new types of investor and a concentration of credit risk in lower-rated tranches…[CDO managers and hedge funds]…Any fall in demand from these investors could cause a sharp rise in the cost of debt to firms
- The embedded leverage in CDOs is common across sub-prime, CRE and corporate credit markets and could magnify the market response if there was a particularly sharp deterioration in the performance of underlying assets.