Article 15.2 Recent deals signal market’s reopening in the same old style
By Jennifer Hughes
Financial Times October 29, 2009
When Northern Rock decided to wind down its Granite master trust - now to be placed in the lender's ‘bad bank' rump - industry insiders predicted the death of a structure that had helped the UK dominate the European mortgage-backed market.
The Granite decision, in November 2008, put all bondholders in a queue for repayments that could take years, regardless of the maturity date of the paper they held.
Investors warned that they would demand far simpler structures before venturing near the sector again.
Less than a year later, however, two master-trust-backed deals in the last month have signalled the reopening of the market in the same old style.
They have reignited a debate about how best to structure an instrument considered crucial for boosting economic growth but which represents the very complexity that triggered the crisis.
Policymakers in Europe and the US have called for simpler, more transparent structures. The industry has responded with guidelines and templates for providing more data that many big issuers have agreed to follow.
But the UK, responsible for about half the total European market before the crisis, is a particular challenge because its biggest lenders use a different structure from the rest of the world.
Most mortgage-backed securitisations are based around stand-alone, ring-fenced bundles of loans.
Bonds are backed by the loans in deals known as ‘pass-throughs' because the mortgage repayments are passed to the bondholders almost as they happen.
This leaves investors with the risk of pre-payment - where the loans are repaid earlier than expected, meaning investors end up with extra cash they must reinvest - or of extension risk, where the bonds mature more slowly than expected.
In the UK, bankers have instead created master trusts - vast pools of mortgages which the lender would periodically top up with new loans and from which it would issue different bonds at different times.
The advantage was that this constant pool allowed the trust to issue the exact bonds investors wanted, such as ones with set maturity dates.
Investors were thereby freed from prepayment and extension risk and left only with credit risk, and the impact of any bad loans would be cushioned by the size of the whole giant mortgage pool.
Master trusts enabled the UK market to expand rapidly. Swathes of the bonds were sold overseas because it was far easier to arrange currency swaps on paper with set maturity dates than it would have been on a pass-through deal with its uncertain quarterly payments.
Investors liked the apparent relative simplicity of the deals. By buying bonds backed by a pool of known quality, they saved on the effort of analysing each deal in great depth.
But the upshot of the simple front was the complexity that lurked behind the master trust. ‘They have got many strong positives but one big negative, and that's the complexity,' said one expert, summing up the industry's dilemma.
‘Either we have a complex security or a simple-looking security backed by a complex structure.'
Some investors favour the former. ‘Master trusts create concentration problems,' says Chris Ames, head of asset-backed securities at Schroders. ‘If I own a 2005 bond and a 2006 bond from the same master trust, then I've simply doubled up my exposure to the exact same pool of mortgages.
‘Furthermore, you lose a lot of information in a master trust pool. Because new loans are added to the existing collateral pool when new bonds are issued, the performance statistics of the older loans are diluted by the new loans.'
Steve Swallow, head of European asset-backed securities at CQS, the hedge fund, believes investors are prepared - or should be - to do the extra work required to analyse stand-alone deals.
‘Providing the investor community with a proposition that requires more diligence and more consideration of risk can only be a good thing, and in the long term, the transparency will encourage more investors into the market,' he said.
Investors are unhappy at the way the structure leaves them at the mercy of the lender's treasury team, which can decide, under certain circumstances, not to repay the bonds until their legal maturity date.
This is further into the future than the set maturity date and reflects the long-term nature of mortgages.
In effect, this happened with Granite, where Northern Rock decided to no longer support the trust with new mortgages and where it will instead simply pay out on the existing bonds when the underlying mortgages are repaid.
‘Before the crisis, people took complexity for granted since what would get them into trouble was so far-fetched, but now that's actually happened with Granite,' said one investor. ‘Everyone is comfortable with credit risk, but it's really also extension risk they've taken. It's not always at the issuer's discretion. They might have to extend if certain things happen.'
Investor unhappiness does not appear to have yet held back the market.
Last month's £4bn ($6.5bn) deal from Lloyds was snapped up by investors who returned this week to take £3.5bn of paper offered by Nationwide, a deal even more notable because its Silverstone master trust was new to investors.
Bankers expect more deals to follow.
‘We've talked to the core investor base and most of them said we want “master trusts”,' said one banker on the Nationwide transaction.
David Basra, head of debt financing at Citigroup, argues that the UK structure is safer for investors. He helped structure the first master trust for Bank of Scotland. ‘I'd argue that stand-alone pass-through transactions may expose investors to greater credit risk, depending of course on which mortgages back their underlying bonds,' he said.
‘I think investors may find that they lose more over the cycle on some stand-alone deals because there is a greater chance they'll end up exposed to poorly underwritten risk.'
Source: Hughes, J. (2009) Recent deals signal market's reopening in the same old style, Financial Times, 29 October.
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Article 15.3 describes the securitisation of Dunkin' Donuts' royalties received from its hundreds of franchises around the world - a steady source of income.