Select Committee on Treasury Written Evidence


Memorandum from the Council of Mortgage Lenders

INTRODUCTION

  1.  The Council of Mortgage Lenders (CML) welcomes the opportunity to provide written evidence to the Treasury Committee Inquiry on Financial Stability and Transparency.

  2.  The CML is the representative trade body for the residential mortgage lending industry. Its 163 members currently lend over 98% of the residential mortgages in the UK mortgage market.

BACKGROUND

  3.  The events we have witnessed in global debt capital markets since early August have been exceptional. A widespread reassessment of the compensation investors require for bearing risk followed unexpectedly severe credit losses in the US sub-prime mortgage market. Most US sub-prime loans are packaged into residential mortgage backed securities (RMBS) and sold to investors across the globe, often being repackaged into other investments such as collateralised debt obligations (CDOs). Although this process can disperse risk, it turned out that some investors, including banks, had unexpectedly large exposures.

  4.  The realisation that some banks had unexpected exposures to US sub-prime debt created a loss of confidence in the interbank lending and commercial paper markets, triggering a requirement for banks to absorb on to their balance sheets the assets of structured investment vehicles (SIVs) which they had set up. This, coupled with other unexpected demands on bank liquidity, exacerbated the reduction in liquidity in the interbank market. The net result has been a serious strain on the global financial system and on bank and non-bank lenders which has not yet been resolved.

  5.  It is important that the underlying causes of these fragilities are analysed and addressed as highlighted in the separate response by the British Bankers Association (BBA). It is clear that a market failure has occurred in international financial markets in the sense that RMBS markets have shut, even for prime mortgage assets over which there seems to be no discernable concerns on credit quality. The need for analysis and, if deemed appropriate, a policy response is given added urgency because the lack of available liquidity that led Northern Rock, a solvent institution with a high quality loan book, to approach the Bank of England is still in evidence.

ILLIQUIDITY IN DEBT CAPITAL MARKETS

  6.  Wholesale debt markets do experience periods when investor demand is reduced to the extent that issuance ceases to take place. These periods have tended to follow disruptive events such as the Asian financial crisis and subsequent Russian government default in 1998. However, past episodes have been resolved relatively quickly with the assistance of central bank liquidity.

  7.  Evidence from the market turmoil that began this August suggests that the reduction in liquidity in private sector RMBS markets is more severe and likely to take much longer to resolve than previous episodes. The implications of an on-going wholesale market illiquidity are potentially widespread not only for mortgage lenders and borrowers but also for policymakers and the wider economy. Roughly 20% of UK mortgages are funded through the RMBS market, including a significant proportion of prime mortgages originated by the larger banks. The proportion of mortgages funded through RMBS is higher still in the adverse credit and buy-to-let markets. Having the RMBS market shut for a prolonged period will create further risk of damage to the UK financial system on top of that resulting from the Northern Rock announcement, which itself was a direct result of the market ceasing to function in August.

  8.  Policymakers should note that throughout this period, the US RMBS market for prime "conforming" mortgages has remained open because of the perceived government backing for the large mortgage funding institutions, Fannie Mae and Freddie Mac, which dominate this market. The structure of the US mortgage industry has largely insulated the prime market from the problems of the sub-prime. This is not the case in the UK prime secondary mortgage market which has suffered a greater contagion effect than the US prime market. This is an insidious result of the current turmoil in funding markets and one that warrants a response from UK policymakers to aid the recovery of secondary market liquidity for prime UK mortgages.

THE NORTHERN ROCK SITUATION

  9.  One very high profile result of the extreme illiquidity of global RMBS and interbank markets was Northern Rock requesting financing assistance. We welcomed the decision by the tripartite authorities to provide robust support for Northern Rock. The government rightly made clear that it is a solvent well capitalised bank, and as such support was fully justified. The credit quality of Northern Rock's loan assets has been good.

  10.  It is vital to confidence in the UK banking system that depositors feel secure and therefore right that the government moved quickly to reassure Northern Rock depositors that their money was guaranteed and to provide a facility which enabled Northern Rock to continue to operate and meet its commitments. Had support (the emergency funding line from the Bank of England and the guarantee to the retail depositors and senior unsecured wholesale creditors) not been forthcoming, the damage to the UK's financial system and reputation would have been very much greater than it was.

  11.  It is accepted that this support cannot, and must not, be open-ended, not least because assistance of this kind for one bank distorts competition. What is less clear is how the government will be able to extricate itself from the support it has given. Although it has made clear its desire to see Northern Rock taken over by another financial institution, any potential bidders will need time to evaluate the proposition, undertake due diligence and raise the necessary funding. In the meantime, the emergency funding line is gradually reducing Northern Rock's profitability as a business as it commands a penalty interest rate.

  12.  We believe that it would be wrong for the government simply to await the outcome of the sale process at Northern Rock. Although the longer term solution may be for Northern Rock to be taken over, the more immediate solution lies in the re-establishment of a rationally priced liquid secondary mortgage market. It is in the interests of UK mortgage borrowers, the financial sector and the wider economy to re-establish a functioning secondary mortgage market.

RE-ESTABLISHING A FUNCTIONING RMBS MARKET

  13.  An agreed strategy on the part of market participants and the tripartite bodies to restore rational pricing and liquidity in the UK secondary mortgage market is one way forward. Investors, including the large issuers, would need to commit to return as RMBS purchasers but the authorities would also need to play a facilitating role.

  14.  The Bank of England could assist the re-establishment of a functioning RMBS market through targeted support by making available a term repo facility exclusively against new RMBS and mortgage covered bond issues (those undertaken after the facility was announced). This facility would need to be made available at a commercial interest rate—a rate that provided the Bank of England with a commercial return based on the credit risk it was taking on, but one that incentivised lenders to use it.

  15.  The rate made available to banks repoing the RMBS of other institutions would be more advantageous than for banks repoing their own RMBS to encourage public issuance. The repo facility could be of three months or more maturity, but the Bank of England would need to confirm its intention to maintain the facility until market conditions improved. To be eligible for the facility, the securities would have to meet certain criteria. It could be applied only to highly rated tranches backed by prime mortgages with lower loan-to-value (LTV) ratios.

  16.  Such a solution would have a number of benefits over current arrangements. It would be a market wide solution, reducing moral hazard and ensuring that support was not focused exclusively on one institution. It should allow Northern Rock to resume funding through the RMBS market, allowing it to reduce its emergency funding line from the Bank of England, potentially smoothing the transition to new ownership. Most significantly, it would show that the UK was prepared to take targeted action to restore confidence in the wholesale funding markets for prime UK mortgages, recognising the credit quality of residential assets in the UK is high and should not be tainted by developments in the US.

BANK OF ENGLAND STERLING MONEY MARKET OPERATIONS

  17.  We welcomed the announcement from the Bank of England on 19 September that it would provide funds of three month maturity secured on a wider range of collateral, including RMBS and mortgages subject to certain criteria. We believe this was an important change in the Bank of England's approach to market support. It recognised the potential benefit to banks at a time of stress of central bank term funding. We also recognise that the Bank of England views such a facility as a response to a specific need and that it wishes to avoid the situation where commercial banks become dependent on such liquidity support. That is why the facility carried a penalty rate of 1% above Bank base rate. But such a high rate exacerbated the potential for stigma for banks that may have used the facility, preventing it from being an effective source of liquidity.

  18.  By accepting RMBS as collateral, the Bank of England has potentially created an important bridge between the money and RMBS markets at a time when the RMBS market is not functioning normally. We believe that the use of repo support collateralised against RMBS can be used to provide targeted support to re-establish a functioning RMBS market for UK prime mortgages.

  19.  The BBA has led the response from lenders to the tripartite on the provision of liquidity by the central bank and we support the BBA's submission on liquidity and its recommendations.

Lessons from the US sub-prime crisis

  20.  We strongly support the Building Societies Association's (BSA) submission in its response on this issue. There are significant differences in the US and UK sub-prime mortgage markets but the interconnected nature of wholesale funding markets has left UK lenders, indeed even those operating in the prime mortgage market, vulnerable to events in the US over which they have no control.

November 2007





 
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