Memorandum from the Council of Mortgage
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
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
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.
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.
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
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.
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 ratea 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
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
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
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.