Alex Maddox, Director of Business Origination and Development, Acenden
Over the last year, the UK’s residential mortgage market has witnessed strong interest from potential investors. This interest has been sparked, in particular, as banks have started a process of deleveraging their non-core units (including their residential mortgage portfolios) in a bid to boost capital margins, generating renewed vigour in the market. According to Ernst & Young, the market for secured mortgage/loan transactions has developed significantly in the last 12 months. Its recent reporti states that the markets – for both non-performing and performing assets – are proving increasingly attractive to institutional investors wishing to deploy funds against credit-related products.
As with all prospective investments, potential acquirers of these portfolios need to carefully analyse their risk positions to ensure they will be able to achieve optimal rewards. For example, investors need to pay close attention to both current and forecasted macroeconomic variables, as these will have an impact how likely it is that mortgage borrowers will keep up with their payment.
For better portfolio performance, investors need to adopt a dual approach. Prior to acquisition, they should apply analytical models at both a loan and portfolio level to understand more about the health of a loan book. If they then acquire the loan book, investors must consider how they intend to service the loans on a day-to-day basis – servicing being the continued administration of the individual loans, including the overseeing of payments and collections and the management of arrears.
If investors apply these forecasting and servicing strategies successfully, they can potentially reach appealing risk-adjusted yields of between six and nine percent, which compares well with other investment instruments available.
Phase 1: Bidding
As investors need to actively assign a value to the portfolios they are interested in during the bidding process, this stage is a key moment for them to conduct stress testing. This allows them to assess the portfolio’s risk exposure, playing different macroeconomic scenarios against the borrowers’ profiles to judge potential performance.
A key consideration in this stress testing is the Bank of England (BoE) base rate. Mark Carney, the current Bank of England Governor, has announced his intention to keep the BoE base rate low for the next few years until core indicators such as the unemployment rate drop. This would suggest that the short-term macroeconomic outlook is quite stable. However, in the long-term, borrowers may encounter problems should the base rate and, consequently, inflation, increase. Changes to these variables can place strain on borrowers’ monthly affordability – their financial capacity in any given month after mandatory deductions.
With this in mind, investors should focus on using analytical outputs to explore how well a portfolio will perform over a number of years, to ascertain how profitable the investment will be.
These outputs can be quite severe. Multiple research papers have highlighted how small macroeconomic changes can impact a typical mortgage portfolio in the UK. For example, according to data from the Mortgage Fiscal Cliff research paper published in May 2013, an interest rate rise of just two percent above the existing base rate, while all other variables remain equal, could have an impact on over half a million loans. This would then place over 150,000 of these at risk of falling into immediate arrears. It is these types of outcomes which investors need to be mindful of when considering a bid. That way, they can understand more about the profitability and risk profile of the loan book and, more importantly, if it is a worthwhile investment.
Due diligence is another key step at this point of the acquisition process. Specifically, investors need to check whether individual repayment plans are enforceable, update borrower credentials and verify property values. While it is not always feasible to gain the appropriate levels of information, desktop research and land registry checks can often provide a decent overview of the properties in question, without sacrificing too much time and resources.
After purchasing a loan book, investors also need to instigate an effective servicing strategy to ensure the loans are managed correctly. Without this, portfolio owners will feel the full force of regulators should their record keeping and decisioning procedures prove sub-optimal.
Many investors have found that a streamlined servicing strategy requires a level of expertise and resources seldom found in-house. It is therefore becoming more and more common to outsource this process to third parties. Partnering with an expert external party provides investors with servicing tools, an operations team and the wider market knowledge to prevent loans defaulting, ensure regulatory compliance and, overall, optimise forbearance procedures should borrowers encounter problems. While it is inevitable that some borrowers will experience negative financial changes during their lifetime; with the support of the latest automated technologies and analytics, portfolio owners can keep borrowers on affordable plans. This maintains borrower relationships, without compromising the profits on the initial investment.
Piecing together the jigsaw
If pre- and post-acquisition procedures are carried out in the correct manner, investors are well positioned to capture lucrative yields from the residential mortgage market. In order to achieve this margin, however, all elements of the puzzle require attention – appropriate counsel and forecasting for acquirers during the bidding rounds and an intelligent servicing strategy to manage the individual loans post-acquisition.