From all of us here at Checkmate Mortgages we would like to wish you a very Merry Christmas. 

To spread a little Christmas cheer, we thought we would share some photos from a recent night out at Jongleurs comedy club! 

MERRY CHRISTMAS and a HAPPY NEW YEAR!

 
As has been covered in depth by various commentators in recent weeks, there is strong difference between statements emerging from the Treasury and the Government and the requirements from the FSA over capital requirements. Lenders have increasingly found themselves caught between a ‘rock and a hard place’ with one side increasing pressure on the lenders to lend as against the increased capital requirements the FSA is insisting upon to cover the increased or perceived increased risk of existing and new loans.

With the seizure of the Capital Markets, increasing levels of bad debts (both mortgage and now corporate) and increased provisioning, the current results are all too apparent in the unavailability of mortgage products at present.

How to get the market moving

Tighter capital requirements and the disappearance of wholesale funding has meant dramatically increased competition for savings. This means that many smaller banks and mutual institutions, which as a whole contributed significantly to the UK mortgage market pre 2008, are now finding savings not only harder to come by but also significantly more expensive to secure. Additionally, slowing pre-payment speed on existing mortgages has meant less redemption income or put another way less cash circulating to be re-lent. The net result is that many, if not most of these organisations, now find themselves in a position of being only able to service existing customers with lending restricted largely to branch based or ‘footfall’ customers only. Unless there is a change is in either regulatory capital requirements and/or a re-opening of the wholesale markets, this is likely to be the position for the near term at least.

The ‘big 6’

If the smaller and medium sized lenders are effectively out of the equation at present it leaves the bulk of the lending requirement down to the ‘big 6’. HBOS/Lloyds, Barclays/Woolwich, Santander (Abbey and A&L), Nationwide, RBS and HSBC. However whilst on paper it appears that these lenders combined lending in 2007 contributed around 65% of gross lending, it does somewhat ignore the fact that HBOS is currently undergoing a merger with Lloyds, RBS has had to have significant capital pumped into it to keep it afloat to the extent that the government/taxpayer now owns 57% of it and Santander is going to be very busy absorbing both A&L and Bradford and Bingley.

An additional question also emerges with an increased dependence on the ‘big 6’, namely around processing and distribution. Whilst some (notably HBOS) have been very intermediary focused and have invested in point of sale technology, several of the largest lenders are still very manual/paper based and underwriter focused. Whilst you can argue the pros and cons of this approach from a risk perspective, what it does mean is that volumes are much more difficult to ‘flex’ given the dependence of paper and human beings. Given the events currently taking place, the ability of the largest lenders to take up the slack and effectively and efficiently process volume business, even if they wanted to, must be open to question.

Filling the mortgage ‘gap’

If the smaller and mid sized lenders are largely inactive and questions remain about the ability and willingness of the ‘big 6’ to fill in the gap, where could the additional lending required come from? As has been said many times before, if you want to go forward you sometimes have to look back, in this case not very far to 2006/7.

Northern Rock was the third largest lender in 2006 with £33 Billion gross advances and still the fifth biggest in 2007. Now wholly government owned, despite some redundancies the infrastructure still remains very much in place. Therefore instead of the government trying to incentivise and cajole existing lenders to increase lending, a very real and much more direct alternative would be to simply change the Rock’s mandate and allow it to re-commence lending on a commercial scale. As most intermediaries reading this article will testify, the Rock was (some criteria issues aside) very good at underwriting and processing loans in a fast and efficient manner.

Return of ‘The Rock’

To get the Rock lending again would mean either slowing down or temporarily suspending the repayment of the government debt, but as we are seeing all too clearly in the current economic crisis, it is a matter of priorities. Given the massive slow-down in mortgage lending and the knock-on effects on the economy as a whole, stimulating demand must surely take precedence over the timing of the repayment of the tax-payer. In light of this, the recent decision to wind down the Granite Master trust programs was very disappointing given the ability that these presented to continue to fund newly originated assets through the capital markets.

When Northern Rock was taken into public ownership, the world was a very different place. As has since become clear, rather than being an isolated example, the Rock was just an early casualty given its greater dependence on the wholesale markets. Surely given this, it is time once again for the government to look at all the tools at its disposal to increase lending and review the role and mandate of what was one of the UK’s largest and most efficient lenders

 By Stephen Knight, Executive Chairman - Checkmate Mortgages

The credit crunch will be longer, deeper and more painful than it needs to be all the time our bankers are shell-shocked, depressed and being pulled in different directions.  The Government, in conjunction with the banks’ boards, must get hold of this situation quickly and, even if you don’t like football, the relevance of a comparison with the turnaround of my team – Spurs – is difficult to avoid.

 Spurs - where it went wrong

Just a few short weeks ago, Spurs were at the bottom of the League, with no win in their first eight matches.  Their manager, Juande Ramos, gave unclear messages, expecting the players to fill in the gaps (exacerbated by the fact that he didn’t learn English).

Ramos made no attempt to understand the culture of the English players, and he hardly ever spoke to them one-on-one.  I was on the players’ plane once, going to a European match, and I witnessed at first hand his unreasonable behaviour, banning the paying VIP guests from having breakfast in case the players (who were only allowed fruit) could smell the food.  Even an old English favourite, tomato ketchup, was banned from the training ground.

The results of all this could be seen on the pitch.  The players were disorientated and demotivated.   As each defeat totted up, failure became the norm.  Very little that was creative or new was tried, until the board brought in a new manager. 

 New leadership and vision

In Harry Redknapp’s first visit to the Spurs training ground, he brought some tomato ketchup with him and said “I hear you boys have been a bit hungry”.  He took every one of the first team squad to one side and told them they were world class, international players.  Harry is no slouch when it comes to tactics, but, if he was a portfolio manager, he would be an instincts man rather than a chartist.

In the next 13 games, that same group of players won 9 and drew 2. Great for a Spurs fan, but how does this help with our analysis of the credit crunch?

 How does this relate to the banks?

Well, the bankers that I meet are shell-shocked by what has happened to their industry.  Many have lost colleagues and large chunks of their personal wealth.  They did not predict the liquidity freeze to their boards (who did?), so those that are still in work are falling over themselves to be pessimistic about the outturn.  I met a banker the other day who was now predicting that we would not see an end to the current recession and liquidity freeze until 2013.

The bankers’ general mood is being tortured by the Government’s lack of skill in man or corporate management.  The banks are being asked to attack (lend more to help the economy) and defend (lend less to build up their balance sheets) at exactly the same time.

They are being summoned like errant schoolboys to the corridors of political power, in the full glare of the media, and told to reduce the loan rates they charge customers when the costs of the funds they used to make those loans has not gone down at all (in some cases) or by much (in others).  See the Spurs connections?

On top of all this, the Government is charging the banks 12% (yes, you heard it right, 12%) for the provision of support capital, adding further to the cost base and the confusion. 

Now, of course, I’m not saying that the banks got it all right in the boom times, nor that the Government was wrong to step in when they did.  The current situation is far too complex for such platitudes.  What needs to be debated, however, is how we get out of this mess, and we simply won’t do it without the banks starting to lend again.  Unless, between them, the Government and banks can start thawing the current freeze, the recession will be far deeper than it needs to be. 

 How do we resolve the lending crisis?

To kick off that process, the Government needs to understand that it has no particular skill in running banks nor, by recent evidence, is it that good at understanding or motivating bankers.  There are plenty of good and wise men available to assist the Government, and the new Lending Panel is well positioned to act as a buffer between the Government and the banks if the right appointments are made.   With the right motivation, the banks’ depression could be arrested.

The Government then needs to work with the banks to achieve some priorities that will get them lending again.  Recent hastily put together Government initiatives have been significant by their lack of impact on new lending availability.  Some measures that might have an immediate effect could include:

1. If the banks can demonstrate on a quarterly basis an increase in lending over the previous quarter in such areas as credit facilities and overdrafts to small business, and residential mortgage loans to prime customers, then they could be given an incentive by way of a reduction in the 12% preferential rate;

2. The Government could consider guaranteeing loans for first time buyers, just as they do with the shared equity Homebuyer Scheme, but to 95% LTV and collecting a “premium” from the many, that should fund the claims of the few; and

3. The Government could bring about the re-introduction of wholesale funding, delivering capacity and competition to the market by implementing Sir James Crosby’s recommendations.

Smarter brains than mine can, I am sure, come up with a host of further and better ideas.   But this issue needs to be addressed quickly. Unlike Spurs, we can’t sack the manager.  So unless the current manager (the Government) realises that the results are still going against him, we will get relegated – to the lower leagues of third world economies.

What we have been witnessing or perhaps, expressed more correctly, are starting to witness (depending on where you believe we are in the current cycle), is a great unwind or deleveraging. As has been covered in much detail in the press, most notably by Robert Peston in his various Blogs, we (as a nation) have consistently been borrowing more than we have been saving and ultimately, as everyone knows, there comes a point when the debt has to start being repaid.

Within the banking system there exists currently a loan to deposit ratio of 145%. In simple terms over £700bn, be it corporate loans, home loans etc, was not financed from internal resources but through the wholesale funding markets. With these now effectively shut, it has fallen to the government to try and fill the substantial funding gap. With regard to mortgage funding, with house prices continuing to fall, it is perhaps understandable that with lender’s finances under severe strain, higher risk loans are unlikely to be written.

The end of the beginning?

Without a re-opening of the capital markets, we are looking at continued government intervention aimed at supporting the banks to continue to lend, at least towards the levels of the last couple of years. If we view the credit bubble of the last few years as an addiction, the role of government is to prevent the UK economy undergoing the equivalent of ‘cold turkey’ which would have massive implications for businesses and the economy as a whole. The question that the events of the last few months lead to inevitably is ‘where is the end or at least the beginning of the end? 

The start of the crisis

What started off as an issue revolving around US sub-prime lending has snowballed in what is now generally regarded as an impending global recession. Whilst the economic debate has now shifted from one of mortgage lending and falling house prices, to that of corporate failure and economic recession, we are firmly of the belief that the stabilisation of house prices will restore confidence and mark, if not the end, but at least the beginning of the end of the current cycle

The importance of housing in the global economy

House prices are important in two respects. From a funding and capital markets perspective, house prices underpin huge amounts of paper debt issued over the last few years. As prices fall, so does the intrinsic value of the debt, hence the huge mark to market losses (MTM) and in many cases on US RMBS paper, real losses. Until the value of underlying assets stops falling, you can’t draw a line and uncertainty remains as to what the overall exposure and loss maybe. Additionally, with literally $ trillions of mortgage debt already in the market, all of it substantially written down, there is little hope of new issuance without either government guarantees or signs that we are reaching the end of falling prices. Secondly, house prices are a ‘barometer’ of general economic confidence. If we as a nation feel good, confident and secure, we spend more and prices rise.

This will not end until US house prices stop falling…(Alan Greenspan)

Despite every evidence (which I will cover a in separate blog later) that there is no linkage between the UK and US housing markets and in turn between US and UK RMBS paper, this is not being reflected in capital markets. Accordingly, the return of the capital markets is almost entirely dependent on US house prices stabilising. At this point, as well as a line being drawn under losses, both MTM and real, new deals, (low LTV and conservatively structured), start making a lot of sense for two reasons;- (1) The loss severity is likely to be low to zero (2) Spreads or margins on deal will be very high meaning good returns for both issuers and also investors. In short, the stabilisation of house prices will represent a complete resetting of the bar for investors and issuers. The million dollar question therefore is when?

Case Schiller index

The most widely regarded index in the US is the 20 city Case Schiller index . Given its sheer scale, the US market has much greater regional variations. This combined with the rapid growth of sub-prime lending in regions such as California and Florida and speculative building in these regions (supported by sub-prime lending), produced a very distorted picture when house prices rose rapidly. The correction is equally distorted, focusing primarily on the regions where prices rose the most. As can be seen from the graph below of the 20 city areas, rapid divergence is now being replaced with rapid convergence (note the stronger red line is the average composite 20 city index) - click on the graph to view in a seperate window

 
With the current rate of decline and the reducing supply side imbalance (private housing starts have fallen by over 30% in the last year) we believe that along similar lines to our view of the UK, the approximate bottom of the market will be viewable in the latter half of 2009. This view is supported by some very interesting research by Nomura on parallels between the Japanese experience in the 1990’s and the current US experience. Click here to view

Given the greater supply in the US, we would anticipate a period of ‘bumping along the bottom’, where prices are flat or in certain months fall or rise slightly, but the large scale corrections that have destroyed confidence in the US housing market will have occurred.

The events of the past year have certainly been unprecedented and the ramifications are all too clear for us to see. Of course these events have had a major impact on the Intermediary market.
 
Supply and demand

With the current liquidity crisis, there have been a number of instances of dual pricing leading to inevitable conflict between Intermediaries and lenders. The Intermediary has and still does supply the majority of lender’s business. But in the current climate, as lenders continue to strive to reduce volumes, lenders face a dilemma in trying to satisfy both intermediaries and also keeping their branches busy.
An additional outcome of the liquidity crisis has also meant that many of the lenders more actively involved in the intermediary markets have funding constraints or have simply disappeared. This has pushed a much stronger focus through the ‘big 6’ (Santander, Lloyds/HBOS, Nationwide, Barclays, RBS and HSBC). All these lenders have large branch networks to satisfy and additionally, some of the ‘big 6’ either don’t distribute via intermediaries or have a limited involvement in this sector.

Compliance and Risk

In addition to pure distribution issues, we are also seeing greater regulatory intervention from the FSA, with TCF requirements becoming ever more pertinent and a number of high profile firms being censured and fined this year.

 
From conversations with various Networks they state that their recruitment enquiries are growing with high numbers coming from the directly authorised channel. With increasing FSA fees and PI premiums, as well as the cost of compliance services, it may well be that the Appointed Representative route may be right for many in the current regulatory environment.

Impact on distribution channels

So we have touched briefly on dual pricing, risk and regulatory issues. How does this leave the Mortgage distribution landscape?
 - Let us firstly look at packagers. With many recent high profile firms already having left the market citing that the financials no longer make sense, it is highly probable more will follow. Those packagers that will survive have already adjusted to the new landscape and have diversified into other areas such as debt management, bridging finance and second charge loans. Technology will be the most important factor for them in the future and where they will need to make their investment.
 - With networks we already have seen some consolidation, but far more is expected in the forthcoming months. We anticipate that within the next 12 months the number of networks remaining will reduce from around 38 today to perhaps as few as 10 – 15.
Running a network requires strength in productivity and a strong product offering and like the packaging market technology will play a pivotal role. Networks that have strong parentage have diversified into noncore mortgage related fields and have sufficient capital reserves.
 - Lastly the Mortgage Clubs. They have diversified into many different fields and continue to build their propositions especially in areas such as compliance services and other income earning streams. Their once biggest attraction, namely exclusives, have been largely removed from their product offering. They will have a role to play in the future but again consolidation will be inevitable.

In summary, the mortgage distribution landscape has started to change and will see more significant changes in the months ahead. Ensuring that lenders develop relationships with the distributers that survive is essential and one that we at Checkmate Mortgages are consistently monitoring.

Peter Izard
Corporate Accounts Director

 
One of the most noticeable fall-outs of the current credit crunch are ‘higher’ LTV loans. Anyone trying to borrow above 75% currently will struggle to find a suitable product let alone a reasonable rate.

In a blog a few days ago I made the point this isn’t the 1990s for a number of different reasons. One additional difference between now and then was the scope of products that remained available. Direct comparison between events 18 years apart is never straight-forward, but in the early 1990s – in the midst of the recession, with high inflation, rising unemployment and falling house prices - you could still obtain higher LTV products. Why?

The answer is obviously multi-faceted including such things as dominance of the lending market by mutual building societies (hence no or very low reliance on capital markets for funding and perhaps a greater social conscience), and also perhaps maybe a little naivety around loan performance in such a market. The biggest factor however was the existence of Mortgage Indemnity Guarantees or MIGs.  

If you can issue loans where the lending typically above 75% is covered by an insurance policy, the risk is substantially diminished if not reduced altogether. At the time of the 1990 down-turn, virtually all business was and indeed had been for a considerable time preceding, underwritten with a MIG in place. This was insurance where the premium was in most cases actually passed onto to a third party insurance company, such as Eagle star, Royal and Sun alliance etc rather than simply taken as additional profit or put aside internally. In other words a genuine hedge with a third party firm underwriting the risk. When the crunch came, payouts running into hundreds of millions were made to the lenders.

The myth of risk-based pricing 

As a result of the 1990s downturn, insurers began to raise premiums and also became more cautious and difficult on pay-outs. Accordingly many lenders began to effectively self-insure by putting the MIG premiums aside and calling them Higher Lending Charges (HLCs) or similar. However, as margins tightened and as MIG premiums often ran into many hundreds of pounds, the obvious temptation was to ignore the MIG premium, charge a fee, and take that as profit day one as a risk-based pricing charge.

As we moved into the 2000s, there was an increasing media clamour for MIGs to be removed entirely, often on the pretext that it wasn’t treating customers fairly. It was argued that lenders often charged higher rates anyway above 75%, so why ‘double’ charge with the addition of a MIG? Well quite simply, the risk premium in the form of a higher rate a lender charged above 75%, as we are now discovering, in no way compensated adequately for the default probability and ultimate loss severity that higher LTV loans actually posed. Depending on the asset class, loans 90% or above have a default probability of at least 5 times that of loans below 75% and in a falling market, the ultimate losses are many times this amount.

Many of the loans in question were bundled up into RMBS paper and sold onto investors, who are now bearing the losses rather than the originating lenders in question. In effect the risk of the assets were passed on, at a significantly cheaper cost than conventional insurance, but as we are seeing now, in a downturn, the market has effectively evaporated as no one at present wants to buy new paper. Whilst it can be argued that the insurance market works in a similar way, in that the premiums all go up when the claims start coming in,  the speed, severity and overall impact on the market would have been very different.

In short the disappearance of MIG from the market in the years preceding this current downturn has had a profound and negative effect on lenders ability to manage products and risk.

 
The future of MIG 

Stephen Knight, in his speech at the CML Conference on 2 December 2008, raised the idea of the government directly insuring more risky loans to higher LTVs and/or to FTBs.  Whilst this may sound to some a highly interventionalist and potentially costly move, this overlooks two important facts.

(1) The markets have ceased and continue to cease to function, so trying to somehow get the market to do this element with house prices still falling is well nigh impossible - without direct government intervention these loans will not get written and the house price decline will be that bit more painful and prolonged.
(2) There is precedent for this type of intervention, particularly in Holland with the NHG (National Mortgage Guarantee). This is effectively a quasi government organisation that provides insurance on certain types of loans for people who may be otherwise unable to obtain a mortgage, typically, FTBs wanting a high LTV and /or lower income families. It works in the same way as MIG with a premium based on the percentage and amount of advance charged upfront.

With effective government insurance, RMBS paper consisting of NHG loans have traded at a significant premiums to other RMBS loans. Even if you assume that you do not currently have the ability to trade these loans in the markets, lenders should have the ability to gain significant regulatory and capital relief with this insurance hedge underlying the loans, making the whole lending process cheaper and more efficient. Whilst the government would bear the risk, they would be receiving significant premiums upfront and (let’s be honest here) ultimately even if the lenders make these loans without insurance, the government are effectively ultimately underwriting the risk anyway!

The government already underwrites the top, risky slice of 100% Homebuy equity sharing loans AND offers unsecured loans to students – so they are technically already in this space.  Offering lenders protection from, say, 85% LTV to 95% LTV for FTBs is less risky than the other areas in which the government invests and should return a profit.

MIG may well be dead, but its return in the current market would be very welcome.

In preparation for our launch in 2009, we are pleased to announce that we have signed contracts with DPR, Experian and Getronics to support our launch.  We have selected to partner with these suppliers to create innovative technology solutions backed with the latest credit and fraud protection products. 

DPR will develop our Point of Sale Offer system using the latest technologies and a team of experienced developers. 

Getronics is to support us with its IT infrastructure, offering IT support services and data centre hosting. 

Experian is providing a range of risk, fraud detection and customer management tools to provide insight that will enable us to quickly and efficiently make appropriate customer decisions.

Barry Searle, our Managing Director of Operations said:  “We have worked closely with KPMG IT Consulting to select like-minded companies to provide best-in-class technology and work is now underway to deliver a cutting edge system to coincide with our launch in 2009.”

We are also delighted to announce that we have signed a lease on new premises in Farnborough, Hampshire.  This office will be our operations centre and the majority of our team have been based there since Monday, although a central London office will also be maintainted.  The office is large enough to support our  recruitment plans for the next few years. 

Barry Searle added:  “We aim to deliver a 5 star service to the intermediary market and are now in a position to be up and running with a full operations centre as soon as market conditions permit.”

Swap rates have fallen inexorably in the last few months and this morning have fallen again with 2 year swap at 2.94% at the time of writing. Given that the two year rate was as high as 6.50% in mid June, these falls over such a relatively short period are unprecedented in recent times.

As we have mentioned in earlier blogs, we are currently going through unprecedented times and this sometimes call for unprecedented action. Accordingly on the back of recent economic data showing a continual and rapid economic slowdown, we are anticipating a rate reduction this Thursday of between 1.0% and 1.50%, bringing Bank Base Rate potentially as low as 1.50%

Whilst this will mean lower mortgage rates, the question remains as to exactly how much of the rate cut banks can realistically pass on. With funding still very constrained, greater and more stringent regulatory capital requirements from the FSA and an increased (and in some cases total) dependence on retail funding, we are likely to continue to see a large spread between BBR and Swap rates and actual consumer interest rates for some time to come.

 
In a blog last week, I made the often over-looked point that when you take inflation into consideration, the 1990s house price decline was actually much more severe than people tend to report now (actually down 45% peak to trough in real terms). I suspect that this was one of several reasons why many people I have spoken with in recent weeks, seem to regard the early 1990s turn-down as much more painful on a personal level than the one we are currently experiencing. Whilst we may still be at a relatively early point in the current cycle, I thought it was worth comparing the current situation to that of the early 1990s, if for no other reason than to address some of the press comments I have seen in recent weeks.

Contextual setting – inflation

• The late 1980s/early 1990s was characterised by a period of high inflation with RPI peaking at 10.9% in 1990. Whilst inflation, driven largely by commodities, rose to over 5.0% this summer, the rapid fall in commodity prices and the recession is likely to see inflation down to circa 1.0% by this time next year. The biggest worry now is deflation rather than inflation.

The fall in house prices in 1990s

• The ‘embedding’ of house prices: - The fall in house prices in the 1990s was preceded by a massive and rapid acceleration in the year immediately before. This was in a large part driven by the ending (or rather the announcement of the ending) of double MIRAS tax relief. In the year preceding the crash, prices were rising at over 30% per annum. If you look at the growth of prices in the 2000s, the only point at which we ever got close was in 2002 with rises at circa 22% per annum. In the period leading up to the current decline, price rises were slowing and were rising at just under 10% per annum, suggesting a gradual levelling. The important point of note is that the longer house prices rise without a subsequent correction, the more embedded they become as people view and accept them.      

• Interest rates:- The 1990s crash was a result of rapidly rising prices against a backdrop of very high interest rates. Whilst liquidity is a problem currently, even those customers stuck on SVRs are looking at rates around 5.5% (and likely to fall further) as against 15%. Even if we take a simplistic analysis and look at the average house price (after inflation) now at circa 130% of the 1990 equivalent price, the additional mortgage indebtedness will still mean that for the average persons mortgage payments remain relatively very affordable.

Macro events and the role of Government

• The early 1990s saw strict monetary policy as the government sought to squeeze inflation out of the economy. Through lower fiscal expenditure, wage restraints and high interest rates inflation was brought under control, but at a price. Conversely, inflation is not a concern and the measures being taken by the government is all about stimulating demand not curtailing it.

Whilst we have yet to see the impact on unemployment of the current down-turn, those remaining in work should overall see a considerable rise in disposable income as the VAT cut, lower interest rates and major retailer discounting all play a part. The current down-turn may be a global phenomenon, but on an individual level, it looks as though the ‘pain’ on average could well be less than that of the 1990s.