Published: June 01, 2008
The Institutional Money Market Fund Association (IMMFA) recently announced that money market funds under management in Europe have continued to rise to new records, exceeding €400bn (£317bn), an increase of 35% over the past year. Many of these funds have similar asset profiles including a relatively small allocation to an asset class which now has the potential to add some meaningful returns for investors compared with highly rated debt issued by conventional bank/corporate issuers. This asset class is called Residential Mortgage Backed Securities (RMBS) which consist of securities that involve the issuance of debt that is secured by a pool of mortgage loans that have a lien over residential properties. In order to comply with rating agency restrictions money market funds are encouraged to hold the senior AAA rated part of these debt structures in securities with an expected life of less than three years. Initially this may be a surprise bearing in mind the level of speculation about the mortgage market. However, the UK is a very different market to the US, the epicentre of the current credit crisis, and investors should seriously consider funds which include UK prime mortgages as part of the portfolio. In this interview, Helen Sanders, Editor of TMI talks to Matthew Tatnell, who oversees the management of Morley’s Aaa-rated Sterling Liquidity Fund and Sterling Liquidity Enhanced Fund.
Why would an investor consider mortgage-backed securities?When UK mortgage-backed securities are structured, they have a high level of subordination (a class of debt in the structure with inferior rights and generally lower credit ratings) typically in the region of 8% - 12%. In addition to subordination the structure usually comes with a pre-funded reserve fund which can build up using excess cashflow (available after making payments to investors) if mortgage deliquencies rise. In addition substantial growth in the UK housing market over the past few years has resulted in an average of around 40% - 50% build up of equity in the underlying mortgages giving investors a great deal of comfort.
Although there has been a dip in some parts of the country, Morley have stressed RMBS structures based upon one of the worst possible historic scenarios of the late 1980s and early 1990s when house prices declined by over 20% in the UK. Even using this severity of fall we concluded that senior noteholders within an UK RMBS structure are extremely unlikely to experience credit degradation, bearing in mind the level of credit enhancement, let alone any chance of a credit loss.
Before the credit crunch, UK prime residential mortgage-backed securities typically delivered a spread of 10-20 bps over Libor for a number of years. As a result of the credit crisis spreads widened to almost 200 bps over Libor and yet the credit quality of the underlying assets remains largely unchanged. Morley considered this spread widening to be severely stretched and some structures represented good relative value. Since the crisis began back in August 2007 markets have recovered somewhat but spreads remain stretched at approximately 100bps over Libor. Morley anticipated spreads were unlikely to remain at their widest levels and now feel that over the medium to long term spreads will continue to contract helped by a number of factors including the ‘special liquidity scheme’ announced recently by the Bank of England allowing RMBS as collateral. [[[PAGE]]]
When sourcing assets for all our portfolios we firmly believe it imperative to perform our own extensive credit research before investing. At Morley, we have a number of credit analysts including a dedicated highly experienced, ex-rating agency ABS specialist focusing on the asset backed sector including RMBS. Our credit analyst has the advantage that he was responsible for rating some of the structures in the first place giving him great insight. Our specialist analyst reviews the underwriting methods used by mortgage originators (typically high street lenders) on a regular basis to assess the lending criteria in place, such as income multiples, the use of affordability measures and methods used to value the property. When looking at the structure itself, Morley review a number of factors including LTV ratios, the geographical spread of the mortgage pool and the type of mortgages within the pool. Morley also assessed the risk that the UK could follow the problems faced in the US mortgage market but concluded the two markets were structurally very different. These differentiators include the contrasting judiciary systems, much tighter regulation of mortgage originators in the UK and a very different supply of housing.
In contrast to conventional bank/building society issuers, where writedown surprises have occurred on a regular basis over the past six months, RMBS has been relatively boring. Servicers provide regular monthly or quarterly reports ensuring investors are kept fully informed of the performance of their investment. In addition the securitisation structure is asset and liability matched i.e. it doesn’t have to keep accessing the money markets for liquidity unlike a bank or building society. Structures are also constructed to withstand downturns in the property market and although there is some mortgage delinquency within structures i.e. people are behind with their mortgage payments, this continues at a very low level and well within the tolerance of the structure. Individual losses are virtually zero. Increasingly as a result of the credit crisis, we see lenders improving the efficiency of their mortgage collection process, often addressing mortgage payment defaults rather than resorting to repossession and tightening new lending criteria e.g. demanding lower LTVs. A number of lenders have also withdrawn products altogether from the market place although this appears much more widespread in the non-conforming sector. Given the stage of the economic cycle in the UK there is likely to be an increase in delinquency levels over the coming months but given the seasoned nature of the structures, we expect this to have a minimal effect on securities.
Morley is a large and well-resourced organisation and we take a very conservative approach to risk within our money market funds. We diversify credit risk and take an active approach to asset class risk as well as restricting duration. Diversification of credit is achieved with the use of a number of asset classes including call accounts, term deposits, certificates of deposits, asset backed commercial paper, UK mortgage-backed securities and conventional FRNs
UK prime mortgage-backed securities can provide an important boost to returns as part of an AAA-rated money market fund. These instruments provide:
i) Liquidity. Assets and liabilities are matched so there is no requirement to raise additional cash from the market place.
ii) Credit enhancement. Robust underwriting techniques, longevity of mortgage lenders in the market, seasoned house price appreciation and subordinated tranches ensure very high levels of credit enhancement which would weather even the gloomiest property predictions.
iii) Transparency. These instruments are highly transparent with regular monthly or quarterly reporting, preventing any shocks from write-downs and avoiding surprises which can occur with conventional stocks.
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