and capital

Securitisation is helping BTL lenders to free up capital and transfer risk, but high interest rates could pose a threat

Words by Rob Langston

has a well-established role in financing the UK residential mortgage market, providing capital for loans and income-paying investments for investors.

While it was considered a factor in the global financial crisis of 2008, assets such as residential mortgage-backed securities (RMBS) have become more widely used and bolstered by regulators.

Securitisation has played a crucial part in helping to release more cash in the BTL space. It allows loans to be bundled and sold into capital markets to investors as a source of income and into different tranches to meet a range of risk appetites.

Typically, securitisation has been used by specialist lenders—such as LendInvest, Together, Lendco and Pepper Money, among others—which do not have the deposits of a bank to fund loans. It therefore increases the range of independent non-bank lenders that borrowers can choose from.

More recently, some banks have been using securitisation to transfer risk from their balance sheets, says Rob Ford, founding partner of TwentyFour Asset Management and a portfolio manager in its asset-backed securities team. “If a bank originates £500m of mortgages and puts those into a securitisation vehicle— typically a special purpose vehicle (SPV) [that] sits away from the liabilities of the bank—conventional debt holders within the bank will not be exposed to those assets, nor have recourse to them,” he explains. “The cashflows from those underlying assets—the principal and interest payments—belong entirely to the note-holders buying individual bonds issued by that bankruptcy-remote vehicle or SPV.”

A deteriorating outlook?

The rising interest rate environment is one of the biggest challenges for the BTL securitisation market. Against a backdrop of higher inflation, central banks worldwide have raised interest rates to levels not seen in many years. In September 2022, Fitch Ratings revised its performance outlook for UK BTL RMBS from “stable” to “deteriorating” on expectations that high inflation would lead to falling real wages and mounting interest rates would result in increased monthly instalments for borrowers.

However, S&P Global Ratings recently noted that, although BTL tenants are not immune from inflationary pressures, landlords’ ability to replace non-paying tenants provides some insulation from broader risks to the economy. Research by DBRS Morningstar’s Ketan Thaker, managing director and head of European RMBS and covered bonds, and Alejandro Tendero, assistant vice-president of European RMBS and covered bonds, found BTL mortgages were less likely to see rate changes within the next two years, as many had already introduced longer fixed-rate periods that will not be revised for another two to three years.

However, these could rise again once those terms end, unless rates, in general, begin to fall. The pair warns that landlords on interest-only BTL mortgages—which they estimate make up 90% of the BTL mortgage market and have an interest rate of 2.5% on average—are at risk of seeing servicing costs double or triple if interest rates climb significantly. Nonetheless, many of these are in a fixedrate period and have a longer time to reset than owner-occupied mortgages.

“Overall, our view on BTL in the UK is that there has been good credit performance and the underwriting is of good quality,” says Ketan. “Having said that, BTL faces a bit more stress than owner-occupied, because the mortgage rate increases we have seen are a bit more significant—while rents have gone up, they are unlikely to go up as quickly as mortgage rates. But most borrowers will be OK because house prices have gone up and, because of that, the LTV may not be very high. The most difficult situation will be for landlords with relatively high LTVs where the rent coverage is not as good.”

A rising rate environment would usually be problematic for borrowers. However, some of the nuances of the BTL sector (such as typically longer-term loan periods and higher deposits, plus recent regulatory initiatives, such as the PRA’s underwriting standards and work on interest coverage ratio) have helped to make it more resilient and better equipped to deal with the changes. This means individual loans may be less likely to experience default, increasing trust in BTL securitisations and fuelling demand.

“The biggest issue is with lenders keeping up with the movements in rates and having to hedge their pipelines while interest rates are changing,” says Rob. “In BTL, most mortgages tend to be five-year loans nowadays. Seven or eight years ago, most loans used to be twoyear facilities. That comes from some of the regulatory changes which have been imposed. In particular, lenders’ interest coverage ratio testing is marginally more favourable for five-year borrowing, even if it is more expensive. If you take out a loan for two years, you’re exposed to what is going to happen to interest rates, whereas if you take out a loan for five years, you’re fully locked in, even if interest rates start to move in the middle.”

Greater appetite

As the fallout from September’s minibudget has settled and the outlook on inflation has started to improve, appetite for BTL mortgages remains strong. This could mean more securitisation activity.

“The second half of 2022 was difficult for public and private capital markets,” shares Hugo Davies, chief capital officer at LendInvest. “You had pretty much every single macroeconomic headwind and unforeseen events, which made capital markets a very difficult place. There was the additional pressure of very high inflation, tackled through monetary tightening, which lifted expectations for interest rates. If you were a mortgage lender borrowing on a floating basis to lend out fixed, it was a difficult relationship to balance without interest rate risk-mitigating tools, such as pipeline hedging, which small platforms wouldn’t have had in place.”

Hugo adds that, coming into the new year, there has been a fundamental shift in the tone of conversation. “Everyone is far more positive about the outlook. Securitisation markets have opened up, and there have been a number of transactions in UK mortgages. Looking at sourcing systems, they will tell you there is an incredible amount of demand [from borrowers] for BTL mortgages.”

Demand is also high among institutional investors, which continue to look for low-risk, income-paying assets offered by securitised BTL loans, says Rob. Much of the RMBS marketplace is issued as floating-rate notes, which offer an attractive alternative to fixed-rate corporate bonds. “Every time [Bank of England governor] Andrew Bailey comes along and adds another 25, 50 or 75 basis points to the base rate, the coupons on our floating rate immediately go up, and that is clearly very attractive to investors [that] believe interest rates may continue to rise,” he says. “The default rate in this product is as close to zero as you can get when you get into the bonds themselves, because of the structural protections and the levels of underlying cash support. At the more senior levels, there has never been a default of any kind, and I’m not even sure that anything has defaulted in the investment-grade spectrum. It is a very different world, and lending criteria over the past 10 years have changed completely.”

A more robust regulatory regime for securitisations and high confidence in such assets contribute to healthy demand for the loans from institutional investors. This should help make it easier for lenders to finance their lending activities, ultimately leading to healthy competition among BTL finance providers and attractive offerings for brokers and their clients.