RBS Could Provide a Bigger Boost to This European Market than the ECB

There are fresh rumblings from a rocky corner of the U.K. mortgage market.

The bedrock of Britain’s residential mortgage-backed securities market was once a securitization program run by Northern Rock and known as Granite.

Granite was the vehicle through which Northern Rock funded almost £50 billion worth of U.K. mortgages. You can see how big it once was in this old Deutsche Bank chart from 2008.

UK mortgage master trusts – Deutsche Bank

But the program has faced an uncertain future ever since Northern Rock was nationalized some seven years ago. U.K. Chancellor George Osborne announced in his pre-election budget that the government has been advised to consider selling Granite’s remaining assets. That’s set off a wave of speculation as to possible buyers for Northern Rock mortgages remaining in the Granite portfolio. Last week Mark Kleinman at Sky News reported that RBS, the bailed-out British bank, was considering a bid.

Why are we talking about a potential bid for a defunct mortgage vehicle? Bear with us a moment because you’re about to get some (more) background.

Banks like securitizing mortgages because it gives them two related things: leverage and cheaper funding. The bank puts mortgages into a securitization vehicle, and the vehicle then sells debt to investors that is backed by those mortgages. Because the bonds are collateralized and also protected by an equity cushion provided by Northern Rock (known as its “seller share”), investors are willing to lend to the bank at a better rate than they would otherwise.

That dynamic changed in November 2008, when a battered Northern Rock could no longer provide that equity cushion, causing a “non-asset trigger event.” Hitting the trigger meant that Northern Rock could no longer receive payments from the Granite trust. Instead funds were diverted to senior bondholders, the trust was put into run-off mode and the leverage and cheaper funding once afforded by the structure — a structure that relied on Northern Rock’s support — disappeared.

Since then, the performance of the underlying mortgages in what remains of Granite has improved, but the vehicle’s funding profile hasn’t really.

Here’s Ben Hayward, partner at TwentyFour Asset Management, with some details:

Shortly after Northern Rock went into public ownership, Granite hit a trigger which put what could have been a perpetual vehicle into wind-down mode. This had  various effects, one of which was that the structure started deleveraging and meant that Northern Rock’s stake (seller share) in the mortgage pool would be paid out last and, at the same time, decreasing the benefit of the funding as the cheaper senior RMBS notes roll off first and decrease the amount of leverage within the vehicle. So while it might currently be attractive for a bank to buy the mortgage pool with funding in place, an additional benefit could be to use excess liquidity to pay off the increasingly inefficient funding and release the seller share at the same time. However, to take advantage of this an institution will require a considerable balance sheet.

In other words, a new buyer for the Granite portfolio could choose to buy back existing Granite debt in order to roll off that inefficient funding.

It’s a long-shot because of the sheer size of such a transaction. But if it were to happen it could, by dint of that scale, provide a significant boost to the wider market for Europe’s securitized debt.

Here’s Hayward again:

We would note that if the buyer was to redeem the existing Granite notes, then that would redeem more than £8bn of issued notes in the European ABS market. That is more than the European Central Bank has positioned through its ABS Purchase Programme since it was launched late last year. This should provide a good degree of technical support to the market if it happened.

The ECB has bought 6.2 billion euros ($6.8 billion) of securitized notes since it began the bond-purchasing program back in November. As Bloomberg’s Alastair Marsh reported on Monday, the impact of the program has been rather lackluster so far. Investors are demanding more compensation in return for buying the securitized debt, with the yield premium on euro-denominated asset-backed securities, or ABS, now at its highest in about four months.

Perhaps a Granite buyer — RBS or otherwise — will have more of an impact.

by  Tracy Alloway

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