Well, I have a spring in my step this morning as I write up my outlook for 2020.

For so many years we have had one dark cloud over the horizon after another. Now, I’m not saying that all is perfect, Brexit has happened (or, if not ‘done’, at least the end of the beginning), but we still don’t know exactly what this will mean and financial services is a big piece of the jigsaw not yet resolved.

But that battle seems to be alive with Mark Carney telling the EU that the size of the City’s markets made them “too important to outsource to Brussels”. A winning argument if ever I heard one (sarcasm alert), but the EU is talking tough as regards the government’s apparent goal of an equivalence approach.

And of course, there’s coronavirus, or Covid-19 as we should now call it, with increasing numbers falling prey to it. Yes, I do worry about the potential global slowdown that could arise from China and how that could affect us. This is turning into a probable pandemic. But there is little more we can do about either of those risks and issues so I suggest we just concentrate on the day job.

We need to keep watch though and not get too focussed on our world of UK mortgages because it doesn’t operate in isolation from the rest of the world.

Whatever your feelings about Brexit, the seemingly endless Groundhog Day in Parliament was beginning to jangle the nerves with apparently no end in sight. Uncertainty and procrastination are the death knell for business and economies as a whole. At last we are getting on with things and the mood seems to be ‘risk on’ right now.

Overall the mortgage market feels buoyant and optimistic. Long may that last.Funding through conventional securitisation markets has been limited for some time now, when compared with historical issuance levels. The main reason being that the major banks just didn’t need to access it given the slew of Bank of England funding and liquidity schemes available. But they are rapidly coming to an end.

The last such scheme, the Term Funding Scheme (TFS), finally runs off in 2022. Drawings are currently standing at £107 billion and falling. This scheme allowed banks and building societies to access funding from the Bank of England at Bank Rate (akin to Base Rate) against lodging collateral with the Bank. This will need to be replaced with new conventional funding which inevitably will cost more and put pressure on margins. So what funding sources are available?

Retail deposits

Retail deposits are difficult and expensive to scale on an economic basis in a world with close to zero interest rates. In part the TFS was introduced as a mechanism to pass a rate cut onto borrowers when the Bank of England recognised that Bank Rate cuts could no longer be meaningfully passed onto depositors.

Negative deposit rates wouldn’t be helpful here. I have often said that a retail funded only solution for mortgages doesn’t fill me with confidence given the usual relative short-term duration of deposits against nominal maturity of 25 years or more for a mortgage. You just can’t assume that the old adage of a five-year average life holds good for a mortgage. It might not!

Any competent treasurer will tell you that the sensible thing to do is to have a diversified funding strategy with different sources and maturity durations. Some retail of course but accessing other funding sources and for different maturities makes sense.

Securitisation and covered bonds

Issuance is on the increase already: Kensington and others are now routinely issuing sizeable deals and the demand for mortgage-backed paper is on the increase. Charter Court are in the market with another deal and I’m aware of others in the pipeline. We are nowhere near the very low coupons on residential mortgage-backed securities (RMBS) paper in the pre-credit crisis era but I think you need to look at those days as an anomaly.

Investors are comfortable with the risk of UK mortgages and the hunt for yield in a very low interest rate world is on. Although the UK never had problems with its securitisation markets, at least from a credit performance perspective, the poorer performance of the US market experience still overhangs our markets in some people’s eyes.

There have been many initiatives over recent years, in part driven by regulators and, in particular, the Bank of England. One of these is securitisations that comply with the ‘Simple, Transparent, and Standardised’ (STS) criteria.

The aim is to set minimum standards designed to make it easier for investors to understand and assess the risks of a securitisation investment. Whether “easier” is the term many investors would use to describe the new regime is a moot point.

Subject to a couple of additional requirements above those of STS alone, it also affords preferential capital treatment for firms which are required to set aside regulatory capital against investments in securitisations. This has been with us since January 2019 and is beginning to gain momentum.

It will be interesting to see whether the revised reporting requirements with the switch from European Central Bank to the European and Securities Markets Authority presents any barrier or causes any shift from securitisations to covered bonds. Personally, I don’t think it will in markets such as UK or the Netherlands where data collection and reporting, at least in recent years, are pretty robust.

Securitisations are designed to be stand-alone funding mechanisms which are structured to be able to survive severe stress scenarios, way in excess of what we have seen thus far.

Covered bonds are not built with the same rigour: they are a form of securitisation but with the twist that there is ultimately recourse to the originator of the loans. They are funding a mechanism, therefore, available only to well-rated banks.

In my opinion securitisations are a more robust and better quality form of investment and funding mechanism; but sadly EU regulators don’t agree with me and regulated financial firms have to set aside more capital against RMBS investment than they do for covered bonds.

Other forms of funding

We have seen a number of lenders writing loans and on-selling them at the point of origination. The so called ‘originate to administer model’ or in old parlance ‘Create and Trade’. Some of these funders ultimately use securitisation as the core funding model and so aren’t that radical.

But other balance sheets have been at work and, in particular, life and pension funds. This makes total sense given these investors are seeking long-term, high-quality assets with a positive yield. In a sense, originating mortgages directly into a structure to be funded, by say a pension fund, disintermediates the market and makes very good sense. Mortgages are ideal.

Interest rates and stress testing

There has been a steady move towards longer-term fixed rate lending during the past year or so and five-year fixed rates have accounted for much lending. One of the attractions is that for five years and beyond, the regulatory stress test on rates is no longer required. For first-time buyers this is helpful.

Even the Conservatives got in on the act during the recent election by setting out their plans on how they would introduce long-term mortgages for first-time buyers, who would require deposits of just 5%.

Long-term fixed rate mortgages

Although detail has been scant and, for those of us who remember the Professor David Miles report in 2004, you may think this is old hat. But there is something in this that today sets it aside when compared with 2004 and that is a very low, flat, long-term interest rate yield curve. If you were going to be able to successfully introduce these products you could argue that there has never been a better time.

And how would they be funded? In the past the rate structure has been fixed through the use of long-term fixed/floating interest rate swaps. That is not the way to structure these products going forward. The obvious candidates to fund them are the pension funds seeking long-term, fixed interest yielding, high quality assets. An improvement on investing in UK government gilts.

So, will they become a large part of the market and be successful this time round? I don’t think so. There are many reasons for this: Long-term fixed rates would need to have very low or non-existent early repayment charges to ensure borrowers don’t feel they are getting trapped. In treasury terms, this means the borrower would be getting a free option – either to stay with the product or switch for no or little cost. This optionality would have to be priced in which would make, say, a 25-year fixed rate more expensive than a five-year, regardless of interest rate yield curves.

Secondly, the lender would be locking in a margin for life. There would be no option to reprice at the end of an initial fixed rate period. This cost would also have to be built in. My guess is that, taken together, these would add another 1% or so to the normal pricing margin of mortgage. It just won’t stack up alongside shorter duration products.

What about brokers? Remortgage volumes are already being hit by five-year mortgage loans rather than two or three year. Imagine what a mass sale of 25-year fixed rate loans would do to the remortgage market. I can’t really see brokers getting behind these products in a major way.

Finally, there is the mindset of the borrower. For so long, borrowers have been offered competitive rates and products and since the global financial crisis rates have been low or very low. Although a long-term fix is a prudent hedge, I don’t think borrowers will see it that way. It’ll just be an additional cost versus a five-year product. And remember, the regulators only apply the stress test to loans of less than five years duration so you don’t need to go to these lengths to achieve the same objective (MCOB 11.6.18 is the relevant section if you want to look it up).

Structure of the UK mortgage market

We have many lenders – too many some would say. I’m not going to repeat my comments in earlier articles but suffice to say most of the £280 billion or so lending is done by about 15 lenders, 10% or so by the rest.

Despite some lenders withdrawing from the market last year (Sainsbury’s, Tesco, Secure Trust Bank etc) new lenders are still appearing. Not a problem if you have clear vison and route to market for a niche or underserved sector or have a special technology proposition that gives an advantage; but woe betide any lender who doesn’t understand this and just slugs it out on price and credit.

There is evidence that margins have continued to be squeezed in 2019 and I don’t see why this is going be different in 2020. We may well see more lenders dropping out of the market on the basis that they can’t make sense of the risk and returns. Axis Bank UK has just announced that it is halting buy-to-let origination as part of a ‘strategic review’.

There is no doubt that the face of buy-to-let (BTL) is changing with a shift from retail amateur landlords towards more professional specialist landlords.

The three catalysts to the change being: additional 3% stamp duty surcharge on purchases; reduced tax relief on interest payments for BTL properties held in a personal name; and the introduction of minimum underwriting standards by a Prudential Regulatory Authority focused on affordability.

BTL lending at the biggest lenders tends to be reducing and shifting across to the specialists like Fleet, Landbay, Paragon and Charter Court. The specialist BTL sector is set to grow and I believe that rental income will rise faster than house prices and yields will improve. It remains a low risk sector when tackled correctly.

Finally, the mortgage market in real terms continues to shrink. Since 2009 we have had around two million of new borrowers enter the market and 3.5 million leave. Ageing borrowers who have paid off their mortgage are going to continue this trend for the foreseeable future. The industry needs to respond to identify ways of capturing new borrowers using perhaps technology and innovation to provide a sound proposition to first-time buyers and to address the affordability requirements.

We also need to find ways of continuing to provide solutions to those borrowers leaving the market. They have been a source of income for many years and just because they are repaying their mortgage it doesn’t have to end there. The different but ultimately inter-twined aspirations, goals and issues of struggling first-time buyers and longer living, stay-put, asset-rich pensioners have still not, in my view, been properly addressed by our market.

The dominant mainstream lenders seem content with maintaining their position in that low-cost, low-risk (at least for now) but, in my view shrinking, ‘middle’; while too few new or smaller lenders are offering meaningful inter-generational innovation but are focused on an ultimately doomed price and credit battle for the big boys’ scraps.

In summary

So, to summarise: securitisation and covered bonds continue to grow in importance and investor demand is strong. This trend will continue in 2020 and we should look forward to established players re-accessing this market.

The role of life and pension companies in funding mortgages will also continue to grow although I don’t expect to see strong growth in long-term fixed rate mortgages. Let’s see if that prediction is right.

There are too many lenders, too few borrowers. Both borrower numbers shrinking and lenders growing continues although we should expect more lenders to ‘throw in the towel’ in 2020.

The UK still has significant headwinds but at least Brexit is moving forward.

I’m looking forward to seeing some true innovation in the mortgage market. We have had very little for many years but innovation could move the dial for lending going forward. It is time for new ideas and technology to break the old paradigms of how things are done.

Despite some challenges I remain very optimistic for the UK economy and the mortgage market in 2020!