**SPECIAL REPORT** The Credit Crunch

Posted on 8 October 2007 by Ray Boulger

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The dramatic events of the last month, with the closing of the securitisation markets, and the virtual freezing of the Libor market other than for overnight money, resulting in the first run on a British bank since 1866, ensured that almost any mortgage related story was front page news. For example when Halifax and Abbey increased most of their tracker rates by between 0.1% and 0.2% this was of great interest to the general news media, whereas normally it probably wouldn’t have even have justified a mention in the Money sections.

The fervour has now died down but the impact of the credit crunch on the mortgage markets will last a long time, particularly in the sub prime market. Traditional wisdom when advising investors is quite rightly not to put all your eggs in one basket. The lenders who have been impacted most by the credit crunch are those who have ignored this maxim and had all or most of their funding options in one basket. I can see no reason why this same "all eggs in one basket" principle shouldn’t be just as relevant for mortgage lenders as other large borrowers. Most large companies have a variety of lending sources – even the SIV lights usually have a backstop facility with a sponsoring bank!

Whilst Northern Rock has been the most public casualty, they have at least, unlike Victoria, been able to honour all the offers made and they continue to accept new business without obviously changing their criteria. Northern Rock will have an even larger proportion of their lending on fixed rates than the market as a whole and I would estimate at least 85% of their new business is on fixed rates. Despite swap rates falling, when they last re-priced, on 12^th August, they increased their fixed rates, which made them pretty uncompetitive, despite the full flexibility they offer. Since then, as swap rates have fallen further, they have become progressively more uncompetitive as other lenders cut their fixed rates.

This was obviously deliberate policy to restrict the number of applications and this, coupled with the current uncertainty that will deter some borrowers from using them, will mean that their current level of applications will have fallen dramatically. Northern Rock’s retention strategy has in the past been particularly successful, which explains why their share of net lending in the first half of 2007 was over 19%, twice their share of gross lending. It appears from what our clients tell us that they are still very active on the retention front. However, their uncompetitive pricing, current negative PR and the expensive £395 so called "product review fee" they charge existing customers will have no doubt made even retaining existing customers much more challenging.

Thus cashflow should now start to improve as they are effectively encouraging redemptions, even though they are trying to retain customers. Furthermore, we are now coming to the end of the typical 2 month period from offer to completion and so the funding requirements to complete business written before the credit crunch started will now be reducing. This, with normal capital repayments, plus redemptions, from the previous higher business levels, will all help cash flow.

Looking ahead, I see no reason why the securitization markets should not be re-established by next year, but it will be on a much more rational basis. The first obvious difference will be that risk will be more properly assessed and priced accordingly. No longer will fund managers, treasurers and others be prepared to buy basic residential mortgage backed securities (RMBS), let alone collateralised debt obligations (CDOs) or collateralised loan obligations (CLOs), just because some rating agency, which may not even understand UK mortgages very well, was paid by the issuer to provide a rating for the security.

I have been told of lenders who have some RMBSs in their investment portfolio who have been looking very carefully over the last few weeks at exactly what they have bought. They should of course have done this before they purchased the asset, but at least in future investors are unlikely to effectively outsource their investment decision to a rating agency!

Part of the reason Nick Leeson was able to run up losses of £800m and bust his bank was that his superiors didn’t understand the derivative contracts he was trading in. One lesson from this episode is that Chief Executives need to understand enough about the complex instruments their company is trading in to assess the risk properly. Perhaps the FSA should set an exam for all Chief Executives of banks and similar institutions who invest in these products to assess if their knowledge of them is adequate, assuming of course enough people at the FSA have the requisite knowledge.

Already some buyers are sniffing around for distressed sales of RMBSs, which confirms there will be an ongoing market for this type of funding. The challenge is to establish a level at which buyers and sellers can be matched. This will be much easier for prime mortgages where the risk is much easier to understand, but in time there is no reason why a market for sub prime can not also be re-established. Whether the slicing and dicing to produce CLOs and CDOs is repeated is a different matter.

At the moment some lenders, of which Woolwich is a prime example, are effectively saying they want to lend and have the funding to do so, whilst others are competing to have the most uncompetitive product range. Woolwich have recently launched market leading fixed rates for 2, 5 and 10 years, all at 5.59% up to 80% LTV, with a £995 fee and on remortgages a free valuation and free legals. Also they have said they are keeping their tracker rates unchanged, including their very competitive lifetime trackers, starting at Bank Rate + 0.17% with no arrangement fee.

Many other lenders have increased their tracker rates, reflecting their funding costs in view of the much higher current (although now reducing) Bank rate – Libor spread.

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