Under the microscope

In the UK mortgage market, we have felt all too keenly the effects of the recent turmoil in global markets, which have caused a massive failure in confidence in the market for residential mortgage-backed securities (RMBSs), making these once liquid assets illiquid, to the extent of causing a clot – albeit temporarily.

To give some background to the scale of the market, in Q1 2009 there were €604.8 billion worth of outstanding securitisations where the country of collateral was the UK. To put that into perspective, that represents €101 for every man, woman and child on the planet.

The problem with RMBS in the UK is not nearly as severe as that in the US, where unregulated predatory mortgage lending ran rife in the years preceding the credit crunch, and arrears and repossession levels are far higher as a result. Nevertheless, the RMBS market has been tainted globally, and the question now is what can be done to improve the confidence of investors in these markets?

Ratings agencies will continue to play a vital role in the valuation of securitisations, despite being accused of failing to correctly assess the risk profile of RMBS in the past. It could be said that this generates a stalemate: the ratings agencies will not accept their part in the mess; the investors will not trust the ratings given. So the clot remains and no mount of chest-beating will remove it.

There are moves afoot within the industry to offer more transparency to all parties in the chain, both from the European Securitisation Forum and from smaller organisations created specifically for this process. Many have suggested root and- branch reform of the entire process – from origination, through issuance and trading via redemption to eventual maturity. But not only would such action require levels of coordination that would be almost impossible in the global markets that we operate in, but it would also be unnecessary.

The way forward is for mortgage originators and issuers to take the lead in introducing transparency and understanding. They must open their books to give investors and the wider market community sufficient knowledge of the content of the bonds and importantly their underlying assets. The ratings agencies must then disclose in detail the methods they use for rating each bond.

Research is currently underway to produce not only the first model based on European Securitisation Forum standard data but also proprietary technology to provide better data or every member of the value chain.

The new methods being developed now are predicated on the ratings agencies continuing to play a part in the rating and initial valuation of RMBS.

What changes is that the part played by ratings agencies becomes passive, rather than active. Enhanced data production and management provided by an independent analytics organisation forms the larger part, enabling investors and others in the value chain to operate more active management of their investment.

By providing a cuboid picture of the risk represented by each asset – both stressed, shocked and unstressed – investors can understand in more depth the content of their investment and more intelligently trade the various tranches of the security.

Furthermore, using the technologies currently under research, methods are being developed that will enable areas of like-risk to be calculated in a more verifiable and scientific way. And in a bid for greater transparency, the implementation of these tests with members of the value-chain will be entirely open-book.

‘Open book’ means that each and every element of the model development and validation process will be open to observation by members of the value chain and that as part of the delivery mechanism the analytics organisation will ensure the client can replicate the process before signing off on delivery.

This represents a step-change in the methods deployed in the past: no organisation has proposed being as open as this before, typically protecting “intellectual property” under the veil of proprietary technology.

Whether greater transparency and understanding of RMBS and their underlying assets will be enough to stimulate investor interest and herald a return of securitisation as a means of mortgage funding remains to be seen. However, a scientific approach to cutting through the smoke and mirrors that characterised the former market has to be a step in the right direction.

Craig Alexander is a consultant at Menelaus Consulting