A guest article by Ray Boulger

The impact of the credit crunch caused by the US sub prime mortgage mis-lending is still spreading through the global markets and rarely a day passes without at least one UK sub prime lender, let alone US lenders, announcing an increase in rates and/or a tightening of criteria. The speed and scale with which the problems have spread around the globe is unprecedented and banks and investors are now so frightened of what they don’t know, ie where the black holes are, that most are not prepared to invest in anything other than top quality stock, which basically means Government securities.

Consequently credit lines have been withdrawn, even from companies who only a short while ago lenders would have regarded as a prime risk. I expect it to be a few months before a reasonable level of confidence is restored and in the meantime things will be very hairy for many of the mortgage lenders who rely primarily on the wholesale markets for the bulk of their funding, either through securitisations or loan sales, especially those who have a large slice of their business in the sub prime market. This will clearly give the Balance Sheet lenders the upper hand in the foreseeable future, although with the advent of Basle II at the beginning of next year the benefits of securitisation over Balance Sheet funding will probably be reduced.

So far we have seen hardly any evidence of lenders tightening criteria in the mainstream, buy to let or self cert markets, but lenders can change their credit score hurdle points without making an announcement and so criteria changes can be made surreptitiously. The flight to quality by investors, and a reassessment of where Bank Rate will peak, has pushed gilt yields sharply lower and so although the spread between gilt yields and swap rates has increased, swap rates have still fallen about 0.2% from their peak, allowing lenders to reduce the price of their mainstream fixed rates.

On floating rate mortgages the story is rather different in terms of funding costs. At the time of writing 3 month Libor has shot up to around 6.6% and 1 month Libor is nearly as high at 6.5%. The premium of 0.85% or 0.75% over Bank Rate respectively will be increasingly painful for lenders as their Libor funding comes up for renewal. As nearly all floating rate mainstream, buy to let and self cert mortgages are priced off Bank Rate, but wholesale money market funding is normally based on Libor, this huge increase in the Bank Rate – Libor spread will make a nasty dent in margins if it continues for too long.

Some lenders may choose to buy a Bank Rate – Libor swap, which currently costs about 0.35% for a year, which at least crystallises the cost of the increased Libor rate; others will no doubt prefer to hope that things return at least partially to normal reasonably soon. Either way, the longer Libor rates remain high the more danger there must be of lenders increasing the price of their tracker mortgages. The silver lining for borrowers with a floating rate is that Bank Rate now looks much more likely to peak at 5.75% and with the Fed likely to start cutting rates at their next meeting on 18 September that may set a trend for other central banks, including ours, to follow in due course.

In the sub prime market we have seen rate increases of up to 2.5%, with some lenders pricing at levels clearly designed to avoid getting much business rather than pull products completely. The more the adverse credit a client has the greater has been the increase in rates. This also applies to criteria changes and those borrowers with the heaviest adverse credit who only a month ago would have found several lenders keen to advance them money now have less choice almost by the day, especially if they are looking for a reasonably high loan to value.

The lenders who fund their sub prime lending in the securitisation markets have no choice but to tighten criteria and increase pricing as they rely on investors to buy their mortgages but the Balance Sheet lenders are not so constrained and have in general not yet made many changes to their criteria or pricing, although no doubt they will take the opportunity to at least increase prices to some extent.

The criteria changes we have seen so far in the sub prime market include:

A reduction in the maximum loan to value on both status and self cert cases.

A reduction in the maximum amount of CCJs accepted on heavy adverse.

A reduction in the maximum amount of mortgage arrears on heavy adverse.

Restrictions on remortgages for borrowers in arrears with another sub prime lender.

On sub prime buy to let reductions in the amount of adverse credit allowed and restrictions on first time buyers.

US lenders and brokers have quite rightly been heavily criticised for much of the toxic sub prime lending to borrowers whose only chance of paying their mortgage was by remortgaging in a rising market so as to rob Peter to pay Paul. However, this lending would not have been possible if myopic investors had done their due diligence properly, rather than buying a pig in a poke purely on the strength of the mortgage backed securities they were buying having been given a certain rating by a rating agency paid by the borrower to provide that rating.

If fund managers don’t have enough expertise to analyse the underlying investments in the securitisations they buy, and put their own value on them after understanding the level of risk, perhaps they are in the wrong job. Rating agencies now have far too much power, but only because investment houses have effectively outsourced too much of the investment decision making process to them. Outsourcing some admin functions may be sensible. Outsourcing investment decisions isn’t!

The author is a Senior Technical Manager with John Charcol and his blog can be found here.