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Structuring ESNs 1: the advantages of using residential mortgages

13 July 2017
Richard Kemmish

In my previous post I suggested that it was time to move on from debates about whether ESNs should happen or not to debates about what they should look like, starting with the rating. Another important aspect to consider is how they will be structured.

Whilst everyone talks about loans to small-and-medium-sized enterprises as the asset class of choice for ESNs, it would be nice to try to keep the discussion asset-class agnostic for now. So rather than look at the specific features of non-traditional assets, how about looking at the specific features of the largest pool of traditional assets – residential mortgages – and how they might influence the structure? Then any new asset class can be measured against what we already have.

Having structured many residential mortgage covered bonds (and securitisations, sorry), there are many features of mortgages that make them the perfect asset class for a structurer.

Most obviously residential mortgages are incredibly homogenous. In almost every case the underlying documents are identical, the loan products are from a very small set of alternative choices and the credit analysis is undertaken by the lender in the same framework and to consistent criteria. All of which makes it easy to model, audit and undertake due diligence on the portfolio.

Also, residential mortgages are, across all covered bond jurisdictions, surprisingly credit worthy compared to other loan products in that country. The credit worthiness extends to a low probability of default, low loss given default, relatively low arrears (relative to outstanding notional at least), granularity, high predictability and a high probability of credit rehabilitation. The fact that the vast majority of people strive to repay what they have borrowed across all cultures and through all economic cycles may or may not say something favourable about human nature, but it certainly makes it much easier to model on a spreadsheet.

Despite being good credits, residential mortgages are also relatively high margin compared with both the yield on the bonds that they back and with loans to non-retail customers. The latter because they are rarely or never subsidised by the bank cross-selling its products, unlike loans to small-and-medium sized companies for example. This may sound like an argument that is only of interest to equity investors but in all spreadsheets principal losses due to mortgages defaulting are, first and foremost, made good by spare interest income on the others.

With all of the above features, portfolios of mortgages can be both valued and traded easily. Refinancing risk is a more minor concern if you have a high degree of confidence about the sale value of a portfolio. This will clearly not apply to most of the proposed non-traditional asset classes.

All of which make residential mortgages ideal structure-fodder. And they set the bar high for other asset classes. But are there any drawback in the asset class? That question will have to wait for the next post.

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