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Structuring ESNs 2: the drawbacks of using residential mortgages

17 July 2017
Richard Kemmish

While residential mortgages cam make ideal structure-fodder for ESNs, there are some features that make them less than ideal assets.

In my previous post, in an effort to think about the structuring implications of new asset classes on covered bond technology, I discussed why residential mortgages are such great assets – a difficult act to follow for the assets that may in future back European Secured Notes. Of course it isn’t all good. There are some features of residential mortgages that make them less than ideal assets for a programme.

Firstly, they attract a lot of political attention, partly because they are retail products, partly because shelter is such a fundamental human need. Mortgage forbearance, data protection and unfair contract terms are just three areas where governments will quite rightly intercede on behalf of the retail borrower and against the interests of the bond holders. Datio in solutum (cancelling the mortgage when you hand back the property) and the redenomination of foreign currency mortgages at off-market fx rates are less justified, but not less problematic. All of these interventions create problems. None of this applies when financing a Boeing 747.

Secondly, for the vast majority of retail mortgages there is no alternative for the borrower. You can’t finance a house any other way. Windfarms, for example can be finance by debt or equity, in the bank or bond market, in securitisations or unsecured. For a structurer this implies, for example, that there is no point trying to accelerate the underlying loans in the case of issuer insolvency. You are stuck with the loan that you wrote for the rest of its life.

There is one minor exception to this – you can always get a mortgage with another bank. That’s precisely what has happened in cases where a bank has failed for idiosyncratic reasons (for example, Northern Rock). But you can’t rely on other banks providing refinancing if you assume that a bank’s failure is systemic.

Thirdly, houses are expensive; so mortgages take a very long time to pay off. Unless the demand for very long dated bonds takes off again the structurer will always be left with an inherent maturity mismatch between the assets and the liabilities. A lot of the over-collateralisation in the market, and a lot of the debates about extendible maturities are a function of this fundamental mismatch between the term of the two sides of the cover pool’s balance sheet.

Finally, there are really a lot of mortgages in the average cover pool, many have hundreds of thousands of individual properties. When a bank fails the transfer of that many assets to a third party requires vast resources, both human and IT resources. At best the transfer in insolvency is expensive and time consuming, at worst, it might prove to be impossible.

On balance, residential assets have both positive and negative implications for the covered bond structurer. Any new asset class has to be considered on a lot of different criteria before we can accept it into the covered bond family. It is not just about credit.

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