The Housing Finance Corp. Ltd.

Transcription

1 Primary Credit Analyst: Magar Kouyoumdjian, London (44) ; Secondary Contacts: Sadat Preteni, London (44) ; Jean-Baptiste Legrand, London (44) ; Table Of Contents Major Rating Factors Rationale Outlook Legal Status And Ownership: Independent Not-For-Profit Society Group Structure: A Network Of Mainly Community Benefit Societies Business Risk Profile: Financial Intermediary To The Social Housing Sector, Benefiting From Competitive Funding Financial Risk Profile: Risk Mainly From Limited Liquid Resources And Personnel Risk Impact Of GRE Methodology Related Criteria Related Research NOVEMBER 7,

2 Major Rating Factors Counterparty Credit Rating A/Stable/A-1 Strengths: Longstanding and relatively strong franchise in the social housing sector as one of the more prominent alternatives to bank finance for housing associations (HAs). Ongoing support from the U.K. government, which underpins very strong borrowers' creditworthiness and minimizes credits risks for the company. Robust collateralization of the loan book and match-funded approach, which minimizes asset-liability risk. Moderate likelihood of extraordinary support from the U.K. government. Weaknesses: Modest liquid financial resources and low capital. Exposure to a single sector, with borrower-concentration risk. Potential stalling of new business volumes after the full utilization of the Affordable Housing Finance (AHF) government guaranteed loans scheme. Rationale S&P Global Ratings' 'A' rating on The Housing Finance Corp. Ltd. (THFC) reflects its status as a core entity to the THFC group, which has an group credit profile (GCP) of 'a' and our opinion that there is a moderate likelihood that the U.K. government would provide timely and sufficient extraordinary support to THFC group if it became financially distressed. However, we do not factor in any uplift in the issuer credit rating (ICR) because of this support, and we maintain the ICR at the level of its GCP. THFC group's GCP reflects its longstanding franchise in the social housing sector and the strong ongoing government support for its borrowers. The GCP also indicates the robust collateralization of THFC's loan book and its match-funded approach, which mitigates asset-liability risk. As THFC lends on substantially the same terms as those on which it borrows, structural interest-rate risk is minimal. The ratings are constrained by our view of THFC's small capital base and modest reserves, and its lack of diversification as THFC lends solely to U.K.-based HAs. Finally, we believe that the risks inherent in a small team make THFC more vulnerable to staff turnover, key personnel risks, and other operational risks. However, THFC has been strengthening its middle management, and we consider its enterprise risk management framework to be adequate. We rate issues by THFC's Affordable Housing Finance (AHF) subsidiary at 'AA' based on the U.K. government guarantee on that entity's debt. NOVEMBER 7,

3 Outlook The stable outlook reflects our view of THFC's stable intrinsic creditworthiness, as well as our base-case expectation of a continuous build-up in reserves, based on a sustained increase, albeit at a slower pace, in lending and earnings over the next two years. The U.K. government's continued support of the social housing sector is also another contributing factor to the stable outlook. We could lower the ratings in the next months if THFC's business position becomes constrained, and if more HAs consolidated, enabling them to tap the debt market directly. The latter could also undermine the important role of THFC for the U.K. central government. We would also view negatively a stalling of new business volumes after the full utilization of the AHF government guaranteed loans scheme. As we also factor ongoing government support in the group's stand-alone credit assessment, given the government's support toward HAs, a sovereign downgrade could indirectly hit THFC's GCP. We could also lower the ratings on THFC if its reserves are eroded as it absorbs losses in the loan portfolio or if we consider that reduced support for the sector could ultimately lead to losses for THFC, in which case we could lower the issuer credit rating by more than one notch. An upgrade is unlikely over the two-year outlook horizon. Legal Status And Ownership: Independent Not-For-Profit Society THFC is a not-for-profit financial intermediary for the social housing sector in the U.K., borrowing from banks and the capital markets to lend to HAs. This provides HAs with cost-effective and reliable access to the capital markets and other lending institutions, such as the European Investment Bank (EIB), which the HAs may ordinarily not be able to access. It also allows investors to lend to the sector while diversifying their risk across underlying HAs. THFC is a finance company with the legal status of a community benefit society under the Cooperative and Community Benefit Society Act It operates under rules registered and approved by the Registrar for Friendly Societies, which is part of the Financial Conduct Authority (FCA). However, THFC is not regulated by the FCA. Its shares are held in two ways: two shares are held, one each, by the Homes and Communities Agency (which includes the English HA sector's statutory regulator) and the National Housing Federation. Each appoints a non-executive director to the board of THFC. The remaining five shares are non-beneficially owned, one each, by the THFC independent non-executive directors. Group Structure: A Network Of Mainly Community Benefit Societies THFC is the parent company of several wholly owned subsidiaries. Although we rate the legal entity called The Housing Finance Corp. Ltd., we use the accounts of the whole group for our analysis and to derive the 'a' GCP. We consider the rated company to be a core and integral part of the larger THFC group, as per our methodology. Therefore, the issuer credit rating of the rated company is at the same level of the GCP. NOVEMBER 7,

4 THFC (Services) Ltd. provides all administrative and management services to THFC and its main subsidiaries. Most of the subsidiaries are separately constituted community benefit societies that were set up to issue bonds and on-lend the proceeds to selected HAs (see chart 1). Importantly for THFC, failure by any of these subsidiaries to service its respective debt would not result in a contractual cross-default of THFC's financial obligations. We do not rate the debt issued by these subsidiaries. In March 2013, THFC set up a new subsidiary--ahf--with the sole purpose of offering guaranteed long-term debt to registered providers that develop affordable housing in England, Wales and Scotland, and that meet the eligibility criteria under the Affordable Housing Guarantee Scheme. In June 2013, the U.K. government granted AHF an exclusive license to implement its Affordable Housing Guarantee Scheme, comprising guarantees of up to 3.5 billion to fund the development of affordable housing across the U.K. The government guarantee was provided through the Secretary of State for Communities and Local Government. At the end of March 2017, AHF's portfolio stood at 2.3 billion and was funded by 845 million EIB loans and 1.5 billion in bond proceeds. Although the Affordable Housing Guarantee Scheme will be fully utilized by 2018, THFC will continue to benefit from the ongoing steady stream of fees NOVEMBER 7,

5 associated with servicing AHF's portfolio for a number of years. The AHF scheme has been the driver of THFC's business growth since 2014, and following its full utilization, THFC will likely revert back to the level of business volumes it generated before obtaining the AHF government guaranteed scheme. THFC is exploring other opportunities to boost its future business through a new vehicle, which we expect will be the main driver of business volumes over the next years. THFC anticipates 300 million of issuance by the new vehicle in 2019, with annual 175 million issuance in subsequent years. THFC also has three orphan funding subsidiaries--t.h.f.c. (Funding No. 1) PLC, T.H.F.C. (Funding No. 2) PLC, and T.H.F.C (Funding No. 3) PLC. The issue ratings on the debt issued by these three subsidiaries reflect the issuer credit rating on THFC (that is to say 'A'). The 'AA' issue rating on debt issued by THFC's subsidiary AHF reflects the exclusive guarantee by the U.K. government, which we consider as timely, unconditional, and irrevocable. NOVEMBER 7,

6 Business Risk Profile: Financial Intermediary To The Social Housing Sector, Benefiting From Competitive Funding Market position In our view, THFC has a longstanding and relatively strong franchise in the social housing sector as one of the more prominent alternatives to bank finance for HAs. We consider that the availability of funding from the EIB--and in particular THFC's sole license to write loans guaranteed by the U.K. government to HAs--have enabled THFC to offer competitive lending terms and strengthen its market position. We also view THFC's franchise as supported by the important niche role that it plays, its long track record, and its strong relationships with borrowers. However, we believe that there are some medium-term risks facing THFC. These relate to ongoing reforms in the social housing sector, which could constrain the sector's creditworthiness. Meanwhile, the U.K.'s planed departure from the EU could impede THFC's competitive advantage if the EIB ceased further lending to THFC following the U.K.'s referendum vote to leave the EU and if THFC did not find an alternative viable source of financing. AHF has been the main driver of business growth for THFC since Following its full utilization, THFC's market position could be harmed if there were no similar government guarantee scheme in place for AHF, which has enabled THFC to provide significantly more cost effective lending than peers. A further threat comes from the trend of consolidation among HAs, which would enable them to issue through the capital market directly, thus avoiding intermediaries such as THFC. THFC's primary objective is the controlled increase of its loan book and remain a competitive lender to HAs. During the year ending March 31, 2017 (FY2017), it was able to raise business volumes supported by competitive rates through its subsidiary AHF. Across the THFC group, there were about 174 borrowers as of end-march 2017, up from 171 at end-march At end-march 2017, THFC reported loan assets of 6.0 billion, representing about 8% of private lending to the sector. At the same time, AHF reported loan balances of 2.3 billion, financed by the EIB's loan facilities and bond proceeds. THFC has also seen an increase in new business against the backdrop of some structural factors, which, in our view, support demand for funding by HAs. Among other things, this demand is due to an increase in refinancing needs by HAs, which continue to develop new properties and expand their business remits into segments of residential housing provision that offer higher returns but are riskier. This is against a backdrop of reduced government grants and lower availability of more costly long-term bank financing. While we expect THFC to continue facing competition from banks, which can often provide a more "all round" service to HAs, bank competition has eased somewhat because of liquidity pressures and higher capital requirements. An increase in private placements by HAs and, to a lesser extent, other competing financial intermediaries (including newcomers) could also present some competition. However, we believe THFC would likely retain its market share over the next years as banks are providing fewer and fewer long-term loans while THFC does not have so far real competitors. Diversification: Single sector exposure We view THFC's sector concentration as a relative rating weakness as it is focused solely on the U.K. social housing sector, although it extends loans to a variety of individual legal entities. That said, we believe the business in which the THFC group operates in is fundamentally low risk with limited competition. This to a large extent underpins the 'A' category rating, despite concentration risks. NOVEMBER 7,

7 Financial Risk Profile: Risk Mainly From Limited Liquid Resources And Personnel Risk Credit risk In our opinion, THFC's credit quality is largely affected by the credit quality of its underlying borrowers, the HAs. We classify these borrowers as government-related entities (GREs) and believe they have a moderately high likelihood of extraordinary government support, in addition to a significant amount of ongoing support. We believe that risks for HAs have slightly increased, but from a very low base, in light of the changes proposed in the 2015 spending review, the Welfare Reform and Work Act 2016, and the Housing and Planning Act Among other things, these reforms include a cap on housing allowance for social housing tenants by 2018, a rent cut by HAs for four consecutive years starting 2017, and no housing benefit for people aged The ongoing reforms in the social housing sector will hit revenue generation and lead to moderately higher credit risk for HAs. Specifically, rents cuts will negatively impact registered housing providers from FY2016/2017 (ending March 31) and until at least FY2019/2020, and the Universal Credit rollout carries risk in terms of rent collection for registered providers. However, we would continue to assess them as investment-grade, in our view. Additionally, the rent settlement recently announced by the U.K. government (that is, social and affordable rent to increase by consumer price index inflation plus 1% from FY2020/2021 and for at least five years), as well as 2 billion of additional funding for affordable homes to be granted by the government, is seen as credit positive for the sector (mainly because it lifts some uncertainties on the future rent policy for HAs). The government has also introduced higher grants for shared ownership, which has encouraged HAs to get more involved in the development of properties for sale as a mechanism to offset the decrease in income from lower rents. This exposes HAs to higher credit risk. In our view, THFC is largely dependent on timely receipts from borrowers to meet its own obligations on time. We believe the scheme will continue to work efficiently, which means the borrowers will have sufficient cash to repay the loans extended by the THFC group when they come due. The way the framework functions has ensured that credit losses are marginal over time, and we expect this to continue. Aside from structural protections--such as debt service reserves and specific covenants ensuring interest coverage by annual net income--we consider THFC's credit risk assessment and proactive monitoring of its borrowers to be paramount. However, we consider that the high collateralization means THFC faces a modest risk of losses in the event of borrower default, which could occur despite the above-mentioned framework. According to THFC, all loans are secured by either a fixed charge over specific properties (with minimum asset coverage of 150% on a market value basis). We understand that the current average coverage across the portfolio is about 237% and consider that this level of collateralization could enable THFC to achieve substantial recoveries, although it could take several months to fully realize the collateral. THFC's creditors are secured by floating charges on its loan assets--they have no direct access to the collateral held by THFC. Therefore, in the event of a default by THFC, lenders would have access to its loan assets alone and recovery would likely depend on the market value of those loans at that time. Although there are no fixed maximum exposure limits for individual HAs, THFC has "soft limits" whereby the annual debt service (less any debt service reserve) should be no greater than a fraction of THFC's reserves. As of June 2017, the highest annual cash flow due from any one borrower group--after adjusting for debt service reserves--was 2.9 million. Lending to the top 10 HAs accounts for 33% of the THFC Ltd.'s loan book (see table 1). We have observed a NOVEMBER 7,

8 decrease in THFC's exposure to the largest borrowers. In our view, most of these borrowers are likely to have high creditworthiness. Geographically, the portfolio is generally well diversified. The exposure to London has remained stable, with 35% of the portfolio located there (see chart 3). Table 1 The Housing Finance Corp. Ltd. -- Business Position --Year ended March Feb Total assets 5,978 5,186 4,239 3,439 3,193 Gross receivables 5,885 5,087 4,155 3,368 3,124 Operating revenues Net income after extraordinaries % Change in operating revenue Net interest margin (%) Liquidity and funding risk THFC's funding is sourced from banks and the capital markets. Bank finance forms about 34% of the current funding structure as of March 31, 2017 and principally comprises loans from the EIB. Capital market debt is issued by funding subsidiaries and on-lent to THFC. Lending to THFC by its funding subsidiaries, banks, and debtholders ranks equally, and defaults on any of these financial obligations would result in a cross-default of all THFC's other financial obligations. Therefore, THFC is ultimately responsible for servicing and repaying this debt. However, we consider that THFC has little to no structural interest rate, funding, and liquidity risk given its match-funding approach, whereby it on-lends funds immediately after raising them and on practically the same terms as they are sourced. In our view, the most significant weakness in THFC's financial structure is the small size of its liquid resources (made up of reserves), which stood at 17.7 million as of March 31, 2017, up from 15.0 million the previous year. However, an important mitigant of liquidity risk is that THFC receives nearly all payments from borrowers one month before it is due to pay its creditors, which also provides THFC with a source of investment income. Refinancing risk for the underlying borrowers and THFC can be material at times, as most of the loans, as well as THFC's debt, have bullet maturities. The next significant maturity is not until If a borrower were to default on interest payments for a significant period and THFC could not realize the value of the associated collateral, THFC's low reserves could be severely depleted. In a hypothetical scenario in which its largest borrower defaulted and THFC had no access to any debt-service reserves, we expect that THFC's reserves ( 17.7 million as of March 2017) would cover the related interest payments ( 2.9 million) for about six years, depending on additional costs. Still, we believe that in the absence of any additional liquidity facilities, a delay in enforcing security or the default of additional borrowers could bring about the default of THFC. We consider such a scenario to be very unlikely. Moreover, due to the regulator's proactive stance, the U.K. housing sector has never experienced a cash payment default. In the fairly rare circumstances where HAs have run into viability problems, the regulator has facilitated an acquisition or rescue by stronger HA peers. However, the sector has never faced a systemic default scenario, which would be harder for the regulator to manage. NOVEMBER 7,

9 Interest-rate risk As THFC does not prefund and generally raises debt only when borrowers are in place, and as lending is materially on the same terms on which THFC borrows funds, it has almost no structural interest-rate risk. However, some of THFC's revenues are exposed to interest-rate risk because falling interest rates reduce its investment income. Given the prevailing low interest rates, we expect THFC's investment income to remain at its current, substantially reduced level in the medium term. Operational risk Key operational risks for an organization such as THFC stem from breaches in internal controls, systems failures, reputational risks, and personnel risk. We understand that these risks are reviewed periodically by the board and that THFC has strengthened its capabilities by hiring additional staff, and strengthening its middle management. Nevertheless, the effective mitigation of operational risk typically requires periodic investment. This could be difficult for an organization like THFC, which has tight cost limits and a limited ability to earn a return from significant investment. Strong profitability supported by a strong business pipeline, although we expect this to reduce THFC reported a pre-tax profit of 6.1 million in 2017 compared with 4.1 million in Operating revenues were slightly higher at 10.3 million, driven by the continuous increase in business volumes. The group earns its income from arrangement fees, annual administration fees, and investment income earned on its reserves and other cash balances. Despite increasing staff costs in line with business growth, administration costs were down in 2017 mainly due to higher pension provisions in the previous year. Pension provisions were made to cover additional deficit reduction contributions in relation to the social housing pension scheme, which came due on April 1, Given that the affordable housing guarantee scheme is almost fully utilized, we expect the pace of new lending and associated arrangement fees to decelerate and investment income to remain constrained over the two-year rating horizon. Proposed changes in several reforms in the social housing sector will also exacerbate this trend. While THFC's business model offers good returns in an expanding market, we consider that it has limited flexibility to quickly adjust operating expenses if new business volumes were to fall materially and interest rates were to remain at low levels. Capital base remains at a very low level As a not-for-profit community benefit society, THFC reinvests all profits in reserves and pays no shareholder distributions. As there are restrictions on the use of some of the reserves, we make a distinction between reserves available to THFC and the group reserves, assuming that only THFC's reserves are available to absorb losses or delays in borrower payments. THFC's capital base increased by 20% to 28.8 million for the consolidated group ( 17.7 million at the company level) in financial 2017 (ending March 31, 2017), supported by a strong surplus of 4.9 million ( 2.7 million at the company level). Despite this growth, however, capital remains low, at 0.48% of loan assets. We don't expect this non-risk-adjusted ratio to increase materially over our rating horizon, given our expectation of slower loan growth. This small capital base provides little flexibility should the credit quality of the sector begin to deteriorate, as HAs adjust to new business models and if they alter their risk appetite, increasing credit risk. Against this background, we view THFC's low absolute capitalization and modest liquid financial resources as key weaknesses that constrain the ratings. We note that the extremely low credit losses lead us to view THFC's capital base, which is supposed to NOVEMBER 7,

10 provide a buffer against unexpected losses, as sufficient when risk-adjusted. Impact Of GRE Methodology We view THFC as a GRE because, in our view, the entity benefits from a closer link with the U.K. government through its subsidiary AHF. In addition, THFC's role for the government, as parent and servicer of AHF, has been enhanced by AHF's unique mandate to provide guaranteed funding to the social housing sector, fulfilling the government's public policy mandate to provide affordable housing. Also the presence of HCA in THFC's board gives it lobbying power in dealing with housing issues. However, we do not factor in any uplift notch in our ICR, which we maintain at the level of the 'a' GCP. We view extraordinary support as that provided over and above the ongoing regulatory and financial support for the sector in the normal course of events, which we incorporate into the GCP. Despite the affordable housing scheme no longer being available to new applicants, with the full guarantee of the state, we still think THFC will retain its important role as a major financier of the HA sector in the U.K. The HCA, as an independent HA statutory regulator, will likely continue to sit in THFC's board over the next years. Additionally the Department for Communities and Local Government nominates up to two members of the AHF subsidiary's board. Housing demand will likely remain high in the U.K. over the next years given the housing shortage and planned lower growth of the economy that may prompt demand for social housing across the country. Furthermore, THFC will continue servicing the loans granted under the government guarantee program for many years to come. In our view, THFC's role for the government could be undermined/compromised if more HAs consolidated and started raising debt from the capital market directly. In accordance with our criteria for rating GREs (see "Rating Government-Related Entities: Methodology And Assumptions," published on March 25, 2015, on RatingsDirect), we base our view of the likelihood of extraordinary government support on our assessment of THFC's: Important role for the U.K. government based on its public policy mandate through its subsidiary AHF, and THFC's major role as a finance provider to the sector via capital markets (THFC delivers about 20% of total new bond issuance by the sector); and Limited link with the U.K. government, demonstrated by the government's limited interference in AHF's operations and limited track record of providing credit support. This combination of a limited link and important role to the government leads us to consider that the likelihood of extraordinary support to THFC when required is moderate. Table 2 The Housing Finance Corp. Ltd. -- Capital, Leverage, And Earnings --Year ended March Debt/ATE (x) Adjusted common equity/total adjusted capital (%) Noninterest expenses/operating revenues (%) Net interest income/operating revenues (%) Fee income/operating revenues (%) Return on average assets (%) NOVEMBER 7,

11 Table 2 The Housing Finance Corp. Ltd. -- Capital, Leverage, And Earnings (cont.) --Year ended March Core earnings/average assets (%) Table 3 The Housing Finance Corp. Ltd. -- Risk Position --Year ended March Growth in gross receivables (%) (YoY) YoY--Year-on-year. Table 4 The Housing Finance Corp. Ltd. -- Funding And Liquidity --Year ended March Stable funding ratio (%) Liquidity coverage metric (x) N.M. N.M. Secured debt/debt + deposits (%) N.M.--Not meaningful. Related Criteria General Criteria: Guarantee Criteria, Oct. 21, 2016 General Criteria: Rating Government-Related Entities: Methodology And Assumptions, March 25, 2015 Criteria - Financial Institutions - Finance Companies: Finance Company Ratios, March 18, 2004 Criteria - Financial Institutions - Finance Companies: Rating Finance Companies, March 18, 2004 Related Research Ratings On The Housing Finance Corp. Ltd. Lowered To 'A' Following U.K. Downgrade; Outlook Stable, July 6, 2016 Ratings On The United Kingdom Affirmed At 'AA/A-1+'; Outlook Remains Negative, Oct. 27, 2017 Ratings Detail (As Of November 7, 2017) The Housing Finance Corp. Ltd. Counterparty Credit Rating Counterparty Credit Ratings History 06-Jul Jun-2004 Sovereign Rating United Kingdom A/Stable/A-1 A/Stable/A-1 A+/Stable/A-1 AA/Negative/A-1+ NOVEMBER 7,

12 Ratings Detail (As Of November 7, 2017) (cont.) Related Entities T.H.F.C. (Funding No. 1) PLC Senior Secured T.H.F.C. (Funding No. 2 ) PLC Senior Secured T.H.F.C. (Funding No. 3) PLC Senior Secured *Unless otherwise noted, all ratings in this report are global scale ratings. S&P Global Ratings credit ratings on the global scale are comparable across countries. S&P Global Ratings credit ratings on a national scale are relative to obligors or obligations within that specific country. Issue and debt ratings could include debt guaranteed by another entity, and rated debt that an entity guarantees. A A A Additional Contact: Financial Institutions Ratings Europe; FIG_Europe@spglobal.com NOVEMBER 7,

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