Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 1 Investing in newly originated Dutch residential mortgage loans by Merijn Bosman, Dynamic Credit Partners Europe B.V. In the past five years Dutch institutional investors have significantly increased their asset allocation towards newly originated Dutch residential mortgage loans making this one of the fastest growing asset classes in the fixed income universe. Newly originated Dutch residential mortgage loans are an attractive sub-sector of the fixed income universe due to the relatively high margins on the loans versus other fixed income alternatives with a similar risk profile and duration. The margins are supported by low realised losses even during the financial crisis, the tightened statutory mortgage loan criteria introduced post-crisis and reduced competition from traditional lenders due to adverse changes in laws, rules and regulation and a shift in mortgage loan demand and supply towards longer fixed rate periods. Non-Dutch institutional investors are slowly discovering the opportunity and are expected to increase allocations to this asset class. Investment formats through which investors can invest in newly originated Dutch residential mortgage loans are either via participations in mortgage funds or direct whole loan exposure via mortgage loan receivables either held by a legal entity owned by the investor or transferred directly on the balance sheet of the investor. Mortgage bonds which are securities in a single-tranche pass-through structure were recently introduced and offer an attractive alternative to the existing investment formats. The investment formats vary in terms of their required investment size, transferability of the exposure and available exit routes. In addition, tax and regulatory (capital) treatment and mandate restrictions play a role in determining which investor format is optimal for an investor. Before discussing and comparing these investment formats, the appeal of investing in newly originated Dutch residential mortgage loans is outlined below. The appeal of investing in newly originated Dutch residential mortgage loans Despite the impact of the financial crisis Dutch residential mortgage loan losses remained low Measured by realised losses the Dutch residential mortgage loan market has proven to be the best performing and most resilient mortgage loan market in Europe. Statistics published by the Dutch central bank show that during the most recent economic cycle average losses for Dutch residential mortgage loans peaked at around 0.2% in 2013. Despite that: 1. the unemployment rate more than doubled - from 3.6% during most of 2008 to a peak of 7.9% in February 2014; 2. housing prices declined significantly in June 2013 the decline was more than 20% compared to the peak in August 2008; 1
Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 2 2 3. the number of housing transactions declined by 45%; and 4. the industry was still largely subject to self-regulation with respect to mortgage loan underwriting criteria which resulted in relatively loose underwriting criteria compared to the statutory criteria introduced postcrisis and the use of broker incentive fees that had the potential to misalign incentives between the various parties involved in the mortgage loan application. Industry self-regulation is largely replaced by stricter statutory mortgage loan criteria The strong historical performance is supported by changes in regulation. Newly originated mortgage loans benefit from tighter statutory underwriting criteria that the Dutch government introduced post-crisis. These include: 1. Ministerial regulation on mortgage credit (tijdelijke regeling hypothecair krediet): The introduction of this legally binding regulation resulted in legal maximum debt service to income percentages based on affordability and loan-to-market-value ( LTMV ) constraints. Per 2013 a 105% LTMV cap was introduced and set to reduce by 1% per annum to 100% by 2018. 2. Amortisation requirement: Since 2013 newly originated mortgage loans are required amortise within 30 years per at least an annuity scheme to be eligible for tax deductibility of interest payments. 3. Inducement prohibition: Since 2013 financial service providers are no longer allowed to pay or receive inducements for acting as an intermediary or adviser on mortgage loans. Only inducements paid by the borrower are permitted (i.e. this ended lender incentive fees for brokers). Gross spreads on newly originated mortgage loan relatively high Gross spreads of newly originated Dutch residential mortgage loans can be determined via the pricing grids of lenders which show the mortgage loan rates per segment where segments are based on combinations of the following factors: 1. the LTMV of the mortgage loan - i.e. the mortgage loan amount at origination or rate reset divided by the market value of the underlying collateral expressed as a percentage. Lenders offer rates for various LTMV buckets; 2. the period for which the interest rate is fixed most Dutch mortgage loans are fixed for at least 10 years because of regulation that incentivises borrowers to fix their mortgage loans rates for at least 10 years; 3. whether the loan benefits from Nationale Hypotheek Garantie (NHG) the Dutch national mortgage guarantee scheme; and 4. the amortisation type of the mortgage loan (parts) annuity, linear or interest only. Exhibit 1 shows the developments in gross spreads obtained by Dutch residential mortgage loan originators for various segments based on the factors outlined above. Although spreads have declined, especially on the higher LTMV mortgage loans as a result of increased competition in those segments, newly originated mortgage loans offer a significant spread pick-up versus the fixed income alternatives with a similar risk profile and duration. Changes in regulation and shift in supply and demand of mortgage loans resulted in reduced competition from traditional lenders Origination in the Dutch residential mortgage loan market has traditionally been dominated by the four large domestic banks Rabobank, ABN AMRO, ING and the Volksbank (formerly SNS Bank). Recent changes in laws, rules and regulation, uncertainties around future changes and a shift in supply and demand of mortgage loans has resulted in reduced competitiveness from the traditional lenders. Three factors that affected the competitiveness are: 1. Tightening of Basel rules: The introduction of Basel III and the forthcoming introduction of a capital floor under Basel rules is anticipated to significantly increase the capital requirements for Dutch mortgage loans for banks even further. 2. Prohibition of front-book/back-book pricing: A statutory single rate policy came into effect on January 1, 2013 which prevents mortgage lenders from charging different prices for new and existing borrowers with
Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 3 Time series of spreads over mid-swap rates for the average top-six price leader mortgage loan rates (excluding action rates) for various fixed rate period and risk segments Exhibit 1 Spread development for average of top 6 mortgage rates Fixed rate Risk class 2015-2016- 2016-2016- 2016-2017- 2017- period 12-31 03-31 06-30 09-30 12-31 03-31 06-30 NHG 1.59% 1.81% 1.88% 1.77% 1.60% 1.46% 1.48% 30-year 20-year 10-year 5-year 60% LTMV 1.49% 1.72% 1.79% 1.69% 1.50% 1.46% 1.48% 80% LTMV 1.73% 1.93% 2.04% 1.88% 1.70% 1.62% 1.61% 100% LTMV 2.52% 2.55% 2.49% 2.37% 2.17% 2.11% 2.08% NHG 1.45% 1.73% 1.73% 1.64% 1.35% 1.31% 1.28% 60% LTMV 1.37% 1.67% 1.70% 1.58% 1.37% 1.23% 1.26% 80% LTMV 1.58% 1.86% 1.89% 1.73% 1.52% 1.39% 1.40% 100% LTMV 2.22% 2.45% 2.40% 2.24% 1.98% 1.88% 1.87% NHG 1.50% 1.95% 1.96% 1.80% 1.53% 1.43% 1.18% 60% LTMV 1.49% 1.94% 1.96% 1.82% 1.62% 1.52% 1.53% 80% LTMV 1.73% 2.14% 2.19% 2.01% 1.83% 1.72% 1.68% 100% LTMV 2.35% 2.73% 2.73% 2.56% 2.29% 2.15% 2.06% NHG 1.87% 2.21% 2.26% 2.25% 1.76% 1.64% 1.61% 60% LTMV 1.90% 2.26% 2.36% 2.28% 1.88% 1.79% 1.75% 80% LTMV 2.19% 2.50% 2.55% 2.46% 2.04% 1.97% 1.90% 100% LTMV 2.74% 3.07% 2.98% 2.94% 2.53% 2.38% 2.26% 3 Source: Dynamic Credit, Bloomberg, Hypotheekbond (2017) similar risk. Consequently, the mortgage loan rates of lenders determine both the inflow of mortgage loans in the front-book and the repricing of mortgage loans at their rate reset date in the back-book. 3. Borrower demand and funding supply moved towards mortgage loans with longer fixed rate periods: The combination of a low interest rate environment and the increased supply of funding from mainly insurance
Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 4 4 companies and pension funds targeting longer fixed rates period resulted in a shift towards fixed rate periods longer than 10 years where banks have difficulty to compete given the relatively short duration of their liabilities in comparison with the duration of liabilities of insurance companies and pension funds. First, to meet the conditions of the tightening in Basel III regulation and its implementation in the European Union via the capital requirements directive, the core capital ratio of Dutch banks increased from less than 8% in 2008 to nearly 15% mid-2016. Ratios are expected to be required to increase further due to the forthcoming introduction of capital floors under Basel rules that are expected to significantly increase the capital requirements of banks for Dutch mortgage loans. The impact of this change is reduced by the implementation timelines. Although the Basel committee initially pledged to issue final standards covering the outstanding revisions to the regulatory framework by end- 2016, the most recent report is that discussions are heading towards capital floors that will be phased in over five years, starting at 45% on January 1, 2021, rising by 5 percentage points per year to a maximum of 75% by January 1, 2027 in combination with a to be determined transitional maximum risk-weight cap for residential mortgage loans. The impacts would vary per bank. In July 2016 Rabobank credit research estimated an impact on Common Equity Tier 1 (CET1) ratios of around 1% (ING Bank) to 6% (Volksbank) based on an assumed floor of 70%. Second, as a result of a strong and very successful consumer lobby, regulation came into force on January 1, 2013 that prohibits lenders from applying a frontbook/back-book pricing strategy. The so-called single rate policy (eensporig rentebeleid) requires mortgage lenders to charge the same rate to new and existing borrower that have a similar risk profile. The Dutch mortgage loan market was traditionally dominated by the large domestic banks. Back-books of these lenders are multiple factors larger than the annual volume of the front-book. The result of the introduction of the single rate policy is that mortgage loan rates offered by lenders determine both the inflow of newly originated mortgage loans in the front-book and the rate at which mortgage loans in the back-book that are at their rate reset date are repriced. Given the reduction in mortgage loan rates over the past few years, new lenders that entered the market after the introduction benefited as their pricing strategy limited itself to originating new mortgage loans (i.e. the frontbook) without having to worry about repricing an existing portfolio (due to the absence of a back-book). Third, supply and demand for mortgage loans shifted towards fixed rate periods of 10 years and longer as is outlined in Exhibit 2. From a supply perspective, the funding from insurance companies and pension funds that started to increase in 2014 for a large part targeted fixed rate periods longer than 10 years. The result of the supply in funding was that it decreased the relative difference between mortgage rates for longer fixed rate periods in comparison with shorter fixed rate periods. At the same time mortgage loan Mortgage loan application volume for the <10 years, 10 years and >10 years fixed rate periods expressed as a percentage of total mortgage loan application volume in the market Exhibit 2 Fixed rate 2017 2016 2015 2014 2013 2012 2011 2010 2009 period (YTD) <10 years 3% 4% 6% 20% 29% 35% 36% 25% 38% 10 years 43% 44% 48% 61% 57% 53% 53% 57% 52% >10 years 54% 51% 46% 20% 14% 12% 11% 18% 10% Source: Dynamic Credit, HDN (2017)
Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 5 rates were reaching historic lows as mortgage loan rates decreased in line with the developments in interest rate markets. The combination resulted in a shift in demand from borrowers towards longer fixed rate periods given that the longer protection against mortgage loan rises was perceived to have become relatively cheap in terms of the increase in monthly cost for the longer protection. As outlined above newly originated Dutch residential mortgage loans offer an attractive investment opportunity. First, Dutch residential mortgage loans historically are characterised by low losses even during a period of crisis. Second, newly originated loans benefit from the stricter statutory mortgage loan criteria introduced by the Dutch government post-crisis. Third, newly originated mortgage loans offer a significant spread pick-up versus fixed income alternatives of similar risk and duration. Fourth, the opportunity is a long-term opportunity given the reduced competitiveness of the traditional lenders. Finally, the investment opportunity is scalable market loan origination volume was around 81bn in 2017 and this amount is expected to increase as both the number of housing transactions and the mortgage loan amounts are increasing. The origination volumes can satisfy investment appetite of even the largest investors 1. Investment formats for investing in newly originated residential mortgage loans Institutional investors wishing to invest in newly originated Dutch residential mortgage loans can do so by buying participations in mortgage funds, buying mortgage loans receivables from originators or by buying mortgage bonds. Investments in a mortgage fund occurs via a participation certificate in the relevant fund. Participation come in two forms. The first form of participations are participations that represents a fractional interest in the assets of the fund. For a mortgage fund, the assets usually consist of mortgage loan receivables and cash. This form of investment allows smaller investors to gain a welldiversified exposure to a pool of mortgage loans that they would not be able to get otherwise given the ticket size of their investment. The mortgage loan pool characteristics correspond to the investment guidelines as outlined in the fund documentation. Transferability of this form of investment in residential mortgage loans is considered to be difficult since the investor does not have full control over the underlying mortgage loan receivables. In general, in the scenario where the investor wants to exit its investment in the fund, the fund either needs to have enough liquidity to redeem the participations of the investor or the investor needs to find a party that is willing to buy the participations. Important to note is that terms and conditions of the fund can restrict the nature of participants. Limits on participant jurisdictions and type are not uncommon (e.g. funds that are only open to Dutch pension funds). The second form of participations are participations that represent full interest in a segregated part of the assets of the fund. This form of fund participations provides investors with exposure to a specific pool of mortgage loans. On the more advanced platforms investors are able to allocate amounts to the various market segments so that a bespoke pool is originated that matches the return, duration and risk-appetite of the investor. However, in comparison with fund participation that represent a fractional interest, larger ticket sizes are required to get exposure to a well-diversified portfolio of mortgage loans. Merijn Bosman, Vice President Dynamic Credit Partners Europe B.V. tel: +31 20 798 1381 email: mbosman@dynamiccredit.com 5
Dynamic Credit_SSF_2018.qxp:XXXX_CB_2011 06/07/2017 13:09 Page 6 6 Although the same limitations on transferability of the participations could apply as outlined for participations that represents fractional interests, the transferability of the investment is significantly enhanced if the investor has full control over the underlying mortgage loan receivables at the moment it wants to exit its investment. In that scenario, not only can the participations be sold, but (parts of ) the loan portfolio could be sold in whole loan format or (a partial) exit via a securitisation could be realised. Investors obtain maximum flexibility in a scheme were the mortgage receivables resulting from newly originated mortgage loans are bought directly from the originating entity of the mortgage loans (whole loan format). As with participations that represent full interest in a portfolio of mortgage loans a bespoke portfolio that matches investor requirements could be originated for the investor. The mortgage loan receivables are then either held by a legal entity controlled by the investor or directly held on the balance sheet of the investor. In case the investor wants to exit its investment, it can sell the mortgage loan portfolio by either selling (a part of ) the portfolio of mortgage loan receivables or by selling (a part of ) the shares of the entity that holds the mortgage loan receivables. Additionally, an exit via a securitisation of (parts) of the portfolio of mortgage loan receivables is an option. However, this is also the most complex set-up that requires the investor to have a broad investment mandate that allows for investments in mortgage loan receivables and a setup where the investor is able and willing to administer the individual loans. Finally, an investment in newly originated mortgage loans can be made via mortgage bonds. Mortgage bonds are securities whereby the mortgage loan receivables are bought from the originator by an SPV with the proceeds of a bond issuance to investors. These securities represent a direct claim of the investors on all that the SPV collects from the assets transferred to it after subtraction of costs. The advantage for investors is that bonds are issued, held and transferred electronically via recognised clearing/settlement institutions and mechanisms, that the investment is represented by a single line item in its administration, that ISIN codes are available and that listing the bonds is an option. The bond format also improves the secondary tradability and financing in comparison to the fund participation and whole loan format. In addition to the considerations outlined above, tax and regulatory (capital) treatment and mandate restrictions play a role in determining which investment format is optimal for a particular investor. About the author: Merijn Bosman is responsible for establishing Dynamic Credit s residential mortgage loan portfolio management and advisory activities. Under his leadership the portfolio management activities that started in 2014 grew to around 7bn in assets under management in 2017. In addition, he headed the advisory team that advised both buyers and sellers of mortgage loan portfolios on several of the largest portfolio transactions that occurred in the Dutch market post-crisis. He holds a master degree with honors in financial engineering from the University of Twente and he started his career at Dynamic Credit as an asset backed security analyst in 2011. Note: 1 Dynamic Credit s annual originating capacity of its mortgage loan origination platforms, for example, is currently estimated at over 5bn. Contact us: Dynamic Credit Partners Europe B.V. Frederik Roeskestraat 97-D 1076 EC Amsterdam, The Netherlands tel: +31 20 770 4876 web: www.dynamiccredit.com