The Paradox of the BrokerThe broker most people know best is the estate agent. You are probably familiar with the deal-the estate agent tells you your house is worth £1m, for the sake of illustration. You instruct him to sell, and he gets 2% of the proceeds, in this case £20k. The estate agent comes back to you after a few weeks and tells you that the market has changed (or whatever), and that you should accept £950k.
What does this mean for the parties? You are out of pocket by £50k, but have saved 2% of £50k (£1k) on agent's fees. So you're down £49k. The agent gets £19k not £20k, a nice deal for him on a quick sale. Was he motivated to put in the extra effort to get to the original price? I'd like to think so, but probably not in all cases.
I once put this to an estate agent: "I'll pay you 1% on the first 90% of your indicated selling price, and and 10% on anything over that. That way, if you get to 100% you're quits, and you make 10% of everything else". Did he accept? No. I wonder why?
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There's been a lot in the consumer press recently about how mortgage lenders-'nice' mutuals as well as 'big bad' banks-have been hiking their mortgage rates. The Sunday Times on 13th Sep reported that Yorkshire Building Society now charges 5.79% for 2 years, and 6.55% for 5 years. That's net spreads of 3.93% and 3.26% over swaps. Traditionally, mortgage margins were a good couple of % lower than this.
Commentators on both the asset and liability sides look at their own bit of the picture in isolation, and lose sight of the whole picture:
"Blimey, AAA RMBS is trading in the 150-200bp area, it used to be 10bp or so";
"Blimey, mortgages are looking expensive given the interest rate environment".
There are two key conclusions from a securitisation perspective:
1. Issuing AAA RMBS would still leave a very healthy net spread, and bring the benefits of match funding and alternative funding.
But no-one is issuing in the primary market. Perhaps because:
2. Banks can still get cheap funding from central banks under the securitise-and-repo model; and they have plenty of cheap deposits from people scared of market volatility.
The RMBS market will be back in a big way once the central banks wean banks off repos, and investors withdraw deposits to invest in higher-yielding assets.
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Someone recently raised with me the difference between a building society and an RMBS. Surely, they said, RMBS can't be as safe as a building society. I raised a few points:
-Both a building society and RMBS are , or should be, simple: in both cases a bunch of residential mortgages funded by senior debt/"shares" plus subordinated debt/"reserves"
-RMBS is match funded; the liabilities match the assets. You can't have a run a la Northern Rock on an RMBS;
-If you have thousands to invest, a building society is safer-HM Govt guarantees you up to £50k. If you have millions to invest, a AAA RMBS is probably a lot safer than a much lower-rated building society;
-BUT the only liquidity for RMBS is a market sale, whilst deposits can be withdrawn at par at any time-as long as the society has access to cash!
-RMBS yields significantly more at present than building society paper;
-An RMBS is "brain dead"-there is no possibility of a bored management looking for fun and yields by branching out into areas where they have no expertise, such as commercial property (Dunfermline) or buy-to-let (Bradford & Bingley).
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Interesting market rumours about Barclays intending to issue a 3-year UK RMBS at a yield of +150 or so. The most fascinating aspect is the proposed buy-back by Barclay's in 3 years' time. Sounds like a good deal for investors: paper backed by Barclay's at a rate higher than Barclays' own senior debt, in addition to solid AAA mortgage backing.
This might at first sight look expensive for Barclays, but a bit more analysis suggests that the bank is assisting its Gracechurch master trust. I just read a good research piece by Merrill on master trusts, which reminds us that extension risk is a big concern. Showing that refinancing is possible will directly help Gracechurch, and indirectly help Barclays and any other banks which have an overhang of RMBS, by calming the market.
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An interesting article in the FT this week ("Disclose the fair value of complex securities") written by a bunch of academics, including one Robert Merton, who on the one hand is a Nobel prizewinner, and on the other has his name written all over the debacle which was Long Term Capital Management, which almost brought down the financial system in the 1990s.
The premiss [sic] seems to be that markets are efficient. This 'picking up nickels in front of bulldozers' approach proved disastrous in the case of LTCM, and even more so in the last 2 years.
'Fair Value' is an emotive term-implicitly, any other price is 'unfair'. What is really meant is 'market price', which is often in and of itself a function of emotion rather than logic. I have recently been putting together a portfolio of high-quality AAA assets with an IRR of 20%. Is that 'fair value'? Maybe not 'fair' to the academics, but it's a rattling good deal!
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