Finally, stress-test capital requirements to cover credit risk (increase in losses) and interest rate risk (for long-dated, fixed rate mortgages) also add to the capital burden.
To solve for this, funding models in the mortgage market have had to evolve.
Asset managers have stepped up to provide long-term capital to this market on behalf of institutional investors searching for attractive returns and diversification away from corporate risk. To manage their capital and balance sheets more efficiently, retail banks have looked to transfer existing, performing loans and other asset exposures from their balance sheets to carefully selected institutional investors from time to time, in order to meet regulatory capital requirements – while still servicing the loan assets for a fee and maintaining relationships with end-consumers.
The role of institutional capital
The long-term investment horizon of institutional asset owners, such as insurance companies and pension funds, makes them ideally suitable as a complementary source of stable mortgage funding and a good match for their long-term liabilities – something policymakers are all too aware of. From a longer-term perspective, a larger role for institutional investors in mortgage markets may be beneficial to the financial system.
Regulations such as Solvency II have certainly played a part in stoking demand for direct exposure to residential mortgage loans. While mortgages do not qualify for matching adjustment relief, the capital treatment of an investment in a portfolio of non-securitised residential mortgages is particularly favourable for insurance companies relative to traditional fixed income investments of equivalent risk. Residential mortgages sit under the counterparty default module for solvency capital requirement (SCR) calculations under the Standard Formula, and SCR is a function of the loan-to-value (LTV) ratio rather than duration and credit rating. Residential mortgages also provide diversification potential as the underlying risk is linked to individuals rather than corporates or government, which most are exposed to via their corporate credit and equity portfolios.
Dutch and Belgian insurers are heavily exposed to mortgages, representing 25% or more of their investment portfolios in some cases, as they have shifted towards higher-yielding assets, with low capital charges proving attractive while default rates on mortgages have been historically low. Investors also have the potential to receive regular, stable income streams as borrowers pay down their mortgages over time, with low levels of duration. Investors can get floating-rate exposure to the asset class (following an interest rate swap on fixed-rate mortgage loans) which can offer built-in inflation protection because returns typically increase as interest rates go up. These pools are backed by property assets whose value can appreciate in an inflationary environment – thereby lowering loss given defaults.
