The U.K. has seen buy-to-let (BTL) loans flourish in recent years. This product has become a popular and profitable investment with the residential housing boom.

However, new entrants to the sector are caught in a confluence of rising interest rates, lower rents and waning capital gains that threaten to whittle away at their profits. This leaves market sources wondering whether landlords will continue to hold on to these investments or cash out.

Over the last two years, interest cover ratios have dropped and the number of self-certified borrowers has increased, raising questions about the quality of the loans being written.

"Up until now, buy-to-let mortgages have performed well, but we have seen some non-conforming lenders loosen criteria in a bid to attract both subprime and buy-to-let borrowers, so that means that the quality of the loans are not as good," said Greg Kohansky, an analyst on Fitch Ratings' European structured finance team. "The quality of the buy-to-let as well as owner-occupied mortgages has declined."

There is one other complication: The buy-to-let sector was virtually nonexistent in the last recession, making it difficult to gauge how these loans will perform in more stressful environments, say market sources.

In the wake of, and as an effect of, the U.S. subprime implosion, some U.K. mortgage lenders have suffered liquidity constraints. This lack of liquidity in the capital markets has not only led to an increase in market lending rates, but also a repricing of lenders' product offerings. Also, some products have already been scaled back in scope, according to Kohansky.

Marketwide Liquidity Problem

Paragon Mortgages, the third-largest buy-to-let lender in the U.K., is the latest victim of the lack of liquidity. At the end of November, the specialist lender announced record pretax profits on the back of increased lending, its loan book's good performance and improved cost-income ratios.

Paragon said it might have to arrange a GBP280 million ($570.6 million) standby rights issue instead of renewing its working capital facility, which is set to expire at the end of February 2008. Paragon's current facility is priced 90 basis points over Libor. Although a renewal has been negotiated in principle, the terms remain unattractive for a number of reasons, including the high cost and short-term nature of the proposals.

"Paragon is facing funding-related pressure, just as Northern Rock did, due to the turmoil in credit markets, [and] their usual sources of funding are not fully open to them," said Maddi Patel, RMBS analyst at Barclays Capital. Patel said that as a nonbank institution, Paragon does not have as many funding alternatives. An important source of funding for banks and bank societies is retail deposits, which Paragon clearly does not have, she said. Also, it cannot use the Bank of England facilities through which RMBS can be issued.

If the ABS market remains an unattractive funding alternative, then Paragon will have to look elsewhere. But it will not be alone. As Paragon's share price has tumbled by over 50%, other leading players in the sector, including Alliance & Leicester and Bradford & Bingley, have also seen their shares fall by more than 40% since the start of 2007.

However, Bradford & Bingley said last week that its annual underlying profits for 2007 are expected to be in line with analysts' expectations. The lender reported that its new business pipeline at the end of October 2007, though lower than in June 2007, was higher than it was a year ago.

According to B & B, higher funding costs and lower growth have led to a decline in its net interest margin. It said that credit quality remains strong, though arrears levels have increased somewhat. "The lender recently sold GBP4.2 billion of residential and commercial property loans in order to improve its cash position, with the residential (social- housing related) portfolio sold for GBP2.2 billion to Dexia SA, while the commercial property loan portfolio was sold to GE Real Estate for GBP2 billion," Deutsche Bank analysts reported. "Of the two, the former was reportedly sold at book value and the latter at a discount." Bradford & Bingley said that it "remained confident about the demand for its buy-to-let mortgages."

Meanwhile, Alliance & Leicester reported that its 2007 full-year core operating profits, excluding treasury investment impairment, are expected to beat analyst expectations of GBP598 million. The company, however, is becoming more dependent on customer deposits and committed wholesale funding, which includes a financing arrangement backed primarily by residential mortgage assets.

"It's a marketwide liquidity problem," one market source said. "Money is tight and if securitization remains closed to players heavily dependent on it, structured finance funding will remain under pressure going forward, but the greater risks are limited to the smaller, less capitalized players."

One Thing Leads to Another

The slowdown in house prices will certainly be a test for the buy-to-let market sector and might begin to challenge the notion that investors are in this product for the long term, say sources. "Everybody talks about the lack of supply in direct correlation with the rise in house prices," Fitch's Kohansky said. "If buy-to-let landlords, especially those who entered the market in the last couple of years, decide they have just hit the cycle at the wrong time and get out, it will alter the supply/demand balance."

In the U.S., rapid house price depreciation has caused borrowers to have no home equity on some loans originated in 2005 and 2006. Some argue that the U.K. housing market cycle looks to be at a different stage - with the housing sector having weathered the 2005 slowdown relatively well. However, Fitch analysts said it would be foolish to think that house price declines seen in the U.S. will not be seen in the U.K.

Nationwide's house price index reported its first monthly decline since February 2006. The index showed a 0.8% fall in house prices in November, the sharpest monthly fall since September 2003. "Looking at the several housing indicators available, it is clear that market sentiment on house price evolution has deteriorated," Societe Generale analysts said. "Perception of house price development is actually much worse than what the U.K. house price index suggests." They added that property derivatives suggest that house prices would fall 7.5% in the coming year. SocGen expects a slight deterioration in U.K. prime RMBS performance as house price growth moderates and lending appetite remains low.

Although the volume of buy-to-let loans makes up a smaller percentage of the overall U.K. mortgage market, the risk is more concentrated than it is in subprime loans.

Kohansky estimates subprime loans account for about 6% to 8% of overall mortgage origination in the U.K., but he acknowledged that no single county has more than 8% to 11% concentrated risk in this sector. By contrast, buy-to-let mortgages make up 10% to 12% of origination in certain counties and in some places, like London, concentration of buy-to-let loans can be upward of 30%. "In the U.S., there was also a heavy concentration risk of subprime borrowers in certain pockets of the country, like California for example," he said.

Even if buy-to-let investors were encouraged to sell off portfolio holdings, first-time buyers will presumably pick up the slack, say sources. It has been argued that house prices are being driven more by buy-to-let investments than by first-time buyers in some areas of the U.K., like London. Without the buy-to-let sector to compete with, first-time buyers would be better positioned to participate in the market, especially if prices continue to dip.

For several years, the performance of buy-to-let mortgages has been remarkably good, often outperforming owner-occupied homes, even after correcting for typically lower loan-to-value ratios and stricter affordability requirements, according to Fitch. "Some economic analysts point out that the rental return of buy-to-let assets is already much lower than alternative investments, meaning that such an investment can only be sustainable under expectations of strong house price growth, and that rental income streams are much more volatile and sensitive to general economic prospects," Fitch analysts said.

There has also been a trend toward lowering lending criteria within the buy-to-let sector, Barclays' Patel said. "Previously, it was uncommon to see the interest rate coverage below 125% of the stabilized margin monthly repayment of a capital repayment mortgage," she said. Recently, there have been instances where ratios are at 100% or less, and, in some instances, they were based off the teaser period rate and an interest-only monthly repayment. This has made the underwriting criteria for non-conforming buy-to-let mortgages significantly less stringent, she added.

Only a very small percentage of buy-to-let buyers fall into the subprime or non-conforming category, Patel said, and they tend to be a very different type of borrower. Generally, the sector tends to attract professional landlords with a number of years of experience, a long-term view and a desire to make capital gains over the long term. Many have entered the sector to take advantage of the relatively high leverage available to supplement their other underperforming investments.

However, beyond the riskier borrower profiles, the sector has also seen a continued "blurring" between buy-to-let and owner-occupied mortgages, Fitch said. Often, owner-occupied properties are rented by the owner without notifying the bank to avoid the extra charges and a potentially higher interest rate. This is often referred to as "disguised buy-to-let." Fitch said there are also borrowers who do not meet the affordability criteria for an owner-occupied mortgage, so they opt instead for a buy-to-let mortgage. This allows them to meet eligibility requirements on interest coverage without actually intending to let the property.

"The question that remains is whether landlords are in it for the long term - clearly the benefits of property investments have fallen off the radar," Kohansky said. "If capital appreciation was threatened, then there exists the possibility that some buy-to-let investors might start looking to liquidate properties and lock in' paper profits in cash.Were this to occur, then any house price declines could be exacerbated by any buy-to-let concentration in the region."

RMBS Performance

The strong growth of buy-to-let origination has not been reflected in buy-to-let RMBS issuance. The latter amounted to only 9.4 billion ($13.74 billion) in 2006 and has so far reached 7.5 billion in 2007, according to a Merrill Lynch report. "Given the small volumes securitized in times of a booming market, it is unlikely that we would see much issuance coming through in the next few months, given the expected slow-down of the buy-to-let market," Merrill Lynch analysts said. "The only exception could be constituted by pre-placed/retained issues."

It is likely, Merrill Lynch analysts said, that when issuance picks up in the buy-to-let sector, spreads will widen away from the earlier tight pricing that brought buy-to-let spreads closer to prime RMBS and away from non-conforming spreads. New deals from the Aire Valley master trust have been posting arrears that are higher than average. Paragon's deals show an increasing share of amateur landlords, which could potentially be the most negatively affected from a slow-down in the housing market.

Barclays' Patel said that prepayments have remained relatively stable over the past four years. By contrast, arrears have picked up as interest rates have started to increase, though they appear to be stabilizing and are now below that of prime RMBS for the first time in three years.

However, Fitch analyst Alison Ho said that though she has seen little in terms of rising arrears, there has been a noticeable pickup in prepayment rates to levels not seen before. "Why have CPRs risen?" she said. "It could be an indication that maybe those landlords with long-term intentions may not be in it for as long a term as before."

It was particularly interesting that the portfolios affected were from larger, more established originators who could be considered savvier market players, Ho said.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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