Although nonbank lenders have played a crucial role in the U.K. residential mortgage-backed securities (RMBS) sector for several years, the effect of COVID-19 has significantly changed the nonbank lending landscape, with demand increasing and nonbanks seeking opportunities to innovate. S&P Global Ratings expects the push to grow nonbank lending volumes--combined with an increasing number of borrowers with complex financial backgrounds and investors' push to invest in social mortgages--to spur the origination of increasingly niche RMBS collateral. Whether forward flow agreements and increased nonbank lending cuts into RMBS supply or becomes an intermediary step before a securitization depends on external variables, such as regulation and a bank's cost of capital and funding mix. Likewise, we expect the definitions of what is considered to be standard buy-to-let (BTL) collateral to also be tested.

Nonbank lending mortgage origination and securitization is active in the U.K., the Netherlands, Ireland, Portugal, Sweden, and Spain, with the U.K. dominating origination--followed by the Netherlands and Ireland. Following the global financial crisis, many nonbank mortgage lenders ceased operations, for example, Rooftop Mortgages Ltd. and Victoria Mortgage Funding Ltd. More recently, new nonbank lenders have come to the market, for example, Pepper Money and Vida Homeloans.

Chart 1

COVID-19 Was A Test For U.K. Nonbank Mortgage Lenders

Nonbanks have indirectly benefited from government measures throughout the pandemic. For example, the lowering of interest rates and the stamp duty holiday fueled house price growth and transaction volume. However, in comparison with their banking peers, U.K. nonbank mortgage lenders have faced difficulties due to COVID-19. Nonbanks were denied direct access to the Bank of England's Term Funding Scheme with additional incentives for small and medium-size enterprises (TFSME), but were also required to pick up the pieces of the hurried implementation of payment holidays. The scale of payment holidays averaged between 20% and 30% at the peak, meaning that nonbank originators--usually the residual noteholders of RMBS structures or equity holders of warehouses--had their equity-to-return assumptions challenged. Despite turbulence, all nonbank lenders active before COVID-19 have since returned to lending. However, the pandemic has given rise to two observable trends, which we consider below.

COVID-19 highlights the fragility of the nonbank market's strategy

Firstly, although the experiences of the global financial crisis highlighted that reliance on a favorable regulatory intervention for nonbanks is ill-advised, some lenders still find themselves reliant on securitization as a sole means of refinancing wholesale warehousing positions. Although the warehousing and term RMBS markets continued to function throughout the pandemic, it has arguably focused lenders' attention on diversifying their business models to place themselves in a better position to weather prolonged periods of market dislocation.

Recent acquisitions and market developments raise market saturation questions

Secondly, low interest rates combined with the positive credit momentum arising throughout the pandemic, means mortgage lending is appealing to a number of institutions in the so-called hunt for yield. Importantly, mortgage lending attracts different types of financial institutions, from banks, private equity companies, and insurance companies. The past year has seen several acquisitions in the U.K. nonbank sector: TML (sold to Shawbrook Bank Ltd.), Fleet (sold to Starling Bank Ltd.), Paratus AMC Ltd. (sold to Athene Holding Ltd.), Oplo (acquired by Tandem Bank Ltd.), and Kensington Mortgages (reportedly for sale). In addition, Capital Home Loans Ltd. has returned to lending and Quantum Mortgages announced it will start originating in 2022.

Two new banks--Monument Bank Ltd. and Recognise Bank Ltd.--have recently announced that they intend to enter the U.K. BTL market. These developments, occurring as they have in a relatively short timeframe, leads to the question of how this new capital will be deployed in the U.K.'s specialist lending market and whether the size of the market in its current form can justify so many lenders. Or, alternatively, whether the level of competition will lead to lenders having to evolve products or operational capabilities to survive and thrive. To meet the twin challenges of developing more robust financing models and also deal with increased competition, we expect to see the following developments.

Forward flow agreements and white labeling

As was the case in the lead up to the global financial crisis, forward flow agreements have been a increasingly common feature of the U.K. nonbank mortgage origination market place for the past three years. Rather than taking credit risk directly, the lender originates loans to a predetermined specification for a purchaser. The purchaser takes the credit risk, and the originator takes fee income for the process of originating the loan. In such arrangements, it is common for the branding of the loan and the legal title holder to be that of the originator.

White labeling is a similar concept, but where the loan branding reflects and retains the purchaser's branding and image, but ultimately is sourced and underwritten by an originator who may be originating for a number of different end purchasers. This model is already employed in the Netherlands.

Such arrangements are likely to be more appealing for both originators and purchasers for a several reasons. Firstly, mortgage products are evolving and mortgage asset purchasers are using mortgage debt in an increasingly sophisticated way to match-fund liability profiles. For example, the move to originate 25+ year fixed-rate mortgage products. Such, a product has appeal to institutions such as insurers who have a similar long-term liability profile and require fixed-rate rather than variable-rate assets. Although an insurance company could establish its own lender and originate in this manner, the cost of establishing a lender, when compared with acquiring mortgages to order from a pre-existing lender, is significant. In partnering with a pre-existing lender, a company can come to market quickly. In using outsourced origination through a forward flow or white labelling agreement, combined with outsourced servicing, an issuer can come to market with limited capital outflow. A recent example of this is Rothesay Life PLC's recent announcement that it will partner with an unnamed lender to originate long-term fixed-rate owner-occupied mortgages.

For banks too, outsourcing through forward flow or white labeling allows quick access to markets, and, if negotiated, a relatively quick exit if a more lucrative risk-adjusted return is available in another asset class. By way of an example, we recently saw Atom Bank PLC partner with Landbay Partners Ltd. to originate BTL products. If the RMBS markets suffer a hiatus, the lender may be able to continue to originate for other channels, and the hiatus would become a roadblock to navigate rather than an existential crisis.

Charts 2 and 3 below illustrate current and possible future nonbank mortgage lender business models.

Chart 2

Chart 3

Cradle to grave business model

Several BTL lenders use the cradle to grave business model to support a property investor from start to finish. This would entail bridging the initial purchase (typically very short term), providing development finance on the renovation (medium term), and financing it to a BTL loan when the property is completed and rentable (long term). Each of these discreet products has a different maturity and from a lender's perspective is funded differently. For example, the BTL product might be funded by RMBS, whereas the bridging and development finance by a leveraged loan. Although all three products are likely to be highly correlated to a housing market downturn, the diversification will provide some hedge to disruption relative to a lender without diversification, especially if maturity overlaps between the products can be avoided.

Although more synonymous with the BTL sector, cradle to grave lending in light of the evolution of long-term fixed-rate lending also appeals to nonbanks. Faced with the constant churn of portfolios when fixed rates elapse, lenders will be able to position themselves as a lender's life partner, offering a loan (secured on various different properties as the borrower trades up and trades down, i.e., the loan is portable) from the first-time buyer to retirement.

Acceleration of nonbank innovation

The U.K. nonbank sector has a long tradition of innovation, having introduced new products such as lending to the self-employed, credit impaired, and the BTL market. It has also spearheaded technological innovations, for example the use of automated valuation models (AVMs) and the development of underwriting systems for portfolio landlords. Although risks associated with innovation have been on occasion under-appreciated, notably AVMs, regulatory and risk cultures are tighter since the onset of the global financial crisis. We therefore expect nonbanks, incentivized by the need to expand and differentiate from larger entities/lenders who are now encroaching on their core markets, to embrace further innovation in the form of both products and digitalization.

End-to-end digitization

Although front-to-back automation in the prime mortgage space has been possible, owing to credit scoring, it has not been possible in nonconforming lending, owing to the need to understand the individual borrower. The evolution of open banking, which allows a lender to view the applicant's banking account would allow some applications some level of automation and allow lenders to target an underwriting resource where it is most valuable.

Nonbanks Are Likely To Dominate Social Mortgage Origination

The market has yet to arrive at a consensus of what exactly a social mortgage is but using the Association for Financial Markets in Europe (AFME) principles, it is serving borrowers who are underserved by traditional financers. The reason many potential borrowers are underserved is not because of fundamental credit unworthiness, but because the product that would benefit such borrowers would not attract enough volume or suit automated decision making. Consequently, banks tend to not offer such products.

The development of social RMBS investing will likely benefit nonbanks. We forecast U.K. house prices to remain broadly flat for the next two years, meaning they will remain at record highs relative to income. Against this backdrop, and the disproportionate credit impact of COVID-19 on younger people struggling to purchase housing, the demand for products that assist borrowers entering the housing market will likely grow. Furthermore, the number of borrowers with a blemished credit record is likely to increase. Although data on registered county court judgments (CCJs) and individual voluntary arrangements (IVAs) is difficult to interpret given limited court action in 2020, evidence of consumer stress is mounting. For example, the English Housing Survey Household Resilience Study, Wave 3 April-May 2021, reports that 10% of households are at least one month behind with a utility or credit card bill. In addition, the scale of dislocation in income and employment has been significant and creates complex circumstances for would-be borrowers. Nonbanks have the skill set to underwrite complex personal circumstances and products (see "Will Innovation Give The U.K. Mortgage Market A Boost?" for a summary of the products and credit considerations).

Likewise, such products may also prove attractive for forward flow partners. Banks are likely to come under increasing pressure to be seen to be at the leading edge of ESG investing. Although individual social mortgage products may lack the scale to interest banks, the use of forward flow agreements means that social lending objectives can be met without the need to invest in establishing an underwriting platform.

The BTL Landscape Further Evolves

Former nonbanks BTL originators who are now part of banking groups and new bank BTL lenders will potentially have a cost-of-funding advantage over their nonbank peers. In order to preserve market share, we foresee that the nonbank BTL market may push the boundaries of what is considered typical for the asset class in one of two ways. For regulated lenders, we anticipate larger and more bespoke rental properties to become more common. For example, houses in multiple occupation (HMOs) to have more rooms and be more niche, such as student-only HMOs. In effect this would move assets traditionally viewed as commercial into RMBS. It is also possible that underwriting criteria that ultimately manages credit risk but is not covered by regulation will be relaxed. For example, lowering the minimum age of borrowers and allowing adverse credit. Unregulated BTL lenders' affordability measures, which control and restrict BTL lending, are likely to be challenged (such as the lowering of debt service coverage ratios).

Moreover, just as new BTL lenders have evolved from bridging lenders, we anticipate that existing BTL lenders would laterally expand into related asset classes, such as bridging and development finance, and may use their securitization experience to fund these assets.

Related Research

• S&P Global Ratings' U.K. Second-Lien Mortgages Primer, Jan. 31, 2022
• European RMBS Outlook 2022: Performance And Issuance At A Crossroads, Jan. 27, 2022
• Credit FAQ: How We Analyze Small Ticket Commercial Real Estate Assets In European Structured Finance, Jan. 19, 2022
• EMEA Structured Finance Chart Book: December 2021, Dec. 2, 2021
• European RMBS Market Update Q3 2021, Nov. 24, 2021
• European RMBS Index Report Q3 2021, Nov. 9, 2021
• European Housing Market Inflation Is Here To Stay, Nov. 2, 2021
• European RMBS Market Update Q2 2021, Aug. 16, 2021
• Why U.K. Buy-To-Let Has Defied Gravity Through COVID-19, Aug. 3, 2021
• S&P Global Ratings' U.K. Buy-To-Let Market Primer, June 1, 2021
• Will Innovation Give The U.K. Mortgage Market A Boost?, Sept. 4, 2019