A long-term fix to an age-old mortgage problem

I’ve been fortunate enough to get to know the team from Perenna in recent months and they have got me thinking about long-term mortgages and the vagaries of the UK housing market. 

I’m positive about Perenna’s long-term-fixed-rate mortgage proposition for two reasons. First, because I hope that they might become clients of Origin one day! And second, joking aside, I think their solution could be a way to recalibrate and re-energise the UK mortgage market. 

A short-term, long-term problem

I grew up in the US, where the 30-year fixed rate mortgage is king, so to me, the UK market’s short-term focus has always seemed strange. Working out a way to offer longer-term fixes could help to free the market by providing a wider range of options, especially to groups such as first-time buyers. What’s easily said is rarely easily done, but several providers are making headway.

Perenna is one of a handful of lenders changing things up, along with others that include the likes of Kensington Mortgages and Virgin Money. Providers are waking up to the possibility that UK home buyers would like the same choice as their US counterparts. Whatever they’re buying, consumers have always valued choice – why should buying a home be any different? 

Young, dynamic companies, like Perenna, are proving that the private sector can test, iterate and bring quality products to the market whilst educating a ‘set in their ways’ consumer base. But UK public policy has a vital role to play, too, if change is going to come. 

A problem with bank funding

One element of the mortgage market that’s close to Origin’s heart is the funding strategy for underwriters of long-term fixed-rate mortgages. 

If you agree that a model for a basic bank looks something like, “take overnight deposits in and lend money for longer terms via mortgages,” you quickly see why banks aren’t keen to offer long-term fixed rates. There is a significant maturity transformation between their funding base (deposits, overnight) and the length of the loans (mortgages of, typically, +30 years). 

Banks mitigate this by offering long-term mortgages but then flip them from fixed to floating after a set period (e.g. 2 or 5 years). If a bank’s deposit funding shrinks, it still assumes it will be able to borrow in the wholesale markets when the fixed-rate rolls off. But banks can’t predict where interest rates will be at that time, hence the flip into a variable rate to preserve profits.

The risk to lenders 

Of course, a lender can decide to take on that maturity transformation risk, but they’ll price the fixed interest rate very high to absorb the risk of the funding mismatch. Absent any other intervention, the price for this product tends to be prohibitively steep, thus putting off consumers and killing the market.

In markets where this works (e.g. the US), there is an active wholesale market where the lender underwrites the long-term fixed-rate mortgage (at a yield of, say, 5%), and can then sell that mortgage in the capital markets to an investor (at a yield of, say, 4.9%). This way the lender isn’t taking maturity transformation risk and the long-term fixed rate can be competitively priced.

This model seems sensible, so it’s hard to see why it isn’t more popular in the UK. However, the reason it works in the US is because of the unique way the system was structured decades ago. 

A unique solution

Amid the Depression in 1938, the US Government wanted to stimulate the housing market to help recapitalise the banking sector while also stimulating the construction industry. To do so, they created an agency to buy mortgages from banks, creating a secondary market for mortgages and stimulating lending. This agency was called the Federal National Mortgage Association, more commonly known as Fannie Mae. 

Since then, they’ve chartered other similar agencies, including a competitor with the same remit called, the Federal Home Loan Mortgage Corporate, i.e. Freddie Mac. Importantly, over the past 90 years, these agencies have benefited from an implicit (and in fact now explicit) guarantee from the US government. So essentially, what they’re doing is squeezing the spread between what the US Government and a private citizen pay for 30-year money. 

If global investors are willing to lend to the US Government by buying 30-year treasuries at 4%, they also would presumably be happy to lend to a government-guaranteed agency at 5%. If that agency can thus borrow at 5%, they can in turn buy mortgages from banks at 5.5% (including a margin to cover defaults). And if banks can offload mortgages at that price, they can offer an interest rate of 6% to a consumer. And then you see how US mortgage holders have the option of going long-term. (6% for 30y mortgages might not seem that exciting due to the current rate environment, but it’s worth highlighting that in the go-go years of the ZIRP pandemic era, 30y fixed rate mortgages hit a low of 2.8%!)

The difference in Europe

In Europe and the UK, we don’t have Government-sponsored entities buying mortgages but we do have our own set of solutions. Europe has an active covered bond market that manages to achieve a similar outcome. The regulatory landscape on the continent tips the scales in favour of covered bonds, helping to achieve a compression of the spread that trickles down to rates. 

Many European banks issue from “mortgage bank” subsidiaries (Boligkreditt in Norway, Hypotek in Sweden, Pfandbrief in Germany, etc) and covered bonds get preferential treatment when it comes to capital ratios etc, helping to suppress rates. In Denmark, due to a structure introduced all the way back in 1797, the market functions based on the “matched funding principle,” where every mortgage automatically creates a bond that is listed and sold to an investor. You can even buy your mortgage back on the open market if you want to (i.e. repay early) without an early repayment charge.

There is a covered bond and RMBS market in the UK, but it’s not as deep or liquid as Europe’s, and there isn’t the same duration, so banks can’t hedge the risk of going long. That’s why, traditionally, long-term fixed rates have been expensive, and consumers went with shorter-term alternatives. 

Policy required 

UK policy can help to ease this problem. Of course, anything that can be done to foster a more deep and liquid secondary mortgage market should be supported. There are plenty of investors looking for long duration assets (pension funds, etc), so the investor capital is there, it just needs to be supported.

Another interesting tweak that could have a pretty instant impact, is to rethink the way that loan-to-income ratios are used. 

After 2008, the Bank of England applied a rule that most mortgages must be capped at a 4.5x loan-to-income ratio. This was put in place to shore up the banking sector's resilience, meaning a mortgage buyer was robustly ‘stress tested’ against future market and interest rate moves. 

But it is a blunt instrument, especially if applied to long-term mortgages. Over the long term, the gross loan value doesn’t matter so much as the borrower’s ability to keep up with the monthly payments. In a long term fixed rate mortgage, those monthly payments are are guaranteed not to change over time. Hence, affordability is easier to determine. Far less stress testing is required and it’s one reason why Perenna claims it can offer 6x income

A long-term hope 

There are many other reasons why the UK doesn’t really have a properly functioning housing market and we can devote 1,200 words to Byzantine planning laws, a lack of housing buildings, stamp duty and inheritance tax another time.

But, by unlocking more affordable lending options, the mortgage market would, at least, be lubricated a little, and more people in the UK would be able to buy houses without taking on debt that they cannot afford. 

And that’s why we’re rooting for Perenna, and others like them, and look forward to welcoming them to the bond markets (via Origin, of course!), as and when they’re ready.