RMBS offer cheapest post-Lehman funding Tainted by association with the financial crisis and out of favour with regulators, Europe's market in mortgage-linked securities has found few buyers since 2008. But since July prices of residential mortgage-backed securities (RMBS) have been rising rapidly. The securities, which offer regular interest payments backed by cash flow from mortgage repayments, have been swept up in investors" "hunt for yield." As a result European banks can now fund their mortgage lending more cheaply through the securitisation market than at any time since before Lehman's collapse. Now debt investors are asking how far the rally can run and economists whether lower yields can revive Europe's moribund securitisation industry and translate into more lending by banks. "Theoretically at least, banks should eventually pass on lower market funding costs to borrowers," says Gordon Kerr, credit strategist at Citigroup. By bundling home loans into RMBS and selling them to investors, banks free space on their balance sheets to lend more. The lower the yield on RMBS in secondary markets, the lower the interest rate banks have to offer investors to buy new securities, reducing bank funding costs and raising the prospect of lower mortgage rates. Such a virtuous circle broke down in the financial crisis when RMBS investors feared heavy losses from rising mortgage default rates. Secondary market spreads widened appreciably and the European Central Bank toughened its stance towards the industry. But the banking industry has since launched a new European kitemark in an effort to revive the reputation of asset-backed securities, while new ECB rules have improved disclosure. There are signs, too, that easing conditions in credit markets are now being transmitted to borrowers. In late August the UK arm of Santander sold €650m of two year RMBS to investors at a spread of just 75 basis points over the benchmark Euribor lending rate. That was the cheapest mortgage securitisation by a UK bank in more than four years, according to Concept ABS, an industry data provider. Two weeks later Santander cut many mortgage interest rates by 0.35 percentage points. Since then the secondary market has rallied further, sending yields, which move inversely to prices, lower. In early September five year RMBS issued by the Dutch lender Rabobank at 125bp over Euribor traded down to a spread of just 100bp within days, suggesting that banks could issue even more cheaply. Such deals, though, are still the exception rather than the rule. Issuance of securitised mortgaged debt to investors has been anaemic for much of this year. Less than €42bn of European RMBS has been issued to investors, according to Citigroup research, and this year is set to be the weakest for public issuance since 2009, when the market was still reeling from the financial crisis. "We've been quite surprised that more banks haven't taken advantage of the low yields to issue," says Patrick Janssen, credit fund manager at M&G, an asset manager. There is robust demand and the market can absorb a steady stream of issuance. One reason for banks" reluctance to issue is that central banks are providing an attractive alternative. In June the ECB began accepting BBB-rated RMBS as collateral from banks seeking short-term funds. A month later the Bank of England launched its Funding for Lending scheme, which encourages British lenders to park RMBS at the bank in return for cheap cash. More than 70 per cent of European mortgage securitisations this year have been retained by banks, generally for use in central bank swaps, rather than issued to investors. Some investors believe the lack of new supply from banks to the secondary market has exerted further downward pressure on secondary market yields. "Clearly the ECB and the UK government are doing what they think they have to do for the wider economy," says Edward Panek at Henderson, an asset manager. But would I prefer to see more securities being issued? Absolutely. And would it mean that spreads would be somewhat wider? Yes, probably. The attraction of central banks" swaps for European mortgage lenders is clear. Even at four-year lows, the 530bp spread over Euribor investors require to hold A-rated Spanish RMBS is relatively high. For UK banks with AAA-rated prime RMBS securities the Funding for Lending scheme still offers a 25-30bp saving, according to Nomura calculations. Analysts warn that unless banks wean themselves off central bank funding and return to public markets, they are unlikely to pass savings on to investors.