UK residential property market offers opportunity for hedge funds

Net lending shows a similarly bleak picture. It is generally forecast that this year will record a negative net lending figure in the region of £25 billion. Banks and financial institutions exposed to mortgage assets have written off nearly $3 trillion in 18 months. It is the stuff of financial nightmares.

For some the state of the mortgage market in Britain presents an opportunity. Where there are storm clouds, there is often a silver lining. In the case of UK mortgage assets, the maxim stands true. While secondary mortgage funding lines are still demonstrably closed, investment in existing mortgage assets can provide a fairly flexible internal rate of return (IRR) for funds with cash to invest.

A lot of funds realise there is money to be made from distressed portfolios of residential mortgages. Non-performing loans often look more interesting because there is a shorter time frame to getting money back.

Despite falling house prices and the discount repossessed properties usually incur, if assets are purchased with a sufficient concession to market value, investors stand to make a very reasonable return.

There is now the means to reap a similar and sometimes improved rate of return from performing assets. Historically, it has been impossible to justify the IRR on investment in prime or performing mortgage asset.

The lifetime of the asset is measured in years, making it of little use as a source of income for hedge funds. However, the turn in the mortgage market has changed the investment dynamic on these assets.

Banks and other financial institutions wanting to divest themselves of responsibility for servicing such assets in unfavourable market conditions are putting them up for sale at a discount. The mark to market value of even performing residential mortgage assets is significantly below par.

UK housing market fundamentals continue to decline.  House prices have dropped 17.7% in the past 12 months according to Halifax. . Even with its 1.2% increase in May, house prices are still well down on a year ago and look likely to deteriorate further.

The Confederation of British Industry delivered a gloomy outlook forecast for unemployment and revised sharply downwards earlier forecasts made in September 2008. It predicts the recession will run for most of 2009 and that unemployment will peak at close to 2.9 million.

Official Office of National Statistics figures released in mid-May showed unemployment had already risen to 2.2 million. With the numbers still showing deterioration in the UK economy, there is pressure on owners of mortgage assets wishing to sell to continue to offer at prices well below par.

The result has been increasing appetite for performing mortgage assets on a commercial scale. Because this category of loan is less prone to arrears the time frame for getting your money back looks less attractive.

For this reason companies have been developing new ways of raising capital from performing mortgage assets by encouraging borrowers to refinance. If this problem can be cracked, there is a completely new dynamic in play that effectively changes potential returns significantly.

In the current economic climate, borrowers are not remortgaging. The Council of Mortgage Lenders recently noted in a market statement that, "much of the recent mortgage lending weakness can also be attributed to low levels of remortgaging activity.

Attractive reversion rates, associated with historically low interest rates, reduce the incentive to remortgage when borrowers reach the end of tie-in periods, while lower house prices mean that some borrowers will not meet lenders' more conservative loan to value criteria, and so will not be able to remortgage away."

In order to recover value via early repayment from borrowers, mortgage asset holders have to offer a financial incentive.

Challenges
The challenge is turning illiquid performing mortgage assets into liquid, tradable assets. It sounds like a hard graft but it is a fairly straightforward process. By assessing the underlying assets in a mortgage book, ascertaining credit quality and borrowers' ability to pay, investors can discern the optimum cash value to award individual borrowers to enable them to remortgage with another lender.

Because the original asset was purchased at below market value, even the additional cost of offering borrower remortgage incentives does not preclude a significant IRR.

For example, an investor buys a mortgage asset for 50p in the pound. Performing credit assessment on the asset, it is possible to ascertain optimum cash incentives which will vary by borrower. If the investor fund offers individual borrowers an average 20% discount on the mortgage to take it elsewhere, they have recovered 80p in the pound from the asset.

It is not unrealistic to expect a 60% return on the original investment, deliverable over a three to six month period.

Investment by funds in mortgage asset is a growing trend - prices are still at rock bottom and interest is hotting up. By that standard, and as indicators show, there may be signs of tentative improvement in the residential property market, the opportunity to reap reward using this type of strategy is now.