Beyond The Subprime Crisis: Decrypting the European and US RMBS Markets

The tightening of monetary policy has given rise to concerns about the health of mortgage markets due to higher interest rates and corresponding corrections to house prices, while asking questions about the expected resilience of residential mortgage backed securities (RMBS), echoing the subprime mortgages crisis in the US during the Global Financial Crisis (GFC). Regulations have played an important role in strengthening both US and European markets since the GFC and while we think both markets should be regarded as high quality and liquid, there are important structural differences between European and US RMBS. We highlight below the different dynamics of the two markets, from the underlying collateral and lending practices to the structural features and important market technicals. 

Our preference leans towards the European product, recognised by its remarkable historical resilience, strong risk retention and full recourse to the borrowers, while having an ability to offer a stable income to investors. The most obvious of these is the European RMBS market which is the largest floating rate market on the continent, offering a hedge against rates volatility, while contrasting with the predominantly fixed rate US RMBS market. In fact, US Agency RMBS has returned 0.1%  compared to 4.5% for UK Prime RMBS YTD at the end of November 2023.

The landscape of RMBS in the US and Europe presents important contrasts, particularly in terms of originators and lending practices. The Dodd-Frank Act introduced by the US in 2014 reshaped the mortgage market, introducing stricter lending standards, in particular regarding an originator’s requirement to demonstrate the ability-to-repay of borrowers. The spectrum of RMBS originators ranges from large national banks to small lenders, resulting in varying applications of the Dodd-Frank Act and leading to different lending guidelines across states. Meanwhile the European RMBS market is served by both traditional banks and non-bank lenders, where European regulations have played an important role in creating a uniform and consistent lending environment across European countries. The quality of lending in Europe led to smaller oscillations in performance, however excesses that were creeping in during the lead up to the GFC were also eradicated, an example being the Mortgage Market Review introduced by the UK in 2014 where amongst other improvements, affordability stresses and documentary evidence requirements were introduced.

Longer term fixed mortgages (typically 30 years) are dominant in the US, while there is a mixture of conventions across European countries. For example, the UK market is dominated with 2- and 5-year fixed rate mortgages after which most will refinance into another fixed rate product with a minority reverting to a floating rate, while France and the Netherlands are typified by longer term fixed rate mortgages. 

Loan-to-value ratios are conservative in both jurisdictions; however, in Europe 60-80% LTVs are typical for mortgages originated post Global Financial Crisis. While the US has an established prime jumbo product with high LTV, the average LTV has declined significantly compared to pre-GFC mortgage origination to around 70%-75% for non-agency RMBS and tend to be higher for agency RMBS at circa 80-85%. Historically, the greatest predictor of default risk has been LTV with homeowner equity being the greatest incentive to maintain payments.

European lenders conduct thorough mortgage affordability tests evaluating borrowers' capabilities to sustain payments under high interest rates. This is further reinforced by the implementation of caps on loan-to-income ratios and an affordability analysis consisting of a full assessment of expenditure and income of the borrowers. This prudent approach is complimented by the ‘recourse’ nature of European loans, enabling lenders to claim other assets of defaulting borrowers in the event of a shortfall once the secured property has been disposed. In our view, this remains an important differentiation and plays a role in influencing the behaviour of borrowers who fall into hard times. 

The US lending practice on the other hand focuses on a borrower’s FICO score, a strong measure of credit worthiness, and uses a debt-to-income ratio as a measure of overall indebtedness of borrowers, while being supported by income verification. The origination of mortgages with a FICO score above 760 (perceived as excellent quality) has increased from 25% pre GFC to more than 60%, suggesting a strong improvement in the quality of US mortgage lending. Subprime mortgages originated pre GFC would have been generally mortgages with low FICO scores (around 620 on average), self-verified income and high LTV among certain characteristics of subprime lending, a product that has ceased to exist after 2008. Meanwhile, since 2017 there has been an expansion of more specialised mortgage lending to those that fall outside conventional guidelines, typically due to a lack of standard documentation or because borrowers have experienced a historic credit event for example, representing non-qualified mortgages (non-QM), one segment of the non-agency RMBS market.

A significant differentiator in the European market is the absence of a government owned or sponsored entity (GSE) akin to the US agency RMBS. The US agency RMBS market, while materially mitigating default risks through government guarantees, is exposed to prepayment risks as borrowers have the ability to prepay with no penalty fees, hence US agency RMBS exhibits negative convexity. European Prime RMBS, comparable to US agency RMBS in terms of collateral are not exposed to this extension risk and are typically shorter 3-5 year bullet-like instruments with optional call dates. Non-prime European RMBS (most closely resembling non-agency US RMBS) are callable and use similar structural features with subordination as a key protection for bondholders. Subordination for AAAs tend to be very high in the US and higher than in Europe, driven by rating agencies’ requirements penalising for negative historical performance, which is not necessary to the same extent in Europe. The European RMBS tend to have strong incentives to call driven by increase in bond coupons if the deal is not called, while these features tend to be weaker in the US (lower cost of funding applying typically only one year after the call date).  

Regulations also play an important part, the EU risk retention regulations, in place since 2011, mandates issuers to retain a minimum of 5% of the transaction for its life, aligning interests with bondholders and promoting ‘skin in the game’ —a commitment introduced in 2014 but less pronounced in the US market. For US RMBS, the 5% risk retention requirement from the sponsor expires on the later of 5 years or the date at which the pool factor is 25% of its original balance (capped at 7 years). In Europe the introduction of STS (Simple, Transparent, and Standardized) transactions further underscores the emphasis on transparency and high-quality lending practices, an aspect not legislated to the same extent in the US. However, disclosures of investor reports and loan level data tape are market standards in both jurisdictions. 

The US market consists mostly of agency RMBS, representing approx. $8.6trn, and being one of the largest and most liquid fixed income markets in the US, where the Fed has historically been the largest buyer through the futures market where the vast majority of agency RMBS trading occurs. The non-agency RMBS market accounts for ~$0.6trn and includes non-qualified mortgages (non QM), prime jumbo and credit risk transfers from GSEs. The European RMBS market is a lot smaller and accounts for ~€125bn, spanning a range of prime, non conforming and buy to let collateral, with the UK and the Netherlands being the two largest jurisdictions. Whilst the European market is a lot smaller, we have seen the start of a resurgence in 2023 as banks need fresh term funding following a decade of central bank support. The investor base is broad and the level of liquidity we saw during the UK LDI crisis in Q4 2022 helped to dispel any historic myths that have tended to linger around the asset class. Agency RMBS spreads have been impacted by a negative technical from the Fed’s quantitative tightening, actively shrinking its balance sheet of $2.45trn of MBS holdings by $35bn per month, but also from the prepayment risk that characterises this product - the higher interest environment has driven lower prepayments from mortgage borrowers and therefore extending the duration of agency RMBS. This is a key difference in how RMBS is used within portfolios. We typically see European RMBS used as a low risk duration management tool in an asset mix for example. To illustrate this, US agency and UK prime RMBS spreads have historically tracked each other, but US agency spreads have been trading wider recently to 54bps over treasuries compared to 43bps over SONIA for UK prime RMBS.

During the GFC, the European RMBS market demonstrated extraordinary resilience, with significantly lower losses compared to the US. Fitch reports a peak of realised losses at 0.1% for EMEA RMBS while the peak of realised losses reached 13% for North America RMBS, for 2007 vintages. 

While the US lending practices have tightened significantly, we view the standardised full recourse as one of the main reason for the outperformance in Europe. Moreover, we have confidence in European RMBS thanks to the conservative lending practices in Europe, with an established regulatory framework and structural protections in place and in our view therefore offering an attractive risk return profile to investors.