We noted with interest two headlines yesterday:
Italy to suspend mortgage payments amid outbreak
RBS and NatWest offer mortgage breaks for customers affected by coronavirus
These sound like similar messages, and at first glance do not appear to spell good news for investors in Residential Mortgage-Backed Securities (RMBS) that might be backed by such mortgages, as the principal and interest payments on the bonds are solely backed by the payments the borrowers in the mortgage pool are making. If the borrowers are allowed to stop paying, what will happen to bondholders?
As always the key thing here is the detail, and specifically to see what here is an actual change to current circumstances. Let’s start with Italy.
In 2007 the Italian government established a scheme to assist mortgage borrowers who were in distress. The scheme allows borrowers to ask for instalments suspension under specific circumstances that could have an impact on their overall income level. It applies only to first lien mortgages and you have to be on a low income, have a mortgage under €250k and be in an early stage of arrears to qualify (i.e. not a historic, long-term case). Borrowers can only qualify if they are unemployed or suffer a sudden physical injury.
The new decree has extended the use of the fund to borrowers who experienced temporary reduced working hours or total suspension for at least 30 days due to the coronavirus outbreak across the country, but importantly the requirements regarding income, historic performance and loan size are all still there. If borrowers qualify then the fund pays their lender the interest payments.
This is a pro-active measure where the government is footing the bill to help what ultimately should prove to be a relatively restricted sub-set of borrowers. This should not be a risk for RMBS investors. We anticipate a significant increase to the size of this fund in the next day or so.
What about RBS and Natwest?
This is different, first of all because it is a lender making the announcement rather than a policy imposed on them by government. This means that if there was anything that materially disadvantaged bondholders, then there would likely be a challenge, and RBS Group would very likely be focused on not creating a negative situation for their bondholders given their reliance on capital markets funding. However, we know from experience that banks can at times do these sorts of things. Could this be one of those cases?
Essentially, RBS is saying that it will look to help mortgage borrowers in stress as a result of the virus. This would be a concern if it was a material change to the servicing standards, which could become a point under which bondholders could challenge the servicer’s behaviour. However, allowing a degree of forbearance for borrowers (typically up to three months) and allowing payment holidays (which could potentially be a contractual element of the mortgage anyway) are standard features in UK mortgage servicing and structuring, respectively. So while this sounds like a very ‘ESG friendly’ announcement from RBS, this is exactly what we would expect them to be doing, and in fact they are required to do under current regulation protecting consumers. You may recall that the treatment banks gave their borrowers was discussed heavily during the global financial crisis, so this is not a new issue, but given the remarkably strong performance of mortgage borrowers in the UK in the interim, it is one that has not typically garnered many headlines in the meantime.
As RMBS investors we can extrapolate the impact of such measures in the modelling of our own holdings, and in stress testing we can increase the impact of arrears and defaults to the point where each tranche of bonds would hypothetically suffer a loss. We have been very comfortable with the results.
In addition, it is probably worth bearing in mind that while there is around €4bn of publicly placed Italian RMBS deals in the market, the current equivalent number outstanding for RBS Group is zero.
We have felt that there is little value in Italian RMBS for a while, on the basis that the European Central Bank has been actively buying the sector for many years, which has had the effect of heavily compressing yields and making the bonds unattractive on a relative value basis versus the rest of the opportunity set in European ABS.