Servicers key as UK rates put pressure on pre-crisis RMBS

Last week Fitch Ratings published a report concerning asset performance deterioration in UK residential mortgage-backed securities (RMBS) originated prior to the global financial crisis (GFC).

The report referenced a persistent climb in the proportion of borrowers in pre-GFC RMBS transactions in arrears (behind on payments). These mortgage pools have been pushed into their current state by the higher interest rate environment the UK has experienced since the short-lived government of Liz Truss, and Fitch’s note will have come as little surprise to anyone following the market closely.

The mortgage market in the UK has undergone a seismic reorientation over the last two decades, resulting in even more stringent underwriting criteria and affordability regulations with bans on practices such as “self-certified income”. Of course, these developments do not apply to mortgages originated pre-2008, and there are multiple factors behind their deteriorating performance.

Pre-GFC UK mortgages are overwhelmingly on variable mortgage rates. Their fixed rate periods have long since ended, which was not a problem when they were enjoying the historically low interest rates of recent years. However, those unable to refinance – often due to the interest-only nature of the mortgage contract or simply poor affordability – have been susceptible to the payment shocks of higher interest rates over the past two years. For some borrowers, a combination of elevated monthly payments, little or no amortisation in their principal balance (given interest-only payments), and a lack resource or planning to repay at maturity create the conditions for rising arrears.

Over time these pre-GFC RMBS (and it is a very small part of the current market) have effectively experienced a negative selection of borrowers. The stronger borrowers in these pools have been able to refinance with other lenders, and as bondholders are repaid, the transactions deleverage and the structural protection strengthens. The prospects for the remaining borrowers depend heavily on the actions of the pool’s servicer.

As a result, we regard due diligence on servicers as vital and we meet with them frequently to assess their rigour. For example, as more borrowers approach their legal final maturity dates, we would expect lenders to proactively contact borrowers and be able to detail exit plans. Servicers that have maintained relationships and are able to engage with borrowers are often able to achieve a higher value for the property in the case of foreclosure, boosting the funds available to bondholders in RMBS transactions.

Performance transparency on pre-GFC deals has improved a lot in recent years, but not for all platforms. At the same time, we appreciate that leverage in a lot of these legacy UK RMBS is incredibly low. In addition, many borrowers have benefited from low rates, increasing house prices and significant wage growth. However, it is clear from the data that the most vulnerable borrowers are now struggling, and servicers will have their hands full in supporting these borrowers.

When interest rates first began to rise and borrowers were facing a maturity wall, we modelled this scenario and the result showed essentially what is happening now; with interest rates remaining elevated, we see evidence that payment rates are falling, and the prospect of refinancing is becoming more remote for some borrowers. As this is now such a small part of the UK RMBS market, liquidity isn’t great in many of the legacy shelves, and while we think credit problems are unlikely, we have sold a fair amount of the little exposure we had left. As we approach the final maturities of these mortgages, transactions supported by a transparent and strong servicer could prove interesting, although the dispersion in outcomes between transactions will be significant. These pools have existed for many years, and though shielded by low interest rates for a prolonged period, the fundamentals have been clear, and their current performance is unsurprisingly deteriorating.

Given the limited upside we see in pre-GFC UK RMBS, we prefer the liquidity, data quality and regulated lending of more recent transactions.