S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Below, we detail the key challenges that European asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) could face in the short and long term as a result of the spread of COVID-19.

Collateral Performance

We expect that the current public health emergency could cause a sudden increase in delinquencies for collateral pools backing European ABS and RMBS, which could be severe in some sub-sectors. This could occur both as a result of some borrowers' inability to pay their installments in full--given interruptions to many business activities and employment--or government-mandated forbearance measures adopted by lenders. However, most ABS and RMBS transactions contain structural features that cover short- and medium-term liquidity stress. The tables below indicate the median number of coupon payments that European RMBS and ABS transactions can cover by sector. In addition, many transactions allow principal receipts to pay interest, which would benefit senior notes at the expense of junior notes, during a more prolonged disruption.

Table 1

Table 2

In the longer term, however, the potential effects on European ABS and RMBS ratings are not yet clear, given downside risks in the macroeconomic outlook. In our view, the Eurozone and U.K economies will likely enter recession in 2020, before returning to growth in excess of 3.0% and 3.8%, respectively, in 2021. We expect unemployment to peak in 2020 before returning to 2019 levels in 2022 (see "Related Research"). Based on this assessment, we anticipate performance related rating changes, if any, to be limited to non-investment-grade rating categories.

Recovery timings remain uncertain

Policy responses that could affect repossession of residential property differ country by country. However, we expect recovery timings for all countries to lengthen irrespective of whether there are government sponsored moratoriums on repossession. Additionally, the lockdowns that are in place across Europe present various practical barriers to enforcing and liquidating security. For example, the ability to value property is limited in countries where there are no automated valuation models, and the ability to auction or sell property by private treaty will be compromised. Similarly, in the case of vehicles, with dealerships being closed returning cars might not be possible, and other ways of repossessing cars might not be executable. In addition, court closures are likely to create a backlog that will endure after the lockdowns end.

Will call options be exercised?

We consider the risk of non-call to have increased substantially. The Bank of England has re-launched the Term Funding Scheme, which may allow banks to obtain liquidity against assets such as mortgage loans. Our current understanding is that non-bank lenders cannot access the scheme directly and their securitizations are therefore at higher risk of non-call than those transactions originated by banks. In our rating analysis we assume the call option is not exercised.

All Transactions Will Exhibit Stress, To Varying Degrees

Collateral performance will likely differ by country, depending on both the scale of the local response to containing COVID-19 and the related response to financially support borrowers who find themselves struggling to make debt payments. For example, the U.K. has introduced deferral of tax payments for certain corporate entities and government schemes to pay 80% of salaries of those affected by the disease. Similar measures have been or will likely be announced across Europe.

Generally, we anticipate that government-led forbearance initiatives will include eligibility criteria to ensure that only those borrowers with a demonstrated need for assistance will benefit. The details and practicalities of such schemes are likely to differ by country, and are still being worked through in many cases. However, getting cash to affected borrowers quickly is imperative to avoid a spike in arrears. Currently, most schemes are set to be in place for three months. It is therefore difficult to predict how many borrowers will qualify for forbearance, for how long, and what the likely take-up rate will be across different jurisdictions.

As noted above, regardless of jurisdiction, most ABS and RMBS transactions contain structural features that cover short-term liquidity stress. However, other structural features for RMBS transactions differ from country to country. There are two generic structures for principal and interest waterfalls, for example: separate and combined. The former document the treatment of interest and principal collections in two independent waterfalls, while the latter do not differentiate between the types of collections and only have a single waterfall. Neither of these two structure types is consistently better placed to deal with liquidity stresses. Ultimately, the specification of triggers that allow principal collections to pay note interest and vice versa will determine the effect on ratings on a transaction by transaction basis.

For seasoned transactions, reserve funds and liquidity provisions were often sized in a higher interest rate environment and in many cases do not amortize following trigger breaches. Recent cuts to central bank policy rates and the likelihood that monetary policy will remain loose for the extent of the COVID-19 crisis are also generally supportive of collateral performance for borrowers on variable rates. Additionally, a number of U.K. lenders have cut their standard variable rates.

We view all European mortgage markets relevant for RMBS as "recourse-based", where borrowers are potentially liable for any loss on the sale of a repossessed property. They are therefore generally incentivized to maintain payments on mortgage contracts and have a reasonably strong willingness to pay. However, we consider that some subsectors of the European RMBS market have more exposure to borrowers with compromised ability to pay and therefore these transactions are likely to exhibit sharp increases in delinquency.

Transactions backed by collateral where there is already evidence of weak performance are at risk of further performance deterioration, including certain legacy U.K. nonconforming RMBS transactions. In 2019, our analysis of these transactions revealed that approximately 25% of legacy U.K nonconforming borrowers had been in arrears at some point in the previous two years, implying that they had little ability to cope with further financial stress. Likewise, we expect poorly performing legacy transactions in southern Europe to show higher sensitivity to a rise in unemployment or underemployment.

The case of buy-to-let RMBS transactions

We expect renters to be affected by potential increases in unemployment, which could in turn flow through to spikes in delinquencies among landlords who are mortgage borrowers backing buy-to-let RMBS transactions, mostly in the U.K.

The U.K.'s "receiver of rent" concept will be less effective in managing delinquent borrowers as underlying rental flows could be disrupted and the costs associated with appointing a receiver of rent may render the appointment of little value. Additionally, tenant forbearance will limit a landlord's ability to evict and replace tenants. Buy-to-let collateral in the U.K. will benefit from similar payment holidays as owner-occupied collateral. Higher-yielding HMO properties and portfolio landlords may benefit from tenant diversification, where overall rental income received is sufficient to pay mortgage commitments at a portfolio level.

Consumer Lending Versus Commercial Borrowers

We expect a differentiation in credit performance between transactions backed by consumer lending and those backed by commercial borrowers. The former typically include RMBS and consumer-related ABS, such as auto and credit card transactions. The latter include equipment ABS transactions, for example.

We expect stimulus measures taken by various governments to support consumers. For example, the above-mentioned U.K. government's offer to pay 80% of salaries will help limit the immediate effect on borrowers' ability to service debt in the short term. Although various governments are also contemplating support schemes for some commercial borrowers, the impact on shoring up credit quality could be less direct.

ABS transactions typically have much lower weighted-average lives than RMBS transactions, resulting in a relatively fast built-up of relative credit enhancement, further protecting strongly performing legacy transactions. For ABS transactions backed by commercial borrowers, we see a likely differentiation by industry, as certain sectors have so far been hit more directly than others, including leisure and lodging, retail and restaurants, and transportation. Transactions with higher exposure to these sectors are therefore at greater risk.

Servicer reporting of COVID-19 related forbearance

The general response from originators and servicers is that any COVID-19 related forbearance will not be classified as a delinquency. Although it will not affect a borrower's credit score, not being classified as a delinquency means that it may not be reported as such in investor reports. Consequently, the scale of forbearance may not be transparent. Additionally, COVID-19 related delinquencies might not be considered when assessing whether transaction triggers have been breached.

Counterparty Risks

Our approach to counterparty-related risk anticipates that transaction counterparties agree on day 1 to certain remedial actions in the event that we downgrade them beneath a certain trigger level. These remedial actions differ depending on the role of the counterparty--for example, whether they are a bank account or derivative provider--the issuer credit rating on the counterparty, and the ratings on the supported securitization obligation. In general, to the extent remedial actions are followed and in accordance with our counterparty criteria, then rating migration owing to any heighted counterparty risk should be mitigated.

Operational Risks

As highlighted above, we anticipate an increase in delinquencies across European ABS and RMBS transactions as a result of governments' responses to slow the COVID-19 outbreak. This could put pressure on servicers, especially given that their own operations may have been simultaneously disrupted.

Historically, servicers' disaster recovery plans have focused on ensuring continuity at a separate site rather than their inability to access a given site. The preparedness to deal with any delinquency spike will inevitably differ from servicer to servicer based on their operational capabilities and the nature of the collateral that they are servicing. Some servicers have recently moved to cloud-based technology, which should make it easier to facilitate remote working at those entities.

Collateral will require more intensive servicing where delinquency rates increase more significantly. Collection agents at servicers will need to be able to fulfill their roles with minimal disruption. We do not anticipate the ability to fulfill these roles remotely to be universal across Europe and active management of cases in arrears may lapse. This in turn will lead to delays in arrears resolution. That said, relative to other geographies, payment by direct debit in Europe is the norm, and requires little operational capacity to process.

In addition, operational procedures to transfer funds from collection accounts to securitization issuers may be disrupted, which could require solutions to ensure an operational ability to make timely payments on securitization liabilities. 

Finally, staff at administrative transaction parties, such as paying agents and trustees, will also need to work and access data remotely. We are not currently aware of any limitations with these administrative key transaction parties, which could result in potential payment disruption. We will continue to monitor the situation as it develops.

More fundamentally, restrictions that limit 'business as usual', such as mandated work from home initiatives, might disrupt established workflows and the ability to reconcile financial information, which could in turn lead to reporting errors.

Related Research

• Coronavirus Impact: Key Takeaways From Our Articles, March 27, 2020
• COVID-19: The Steepening Cost To The Eurozone And U.K. Economies, March 26, 2020
• European Corporate Securitizations: Assessing The Credit Effects Of COVID-19, March 26, 2020
• European CLOs: Assessing The Credit Effects Of COVID-19, March 25, 2020
• Global Covered Bonds: Assessing The Credit Effects Of COVID-19, March 25, 2020
• European CMBS: Assessing The Credit Effects Of COVID-19, March 24, 2020
• COVID-19 Macroeconomic Update: The Global Recession Is Here And Now, March 17, 2020
• COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure, March 17, 2020
• Credit FAQ: Will Mortgage Payment Suspensions Related To COVID-19 Affect European RMBS?, March 13, 2020
• U.K. RMBS 2.0 Origination And Structural Evolution Combine To Reduce Credit And Reinvestment Risk, Jan. 7, 2019
• U.K. Nonconforming RMBS: One In Four Borrowers Are Just About Managing To Make Their Monthly Payments, June 3, 2019