In the next 12 months, 31 European RMBS transactions have a call date on which the issuer may exercise their call options (see chart 1). Among these, there are 19 U.K. transactions that were issued between 2015 and 2018, which include legacy and recently originated loans from specialized/buy-to-let lenders (see appendix section for the full list of transactions).

With these transactions' call dates approaching, S&P Global Ratings looks at call holders' ability and incentives to exercise the option. We also compare transactions' weighted-average margins at closing with their current weighted-average margins to show how the present economic conditions may reduce incentives to use the call option. Incentives have weakened considerably, in our view, especially for nonbank lenders (see "U.K. RMBS Refinance Risk Is All About The Call," published on June 3, 2019).

A call option in a bond gives the holder the ability to repurchase the assets from a securitization at a defined point in the future for a predefined amount, and in doing so, repay the investors at par, including any accrued interest. The call date is typically set at about three or five years after the transaction closes. At the call date, the note margins typically "step up" to a higher level, which usually acts as a strong incentive for originators to call their outstanding transactions to avoid higher funding costs.

Broadly speaking, a call option will be exercised when the optionholder has both the ability and the willingness to do so. The willingness will generally exist when the primary market offers funding costs that are advantageous relative to the cost of funds on the existing transaction, while the ability to call exists when there are funding sources available. To some degree, the ability and willingness are linked.

Chart 1

We assumed that legacy transactions would not be called for several reasons. Firstly, it may not make economic sense to exercise the call if the step-up margin is lower than the margin would hypothetically be on a new transaction, should the originator/issuer call the existing transaction and refinance. Secondly, the originator/issuer may no longer exist, e.g. in the case of Lehman-sponsored transactions. Last but not least, issuers would have had plenty of time by now to do so since the first call date (in most cases close to a decade ago) and we think that there is therefore no reason why they would exercise their call now.

COVID-19 Credit Distress Could Delay The Exercise Of The Call

COVID-19 has adversely affected both the willingness and ability to exercise calls: the public primary RMBS market has contracted and funding sources--especially for nonbank lenders--have become scarce. In the European asset-backed securities (ABS) space, this recently led a point of sale lender to delay the exercise of its call option by one year to next April, while in RMBS an asset manager announced that the refinancing of its U.K. RMBS in May will be challenging.

We calculated the weighted-average margin (over the index) at closing for each of the 19 U.K. RMBS transactions and estimated the current weighted-average margin based on the capital structure as of the current payment date (see chart 2).

Chart 2

The weighted-average margin payable for a given transaction will change over time, for two reasons. First, as most transactions pay sequentially, lower-cost funding is repaid sooner, resulting in a higher overall average. Second, the transaction may not call, causing the note margins to step up.

The degree and effect of deleveraging will depend on the underlying assets' prepayment and repayment rates, and pools with higher rates show greater variation in weighted-average margin from the closing date. In other words, the higher the range between the senior and the junior classes of notes, the higher the margin on the junior tranche, the higher the constant prepayment rate, or the higher the weight of the senior tranche at closing, the greater the incentive to call. Logically, buy-to-let transactions, which tend to be backed by exclusively interest-only loans, will have a low differential between the current and initial margin.

The estimated current weighted-average margin for our sample of 19 U.K. transactions is 1.47% on average. After the step-up margin, we calculate the estimated weighted-average margin to be 2.27%, compared to an initial weighted-average margin of 1.19%.

In addition, we witness a clear change in incentives by comparing our current hypothetical weighted-average margin (this is not intended to represent an estimate of current market spreads) with that prevailing a year ago. It has almost doubled over this period as a sign that the environment has clearly become less favorable.

In continental Europe, 12 callable RMBS bonds have a call date in the next 12 months, primarily in The Netherlands (see table 4 for the full list of continental European RMBS transactions). In our view, these transactions are more likely to be called as most originators are banks with deeper pockets than nonbank originators.

Calling a transaction is all about optimizing the capital structure

As transactions deleverage, the increase in credit enhancement, and tranches' overall de-risking may result in ratings on what was initially mezzanine debt being raised. For example, table 1 shows a stylized U.K. RMBS transaction's six-tranche capital structure. The class D notes may have been initially rated 'BBB' as the fourth-most senior tranche, but now as the most-senior tranche, they are rated 'AAA'. However, as pricing liabilities is a one-time event, and presuming there is no movement in market overall spreads, the class D notes in this example are now receiving a margin associated with 'BBB' risk for what was 'AAA' risk.

Table 1 compares a scenario in which existing transactions are retranched, meaning the liability structure is restructured, achieving a capital structure equivalent to that when the transaction closed (with the same level of credit enhancement at closing). In this example, we assume the following hypothetical margins. In a period of stress, the usual flight-to-quality from investors may result in higher expectations in terms of level of subordination and/or step-up margin (especially at the mezzanine and junior level), in our view. As recent capital structures are merely a guide, there is an element of uncertainty to what the capital structure might look like.

Table 1

Bank of England Monetary Policy May Tier Originators Between Banks And Nonbank Lenders

In just over a week in the first half of March 2020, the Bank of England announced several significant monetary policy decisions. First, there were two cuts in interest rates to a 325-year low of 0.1%, followed by the restart of its quantitative easing program (with additional bond purchases of £200 billion). More importantly, the Term Funding Scheme was restarted with additional incentives for small and midsize enterprises (TFSME).

The TFSME will offer over the next 12 months four-year loans at an interest rate close to or at the base rate for an equivalent of 10% of the participants' lending to the real economy. This may have a dampening effect on new issuance as banks tapping this scheme may refinance both their maturing TFS loans and their callable bonds, including RMBS. The only silver lining is that U.K. RMBS is classified as 'collateral C' and could qualify as eligible collateral for the scheme.

One important feature is that the various monetary policy schemes are open to banks and building societies only, excluding specialist lenders. Nonbank lenders have raised their concerns to the government and the Bank of England asking for emergency funding as they may struggle to access the wholesale funding markets or take out their warehouse facilities. Thus, exercising the option on their callable bonds may not be their top priority unless they deem the reputational damage outweighs the cost of such an exercise, in our view. Investors will remember the non-exercise of the call and may request more investor-friendly terms once the issuer decides to come back to the market with a callable bond in the future, in our view.

Structural features designed to mitigate against the non-exercise of call will become less effective

RMBS transactions deal with the scenario of a non-exercise of the call option using different structural features. The table below details some of the techniques used either individually or in combination with others and summarizes their potential effectiveness.

Table 2

Our Analytical Approach Assumes No Call

The examples we presented in this article provide a broad directional analysis of the topic. There are certain factors we have not considered, including the cost of refinancing a transaction into a new securitization vehicle, the cash credit enhancement, or the benchmark interest rate movements. Finally, it may not be possible to restructure transactions to match their initial capital structure, and the increase in spreads may also alter the capital structure. This is especially true in periods of high volatility and uncertainty such as the one we are currently experiencing.

Because there is no guarantee that a transaction will call, as part of our rating analysis, we assume call options are not honored.

Call options are typically exercisable quarterly from the first call date, i.e., an issuer facing liquidity issues on the call date may well have sufficient funds six months later and exercise the option then. In other words, the call might be delayed rather than not happen at all.

Appendix

Our universe of transactions comprises European RMBS transactions issued post crisis with at least one callable class of notes from second-quarter 2020 through first-quarter 2021, and one step-up coupon.

Table 3

Table 4

Related Research

• European ABS And RMBS: Assessing The Credit Effects Of COVID-19, March 30, 2020
• COVID-19: The Steepening Cost To The Eurozone And U.K. Economies, March 26, 2020
• U.K. RMBS Refinance Risk Is All About The Call, June 3, 2019