The pandemic's path remains uncertain, as Europe is now learning. This could mean more upheaval for Japan in the future, and possibly pressure the performance of securitizations in the country, if the COVID-19 infection rate rises. Job losses among obligors, in particular, could push up delinquencies and defaults as borrowers struggle with repayments.

S&P Global Ratings believes a deterioration of delinquency and default rates of underlying loans may affect the ratings on existing residential mortgage-backed securities (RMBS) transactions in Japan. Meanwhile, differences in repayment methods and progress in repayments are factors producing variations in pandemic impact between transactions.

This analysis focuses on the pandemic's impact through an examination of potential changes in default rates and real estate prices. We look at how larger deteriorations than we currently see would affect existing RMBS transactions in Japan in a scenario analysis.

RMBS Performance Developments

Negative GDP growth and an only marginal increase in unemployment are likely in 2020.   We forecast -5.4% real GDP growth for Japan in 2020, in part because of the impact of the pandemic. The unemployment rate, which strongly correlates with defaults and delinquencies of the loans underlying RMBS transactions, will in our view deteriorate to 2.7%. However, this limited deterioration in the rate is likely to be short-lived and we expect the unemployment situation to improve moderately from 2021 (see "Credit Conditions Asia-Pacific: Recovery Roads Diverge," published Sept. 29, 2020). Meanwhile, we continue to closely monitor the increase in the number of jobless, especially among nonpermanent staff, many of whom have had contracts terminated.

Table 1

No material changes so far in the performance of existing transactions.  We have not observed material changes so far in the performance of RMBS transactions we rate. Recently, we have seen higher delinquency rates in some transactions, but within historical ranges of volatility. Many lending institutions have launched consultation helpdesks for obligors struggling with repayments and hope to revise the terms and conditions of their loans. This is likely to enable obligors to continue payments for a while. Accordingly, we expect to see a slight delay between obligors falling into financial distress and delinquencies.

The Pandemic's Impact On RMBS Transaction Ratings In Japan

Unemployment and delinquencies/defaults correlate.  Obligor job losses are likely to trickle down into monthly loan repayments. This is likely to have a larger impact on loans held by self-employed and nonpermanent workers, because their income is less stable than that of salaried (permanent) employees. The obligors of loans backing RMBS transactions we rate are mostly salaried workers. However, if the pandemic persists, its effects may reach more loans, regardless of obligor employment contract conditions.

Delinquencies are the canary in the coalmine when obligor repayment capabilities deteriorate. If obligors fail to continue repayments, loans default after several months of delinquencies. Obviously, rises in defaults have an adverse impact on RMBS transactions. In some cases, obligors may request lenders revise terms and conditions for repayment of loans before delinquencies. In many cases, originators repurchase loans when their terms and conditions are revised. We therefore consider the rate of repurchased loans to be an indicator of the ability of obligors to repay loans.

Repayment of loans through property sales might be difficult if real estate prices fall.  Standard land prices ("kijun chika" for all uses nationwide) released from Ministry of Land, Infrastructure, Transport and Tourism have decreased for the first time in three years, by 0.6%. The pandemic has led some potential buyers of property to avoid the market. In addition, demand for real estate is changing as more people work at home and real estate dealers voluntarily refrain from sales activity. These trends may impact real estate prices, in our view.

Real estate price volatility can affect the ability of obligors to repay loans and can thus impact RMBS transactions. If an obligor experiences financial distress and struggles to repay a loan, they can avoid default by selling the collateral property if its price exceeds the outstanding balance of the loan. Obligors can also take advantage of higher real estate prices when negotiating with lenders, in terms of factors such as refinancing and revisions to terms and conditions. If property prices decline, on the other hand, such advantages for the obligor are lost.

Furthermore, in case of default, proceeds from property sales can be allocated to repay loans. However, these proceeds might decrease and be lower than loan outstanding balances if real estate prices fall.

Ratings impact varies, by transaction structure.   In our credit analysis of RMBS transactions:

• An increase in delinquent and default receivables is reflected in a rise in the assumed cumulative default rate; while
• A fall in real estate prices is reflected in a rise in assumed cumulative default rates (a rise in loan-to-value rate) and a rise in assumed loss severity rates (=1-recovery rate).

There are two major repayment methods for rated debt for RMBS transactions under our classifications: sequential and pro rata. In the sequential payment method, credit enhancement rises as repayment of the rated debt progresses. This creates a gap between the actual credit enhancement ratio and the credit enhancement ratio required to maintain the rating that serves as a buffer. On the other hand, the pro rata payment method does not create a buffer during the transaction's tenor: The credit enhancement level remains unchanged from the closing date.

If the pandemic imposes larger additional stress on a transaction than its buffer can cope with, this can affect a rating. This is likely to occur more with transactions that have pro rata payment methods. Transactions with sequential payment methods with less seasoning and repaid debt will have smaller buffers and consequently ratings on them are more likely to be impacted by the pandemic.

Scenario Analysis

Hypothetical scenarios

Below, two scenarios examine the impact of the COVID-19 pandemic on existing RMBS transactions. Under the first, we examine a rise in default rates. Under the second, we look at a fall in real estate prices. We have added pandemic-related stress assumptions to those assumptions we had made for specific transactions. Specifically, we have divided the actual credit enhancement rate of each class by the credit enhancement rate required to maintain current ratings. If the resulting figure is below 1x, we consider the classes to have a negative impact from the pandemic.

Scenario 1--A rise in default rates:  In order to simplify our scenario, we assume additional loans equivalent to 5% of outstanding balances of the pools of receivables default. This scenario's default rate is higher than the actual cumulative default rate of private sector RMBS transactions we rate, which is about 1% of initial loan balances.

Scenario 2--A fall in real estate prices:   We assume real estate prices fall 5% after taking into account price declines, including market value decline assumptions and collateral liquidation value, covered in our criteria (see "Methodology And Assumptions For Rating Japanese RMBS", published Dec. 19, 2014). Our assumption under this scenario is slightly higher than the 4% decline in nationwide residential land prices that the Japanese government published during the financial crisis triggered by the bankruptcy of Lehman Brothers Holdings Inc.

Results

We found potential for downgrades in about 1% of the classes we rate if defaults rise by 5%. A real estate price decline of 5% would impact about 4% of the classes. (See the Scope of Analysis and Assumptions section below for further details.)

For many classes, principal redemption of rated debt has progressed because reasonably long periods of time have passed since closing dates. As a result, credit enhancement levels have risen for transactions with a sequential payment method. These enhancements cover the negatives triggered by higher default rates or real estate price declines. We also consider progress in repayment of underlying loans, which pushed down loan-to value (LTV) ratios and helped support our ratings.

Our analysis showed only classes with either of the two following characteristics would face the prospect of downgrades. First, they would have to have been issued relatively recently and have only seen a limited rise in credit enhancement since closing. Or second, they would have to be under pro rata payment methods with credit enhancement levels unchanged since closing.

Chart 1

Under a scenario where the default rate rises and real estate prices fall, ratings on about 8% of classes would likely be lowered. By ratings category, we found that about 7% of classes rated 'AAA' and about 22% rated 'AA+' and below would likely be lowered. The higher possibility of downgrades for classes rated in categories 'AA+' and below is attributable to the limited gap between the actual credit enhancement rate and the credit enhancement rate required for maintaining current ratings. This is because we have raised ratings if credit enhancement rates rise.

Chart 2

A prolonged pandemic may hurt, but its impact has been limited so far.  As a result of our scenario analysis, we think the negative impact on ratings will be relatively limited. Default rates and real estate prices of actual RMBS transactions have not deteriorated as much as we assumed in the scenario. Accordingly, we consider the spread of coronavirus a negative factor for only a limited number of transactions. At the same time, however, as uncertainty on the path of the pandemic endures, we will consider revising our assumptions for analysis when necessary.

In this scenario analysis, we examined the pandemic's impact on existing RMBS transactions under certain simplified conditions. In actual cases, however, we determine whether a rating action is necessary or not after considering numerous factors, including the current status of pooled receivables, performance, and rated debt, as well as the economic environment surrounding Japanese RMBS transactions.

Scope Of Analysis And Assumptions

• This analysis was applied to all RMBS transactions outstanding as of May 31, 2020.
• When two or more classes are issued in one transaction and are equally rated, we adopted the most junior class. We excluded transactions, such as repackaged securitizations, for which creditworthiness is dependent solely on factors other than the creditworthiness of the asset pool, such as counterparty ratings.
• Base-case scenarios are based on our assumptions as of our most recent rating analysis on the classes. They do not reflect updated status of repayments and performance.
• When real estate prices are declining, we calculate the assumption of cumulative default rate for the scenario analysis by multiplying the assumed cumulative default rate in the base-case scenario by the additional stress owing to the rise in LTV ratio. The additional stress level varies depending on the seasoning of each transaction after closing.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Related Criteria

• Methodology And Assumptions For Rating Japanese RMBS, Dec. 19, 2014

Related Research

• How Will COVID-19 Affect Japanese Structured Finance? April 8, 2020
• Japan Structured Finance 2020 Outlook: Potential Apartment Loan RMBS Woes Amid General Tranquility, Jan. 8, 2020
• Outlook Assumptions For The Japanese Residential Mortgage Market, Jan. 8, 2020

In this report, figures include rating actions by S&P Global Ratings and S&P Global SF Japan Inc. (SPSF). SPSF is a registered credit rating agency under Japan's Financial Instruments and Exchange Act (FIEA) but is not registered as a Nationally Recognized Statistical Rating Organization (NRSRO) under U.S. Laws. Therefore the credit ratings assigned by SPSF are Registered Credit Ratings under FIEA but are not Credit Ratings issued by an NRSRO under U.S. laws. Therefore, the credit ratings assigned by SPSF are Registered Credit Ratings under FIEA but are not Credit Ratings issued by an NRSRO under U.S. Laws.