The U.K. residential mortgage-backed securities (RMBS) market has seen a significant increase in the number of transactions using prefunding. In 2021, we rated eight U.K. RMBS transactions with prefunding compared with just three transactions with prefunding between 2017 and 2020. This increase is due to the low cost of funding within the U.K. RMBS securitization market and the influx of new specialist lenders with securitization as their major source of funding who have entered the market since 2015.

Prefunding, the scope and duration of which differ between transactions, creates additional risks as the final collateral composition is uncertain at closing. Despite this uncertainty, the credit quality of U.K. RMBS collateral has not materially deteriorated at the end of the prefunding period within the transactions that we rate. In this article, S&P Global Ratings addresses key questions relating to what we have observed in the market and our analytical considerations when assigning ratings to transactions that feature prefunding.

Frequently Asked Questions

What is prefunding?

Prefunding is a feature where the transaction documentation permits the issuer to purchase additional mortgage loans, over which the notes will be secured, after the closing date. On the closing date, the total proceeds from the issuance of asset-backed notes exceeds the balance of the assets that are sold to the issuer. The difference, known as the prefunding amount, is typically held in the transaction account. Prefunding is typically used to reduce the overall cost of funding as securitization is likely to have a lower cost of funding than using a warehouse facility. Prefunding allows lenders to maximize the benefits of securitization as they can sell additional mortgage loans after the closing date. It allows for the securitization of loans that have either not yet made their first payment or are not originated at closing with the cost of securitization already locked in.

Which kinds of originators are using prefunding?

The prefunding feature is most commonly used by specialist lenders, in our experience. An influx of new specialist lenders, who rely on securitization as a funding source have entered the U.K. mortgage market since 2015. Prefunding allows these lenders to achieve the largest possible transaction size and lock in a certain funding cost.

What have been the main trends in the usage of prefunding for RMBS over the past three years?

Interest rates have been historically low and the cost of funding within the primary U.K. RMBS securitization market has also been low. Lenders are therefore incentivized to maximize the amount of funding that they can secure while market conditions remain favorable.

Over the past three years, the number of transactions that we rate with prefunding features has increased. All of these transactions have had prefunding only up to the first interest payment date (IPD). The average prefunding size has increased over time, with 2020 being an exception due to market uncertainty owing to the COVID-19 pandemic.

Chart 1

Table 1

Though the credit quality of the collateral may deteriorate during the prefunding period, the credit quality of the assets during the prefunding period has not changed significantly.

Across transactions with prefunding that we have analyzed, we have compared movements in key drivers of credit quality by comparing the loans that were sold to the issuer on the closing date with the loans that the issuer holds at the end of the prefunding period. In the below calculations, we have applied equal weight to all transactions.

Table 2

While the eligibility criteria for purchasing additional assets varies by transaction, with some being extremely tight and some having looser criteria, most transactions with prefunding features share the following characteristics:

• Prefunding is typically up to the first IPD, or the second IPD if there is a short period between the closing date and the first IPD;
• Typically, unused prefunding amounts are used to redeem the asset-backed notes pro rata, meaning no effect on credit enhancement;
• Most transactions feature a prefunding revenue reserve to cover the risk of negative carry; and
• Transactions typically require borrowers to have made their first interest payment prior to being purchased by the issuer.

What are the different types of prefunding that are commonly used?

Mortgages already identified:

• In this type of prefunding the assets are generally already originated and identified.
• This typically happens when the loans are originated but where the borrower has not made their first payment.
• However, this may also occur when there are loans that are in the offer pipeline but where the funds have not yet been advanced to the borrower.
• As the assets have been identified, we can assess the credit quality of them and there is less uncertainty compared with prefunding using assets that have not yet been identified.

Mortgages not identified:

• In this type of prefunding the assets have not been originated.
• Typically, this happens when the lender expects to originate these loans in future.
• As the assets have not yet been identified, we cannot analyze their credit quality and so there is greater uncertainty compared with prefunding using assets that are already identified. We typically rely on the eligibility criteria and origination history to assess the credit quality for such structures.

Hybrid approaches:

There may also be cases where the prefunding mechanism features a combination of identified and not yet identified assets. For example, the transaction documentation may outline that a certain proportion of the prefunding amount must be used to purchase assets that are identified and the remaining amounts can be used to purchase assets that are not identified. Where assets have been identified and there is a commitment to purchase these assets during the prefunding period, uncertainty is reduced.

How do transaction documents address prefunding?

Transaction documents typically feature eligibility criteria that outline limits for credit quality deterioration. The limits may apply solely to the additional loans to be purchased or may apply to all assets (e.g., the limit may reference the loans sold on the closing date and the additional loans that are purchased, and not just the additional loans). If the documented final additional loan purchase date has not passed, assets can then be purchased subject to the eligibility criteria being met.

What are the potential risks associated with prefunding?

The risks associated with prefunding can be broken down into five key areas of analysis.

Table 3

Are there any qualitative factors that you consider?

Qualitative factors that we consider in our analysis when considering credit quality deterioration include:

• The extent to which the originator relies on securitization as a funding source. Lenders that rely on securitization may be less incentivized to worsen the credit quality of the assets within the transaction.
• Stability in underwriting and lending policies enables us to reasonably conclude that future originations will resemble current originations.
• The extent to which the amount of permitted prefunding differs from the current rate of origination. For example, if £50 million of prefunding is permitted within a three-month period until the first IPD, but the originator usually originates £10 million per month, the originator may need to deviate from its usual offering, which it has expertise in, to fully use the prefunding option assuming it does not have a large book of mortgages.
• In our analysis, we also consider the size and duration of prefunding, while assessing the originator adjustment stress that we apply to capture the risk of credit quality deterioration. If the prefunding period is very short and the prefunding amount is limited, then this would imply less uncertainty for the credit quality of the final pool, as the future originations are likely to be under the same underwriting criteria as the current pool. If the prefunding period is longer and the size is substantial, then the analysis will resemble that for revolving pools as it is likely that the credit quality of the final pool may differ from the closing pool.

Related Criteria And Research

• Economic Research: Global Macro Update: Preliminary Forecasts Reflecting The Russia-Ukraine Conflict, March 8, 2022
• European RMBS Index Report Q4 2021, Feb. 17, 2022
• The Future Of U.K. Nonbank Mortgage Lending And How It Will Affect RMBS, Feb. 9, 2022
• S&P Global Ratings' U.K. Second-Lien Mortgages Primer, Jan. 31, 2022
• European RMBS Outlook 2022: Performance And Issuance At A Crossroads, Jan. 27, 2022
• Credit FAQ: How We Analyze Small Ticket Commercial Real Estate Assets In European Structured Finance, Jan. 19, 2022
• Why U.K. Buy-To-Let Has Defied Gravity Through COVID-19, Aug. 3, 2021
• S&P Global Ratings' U.K. Buy-To-Let Market Primer, June 1, 2021
• Will Innovation Give The U.K. Mortgage Market A Boost?, Sept. 4, 2019
• EMEA Structured Finance Chart Book, published monthly
• Credit FAQ: What's Behind Our Investment Criteria Update For Temporary Investments In Transaction Accounts?, Oct. 8, 2012
• Global Investment Criteria For Temporary Investments In Transaction Accounts, May 31, 2012