2022 was billed by some as the year where European residential mortgage-backed securities (RMBS) and other variable structured finance asset classes came into their own as almost continual interest rate declines over the last 14 years waned. Buoyed by a strong credit performance across Europe before and throughout the COVID-19 pandemic, hopes were resting on the RMBS market to leverage its variable rate nature to attract a broader investor base--specifically, from investors who have been cold on the asset class since the financial crisis. Geopolitical events and their ensuing impact on the macroeconomic picture have delayed this renaissance. While this is not to say the European RMBS renaissance will not happen, S&P Global Ratings believes rising interest rates will pose both challenges and opportunities to European RMBS and underlying mortgage markets.

Rising Swap Rates Play Havoc With Deal Dynamics

As shown in charts 1 and 2, swap rates for different tenors between one and 30 years have been increasing across both the euro and British pound sterling markets. For a mortgage lender, the costs of hedging the fixed rate is a direct cost and it usually passes this on to the borrower in the rate the borrower is charged. However, not all lenders hedge their new fixed rate lending using the same process. Some hedge on a loan-by-loan basis, some at a portfolio level. Furthermore, not all lenders hedge their pipeline, meaning that there is a time gap between the loan being offered and loan pricing determined and the loan becoming live when the lender is at risk of swap rate movements.

Chart 1

Chart 2

How lenders and individual transactions deal with these hedging cost increases depends on the choices of each lender/issuer. While some lenders have increased the price of their fixed rate products, this is by no means universal and depending on competitive dynamics in the market it may not be within the gift of a lender to increase loan pricing. For example, a lender who had elected not to hedge its pipeline may be competing in a space with lenders that did. In this scenario lenders who can hedge more effectively may be able to keep loan pricing lower for longer, leaving the other lender little option but to follow suit even though its cost of funding has increased.

We also expect to see some issuers deal with the cost of hedging either outside a transaction or at a subordinated level within a transaction by paying an upfront fee to a swap provider in exchange for lower swap pricing within the transaction. This upfront cost may form part of the subordinated loan in a given transaction. Other issuers may elect to simply accept the cost of hedging which unless the lender has passed on the higher cost of hedging to the borrower will, in effect, lower excess spread in a transaction. Here, issuers will feel the cost through lower payments on residual notes and highlights that while structurers can alter where in the capital structure the costs are felt, there is no cost-free option from an originator's perspective.

Differing structural ways of dealing with the rising cost of hedging mean that comparability of transactions with similar characteristics may be more involved. For example, if we take two identical transactions--deal one where the issuer had elected to pay the swap provider an upfront fee in exchange for lower swap pricing and deal two where the issuer had accepted that they needed to pay a higher rate for the swap provider for the life of the swap. In deal one, the issue would be felt largely by the residual noteholder which would often be linked to the originator. In deal two, all notes, including senior rated notes would have potentially lower excess spread available to them. The impact of excess spread can significantly affect rating outcomes, especially at speculative-grade levels. This means that two deals with similar characteristics may end up with different ratings.

How Will Rising Hedging Costs Affect Mortgage Products?

Several developments could occur as a response to the increase in the forward interest rate curve. For certain tenors, the Sterling Overnight Index Average (SONIA) swap curve is inverted, meaning that some longer tenors are lower (costs less to hedge) than shorter ones (see charts 1 and 2). For example, the 30-year tenor has a lower cost than the 10-year tenor for both SONIA and three-month EURIBOR. This reverses the typical trend, where hedging for longer is more expensive, and all things being equal, makes it relatively cheaper to hedge 30-year products than 10-year products. This may stimulate the nascent U.K. long-term fixed rate mortgage as borrowers are drawn in by the lower cost of taking out a longer-term fixed mortgage rather than a shorter one. Similar trends are also visible in EURIBOR markets, but longer-term fixed rates are already common in most European markets. Notably, in Ireland the fixed rate duration of mortgages resembles the U.K. at two to five years, but recently we have seen more longer-term fixed rates offered and would expect this to continue. Countries that already have high fixed rates may start moving toward shorter and cheaper fixed rates. For example, where 10-year fixed rates are common shorter fixed rates may become more popular.

Secondly, lenders may choose to avoid the cost of hedging altogether by originating variable rate products such as discounted variable mortgages. Such products were relatively common in the run up to the financial crisis in the U.K. These products may be superficially appealing to borrowers as they will likely have a lower rate than a comparable fixed rate product and, so, the monthly payment at closing will be lower. However, borrowers will be exposed to rate rises as soon as they happen. Although such borrowers would be left with high monthly payments, lenders in most countries are required to assume interest rate rises beyond the rate the borrower is paying when the loan is underwritten. Depending on the interest rate the asset is priced to relative to the rated liabilities, replacing fixed-rate products with variable-rate products would replace interest rate risk with basis risk.

How Will Rising Hedging Costs Affect Mortgage Markets?

We expect homeowners and would-be homeowners in most European countries to show increased urgency in trying to acquire more property in an attempt to lock into rates before they increase. So, for countries where fixed rates are prevalent, such as Italy, Spain, France, and the Netherlands, the summer months of 2022 may see high lending volumes. To some degree this is already happening. In the Netherlands in the first quarter, banks processed over 191,000 mortgage applications for remortgages--an increase of 37% since Q1 2021 (according to figures from mortgage data network HDN). This may increase prepayments in most countries over the coming months.

Italy presents another example of how rates affect mortgage markets. The Italian state guarantee on 80% of the principal due on residential mortgage loans granted to low income people under 36 is set to expire at the end of 2022. Thanks to this scheme, guaranteed mortgage loans to young people represented a large portion of new volumes in the first quarter of 2022. However, more recently we have observed Italian banks no longer offering fixed rate loans under this scheme. The interest rate on the loan cannot exceed the limit set quarterly by the Bank of Italy, which is currently 1.99% until June and is, given rate rise expectations, below the current market level. As a result, we understand originations slowed down in April. Eligible borrowers may still opt for floating rate loans under this scheme, however the current rising interest rate environment may be a concern. In fact, over the last months the vast majority of new mortgage loans originated in Italy were fixed rate loans.

The increase in the forward curve may also hand a competitive advantage to banks relative to non-banks. As non-deposit takers, the only way non-banks can achieve fixed-rate funding is through the use of derivatives, which leaves them open to market movements. Certain banks have greater funding diversity and depending on their funding model, may be able to achieve an overall lower cost of medium- to long-term funding through retail deposits.

U.K.: Rate Rises Could Be Problematic For Some Buy-To-Let Borrowers

The idiosyncrasies of the U.K. tax system and how it treats buy-to-let (BTL) lending may leave some borrowers yields eroded and for some, marginally profitable properties become loss making. This is because for higher and additional rate taxpayers only 20% of any increase in interest cost is deductible and the remaining 80% is a cost that they receive no tax relief on leading to a higher overall tax bill. A further nuance is that any borrower who took out a five-year fixed rate in 2017 may struggle to refinance given the combined effect of the increased interest and tax rates.

Although this could be a major issue for individual borrowers, we would not expect this to be a major issue for RMBS transactions overall for two main reasons. Firstly, we have seen a shift toward Limited Company BTL with different and favorable tax rules for recently originated BTL loans backing most recent RMBS deals. Secondly, the impact will hit higher rate and additional rate taxpayers who are likely to have the financial means to ensure loans remain current before a smooth exit from the property. Additionally, the movement to five-year fixed rates means that the rate rise for many is not immediate. However, for a non-immaterial portion of legacy BTL loans rate rises do threaten profitability. That said, such loans benefit from significant seasoning meaning loan-to-value ratios are low and they are exposed to high rental price inflation since origination.

New capital continues to enter the mortgage market

New capital combined with new ownership is likely to bring with it new products and innovation. It may also change certain lenders' risk appetite and lending standards in a way that alters credit risk. One U.K. BTL lender, Molo Finance has temporarily ceased lending citing reported funding issues. However, at the same time at least two new BTL lenders, Catalyst Property Finance and Glenhawk (both born from existing bridging/development finance businesses) have entered the BTL market. The Office for National Statistics recently reported rental prices had increased in the 12 months to the end of April by 2.7% which combined with house prices increased by 9.8% to the end of March means that existing landlords' equity has risen significantly over the last two years and will likely see borrowers seek to acquire new property.

The interest in U.K. residential lending as an investment proposition continues with news that 49% of Together Money, the U.K. specialist finance provider, is up for sale. In addition, earlier this year Tandem Bank recently completed the purchase of Oplo Finance, which completed its inaugural securitization in 2021.

Table 1

Consultation on relaxation of affordability rules

The Bank of England's Financial Policy Committee has just closed its consultation of underwriting standards in the U.K. Since 2014 mortgage affordability in the U.K. has been underpinned by two separate rules. Firstly, the so called "Flow Rule" which restricts to 15% the amount of a mortgage lender's new mortgage lending over 4.5 times of income. Secondly, the "affordability test" which mandates that a loan be underwritten using a certain stressed interest rate. The recommendation of the consultation which ended on May 6, 2022 was to remove the affordability test. The Financial Policy Committee argue that the Flow Rule should be enough to guard "against an increase in aggregate household indebtedness and the number of highly indebted households." On the premise the outcome of the consultation resembles the recommendation, this creates risks for RMBS transactions that are worth highlighting. Given these transactions are backed by a specific pool of assets and depending on the selection of those assets, we do not benefit directly from the "Flow Rule". In other words, they could be entirely backed by loans that are underwritten without the affordability test. Although we would reflect this in our analysis through higher adjustments for loan affordability it could result in a relative credit loosening for some RMBS portfolios.

Energy performance certificate uncertainty continues

The outcome of the U.K. government's consultation on energy efficiency governing rented residential property and therefore BTL remains to be seen. The most recent drafts push the deadline to the end of 2025, but the industry expects this to be further delayed to 2026 for new tenancies and 2028 for existing ones. Given shortages of both raw material and labor, industry disquiet prevails on the achievability of this deadline. The deadline may also influence landlord behavior as some, particularly with loans originated over a decade ago, elect to sell their properties. Alternatively, they may be forced to refinance to pay for necessary upgrades.

We believe when and exactly how EPC-related legislation is enacted may have important implications for credit risk. In its current form, we understand that properties with an EPC lower than C will be unlettable to new tenancies in 2025. Although such properties could be sold for owner occupation, without modification and upgrade, they would be likely unmortgageable on a BTL basis. As such, this illiquidity premium could affect property values (similar legislation is proposed in France, please see the France section below).

Portugal: New Lending Rules Likely To Lower Overall Credit Risk

In July 2018 the central bank (Banco de Portugal) recommended underwriting criteria limits to minimize default risk. Since then, credit institutions have broadly complied with the guidelines. However, the average maturity of new loans for house purchases has not converged toward 30 years, in line with the recommendation. Therefore, since April 1, 2022, the central bank has recommended new limits to the maximum maturity based on the age of borrowers to move to an average 30 years maturity by the end of 2022. The maximum maturity of these loans will be 40 years for borrowers aged 30 or under; 37 years for borrowers aged over 30 and up to and including 35; and 35 years for borrowers aged over 35.

Extending the loan maturity is one loan feature that a lender can alter which will lower the overall monthly payment and increase the possibility of a loan meeting the lender's loan approval criteria. Overall, such a move would likely be credit positive for new mortgages.

France: Energy Efficiency Laws Tighten The Mortgage Market

In the second half of 2021, the French Parliament adopted legislation preventing landlords from renting their property if it does not meet certain energy efficiency standards. From January 2023, the ban will exclude from the market properties with total energy consumption exceeding 450 kWh/m2/per annum. Then from January 2025, renting will not be possible for all properties with an EPC of "G", followed by "F" properties from January 2028 and by "E" properties from January 2034. Also, from August 2022, landlords will not be able to increase the rents of properties with label "F" and "G". The consequence of this law is that owners will need to either make renovation or sell their properties. Our expectation is that there will be a lower demand for those properties on the market, and they are likely to be sold at a discounted price.

As mentioned above in the U.K. section where legislation is afoot, the quantification of the issue from a credit perspective is hard to assess as data on EPCs backing existing loans is not universally available. At this stage, banks do not require the EPCs as part of their loan underwriting process. However, we expect banks to gradually start considering those certificates, especially for first time buyers and BTL investors. Whether the loan is granted to purchase a primary residence or for a BTL purchase, if renovation is not conducted and the borrower defaults, repossession of the non-energy efficient property may take longer than for a standard property, and at a discounted price. In the case of BTL property, in most cases banks will need to include the renovation cost into the loan balance, without exceeding the maximum debt-to-income ratio of 35%.

Spain: Regulatory Changes Cause Market Uncertainty

Catalonia seems to be in a game of cat and mouse with the Spanish Constitutional Court. The introduction of Law 1/2022 recovers and extends the provisions of Law 17/2019 that the Spanish Constitutional Court declared unconstitutional. Noteworthy aspects are that it introduces a concept of 'large holders' of residential property and sets this at 10 units. Large holders are obliged to offer a social rent proposal to individuals at risk of housing exclusion before serving an eviction notice and repossessing. This, in theory, means that large holders need to offer the property for rent rather than repossess. If they fail to do this then Catalonia can, mandatorily purchase unoccupied properties paying half their market value.

Feedback received from Spanish servicers indicates that at this stage, it is difficult to conclude fully on the practical implications of the law, in part due to its recent implementation and because this kind of law takes substantial time to be fully developed and to show a real impact. Also, the law could again be declared unconstitutional, either totally or partially. The more immediate impact is that it introduces uncertainty into certain scenarios and would likely mean asset purchasers will need to tread more carefully when purchasing such assets.

As commented in our European RMBS Market Update For Q3 2021, published on Nov. 24, 2021, Spain has one of the highest home ownership rates in Europe. However, a gradual move toward renting has been happening for more than a decade as affordability constraints and a desire for more mobility particularly among those aged under 40 reshape housing demand. As demand for rent increases, new build to rent developments in Spain have become more prominent.

Build to rent phenomenon may translate to single borrower deals

Unlike in a conventional property development where the goal is to build with the aim of selling the properties, under a build to rent model, the developer will deal with prospective tenants and manage the building(s). Potential advantages for tenants are the use of premium amenities which are typical in these developments and more favorable lease agreements when compared to a standard tenancy. On the flip side, these often come at a premium cost and the fact that the build to rent model is somehow a novelty in Spain mean some of the legal frictions between tenants and the landlords might not yet have been tested.

The recently passed Spanish Housing Act might slow down the pace of new build to rent developments as it intends to create some barriers to corporate landlords. That said, the application of the law is intended to have a regional emphasis, meaning that local governments might act differently in different parts of the country. As such, the full impact of the new law will only be clearer in years ahead.

We do not expect the build to rent model to translate into securitized products in the short term. However, the rental cash flow from borrowers represents a granular cash flow and depending on the nature of the dwellings constructed, the assets themselves may be very comparable, albeit concentrated in certain localities, to those seen in RMBS portfolios. Single borrower RMBS deals exist in the U.S. and although operational risks and refinancing risks (given there is one loan rather than thousands of loans) differ, a structured finance solution may be viable. The typically large loan sizes, lack of historical data backing the product, and non-existence of a (simpler) standard BTL product in Spain are factors that we believe will underpin the funding mix for the build to rent model.

Italy: Consumer Credit Markets Are Likely To See Innovation

Italy has long been one of the most traditional credit cultures in Europe. As a result, innovation in mortgage lending and products has been very limited. Recent news might point toward a more dynamic mortgage market than has recently been the case.

Emanating out of Decree Law 34/2019, the so called 'Growth Decree', the Ministry of Economy and Finance, launched a regulatory 'sandbox' which is a controlled environment where supervised entities and FinTech operators will be able to test, technologically innovative products and services in the banking, financial, and insurance sectors.

Although current regulation in Italy limits mortgage lending to banking groups, immediate innovation is more likely to be seen in the unsecured consumer space than the mortgage market.

Ireland: Variable-Rate Mortgages Are Likely To Appeal To Investors

Given Ireland's banking system is still working through the fallout from the financial crisis, the impact of rate rises is varied. Both KBC and Ulster Bank are exiting the Irish market. Rising interest rates and the fact that virtually all legacy mortgages are linked to a variable rate mean that portfolios of Irish mortgages, for example tracker mortgages, instantly have more appeal for investors/portfolio acquirers looking for variable exposure. In this vein, Allied Irish Bank has entered talks with the NatWest Group to acquire €6 billion of tracker mortgages. In March this year Irish Central Bank data showed the average interest rate on new variable mortgage agreements had risen to 2.76%, more than double the eurozone average of 1.31%. Inevitably rising rates have started to feed through into higher fixed rate loan prices, except for green mortgage deals seeing rate cuts from some lenders.

The Irish mortgage market continues to change shape

The departure of Ulster Bank and KBC from the Irish market has created opportunities for the remaining lenders and non-bank lenders in particular are making inroads, with Dilosk recently reportedly hitting a 5% market share. This shift shows Irish borrowers are less loyal to high street banks than they have previously been. Borrowers now seem to be more influenced by pricing than before, which is borne out by a 57% increase in year-on-year in remortgages. In addition, almost 45% of loans are now originated by brokers. Although banks will likely retain a funding cost advantage over non-banks, the barriers for banks to appear to be getting less sizeable which in the longer term may see more secured residential funding transactions, including RMBS.

Changes to macroprudential rules are more likely to be hopes than expectations

Market participants have urged the Irish Central bank to reconsider its macroprudential rules which govern mortgage underwriting in Ireland. Recent announcements in the U.K. that elements of its mortgage underwriting regulation were up for consultation had raised hopes that similar relaxations might happen in Ireland. However, The Central Bank of Ireland is reportedly not in favor of European Union wide mortgage regulation and argues that regulation needs to reflect Ireland's cultural norms. In addition, at its own recent conference the Irish Central Bank indicated that relaxation was unlikely.

The Netherlands: Rental Prices Continue To Rise

The Dutch Housing Minister has recently announced more measures aimed at easing high rents, which is becoming an increasingly political issue. The recently announced measures include the construction of 44,000 homes in the Netherlands with over half classified as social housing. Rent classified as social rent (controlled by rental controls) is also planned to rise to €1,250 from 2024 up from approximately €760 currently, but such measures are not likely to have any immediate impact on the mortgage and rental markets. Indeed, CBS – Statistic Netherlands data highlighted that despite a push to build more houses in the Netherlands in Q1 2022, only 16,600 building permits were issued (down by 13% from Q1 2020).

Nationale Hypotheek Garantie (NHG) has launched a pilot scheme designed to allow people with a track record of paying rent but cannot be approved for a mortgage on the grounds of affordability to have normal affordability rules relaxed. To qualify, prospective purchasers must have paid rent for at least three years without arrears. The scheme is envisaged to be a trial of 1,000 loans, but is worth monitoring as it may lead to changes in affordability regulations that govern Dutch mortgage originations.

The housing market appears to be cooling

The Dutch Land Registry announced that it registered just under 16,000 residential transactions in April, approximately 16% less than a year earlier. In addition, just under 60,000 homes were sold in the first four months of 2022 a drop of 30% compared to the same period a year ago. In addition, house prices rose by only 0.2% between March 2022 and April 2022. This is compared to an average monthly increase of approximately 1.6% from March 2021 to March 2022. Overall, irrespective of a cooling the fundamental issue of lack of supply does not look like it will be solved imminently and will continue to support the market.

Germany And Austria: Market Heat Brings Regulatory Shifts

Germany has seen several years of rising house prices. The Association of German Pfandbrief Banks reported house price growth in 2021 of 11.3% compared to 7.5% in the previous year. The central bank (Deutsche Bundesbank) also reported strong house price growth, even outside the main cities. This is partially due to the increasing price of building materials through supply shortages and persistent high demand. By contrast, household income growth was much lower at 1.8% in 2021. Due to these developments the European Systemic Risk Board (ESRB) has advocated for Germany and Austria to introduce further measures to minimize systemic risk.

The Federal Financial Supervisory Authority (BaFin) has already introduced new policies. Firstly, German banks need to create an additional capital buffer of €22 billion in the next 12 months. On April 1, 2022, the regulator introduced another buffer that specifically applies to residential mortgages (most already meet these requirements), and supervision of lending standards will be more scrutinized. However, Germany is yet to have any specific measures to constrain lending.

From mid-2022, Austrian authorities plan to implement capital requirements for borrowers of new loans that were voluntary recommendations but will now become compulsory. The Austrian central bank is implementing these rules that are also based on the ESRB findings. Mortgage applicants will now need a deposit of at least 20% of the property value, the monthly repayment will be capped at 40% of income, and the duration can be a maximum of 35 years.

Related Research

• EMEA Structured Finance Chart Book: May 2022, May 18, 2022
• European RMBS Index Report Q1 2022, May 16, 2022
• Residential Mortgage Market Outlooks Maintained For 15 European Jurisdictions Following Revised Economic Forecasts, April 28, 2022
• Credit FAQ: What Is Prefunding And How Does It Affect U.K. RMBS Transactions?, March 24, 2022
• Asset Price Risks: Inflated Property Values Mean Higher Loss Assumptions In European RMBS And Covered Bonds, March 21, 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 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
• European RMBS Market Update Q3 2021, Nov. 24, 2021
• European Housing Market Inflation Is Here To Stay, Nov. 2, 2021
• Why U.K. Buy-To-Let Has Defied Gravity Through COVID-19, Aug. 3, 2021

Editor: Claire Ellis.