Irish borrowers are facing the biggest cost of living squeeze in decades: consumer price inflation reached abnormal levels during 2022 and interest rates are expected to continue to rise. These pressures could push more vulnerable borrowers into mortgage arrears. While arrears levels can indicate immediate borrower stress, analysis of borrowers who are now current on their payments but have recently been in arrears may indicate the level of vulnerability to future pressures, such as the rising cost of living. Based on this, S&P Global Ratings conducted a scenario analysis of seven of the Irish reperforming transactions that it rates to investigate how the rising cost of living could affect borrowers. While 'AAA' to 'BBB' tranche ratings should remain largely stable, 'B' and 'BB' rated tranches--which have less credit support to protect against performance changes and rely more on excess spread--are most exposed to rating changes. However, recently originated prime RMBS collateral is likely to remain relatively resilient to cost of living pressures due to their higher proportion of fixed rate products, typically more stringent underwriting standards, and the strong historical performance of these transactions.

Inflation Outlook: Effect On Borrowers Unclear

We expect consumer price inflation to average 8.0% in Ireland in 2022, falling to 3.7% in 2023, and interest rates to continue rising in 2022 and beyond. Exactly how inflation affects individual households depends on their consumption habits and other factors. For some borrowers, pay rises will erode the effect of rising inflation. Total borrower income will also play a role, for example, lower income borrowers will likely be hit harder by increases in energy and other consumer prices.

Chart 1

Fifty-six percent of Irish mortgage loans underlying our rated residential mortgage-backed securities (RMBS) transactions currently pay a variable rate. They are exposed to payment shock as mortgage interest rates rise over time in conjunction with market rates. Nearly 68% of these loans are European Central Bank (ECB) tracker mortgages, which have paid low interest for 10 years and thus will be particularly affected by rising rates.

Table 1

Reperforming Pools Are More Vulnerable Than Prime

We expect the collateral supporting our prime RMBS rated transactions to remain relatively resilient to cost of living pressures. Significantly, the assets supporting the prime transactions we rate were primarily originated under stringent central bank underwriting rules undertaken since 2014. Under these rules, the ability to withstand stressed affordability is incorporated into the approval process. These transactions also do not include reperforming loans.

These transactions typically include more borrowers with an initial fixed rate period, which helps protect against near-term rate rises (currently 45% pay a fixed rate).

Table 2

However, legacy mortgage loans in reperforming transactions are particularly vulnerable to rate increases as the borrowers in these transactions predominantly (94%) pay a variable rate of interest. These borrowers are typically among the worst credit performers and their performance will likely deteriorate when hit by both CPI stress and rate rises.

Many reperforming loans are interest only. These borrowers are further compromised by rising rates, given they pay a limited amount of principal in their monthly payments. The combination of an expected increase in debt servicing costs and previously compromised performance means that late-stage arrears could materially increase for these transactions. Arrears levels can indicate immediate borrower stress, while analysis of borrowers who are now current on their payments but have recently been in arrears may indicate the level of vulnerability to future pressures, such as the rising cost of living. With this in mind, we conducted a scenario analysis of seven of the Irish reperforming transactions we rate to investigate how the rising cost of living could affect borrowers.

Chart 2

Scenario Analysis: Despite High Arrears, Reperforming Loans Are Resilient

Our scenario analysis examines the impact of a low, medium, and high performance shock on Irish reperforming RMBS. It covers a series of hypothetical stress scenarios of increased arrears.

For each respective reperforming loan transaction, we considered loans that are now current but have been in arrears since January 2020 as a starting point for each stress level--low, medium, and high--in our scenario analysis. This is because we consider any borrower who has been in arrears at any point in the past two years as unlikely to have personal financial reserves--such as cash savings or liquid investments--to absorb the shock of increased prices and rate rises.

The three stress levels reflect progressively strenuous scenarios resulting from the increased cost of living.

Table 3

To perform our scenario analysis, we created three adjusted pools for each transaction, reflecting the three stress levels. For each transaction, we picked loans randomly from the full pool to add the required amount of arrears balance within each scenario.

Table 4 summarizes this approach. Performance correlation between transactions is minimal due to the differing pool compositions across reperforming transactions.

Table 4

When arrears are applied the loans lose any seasoning benefit (which starts at more than five years) and attract the foreclosure frequency adjustment. This is applied as 2.5x to 30-60 days in arrears, 5.0x to 60-90 days in arrears, and a 100% probability of default to loans in 90+ days in arrears.

Table 5

Our analysis indicates greater rating migration further down the capital structure. The 'B' and 'BB' rated tranches are most vulnerable to rating changes, suffering the most frequent downgrades with the added arrears.

By contrast, 'AAA' to 'BBB' tranche ratings are expected to remain largely stable. Low investment-grade ratings ('A' and 'BBB') showed rating migration of one to two notches, primarily in the most severe scenario.

The high scenario demonstrates the most downgrades in the more junior tranches of the transactions, due to the significant additional arrears directed to the 90+ days in arrears bracket, which in our analysis have a 100% probability of default.

However, the severity of the impact on ratings is limited. This is because many of the loans in the reperforming portfolio already have high foreclosure frequency assumptions in our analysis due to the application of other adjustments, such as reperforming adjustments and relatively high originator adjustments considering the collateral. Other borrower and loan characteristics--including high proportions of interest-only and BTL loans--also play a role.

Structural Features Provide Protection

While our scenario analysis demonstrates some rating sensitivity, all the Irish reperforming transactions we rate contain various structural features that will help mitigate short- to medium-term liquidity stresses caused by increased arrears. Some contain features that can create additional protections from downgrade or default for some notes, while increasing downgrade or default risk for others.

Any ultimate rating impact or rating migration will depend on the stress timing, deal deleveraging, and total excess spread up to that point.

Structural features

Reserve and liquidity reserve funds:   The transactions we analyzed include reserve funds or liquidity reserve funds. These can fund interest payments, with slight variances in the mechanics for each transaction.

Deferrable notes:   All the transactions include deferrable notes, which allow interest payments to be delayed if there is a liquidity shortfall. This feature doesn't apply to the 'AAA' rated senior notes or--in most cases--the most senior note outstanding.

Using principal to pay interest:   This feature is also referred to as principal borrowing or principal additional amounts. It works by using collected principal that would otherwise be distributed to noteholders to cure any temporary interest shortfalls. All Irish transactions that we rate have this feature.

Provisioning mechanisms:   Certain transactions provide for arrears rather than losses, which helps support the ratings by trapping excess spread earlier, i.e., before a loss.

Total excess spread:   Total excess spread will affect ratings migration. Transactions generating more excess cash flow can clear balances on principal deficiency ledgers and top up depleted reserve funds.

Appendix: Scenario Analysis Approach

We added arrears at the loan level and performed a cash flow analysis for each transaction structure to assess possible rating transitions. This analysis looks at asset-level performance assumptions and cash flow stresses only. It does not incorporate the impact of changes in counterparty or sovereign ratings. It also does not consider potential unmitigated operational risks, such as a servicer default.

The analysis does not consider pool amortization given prepayment is generally low for reperforming deals. By inference these borrowers cannot afford to do so. Compounded by a high proportion of interest-only loans, overall transaction deleveraging tends to be low.

For notes that do not pass our 'B' cash flow stresses (referred to as 'B-' or lower in the figures above) we would apply our 'CCC' ratings criteria, to assess if either a 'B-' rating or a rating in the 'CCC' category would be appropriate. For the purposes of this analysis, our results only highlight where our 'B' cash flow stresses do not pass. We will continue to closely monitor performance developments to assess the impact of potential macroeconomic deterioration on outstanding RMBS ratings.

Related Research:

• Cost Of Living Crisis: Despite Pockets Of Weakness, European Consumer ABS Shows Structural Resilience, Oct. 6, 2022
• Credit Conditions Europe Q4 2022: Hunkering Down For Winter, Sept. 27, 2022
• Cost Of Living Crisis: U.K. RMBS 2.0 Has Built-In Resilience, Sept. 6, 2022
• Europe Braces For A Bleak Winter, Aug. 29, 2022
• Irish Snapshot H2 2022, Aug. 9, 2022
• Cost Of Living Crisis: How Bad Could It Get For U.K. RMBS?, May 20, 2022