With interest rate hikes, spread widening, and consumer uncertainty dampening credit growth for European residential mortgage-backed securities (RMBS), S&P Global Ratings takes a closer look at the challenges RMBS and mortgage lenders are currently facing in the U.K. and beyond. Despite significant headwinds, we believe market conditions are not currently comparable to the global financial crisis era.

U.K. Mini Budget Fallout Causes Lenders To Rethink, Which Could Affect RMBS Credit Performance

Expected rate rises are happening sooner than generally predicted at the start of the year. The most affected market is the U.K. where the short-lived so-called U.K. "mini-budget" accelerated expected rate rises. This, in turn, caused many lenders to withdraw mortgage products and relaunch them at significantly higher rates days later. This represents a paradigm shift for the U.K. mortgage market, which could affect the collateral performance of RMBS transactions.

Prepayments are likely to increase, but not for the same reason in all transactions

Generally, we anticipate the rush to refix mortgages will increase prepayment rates in the short term. For example, many U.K. borrowers have been advised it is better to pay an early redemption charge if they are approaching the end of their existing fixed rate. As a refix of an existing loan often results in a repurchase of that loan from an RMBS transaction, we expect reported prepayments to increase. Likewise in Spain, borrowers who are on variable rates have reacted to rising rates by shifting to fixed-for-life mortgages.

Prepayments may increase not only because of borrowers' desire to lock into as low a rate as possible, but because of the historical perception that there was little point in paying a mortgage off when rates were low. Many borrowers with excess liquidity chose to invest surplus liquidity elsewhere, confident that they could generate a post-tax return that exceeded the cost of servicing their mortgage debt. This has reversed, almost overnight. For many this will no longer be the case, and so, borrowers will elect to partially prepay mortgage debt. Many U.K. fixed-rate mortgages allow annual cost-free prepayments of up to 10%. Some borrowers will take advantage of this, with the added desire to lower their loan-to-value (LTV) ratio, and so attract as low a rate as possible. Elsewhere, for example in Spain, France, and Italy, the prepayment of fixed-rate mortgages does not attract any prepayment penalties, and so prepayments in what are largely fixed-rate markets may increase. In addition, rate rises in the U.K. are, anecdotally, eating into buy-to-let (BTL) returns and it is possible that some investors decide the time is ripe to divest of BTL property when house prices remain high.

Locking in low interest rates is not the only motivation to refinance in the current market. In the U.K. the expectation of future rate rises and potential house price declines means that borrowers are scrambling to consolidate debt from unsecured finance to secured before possible falling house prices erode equity. Similarly, borrowers are likely to take out second-lien financing (the Finance and Leasing Association reported lending volumes that were 45% higher in August 2022 than in August 2021). Using property to refinance debt is not common in other European countries. Therefore, the impact of equity withdrawal is less visible.

Prepayments may rise in transactions that have up until now assumed low prepayment rates

Many U.K. legacy RMBS borrowers cannot refinance by virtue of either being in, or recently in arrears or because they have some other feature in their borrower profile that makes them unfinanceable (so-called "mortgage prisoners"). Our 2019 report says that approximately one-third of borrowers in U.K. legacy transactions were mortgage prisoners. Although who can refinance is fluid, given the impact of COVID-19 and lack of products to assist those who cannot refinance, we expect the overall position to be materially the same today now as it was in 2019.

Notably, such pools may contain a non-negligible number of borrowers who have not refinanced who are on high variable rates due to borrower inertia. Media attention on rising rates could focus some borrowers' attention on refinancing. Legacy nonconforming RMBS transactions are also backed by a high proportion of interest-only loans, with relatively predictable and low prepayment rates. The "low forever" prepayment assumptions for such transactions are now challengeable in the short term. Whether this is a positive factor for investors will depend on whether they can reinvest at a higher rate elsewhere. Elsewhere in Europe, legacy loans generally tend to be priced lower than the current market and so the incentive to refinance may not be as high. But, as highlighted above, some borrowers will rush to secure mortgages at fixed rates before interest rates further rise, a phenomenon that is being reported anecdotally in Spain.

Impact of prepayment speed depends on capital structure positions

The impact of full and partial prepayment for a transaction is the same. All else remaining equal, it will de-lever transactions causing credit enhancement to build up. Further down the capital structure, higher than expected prepayments in the short term may compress overall levels of excess spread, which can extend the life of excess spread notes. This is not likely to have any rating impact as we test high prepayment scenarios when analyzing excess spread notes. Likewise, residual notes may receive lower overall cash flows.

Partial prepayment also de-levers the individual loan, and assumes stable house prices will lower the LTV ratio. However, borrowers with high levels of cash opting to deleverage loans may lead to negative selection of loans in the pool. In other words, better credit quality borrowers will exit the pool leaving a larger proportion of lower quality credit loans. This would mean that junior notes, could be exposed to more adverse selection than would ordinarily be the case. Recent market behavior would mean that transactions would be called before this would likely occur (see Towd Point non-calls example).

Escalating prepayments could change the likelihood of transactions remaining pro rata

Legacy transactions often pay principal pro rata, where if they are performing well, notes are paid by their relative share of the capital structure and not in order of seniority. Prepayment generally, and especially prepayment of higher quality loans, may mean that arrears relative to the overall balance of outstanding loans increases, which in some cases may move transactions from pro rata to sequential payment far sooner than we would have assumed to be the case. Given we test pro rata and sequential structures in our analysis, the switch is unlikely to affect ratings, but note duration may be altered materially.

Not all borrowers are incentivized to refix and prepay

Although we generally anticipate prepayments to pick up in the short term, the overall position is nuanced. For example, some U.K. RMBS transactions backed by legacy collateral contain loans backed by tracker mortgages, which track the Bank of England base rate (such as Harben Finance 2017-1 PLC and Ripon Mortgages PLC). For all tracker loans in our rated portfolio the weighted-average margin over the Bank of England base rate is 1.8%. Given the cost of a two-year fixed-rate mortgage is currently approximately 6%, an immediate cost saving to be realized would require the base rate to exceed 4%. Often the margin over the base rate is lower than the average. Given we expect the forward curve to lower beyond the two-year point, and the credit spread is likely to always be lower for some legacy loans, some tracker borrowers will likely retain their tracker mortgages. The same scenario that tightly priced legacy loans may give low borrowers low incentive to prepay is true of other markets across Europe such as Ireland, Spain, Italy, and Portugal.

What might this mean for new collateral?

Borrowers facing a sharp rise in interest rates have different options. For countries which permit interest-only lending, such as the U.K. and Netherlands, this may see borrowers elect part-and part repayment. The other option would be to lengthen the maturity of the loan, thereby lowering the monthly installment to minimize the extent of the rate rise. Both would make it more likely that new mortgage production would have a longer weighted-average maturity.

Financing Conditions Are Not Yet Problematic For Europe's Non-Banks

One of the notable features of the financial crisis was the wholesale disappearance of financing available to non-banks in Europe. This in turn meant that when warehouses ended, and no "term" deal was viable, collateral was dumped on an already fragile market, creating a supply glut. Consequently, new lenders who emerged following the financial crisis found it difficult to scale quickly due to limited financing opportunities. Recent feedback from non-bank finance providers suggests that current market dynamics have changed significantly since the fall-out of the financial crisis. Although pricing of RMBS warehouses has increased in line with general RMBS spread widening, wider market events such as the evolution of forward flow agreements and non-banks being acquired by banks, remain supportive. These dynamics mean that, to some degree, warehouse providers are chasing a smaller overall lender pool, which supports the sector. So, for now lenders can raise finance, but at a higher cost, however rising interest rates and spreads are affecting transaction volumes.

Ramp-up risk is key for finance providers funding new lenders or starting new warehouses

Fledgling lenders may find financing harder to come by as finance providers choose to back established players, rather than exposing themselves to "ramp up risk", the risk that a new lender does not originate a critical mass of mortgage loans required for a "term deal" and the warehouse provider is left with a small portfolio that may be uneconomic to securitize. This may stifle product innovation in Europe's non-banks in the short term.

Despite spread widening, transactions are still pricing

Market attention has inevitably turned to issuance volumes, and although year-to-date volumes for both the U.K. and Netherlands are lower than in 2021, transactions are still launching (see charts 1 and 2). The summer period saw several pre-placed transactions executed which reinstated a tentative "public" market. Still, we should not assume that anyone launching a transaction has an absolute need to. Whether it is financially advantageous to execute a transaction often involves complex consideration of many factors, including future origination opportunities, capital efficiency, funding alternatives, and the impact of gain on sale accounting. Many lenders have locked in warehouse funding before the recent spread widening. Hence, for some lenders for now, warehousing mortgage loans, is cheaper than seeking "term funding" in RMBS markets. Although at some point warehouse providers may pressurize non-banks to exit warehouses either to free up capital and/or liquidity, some lenders seem content, for now, to maximize warehouse funding for as long as is advantageous and if there is no alternative to using the "term" markets, for example, banking relationship reasons.

Chart 1

Chart 2

Towd Point Mortgage Funding 2019 - Auburn 13 PLC and Towd Point Mortgage Funding 2019 Vantage 2 non-calls (Towd Point transactions)

Towd Point's trustees announced that neither of these transactions would not be called on their first optional redemption date. The announcements cited market conditions, and that they may be called on the subsequent optional redemption date. Given that non-calls have been relatively rare, these non-calls raise the question: Will this be the first of many?

Call incentives are complex, but lenders with an active origination business have, logically more incentive to call transactions as this protects their market brand and gives investors some comfort that they will honor future calls. This in turn may cause pricing of liabilities to pick up at the new issue stage. Lending costs are significant, especially for lenders in the regulated owner-occupied stages. Hence, often protection of significant franchise value is key relative to the global financial crisis period. Although not preferable, some lenders may over time—and assuming no spread contraction—think that exercising a call option and replacing it with more expensive warehouse funding or a portfolio sale is necessary to maximize longer-term franchise value. Although many non-banks' short-term lending volumes are likely to be significantly lower than predicted at the start of the year, the medium-term outlook for specialist lenders is strong as the cost of living crisis is causing a larger pool of borrowers to withdraw from mainstream lenders. Therefore, some lenders may be begrudgingly prepared to accept some short-term pain (calling transactions) in exchange for the increased likelihood of being able to access the market at a later date. So, for now, we don't interpret the Towd Point transactions' non-calls as being a trend-setter.

Table 1

Major RMBS Markets Are Derisking, With Demand Contracting And Sentiment Weakening

The European Central Bank's (ECB) October 2022 Bank Lending Survey is notable for three reasons. Firstly, banks surveyed for the study saw a significant net decline in housing loans demand in the third quarter of 2022. Overall respondents reported a 42% drop in demand for loans to households for house purchase. This follows a 10% drop in Q2 and excluding the pandemic period is the largest decrease since the first quarter of 2012. Respondents cited interest rates, consumer confidence, and housing market prospects as the main reasons. In the fourth quarter of 2022 banks expect a further strong net decline in the demand for housing loans (net percentage of -64%).

Secondly, it states that eurozone banks reported a net increase in the share of rejected mortgage applications since the series began in 2015 at 31% (28% in Q2 2022 from 1% in Q1).

Thirdly, banks reported a strong net tightening of overall terms and conditions for housing loans in the third quarter of 2022. Although the specific details are not covered, lowering of LTV ratios and increased pricing are both discussed. Respondents expect a further net tightening in Q4. Although this remains to be seen, rising rates will inevitably result in an adjustment phase where lenders are aware of being left as the only lender in a particular market segment. Many lenders are likely to be more than happy with this "safety in the pack" approach.

Country Summaries

Ireland: A mixed bag for the mortgage sector

A possible new lender (MoCo) is seeking authorization from the Central Bank of Ireland to enter the Irish mortgage market in 2023. This comes at a time when the number of lenders in the Irish market continues to contract following the recent exit of two retail banks, KBC and Ulster Bank. This leaves only three pillar banks: AIB, Bank of Ireland, and Permanent TSB. We understand MoCo is targeting the Irish digital banking space. See "Irish Nonbank Lenders May Capture More Of The Irish Mortgage Market" for more detail on the future of Ireland's non-bank mortgage sector.

Like other non-bank lenders, MoCo is likely to finance its operations through the capital markets. The lender will leverage An Post's brand name, while using a business model that will seek to offer a completely digital platform where customers can access a streamlined mortgage approval process and application in a more efficient timeline than within a traditional retail bank setting. The start-up also aims to operate through a broker channel.

MoCo is yet to comment or release any specific mortgage products, however some of the current non-bank lending players such as Finance Ireland and ICS Mortgages have recently raised their fixed rates—a common trend among non-banks as they are exposed to growing financing costs due to rising interest rates. Another non-bank lender—Dilosk—also recently stepped back from the market by decreasing the maximum loan-to-income available to 2.5x from 3.5x annual salary.

A second fully digital non-bank lender is also seeking to enter the Irish mortgage market. Nua money seeks to operate wholly online, offering mortgages and green loans. Authorization of both lenders to compete within the Irish market will bring the number of non-bank lenders we are aware of to six and is likely to spur market competition. Data in recent Banking and Payments Federation of Ireland reports show a growing appetite for remortgaging/switching. Remortgaging/switching increased by 129.3% year-on-year from May 2021 to May 2022. This indicates that customers are more open to shopping around for the best pricing rather than focusing on relationship banking.

The Irish Central Bank announced in October a relaxation to its maximum affordability limit for residential lending to 4.0 times from 3.5 times for first-time buyers only. Effective from January, while its impact could increase mortgage production, it is unlikely to change the risk profile of RMBS transactions in the short term. In addition to the relaxation of the income multiple, the central bank increased the maximum loan-to-value (LTV) ratio for owner-occupied loans to 90% for both first-time buyers and subsequent buyers.

An eviction ban was also announced, but we understand this is a ban on terminating tenancy agreements up until the start of April 2023, and that exceptions may apply if the landlord is not being paid rent. Consequently, it would prevent landlords evicting tenants and selling their property but means they could sell property with tenants in residence. Similar to the Scottish rent freeze highlighted below, this reflects governments' increased willingness to become involved in the housing market.

Spain: Government and banks are discussing how to help vulnerable borrowers

Spanish banks are working together with the government to extend and reinforce the already existing Code of Good Practise, that provides protection to families with difficulties paying their mortgages. One of the main measures still under discussion, is the extension of the mortgage term to loans that become 30% more expensive, due to the rise of the Euro Interbank Offered Rate (EURIBOR).

Another proposal under discussion the freezing of mortgage installments for one year. The impact of these measures, from a securitization perspective, would depend on each underlying transaction's specific features. Most of Spain's recent mortgage originations are fixed for life and would not be affected by such a move (73% of new mortgages in Spain in H1 2022 were fixed for life). However, this is not true for RMBS or indeed residential collateral backing reperforming or nonperforming transactions which tends to be variable rate (approximately 90% of the collateral backing our rated Spanish RMBS transactions is variable).

Specific details of the entire proposal will be key to understand the impact—specifically to which debtors it applies to, eligibility requirements, duration, and other potential protective measures. These measures are likely to only be offered to vulnerable borrowers under the Code of Good Practise. As these borrowers are a minority, we believe any ratings impact is unlikely.

The collaboration of the government with banks to propose new measures that could revise the existing Code of Good Practise highlights that intervention across Europe cannot be ruled out in the wake of mounting consumer pressure. See also observations on Portuguese Government term extensions and Scottish Government rent freeze below.

More product innovation  Spain faces many of the challenges faced by other European housing markets. Many Spanish young borrowers and first-time buyers are struggling to get on the property ladder at a time when affordable rentals in major cities are becoming harder to find. High house prices make it more challenging for Spanish young borrowers to build up deposits required to purchase a house. So far, we have seen schemes such as rent-to own and build-to-rent recently gain some traction. The Spanish market has seen more public sector intervention designed to deliver house ownership to those that want it. The Community of Madrid is looking to implement a new help-to-buy scheme, "My First Home," similar to U.K. schemes for first-time buyers under the age of 35, whereby banks, will grant mortgage loans up to 95% of the property value (with a maximum of €390,000), reducing the down-payment younger borrowers need to acquire their first residence. The Community of Madrid will guarantee the portion exceeding 80%. The Governing Council has approved an investment of €18 million to this scheme and these schemes are designed to bridge the gap between younger borrowers and standard down payments.

Portugal: Mortgage legislation in progress

The Portuguese government is working on legislation that would require lenders to proactively engage with customers who see their debt-service-to-income (DSTI) to surpass 36% of their monthly net income by renegotiating loan terms. The aim of the legislation is to support borrowers with spiraling monthly outgoings due to a combination of high inflation and rising EURIBOR. According to the central bank, 93% of the country's outstanding mortgages are linked to a variable rate which exposes the overall mortgage market further shocks.

Central bank data suggest that 90% of loans advanced since 2019 had a DSTI of less than 27%, well below the 36% threshold currently being considered.

We generally expect changes in loan terms, such as a reduction in loan spread or an increase in the maturity to negatively affect the securitization market. Nevertheless, it is important to consider each transaction's structural features of each transaction, such as available liquidity funds, loan seasoning, and available credit enhancement.

U.K.: The return of basis risk

Of U.K. RMBS transactions where the liabilities transitioned from LIBOR to a Term-SONIA-linked rate, 23% are exposed to levels of basis risk that may lead to reductions in excess spread and reserve fund draws. These reductions in excess spread and reserve fund draws do not signify collateral deterioration. We have observed this in a small number of rated transactions and this may also occur in other transactions that we rate.

We do not expect there to be any ratings impact for these transactions to the extent that these transactions transition off a term-SONIA linked rate. However, if the level of basis risk currently observed persists for a prolonged period or the difference between the Bank of England's Base Rate and Term-SONIA reference rate further increases, there may be ratings impact for mezzanine and junior notes.

Transactions that were not affected by LIBOR transition are also exposed to basis risk, though the level of basis risk is lower. For these transactions, we do not expect there to be any ratings impact (see "Basis Risk, Not Collateral Performance Affecting U.K. RMBS").

Scottish rent freeze represents government housing market intervention   In September, The First Minister of Scotland announced a rent freeze that covers both the private and social sectors. In isolation such a move is not likely to have any ratings impact. Firstly, not all BTL transactions have exposure to Scotland and where Scottish loans are present, they tend to total about 5% of the portfolio. In addition, most borrowers will have a fixed rate for the period, insulating themselves from any rates increase over the next six months. Scotland's move is potentially significant in that it is a further example of government interaction in the housing market. We have highlighted other similar examples in past updates. A supply and demand imbalance continues across European economies, which is increasing rents and/or house prices to the extent that housing supply is rapidly becoming a political issue. This in turn may increase the risk where regulatory interventions change risk profiles for certain residential assets. Holiday rentals and BTL assets are more exposed to this risk, in our view.

The Netherlands: Housing supply is becoming increasingly political

As highlighted in our Q1 2021 European RMBS Market Update, housing supply issues and the increasing cost of both renting and buying has turned housing into a mainstream political issue in the Netherlands. So far, political interventions such as restricting the purchase of new builds to investors and thereby forcing developers to sell to owner occupiers has been forward-looking, and by virtue of restricting future rental supply has supported existing supply. However, recent Dutch Housing Ministry proposals suggest that local officials can allocate 50% of housing stock to people who already live in an area. Current rules allow localities to allocate rental properties to local residents. These proposals seem to go beyond that and also cover owner-occupied loans up to the Nationale Hypotheek Garantie (NHG) guarantee limit (currently €355,000). Such a proposal may mean that borrowers can only sell to local residents and therefore limit the pool of demand for a property meaning that values may be supressed in areas where local demand is low.

Editor: Claire Ellis.

Related Research

• European RMBS Index Report Q3 2022, Nov. 7, 2022
• Basis Risk, Not Collateral Performance Affecting U.K. RMBS, Nov. 2, 2022
• Cost Of Living Crisis: How Bad Could It Get For Irish Reperforming RMBS?, Oct. 25, 2022
• Irish Nonbank Lenders May Capture More Of The Irish Mortgage Market, Oct. 25, 2022
• Cost Of Living Crisis: U.K. RMBS 2.0 Has Built-In Resilience, Sept. 6, 2022
• U.K. Nonconforming RMBS: Looking Beyond Headline Arrears, Aug. 25, 2022
• European RMBS Market Update Q1 2022: Challenges And Opportunities From Rising Interest Rates, June 1, 2022
• Cost Of Living Crisis: How Bad Could It Get For U.K. RMBS?, May 20, 2022
• What Is Prefunding And How Does It Affect U.K. RMBS Transactions?, March 24, 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