Key Takeaways
- Despite rising interest rates, the size of external liquidity reserves in most European ABS and RMBS transactions have remained broadly unchanged since 2020.
- Between Q1 2022 and Q2 2023 ABS and RMBS originators did not reflect higher interest rates to borrowers, while at the same time funding spreads and swap costs increased. This resulted in depleted excess spread and increasing reliance on external liquidity support.
- Consequently, some transactions have less available external liquidity to address significant event-driven liquidity disruptions, such as those deriving from commingling or cyber-attack risks.
- Generally, transactions have structural features to mitigate liquidity events, such as using principal to pay interest and deferrable notes. However, such mechanisms may affect the timing and repayment of the junior notes.
The structural features of European asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) transactions often rely on external liquidity support, such as reserves, which can provide liquidity and credit support. External liquidity support ensures the timely payment of interest on the notes and is usually calculated as a percentage of the closing asset balance. Generally, external liquidity measures always support the most senior notes. Support for junior notes differs by transaction.
Eurozone interest rates have increased significantly since July 2022. The European Central Bank (ECB) increased its interest rate to 4.5% from 0.0% between July 2022 and January 2024, and the Bank of England (BoE) base rate increased to 5.3% from 0.3% over the same period. Consequently, transactions have relatively less external liquidity and less excess spread, diminishing their capacity to face potential external liquidity tension and shock, such as those deriving from commingling risk or cyber-attack.
We analyzed European ABS and RMBS transactions rated between Q1 2020 and Q3 2023 and observed that since Q3 2022, considering rising interest rates and weakening macroeconomic conditions reflected in increased delinquencies and defaults in some countries, transactions could have relied more on external liquidity support. However, the absolute level of available external liquidity has remained largely unchanged for these transactions. In this article, S&P Global Ratings takes a closer look at this trend and its ratings impact.
Since 2020 Liquidity Remains Stable, But Excess Spread Decreases
Charts 1 and 2 show annual fluctuations in the absolute levels of European ABS and RMBS transactions' external liquidity calculated as a percentage of the class A notes' closing balances--the most senior classes in our rated transactions between Q1 2020 and Q3 2023. We consider external liquidity to be the aggregation of the general and liquidity reserve. The absolute level of liquidity remains broadly consistent year-on-year. This is despite the ECB base rate being 0.00% and BoE rate at 0.10% for most of 2020, increasing to 4.50% and 5.25% respectively, in December 2023.
Chart 1
Chart 2
To illustrate the point, let's consider a transaction with the class A notes' margin linked to the ECB policy rate plus 50 basis points (bps) rated in 2020 versus 2023. In 2020, the average general reserve, calculated as a percentage of the class A notes' closing balance was 3.2% for RMBS and 1.3% for ABS. Given the ECB rate was 0% in 2020, the annual total cost of the class A notes would have been only the cost of the class A notes' interest payment, such as 50 bps. This means the external liquidity support could pay 6.4 years and 2.6 years of class A notes' interest for RMBS and ABS, respectively.
In 2023 the picture looked very different. With the ECB rate on average at 3.8% and assuming the same margin of the class A notes (50 bps), the total costs were 4.3%, i.e., the ECB rate (3.8%) plus the class A notes' margin (0.5%). The average liquidity reserve amount in 2023 was 3.1% and 1.2% of the class A notes' closing balance for RMBS and ABS, respectively. External liquidity could only cover 0.7 years of the class A notes' interest for RMBS and 0.3 years for ABS. The above examples ignore items senior to class A interest such as servicing fees which may further limit external liquidity coverage.
Table 1
| Comparison of class A notes' interest coverage | ||||
|---|---|---|---|---|
| RMBS 2020 | RMBS 2023 | ABS 2020 | ABS 2023 | |
| ECB policy rate (%) | 0.0 | 3.8 | 0.0 | 3.8 |
| Class A notes' margin (%) | 0.5 | 0.5 | 0.5 | 0.5 |
| Total class A notes' costs (%) | 0.5 | 4.3 | 0.5 | 4.3 |
| Liquidity reserve (as % of class A closing balance notes) | 3.2 | 3.1 | 1.3 | 1.2 |
| Liquidity coverage (years) | 6.4 | 0.7 | 2.6 | 0.3 |
This means that in stressed macroeconomic conditions and/or in cases of performance deterioration (such as when delinquencies and defaults increase), less available external liquidity support may reduce the capacity to absorb significant operational disruption caused by some events, such as commingling risk and cyber-attack. This may particularly apply to monthly pay transactions, which have less available time to resolve external shocks before payment is due.
For example, in the case of a cyber-attack, a transaction may not have full visibility or access to collections, and it could use external liquidity support to ensure timely interest payments on the notes.
Structural mitigants
To mitigate any operational disruption and the effects of higher rates and/or performance deterioration, transaction structures typically have several features that can ensure the payment of senior interest notes, such as:
- Principal to pay interest; and
- Interest deferability on mezzanine and junior notes that can ensure timely payment of interest on highly rated tranches.
We consider these factors in our cash flow modeling and test them based on the transactions' characteristics and structural features.
Junior Tranches Could Be More Vulnerable To Liquidity Shock
Our analysis shows that although equivalent ratings may still be achievable for transactions issued in higher interest rate conditions such as in 2023, junior notes could be more vulnerable in terms of timing and cash flow payments.
In a higher interest rates scenario, with less excess spread available, transactions may have to rely more on structural mechanisms such as deferrable interest or principal borrowing, to pay timely interest on the senior notes. This means junior notes might suffer delayed repayment and the amount due could increase due to higher interest accrued on deferrable notes.
The scenario may differ significantly in a similar transaction issued in a lower interest rate environment, such as in 2020, with lower hedging costs. In this scenario, interest on junior notes may not have been deferred because sufficient available funds could repay interest on senior notes.
In our view, interest rates may have reached their peak, and we expect the ECB to start cutting them in the second half of the year. However, it will take some time for swap costs to stabilize, which may generate more excess spread for European ABS and RMBS transactions. In the transactions closed since the beginning of 2024, spreads and swap costs have already started to decrease. Additionally, originators have repriced loans, generating higher excess spread and supporting transactions to address significant event-driven liquidity disruption.
Appendix
Chart 3
Chart 4
Chart 5
Chart 6
Related Research
- European RMBS Index Report Q4 2023, Feb. 9, 2024
- European Auto ABS Index Report Q4 2023, Feb. 7, 2024
- Unraveling Irish Reperforming RMBS Uncertainty, Jan. 30, 2024
- European Housing Markets: Forecast Brightens Amid Ongoing Correction, Jan. 25, 2024
- European RMBS And ABS Monitor For Q4 2023, Jan. 25, 2024
- European Structured Finance Outlook 2024, Jan. 9, 2024
- Credit Conditions Europe Q1 2024: Adapting to New Realities, Nov. 28, 2023
- Economic Research: Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing, Nov. 27, 2023
- U.K. Economic Outlook 2024: More Stagflation Ahead, Nov. 27, 2023
- Credit FAQ Outlines How Product Switches Affect U.K. RMBS, Oct. 30, 2023
- How Could Cyber Risks Affect Structured Finance Transactions?, Sept. 8, 2021
This report does not constitute a rating action.
| Primary Credit Analyst: | Giovanna Perotti, Milan + 39 02 72 111 209; Giovanna.Perotti@spglobal.com |
| Secondary Contact: | Alastair Bigley, London + 44 20 7176 3245; Alastair.Bigley@spglobal.com |
| Research Contributors: | Kayur Chheda, CRISIL Global Analytical Center, an S&P affiliate, Mumbai |
| Deepika Sisodiya, CRISIL Global Analytical Center, an S&P Global Ratings affiliate, Mumbai |
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