TwentyFour Asset Management
In recent days we have seen policy announcements in Italy, and from Royal Bank of Scotland in the UK, designed to support borrowers who are affected by COVID-19 directly and indirectly. Announcements like these look set to become common place.
As part of huge global monetary and fiscal stimulus packages, we see governments’ and banks’ willingness to support vulnerable citizens as entirely appropriate and positive. In the UK, “treating customers fairly” and also support for “vulnerable” customers is something that has been a normal operating practice since wide scale reforms under the Mortgage Market Review in 2014. So we see announcements as supportive headlines but not new measures, which also means they are tested protocols.
From a mortgage performance point of view, three trends are likely. The first is rising arrears, with disruption to everyday lives and unemployment likely to cause some borrowers to miss payments, most of these will likely be those indirectly impacted by COVID-19 but directly impacted by the economic fallout. Bank support here is critical. Secondly, and as a consequence of support being offered, we would not expect to see a high proportion of these arrears translate into defaults. Finally, monetary policy will feed into mortgage interest rates, reducing payment burden over time, though the quantum of this boost is limited given the low starting point for rates.
The combination of these three mean we expect a short term but transitory impact on residential mortgage performance.
How do we expect that to impact residential mortgage-backed security (RMBS) deal performance?
RMBS deals are structured with a number of protections to cope with periods of crisis and disruption to performance, designed to keep bond payments flowing even in acute periods of stress. The three main pillars of protection for bondholders, in order, are excess spread (the net profit of a deal after bond payments are made), cash reserve funds and then subordination (any losses that do occur impact junior rated bonds first).
Importantly, a short term issue in one period for an RMBS can be repaired in later periods, unlike a corporate loss. So if a deal needs to borrow £1m from a reserve fund in Q2 2020, it could use excess revenue from the pool in later periods to replenish the reserve fund. The power of this can be seen using an example of an acute period of stress like the one we are likely to face in the coming weeks.
RIPON 1 is a £7.6bn benchmark UK RMBS deal, issued in 2017 with 0.38% of loans in arrears currently. If we assume 100% of borrowers in the mortgage pool miss interest payments for 24 months, and it then takes a further 18 months for those borrowers to gradually make whole payments, the BB rated class F bond would continue to receive its full coupons and would redeem at par. This is a good proxy for lenders granting payment holidays. However, to give context, this portfolio (under Bradford and Bingley’s RMBS programme) saw arrears peak at 5.7% in 2009.
This gives us reassurance that headlines will not serve to undermine the credit quality of our RMBS holdings, and also shows that we should not fear lenders accommodating borrowers’ short term needs for an extended period of time.