Moody’s, the credit rating agency, published a report a few days ago on the asset backed securities market. One section of the report has attracted some media attention – it details the agency’s thoughts on UK interest-only residential mortgage-backed securities (RMBS).
Moody’s reaches the fairly unsurprising conclusion that when interest rates start rising in the UK delinquencies on interest-only mortgages will pick up. They go on to say that this effect will be greater in the non-conforming sector than in the prime segment of the market. This makes sense, as borrowers who have an impaired credit history usually fall into the non-conforming bucket and are therefore, on average, more likely to have trouble paying their mortgages than those who qualify as prime borrowers.
This isn’t as bad for RMBS deals that are backed by interest-only mortgages as one might think. A large proportion of RMBS deals are structured with features that protect investors in the more senior notes to the detriment of those who own the more junior ones. A variety of trigger levels are usually built into the deals which amongst other things reference delinquencies and credit enhancement. If these triggers are hit, cash flows are diverted to the most senior tranche of notes, bringing forward their maturity date and increasing their yield.
A deal I have been looking at recently is 95% backed by interest-only mortgages and has a trigger when 7.5% or more of the mortgages are more than three months in arrears. Delinquencies are currently much lower than that but if they did breach the 7.5% level the deal would switch from paying pro-rata to sequential. This means that any excess cash that is generated through repossessions or borrowers re-mortgaging will all be paid to the lenders at the top of the stack instead of being shared by all the note holders. An increase in interest rates and delinquencies would in this instance clearly be of benefit to the senior notes.
Another dynamic to be aware of is when the mortgages backing the deal were originated. Mortgages taken out closer to the peak of the credit bubble in 2007 are generally of a lower quality because lending standards were weaker and borrowers generally have less equity in their property. As a result, these mortgagees have less of an incentive to keep paying their mortgage each month.
Holders of junior notes in later vintage deals should definitely be worried by the prospect of higher interest rates in the future. Senior note holders – whilst remaining attentive to movements in the market – should be fairly comfortable with the credit quality of their bonds, even in a climate of higher interest rates.