With another record year under its belt, the U.K. RMBS master trust looks ready to lead another year of strong RMBS volumes - but have the worsening economic conditions finally put these structures to the test?
According to JP Morgan Securities, pricing on the latest jumbo U.K. RMBS deal, Northern Rock's Granite, has provided indicative spread levels for the benchmark mortgage-backed sector: Granite's five-year triple-A Euro- and Sterling-denominated paper came at 24 basis points over the three-month Libor, two to five basis points behind pricing levels seen at the end of third quarter 2002. Five-year triple-Bs are now at 145 basis points over three-month Libor, pricing 20 basis points behind 2002 third quarter levels.
"The emergence of Granite served as an indicator for the market," said analysts at Commerzbank. "Granite effectively demonstrated that concerns about the U.K. housing market, changes to the collateral profile and the threat of war remain. Investors clearly require compensation for the additional credit work and specifically getting comfortable with the risk against uncertainty over market conditions."
Since last year, the master trust structure has experienced the progressive elimination of the mortgage indemnity guarantee (MIG). According to Moody's Investors Service, the MIG provides varying protection from losses on loans with higher LTVs, with the threshold protection level normally at 75%; the MIG provider agrees to pay the difference between the actual LTV and this threshold in a recovery situation.
The latest Northern Rock deal will include self-certified mortgages and will not include MIGs for loans with LTVs below 85%. At closing, the transaction will include a relatively low weighted average LTV of mortgage loans, but over time the structure will incorporate loans with LTVs over 75% that will not feature MIG (with LTVs below 85%).
"The key message is that we see an increasing range of prime' collateral in prime transactions - including self-certification mortgages, non-MIG mortgages and higher LTV mortgages," explained Iain Barbour, head of structured finance research at Commerzbank. "This blurs the differentiation between prime and sub-prime, and certainly between prime conforming and prime non-conforming.
Nonetheless, the rating agencies have refined their analysis and rating approach for prime U.K. RMBS to respond to the changes in these pools; these transactions are consequently structured with these requirements in mind, with appropriate enhancement for the risk profile of the assets.
In Abbey National's Holmes Master Trust, the rating agencies required increased enhancement against higher LTV loans - not in the trust structure but via fees - as a replacement for the MIG. According to market sources, HBOS also no longer uses MIG policies, and is required to use high LTV fees for these loans as well if they are put into an ABS.
As a response to the lack of an MIG in the Granite transaction, the rating agency sized only an additional 10 basis credit points to the reserve fund at the master trust level and not the issuer specific fund. "What this says to me is that the agencies weren't really giving the inclusion of the MIG that much credit - they already look at recoveries more from the perspective of how much one would be able to sell the house for and how long it will take to sell," said Jenna Collins at Merrill Lynch. "So not having the MIG is not really as huge of a concern as it might seem at first."
Increasingly, banks are looking to leave out this extra credit enhancement because the premium paid to get MIG coverage far outweighs the claims they actually make. These banks are paying money for something they don't use, which could be interpreted as a positive sign for investors. "But this also has to be considered in the recent economic environment," said Collins. "It makes sense that MIG isn't used much in a period of rising house prices; the question is, would this be the case if there are severe house price declines?"
The immediate sense going forward is that RMBS will remain the backbone of the European ABS market. According to the Royal Bank of Scotland, despite economic concerns, arrears and losses on residential mortgages have remained at low levels and this loss trend should continue into 2003, although increased lender forbearance and slower economic growth could push arrears higher. Moody's added that 2003 should prove to be an equally busy year for the master trust and said that the structure is showing signs that it is coming of age.
"Right now I think the feeling is that we are certainly expecting to stay reasonably stable," said Barbour. "We expect a bifurcation of spreads between those transactions featuring more divergent pools of prime' collateral and those focused on purer prime collateral."
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