Last week Fitch Ratings said that Eurosail 2006-3 NC plc had drawn on its reserve fund as of the March 2008 payment date. The draw is one of a number seen in U.K. nonconforming transactions in recent weeks.
However, unlike prior draws, this latest one is performance related and not about structure.
A number of recent draws within U.K. nonconforming deals have been caused by structural issues such as a lack of a fixed-floating swap or a basis risk swap. By the fourth quarter of last year, rating agencies began to show signs of greater caution toward deals with unhedged basis.
However, the Eurosail deal did have appropriate hedging mechanisms in place. The draw, analysts said, has been driven by a deterioration in the transaction's performance along with the impact of a step-up in the margin paid on the detachable A coupon (DAC). The DAC is attached to the A3 note and excess spread notes.
The Eurosail transaction contains a detachable coupon on the A3 notes as well as subordinated excess spread notes (the ETc and FTc notes). Both the A3 DAC and the ETc notes strip interest from the structure senior to the reserve fund in the payment waterfall.
Excess spread-stripping DACs reduce the available excess spread and differ between deals, both in timing and relative size. Their impact is exacerbated by slowing prepayments and weakening pool performance. According to market analysts, turbo tranches typically strip far less excess spread than DACs, and do so further down the capital structure, but still have a detrimental effect on available excess spread.
Loans in arrears by more than three months, including loans in possession, comprised 18.3% of the outstanding portfolio as of December 2007, with cumulative losses of 0.05% of the original portfolio balance. Fitch said it would undertake further analysis on the performance of Eurosail 2006-3 following the draw.
Chris Greener, senior analyst at Societe Generale, said that the reserve draw is similar to those seen in Kensington's RMS 15-17, though these were arguably because of related loan defaults rather than general performance deterioration. "Eurosail's draw was predominantly caused by excess spread stripping - a strong negative in our view - though it does highlight the deterioration in performance likely to continue through 2008," Greener said. "It is therefore highly likely that those deals with heavy excess spread stripping will face reserve draws going forward."
Phil Adams, RMBS research analyst at the Royal Bank of Scotland, said that the rise in interest rates experienced by borrowers in this market segment has been substantial, resulting in a potentially significant payment shock for anyone coming off of a two-year fixed-rate deal. The latest interest rate cuts might have mitigated the impact slightly, but the potential for payment shock is greater now than the last peak in 2005. This was when the market also saw some reserve draws.
"It is interesting that this is supposed to be a performance deterioration-related reserve draw rather than a structural issue, given that the presence of DACs and Turbo notes depleted the cash flows reaching the reserve fund," Adams said. "However, a collateral performance deterioration is the major contributory factor, and I would expect to see more such events through 2008."
Proceed with Caution
Analysts agree that there are weak deals to watch out for within the U.K. nonconforming space, but the sentiment in this market sector is far from U.S. subprime. "The timing is just not the same," a market source said. "In Europe, the music stopped with what was happening in the U.S. Potentially, in another six months the market could have reached the level of lending that the U.S. saw, but it had to curb itself before it ever got out of control."
Deutsche Bank analysts explained that performance within the sector is largely driven by the fear that trends in the U.K. nonconforming market will come to mirror that of its closest perceived comparable, the U.S. subprime mortgage market.
"I don't believe that U.K. nonconforming is falling to pieces' like the U.S. subprime deals," Adams said. "The U.K. is performing significantly better and has reasonably good support from economic factors, such as unemployment rate and earnings growth, despite the expected slowdown. House prices are also expected to be more resilient this side of the Atlantic."
Greener said that arrears and losses will continue to grow, mainly driven by the lack of refinance availability, causing pressure as loans revert to standard variable rates, but the Lehman Brothers-led loan modification program for Capstone Mortgages (ASR, 1/21/08) should have some positive performance implications, allowing those borrowers who are willing and able to pay to withstand the storm.
For those more distressed borrowers, property disposals are likely to increase, but LTVs were typically lower in the U.K. than in the U.S., with heavy adverse products limited to 75% LTVs. Losses should also prove more limited. Analysts are most cautious on deals with heavy concentrations of the riskiest loan or borrower types, which include recent vintage adverse credit quality, high-LTV, second-lien and self-cert loans.
"We are very concerned with second-lien loans, where high losses are likely given the loan seniority and smaller size," Greener said. "Valuations for remortgages and second liens are also harder to verify, given that the property has not actually changed hands. We believe that any principal losses will be restricted to the most junior tranches of recent vintage transactions with heavy excess spread stripping, unless high proportions of second-lien loans exist."
According to Deutsche Bank analysts, second-lien mortgages average 5% of U.K. nonconforming deals but can account for up to 30% of the loans in some pools. These mortgages make up a significant portion in four series that included the Eurosail, the London Mortgages MARS and the Kensington Mortgage transactions.
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