Drawing on reserve funds has become more common among U.K. subprime RMBS transactions, with two deals siphoning cash just this month and others likely to follow.
Last week Fitch Ratings and Standard & Poor's took action against Rooftop Mortgages' Farringdon Mortgages 1 U.K subprime issue, following a tap made on the transaction's reserve fund. S&P placed the Class M2 and B notes on credit watch with negative implications while earlier in the week Fitch placed the entire capital structure on ratings watch negative.
Tapped out?
The Farringdon Mortgages tap closely follows the early April draw made on Southern Pacific Securities 04-2 Plc reserve funds, which garnered no negative consequences. "Some market participants believe that reserve fund draws are gloomy news for investors," wrote analysts at S&P in a report on the sector. "We consider that, provided that there is sufficient credit enhancement, a reserve fund draw should not be an immediate cause for concern."
Farringdon and Southern Pacific Securities 04-2 both used the aggressive stripping of cash flows at the top end of the waterfall. Analysts at Royal Bank of Scotland said that issuers typically use such techniques because rating agencies offer limited credit for excess spread and almost no credit for prepayment penalty fees. At the same time, issuers can use the securitized interest strips and prepayment fees as collateral for additional borrowings. S&P noted that its rating criteria are based on the timely payment of interest and ultimate payment of principal, not on the drawing of reserve funds. The stresses applied to these transactions at closing inevitably trigger these reserve draws.
Southern Pacific Securities 04-2 Plc made a drawdown on its reserve fund over the same period as Farringdon. Both transactions have exhibited rising arrears, repossessions and losses in the underlying portfolio as well as a step-up in the detachable coupon. However, analysts at S&P said that there still remains sufficient enhancement in the Southern Pacific Securities transaction to prevent any immediate cause for concern.
Farringdon, on the other hand, exhibited poor collateral performance in its latest report, with losses overwhelming excess interest. As a result, the transaction tapped its reserve to make up for the shortfall. At such an early stage in the transaction, the effect of a draw has caused some concern.
Deal analysis
Fitch's latest loan-by-loan analysis found that the amount drawn is GBP216,187, out of a total reserve of GBP1,371,535. This reduces the size of the reserve fund to 0.92% from 0.98% of the initial note balance. "A number of other U.K. nonconforming issues have faced recent reserve draws but Farringdon Mortgages 1's draw... amounted to 18.7% of the first loss fund including one-time legal and accounting expenses," reported analysts at RBS. "In the other cases, reserve draws were relatively small generally amounting between 1% and 4% of reserves, [and] those deals were also more seasoned and therefore reserves were higher as a percentage of outstandings."
According to Fitch's UK non-conforming index, the Farringdon transaction, which closed earlier this year, remains relatively unseasoned with a weighted average seasoning of 16 months and has 18.76% of loans that are more than 90 days in arrears compared with an average of 8.76% for similarly seasoned U.K. subprime RMBS deals. "We do not believe that these draws are inherently bad, demonstrating the resilience built into structures; however, the magnitude of the Farringdon draw is troubling, early on in the transaction," reported RBS analysts.
Sarah Barton at Morgan Stanley reported that Preferred Mortgages Limited has also seen performance deterioration while analysts at RBS suggest that Bluestone 2004-1 has seen excess spread pinched to very thin levels in its latest investor report and could draw on its reserves at its next IPD.
The recent actions have so far caused little market reaction - nonconforming RMBS spreads last week continued to trade flat to recent activity on light volumes. But analysts at RBS are concerned that not enough tiering exists in the market, and recommended that investors buy credit protection on weaker names and sell credit protection on better quality ones.
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