Conservative lending practices might be easing banks back into shape, but on the borrowing end, the scenario continues to get messier.
Without a correction in interest rates, U.K. borrower affordability will continue to be pinched as mortgages come off their teaser periods. Market sources said it could have a much greater impact than originally thought for arrear performance.
Deutsche Bank analysts estimate that a typical prime borrower faces an incremental 10% spike in repayment costs upon reset should they take out a two-year fixed-rate product.
Meanwhile, U.K. banks last week reported that arrears in most lender mortgage books continue to rise, but absolute levels remain relatively low.
According to Deutsche Bank, Northern Rock reported three-month-plus delinquency levels rising to 0.95% at the end of April 2008 from 0.57% at year-end 2007. The beleaguered mortgage firm said that the rise is partly a result of the shrinking mortgage book and changes in how borrower arrears are capitalized.
Late-stage arrears in Northern's Granite master trust have, as a consequence, also increased over the same period from 0.52% to 0.75%, an almost 50% rise.
As borrowers face rising mortgage payments, the number of court-ordered home foreclosures has also increased.
Foreclosures have already seen an increase in 4Q07 and market analysts said that, as the impact of rising interest rates continues to rock households, repossessions are likely to exceed 1991 to 1992 levels because of the increased leverage created by nonconforming mortgages and buy-to-let products.
"Nonconforming mortgages, offering riskier loans, have increased the repossession statistics over recent years," Societe Generale analysts said. "However, increased risk appetite and rapid house price inflation allowed most borrowers under duress to refinance out of trouble. These inflated loan balances are likely to transfer the default risk forward to the present day."
SocGen analysts said that the deals that are likely to be impacted the most benefit from a significant built-in credit enhancement and are available at generous margins.
In some instances, triple-A credit enhancement would cover a 35% fall in house prices and allow a further 10% margin for accrued interest and costs. "We continue to believe that some of these transactions offer value, which is overlooked by the market," analysts said.
It's CPRs that might potentially cause the most damage in this widening spread environment.
"To extract the most value out of current markets, it is almost more important to buy as CPR expectations bottom out than when spreads do so," said SocGen analysts. "Given that CPRs will likely accelerate once lending recovers, especially in the prime market, value is relatively abundant."
According to them, transactions like the Arran prime U.K. RMBS deals have seen CPR rates fall significantly to around 16, which allows buyers to negotiate heavy cash discounts and probably benefit from a recovery in lending in 2009, causing CPRs to rise.
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