The U.K. non-conforming market continues to show strong performance, despite looming doubts that tougher market conditions could negatively impact the resiliency of this structure. However, the credit protection in these structures - delivered through borrower equity, excess spread reserve funds and subordination - means that U.K. RMBS is sufficiently enhanced at all rating levels, ensuring that all noteholders should continue to be paid on time and in full in even the most adverse credit environment.

According to Morgan Stanley, over the past three years the market has generated over $4 billion in issues. So far the transactions continue to record low loss levels, and fast prepayments have caused a number of upgrades of the mezzanine and subordinated notes - even with the twin threat of a deteriorating housing market and growing unemployment rates

"Skeptics will argue that this success was achieved in an extremely benign environment," reported analysts at Barclays Capital. "It is true that this period has seen both unemployment and interest rates decline as well as rising wages in real terms and strong growth in house prices. This has resulted in a period where all lenders are experiencing very low loss rates."

If the market were to crash, however, analysts say that the structures could withstand even a worst-case scenario. "If conditions were to deteriorate and if there was a weakening housing market, these transactions could potentially experience a surge in arrears and sentiment could cause spreads to widen," said one analyst at Morgan Stanley. "But the credit quality is sound [within the structure], and we believe there is enough credit enhancement that if arrears and losses were to increase, excess spread and credit enhancement would sufficiently cushion any losses."

From 1989 to 1996, the U.K. passed through the worst housing recession since World War II. According to a Moody's Investors Service study on the U.K. residential market conducted last year, the projected cumulative loss rate for mortgages originated during that period was at just under 4.5%. The study concluded that U.K. RMBS transactions were enhanced adequately enough to "comfortably" accommodate an historical severe-loss scenario.

Barclays Capital took the test a step further and used an analysis modeled on a projected housing recession far worse than that of the early 1990's. In this scenario, house prices would fall further and faster, with default rates increasing five times over those seen in the early 1990's. Barclays concluded that, while credit enhancement levels could potentially erode in this situation, noteholders would still expect to be paid on time and in full.

But with interest rates at an all-time low, it's unlikely that mass depreciation will occur, at least not in the short term. Nonetheless, if the market were to crash the structures would likely withstand even a worst-case scenario.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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