The Bank of England lowered base rates by 25 basis points last week in what is expected to be the first in a series of rate adjustments over the coming months.
But as the U.K. market scrambles to contain housing sector woes, the base rate cut might be doing more harm than good to the country's RMBS.
To be sure, borrowers can look forward to reduced monthly payments plus other additional relief provided by the rate cuts slated to happen in 1Q08.
Market sources said that in the current market environment, the number of base linked mortgages is increasing as borrowers find it more advantageous to track rates and because they view the product as more transparent.
However, the rate reduction is doing little to alleviate problems in the securitization market.
"At this stage, we do not see the scale of this rate cut benefiting mortgage credit trends, not at least in the non-conforming market where we see the greatest risk to performance going forward," Deutsche Bank analysts said.
What it's done instead is to create a disparity between the Libor rates earned on RMBS notes and the Bank of England base rate. The differential between these rates limits the available excess spread for RMBS transactions, which means less funds available to pay off notes.
The effects of this divergence are starting to show. Last week, Fitch Ratings downgraded the Class S notes of RMBS deal Ludgate 2006-FF1 to B' from BB-', with the outlook remaining negative. The Class D (BBB') and Class E (BB') notes have been affirmed but have a negative outlook.
By Tuesday, investor reports on GMAC-RFC's RMAC transactions disclosed that there had been drawings on reserve funds for all the 2006 vintage deals and a small drawing for RMAC 2007-NS1. Here too, the draw on reserves was driven by the high proportion of unhedged (or partially hedged) fixed-rate mortgages in the collateral pools.
There will likely be more bad news. Two additional Bank of England base rate cuts are slated for the first half of 2008.
This could create an even bigger disparity between the Libor and base rates, an event that potentially affects any deal backed by mortgages resetting on a monthly basis, Fitch said.
With the growing differential, deals like Ludgate could see their reserve funds substantially depleted. "It would be the first time that we have ever seen this in deals like Ludgate," a market source said.
The real benefits for the securitization market will come into play when the Libor rate cuts begin, which most agree is definitely on the agenda.
The only problem is that Libor rates are set quarterly, which means that to get a real bargain, the market will have to wait it out until March of next year.
"Further rate cuts - provided they are reflected in Libor - should help improve the situation over the coming quarters until the fixed-rate period starts to expire," Royal Bank of Scotland analysts said.
They added that, in such an environment, cash flow coverage would improve. This would, in turn, translate to fewer draws on reserve funds and, in some cases, replenish reserves that have been depleted during this difficult year in the market.
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