Something doesn’t add up in legacy RMBS
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Something doesn’t add up in legacy RMBS

Ruined house, Vaul, Tiree, Inner Hebrides, Scotland.

Arrears are rising as expected, but downgrades are creeping in as well

In the European residential mortgage-backed securities market, there is still a serious amount of hairy collateral kicking around from before 2008.

These legacy deals, as they are known, have always been seen as an asset class of their own. But recent interest rate rises have highlighted just how different its performance can be from recently originated non-conforming mortgages.

Consider Cerberus’s legacy deal Towd Point Mortgage Funding 2024 – Granite 6, priced in April. According to Fitch’s ratings report, 23.7% of the pool is at least one month in arrears. The class ‘D’ notes, rated BBB by Fitch and Baa3 by Moody’s, have just 5.75% credit enhancement.

It seems like a contradiction, but arrears don’t necessarily mean losses for RMBS noteholders. The servicer can repossess the properties and sell them to pay back investors.

That should make these bonds quite safe, considering nearly two decades of rapid house price growth have dragged down loan-to-value ratios to the point where Fitch put the Towd Point deal's average current LTV at 44%.

Plenty of headroom then — but such a calculation makes two crucial assumptions that do not necessarily hold up under scrutiny.

First, that it will be possible to repossess the properties in a timely fashion and second, that the LTVs are correct.

On the first, these borrowers are unlikely to willingly hand over their keys. They will have been in their homes since the early 2000s. That means they made it through the 2008 financial crisis and all that followed without having their homes repossessed. UK law grants a savvy borrower options to help them hang on while they wait for interest rates to fall.

On the second, for most deals, valuations are calculated using the home's initial value, altered according to an index of property values.

Considering that borrowers who end up getting repossessed have no money to pay their mortgages, it is unlikely they have the funds to invest in the upkeep of their properties.

That’s fine if it’s a recently originated loan, but if the original valuation was made over 15 years ago, that’s plenty of time for a property to suffer damage.

S&P noted just such a pattern in its presale report for another legacy deal, Stratton Mortgage Funding 2024-2, which refinanced the 2021-1 edition.

“The observed loss severity reported at the closing of Stratton 2021-1 for some loan vintages for properties repossessed and sold between 2013 and 2020 was high, but not unusual for legacy loans,” the report said. Accordingly, it “applied haircuts to valuations”.

That deal was a rare example of a legacy trade being marketed publicly. Investors forced the mezzanine notes wide of initial pricing thoughts.

The deal had triple-B credit enhancement of 9.64% compared to arrears of 28% of the pool, according to S&P. The current LTV was put at 55%.

Downgrades mount

There has also been a creep of downgrades of such deals, quite soon after they were rated, most commonly because arrears were rising more quickly than expected.

Everyone expected arrears to go up in these pools. The loans are mainly floating rate and often interest-only, which means the borrowers' exposure to recent rate rises is particularly acute. What is more, the borrowers left in the pool are probably paying high interest rates, unable to refinance elsewhere.

Some of that has been priced into ratings, but downgrades still seem to be accruing in the lower reaches of capital structures.

S&P and KBRA have both lowered ratings on Parkmore Point 2022-1, priced in August 2022, with S&P even downgrading the ‘C’ notes.

S&P and Fitch have both cut ratings on Bridgegate Funding, issued in January 2023, though in part for S&P that was down to a calculation error.

S&P also lowered ratings on some tranches of Irish reperforming deals Primrose Residential 2022-1 and Shamrock Residential 2023-1 from March and February in the years the names suggest. And it downrated three tranches of Grosvenor Square 2023-1, a post-financial crisis but long-seasoned deal, priced in March 2023.

There are other problems that make these deals a different beast from recently originated collateral. Data on them sometimes only arrives quarterly, which can lead to an immediate jump in arrears when the new figures come in.

It will likely be a slow burn, but expect more credit snags in this vintage of legacy refinancings.

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