- The extended furlough and mortgage payment deferral schemes, along with the tactical use of these schemes by borrowers, mean that U.K. RMBS arrears will rise slower and to lower peaks than would otherwise be the case.
- Servicing strategies and enhanced servicer operational readiness, when compared with the Global Financial Crisis (GFC), mean that reported arrears are likely to take time to build up.
- Generally robust housing equity levels at a borrower level, combined with the low interest rate environment, will positively affect borrower behavior compared with the GFC.
- Later stage arrears buckets are unlikely to clear quickly as court backlogs and the prevailing mood for servicers to be seen to be reasonable and offer as much flexibility as possible will combine to limit repossession activity.
The COVID-19 pandemic has suppressed the U.K. economy and U.K. consumer activity. Consequently, GDP has contracted approximately 10 percentage points between March 2020 and August 2020 and unemployment increased to 4.0% from 4.8% between March 2020 and November 2020 according to data from the Office of National Statistics. In addition, many people took advantage of either the Coronavirus Job Retention Scheme or the Self-Employment Income Support Scheme (the furlough schemes). S&P Global Ratings currently expects unemployment to rise further and is currently expected to peak at 6.3% in 2021. The exhibited and expected increase in unemployment will lead to increased arrears levels at all stages for most transactions. However, for the reasons highlighted below, we generally expect the increase to be gradual and for the peak arrears levels not to occur until the second half of 2021. Overall, we expect arrears levels to be far more correlated to unemployment increases, and therefore lower than observed in the fallout of the GFC.
Furlough Schemes And Payment Deferral Will Smooth Arrears.
The furlough schemes and the payment deferral (payment holiday) scheme currently extend to the end of March 2021 and July 2021, respectively. These schemes are intended to assist borrowers and earners until economic recovery hopefully takes hold.
The current understanding of the payment deferral scheme is that a borrower can defer payment for six months in total. Meaning that if they deferred payment for three months between March and June 2020, they can defer for another three months. If a borrower has not used this scheme to date, they are entitled to the full six months. If a borrower has already used six months of payment deferral then they are not currently entitled to any further deferral under the scheme. These borrowers will be treated in accordance with the standard forbearance procedures of the servicer/lender. Payment deferrals under six months are typically not classified as being in arrears. Borrowers who do not resume payments after six months of deferral will be classed as in arrears and reported as such to credit reference agencies. We understand that a borrower can apply for a payment deferral up until Jan. 31, 2021.
Peak U.K. payment deferral was high, with average uptake rates of 20%-30% for nonconforming loans, 15%-20% for prime loans, and 10%-25% for buy-to-let (BTL) loans (see "U.K. Mortgage Payment Holiday Risks Emerge As COVID-19 Requests Have Peaked," published on Sept. 2, 2020). However, the peak was relatively short lived. Many nonconforming transactions were showing single-digit payment deferral by July. This means that the vast majority of borrowers have not exhausted their six months of total deferral before a nonpayment would be classed as arrears.
The expectation in the short term is for payment deferral rates to increase, but well below the levels seen in late spring and early summer. From an RMBS transaction perspective, as few transactions drew on reserve funds at the peak of payment deferral use, we consider the peak liquidity risk to transactions to have passed. Transactions are expected to have sufficient external or internal liquidity, in the form of "principal borrowing," to deal with any unexpected spike in nonpayment. We also note that prepayment rates have recovered from the lows seen in the late spring/early summer period and will be available to provide liquidity for transactions with principal borrowing mechanisms.
Tactical Borrower Use Of Available Assistance Likely To Smooth Arrears
We have commented previously that, in our opinion, the payment deferral rates seen in the late spring/early summer period were not all due to borrower need. Some borrowers who were furloughed, and paid 80% of their income, and borrowers who were not furloughed, took up payment deferral. This means that some borrowers will, if prudent, have been able to build up reserves to cover payments if they become unemployed. We also expect that some borrowers may tactically use the deferral scheme shortly before it expires if the economic landscape looks unclear when the furlough and deferral schemes near their end dates. Given that the vast majority of borrower have not used the deferral scheme at all, this prospect cannot be discounted.
Servicing Strategies Will Affect Reported Arrears.
We expect that borrowers who cannot pay, and who have already used their full entitlement of six months of payment deferral, will be treated in accordance with the policies of their servicer/lender and will be afforded the protections of applicable regulations. Generally, borrowers will be treated on a bespoke basis depending on their individual circumstances. There are multiple servicing strategies that could be employed in such scenarios, all of which, to a limited degree, may have been used before COVID-19, for example rate reductions, term extension, and in extreme cases principal forgiveness. However, in the short term, we expect part payment or temporary movement to interest-only payment (or partial interest-only payment) to be two of the most common types of forbearance. It is important to highlight how these two most common types of forbearance will affect reported arrears.
Part payment involves the borrower paying some, an amount deemed affordable having looked at the borrower's circumstances, but not all of their monthly instalment. If a borrower is contracted to pay £1,000 a month and pays £500, they will be £500 in arrears at the end of a month. As arrears buckets are calculated as cumulative unpaid amounts divided by monthly instalment, in this example, if a borrower pays £500 a month for six months, they will be £3,000 (£500 times six months) in arrears. As the contracted instalment is £1,000 the borrowers would be three months (£3,000/£1,000) in arrears at the end of six months. In other words, as the collection rate in this example is 50% it would take the borrower six months to show as three months in arrears. Therefore, the collection rates for borrowers in arrears will be a key metric in U.K. RMBS in the coming year.
Borrowers paying interest only have lower monthly payments as no capital is due. Typically, in this method of forbearance, payment is measured relative to the lowered, interest-only amount due, not the contracted capital and interest payment. A borrower with a scheduled monthly capital and interest payment of £1,000 who is given forbearance of a monthly interest-only payment of £500, and makes that payment, will not be classified as in arrears.
Both of these forbearance strategies will result in more gradual build up of arrears. We recognize that the widespread use of short-term interest-only forbearance may mask the actual levels of borrower distress. Furthermore, loans that are already interest only, which include most BTL assets and a large portion of pre-GFC era owner-occupied collateral, will not benefit from the ability to move to interest only.
Servicers Are More Operationally Capable Than In 2008
Generally, we observe that servicers are now far better operationally equipped to deal with the servicing intensity required to manage borrowers facing economic stress than they were in the wake of the GFC. The combination of deferral and furlough schemes has given servicers over six months to analyze where risks lie within their portfolios. Servicers have been able to devise and roll out servicing strategies such that borrowers with the greatest needs are afforded the most consideration. Operational capabilities of servicers in light of COVID-19 are discussed in more detail in "How European ABS And RMBS Servicers Are Managing COVID-19 Disruption And Payment Holidays," published on June 4, 2020.
Borrower Equity Levels And Low Interest Rates Underpin Borrower Behavior
We also anticipate that borrower behavior will, in certain situations, be materially different than that observed in the fallout of the GFC. Generally, and because of more stringent underwriting, borrower affordability is better than following the GFC. Therefore, borrowers typically have more ability to withstand shocks. The evolution in U.K. mortgage underwriting standards since the GFC are discussed in "U.K. RMBS 2.0 Origination And Structural Evolution Combine To Reduce Credit And Reinvestment Risk," published on Jan. 7, 2019. Crucially, loan-to-value (LTV) ratios (both current and original) also tend to be lower than observed in originations leading up to 2008. Lower LTV ratios and the low-interest-rate environment combine so that borrower equity is generally preserved as arrears increase. Preservation of borrower equity means that very low or negative equity scenarios where lenders are more likely to suffer losses are, absent significant house price falls, likely to remain the exception.
Late Stage Arrears Buckets Likely To Be Sticky
The moratorium on repossessing residential property has been extended to the end of January 2021, by which time the repossession process will have effectively been halted for 10 months. Upon the resumption of litigation activity, in earnest, currently scheduled to be in February 2021, courts are likely to face a backlog of cases from before and during the COVID-19 pandemic. This means that any new litigation will have to wait for the backlog to clear, lengthening the overall time to recovery.
Notwithstanding the court process, there may be other practical barriers to repossession. Firstly, lenders are likely to need to demonstrate that a borrower's position cannot be realistically resolved, and that repossession is the only solution. This could potentially be difficult if COVID-19-related disruption in employment is the sole cause of arrears.
Also, as highlighted above, owing to generally solid borrower equity levels and the low-interest-rate environment, lenders can and are likely to offer borrowers who are in arrears the time needed to recover financially.
While this summarizes our general expectations in the U.K., it is possible, however, that idiosyncratic features of individual assets may cause individual transactions to deviate from the general trends. For example, pools that have become negatively selected owing to higher quality loans leaving the pool or that were negatively selected at origination may show higher volatility to unemployment. Characteristics that define negative selection can vary but include exposures to any or all of: self-certification, interest only, prior mortgage arrears, and past adverse credit markers.
S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic. Reports that at least one experimental vaccine is highly effective and might gain initial approval by the end of the year are promising, but this is merely the first step toward a return to social and economic normality; equally critical is the widespread availability of effective immunization, which could come by the middle of next year. We use this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
- Pandemic Won’t Derail European Housing Price Rises, Oct. 20, 2020
- The Second Wave And Brexit Will Test The U.K., Oct. 1, 2020
- U.K. Mortgage Payment Holiday Risks Emerge As COVID-19 Requests Have Peaked, Sept. 2, 2020
- How European ABS And RMBS Servicers Are Managing COVID-19 Disruption And Payment Holidays, June 4, 2020
- Residential Mortgage Market Outlooks Updated For 13 European Jurisdictions Following Revised Economic Forecasts, May 1, 2020
- COVID-19 May Be A Litmus Test For European RMBS Calls, April 15, 2020
- European ABS And RMBS: Assessing The Credit Effects Of COVID-19, March 30, 2020
- U.K. RMBS 2.0 Origination And Structural Evolution Combine To Reduce Credit And Reinvestment Risk, Jan. 7, 2019
This report does not constitute a rating action.
|Primary Credit Analyst:||Alastair Bigley, London + 44 20 7176 3245;|
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