Key Takeaways
- Of U.K. RMBS transactions where the liabilities transitioned from LIBOR to a Term-SONIA-linked rate, 23% are exposed to levels of basis risk that may lead to reductions in excess spread and increases in reserve fund draws.
- These reductions in excess spread and increases in reserve fund draws do not signify collateral deterioration. So far, we have observed these reductions in a small number of rated transactions, but this number could increase.
- We do not expect there to be any ratings impact for these transactions stemming from their transition off a Term-SONIA-linked rate. However, if the level of basis risk currently observed persists for a prolonged period or the difference between the Bank of England Base Rate and Term-SONIA reference rate further increases, it may be detrimental to the creditworthiness of the mezzanine and junior notes.
- Transactions that were not affected by LIBOR transition are also exposed to basis risk, though the level of basis risk is lower. For these transactions, we do not expect there to be any ratings impact.
We have begun to see divergence between indices for U.K. residential mortgage-backed securities (RMBS) transactions. This basis risk has led to reduced excess spread and reserve fund draws in rated U.K. RMBS transactions. However, this is not a sign of collateral deterioration.
Transactions that were affected by LIBOR transition, which are legacy U.K. RMBS transactions, will be most affected by this increase in basis risk. As these transactions transition away from forward-looking reference rates, the level of basis risk will decrease, though it will still exist. This risk is currently captured within S&P Global Ratings' basis risk stresses as well as other stresses that we apply to assess liquidity in transactions.
Not All Basis Risk Is Equal
To the extent that the assets within transactions do not reference the same rate as the liabilities, and instead reference the Bank of England Base Rate (BBR), collections will not increase as fast as the increase in interest due on the liabilities, assuming asset performance remains stable. This is due to the index on the liabilities increasing at faster rate than the BBR on the assets, or delays in passing on BBR increases to borrowers.
This risk is more pronounced for liabilities that reference synthetic LIBOR as opposed to daily compounded SONIA.
Synthetic LIBOR is composed of a Term Sterling Overnight Index Average (SONIA) reference rate plus a credit adjustment spread. Term SONIA is a forward-looking risk-free reference rate, which is therefore more exposed to general market uncertainty and volatility, compared with daily compounded SONIA, which is compounded and backward-looking.
We currently rate 62 U.K. RMBS transactions with classes of notes that previously referenced sterling LIBOR. Of these transactions, 69% have transitioned to daily compounded SONIA, with the remaining 31% to synthetic LIBOR.
While basis risk still exists between daily compounded SONIA and BBR, the level of basis risk is lower compared with basis risk between a Term SONIA reference rate and BBR and stems from delays in passing on base rate increases by the servicer rather than divergence in the rates. Therefore, we also expect to see this divergence in transactions with unhedged exposure to daily compounded SONIA.
Chart 1
Basis Risk Has Led To Reserve Fund Draws
As a result of this basis risk, we have observed lower excess spread in some transactions, which has caused reserve fund draws and some interest shortfalls. This is not due to deterioration in asset performance. In all cases, interest shortfalls have only occurred on notes that allow for deferral of interest payments.
Of U.K. RMBS transactions where the liabilities transitioned from LIBOR to a Term-SONIA-linked rate such as synthetic LIBOR, 23% are exposed to BBR versus Term SONIA basis risk.
For some of these transactions, there is a basis risk swap to hedge the index mismatch. However, the credit adjustment spread that was applied for these transactions is unlikely to be sufficient to fully mitigate basis risk.
This risk also exists for U.K. asset-backed securities (ABS) transactions. However, the assets in these transactions are typically fixed rate and the basis risk is typically hedged via a swap.
A Known Risk, But Not A Temporary Risk
We observed a similar increase in basis risk in 2008. This time, we expect the risk to decrease as transactions that transitioned to synthetic LIBOR will need to transition again to an alternative rate, such as daily compounded SONIA, given the U.K. Financial Conduct Authority could cease publishing the synthetic index as early as March 2023. However, there is still basis risk for daily compounded SONIA-linked liabilities, though the basis risk is lower compared with Term SONIA. In addition to this, as interest rates stabilize, we expect the basis risk to decrease.
Ratings Impact
This divergence between indices is currently captured within our basis risk stresses. In addition to this, we apply delinquency stresses that stress liquidity in transactions and typically perform other sensitivities that stress liquidity.
For the most at-risk transactions, there is liquidity support from reserve funds and liquidity facilities to mitigate reductions in excess spread. As these transactions are transitioning off a Term-SONIA linked rate, we do not expect the ratings to be affected. However, if the level of basis risk currently observed persists for a prolonged period or the difference between the indices further increases, it may be detrimental to the creditworthiness of the mezzanine and junior notes.
We have currently observed reserve fund draws on two transactions that were affected by LIBOR transition (see "Appendix").
Transactions that were not affected by LIBOR transition are also exposed to basis risk, though the level of basis risk is lower.
This has been observed in Warwick Finance Residential Mortgages Number Four PLC, which is a U.K. nonconforming transaction that securitized a pool of residential loan mortgages (first-ranking nonconforming owner-occupied and buy-to-let). Collateral performance has not deteriorated, and we have observed interest shortfalls due to basis risk. On the last interest payment date (IPD), while collections did increase, the rate of increase was not sufficient to prevent interest shortfalls on the junior and mezzanine notes. However, under the terms of these notes interest payments on the junior and mezzanine notes can be deferred until maturity, even when the notes become the most senior class outstanding, and our ratings address the ultimate payment of interest.
Appendix
| At-risk transactions | ||||||||
|---|---|---|---|---|---|---|---|---|
| Transaction name | Liabilities reference Term-SONIA/synthetic LIBOR? | Assets reference BBR? | Reserve fund draws on last IPD? | |||||
| Great Hall Mortgages No. 1 PLC 2006-01 | Y | Y | Y | |||||
| Great Hall Mortgages No. 1 PLC 2007-01 | Y | Y | N | |||||
| Great Hall Mortgages No. 1 PLC 2007-2 | Y | Y | N | |||||
| Landmark Mortgage Securities No.2 PLC | Y | Y | N | |||||
| Landmark Mortgage Securities No.3 PLC | Y | Y | Y | |||||
| Ludgate Funding PLC 2006-FF1 | Y | Y | N | |||||
| Ludgate Funding PLC 2007-FF1 | Y | Y | N | |||||
| Ludgate Funding PLC 2008-W1 | Y | Y | N | |||||
| Newgate Funding PLC 2006-1 | Y | Y | N | |||||
| Newgate Funding PLC 2006-2 | Y | Y | N | |||||
| Newgate Funding PLC 2006-3 | Y | Y | N | |||||
| Newgate Funding PLC 2007-1 | Y | Y | N | |||||
| Newgate Funding PLC 2007-2 | Y | Y | N | |||||
| Newgate Funding PLC 2007-3 | Y | Y | N | |||||
| BBR--Bank of England Base Rate. IPD--Interest payment date. | ||||||||
Related Criteria
Related Research
- U.K. RMBS And ABS LIBOR Transition: Beware Of Early Success, Sept. 5, 2022
This report does not constitute a rating action.
| Primary Credit Analyst: | Aarondeep Hothi, London + 44 20 7176 0111; aarondeep.hothi@spglobal.com |
| Secondary Contacts: | Alastair Bigley, London + 44 20 7176 3245; Alastair.Bigley@spglobal.com |
| Vedant Thakur, London + 44 20 7176 3909; vedant.thakur@spglobal.com |
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