Key Takeaways

• Audit fees in certain U.K. residential mortgage-backed securities (RMBS) transactions have increased significantly above inflation over the past year.
• These rises are due in part to changes in audit regulation, particularly regarding validating International Financial Reporting Standard (IFRS) 9 loss provision methodology, and issuers are feeling the brunt of increased audit services costs.
• Excess spread in transactions exposed to consistently higher annual audit fees will decrease, which could result in increased risks toward the end of the transaction's life and affect ratings.

Rising audit fees--of over 100% in some cases--are increasing the vulnerability of some U.K. residential mortgage-backed securities (RMBS) transactions' risk to loss, or "tail risk," as they amortize. To assess the potential impact, we reviewed audit fees across a sample of RMBS transactions that we rate. U.K. RMBS issuers, like almost all structured finance issuers, issue from a stand-alone corporate entity known as a special-purpose entity (SPE), subject to the requirements of company law, including annual audits. The associated fees, such as servicing and legal fees, are generally paid senior in the priority of payments before any distribution to rated noteholders. Although fee increases tend to be relatively low, 2020-2022 saw fees almost double on average for some U.K. RMBS transactions (see table 1).

Regulation Spurs Rising Audit Fees

Audit is a statutory requirement and demand for it is relatively inelastic, meaning audit firms are able to pass on costs to clients, including issuers. On an "all things being equal basis" increases of 20% are not uncommon for U.K. RMBS issuers.

Furthermore, regulatory changes from the Financial Reporting Council have increased the scope of work that auditors are required to perform. For issuers that have converted to IFRS 9, with its requirement for forward-looking loss provision estimates, U.K. auditors need to analyze not only the overall loss provision number/cost, but also the issuer's model that calculates it. This requires audit firms to utilize in-demand and possibly expensive risk modelers. Additional costs apply to firms to comply with International Audit Standard 315 (IAS315). IAS 315 introduces five new inherent risk factors to aid in risk assessment--subjectivity, complexity, uncertainty, change, and susceptibility to misstatement due to management bias or fraud--and places requirement on IT testing. Both of these increase costs, which are then passed on to issuers.

Fee Increases Don't Apply Across The Board

Material increases have so far only been noticed in the U.K. and in RMBS transactions, with explanations from transaction parties to date being consistent with this. However, they may arise in other transactions and jurisdictions in time.

Firstly, not all issuing SPEs have converted to IFRS and so additional costs associated with validating loss provisioning models may not apply. Secondly, audit fees are often negotiated centrally at a group level and then distributed to the groups' subsidiaries. No specific industry consistent rules apply to dictate how this allocation works. For example, a non-bank issuer may have four separate warehouse lines, may be the residual noteholder for five RMBS transactions, or may originate loans on its own balance sheet. The cost of auditing could be agreed at the group level and allocated to each of the subsidiaries. That said, a similar business may have different methodologies for allocating these costs. This can lead to different audit costs being allocated for what may appear to be similar entities.

Thirdly, in the context of IFRS 9, collateral that has been traded multiple times as well as nonstandard assets may require greater resources to complete all validation checks to the required standard. These SPEs would have a higher cost allocation than a prime originated pool of assets.

Fourthly, larger bank issuers may decide to absorb the cost themselves rather than pass it to the SPE because absorbing this cost is immaterial at a group level.

Finally, "orphaned" issuers--where the original lender had ceased lending--may not benefit from economies of scale of spreading some of the increased audit costs across several entities in a group.

We took a sample of RMBS transactions currently rated across Europe and assessed the level of increases over the three-year horizon (2020-2022). Of these transactions, 86% reported audit fees separate from other third-party fees. The average fee was £337,000 per year for the 2020 to 2022 period. However, in 2022, the maximum annual audit fee was almost £659,000, a 37% increase from 2021 for that transaction.

Table 1

Call Options Help Mitigate Tail Risk

Because audit fees are a fixed cost, that is they may not always decrease relative to the portfolio balance, they can become more material toward the end of a transaction when fewer assets are generating interest to service fixed costs (tail risk). Although many U.K. RMBS transactions have call options that in stable market conditions would be exercised, several U.K. RMBS transactions issued before the financial crisis have not exercised the call option. Furthermore, although many of these transactions have a 10% clean-up call, whereby the call option holder can exercise the option when the asset balance falls below 10% of the initial asset balance, there is no guarantee this option will be exercised. We will continue to monitor these fees when rating new transactions as well as in our ongoing surveillance.

Related Criteria

• U.K. RMBS Refinance Risk Is All About The Call, June 3, 2019
• Global Methodology And Assumptions Assessing Pools Of Residential Loans, Jan. 25, 2019