Last week, S&P finalised its ratings actions resulting from changes to its methodology and the downgrade to QBE LMI which were announced earlier this year. With this uncertainty resolved it is now appropriate to look at those changes and what it means for the market, particularly on the junior end of the capital structure
Key points
- Standard and Poor’s (S&P) has affirmed investment grade credit ratings on all the legacy junior prime Residential Mortgage-Backed Securities (RMBS) it rates following its implementation of new Lenders Mortgage Insurance (LMI) criteria.
- Market developments since S&P announced the change have led to wider pricing on a relative value basis.
- Wider pricing makes RMBS an even more attractive option for investors looking for medium term floating rate exposure.
What was the change by S&P?
The Prime RMBS market in Australia has historically been 100% covered by Lenders Mortgage Insurance. S&P used to give 100% credit to mortgage insurance up to the rating of the mortgage insurer. That is to say, if a mortgage insurer was rated AA-, S&P would assume that it would pay out 100% of claims on all losses expected to be incurred under the level of stress that a security needs to be able to withstand to qualify for a AA- rating. Accordingly, it rated junior notes in prime RMBS transactions AA- because they had mortgage insurance covering the entire portfolio from a combination of QBE LMI and Genworth (which were both AA- rated).
In line with movements made by Fitch and Moody’s several years ago, S&P has made a global change to how it treats mortgage insurance. Now, it won’t just consider capacity to pay (i.e. the solvency of the insurer, reflected by its credit rating) but it will also give credit to the insurer’s willingness to pay (i.e. how likely it will be to fight claims and try to not pay them).
S&P now assumes a standard level of write-downs that insurers will make based on S&P’s assessment of each originator/ bank and each mortgage insurer. The minimum write down S&P will assume is 10%. The maximum will be 40%. Importantly, this won’t vary based on ratings level. The same write down will be assumed regardless of whether it is seeking to apply a AAA or a B rating. This means that S&P will require more hard credit enhancing subordination at each ratings level than it previously has.
How have existing RMBS securities been affected by this change?
S&P announced last week that it had finished reviewing all 453 tranches of RMBS it rates and that there will be no ratings changes to any securities. Further, it said that the 113 tranches which had been placed on credit watch negative would be removed from that designation.
In its update, it said this was made possible as a result of two key factors:
- It assessed all Australian originators as qualifying for the least severe claims adjustment rates (“CA1”)
- It analysed each transaction to assess the effect of increasing credit enhancement over time, including giving consideration to the likelihood of excess spread being available to cover potential losses
While S&P’s criteria change didn’t affect the underlying credit of the transactions, if the change had substantially affected the ratings of securities (particularly if they had been downgraded to sub-investment grade), there was a chance that it would have meaningful price effects. By S&P affirming these ratings, this risk has dissipated.
However, in the meantime, there have been other substantial market developments which may affect pricing as investors consider the relative value of these legacy securities compared to new issues.
How has the market developed?
Historically, the most junior tranche in Prime RMBS would be AA- rated, while new structures have typically included a AA, A, BBB and unrated tranche. Importantly, this has led to wider pricing.
Figure 1 shows the composition of the junior portion of the capital structure for the last deal issued under S&P’s old criteria. The average cost of capital for the sub AAA portion of the structure was 217bps over the 1m BBSW rate. The average cost of capital supporting the AA- rated B1 note was 250bps over.
Figure 1. Ratings, volume and pricing for junior portion of SMHL 2014-1
Source: ABS Perpetual, Bloomberg, FIIG Securities
In contrast to this, Figure 2 shows the composition of the junior portion in the Apollo 2015-1 transaction issued earlier this year under S&P’s new criteria. Weighted average pricing supporting a AAA rating has increased by 42bps to 259bps over the BBSW, while pricing supporting a AA rating has increased 127bps to 377bps over.
Figure 2. Ratings, volume and pricing for junior portion of Apollo 2015-1
Source: ABS Perpetual, Bloomberg, FIIG Securities
Given that there are minimal meaningful differences between the credit quality of these two structures we would usually expect that pricing should be the same. Conversely, we do need to adjust for the fact that an investment grade credit rating does broaden the potential sources of demand for this stock. Taking both of these factors into account, we would expect that current primary market pricing indicates that old style B1 notes should reprice in the low 200s area and old style B2 notes should reprice in the low 300s area on a relative value basis.
These margins are based on a vanilla structure with a five year weighted average life and should be considered with the caveat that each RMBS transaction has its own distinct features and performance characteristics which will affect pricing for individual securities.
Conclusion
S&P finalising the ratings treatment on legacy RMBS removes a key source of uncertainty from this market. Equally important, its affirmation that they retain investment grade credit ratings highlights the extent to which the fundamental asset quality in Australian prime RMBS remains sound and improves over time as transactions “season” in the market.
For investors who are willing to learn how these structures operate, RMBS can provide a highly rated floating rate exposure at margins which appear very compelling when compared to equivalently rated corporate exposures.
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