Standard & Poor’s (S&P) has updated how they treat Lenders Mortgage Insurance in rating Residential Mortgage Backed Securities (RMBS). This article details who these changes are relevant to and what the likely effects will be.
What’s changing
This is relevant to anyone holding ‘B Notes’ or ‘B2 Notes’ in a prime (i.e. covered by lenders mortgage insurance) transaction. Notably, this will have no effect on any non-conforming lines which don’t benefit from mortgage insurance (i.e. Sapphire, Liberty, Pepper, etc.).
Why it’s changing
S&P used to give 100% credit to mortgage insurance up to the rating of the mortgage insurer. This is to say that if a mortgage insurer was rated AA-, S&P would assume that they 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, they rated junior notes in prime RMBS transactions AA- because they had mortgage insurance covering the entire portfolio from insurance companies QBELMI and/or Genworth (who were both AA- rated).
In line with movements made by Fitch and Moody’s several years ago, S&P is making 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 insurers’ willingness to pay (i.e. how likely they will be to fight claims and try to not pay them).
The method S&P has landed on to implement this change is to assume 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 they’re seeking to apply a AAA or B rating. This means that S&P will require more hard credit enhancing subordination at each ratings level than it has previously. This effect will be most strongly felt on junior tranches which currently benefit from zero hard credit subordination.
What do we expect the effect to be on ratings and pricing
The exact ratings outcome that this change will drive is still unknown. Two weeks ago, S&P placed all prime Australian RMBS tranches on UCO, a designation indicating that they are under initial observation due to a criteria change. We expect that within the next few weeks, S&P will take all Lenders Mortgage Insurance independent tranches off this designation and place all other tranches on credit watch negative. We expect that it may take a number of months for S&P to fully resolve the ratings impact across the board.
For transactions which have already built up excess spread reserves, the effect could be minimal. Depending on how much credit S&P is willing to give to future expected excess spread, existing junior notes could be downgraded from AA-/A+ to anywhere between BBB and unrated. While so much uncertainty exists, the best pricing comparison is new primary prime RMBS transactions which are coming to market. The two tranches which are replacing old B2 tranches are being called either C Notes and D Notes or B2 Notes and B3 notes. These are pricing at a weighted average margin in the area of +440 basis points. The tranches replacing old style B notes are pricing at +315bps. Investors should expect their holdings to reprice to this level (subject to getting tighter the longer they’ve been outstanding) for so long as these new securities offer a clear and logical relative value comparison.
Given that there is some chance that they may retain investment grade ratings (which will have a positive impact on potential demand and therefore price), we see value in maintaining these holdings until this uncertainty is removed.
What’s the effect on the underlying credit
Investors should ultimately remember that this change does not reflect any move in the underlying credit of these securities. It exclusively represents S&P changing the technicalities of how it treats mortgage insurance. Given that other ratings agencies made equivalent changes several years ago, we believe that the market was aware of the factors driving the change, and that existing pricing should logically have factored this in. Accordingly, we’d expect this market to tighten over time as the changes are fully digested.
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