Blurred Lines

When one contemplates a new Prime RMBS deal, originated and sponsored by a UK bank and carrying the STS-compliant 'hall mark' stamp of approval, it should conjure up warm fuzzy feelings around the quality of the underlying collateral, the likely unquestionably strong collateral performance over the life of the transaction and the certainty that you’ll get your principal back once the deal is called, without having to be seduced by the additional financial incentives in the unlikely event that it doesn’t.

So it’s always a little bit disappointing when, somewhat inevitably in a strong market, a deal comes along which on the face of it purports to be a Prime RMBS deal, and technically meets all the criteria to attain its STS designation, but after closer inspection doesn’t really reflect most of those fundamental characteristics that investors would normally take for granted in a true Prime deal and therefore begs the question - where does one draw the line?

Generally speaking, a Prime mortgage borrower in the UK will need to be in full-time employment with a historical earnings track record in order to qualify for a mortgage - usually from their high street bank or building society - and they will therefore be able to source the most competitive rates available in the market. Self-employed borrowers are not excluded but normally need to meet comprehensive earnings track record criteria in order to be considered and so most tend to source mortgages from more specialized lenders, and there are plenty of them, who cater for this sector admirably but at slightly higher rates of interest.

So when a new deal comes to the market - in this case a deal from One Savings Bank's Charter Court programme - containing 34% of self-employed borrowers with just one years' income verification (plus 30% of Help-to-Buy loans), and an interest rate more akin to portfolios of Non-Prime loans, we have to raise our eyebrows and ask how 'Prime' are these borrowers compared to other Prime pools? Further analysis of the historical performance of the lender's previous deals with similar characteristics shows that delinquencies are higher compared to other benchmark Prime portfolios and are currently trending higher still. This isn't necessarily a problem, especially as the higher interest rate provides greater protection for bondholders but once again begs the question of whether it is really a Prime deal?

Above all though, one of the most important fundamentals in the Prime RMBS market is meeting the expected maturity date of the transaction as most deals are priced to a call option. There is a general expectation in the whole market that deals will get called on their call date. This is particularly the case in the Prime RMBS sector where investors would expect sponsor banks to step up to the plate in all but the most exceptional circumstances. Notwithstanding this, calls typically come with a standard coupon step-up, which when combined with the paydown of the notes can make it economically punitive not to call the notes. Of course, there can be exceptional circumstances, such as the market cessation in the early aftermath of the coronavirus outbreak, but these are very much the exception and expected to be rectified as soon as conditions normalise somewhat. After all, issuers want to come back to the market with repeat deals in order to continue to finance their business.

But, not all so-called 'Prime' deals are the same. We generally just consider them as part of the broader funding mix for the big bank issuers, but for the smaller issuers; some also want to maximise their leverage, and issue not just senior 'funding' notes but also mezzanine tranches similar to a so called 'Non-Prime' deal, and we understand that some have gone even further and subsequently sold the call rights to a third party. In our minds this doesn’t exactly align the interests of the issuer with bondholders, especially, should the third party option holder decide not to or be unable to call the deal, which we understand has happened. This leaves bondholders in limbo, with no idea when they might receive their money back.

Of course, the AAA holders can still sleep soundly in their beds knowing that the deal structure will amply protect their capital, albeit the extension of their bond maturity may cause them a modicum of short-term mark-to-market pain. But mezzanine notes could extend for years. Several Non-Prime deals from before the GFC still have mezzanine notes outstanding 15+ years later, and these now contain the tail-risk of the residual loans in the pools that potentially can't or won't pay!

In the 'true' UK Prime RMBS space we don’t recall any deals which haven't been called in a timely fashion. If an issuer purports to be a Prime lender and doesn’t call a deal for a short period due to exceptional circumstances then that can be forgiven. However, if they fail to call a second deal - as has happened with two deals from this issuer, it really begs the question of why do they expect investors to trust them going forward?

So our concern in these circumstances is not the deals themselves, but the presentation of them as truly 'Prime'. If they are Non-Prime we will assess, treat and price them as such; whether from an expected credit performance, maturity or liquidity point of view. It is also worth noting that with an STS label these deals qualify for preferential Liquidity Capital Ratio (LCR) treatment for bank investors and yet trade with similar levels of liquidity to Non-Prime deals. Buyer beware - if you ever want to become a seller! At the very least expect to get paid something closer to the Non-Prime yield and not the Prime yield.

There has been a noticeable pick up in Prime UK RMBS so far this year with demand clearly outstripping supply. Recent benchmark size deals from both Lloyds and Clydesdale both saw impressive book coverage levels, both pricing at SONIA +52bps. A stand-alone deal from Aldermore’s OAK platform issued £400mm at SONIA +62Bps with a healthy 1.4x coverage also priced last week. The Charter Court deal priced deal this week, with £300m of senior notes at SONIA +67Bps thereby reflecting the differences in the collateral pools, and just 1.0x coverage despite having the collateral to have priced a larger deal closer to £500m. Furthermore, it was a little disappointing to see bonds being offered in the secondary market on the break, maybe reflecting a smaller pool of investors given previous disappointments.