Many European governments quickly announced mortgage payment holidays as the scale of the impact that Covid-19 will have on economies across the region became clear in mid March.
Italy announced a payment holiday of up to 18 months for mortgage borrowers on March 16, followed by UK banks offering a three-month non-mandatory moratorium a day later. Ireland announced a moratorium of between three and six months on March 18, the same day as Spain announced similar measures and Canada’s six largest banks announced a six-month deferral scheme.
Many Nordic countries already have standing arrangements for payment holidays of up to three months, as does Australia. The Dutch government has also announced very strong support for mortgage borrowers.
Such schemes – along with parallel arrangements for small and medium-sized enterprise borrowers – have been a key component in quelling panic among a widely quarantined European population. For now at least.
Some of the schemes are government-led, such as Italy’s (which is now a decree), and others are bank-led. The implications for lenders are important: in Italy, the banks are required by law to inform eligible borrowers about their right to such payment suspensions by the end of March. If they don’t, payments will be suspended until mid November.
The fallout for European residential mortgage-backed securities (RMBS) is important too. Payment moratoria will lead directly to a reduction in cash flow into these structures, while issuers must keep making interest payments on the notes. If cash flow into the deal is reduced to a point at which the interest payments on the senior notes are suspended, then the deal defaults.
Could that happen?
“If there is an opportunity to apply for these schemes then many borrowers may do so. It is unclear how high the take up will be and what is important is how the eligibility criteria are set and how easy it is to apply,” says Suzanne Albers, senior director of EMEA structured finance at Fitch Ratings in London. “Individual transactions in some markets are likely to be at risk of deferring junior interest if there is high take up of payment holidays, particularly ones that have depleted reserves.”
The key question is how the payment moratoria will be treated by the structure.
Under normal circumstances loans that are more than 90 days past due would be treated as non-performing, which hits the asset coverage test for the securitization pool.
It is not yet clear if all borrowers that have taken payment holidays will be deemed to be in arrears for the purposes of the RMBS pool.
It is likely that the rating agencies will take the position that they don’t want to be the ones to make the situation worse
Given the extraordinary circumstances, it seems inconceivable that the breach of the asset coverage covenant as a result of Covid-19 payment holidays would lead to an event of default. But it is not impossible.
One European RMBS banker believes that the rating agencies are still acutely aware of the criticism that was directed at them over their role in the sub-prime mortgage crisis of 2008 and will act accordingly.
“It is likely that the rating agencies will take the position that they don’t want to be the ones to make the situation worse,” says the banker. “I would expect that even if pools deteriorate, they will suspend action and won’t downgrade due to the extraordinary circumstances.”
The banks themselves have been wrestling with the implications of payment holidays on their loan provisioning requirements, which will increase under IFRS 9.
However, on March 25, the European Securities and Markets Authority (Esma) stated that “the measures taken in the context of the Covid-19 outbreak which permit, require or encourage suspension or delays in payments, should not be regarded as automatically having a one-to-one impact on the assessment of whether loans have suffered a significant increase in credit risk (SICR). Therefore, a moratorium under these circumstances should not in itself be considered as an automatic trigger of SICR.”
How do rating agencies distinguish between borrowers that are only experiencing a temporary liquidity squeeze and those that were heading for arrears before the pandemic hit, and for whom the impact of the holiday simply delays the inevitable?
There needs to be a common-sense approach to how loans with arrears of more than 90 days are now treated, and that is something that accounting bodies, regulators and banks are trying to thrash out.
With first-quarter figures due at the end of April, everyone needs clarity on accounting treatment of forborne loans under these schemes.
RMBS investors draw a lot of comfort from the fact that these deals have built-in liquidity reserves that are designed to cover the structure in times of stress.
Analysts at S&P calculate that most Italian RMBS transactions they look at have cash reserves or liquidity facilities that would cover expenses and interest payments for at least two years even if cash inflows to the transaction fell to zero.
But for some deals with cash reserves already depleted, there might now be a need for originators to inject more cash into deals while payment holidays are in place.
This could, however, throw up the need for further flexibility in the rules. In order to receive off-balance sheet treatment, assets in a securitization pool must have been sold to the structure’s special purpose vehicle and be entirely non-recourse to the issuer. This is known as true sale.
If originators now pump cash into RMBS deals that are experiencing large-scale payment moratoria, then this would call into question the non-recourse nature of the structures.
That is something the accounting bodies need to think creatively about as well: are they going to penalise originators for stemming defaults due to an external extraordinary event?
The good news is interest rates.
“A positive in Europe is how low interest rates are,” says Albers. “Liquidity reserves have been well sized, and in many cases, transactions have more liquidity than in a more standard rate environment.”