ARC Ratings on RMBS

UK vs Italy comparison : Same Product, Different Risks

Residential Mortgage-Backed Securities (RMBS) play a crucial role in the financial markets of both the UK and Italy. However, despite being structured similarly, the risks associated with RMBS in these two jurisdictions differ significantly due to variations in economic conditions, legal frameworks, and lending practices. A recent research report by ARC Ratings examines these differences and highlights how they impact probability of default (PD) and recovery rate assumptions in each country.

Key Differences in RMBS Risk Assessment

The assessment of RMBS risk is not solely dependent on borrowers’ characteristics but also on the broader economic and regulatory environment. ARC Ratings employs a tailored approach for the UK and Italy, focusing on three key areas:

1. Establishing Baseline PDs

Baseline probability of default (PD) is determined based on historical data, underwriting standards, and market conditions. A major factor influencing PD is the loan-to-value (LTV) ratio:

• UK RMBS: ARC’s analysis of European DataWarehouse (EdW) data from 1990-2023 shows that mortgage default rates increase significantly when LTV exceeds 80%. For example, loans with 90% LTV exhibit a default rate of 5.5%, while loans at 100% LTV have a staggering 41.9% default rate.

• Italy RMBS: While default rates start at a higher baseline compared to the UK, they increase more gradually across LTV bands. Interestingly, at LTV levels above 80%, Italy exhibits lower default rates, suggesting more conservative lending practices, such as additional collateral or guarantees required for high LTV loans.

2. Adjustments to Baseline PDs

Baseline PDs are further adjusted based on borrower, loan, and property-specific factors:

• Debt-to-Income (DTI) Ratios: High DTI ratios have a stronger impact on default levels in the UK than in Italy, leading to higher PD penalties for UK borrowers.

• Income Verification and Employment Type: Public sector employees in both countries benefit from a 25% PD reduction due to lower observed default rates. Conversely, self-employed borrowers face PD increases due to higher default risk.

• Foreign Currency and Non-Resident Borrowers: Non-resident borrowers are penalized more heavily in Italy (150% PD increase) than in the UK (100% PD increase) due to heightened risks associated with currency fluctuations and cross-border employment.

• House Price Affordability: UK borrowers are more financially stretched, with house price-to-income (HPI) ratios often exceeding 8x compared to Italy’s 4-7x. This makes UK borrowers more vulnerable to economic shocks and increases PD penalties.

3. Recovery Rate Calculations

In addition to PD, ARC Ratings assesses the expected recovery rates based on property valuations and market conditions.

• Market Value Declines (MVD): UK property prices are currently overvalued by approximately 13%, while Italian properties are undervalued by around 10%. As a result, ARC applies slightly higher MVD assumptions in the UK.

• Forced Sale Valuation Stresses: Italian properties sold at auction typically fetch 20-30% below market value, leading to forced sale valuation stresses of 30-40%. In contrast, UK residential properties face lower forced sale stresses of around 10%.

• Foreclosure Timelines: The UK has a relatively efficient foreclosure process (12-24 months), whereas Italy’s foreclosure process often exceeds five years due to legal complexities. This results in higher enforcement costs and longer recovery periods for Italian RMBS.

Conclusion

Despite being the same financial product, RMBS in the UK and Italy are subject to vastly different risk factors. The UK market is characterized by higher house price affordability risks and greater exposure to economic downturns, whereas Italy's market exhibits more conservative lending practices but faces challenges such as lengthy foreclosure processes. Understanding these differences is essential for investors, regulators, and financial institutions assessing RMBS risk across jurisdictions.

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RMBS IN THE UK AND ITALY: SAME PRODUCT, DIFFERENT RISKS

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