Fourth-quarter 2024 has seen market sentiment swing on the direction of U.K. interest rates. The Bank of England announced a "more activist" approach at the start of October, and cut its rate in early November. However since then lenders have raised their mortgage rates following revised expectations that future interest rate cuts may not come as fast and as frequently. Against this backdrop, gauging rate movements is anything but certain. In this report we look at how changing interest rates may affect U.K. mortgage arrears. Counterintuitively, a declining rate environment may actually see arrears rise in legacy U.K. nonconforming transactions.

The outlook for both policy rates and market rates is more favorable for mortgage borrowers than 12 months ago. However, we do not anticipate a rapid improvement in reported arrears in U.K. legacy RMBS transactions.

The Technical Side: How Months In Arrears Are Calculated

The amount of months a loan is in arrears for is generally calculated as a ratio of the total arrears balance divided by the monthly mortgage instalment. For example, if a borrower has £3,000 of unpaid mortgage arrears and the monthly instalment is £1,203, then the months in arrears is 2.5 months (based on £3,000/£1,203). As the monthly instalment (denominator) falls, the ratio will increase.

In table 1, the arrears severity increases to 4.2 times from 2.5 times; while the mortgage terms and arrears balance remain unchanged, the current interest rate fell to 4.5% from 6.5% and the loan amortized by 15%. Simply put, for variable rate collateral, as interest rates and monthly instalments fall in lock step, reported delinquencies will rise, all else being equal.

As counterintuitive as it may seem, this is one reason why we expect reported arrears to be slow to improve in a falling rate environment. We observed similar delinquency spikes when policy rates were cut sharply in 2008 and 2009 for some variable rate U.K. RMBS deals.

Table 1

Reducing Arrears Will Take Time

At a fundamental level, the sharp increase in mortgage arrears between 2022 and 2024 for certain sectors was down to interest rates, and not unemployment.

The sharp rise in interest rates caused pain for variable-rate borrowers, especially those on interest-only mortgages. Despite low unemployment rates, many borrowers faced a crisis of affordability.

Therefore, in our view, borrowers who have maintained employment will unlikely see a rapid improvement in their financial position and affordability. We only expect marginal improvements to emerge over time as a combination of rate cuts and wage inflation takes hold. This is broadly the inverse of what happened when post-pandemic interest rates rose. Borrowers paid what they could afford rather than stopped paying altogether, which accounts for why arrears were slow to increase.

Our observations on future collateral performance in this report relate to owner-occupied collateral. For buy-to-let collateral, where repossession and liquidation are more likely outcomes, the dynamics may be different (see "Legacy U.K. Buy-To-Let RMBS: Crunch Time For Arrears And Losses," published on July 18, 2024).

Scenario Analysis: Rates Drop But Collateral Slow To Improve

Many legacy U.K. RMBS transactions have triggers based on the proportion of loans which are in severe arrears (greater than 90 days). A trigger breach would switch the transaction's priority of payments to sequential from pro rata. This would typically mean an extension of the junior notes' weighted-average life and/or a lack of credit enhancement build-up for senior notes (i.e. credit enhancement will barely rise, if at all, while the priority of payments is pro rata).

We analyzed all the transactions in our U.K. RMBS universe and identified 16 that currently pay pro rata. These are all legacy nonconforming transactions, with the vast majority of loans paying floating interest rates on interest-only mortgages. We then projected how interest rate cuts would affect arrears severity and considered the possibility of a pro rata trigger breach (see chart 1).

Note that we rebased the arrears severity and trigger for each transaction, as trigger levels may differ across transactions (please see table 2 for each transaction's respective trigger level, and the full universe of transactions analyzed). Only the transactions that breach or come close to breaching their triggers are shown in chart 1.

We assume a constant prepayment rate of 15%, in line with our nonconforming legacy RMBS index (see "Related Research") while borrowers' creditworthiness does not improve (i.e., the arrears balance does not reduce).

Chart 1 shows that it would take a very sharp rate cut for three of the transactions to breach their triggers and switch to a sequential priority of payments. A fourth transaction would only breach under a rate cut of more than 200 basis points. Six of the transactions are already well above their respective switch triggers--a rate cut would thus have no effect on their priority of payments. Finally, six other transactions are totally unaffected by interest rate movements given their low levels of severe arrears (they are not shown on chart 1).

Chart 1

What else would we track under a falling interest rate scenario?

In a period of rising arrears severity amid a falling interest rate environment, we would also focus on collection rates. At the pool level, collection rates should improve (all else being equal) as the denominator--the payment due--declines.

Does this go beyond U.K. RMBS and into other European jurisdictions?

In Spain, capital repayment mortgages are prevalent (versus interest-only products) and tend to have a high seasoning in our rated universe. As a result, the capital is usually the main component of the borrower's repayment, and, under a falling rate scenario, would cushion any fall in payment due and lead to only a mild rise in arrears severity.

We do not currently expect arrears to breach any triggers in a potential falling rate scenario, as the triggers that are not reversible were already breached when losses or delinquencies peaked in 2010-2015.

In Ireland, fixed-float repayment mortgages are the most common type of new mortgage originations (with a reversion after two to five years; legacy loans are mainly floating rate, with high seasoning ensuring capital is the main proportion of the payment due). Most of the Irish RMBS transactions that we rate already follow a sequential priority of payments. In other words, the risk of a significant rise in arrears is remote, and there would be limited sequential switches.

Appendix

Table 2

Chart 2

Related Criteria

• RMBS: Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019

Related Research

• U.K. Economic Outlook 2025: Monetary Policy And Trade To Offset Fiscal Impetus, Nov. 26, 2024
• European RMBS Index Report Q3 2024, Nov. 14, 2024
• Legacy U.K. Buy-To-Let RMBS: Crunch Time For Arrears And Losses, July 18, 2024