ERMs are prevalent in the UK, North America and Australia and growth has been significant in the UK both in terms of new plans subscriptions and total amount released. The volume of outstanding UK ERMs is estimated to be in the GBP 20bn range, supported by roughly 45,000 new plans per year.

“ERM securitisations allow issuers to transfer economic risk, manage liquidity and stabilise long-dated cash flow variability to improve liability matching,” said Olivier Toutain, executive director in the structured finance team of Scope Ratings and co-author of a report on ERMs out today. “Structures are complex, however, and typically include one to four senior notes to reduce fundamental spreads and manage downgrade risk; these notes account for 75% to 99% of the total value of the notes issued,” he added.

Since the financial crisis, few UK ERM securitisations have been publicly rated. This is partly because the Prudential Regulation Authority allows insurance companies to use internal risk management and rating methodologies to assess associated credit risk when investing in them.

From an investor perspective, the risks associated with ERMs are product-specific and cannot really be captured using similar approaches to typical residential mortgage pools. The Non-Negative Equity Guarantee (NNEG) which represents the risk that the accrued mortgage value is not covered by the house proceeds, and involuntary pre-payment (when the borrower enters long-term care) are two examples of the uniqueness of ERMs.

“Along with those risks, investors and originators have to consider factors such as longevity risk. And since underlying collateral will be seized at some point in the future, analysing long-term house price developments is also essential,” said Toutain.

“The price of all properties matters for ERMs whereas only the price of the defaulted borrower’s property is relevant in classic RMBS. And because transactions are generally of long duration, a long-term analysis of house prices is more important than reliance on initial housing market conditions.”

Scope approaches house price developments using specific multiple scenarios corresponding to target ratings. Drawing on empirical studies of house-price declines in developed economies since 1970 in terms of duration and maximum drawdown, Scope stresses house prices based on rating-conditional haircuts, similar to what is done in other asset classes. The AAA scenario would generally capture a drop level of at least the magnitude found in the studies, irrespective of the country.

“Depending on the exact composition of the portfolio and the liability structure of a securitisation, investors may be exposed to interest-rate risk in case of asset-liability mismatches,” cautioned Toutain. “Another specific feature of these transactions is the liquidity risk arising from the lack of scheduled payments, particularly acute during the initial phase of the transaction if the pool is not sufficiently seasoned.”

Voluntary ERM pre-payments will be generally linked to a refinancing of the initial mortgage or a move into a new home. Involuntary pre-payments arise from the entry of the borrower into long-term care, which is a specific feature of those pools and not in any way linked to the evolution of interest rates. The occurrence of higher-than-usual pre-payment rates will accelerate payments from the underlying pool, thereby lowering excess spread to the transaction while suppressing any future uncertainty from house-price risk for such properties.

The timing of repayment within reverse mortgage pools is mostly defined by the death of the borrowers, triggering a requirement for the analysis to include assumptions around death probabilities. Due to the granular nature of the pools, mortality tables can be used to compute the expected timing of disappearance.

“The underlying assumptions for those will be mainly derived from the historical experience of the originator but pre-payments need to be borne in mind,” added Toutain. “Longevity risk stemming from improvements in mortality increases the duration of the mortgage, leading to more frequent negative equity. This is particularly relevant for a portfolio of reverse mortgages as all loans would be affected.”

The full report can be downloaded here.