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Impact of EU Referendum on UK Mortgage Performance: UK and Ireland Mortgage and Property Research PDF Print E-mail
Monday, 04 July 2016
Welcome to the Summer 2016 edition of the UK and Ireland Mortgage and Property Report. In this issue we examine the potential impact of the UK’s referendum vote on UK mortgage performance, laying out three scenarios (Remain, Brexit Base Case and Brexit Downside Case) and analysing the impact of each. 

Macro Economics Scenarios
We reviewed a large number of macro-economic forecasts provided by banks, the government and other advisors prior to the referendum to estimate a market view of the macro-economic outlook in a Brexit Base Case and a Brexit Downside Case, comparing these with a No Brexit Case.

The Vector Model
The Northview Group has access to a very large mortgage performance dataset. This data includes daily and monthly data observations at the loan level. We use this data to calibrate our in-house state-transition model called Vector. Vector looks at a number of loan level attributes, including historical performance, as well as exogenous macro-economic variables such as house prices, unemployment and interest rates. The output from Vector is the probability of a loan existing in each performance state each month for its remaining term. These states are performing, prepaid, defaulted and multiple arrears levels.

The Vector model is built in the .NET framework, with the input-files in excel and calculations computed in C# which confers significant speed and efficiency. The model is able to forecast monthly loan level performance in ~35 minutes (5,000 loans/second) for the whole UK mortgage market (11 million loans).

The Mortgage Portfolios
We have considered five different mortgage portfolios in order to assess whether some types of loan are more sensitive to the impact of Brexit. The portfolios have been constructed based on a large number of real loans’ in order to capture any inherent correlation of loan attributes that is especially common in legacy portfolios. These five portfolios are diversified by vintage and collateral type, and include both high and low LTV, and performing and non-performing loans. Table 2 provides further detail on the collateral of each portfolio used in our analysis. The performance of each of the five portfolios was analysed in all three macro-economic scenarios.

Impact of Brexit on CPR
Our analysis shows that the impact of Brexit on prepayments is very different for new originations compared to legacy portfolios. CPR on legacy portfolios will likely slow from current levels in a Brexit Base Case scenario (and even more so in the Brexit downside scenario), as borrowers will find it more difficult to refinance in the face of falling house prices and higher rates (in the Brexit Downside Case). Prepayment rates on new originations, which are by nature much higher than on legacy portfolios, will likely be less impacted by the exit.

Impact of Brexit on Arrears Rates
One of the major benefits of using a state transition model like Vector is that it can forecast the probability of a loan being in a given arrears state (e.g. 1 month or 6 months) at each point during the life of a loan. We have used Vector to calculate this for each loan, in each scenario and looked specifically at the percentage of loans in each portfolio that has fallen over 90 days in arrears.

The Legacy PL portfolio is positively impacted by the Brexit Base Case of a longer decrease in interest rates as most of the loans in the portfolio (and in Legacy PL portfolios generally) are floating rate, leading to better affordability as rates decrease. New originations for both Prime and Specialist assets performed worse in both Brexit scenarios although the absolute levels of arrears are very low for both. The High LTV NPL portfolio experienced a decrease in arrears in the Brexit Base Case, which is explained by late arrears loans exiting the portfolio through the repossession process. Investors with exposure to arrears levels through investments in RMBS with pro-rate/sequential triggers may want to consider whether any of these scenarios could impact the likelihood of triggers being hit.

Impact of Brexit on Cumulative Defaults and Losses
The combination of dropping house prices and rising interest rates (Brexit Downside Case) is always a very negative scenario for mortgages, and indeed had the most impact on all five portfolios analysed in terms of cumulative defaults.

As would be expected, the legacy portfolios were the hardest hit, and the High LTV NPL portfolio was projected to experience the highest cumulative losses. Cumulative losses for both of the new origination pools are expected to remain very low even in the Brexit Downside Case, primarily as a result of the low LTV and lack of risk layering.

What kind of macro scenario could cause a material impact on performance?
Vector is able to forecast how a portfolio will perform under much a more extreme macro-economic scenario than that applied in the Brexit Downside Case. To demonstrate this, we ran the Legacy PL portfolio under an extreme scenario in which the decrease in house prices across the UK mirrored the decrease experienced in Ireland at the onset of the financial crisis for 5 years (a drop of over 50% and broadly comparable with the stress that the rating agencies assume for AAA). This was coupled with a rising unemployment rate, which peaked at 10% after 3 years, stayed flat for 2 years, before gradually normalizing again.

Our analysis found that a very extreme scenario like this could cause a significantly worse performance, with arrears more than triple the level they reached in the Brexit Downside Case, and cumulative losses reaching 11.41% in Year 10, compared to 0.51% in the Brexit Downside Case. Similarly, Average CPR dropped significantly to approximately 2%, reaching a level even lower than that of the Legacy NPL High LTV portfolio in the Brexit Downside Case.

This demonstrates that, even though such an extreme scenario is not expected in the post-referendum market, UK mortgage performance could deteriorate materially if there was an extreme ‘AAA type’ housing market crash.

The vote to leave the EU has and may continue to cause significant volatility in the capital markets, however the loan level credit analysis that we have undertaken shows that in the scenarios set out above the impact on mortgage credit performance is likely to be muted. We would need to see a significantly worse macro-economic downturn for credit performance to be impacted in a material way. Let’s hope that does not happen, not just because of the impact on mortgage performance.

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