STRUCTURED FINANCE RESEARCH

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates
Primary Credit Analyst: Mark S Boyce, London 02071768397; mark.boyce@standardandpoors.com Secondary Contact: Andrew H South, London (44) 20-7176-3712; andrew.south@standardandpoors.com

Table Of Contents
U.K. RMBS Payment Rates Remain Low Borrowers' Incentive To Remortgage Has Increased But How Long Will Fixed Rates Stay Low? Related Research

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 1

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates
Principal payment rates on U.K. mortgage loans have fallen sharply since 2007, but lower interest rates on new loans in the past year mean that up to half of borrowers might now be both willing and able to refinanceup from about one-third a year agoaccording to an analysis by Standard & Poor's Ratings Services. Compared with some other European markets, U.K. mortgage loan payment rates have historically been high. This is because many U.K. loan products feature a short introductory period of two or three years, after which the interest rate often steps up to a higher reversionary rate, so that borrowers have an incentive to secure a lower rate by remortgaging again. Since 2008, the gap between typical reversionary rates and rates on new loansand hence the remortgaging incentivehas decreased, partly explaining the falling principal payment rate in mortgage loan pools backing U.K. residential mortgage-backed securities (RMBS). However, more recently, the gap between these rates has widened back to pre-2008 levels, meaning that remortgaging activity could start to pick up again, in our view. In May 2013, the volume of mortgage redemption payments jumped 20% year-on-year, and the number of remortgaging approvals touched a two-year high. This could in turn increase the amortization rate of some U.K. RMBS, which may be credit positive. Overview The growing gap between U.K. mortgage lenders' standard variable rates and the fixed rates they are offering on new mortgage loans could be leading to an increase in remortgaging activity, in our viewpotentially pushing up U.K. RMBS payment rates. We estimate that 51% of borrowers (by mortgage balance outstanding) from a sample of two million loans might be willing and able to remortgageup from 35% in Q1 2012.

U.K. RMBS Payment Rates Remain Low

For more than three years, the average principal payment rate in U.K. prime RMBS transactions that we rate has remained depressed at about 15%well below the typical level before 2007. Data from the Bank of England suggest that the overall U.K. mortgage marketincluding unsecuritized loanshas followed a similar trend (see chart 1). The largest volume of principal repayments is due to borrowers redeeming their mortgage loans in full, usually accompanied by taking out a new loani.e., remortgaging.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 2

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates

Chart 1

Most prime U.K. mortgage borrowers take out loans that feature a two- to five-year introductory period, during which the interest rate is either fixed or floating at a set margin to some benchmark rate (in the case of "discount" or "tracker" loans). After this period, the interest rate typically reverts to the lender's standard variable rate (SVR). Borrowers generally don't redeem their loan and remortgage during the introductory period, as this would usually incur an early repayment charge. Once the introductory period has ended, a borrower's willingness to refinance likely depends on the difference between the current interest rate on their loan (at that point, usually the lender's SVR) and the prevailing interest rates on new fixed- or floating-rate loans. Traditionally, lenders' SVRs were higher than the interest rates on new fixed- and floating-rate loans, leading to relatively high remortgaging and, therefore, mortgage payment rates. For example, between 2005 and 2007, U.K. lenders' SVRs were on average about 1.5 percentage points higher than their rates on new two-year loan products for borrowers with a 75% loan-to-value (LTV) ratio (see chart 2). A borrower due to revert onto their lender's SVR would therefore have had a significant incentive to instead remortgage onto a new loan product, since the saving in monthly interest payments would generally have exceeded the fees associated with taking out a new loan. This incentive to remortgage fell sharply between 2008 and 2010, consistent with declining mortgage payment rates. However, more recently, the gap between SVRs and the rates on new loan products has widened once again, and is

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 3

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates

now close to pre-2008 levels.

Chart 2

Borrowers' Incentive To Remortgage Has Increased

As a result, more borrowers whose loans are past their introductory period could be financially better off by redeeming their existing loans and remortgaging. In May 2013, the volume of mortgage redemption payments rose by 20% year-on-year and the volume of remortgage approvals hit a two-year high. To further quantify how many borrowers are both willing and able to refinance, we analyzed a sample of about two million mortgage loans backing U.K. prime RMBS transactions that we rate. We estimated the size of each borrower's incentive to remortgage as the difference between the market-average SVR and the average interest rate on a new two-year fixed-rate loan, which in turn depends on the borrower's LTV ratio. We used several major U.K. lenders' rate cards to determine prevailing two-year fixed interest rates for different LTV ratios, and estimated borrowers' current LTV ratios by indexing their property values using regional house price indices. Our analysis suggests that borrowers with an indexed LTV ratio of up to 85% would now typically have an incentive to remortgage. By contrast, in Q1 2012, we estimate that only those with an LTV ratio below 75% had an incentive. Here,

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 4

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates

we assume that a borrower only has an incentive to remortgage if the corresponding reduction in the annual interest rate would be at least 50 basis points (bps), in order to compensate for one-off remortgaging costs (see table 1).
Table 1

Estimated Interest Rate Incentive To Remortgage (Basis Points)

LTV ratio (%) <60 60-65 65-70 70-75 75-80 80-85 85-90 LTV--Loan-to-value. Source: Standard & Poor's, Bank of England, lender rate cards. Q1 2013 210 200 200 170 110 50 0 Q1 2012 140 120 110 90 40 10 0

As a result, we estimate that half of borrowers in our sample pool (by mortgage balance outstanding) might be both willing and able to remortgage, up from about one-third a year earlier (see chart 3). We assume that borrowers with less than 10% equity will be unable to remortgage, and that those whose loans are still in their introductory period will be unwilling to do so because they would incur an early repayment charge. We also assume that some borrowers who may have a financial incentive to remortgage and would likely be able to secure a new loan, nevertheless do not do so in practice. For example, they may not be actively reviewing their financing arrangements and may be unaware of the financial advantages of remortgaging. As a proxy for such borrowers, we have excluded from the pool of potential remortgagors, any borrowers whose loans are highly-seasoned (i.e., were originated before 2005), and who have therefore likely foregone previous opportunities to remortgage. Excluding such loans, the proportion of mortgage balances that we might realistically expect borrowers to refinance increased to 51% in Q1 2013 from 35% in Q1 2012. Our analysis ignores the potential effect of new U.K. mortgage market regulations, set to become effective from April 2014. For example, lenders will have to assess affordability for interest-only loans on a repayment basis, unless the borrower provides credible evidence of an alternative source of capital repayment. Some lenders have already significantly tightened interest-only lending criteriaor withdrawn from interest-only lending altogetherin anticipation of the new regulations. We believe the new rules could depress the refinancing of interest-only loans, which account for about 40% of our sample balance (see "U.K. Interest-Only Mortgage Borrowers Could Struggle To Refinance Under Tighter Lending Rules," published on July 27, 2012).

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 5

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates

Chart 3

But How Long Will Fixed Rates Stay Low?

The gap between lenders' average SVRs and fixed rates on new loans has widened over the past year, as the latter have fallen, while SVRs have remained broadly flat. Falling fixed mortgage rates have mirrored the trend in the two-year sterling swap rate, which in the 12 months to April 2013 declined by about 80 bps (see chart 4). However, more recently, the two-year swap rate has edged up, touching levels last seen in mid-2012. General market volatilitypartly stemming from the U.S. Federal Reserve's plan to scale back its quantitative easing programhelps to account for this rise, in our view, so the swap rate may be susceptible to changes in investor sentiment. However, if swap rates continue to rise, interest rates on fixed mortgage products may stop falling and could even edge up again. Borrower behavior would then depend on whether lenders also raise their SVRs, maintaining the current reemerging incentive to remortgage.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 6

1162768 | 301112013

U.K. Mortgage Borrowers' Rising Remortgage Incentive Could Increase RMBS Payment Rates

Chart 4

Related Research
U.K. Interest-Only Mortgage Borrowers Could Struggle To Refinance Under Tighter Lending Rules, July 27, 2012 U.K. RMBS index report, published quarterly
Additional Contact: Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 7

1162768 | 301112013

Copyright 2013 by Standard & Poor's Financial Services LLC. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor's Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an "as is" basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT'S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P's opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof. S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process. S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription) and www.spcapitaliq.com (subscription) and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

WWW.STANDARDANDPOORS.COM/RATINGSDIRECT

JULY 18, 2013 8

1162768 | 301112013