Structured Finance

European RMBS
Special Report
A Guide to Cash Flow Analysis
for RMBS in Europe

Analysts Q Summary
Matthias Neugebauer This report describes Fitch Rating’s approach to analysing
+44 20 7417 4355 residential mortgage-backed transactions, which rely on the cash
[email protected] flows generated by the underlying mortgage loans to meet the
issuer’s interest and principal payment obligations under the notes.
Euan Gatfield
+44 20 7417 6306
The report focuses primarily on structural analysis and
[email protected] supplements the country-specific Residential Default Model
reports (available from www.fitchratings.com).
Stuart Jennings
+44 20 7417 6271 Fitch’s RMBS ratings generally address timely payment of interest
[email protected] and ultimate payment of principal. The ratings depend among
other factors, crucially on the performance of the mortgage
collateral and may be jeopardised by defaulted and delinquent
loans. Cash flow analysis is performed in order to test whether
Contents sufficient credit enhancement and liquidity support is available for
the ratings to survive Fitch’s stress scenarios.
• Cash Flow Structures
• Building Blocks
Credit enhancement in European Cash Flow RMBS is provided by
− Excess Spread excess spread (“ExS”), sub-ordination and over-collateralisation
− Principal Deficiency Ledger (assets of the issuer exceed the liabilities). One of the primary
− Reserve Fund objectives of cash flow analysis is to determine the amount of
− Swaps credit support provided by ExS, which depends not only on
− Liquidity Facility collateral performance – such as prepayments and default – but
− GIC Account, Negative Carry, also on the effectiveness of the structure to utilise ExS in respect
Authorised Investments of losses.
− Step up Margins
− XS Certificates Another objective of cash flow analysis is to test whether the
• Cash Allocation ‘liquid’ forms of credit enhancement (i.e. ExS and cash reserve)
− Priority of Payments are sufficient to compensate for a temporary liquidity shortfall
− Senior Notes Protection caused by delinquent mortgage loans and adverse interest rate
• Specific Structures movements. Additional liquidity support may be necessary in
− Provisioning Fitch’s scenarios in order to ensure the issuer is able to meet its
− Non standard Swaps interest payment obligations under the notes in full and on time.
This can take the form of external third party liquidity facilities or
− Pro Rata Amortisation
internal liquidity by way of ‘borrowing principal funds’ to pay
• Fitch’s Cash Flow Scenarios
interest. The agency models the cash flowing from the mortgage
− Prepayments portfolio and its reallocation within the structure to pay interest
− Margin Compression and principal under the notes in accordance with the specific
− Default and Recovery Rates priority of payments (or ‘waterfall’). To ensure consistency across
− Default and Loss Timing transactions, the agency has developed a cash flow model that can
− Delinquency Assumptions incorporate the various structures described in this report.
− Interest Rates
• Appendix I The report is subdivided into five sections. The first section
− Prepayment Rates in Europe provides a brief description of cash flow structures. Sections two,
• Appendix II three and four describe in some detail the main ‘building blocks’
− Fitch’s CPR Assumptions and structures of cash allocation used in European RMBS. The
final section provides an overview of the key variables affecting
principal and interest payments generated by mortgage portfolios
as well as their stressed levels assumed in Fitch’s cash flow
analysis.

20th December 2002

www.fitchratings.com
 Structured Finance
Transaction Diagram

Swap GIC Liquidity

Counterparty Counterparty Provider

Guaranteed
Interest Rate / Investment Liquidity
Currency Swap Contract Facility

3m Euribor + 30bps Senior Notes

Interest
Collections rated ‘AAA’
Principal

Issuer
Mortgage Special Purpose
Portfolio Vehicle (SPV) 3m Euribor + 70bps
Mezzanine Notes
Principal rated ‘A’
Collections Principal (if Senior
Notes are amortised)

3m Euribor + 90bps
Reserve Fund Junior Notes
rated ‘BBB’
Principal (if Mezz
Notes are amortised)
Subordinated
loan
Servicing
Agreement

Servicer Seller

Q Cash Flow Structures The chart above depicts a typical ‘true sale’
Cash flow analysis is mostly associated with ‘true arrangement, as is fairly standard in European
sale’ transactions, where the issuer acquires a RMBS. The issuer’s capital structure generally
portfolio of mortgages from the originator/seller, includes senior, mezzanine and junior notes, as well
financed through the issuance of notes. The holders as either a reserve fund or unrated subordinated
of such RMBS notes obtain a security right over the notes, which represent the first loss piece (FLP).
mortgages. Interest and principal payments under the
notes are met with funds received from the Losses which exceed available ExS and the FLP will
mortgages. be allocated in reverse sequential order starting with
the junior notes, then the mezzanine notes and finally
To administer the mortgage loan portfolio, the issuer the senior notes. Thereby the mezzanine and junior
will enter into a servicing agreement with either a notes together with the FLP provide credit enhanced
third party specialised mortgage servicing company to the senior notes in the form of subordination.
(common in the UK sub-prime market) or the seller
of the mortgage portfolio (typical in most other Principal funds received from the mortgages are
transactions in Europe). usually ‘passed through’ by the issuer to amortise the
notes sequentially starting with the senior notes,
In ‘synthetic’ structures (common only in German followed by the mezzanine notes and finally the
RMBS), the seller buys protection in respect of a junior notes. Pro rata payment is possible subject to
portfolio of mortgages, but remains the legal owner certain conditions being fulfilled (see page 11).
of the mortgage loans. Cash flow analysis is
typically not required, as the payment of interest There are several other counterparties that play key
under the notes is guaranteed by the seller and roles in the transaction, which will be described in
structures do not benefit from excess spread. One more detail in the following section.
notable exception was the Swedish FARMS
transaction, which benefited from synthetic excess
spread.

A Guide to Cash Flow Analysis for RMBS in Europe

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 Structured Finance
Q Building Blocks provisioning for defaults (see page 9) would capture
more ExS prior to losses occurring.
Excess Spread (ExS)
Excess spread is the difference between (i) the Principal Deficiency Ledger (PDL)
interest earned on the mortgages, and (ii) the coupon The PDL is a record of uncovered losses on the
on the notes and senior expenses of the issuer. Most mortgages (i.e. net of any ExS and monies in the
cash flow RMBS transactions are structured to reserve fund) that would result in a principal
generate a certain level of ExS, which can range deficiency on the notes were the transaction to
from as much as 300bps or more in certain UK sub- unwind at that point in time. The reader should note
prime mortgage transactions, to as little as 25bps in that the PDL is not a physical cash account but rather
some Dutch RMBS. a ledger that is debited on each payment date in
respect of losses (plus in certain structures, principal
ExS represents the first layer of protection in funds being used to cover interest shortfalls) and
European RMBS, and is used to absorb losses, top credited in respect of available funds.
up the reserve fund, as well as to provide liquidity
support. A PDL mechanism is usually associated with
separate principal and interest priority of payment
The amount of ExS available over the life of the (waterfall) structures and allows the transfer of
transaction depends significantly on the level of revenue funds to cover principal losses registered on
prepayments experienced by the assets: the higher the PDL, and thereby to accelerate the amortisation
the rate of prepayment, the lower the lifetime volume of the notes. Crediting of the PDL takes place in the
of ExS. revenue waterfall on each payment date using funds
available after all items senior to it have been paid in
Moreover, the level of ExS is not constant for the life full.2
of the transaction (unless it is guaranteed by a swap,
as is usual for example in Dutch RMBS), and Any funds credited to the ledger will reduce the debit
depends on two factors: balance (principal shortfall), and form part of
available principal funds used to redeem the notes. If
a. The weighted average margin (WAM) on the there is insufficient revenue to extinguish a debit
notes: as lower margin senior notes pay down balance, it is carried forward on the PDL to the
prior to higher margin subordinated notes, the following payment date.
note WAM will increase, reducing the level of
ExS.1 The PDL is usually split into sub-ledgers
b. The WAM on the mortgages: if borrowers corresponding to each note class. If we assume two
paying higher margins repay their loans more note tranches, a senior one (A) and a junior one (B),
quickly, the WAM of the mortgages will then a debit balance is first established on sub-ledger
decline, and so with it the level of ExS. This is B. This is credited only after the full payment of
referred to by Fitch as ‘WAM compression’ and interest on B is made. Note that funds credited to the
is discussed in greater detail on page 14. B sub-ledger will be used to redeem the class A
notes until fully redeemed.
The amount of ExS available to support the notes is
dependent not only on the prepayment rate, or WAM While uncovered losses may continue to accumulate,
compression, but also on how the structure is able to the maximum debit balance that can be recorded on
capture the additional revenues. In most cash flow the B sub-ledger is capped at the outstanding balance
RMBS structures, ExS is available to cover losses of that tranche. This reflects the fact that B note-
only on a ‘use it or lose it’ basis, so that prior to holders could not lose more than the outstanding
shortfalls occurring, all ExS will be paid back to the principal of their investment were the deal to unwind
originator. In order to retain some of the ExS prior to at that point. Hence, any further losses would be
losses, the reserve fund (see Reserve Fund on page registered on the A sub-ledger, indicating that senior
4) may be structured to build by capturing and bondholders are now at risk of suffering an ultimate
retaining ExS up to a required amount. Alternatively principal shortfall. In such circumstances, in order to
protect the senior tranches, payment of interest under
the B notes is subordinated to the payment of funds
1
The reverse may be true temporarily for deals with high senior
2
detachable coupons (fairly common in UK sub-prime RMBS). With combined waterfall structures (which allocate principal
Also, where the notes amortise pro rata, the notes’ WAC will and interest funds together according to a single schedule), there is
stabilise. no need to make this special transfer.

A Guide to Cash Flow Analysis for RMBS in Europe

3
 Structured Finance
needed to reduce to zero the debit balance on the A of that at closing. Furthermore, amortising reserves
sub-ledger. Such a waterfall can be represented as are always subject to an absolute floor to protect
follows: noteholders from exposures to large loans remaining
in the later stages of the transaction. The floor is
1. Interest on Class A notes, determined in relation to the size of the largest loans
2. Amounts to reduce to zero any debit balance on in the mortgage portfolio.
PDL sub-ledger A,
3. Interest on Class B notes, Swaps
4. Amounts to reduce to zero any debit balance on European RMBS typically pay a floating rate of
PDL sub-ledger. interest based on either of the two main indices in
Europe, STG Libor or Euribor. The mortgages, on
Reserve Fund (RF) the other hand, can be fixed or floating and
Most cash flow RMBS structures in Europe benefit variations thereof. Floating rate mortgages can also
from a reserve fund, which provides credit be based on indices other than Euribor or Libor (e.g.
enhancement as well as liquidity support to the UK standard variable rates) or versions of Euribor or
issuer. In order to fund the cash reserve at closing, Libor (for example one-month, three-month or six-
the originator will typically grant a subordinated loan month) with reset dates that differ from that of the
to the issuer (SPV), which is repaid from excess notes. The mismatch between the interest basis for
spread. Alternatively, the issuer may seek funding the mortgages and that for the notes would therefore
for the RF through the capital markets. This can be expose the issuer to interest rate risk.
achieved by issuing XS certificates (see XS
certificates page 6). Another factor that may need to be hedged is
currency risk, where the notes and mortgages are
The amounts standing to the credit of the RF will denominated in different currencies.
form part of available revenue funds on each
payment date, and will be distributed in accordance To hedge such risks, European RMBS issuers
with the revenue priority of payments. The RF will generally enter into derivative agreements, which
be credited again at some stage in the waterfall from usually fall into the following categories:
remaining revenue funds after payment of all senior
positions. 1. Basis swap: issuer pays one index and receives
another;
Standard RFs are credited only after interest on the 2. Fixed-Floating swap3: issuer pays a fixed ‘swap
notes and payments in respect of the PDL, thereby rate’ and receives Euribor/Libor;
providing credit enhancement as well as liquidity 3. Currency swaps: in respect of both principal and
support. Some structures restrict the use of the interest, issuer pays an amount in one currency
reserve fund to provide liquidity only, by, for and receives an amount in another. Calculated
example, crediting the reserve prior to the PDL in with respect to a fixed exchange rate specified in
the waterfall. This means that the reserve fund would the swap agreement at the closing date.
not be available to credit the PDL and amortise the
notes until the last payment date, when the reserve is European RMBS typically involve ‘balance
no longer required to be replenished. guaranteed’ swaps, whereby the swap notional is
defined in relation to the mortgage balance (or
A RF can also be used to ‘trap’ ExS before it is occasionally the note balance). Prepayment risk in
released from the structure. This is the case where such swaps is thereby transferred to the swap
the reserve fund ‘required amount’ is greater than the counter-party, thus largely mitigating the risk to the
amount that was funded initially at closing. The issuer of under/over-hedging, which could arise were
amount of ExS retained in this way is limited by the the amortisation of the swap notional set according
required amount. Once the RF is fully funded, any to a fixed schedule.
further revenue funds are used to satisfy
subordinated items in the waterfall before being Although the use of swaps may mitigate the interest
released. rate and FX exposure of the issuer, it introduces

If the required amount is expressed as a percentage 3

An important point of departure from a swap is that a cap
of the current outstanding note balance, the reserve counterparty is never ‘in the money’ (at the expense of the issuer).
fund will amortise over time. In order to restrict this, This means that, ceteris paribus, the issuer is able to benefit from
Fitch usually introduces a delinquency and/or default greater excess spread in a low interest rate scenario where a cap is
trigger and asks that credit enhancement to the senior incorporated compared to a swap. However, this is compensated
for with the payment of premia to the cap counterparty.
notes be a multiple (decided on a case-by-case basis)

A Guide to Cash Flow Analysis for RMBS in Europe

4
 Structured Finance
counter-party risk in respect of the swap provider. deposit with an appropriately rated financial
This risk is generally addressed through the use of institution.
rating triggers. For standard swaps the swap
counterparty should generally be rated F1 or higher Guaranteed Investment Contract (GIC),
to support a ‘AAA’ rating Negative Carry and Authorised
Investments
Swaps used in European RMBS can, however, Under the guaranteed investment contract, the GIC
deviate considerably from ‘plain vanilla’ interest rate counterparty agrees to pay a guaranteed rate of
and currency swaps (see ‘Non-Standard Swaps’ on interest on the issuer’s transaction accounts (which
page 10). Any deviation from simple swap structures will contain principal and interest collections
has to be analysed, and an assessment made as to between note payment dates and amounts standing to
how difficult it would be to replace or collateralise the credit of the reserve fund). The agreed rate of
the swap. The minimum rating may be ‘F1+’, where interest is usually Libor or Euribor minus a margin
the swap is more difficult to replace or collateralise. (currently between 15 and 25bps).

Liquidity Facility (LF) Although the GIC account mitigates reinvestment

In order to ensure timely interest payments under the risk exposure of the issuer by guaranteeing a margin,
notes, the issuer may require some form of dedicated the issuer still incurs ‘negative carry’ costs
liquidity support to cover possible revenue shortfalls associated with holding cash. For example, if the
arising from delinquent and defaulted mortgage mortgages were to pay monthly and the notes
loans. Third-party liquidity facilities are usually quarterly, the issuer would be exposed to negative
associated with strictly separate waterfall structures carry costs due to the differential between (i) the
that restrict principal from being used to fund interest received on mortgages and the transaction
revenue deficits. accounts over a quarter, and (ii) the interest due on
the notes. The impact of negative carry on ‘pass-
Under an ordinary LF contract, the issuer is entitled through’ structures is usually negligible since neither
to draw down funds up to an agreed amount in order interest nor principal is held in cash for any
to cover interest shortfalls on the notes. significant length of time. However, negative carry
can reach considerable proportions, for example,
Availability of the facility for junior notes is usually during the cash accumulation periods necessary for
subject to the performance of the transaction, and controlled amortisation and bullet notes that are
will expire should the performance deteriorate frequently seen in RMBS master trusts (used in
beyond the level consistent with the rating of these France and the UK). Negative carry costs also arises
notes (see Protection of Senior Notes page 8). For over the first 18 months in Italian RMBS, during
example, in Dutch RMBS, the issuer can draw on the which period the notes can not be redeemed and any
LF to cover interest shortfalls on subordinated notes principal collections have to be held by the issuer.
only as long as there is no debit balance on the PDL
sub-ledger corresponding to that tranche. In order to mitigate negative carry, the issuer may
invest such funds in ‘authorised’ (or ‘permitted’)
In order to ensure such facilities do not constitute investments, which would yield a return in excess of
credit enhancement, all amounts due to the facility the guaranteed rate under a GIC. However, such
provider including drawn amounts, as well as investments would also carry a higher risk compared
interest, are paid at the top of the revenue priority of to holding cash. Therefore investments typically
payments (usually after senior expenses but ahead of must mature by the next payment date to avoid loss
interest payments to the senior notes). in value due to market value risk, and should consist
of highly rated, liquid securities (rated ‘F1’ or ‘F1+’
The cost of a facility includes a commitment fee depending upon the frequency of payments under the
currently in the region of 10 to 20bps on the notes)
available amount, together with a floating rate of
Libor/Euribor plus a margin, which is currently Step up Margin
between 15 to 30bps on any drawn amounts. The terms and conditions of most RMBS notes in
Europe include an increase in the note margin taking
Most facilities are 364-day commitments. Should the effect after the call date4 (also referred to as the step-
provider decide not to renew the facility, or if it were up date). The increased cost of funding to the issuer
downgraded below the minimum rating and unable provides an incentive to redeem the notes at their call
to find a suitable replacement in a given period, then
the issuer would ordinarily have the right to draw 4
Fixed rate notes generally revert to floating at the step up date.
down the available amount in full and place it on

A Guide to Cash Flow Analysis for RMBS in Europe

5
 Structured Finance
option date from funds received from selling the XS certificate. The earlier defaults occur, the less
mortgages (usually back to the originator). There is, ExS is available to repay the certificate. When
however, no guarantee that the originator or another analysing XS certificates, Fitch runs front-loaded
party will be able or willing to provide funding to the recession scenarios starting soon after closing (see
issuer to redeem the notes; hence Fitch is unable to page 14 for timing of default).
rely on the exercise of such an option.
By exercising its call option, the issuer could also
The increased note margin post-step-up date will drastically reduce the volume of excess spread, if
compress the level of excess spread available to the any remaining balance of XS certificates at the call
issuer considerably. This may lead to negative ExS date would be written off. This is usually the case in
post step-up, so that the issuer has to pay out more Dutch RMBS. Therefore, Fitch will assign a rating
than it is receiving from the mortgages. In such only if sufficient ExS is generated prior to the call
situations Fitch assumes that the call option is not date to repay the XS certificates.
exercised and the negative excess spread post step-
up is incorporated in the required credit The ratings of XS Certificate address ultimate
enhancement.5 payment of principal and interest to the holders of
the XS certificates, but may or may not address
XS Certificates timely payment of interest. Given that interest is
XS Certificates, prevalent for some time in the US, deeply subordinated, it is sometimes not possible to
were only recently introduced in European RMBS obtain a rating for timely payment of interest, since
transactions. They have been used in a number of the PDL and reserve fund replenishment would
Dutch and UK RMBS transactions including Arena absorb any available excess spread under stressful
I,II and III, Hermes III (all Dutch), and Holmes and circumstances. Accordingly, to achieve timely
Granite (both UK Master Trust) among others. payment of interest, it is usually necessary to
structure the priority of payments so that XS
XS certificates are issued mainly to fund the initial certificate interest is paid prior to the most junior
reserve account and transaction expenses; they act as PDL/principal and any replenishment of the reserve
an alternative to a subordinated loan granted by the fund.
seller to the issuer. XS certificates are not backed by
mortgage collateral – rather, interest and principal is Q Cash Allocation
paid exclusively from ExS generated by the
structure. Priority of Payments
The priority of payments or ‘waterfall’ of a
Therefore the repayment of principal and interest transaction determines the order in which available
under the XS certificates is crucially reliant on the funds are allocated at fixed intervals in satisfying the
level and timing of excess spread, which itself is liabilities (interest and principal under the notes) of
dependent on the rate of prepayment (see page 13 for the issuer. Junior-ranking positions receive funds
more detail), the timing of defaults, and also the only after more senior items have been paid in full.
possibility of the issuer to exercise its call option
under the notes on the step up date. There may be several priorities of payments in a
single transaction, each corresponding to a category
The higher the rate of prepayment the lower the of funds (revenue or principal) and/or the status of
volume and level of ExS received from the the deal (e.g. pre- or post-enforcement of the notes).
mortgages. To stress the volume of ExS, Fitch runs
high prepayment scenarios assuming a certain rating In combined waterfall structures, which are
dependent stress level of prepayments (see page 23 common in Spain, France and Italy, principal and
for Fitch’s prepayment stresses). interest collected from the loans are merged and
distributed according to one priority of payments.
Furthermore, ExS is the first source of credit and Principal payments to each note class are typically
liquidity support to the issuer. Therefore any defaults subordinated to payment of interest on the related
and delinquencies will further diminish the volume note tranche. The following example shows part of a
of ExS available to the holders of the XS certificates. two tranche combined waterfall:
The timing of defaults is crucial for the rating of the
Interest A– Principal A – Interest B – Principal B
5
For the case that there is still a positive level of ExS post step up Principal B will only be paid once the senior notes
date Fitch assumes that the call option is exercised and no credit is
given for the additional ExS. have been redeemed in full (except for ‘pro rata’
amortisation; see page 11).

A Guide to Cash Flow Analysis for RMBS in Europe

6
 Structured Finance
The amount distributed as principal in respect of the
most senior notes outstanding is usually capped at Example: MECENATE (Italian RMBS)
the ‘Maximum Redemption Amount’, which is (Summary – combined waterfall)
generally defined as the difference between the
balance of notes as at the last payment date and the Priority of Payments for Issuer
current balance of the mortgages. This cap ensures Available Funds
that items junior to principal can also receive 1. Fees (Servicer; Paying Agent and others)
payments. The definition of Maximum Redemption 2. Prior to an event of default under the Swap
Amount is a critical component of many all amounts due to the swap counterparty
provisioning mechanisms, and will be looked at 3. Interest due to the Class A notes
separately in the next section. 4. Interest due to the Class B notes
5. Interest due to the Class C notes
With a waterfall structure as outlined above, 6. Principal Equivalent Amount up to the
principal funds only provide liquidity support to the Maximum Redemption Amount (see Section
most senior ranking notes outstanding on each 3 - Provisioning )
payment date. Interest payments to the class B notes, 7. Any shortfall of principal fund due but
(while class A notes remain outstanding), are unpaid on the last payment date
subordinated to principal, and therefore more 8. Replenishing the Reserve Fund up to its
exposed to temporary interest shortfalls caused by a required amount
rise in delinquencies or interest rates. In order to 9. Following an event of Default under the
achieve a rating for timely payment of interest on the Swap all amounts due to the swap
junior notes, combined waterfalls usually begin as counterparty
follows: 10. Various subordinated items

Interest A – Interest B – Principal A - Principal B The waterfall will change subject to the ratio of
(A) the aggregated amount of defaults to (B) the
With such a schedule, principal payments on the current outstanding balance of mortgages.
senior notes are subordinated to junior note interest
providing liquidity support to all tranches from day If A/B >11% then Interest on Class C notes will
one. However, this is normally subject to certain be deferred and paid as item 7
performance triggers (see Senior Note Protection
below), which, if breached, will promote the position If A/B >15% then Interest on Class B notes will
of principal on the class A notes above interest to the be deferred and paid after as item 7
class B notes. In the simple example above, this
would revert to the following:
While it is possible to use revenue funds to cover
Interest A – Principal A - Interest B – Principal B principal shortfalls (via the PDL), the reverse is
generally not allowed in Dutch RMBS. In order to
To illustrate such structures consider the following ensure timely payment of interest on the notes the
example of a combined waterfall, which was taken issuer usually has access to an external Liquidity
from the MECENATE transaction (Italian RMBS). Facility, which is initially available for both senior
The transaction includes senior, mezzanine and and junior notes. However, this is once again subject
junior notes. All of which are rated for timely to performance triggers, which, if breached, would
payment of interest and ultimate payment of terminate the availability of such facilities to junior
principal. The waterfall incorporates separate notes.
triggers based on the proportion of defaulted
mortgage loans for junior interest and mezzanine Furthermore, to ensure timely payment of interest on
interest. the junior notes in separate waterfalls, payments
associated with crediting the PDL are usually
With separate waterfalls, typical in Dutch and UK subordinated below interest on the junior notes.
RMBS, principal and revenue funds (the latter being However, once the PDL debit balance exceeds the
inclusive of the reserve fund) are kept segregated remaining outstanding balance of the junior notes, it
and applied in their own respective waterfalls.6 should be credited prior to interest on the junior
notes in order to protect the senior notes. This is
6
Any recovery amounts are also kept segregated as interest and
typically achieved by splitting the PDL into sub-
principal recoveries. Interest recoveries are distributed through the ledgers, each corresponding to a particular note
revenue waterfall, while recoveries in respect of principal are tranche (see section 1 – PDL). This means the
usually allocated together with principal collections. allocation of interest to repay principal deficiencies

A Guide to Cash Flow Analysis for RMBS in Europe

7
 Structured Finance
is ‘automatically’ regulated by the performance of Any liquidity support to the notes (whether provided
the deal. by principal and external facility) comes at a certain
cost, which is inherent one way or another in both
The following example was taken from the Dutch combined and separate waterfalls and which can be
transaction STReAM I. In this particular structure described as the economic cost of liquidity. Separate
any remaining ExS after crediting the PDL was used waterfall structures supported by external liquidity
to amortise the junior notes instead of being released, facilities incur a direct cost made up of a relatively
thereby creating overcollateralisation. The amount of small commitment fee for the availability of the
credit enhancement remained unchanged. facility (normally charged as a percentage of the
available amount of the facility), and an interest rate
charged on any drawn amount (see Liquidity
Example: STReAM I (Dutch RMBS) Facilities on page 5).
(Summary – separate waterfall)
Using principal as a source of liquidity also incurs a
Notes Interest Available Amount ‘time value of money’ cost arising from continuing
Interest on the Mortgages; GIC Interest; to pay interest on a note balance that would
Prepayment Penalties; Drawings on the Liquidity otherwise have amortised. This cost is equal to the
Facility; Reserve Fund; Swap payments; coupon on the most senior class of notes in
Recoveries relating to Interest sequential structures, and the WAC on the notes in
pro rata structures.7
Interest Priority of Payments
1. Fees (Trustee; Servicer; Paying Agent etc.) Senior Note Protection
2. Payments to the Liquidity Facility Provider The continued availability of liquidity sources
3. Payments under the Swap (except termination (principal collections or external facilities) for junior
payment) note interest in a scenario where the performance of
4. Interest on the class A notes the mortgage collateral deteriorates beyond a level
5. Class A PDL consistent with the rating of the junior notes
6. Interest due to the class B notes represents a significant outflow of funds, which has
7. Class B PDL to be addressed when sizing credit enhancement for
8. Interest due to the class C notes the senior notes. For example, where principal is
9. Class C PDL used to provide liquidity support, senior notes would
10. Replenishing the Reserve Fund up to its only be repaid once interest on the junior notes has
required amount been paid in full. Similarly, since liquidity facilities
11. Payments under the Swap in respect of are replenished prior to senior note interest in the
termination payments waterfall, their unlimited availability to service
12. Additional amounts to the Liquidity Facility junior notes would, in effect, redistribute funds away
13. Repayment of the notes starting with the from the senior notes to the junior notes.
Class; then Class B and finally Class A
In order to complete the subordination of junior
Notes Redemption Available Amount notes and to preserve more funds for the senior
Scheduled and Unscheduled Principal Receipts notes, the availability of liquidity support to junior
from the Mortgages; Recoveries with respect to notes is typically conditional upon performance
Principal; Revenue Funds credited to the PDL measures and/or ‘caps’, as is the case in some UK
structures (see above).
Principal Priority of Payments
The challenge for structurers is to find an appropriate
Sequential starting with Class A, then Class B and point in time for terminating the use of liquidity
finally Class C. facilities or the application of principal in respect of
junior note interest. If the switch happens too early,
UK structures also have separate waterfalls for insufficient funds may be available for junior interest
interest and principal, but often allow principal to be thereby causing a temporary interest shortfall. On the
used within certain limits to cover revenue shortfalls. other hand, if such termination takes place too late, it
Any principal funds re-allocated to meet interest may create a principal shortfall on the senior notes.
payments are debited to the PDL. Rather than using
performance triggers, the ‘borrowing’ of principal to
meet junior interest payments is only possible for as
long as it does not create a debit balance on the next 7
Note that there is no equivalent to the facility commitment fee.
senior ranking PDL sub-ledger.

A Guide to Cash Flow Analysis for RMBS in Europe

8
 Structured Finance
Very often, not one, but two triggers are used, which
take into account defaults/arrears as well as losses. Example
The default/arrears trigger (used for example in the Class A rated AAA; Class B rated A; Class C rated BBB
Italian MECENATE transaction – see above) would Expected Principal Deficiency Loss
AAA =7%; A= 5%; BBB = 2%
capture a sudden deterioration of the asset
Expected Maximum Current Defaults
performance, while the loss trigger is designed for a AAA = 20%; A = 15%; BBB = 10%
scenario where defaults and losses are more evenly x = Current Defaults as a percentage of the initial balance
spread over the life of the deal. y = Current Principal Deficiency as a percentage of the
initial balance
x < 10% or 10% < x < 15% or x > 15% or
A loss trigger alone, for example, might stop y<2% 2%<y<5% y>5%
liquidity support for junior interest too late if a Interest A Interest A Interest A
sudden spike in defaults occurred. This is especially Interest B Interest B Principal
pertinent to jurisdictions with long foreclosure Interest C Principal Interest B
periods, such as Italy, Spain and France, where it can Principal Interest C Interest C
take more than two years before recoveries and
losses are realised. In such a scenario, liquidity
support would continue to be provided to junior Q Specific Structures
notes while the portfolio was deteriorating, but had
not yet realised significant losses. Provisioning
Provisioning refers to the use of revenue funds or
Ideally, complementary triggers are sized with ExS to cover for expected losses (i.e. which have not
respect to an expected amount of defaults and losses. yet been realised) in respect of highly delinquent and
However, there are various ways in which such defaulted mortgage loans. In other words, instead of
triggers can be calculated. The most common waiting for a loss to materialise, ExS will be
performance measures are current defaults and captured and used to amortise the note balance in
uncovered loss or principal deficiency.8 These can be respect of the amount provisioned. This will
expressed as a percentage of either the balance at temporarily create over-collateralisation and reduce
closing or the current outstanding balance of the the total interest due on the notes. Once recoveries
notes. are received and a loss is realised, any excess
recoveries will flow back to the originator as ExS.
In order to remove some complexity when sizing
these triggers, Fitch recommends expressing them as Italy provides some interesting examples of
a percentage of the balance at closing. This also provisioning techniques, mainly owing to a
confines the stress to ‘front-loaded’ scenarios, and prohibitively lengthy foreclosure process, which in
hence is less likely to interrupt junior interest some Italian regions (‘tribunali’) can last up to ten
payments once the deal has substantially paid down. years. This refers to the time it takes to recover
property sale proceeds from loans in default (‘in
These triggers may or may not be reversible if the sofferenze’). Similarly, RMBs structures in France
balance of current defaults or uncovered losses fall and Spain also use provisioning to mitigate for the
below the set trigger ratio. longer foreclosure periods which on average last 30
months.
Fitch is able to model the breach of different types of
trigger in its cash flow analysis to make sure that With such drawn-out foreclosure processes, and
both its ratings for timely interest and ultimate without accelerated amortisation/provisioning, a
principal survive under specific stresses. large differential could arise between the note
balance and the balance of performing mortgage
To illustrate the use of performance triggers in loans. This would cause a shortfall between the
combined waterfall structures consider the following issuers’ income and expenses (referred to as ‘cost of
example. carry’) for the issuer, who will have to service the
notes inclusive of the proportion corresponding to
such non-performing positions. Moreover, if
subsequent recoveries are insufficient to cover both
8
Current defaults exclude the balance of previous defaults that principal and interest up to an amount the issuer paid
have foreclosed, and therefore reflect the intensity of defaults at a under the notes, such cost of carry will cause or
point in time rather than their accumulation. Uncovered losses (as compound principal deficiencies.
opposed to cumulative losses) could decline due to the
reallocation of revenue funds to redeem the notes (see
Provisioning or PDL).
Provisioning for defaults is usually achieved by
defining the Maximum Redemption Amount (see

A Guide to Cash Flow Analysis for RMBS in Europe

9
 Structured Finance
Section 2 - Combined Waterfalls) to be inclusive of the performing part of the portfolio, the swap
the balance of loans in default. A loan is considered notional can also be defined to include delinquent
defaulted if it is in arrears for a certain period of and defaulted mortgage loans, or even losses. This
time. The definition of default can vary between would be the case, for example, if the swap notional
transactions. is based on the note balance. As a result, the
counterparty could, in certain circumstances, have to
As a result of provisioning, funds that would make interest rate contributions on non-performing
otherwise be paid to items ranking junior to the assets. Such contributions, although generally small
redemption amount in the priority of payments are in respect of a basis swap, could be substantial for a
used to accelerate the repayment of the notes. fixed-floating interest rate swap during periods of
high interest rates.
Some transactions even define the Maximum
Redemption Amount to be inclusive of a proportion In the case of defaults arising, the issuer would be
of highly delinquent loans, as was the case for ‘over-hedged’, which would increase the extent that
example in the MECENATE deal. Here the it would be ‘out of the money’ if Libor/Euribor fell
redemption amount included, for example, 25% of below the swap rate. On the upside, the issuer’s
the notional balance of those mortgage loans which exposure to rising interest rates in respect of
were more than four months overdue. As a result, in defaulted loans (see ‘Cost of Carry’ on page 16) is
such a structure accelerated repayment of the notes locked in at the swap rate.
starts even earlier.
Total Return Swaps – as the name suggests –
exchange the ‘total return’ of the portfolio for a
Example: MECENATE (Italian RMBS) predictable cash flow. The hedge counterparty
Maximum Redemptions Amount on each payment date assumes the risk that the weighted average margin
Outstanding Note Balance minus the Aggregate Notional
Amount outstanding of mortgage loans as of the preceding
on the mortgage loans may decrease over time as a
payment date. result of skewed prepayments. This could arise if
higher yielding loans amortised more quickly. In
Aggregated Notional Amount Outstanding
Defined as the product of (a) the outstanding principal contrast with a ‘plain vanilla’ fixed-floating or basis
amount of each mortgage loan, and (b) the Performance swap, WAM compression would be borne by the
Factor applicable to each mortgage loan. issuer.
Performance Factor In order to give credit to such external support, Fitch
Arrears Level (No. of missed payments) Performance
imposes stringent replacement or collateralisation
For quarterly payment frequency
0-3 100%
triggers upon downgrade of the counterparty;
4-6 75% furthermore, full credit may not be given at higher
>6 65% rating scenarios if there are doubts over the ability of
Defaulted Loans 0% a replacement to be found or collateral to be posted
For semi-annual payment frequency in respect of a particular swap position that is not
0-2 100%
3-4 75% deemed a marketable liquid hedge.
>4 65%
Defaulted Loans 0% Such a complex swap structure is less marketable to
alternative counterparties, and may go hand-in-hand
with a ‘back-to-back’ swap arrangement between the
Non-standard Swaps swap counterparty and the originator, which fully
Swaps used in European RMBS can deviate mirrors the swap terms between the issuer and the
considerably from the ‘plain vanilla’ interest rate swap counterparty. This means that the ability to
swap described in Section 1. replace a swap counterparty following a downgrade
may also hinge upon the then credit quality of the
In this section we will consider two further originator – if this has deteriorated, then a
departures from the ‘plain vanilla’ interest rate swap: replacement counterparty may view the originator as
(i) complex swap notionals and (ii) “total return an unacceptable credit for a ‘back-to-back’
swaps”. arrangement.

We have already described how European RMBS Swap Examples: The following section takes a
typically involve ‘balance guaranteed’ swaps closer look at representative swap structures for
whereby the swap notional is set in relation to the Italy, the Netherlands and the UK.
mortgage balance. Prepayment risk is thereby
transferred to the swap counterparty. In addition to

A Guide to Cash Flow Analysis for RMBS in Europe

10
 Structured Finance
In Italy, most RMBS involve a total return swap Similarly to the Italian Swap, the issuer pays the
based on the performing balance of the mortgage scheduled interest on the mortgages minus a margin
portfolio, with the counterparty guaranteeing a and senior expenses and receives the interest on the
margin. As a result, the agency can set aside the risk notes. Once more, this counteracts any WAM
of WAM compression in its cash flow analysis. In compression on the mortgages.
the GIOTTO transaction, the issuer and swap
counterparty agreed to exchange the total scheduled Unlike the Giotto example, shortfalls in respect of
interest minus a specified margin and senior the payment obligation of the issuer would lead to a
expenses from the mortgages in return for the ‘euro for euro’ adjustment. This means, if interest
interest on the notes. This means the counterparty is rates rose to place the issuer ‘in the money’ while a
effectively guaranteeing an amount of ExS on the proportion of the portfolio was in default, then the
swap notional. However, any shortfall owing to net swap payment would effectively incorporate
delinquent or defaulted loans would lead to a interest contributions on defaulted and delinquent
reciprocal proportional adjustment of payments due loans.
by the swap counterparty.9
Example: PERMANENT FINANCING
Example: GIOTTO FINANCE (No.1)
Exchanges of amounts actually received. Swap Notional: Note Balance less PDL and
Scheduled Interest on the Mortgages amounts in the GIC
less margin and senior expenses
Giotto ABN Amro Netted Payments
Finance The Swap weighted average of
The issuer Provider
1. SVR basket rate
Interest due on the Notes
2. Tracker Rate
3. WA Fixed Rate
Permanent Halifax
Funding The Swap
Proportional Adjustment The issuer Provider
3 month STG Libor
If the Issuer has insufficient funds to pay amounts due plus a spread
to the Swap counterparty, the Issuer’s payment
obligations are reduced by such an amount and the SVR basket rate is an average of SVR’s of Halifax’s
payment obligations of the Swap counterparty will be main competitors. Although it has been highly
reduced by the proportion the shortfall bears to the correlated to the Halifax SVR over time, the two rates
payment due by the Issuer could deviate, leaving some sundry risk for the Issuer.

Swaps used in Dutch RMBS are also total return In the UK, most transactions use a more standard
swaps, as the example of Delphinus III shows. interest rate swap, whereby the issuer is due Libor in
return for a swap rate. The swap used in the
Permanent Master Trust was set against the note
Example: Delphinus III balance minus PDL and any amounts in the
Exchanges of amounts actually received. Redemption Account. This, therefore, also includes
defaults as well as delinquencies. As both legs of the
Scheduled Interest on the Mortgages
plus interest on the Collection Account swap are netted the effect is similar to the ‘euro for
less margin of 50bps * Note Balance
less senior expenses
euro’ adjustment in the Dutch swaps. The issuers’
Delphinus
2001-I
Rabobank
The Swap leg is calculated by reference to a weighted average
The issuer
Interest due on the Notes
Provider of mortgage rates while the swap counterparty
adjusted for
any debit balance on the PDL
‘guarantees’ a margin over Libor, thus hedging the
risk of WAM compression. The issuer remains
Euro for Euro Adjustment exposed to a sundry risk of compression in respect of
the standard variable rate mortgages, as the issuer’s
If the Issuer has insufficient funds to pay amounts due leg of the swap is defined with respect to a basket
under the swap, the payment obligation of the Issuer SVR rate of the major mortgage lenders in the UK
will be reduced by an amount equal to such shortfall.
At the same time the payment obligation of the Swap
rather than Halifax’s own SVR.
counterparty will be adjusted accordingly on a ‘euro for
euro’ basis by the amount of the shortfall. Pro Rata Amortisation
Pro rata, as opposed to sequential, amortisation
refers to the allocation of available principal funds to
redeem the senior and junior notes proportionally in
9
This mirrors a swap which is based on the performing balance of accordance with their respective outstanding
the mortgage portfolio.

A Guide to Cash Flow Analysis for RMBS in Europe

11
 Structured Finance
balance. In order to demonstrate the effect of pro of which are indicators of deteriorating credit
rata amortisation, consider the following example: quality) allocation of principal funds should revert to
sequential.
Senior Junior
Notes Notes Q Fitch’s Cash Flow Scenarios
Initial outstanding Balance 150 50
Fitch runs various stress tests on the key variables
Credit Enhancment 25% -
Available Redemption Funds: 20 affecting cash flows generated by the mortgage
Sequential portfolio, including prepayment speed, interest rates,
Allocation of Funds 20 0 default and recovery rates, recession timing, WAM
Remaining outstanding Balance 130 50
compression (if necessary) and delinquencies. The
Credit Enhancement 27.8% -
Pro Rata agency models the cash flows received from the
Allocation of Funds 15 5 mortgages (as well as from other sources such as
Remaining outstanding Balance 135 45 hedging instruments and GIC accounts) and their
Credit Enhancement 25% - reallocation in accordance with a specific deal
structure. In order to ensure a consistent approach
As a result of sequential pay-down, credit across transactions, Fitch has developed a cash flow
enhancement as a percentage increases over time but model that can incorporate the various structures
remains the same in absolute terms. With pro rata described in the previous parts.
amortisation, credit enhancement remains the same
as a percentage and decreases in absolute terms. The following section provides an overview of
Fitch’s assumptions for the individual risk factors,
Pro rata amortisation has the benefit that the focusing primarily on the major markets in Europe
weighted average cost of funding remains constant including the UK, France, Germany, the
over the life of the transaction, and hence the level of Netherlands, Spain and Italy.
ExS is more stable (although it could still decline
due to WAM compression on the mortgages). By Amortisation Profile
contrast, under sequential pay-down structures that To model the pay-down of the mortgages Fitch uses
retire senior notes first, the weighted average cost of either the amortisation profile provided by the
funding rises over time as the proportion of more originator of the loans, or, if this is not available, an
expensive junior notes increases.10 The level of ExS approximation that is based on loan-by-loan
therefore declines for a sequential structure as time information. The expected amortisation is calculated
goes on. for each loan assuming zero prepayments and no
defaults, and taking into account the current
Nevertheless, a pro rata allocation of unscheduled mortgage rate, remaining term to maturity, the
principal payments under the mortgage loans current balance and the repayment type (whether
(prepayments) raises the risk of “adverse selection”: interest-only or repayment). The aggregated
better credits will prepay first, leading to a repayment profile forms the basis for modelling the
deterioration of credit quality in the mortgage pay-down of the portfolio. The following chart
portfolio. Adverse selection is a particular concern provides an example amortisation profile for a
for sub-prime mortgages since borrowers are likely portfolio, which includes approximately equal
to refinance with a prime lender (and thereby reduce proportions of interest-only and repayment loans.
their margin) at the earliest opportunity their credit
profile allows. Scheduled Amortisation Profile
As s um ing No Prepaym ents
In recognition of the greater credit risks associated
with pro rata pay-down, Fitch generally asks that a (GB P m)
120
period of sequential pay-down takes place from
closing to allow a certain percentage increase in 100
credit enhancement prior to pro rata amortisation 80
commencing. In addition, pro rata amortisation is
subject to various other conditions; for example, if 60

there is a PDL debit balance, an outstanding draw on 40

the reserve fund or a material increase in arrears (all
20

10 0
For deals with high senior detachable coupons (fairly common 1 41 81 121 161 201 241 281 321
in UK sub-prime RMBS) sequential amortisation may temporarily M o nths after Clo sing
lead to a decrease of the cost of funding.

A Guide to Cash Flow Analysis for RMBS in Europe

12
 Structured Finance
The kinks in the curve are a result of interest-only criteria or representations and warranties given by
loans redeeming in one amount at maturity (a the seller at closing. Although generally a small
“bullet” repayment) rather than amortising over time. proportion, such repurchase can, under certain
circumstances, significantly increase prepayment
Prepayments, delinquencies and defaults are speed. This is, for example, the case in some UK
‘overlayed’ on the scheduled pay-down of the master trusts where the seller is required to
portfolio. repurchase loans that have been subject to a further
advance since closing. As a result, prepayment rates
Prepayment Speed reported for these transactions (at around 40%) are
Prepayment speed is a key variable in determining approximately twice the borrower rate of
the lifetime volume and periodic percentage of prepayment. Nonetheless, owing to the impact of
excess spread received from the mortgage portfolio. such inflated rates on ExS, Fitch will increase the
The faster the amortisation of the portfolio, the lower assumed CPR rate whenever the seller is entitled or
the volume of ExS available for noteholders. Higher obliged to repurchase in respect of loans subject to a
prepayments of high margin loans would lead also to further advance.
a lower percentage of excess spread (unless
guaranteed by a total return swap). Taking actual experience in each country as the base
case, Fitch has determined rating-specific
The following chart demonstrates the effect of prepayment stresses (see Appendix II). The applied
different prepayment rates on the amortisation prepayment stress increases for more severe rating
profile of the mortgage portfolio. scenarios. For example, prepayment rates
experienced by UK prime portfolios have recently
Amortisation Profile for Various CPR
been as high as 25% p.a. (see data provided in
Appendix I). Fitch assumes the following stressed
Zero CP R 2% CP R 5% CP R
15% CP R 25% CP R
prepayment rates for UK prime portfolios:
(GB P m)
100
CPR
AAA 35%
80
AA 33%
A 30%
60
BBB 27%
BB 25%
40

20
The following chart shows the assumed country-
0 specific ‘AAA’ prepayment vectors (for other rating
0 50 100 150 200 250 300
scenarios see Appendix I).

With a prepayment rate of 25% per annum, 80% of Assumed AAA Prepayment Vectors
the portfolio will have prepaid five years after 50%
closing.
UK (sub-prime)
40%
The level of prepayments experienced in Europe UK (prime)
varies significantly across countries, and depends D;NL;Fr
30%
inter alia on interest rates, competition among Spain
lenders, the magnitude and term of prepayment Italy
penalties, the financial adeptness of borrowers, 20%
customer loyalty and administrative barriers to
refinancing. A comparison of prepayment experience 10%
across different European countries is provided in
Appendix I, including historical data where 0%
available. 1 9 17 25 33 41 49 57

M o nths after Clo sing

In the context of RMBS reporting, prepayments can
also include mortgage loans repurchased by the
seller. Such repurchase is usually required if a loan is Historical experience suggests that the propensity to
found to be in non-compliance with the eligibility prepay is low in the years immediately after
origination, owing in part to incentive rates or

A Guide to Cash Flow Analysis for RMBS in Europe

13
 Structured Finance
prepayment penalties. Therefore Fitch models a criteria for the UK, Italy, Germany, Spain, France
‘ramp-up’ period of up to three years for unseasoned and the Netherlands available on
portfolios. www.fitchratings.com).

The prepayment rate is applied to the performing The default models generate rating-specific default
balance (i.e. exclusive of defaulted and delinquent and recovery rates for each mortgage loan in the
loans). The effective prepayment rate therefore portfolio. The individual rates are then aggregated11
declines as the rate of defaults and delinquencies to yield a weighted average for the portfolio. These
rises. results, also referred to as WAFF (weighted average
foreclosure frequency) and WARR (weighted
These stress assumptions are based on currently average recovery rate), are used in the agency’s cash
available CPR data (see Appendix I), and may be flow analysis.
adjusted on a case-by-case basis should an individual
lender’s experience differ significantly (or, as Recovery Rates are calculated based on the
mentioned above, where there are specific loan following formula:
repurchase provisions as in some of the UK master
trusts). Minimum of:

Although under most circumstances high i. Outstanding Balance + Accrued Interest

prepayments are generally more stressful for cash ii. Estimated Recovery Value
flow RMBS transactions (owing to the reduced
volume of ExS), there may be circumstances under Divided by the Outstanding Balance
which low prepayment rates could pose an additional
risk factor. This is the case, for example, for the Accrued interest is calculated by reference to the
‘bullet’ notes (which are redeemed in full at maturity current mortgage rate for fixed rate loans (or, in the
and have much shorter terms) issued from UK case of Italy, the legal rate), or a stressed rate for
master trust programs, since it is necessary to floating rate mortgages equivalent to the
accumulate sufficient cash in time to meet the Libor/Euribor stress applied during the recession
repayment of such bullet notes. To test such scenario as outlined below.
structures Fitch will also run low prepayment
scenarios. The estimated recovery value is based upon the
property value, conservatively adjusted using house
Margin Compression price indices in order to provide a cautious estimate
Prepayments will also lead to a decline in the of current values. This value is reduced by a market
weighted average margin (WAM) on the underlying value decline factor; any prior charge amounts,
mortgage portfolio, if high margin mortgage loans accrued interest on prior charge amounts and costs
prepay faster than those with low margins. incurred during the foreclosure process. For more
information please refer to www.fitchratings.com for
The magnitude of any compression depends on both the country-specific residential mortgage default
prepayment speed and the dispersion of loan margins model reports.
in the portfolio. A relatively homogenous pool will
likely experience less margin compression than a Default and Loss Timing
portfolio with a wide range of margins. The observed default pattern of residential
mortgages suggests that defaults are more likely to
WAM compression will reduce the percentage of occur during the first years after origination of the
excess spread, unless otherwise guaranteed by a total loan12. The following chart shows the timing and
return swap (see Sections 1 and 2). magnitude of repossessions for static portfolios of
UK prime mortgages:
Fitch accounts for WAM compression by allocating
11
a certain percentage of prepayments to the highest In the case of default probability, a pool average is determined
margin loans in the portfolio. As the assumed by weighting the loan default rates by their corresponding current
balances. However, loans with higher default probabilities also
prepayment rate is higher for higher rating scenarios, typically have lower recoveries, as both are dependent on LTV.
the extent of WAM compression also increases. Therefore a pool average must be derived by weighting the loan
recovery rates by their respective current balances and default
Default and Recovery Rates probabilities, which will ensure that loans with higher default
probabilities would also receive greater weight in calculating the
Fitch determines portfolio default and recovery rates aggregated recovery rate.
using a loan-by-loan default model, customised for
each country (see individual RMBS Default Model 12
This may be less likely for remortgages of seasoned loans.

A Guide to Cash Flow Analysis for RMBS in Europe

14
 Structured Finance
Number of Repossessions per Year as Assumed Default Vector
Percentage of Total Number for Each Year of Months after
Origination 1-9 10-22 23-34 35-46 47-58 59-70 71-82
Closing
average (1982-1987) average (1988-1990) % of WAFF 2.5% 20% 30% 20% 15% 10% 2.5%
average (1991-1996) The defaults for each period are spread evenly.
1.6%
1.4%
1.2% Fitch Default Distribution
1.0%
0.8%
0.6% 5% 120%
0.4%
0.2% 100%
4%
0.0%
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 80%
3%
Years after origination 60%
Source: FitchRatings 2%
40%

Please note that for UK prime mortgages the time to 1%

20%
repossession measured from the first missed
0% 0%
payment is typically in the range of 12 to 18 months.
1 19 37 55 73 91 109 127 145
The available data shows that the rate of
repossession rises during the first two to four years M o nths after Clo sing

after origination peaking in years four to five.

The propensity to default tends to decline as the The agency models 87.5% of the defaults occurring
ability of private borrowers to withstand financial in the first five years after closing of the transaction.
stress increases. This has been due to several factors, The amount of defaults is calculated in reference to
including rising house prices and rising personal the closing rather than the current balance, assuming
incomes. Moreover, the borrower often deleverages that better credits are likely to prepay first. To
by amortising the mortgage loan over time. illustrate the methodology consider the example on
Amortisation and house price inflation increase the the following page (assuming a WAFF of 20% and a
borrower’s equity in the property and reduce the closing balance of 1000).
LTV. The higher the equity held in the property the
greater the incentive for the borrower to avoid Quarter New Defaults WAFF Defaulted Amount
default. In addition, the lower the LTV, the higher 1 0.83% 0.167% 1.67
the recovery rate would be should the borrower 2 0.83% 0.167% 1.67
3 0.83% 0.167% 1.67
indeed default. Therefore defaults are generally more
4 5.00% 1.000% 10.00
stressful during the early years after closing of the 5 5.00% 1.000% 10.00
transactions (although a greater amount of ExS - 6 5.00% 1.000% 10.00
available on ‘use it or lose it’ basis - is captured). 7 5.00% 1.000% 10.00
8 7.50% 1.500% 15.00
9 7.50% 1.500% 15.00
However, this pattern is also subject to economic 10 7.50% 1.500% 15.00
factors such as the rate of interest and 11 7.50% 1.500% 15.00
unemployment, as seems to be implied by the 12 5.00% 1.000% 10.00
13 5.00% 1.000% 10.00
elongated peak in the 1991-1996 cohort.
14 5.00% 1.000% 10.00
15 5.00% 1.000% 10.00
Based on the actual experience Fitch usually 16 3.75% 0.750% 7.50
assumes a front-loaded stress, with defaults starting 17 3.75% 0.750% 7.50
18 3.75% 0.750% 7.50
soon after closing of the transaction.
19 3.75% 0.750% 7.50
20 2.50% 0.500% 5.00
The following table/chart illustrates Fitch’s standard 21 2.50% 0.500% 5.00
default curve assumed for all rating levels, expressed 22 2.50% 0.500% 5.00
23 2.50% 0.500% 5.00
as a percentage of the relevant WAFF.
24 0.63% 0.125% 1.25
25 0.63% 0.125% 1.25
26 0.63% 0.125% 1.25
27 0.63% 0.125% 1.25
Total 100.0% 20.0% 200

A Guide to Cash Flow Analysis for RMBS in Europe

15
 Structured Finance
Nevertheless, a ‘back-loaded’ recession may be more In order to determine appropriate delinquency
stressful, for example, for replenishing portfolios, assumptions, the agency analysed available arrears
which allow the seller to add new loans to the data. The findings of this study are provided on page
mortgage portfolio (generally only for a limited time 23. Based on these findings, the agency assumes a
period). As a result, the portfolio will exhibit slower multiple of the monthly defaulting loan balance falls
seasoning (if any) compared to static portfolios, delinquent for a certain period. Thereafter, the
which will delay the decline in default propensity delinquent balance becomes fully performing again
associated with static portfolios. Modelling back- and the accrued arrears interest is assumed to be
loaded defaults will significantly compress the fully repaid over the following 10 months.
amount of ExS available to cover losses; this would
be exacerbated if there was a ‘step-up’ of interest Loans in arrears are usually restructured, allowing
(see page xx). the borrower to repay the amount in arrears in
addition to ongoing scheduled mortgage payments
The assumed length of the ‘work out’ process (time over a limited period. The length of such
to foreclosure) is based on experience in each arrangements depends on an individual lender’s
jurisdiction, and depends on the regulatory collection and servicing guidelines and on the
framework governing the foreclosure process. The financial means of the borrower.
following table lists the time to foreclosure assumed
for all countries under consideration. As the assumed level of delinquencies is based on
the WAFF – which is always higher in more severe
recession scenarios – arrears are more widespread
Average Time to Foreclosure under more stressful rating conditions. To temper
WA time to foreclosure for each
Italy
tribunale (up to 84 months)
this, and to support the assertion that in economic
France 30 months recessions a greater proportion of financially
Germany 24 months distressed borrowers will ultimately default, the
UK 18 months multiple applied to the WAFF is reduced in more
Netherlands 12 months
Portugal/Spain 36 months
severe rating scenarios.
Measured since initial missed payment date
The assumed duration of delinquency depends on the
payment frequency of the mortgages. For example,
The following chart shows the nominal and the period of delinquency is expected to be longer
performing collateral balance for a front-loaded for mortgage loans that pay quarterly and semi-
default scenario. annually compared to those which pay monthly.

The tables below detail Fitch’s standard delinquency

Notional vs. Performing Balance
assumptions, which are primarily based on UK
(Notional Balance Inclusive of Defaults and Losses)
experience and may be adjusted for other countries
P erfo rming No tio nal as more data becomes available.
(GB P m)
120

100 AAA AA A BBB BB

Multiple of monthly
80 1.5 2 2.5 2.75 3
defaults
60

40
Payment Assumed Number of Assumed No
20
Frequency Missed Payments months
0 Monthly 7 7
1 41 81 121 161 201 241 281 321 Quarterly 3 9
Semi-annually 2 12
M o nths after Clo sing
Annually 1 12

Delinquency Assumptions To illustrate our approach consider the following

In order to achieve timely payment of interest, the example: assuming ‘BBB’ scenario (multiple of
structure has to provide sufficient liquidity support to 2.75) and a WAFF of 20%, which is evenly spread
the notes to sustain a stressed level of delinquencies over a period of 36 months, the following schedule
in addition to defaults in a climate of rising interest shows the amount assumed to become delinquent
rates. each month:

A Guide to Cash Flow Analysis for RMBS in Europe

16
 Structured Finance
Delinquency Study
In order to define the maximum expected amount of delinquent loans based on the assumed amount of
defaults, Fitch analysed the arrears development of a large portfolio of UK mortgages (approximately 1.5
million loans, all of which pay monthly). The matrix below shows the migration rate between different arrears
buckets over a period of six months. It can be seen that a sizable proportion of loans that at the outset were in
arrears began to perform again during the six months, but fell into arrears again at the end of the observation
period. This explains why, for example, 63% of the loans initially in arrears between one and two months
remained at this level six months later.

1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9+ Repo-

Performing Months Months Months Months Months Months Months Months Months ssession
Performing 96.0% 3.6% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1%
1-2 Months 31.1% 63.0% 3.1% 1.4% 0.6% 0.3% 0.2% 0.1% 0.0% 0.0% 0.2%
2-3 Months 20.2% 27.0% 20.5% 14.2% 8.4% 4.1% 2.1% 1.2% 1.5% 0.0% 0.8%
3-4 Months 15.1% 19.0% 11.7% 18.9% 13.9% 9.1% 4.5% 2.3% 1.4% 2.4% 1.5%
4-5 Months 14.9% 14.6% 7.2% 10.8% 16.4% 14.9% 7.5% 4.4% 2.6% 4.4% 2.2%
5-6 Months 12.0% 11.5% 5.2% 7.1% 10.3% 16.5% 14.1% 7.8% 4.2% 7.4% 3.8%
6-7 Months 12.6% 11.5% 2.3% 3.7% 6.5% 9.0% 14.8% 12.8% 7.4% 13.7% 5.7%
7-8 Months 10.8% 8.7% 1.5% 2.7% 2.8% 5.5% 9.8% 16.6% 12.9% 20.0% 8.7%
8-9 Months 9.5% 7.7% 2.4% 2.1% 2.4% 3.3% 6.0% 9.1% 15.2% 31.9% 10.3%
9+ Months 10.1% 5.5% 0.9% 1.3% 1.0% 1.1% 1.4% 2.5% 3.8% 58.7% 13.5%
Repossession 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 100.0%

Assuming that the migration rates remain constant, this matrix can be used to calculate the number of
mortgage loans which migrate all the way to default. This was done using a Markov Chain methodology
assuming that no new loans fall into arrears and that loans that became performing again would not fall back
into arrears.

Based on the six-month transition matrix, as shown above, the agency estimated that approximately 27% of
loans initially in arrears for more than two month would be foreclosed upon, with the remaining 73%
becoming performing again. In other words, the ratio of arrears to defaults for the portfolio in question was
estimated to be around 2.7. Unfortunately no such detailed data is available for other European countries.

indices in Europe). This is generally hedged in

respect of performing mortgage loans through the
Quarter New Defaults New Arrears Total Arrears use of balance guaranteed swaps (see section on
1 1.7% 5.0% 5.0% Swaps on page 4).
2 1.7% 5.0% 10.0%
3 1.7% 5.0% 10.0%
4 1.7% 5.0% 10.0% Non performing positions (defaulted and delinquent
5 1.7% 5.0% 10.0% loans) are usually un-hedged in European RMBS.
6 1.7% 5.0% 10.0% Therefore a rise in interest rates would increase the
7 1.7% 5.0% 10.0%
8 1.7% 5.0% 10.0%
differential between income and expenses (referred
9 1.7% 5.0% 10.0% to as ‘cost of carry’) for the issuer, which will have
10 1.7% 5.0% 10.0% to service the notes inclusive of the proportion
11 1.7% 5.0% 10.0% corresponding to such non performing positions.
12 1.7% 5.0% 10.0%
13 0.0% 0.0% 5.0%
Delinquent loans that subsequently return to
14 0.0% 0.0% 0.0% performing (and pay off all accumulated arrears
interest) apply a liquidity stress only, which lasts
until full recovery of the delinquent amounts. The
The duration of non-payment is assumed to be two magnitude of the stress depends on the length of time
quarters, after which the loan becomes performing a loan is delinquent, which is typically not more than
again. Hence in aggregate, after the initial six-month six months, and on any change in interest rates.
period, the outstanding balance of loans in arrears
remains the same, as newly-delinquent loans are The cost of carry is significantly larger for defaulted
offset by those that become performing again. positions, for which the time to recovery can last
several years, depending on jurisdictions. If
Interest Rates
subsequent recoveries are insufficient to cover both
principal and interest up to the amount the issuer
Interest rate risk (on any mismatch between assets
paid under the notes, such cost of carry will cause or
and liabilities) may leave the issuer exposed to
compound principal deficiencies. To mitigate cost of
adverse movements in Libor/Euribor (the two main
carry, certain transactions include provisioning

A Guide to Cash Flow Analysis for RMBS in Europe

17
 Structured Finance
mechanisms designed to capture revenue funds The change is applied monthly, quarterly or semi-
(including ExS), which are then used to amortise the annually, depending on the length of the actual
notes in advance of any recovery being made on payment period under the notes.
defaulted loans (see Provisioning on page 9)..
Applied Interest Rate Stress Vector for Euribor
In order to address a possible hedging mismatch
(Assuming 3 month Euribor is 4% at closing)
(although rare in European RMBS), as well as to
stress the ‘cost of carry’, Fitch assumes a rise in the AAA AA A
note index during the first three years after closing. BBB BB
14%
Stress scenarios for a rise in STG Libor and Euribor
were developed based on the historical volatility of 12%
both indices. The following tables show the assumed 10%
rise in Libor and Euribor. 8%
6%

3 month STG Libor 4%

Year 1 Year 2 Year 3 Year 4 Total 2%

AAA +4.9% +2.5% +1.1% -1.6% +6.9% 0%

AA +4.2% +2.2% +0.9% -1.3% +6.0% 0 7 14 21 28 35 42 49 56 63 70 77 84 91 98 105 112 119
A +3.5% +1.9% +0.8% -1.2% +5.0% M o nths after Clo sing
BBB +2.9% +1.4% +0.6% -1.0% +3.9%
BB +2.2% +1.1% +0.6% -0.7% +3.2%

These stresses may be adjusted depending upon

future interest rates movements. In particular, the
3 month Euribor stress may be increased if Libor and Euribor were to
Year 1 Year 2 Year 3 Year 4 Total fall significantly and vice versa for a rise in either of
AAA +4.3% +2.2% +1.0% -1.4% +6.1% the indices.
AA +3.7% +1.9% +0.8% -1.1% +5.3%
A +3.1% +1.7% +0.7% -1.1% +4.4% Q Related Research
BBB +2.6% +1.2% +0.5% -0.9% +3.4%
BB +1.9% +1.0% +0.5% -0.6% +2.8% The following research is available on the Fitch web
site at www.fitchratings.com:
Interest rate stress scenarios are more severe for • 'German Residential Mortgage Default Model
investment-grade ratings. In a ‘AAA’ scenario, for II', 7th September 2001
instance, STG Libor is assumed to increase by 4.9% • ‘Italian Residential Mortgage Default Model',
during the first year, 2.5% during the second year 14th June 2002
and 1.1% during the third year. In recognition of the • 'UK Residential Mortgage Default Model II',
assumed recession, Fitch decreases the interest rate 13th October 2000
stress in year four. The resulting rate is held constant • 'Dutch Residential Mortgage Default Model II',
for the remainder of the transaction’s life. For 28th January 2000
example, if three-month Libor equalled 4% at • 'Spanish Mortgage Default Model', 20th January
closing, Fitch would model the following forward 1999
curves for individual stress scenarios: • 'French Residential Mortgage Default Model',
14th June 2001
Applied Interest Rate Stress Vector for Libor
(As s um ing 3 m onth Euribor is 4% at clos ing)
AAA AA A
BBB BB
14%
12%
10%
8%
6%
4%
2%
0%
0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96 102108114
M o nths after Clo sing

A Guide to Cash Flow Analysis for RMBS in Europe

18
 Structured Finance
Appendix I – Prepayment Rates in Europe

The UK
Unlike other European Total Redemption (Prepayment + Repayment) by Vintage Year
countries, the UK mortgage Based on Outstanding Balance at the Beginning of Each Year
market is dominated by
floating-rate mortgages. The 25%
majority of these products are
based on the lenders’ standard 20%
variable rates (SVRs), which
are adjusted at the discretion of 15%
each lender, but generally tend
to move in tandem. Most 10%
lenders offer incentive periods
of between three and five years 5%
in order to attract customers,
0%
who usually pay a discounted,
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
capped or fixed rate during this
initial period and revert to SVR
Source: Citigroup
thereafter. During the incentive
period, most mortgages are
subject to prepayment penalties Total Redemption (Prepayment + Repayment) by Vintage
of around 2–5% of the amount Year
prepaid. Given the
Average 1998 1999
characteristics of the UK
45%
mortgage market, the level of
40%
prepayments is driven mainly
35%
by the competitiveness of the
30%
market, the level of prepayment
25%
penalties, the financial
20%
adeptness of borrowers and the
15%
volatility of interest rates.
10%
5%
Chart one shows the static
0%
repayment experience of a large
1 2 3 4
portfolio of UK prime
Source: Fitch Ratings
mortgages. Although the data
does include scheduled repayments too, these are likely to be minor compared to prepayments throughout the
early years of a loan. In the past, repayment rates tended to peak around three to four years after origination at
around 15% per annum. The timing reflects the average incentive period, after which there is an increased
likelihood of refinancing. More recently, repayments have increased to over 20%, as borrowers become more
financially adept, more able to process readily available information (especially on-line), and consequently more
likely to ‘shop around’. These factors even led to an increase in repayment rates for highly seasoned loans, as
seen in chart one. Prepayment experience in the UK also differs between prime and sub-prime mortgages, as
shown in chart two.

Prepayment rates have been significantly higher in the sub-prime sector than for prime mortgages. Like their
prime counterparts, sub-prime lenders do charge prepayment penalties during the early years, but these are
perhaps less of a deterrent to prepay than for prime borrowers. The decision to prepay is driven instead by a
borrower becoming eligible for prime, and hence cheaper, credit. This, in turn, depends on a borrower fitting the
lending criteria applied by the prime lender in terms of credit performance (e.g. following the expiry of impaired
credit indicators such as CCJs or arrears recency) and suitability (e.g. ability to obtain external certification of
income, moving out of a right-to-buy property).

A Guide to Cash Flow Analysis for RMBS in Europe

19
 Structured Finance
The Netherlands
Approximately 90% of Annualised Constant Payment Rate (Prepayments and Repayments)
mortgages in the Netherlands
are fixed rate loans that reset
every five to 20 years EMS 1 Dutch MBS 97-1 Dutch MBS 97-2
Dutch MBS 98-1 Dutch MBS 99-1
(remaining fixed rate until
maturity). Interest payments are 40%

fully tax-deductible, giving 35%

borrowers an incentive to 30%
maximise their borrowings over 25%
the whole life of the mortgage; 20%
for this reason most mortgages 15%
in the Netherlands are interest- 10%
only loans linked to repayment 5%
vehicles, such as savings 0%
accounts, life insurance policies 09/97 01/98 06/98 11/98 03/99 08/99 01/00 05/00 10/00 03/01 08/01
or investment contracts. The Source: Fitch Ratings
return from such investment
vehicles is also tax free. Dutch mortgages historically have had very long terms; however, this is now often
limited to 30 years, when tax-deductibility expires. If borrowers prepay, they tend to refinance their entire
mortgage (as a result of moving home or remortgaging) as opposed to making partial prepayments: given the tax
advantages of borrowing, surplus cash flow can be more economically diverted in making higher contributions
towards savings accounts, investments or life insurance policies. Refinancing fixed rate loans between reset
dates is subject to prepayment penalties. Under fixed rate mortgages, borrowers are allowed to refinance at reset
dates without incurring prepayment penalties. Between reset dates most lenders charge prepayment penalties
designed to compensate for the cost of unwinding hedging instruments. Therefore the decision to refinance
between reset dates is only economic for the borrower if the saving achieved under lower interest rates offsets
the penalty incurred by prepaying. Consequently, prepayment activity in the Netherlands not taking place on
reset dates is heavily influenced by movements in interest rates. The chart above shows annualised payment
rates on five Dutch MBS portfolios between 1997 and 2001. For most of this period, payment rates were below
15%; however, in 1999, this increased sharply to as high as 35%, at a time when interest rates had fallen to a 25-
year low.

Spain
The vast majority of Spanish
Annualised Constant Payment Rate (Prepayments and Repayments)
residential mortgages are
floating-rate loans linked to a TDA2 TDA3 TDA 4 TDA 5
variety of indices including TDA 6 TDA 7 TDA 8
Mibor (Madrid Interbank
Offered Rate; now replaced by 25%
Euribor), CECA
(Confederación Espanola de 20%
Cajas de Ahorros) or IRPH
(Interés de Referencia del 15%
Mercado Hipotecario) to
mention only the most 10%
prevalent. Most mortgage loans
are also amortising with terms 5%
between 20 and 35 years.
Prepayment penalties in Spain 0%
are among the lowest in Europe, 09/94 09/95 10/96 11/97 11/98 12/99 12/00 01/02
capped by law (Real Decreto
Source: FitchRatings
3499/1994) at 1% of the prepaid
amount. Prepayment behaviour
of Spanish mortgage borrowers is less sensitive to changes in interest rates since most products’ rates are linked
to indices highly correlated with Euribor. However, the royal decree from 1994 has contributed considerably to
increased competition among lenders, by cutting prepayment penalties and giving borrowers the opportunity to
refinance with minimal costs. The following chart shows the annualised constant payment rate of seven Spanish

A Guide to Cash Flow Analysis for RMBS in Europe

20
 Structured Finance
MBS portfolios (TDA 1 to TDA 7). The highest annualised rates were experienced during 1994 (around 20%)
and 1997 (between 12% and 20%). The increasing popularity of flexible mortgage products in Spain is another
factor that could increase prepayment rates as traditional loans are refinanced. In addition, such flexible loans
encourage overpayments since such amounts can typically be redrawn.

France
While French mortgage Annualised Constant Payment Rate (Prepayments and Repayments)
products remain predominately
fixed rate, the popularity of TITRILOG 06-97 TITRILOG 11-98
floating rates is on the increase. DOMOS 5 MASTERDOMOS
Specialised lenders, which are 30%
the main users of securitisation
(as they have not access to retail 25%
funding) have shifted their 20%
production to floating rate loans
over the last few years. As a 15%
consequence, the recent
10%
securitised portfolios are a mix
of fixed and floating rate loans. 5%
Most lenders charge
0%
prepayment penalties, capped
09/97 02/98 07/98 12/98 05/99 10/99 03/00 08/00 01/01 06/01 11/01
by law at 3% of the prepaid
amount. Although at the Source: FitchRatings
moment the impact of interest
rate variations on prepayments is slight compared to other European countries, a few transactions have been
sensitive to rate variations. Titrilog 06-97 and Titrilog 11-98, which are composed mainly of fixed-rate
mortgages originated in high interest rate environment, have experienced high prepayment rates as interest rate
decreased (CPRs of 20% to 28% in 1999). However, these levels are not expected to occur again in the near
future as the older, higher interest rate mortgages which have not yet prepaid are less likely to do so now, and
fixed rate mortgages with lower rates as well as floating rate mortgages are less sensitive to future rate
variations. Interestingly, prepayments start to show a cyclical trend in 2002, with increases during summer time,
probably as families move houses in time before the school's start. Finally, loans granted at subsidised rates by
French utilities EDF and Gaz de France to their employees demonstrate, as expected, a moderate prepayment
pattern, at an average of 4% per annum in Electra 1.

Italy
The Italian mortgage market has
Annual Prepayments as % of Outstanding Principal
been very fragmented to date,
with small banks that focus on Seashell BancApulia
specific geographic regions 12%
constituting a major share of the
10%
market. Fixed rate products are
estimated to account for 8%
approximately 53% of all
outstanding mortgages in Italy 6%
(Source: Nomisma), with the
4%
remainder being either floating
or mixed rate (which are 2%
initially either fixed or floating-
rate for a set period of time, 0%
after which the borrower has the 1991 1992 1993 1994 1995 1996 1997 1998 1999
option either to refix or obtain a Source: Offering Circular
variable rate). Most newly-
originated floating-rate mortgages are linked to one, three or six-month Euribor, which has largely replaced
most of the other indices such as, for example, the ABI (Associazione Bancaria Italiana) prime rate and TUS
(Tasso Ufficiale di Sconto). Most Italian mortgages are amortising annuity loans, with typical terms of around
15 years. Prepayment penalties have declined and are now in the region of between 1% and 3% of the prepaid
amount.

A Guide to Cash Flow Analysis for RMBS in Europe

21
 Structured Finance
Historically, Italy has Banco di Brescia San Paolo
experienced very low Prepayments Per Year After Origination
prepayment rates of between 1993 1994 1995
2% and 6% per annum. (%) 1996 1997 1998
5.0%
Prepayment rates are very low
4.5%
during the first two years of a
4.0%
typical mortgage. Thereafter
3.5%
prepayment speed increases
3.0%
and peaks at a maximum of
2.5%
approximately 5% per annum 2.0%
(varying across lenders) three 1.5%
years after origination. The 1.0%
reasons for the relatively low 0.5%
propensity to prepay in Italy 0.0%
are the limited level of 1 2 3 4 5 6 7
competition amongst lenders Source: FitchRatings
(owing to the regional
fragmentation of the mortgage market), the high level of customer loyalty to their local branch, as well as the
reluctance of most lenders to advance a remortgage loan.

Germany
The German mortgage market is dominated by fixed-rate mortgage loans with reset periods of five to 15 years.
Most products are either repayment annuity mortgages or interest-only loans linked to savings contracts
(‘Bausparverträge’) or life insurance contracts. Since 1996, interest payments on residential mortgages have
only been tax-deductible for investment properties. Instead, each borrower receives a subsidy
(‘Eigenheimzulage’) of up to 5% of the property value per year for a period of eight years. At reset dates,
borrowers are allowed to repay the entire loan amount without being charged prepayment penalties. On reset
dates, most lenders levy heavy prepayment penalties calculated as the ‘make whole’ amount in respect of
interest that will be foregone until the next reset date. While common practice for some time with commercial
banks, mortgage and savings banks (‘Sparkassen’) have only recently started to offer contracts allowing
borrowers to partially prepay their mortgage (up to a contractually agreed amount) without penalty. Historical
prepayment data is still limited in Germany. However, market participants estimate prepayments to be between
10% and 20% per annum, driven mainly by interest rate development. As in most other European countries, the
rate of prepayment has increased over the 1990s as borrowers have become more financially adept and more
information has become available.

A Guide to Cash Flow Analysis for RMBS in Europe

22
 Structured Finance
Appendix II – FITCH’s CPR Assumptions

Year 5 and
UK Prime Year 1 Year 2 Year 3 Year 4
thereafter
AAA 15% 22% 29% 35% 35%
AA 14% 20% 26% 33% 33%
A 13% 19% 25% 30% 30%
BBB 12% 17% 22% 27% 27%
BB 10% 15% 20% 25% 25%

Year 5 and
UK SUB Prime Year 1 Year 2 Year 3 Year 4
thereafter
AAA 15% 27% 40% 40% 40%
AA 15% 27% 40% 40% 40%
A 15% 27% 40% 40% 40%
BBB 15% 27% 40% 40% 40%
BB 15% 27% 40% 40% 40%

Netherlands; Year 5 and

Year 1 Year 2 Year 3 Year 4
Germany; France thereafter
AAA 15% 20% 25% 30% 30%
AA 14% 19% 24% 28% 28%
A 13% 17% 21% 25% 25%
BBB 12% 16% 20% 23% 23%
BB 10% 13% 16% 20% 20%

The key driver for prepayment speed in France, Germany and the Netherlands is the level of interest rates.
Therefore Fitch assumes the same prepayment stresses for all three countries.

Year 5 and
Spain Year 1 Year 2 Year 3 Year 4
thereafter
AAA 15% 19% 22% 25% 25%
AA 14% 17% 20% 23% 23%
A 13% 15% 18% 20% 20%
BBB 12% 14% 16% 18% 18%
BB 10% 12% 14% 15% 15%

Year 5 and
Italy Year 1 Year 2 Year 3 Year 4
thereafter
AAA 10% 13% 17% 20% 20%
AA 9% 12% 15% 18% 18%
A 8% 11% 13% 15% 15%
BBB 7% 9% 11% 12% 12%
BB 5% 7% 9% 10% 10%

Copyright © 2002 by Fitch, Inc. and Fitch Ratings, Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.
Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the
information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources Fitch believes to be reliable. Fitch does not audit or verify the
truth or accuracy of any such information. As a result, the information in this report is provided “as is” without any representation or warranty of any kind. A Fitch rating is an opinion as
to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the
offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified, and presented to investors by the issuer and its
agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at any time for any reason at the sole discretion of Fitch. Fitch does not provide
investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security
for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and
underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number
of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to
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