DBRS Morningstar Finalises Provisional Ratings on Avon Finance No. 2 plc

DBRS Ratings GmbH (DBRS Morningstar) finalised its provisional ratings on the following classes of notes issued by Avon Finance No. 2 plc (Avon 2 or the Issuer):

-- Class A Notes at AAA (sf)
-- Class B Notes at AA (low) (sf)
-- Class C Notes at A (low) (sf)
-- Class D Notes at BBB (low) (sf)
-- Class E Notes at BB (low) (sf)
-- Class F Notes at B (high) (sf)

The rating on the Class A Notes addresses the timely payment of interest and the ultimate repayment of principal on or before the legal final maturity date. The rating on the Class B Notes addresses the timely payment of interest once most senior and the ultimate repayment of principal on or before the legal final maturity date. The ratings on the Class C, Class D, Class E, and Class F notes address the ultimate payment of interest and repayment of principal on or before the legal final maturity date. DBRS Morningstar does not rate the Class Z notes, the Class S and Class Y Certificates, or the VRR loan note.

Avon 2, a bankruptcy-remote special-purpose vehicle incorporated in the United Kingdom, comprises seasoned owner-occupied and buy-to-let (BTL) nonconforming loans from the Warwick Finance Residential Mortgages Number One Plc securitisation, which will be called on 21 September 2020.

DBRS Morningstar was provided with information on the mortgage portfolio as of 31 August 2020. The portfolio consists of 8,415 mortgage loans with an aggregate principal balance of GBP 855.4 million. Of the loans in the portfolio, 58.2% were originated by Platform Funding Limited and the remaining 41.8% by GMAC-RFC (now called Paratus AMC Limited). Western Mortgage Services Limited is servicing the loans. At closing, there was no backup servicer in place, but CSC Capital Markets UK Limited was appointed as the backup servicer facilitator. Avon Seller Limited (the seller) has sold the loans to the issuer at closing of the transaction.

A large portion of the portfolio (79.2%) was originated pre-crisis, in the years 2006, 2007, and 2008. The portion of loans originated in 2005 or before, where the origination criteria by subprime or nonconforming UK lenders were known to be relatively tighter than those in 2006, 2007, and 2008, is relatively low at 19.9%. DBRS Morningstar has assessed the performance history of the loans, which is limited and does not show a complete economic cycle covering arrears history from August 2015 up to May 2020. Based on this data, approximately 9.4% of the mortgage portfolio was in cumulative three months-plus arrears status and 5.0% was in cumulative six months-plus arrears status as of May 2020. The transaction also includes 49.5% of loans that have been restructured at some point in the past. Most of the restructurings were implemented between 2009 and 2012, with the majority of these loans being under a higher-than-normal monthly payment arrangement. With regards to delinquencies, a decreasing trend was observed starting from the end of 2016 until early 2020, which is expected to have been mainly driven from the cure to the performing status of the restructured loans. The first and second quarter of 2020 show increasing arrears trend.

Approximately one quarter of the pool (24.3%) are BTL loans, with the remaining being owner-occupied loans (75.7%). However, as was common before the financial crisis, most of the owner-occupied loans (58.6% of the mortgage portfolio) are also on an interest-only (IO) payment schedule. With respect to the provisional portfolio, 81.5% of the loans are IO loans, with the remaining being repayment amortising loans. This poses a risk at the maturity of the loan if the borrower does not have a repayment strategy in place or is unable to refinance before the maturity date. While the maturity profile is quite staggered, there is a peak in concentration in 2031-2032 at 32.3% of the IO loans. Given the long seasoning of the portfolio (almost 14 years), it is natural to see a greater prevalence of IOs compared with repayment loans. DBRS Morningstar assumed a higher probability of default (PD) for 19.8% of the IO loans and included an additive default amount of 5% of the risky IO loan balance at maturity to the forecast default balance, in line with its “European RMBS Insight: U.K. Addendum” methodology.

Of the IO loans, 1.3% have reached their maturity date and have not been foreclosed yet. The portion of matured loans with an indexed CLTV greater than or equal to 80% is 14.6% and the share of matured loans currently in some form of arrears is 64.3%. In DBRS Morningstar’s opinion, such loans will have limited ability to refinance or repay principal from other sources, hence DBRS Morningstar assumes these loans as defaulted in its analysis.

In addition to the BTL loans that have by definition an investment purpose, a further 17.9% of the portfolio was granted for a re-mortgage and an additional 19.3% of the pool was issued to release equity from the property through a re-mortgage. Moreover, 3.3% of the loans were granted under the Right to Buy scheme that was active in those years and 0.5% of the loans were granted for equity release. Consequently, 34.7% of the pool was granted for purchase purposes.

With regards to the employment status of the first borrower, almost half of the pool (48.5%) comprises borrowers that are self-employed, with the remainder being full-time employees. Only 36.2% of the pool was originated after a full verification of the income, with the remaining borrowers having self-certified their income.

The weighted-average indexed CLTV of the mortgage portfolio is 59.3% (based on DBRS Morningstar’s calculation) and is slightly lower compared with other UK nonconforming RMBS transactions, which is a reflection of house price appreciation in the UK notwithstanding the high proportion of loans that repay on an IO basis. The proportion of loans with an indexed CLTV equal to or above 80% is 14.0%.

Credit enhancement to the Class A Notes is 18.0% at closing and is provided by the subordination of the Class B to Class Z notes. The Class A and the Class B notes benefit from further liquidity support provided by an amortising liquidity reserve fund (LRF), which can support the payment of senior fees, interest on Class S Certificates, and interest on the Class A and Class B notes. If there is any Class B interest shortfall, the LRF can only be used if Class B is the most senior outstanding note or if the Class B PDL is less than 10% of the original balance of the Class B Notes. The LRF has been funded at closing through the issuance of the Class A to Class Z notes and the VRR loan note with an amount of 1.5% of the initial balance of the Class A and Class B notes, and any subsequent use of the LRF will be replenished from revenue receipts. Before and including the step-up date, the required amount of the LRF will be the maximum of 1.5% of the outstanding amount of Class A and Class B notes at each interest payment date and 1.0% of the initial balance of the Class A and Class B notes at closing. After the step-up date, the required amount will be 1.5% of the outstanding balance of the Class A and Class B notes at each interest payment date. Once the Class A and Class B notes have been redeemed in full, the LRF will be zero. Any excess amounts of the LRF before and including the step-up date will be part of the revenue available funds whereas excess amounts after the step-up date will flow to the principal available funds.

The notes pay interest linked to the Sterling Overnight Index Average (Sonia) and, in comparison, the loans in the mortgage portfolio pay interest linked to the Bank of England base rate (51.6%) or linked to the three-month Libor rate (36.4%), with the remainder paying interest linked to a standard variable rate. The resulting basis risk is not hedged in the transaction. DBRS Morningstar has applied additional stresses to simulate basis risk between different interest rate indices’ BBR, standard variable rate, three-month Libor, and Sonia.

Available principal funds can be used to provide liquidity support to the transaction. Following the application of the available revenue funds and liquidity reserve, available principal funds can be used to pay senior fees and interest shortfalls on the Class A to Class F notes provided they are the most senior notes outstanding and given that the available revenue funds and the LRF have been applied first. Any use of principal funds will be recorded as a debit in the principal deficiency ledger.

The coupon on the notes will step up on the interest payment date falling in September 2023, which is also the first optional redemption date. The notes can be redeemed in full, at the outstanding balance plus accrued interest, on any subsequent payment date. DBRS Morningstar has considered the increased interest payable on the notes on the step-up date in its cash flow analysis.

The issuer account bank is Citibank N.A., London Branch. Based on the DBRS Morningstar private rating of the account bank, the downgrade provisions outlined in the transaction documents, and structural mitigants, DBRS Morningstar considers the risk arising from the exposure to the account bank to be consistent with the ratings assigned to the notes, as described in DBRS Morningstar's "Legal Criteria for European Structured Finance Transactions" methodology.

DBRS Morningstar based its ratings on a review of the following analytical considerations:

-- The transaction capital structure and form and sufficiency of available credit enhancement.
-- The credit quality of the mortgage portfolio and the ability of the servicer to perform collection and resolution activities. DBRS Morningstar calculated probability of default (PD), loss given default (LGD), and expected loss (EL) outputs on the mortgage portfolio, which are used as inputs into the cash flow tool. The mortgage portfolio was analysed in accordance with DBRS Morningstar’s “European RMBS Insight: U.K. Addendum” methodology.
-- The ability of the transaction to withstand stressed cash flow assumptions and repay the Class A, Class B, Class C, Class D, Class E, and Class F notes according to the terms of the transaction documents. The transaction structure was analysed using Intex DealMaker.
-- The structural mitigants in place to avoid potential payment disruptions caused by operational risk, such as a downgrade, and replacement language in the transaction documents.
-- DBRS Morningstar’s sovereign rating on the United Kingdom of Great Britain and Northern Ireland at AAA with a Negative trend as of the date of this press release.
-- The consistency of the transaction’s legal structure with DBRS Morningstar’s “Legal Criteria for European Structured Finance Transactions” methodology and presence of legal opinions addressing the assignment of the assets to the issuer.

The Coronavirus Disease (COVID-19) and the resulting isolation measures have caused an economic contraction, leading to sharp increases in unemployment rates and income reductions for many borrowers. DBRS Morningstar anticipates that payment holidays and delinquencies may arise in the coming months for many RMBS transactions, some meaningfully. The ratings are based on additional analysis and adjustments to expected performance as a result of the global efforts to contain the spread of the coronavirus. For this transaction, DBRS Morningstar assumed that there was a moderate decline in residential property prices.

On 16 April 2020, the DBRS Morningstar Sovereign group released a set of macroeconomic scenarios for the 2020-22 period in select economies. These scenarios were last updated on 10 September 2020. For details, see the following commentaries: https://www.dbrsmorningstar.com/research/366542/global-macroeconomic-scenarios-september-update and https://www.dbrsmorningstar.com/research/359903/global-macroeconomic-scenarios-application-to-credit-ratings. The DBRS Morningstar analysis considered impacts consistent with the moderate scenario in the referenced reports.

On 5 May 2020, DBRS Morningstar published a commentary outlining how the coronavirus crisis is likely to affect the DBRS Morningstar-rated RMBS transactions in Europe. For more details, please see: https://www.dbrsmorningstar.com/research/360599/european-rmbs-transactions-risk-exposure-to-coronavirus-covid-19-effect and https://www.dbrsmorningstar.com/research/362712/european-structured-finance-covid-19-credit-risk-exposure-roadmap.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

For more information regarding structured finance rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/358308.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

Notes:
All figures are in British pound sterling unless otherwise noted.

The principal methodologies applicable to the ratings are: “European RMBS Insight Methodology” (2 April 2020) and the “European RMBS Insight: U.K. Addendum” (8 November 2019).

DBRS Morningstar has applied the principal methodologies consistently and conducted a review of the transaction in accordance with the principal methodologies.

Other methodologies referenced in this transaction are listed at the end of this press release. These may be found at: https://www.dbrsmorningstar.com/about/methodologies.

For a more detailed discussion of the sovereign risk impact on Structured Finance ratings, please refer to “Appendix C: The Impact of Sovereign Ratings on Other DBRS Morningstar Credit Ratings” of the “Global Methodology for Rating Sovereign Governments” at: https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments.

The sources of data and information used for these ratings include Citibank Europe plc. DBRS Morningstar was provided with loan-level data as of 31 July 2020 with updated dynamic fields as of 31 August 2020 and historical performance data (delinquency and prepayment data) covering the time from August 2015 to May 2020.
DBRS Morningstar did not rely upon third-party due diligence in order to conduct its analysis.

DBRS Morningstar was supplied with third-party assessments. However, this did not impact the rating analysis.

DBRS Morningstar considers the data and information available to it for the purposes of providing these ratings to be of satisfactory quality.

DBRS Morningstar does not audit or independently verify the data or information it receives in connection with the rating process.

These ratings concern a newly issued financial instrument. These are the first DBRS Morningstar ratings on these financial instruments.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com.

To assess the impact of changing the transaction parameters on the ratings, DBRS Morningstar considered the following stress scenarios, as compared to the parameters used to determine the ratings (the Base Case):

-- In respect of the Class A Notes, a PD of 37.5% and LGD of 44.6%, corresponding to the AAA (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.
-- In respect of the Class B Notes, a PD of 32.4% and LGD of 37.3%, corresponding to the AA (low) (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.
-- In respect of the Class C Notes, a PD of 27.2% and LGD of 30.8%, corresponding to the A (low) (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.
-- In respect of the Class D Notes, a PD of 22.2% and LGD of 23.9%, corresponding to the BBB (low) (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.
-- In respect of the Class E Notes, a PD of 15.6% and LGD of 19.7%, corresponding to the BB (low) (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.
-- In respect of the Class F Notes, a PD of 13.7% and LGD of 18.8%, corresponding to the B (high) (sf) rating scenario, was stressed assuming a 25% and 50% increase in the PD and LGD, respectively.

Class A Notes risk sensitivity:
-- 25% increase in LGD, expected rating of AA (sf)
-- 50% increase in LGD, expected rating of A (high) (sf)
-- 25% increase in PD, expected rating of AA (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of A (high) (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of A (low) (sf)
-- 50% increase in PD, expected rating of A (high) (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of A (low) (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of BBB (high) (sf)

Class B Notes risk sensitivity:
-- 25% increase in LGD, expected rating of A (high) (sf)
-- 50% increase in LGD, expected rating of A (low) (sf)
-- 25% increase in PD, expected rating of A (high) (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of BBB (high) (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of BBB (high) (sf)
-- 50% increase in PD, expected rating of BBB (high) (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of BBB (high) (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of BBB (low) (sf)

Class C Notes risk sensitivity:
-- 25% increase in LGD, expected rating of BBB (high) (sf)
-- 50% increase in LGD, expected rating of BBB (sf)
-- 25% increase in PD, expected rating of BBB (high) (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of BBB (low) (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of BB (high) (sf)
-- 50% increase in PD, expected rating of BBB (low) (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of BB (high) (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of BB (high) (sf)

Class D Notes risk sensitivity:
-- 25% increase in LGD, expected rating of BB (high) (sf)
-- 50% increase in LGD, expected rating of BB (high) (sf)
-- 25% increase in PD, expected rating of BB (high) (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of BB (high) (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of BB (low) (sf)
-- 50% increase in PD, expected rating of BB (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of BB (low) (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of B (high) (sf)

Class E Notes risk sensitivity:
-- 25% increase in LGD, expected rating of B (high) (sf)
-- 50% increase in LGD, expected rating of B (high) (sf)
-- 25% increase in PD, expected rating of B (high) (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of B (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of B (low) (sf)
-- 50% increase in PD, expected rating of B (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of B (low) (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of CCC (sf)

Class F Notes risk sensitivity:
-- 25% increase in LGD, expected rating of B (low) (sf)
-- 50% increase in LGD, expected rating of B (low) (sf)
-- 25% increase in PD, expected rating of B (low) (sf)
-- 25% increase in PD and 25% increase in LGD, expected rating of CCC (sf)
-- 25% increase in PD and 50% increase in LGD, expected rating of CCC (sf)
-- 50% increase in PD, expected rating of CCC (sf)
-- 50% increase in PD and 25% increase in LGD, expected rating of CCC (sf)
-- 50% increase in PD and 50% increase in LGD, expected rating of CCC (sf)

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Ronja Dahmen, Assistant Vice President
Rating Committee Chair: Ketan Thaker, Managing Director
Initial Rating Date: 15 September 2020

DBRS Ratings GmbH
Neue Mainzer Straße 75
60311 Frankfurt am Main Deutschland
Tel. +49 (69) 8088 3500

Geschäftsführer: Detlef Scholz
Amtsgericht Frankfurt am Main, HRB 110259

The rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

-- European RMBS Insight Methodology (2 April 2020) and European RMBS Insight Model v. 4.3.1.0.
https://www.dbrsmorningstar.com/research/359192/european-rmbs-insight-methodology.
-- European RMBS Insight: U.K. Addendum (8 November 2019),
https://www.dbrsmorningstar.com/research/352573/european-rmbs-insight-uk-addendum.
-- Legal Criteria for European Structured Finance Transactions (11 September 2019), https://www.dbrsmorningstar.com/research/350234/legal-criteria-for-european-structured-finance-transactions.
-- Interest Rate Stresses for European Structured Finance Transactions (10 October 2019), https://www.dbrsmorningstar.com/research/351557/interest-rate-stresses-for-european-structured-finance-transactions.
-- Derivative Criteria for European Structured Finance Transactions (26 September 2019),
https://www.dbrsmorningstar.com/research/350907/derivative-criteria-for-european-structured-finance-transactions.
-- Operational Risk Assessment for European Structured Finance Servicers (28 February 2020),
https://www.dbrsmorningstar.com/research/357429/operational-risk-assessment-for-european-structured-finance-servicers.
-- Operational Risk Assessment for European Structured Finance Originators (28 February 2020),
https://www.dbrsmorningstar.com/research/357430/operational-risk-assessment-for-european-structured-finance-originators.

A description of how DBRS Morningstar analyses structured finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/278375.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].