Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Copyright © 2011 Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. All rights reserved. U.K. Prime RMBS: What Is The Loan Level Data Telling Us? Andrew South Senior Director Structured Finance Research April 26, 2012

2. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Interest-only borrowers are facing tighter lending criteria Interest-only mortgage loans grew popular in the 1980s But since 2000, more than half of IOs have no specified repayment vehicle FSA's Mortgage Market Review suggests IO lending should be a niche activity Some lenders have tightened their IO lending criteria in early 2012 Source: Mortgage Solutions, Standard & Poor’s

3. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. What are the credit risks in IO loans?

4. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. How much riskier are interest-only loans than repayment loans? Sample pool statistics* Source: Standard & Poor’s; *Based on 1.5m loans from U.K. master trusts; **Ratio of scheduled monthly mortgage payment to gross income RepaymentInterest-only Proportion of pool (%) days arrears (%) days arrears (%) Time to maturity (years)1814 Original LTV ratio (%)6771 PTI ratio** (%)2110 First-time buyer (%)2413 Indexed LTV ratio (%)6169 Self-certified (%)1020

5. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. IO loans in our sample have higher indexed LTV ratios Indexed LTV ratio distribution About 20% of IO borrowers have less than 10% equity –Only 13% for repayment borrowers 8% of IO borrowers in negative equity –Only 4% for repayment loans Fails to capture any offsetting equity in savings vehicles Is this a source of maturity risk? Source: Standard & Poor’s

6. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Risk of principal default at maturity is not an immediate concern Loan maturity date distribution About 70% of IO loans are more than 10 years away from maturity 85% for repayment loans Source: Standard & Poor’s

7. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Higher LTV ratios do not explain higher overall arrears for IO loans 90+ arrears rate, by indexed LTV ratio Source: Standard & Poor’s

8. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Nor does higher proportion of self-cert borrowers 90+ arrears, by income certification type Source: Standard & Poor’s

9. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Some borrowers may have used IO to improve affordability Source: Standard & Poor’s IO portion of sample, by original loan size

10. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Including principal, IO loan affordability ratios are more stretched PTI Ratio Distribution Gross PTI ratio ~10% for IO loans, compared with 20% for repayment loans… …but would be ~30% for IO borrowers forced onto a repayment basis FSA data suggests loan-to- income ratios are higher for IO loans in post-2000 originations Source: Standard & Poor’s, FSA

11. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Higher IO arrears may also have less tangible drivers Source: Standard & Poor’s, FSA IO borrowers may have lower "income quality" –Interest-only gives greater flexibility to manage monthly payment –More likely a choice for borrowers with volatile or "at risk" income –May have suffered disproportionately from weak employment market Forbearance may inflate IO arrears figures –FSA estimates 5%-8% of mortgage loans have had forbearance –Switch to interest-only is a likely favored method –Estimates suggest ~40% of forbearance cases with a missed payment involved a switch to interest-only

12. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. How will new lending criteria affect IO refinancing?

13. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Nearly 80% of IO borrowers are now on SVRs Breakdown of IO loans, by rate type Most previous short-term fixed or discount rates will have expired… …with borrowers switching to a (currently low) SVR Source: Standard & Poor’s

14. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Prepayment rates are low, partly due to lack of refinance incentive Source: Standard & Poor’s, Bank of England; *On new lending, assuming 75% LTV ratio U.K. prime RMBS payment rate Typical U.K. mortgage rates

15. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Incentive to refinance could rise if rate patterns normalize… Approx. interest rate incentive to refinance (bps) Source: Standard & Poor’s, Bank of England, lender rate cards LTV ratio (%)Current Future scenario < Assumes a switch from SVR to a 2-year fixed rate Assumes minimum rate reduction of 50bps needed to compensate for fees

16. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. …but new criteria significantly dampen IO refinancing potential Source: Standard & Poor’s Current rate environment Normalized rate environment

17. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Breakeven interest rate drop* Assume a switch from an IO loan on an SVR… …to a repayment loan on a new 2-year fixed rate loan Initial IO rate and would need to be very high… …new repayment term very long… …and/or new fixed rate very low… …for monthly payment to stay the same Switch to repayment costs more, unless rate is much lower Source: Standard & Poor’s; *Minimum drop in interest rate for which repayment instalment would be lower than previous interest-only instalment BACK-UP

18. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Takeaways Significant regulatory concern over post-2000 interest-only lending Maturity risk not likely to be significant for several years… …but IO loans do show higher arrears Some evidence of stretched affordability among IO borrowers… …although use of IO as a forbearance tool means negative selection Tighter lending criteria could keep downward pressure on IO prepayment rates

19. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. What is the geographic spread of U.K. mortgage risk? BACK-UP

20. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. The north-south divide in arrears rates persists 30+ day arrears by region, Q Arrears in the north have remained consistently higher since 2010 Partly due to widening gap between unemployment rates… …and industry mix Source: Standard & Poor’s. From a sample of U.K. prime RMBS pools. Figures in parentheses are for Q BACK-UP

21. Permission to reprint or distribute any content from this presentation requires the prior written approval of Standard & Poor’s. Borrower equity positions are also worse in northern regions Negative equity by region, Q Driven by diverging regional house price trends In 2011 –Up 2.6% in the south –Down 0.6% in the north Source: Standard & Poor’s. From a sample of U.K. prime RMBS pools. Figures in parentheses are for Q BACK-UP

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