Moody's: Credit impact of rising rates will be mixed for US structured finance sectors

Rising short-term interest rates in the US will have varied credit effects on new and existing mortgage-backed, asset-backed and other securitizations, according to Moody's Investors Service.

In the report "Rising US Rates Will Weaken Some US Structured Finance Sectors," Moody's analysts say that rising rates will be credit negative for commercial mortgage-backed securities (CMBS) and largely credit neutral for most consumer and commercial asset-backed securities (ABS) sectors, residential mortgage-backed securities (RMBS) and collateralized loan obligations (CLOs).

Performance risk will increase for CMBS

For newly originated loans backing CMBS deals, rising interest rates will lead to lower debt service coverage ratios and increased risk of default during the loan term. Existing CMBS deals will also be at risk as capitalization rates rise and put pressure on property values, making it more difficult to refinance a loan at maturity or pay it off with a property sale.

"Competition is intense among CMBS loan originators," says Tad Philipp, Moody's Director of Commercial Real Estate Research. "Underwriting standards continue to slip as CMBS lenders vie for share, and rising interest rates will exacerbate this trend."

Exposure to variable-rate debt key to impact on ABS

The credit effects of rising rates on consumer and commercial ABS sectors will be mostly credit neutral. Although rate hikes will negatively affect some ABS sectors, the extent of the impact will largely depend on the exposure in individual ABS transactions to obligors with variable-rate debt.

"Obligors with variable-rate debt have less disposable income when interest rates rise, which affects their ability to make their loan payments and in turn lowers the credit quality of the securitizations backed by these loans," says William Black, a Moody's Managing Director for ABS.

Moody's notes, however, that if the US economy continues to strengthen as interest rates rise, falling unemployment and increased income gains could positively affect performance in consumer and commercial ABS.

Rising rates will be credit negative for most student loan ABS because they will likely lead to increases in delinquencies and net losses, while also accelerating refinancing activity and reducing excess spread.

An increase in interest rates will be mostly credit neutral for RMBS. "The rate changes will not materially affect existing deals," says Navneet Agarwal, a Moody's Managing Director for RMBS. "But the impact on new RMBS deals will depend on what happens with long-term interest rates, which will affect the attractiveness of different types of mortgage loans to borrowers."

New CLOs will either adapt or decline in number in response to rising interest rates for an overall credit-neutral impact. "But excess spread will decline in existing deals and at least initially be credit negative by reducing this source of income," says Yvonne Fu, a Moody's Managing Director for CLOs.