These loans, currently popular in traditionally 'floating-rate markets' such as Italy and Spain, are floating-rate loans whose instalments (comprising interest and principal) are calculated according to the actuarial amortisation formula (also known as "constant instalment formula") but are capped at a certain amount. When interest rates increase, the principal component of the instalment will be progressively compressed, potentially up to zero; the unpaid principal effectively adds one or more instalments to the loan and thereby increases its maturity up to a certain pre-agreed maximum maturity. Conversely, decreases in interest rates will shorten the loan's maturity.
With these products, an increase in interest rates during the life of the loan could cause the postponement of all principal payments to the last instalments, especially if it occurs in the early stage of the loan. "This would transform these products into bullet loans and thereby add an unanticipated refinancing risk to the borrower, whose propensity to default is likely to increase unless he has enough savings or other financial resources to repay the full loan principal at maturity," says Michele Cuneo, Senior Director in Fitch's RMBS team.
For this reason, some lenders have modified their products to mitigate the bullet risk, for example, by setting a minimum principal component for each instalment or by introducing automatic upward adjustments of the instalment if certain principal repayment targets are not met.
In its rating analysis, Fitch takes particular care in assessing the potential bullet risk arising in the increasing interest rate environments tested by the agency according to its RMBS criteria, and assumes higher default probabilities for these loans when the bullet risk is present. Fitch replicates the features of the floating maturity product in a model and then tests the amortisation of the loan under various interest rate stress scenarios to determine the materiality of the bullet risk.
