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Wednesday, December 2, 2009

Where’s securitisation heading?

After yesterday’s decisions by Wayne Swan to formally commit another $8 billion of hard cash to supporting Australia’s securitisation market, and by Westpac to jack up its variable mortgage rates by an incredible 45 basis points (ie, nearly double the RBA’s 25 basis point hike), it is instructive to reflect on a recent speech by one of the RBA’s most senior executives, Dr Guy Debelle, that touches on both these matters.

At a high level, Debelle focuses on the current state of, and future prospects for, Australia’s residential mortgage-backed securities (RMBS) market, which up until the GFC used to seamlessly supply the funding for a quarter of all home loans in Australia and was a critical foundation-stone underlying the regional banks, building societies, and now largely extinct non-bank lenders.

Regular readers will know that this is a topic that we have spent a considerable amount of time thinking about. In fact, we were responsible for coming up with the idea for the government to support the liquidity of this sector in an unprecedented manner with direct investments in RMBS via the Treasury’s AOFM. To date, $16 billion has been successfully committed to this cause, which has thrown a lifeline of liquidity to many smaller lenders, a number of whom would have faced potentially terminal consequences in the absence of such support.

Before reviewing Dr Debelle’s speech in more detail, it is useful to take a step back in time to early 2008, when many leading observers thought that the worst of the GFC was behind us, and the RBA was evidently confident enough of this view that it hiked interest rates for the third time in four sitting months (only to suddenly reverse course 180 degrees some months later). In a study published by Melbourne University in March 2008, I tendered the following rather contrary arguments (with my co-author, Professor Joshua Gans):

“The current global credit market crisis exemplifies the need for the Commonwealth Government to introduce an important policy innovation that would insulate Australian households, and the key financial institutions that provide them with funding, from external capital market shocks that have nothing to do with the integrity of the Australian economy, its financial system, or the quality of Australian home loans. This solution is motivated by the growing frequency with which extreme financial market dislocations appear to be occurring.

As the world’s economies become increasingly open and integrated, the impact of these seemingly unrelated circumstances is transmitted through the global financial system with stunning speed and often carries unforeseen consequences…

Where these external shocks wreak unjustified havoc at home there is a role for government to prevent effective ‘market failures’ of the type that we are seeing in the primary residential mortgage-backed securities (RMBS) market today.

In particular, we believe that when key economic markets irregularly collapse governments have a responsibility to supply the ‘public goods’ of a minimum level of liquidity and price discovery. While governments are increasingly recognising that markets are not as efficient, and the investors that populate them not as rationale, as was once believed, to date interventions in Australia by the central bank have been limited to the banking sector…Put differently, government is currently providing liquidity to the organisations least in need of it...The market failure we identify is akin to the problems associated with ‘bank runs’, albeit applied to the ‘shadow’ banking sector. Bad decisions can, by virtue of a lack of transparency in certain overseas markets such as the US, translate into increased costs and a lack of liquidity elsewhere. This is precisely what we have seen in global debt markets over the last eight months.

We believe that the global liquidity crisis, and the desertion of demand for primary residential mortgage-backed issuance in Australia more specifically, is bringing about the most profound transformation of the Australian home loan industry since the emergence of mortgage-backed securitisation in the mid 1990s. Amongst other things, these ructions have significantly increased costs for borrowers (over and above RBA-induced rate changes), dramatically reduced competition in the mortgage origination market, and commensurately increased the market share and bargaining power of the Big-5 major banks [Editor: now Big-4]. According to market participants, there have also been other, equally insidious consequences, such as a rationing of credit by the major banks from more capital-intensive sectors, like small business lending…Based on this analysis, both households and small businesses ultimately suffer.”

These observations proved with time to be quite accurate, and are now accepted as conventional wisdom.

In his wide-ranging contribution to our understanding of the residential mortgage-backed securities market, Debelle offers a short history of securitisation in Australia, recounts the impact of the GFC on the liquidity of the local industry, articulates important differences between Australia’s securitisation process and the quality of the assets originated here compared with those in the US, provides a valuable update on the latest market developments, and concludes with some advice as to how the integrity of securitisation as a form of funding could be reinforced.

While the speech is generally excellent it comes up short on a number of fronts. Now some of this criticism may be unfair, since it is not always easy for public officials to aggressively tackle controversial topics. But if we were to ignore this constraint, we would conjecture that:

• The speech furnishes no analysis of the fundamental policy question of the relative merits of balance-sheet funding and securitisation as alternatives sources of system-wide finance;

• On a related note, it does not draw attention to the profound asset-liability mismatch that sits at the heart of the traditional bank’s business model wherein they fund 25-30 year home loans, which account for 60% of their assets, with at-call deposits and short-term wholesale debt;

• This underlying asset-liability frailty, which opens banks up to extreme vulnerabilities in the event that either (a) depositors withdraw their savings or (b) they cannot roll-over their wholesale debt, necessitates a range of deep public subsidies to ensure their survival during major crises (or, put differently, to preserve their euphemistically-termed ‘maturity transformation process’ whereby they borrow short and lend long). It would have been fascinating to hear Debelle’s views on the contrast between balance-sheet funding and the superficially safer “matched” funding model enabled via securitisation (which, of course, has one potential failing: moral hazard induced by the originate-to-securitise model);

• Further to this point, the speech does not evaluate the question of why, for instance, taxpayers are required to guarantee trillions of dollars worth of bank deposits and bank liabilities, and provide deposit-taking institutions with sub-market liquidity support via the central bank, yet securitisation as a form of funding had, prior to the AOFM’s interventions, received no such support;

• Nor does it consider the crucial issue of what the longer-term public policy framework should be for sustaining securitisation during periods of extreme duress given the ad-hoc (ie, non-strategic) nature of the AOFM initiative, which was effectively conceived on-the-fl y to deal with exigent circumstances;

• Here it would have also been informative to see an examination of the opportunities and risks associated with the AOFM’s proposed ‘liquidity facilities’, which the Treasurer, Wayne Swan, has instructed the AOFM to evaluate;

• As a penultimate observation, it is not clear why given the learnings from the GFC around the need for greater transparency on the underlying portfolio risks, and a stronger alignment of interests between originators and investors, which, as Debelle notes, mostly already exist in Australia, combined with the liquidity support now available care of the AOFM, securitisation could not grow to account for an historically bigger share of the funding pie;

• This would, of course, necessitate a further reduction in spreads, which will only be driven by higher investor demand. And that demand will, in turn, only materialise once super fund asset-allocations change (ie, via reduced equities weights and larger fixed-income exposures), which, as Debelle correctly opines, will require a significant re-education of trustees and their advisors;

• A final quibble relates to a recent newspaper report that claimed Debelle had insinuated that the decline in the major banks’ net interest margins on their mortgage books opened the door for them to jack up home loan rates beyond changes to the RBA’s targe cash rate. This is particularly relevant given Westpac’s decision yesterday;

• Aside from the fact that Debelle simultaneously drew attention to the fact that the banks’ overall net interest margins had not actually fallen, the focus on this specific metric as a proxy for a bank’s profitability or return on equity is quite spurious and something the RBA should arguably de-emphasise (or at least tie together more closely with RoE analysis of the banks’ home loan books);

• The banks’ profitability on their mortgage and business lending assets is determined by a range of other factors over and above net interest margins, including the cost of actually originating the assets, a key component of which is broker commissions, the amount of money they have to spend on advertising and marketing, their loss-rates, the variable or unit costs of processing these loans, and other top-line revenue opportunities generated by related fees;

• While the banks’ net interest margins may have declined, this has, judging by the way they have been allocating their capital (clearly in favour of home loans to the detriment of business lending), been presumably offset by a 30% plus fall in broker commissions, lower unit costs given that they have had substantial growth in the size of their highly scalable home loan books (relative to the system), reduced advertising and marketing spend enabled by the extinction of much of the competition, and higher associated fee opportunities liberated by a decline in the need to discount their charges in order to stimulate consumer demand.

Debelle begins his speech by documenting what we have noted before with respect to the inverse relationship between the size of an institution and its reliance on securitisation as an alternative form of funding:

“Prior to mid 2007, regional banks securitised around one-third of their housing loans while the major banks securitised less than 10 per cent. As a result, despite their smaller size, the regional banks accounted for roughly 40 per cent of RMBS issuance whereas the major banks accounted for 20 per cent.”

Two years ago we were among the first to observe that the exogenous shock that was US households defaulting on their non-recourse sub-prime loans quickly wreaked havoc on the ability of local lenders to fund themselves despite the striking differences between the two markets:

“The evaporation of third-party liquidity for Australian home loans has occurred in spite of their extraordinarily low historic default rates, which rank among the best in the world, and the exceptional overall health of the domestic economy.”

Debelle echoes these comments when commenting that securitisation globally suffered significant ‘brand damage’ as a result of the US calamity. The catalysts for this crisis were, of course, exceedingly high default rates combined with opaque security structures, “which sliced and diced the underlying mortgages until they were often unrecognisable.” Here Debelle recounts:

“The Australian RMBS market was tarred with the same brush despite the absence of these issues of transparency and overly complex securities and their continued strong performance…As Andre Agassi used to say ‘Image is everything’, and the image of securitisation was, and to a large extent still is, very much on the nose.

Issuance of RMBS in Australia dried up as it did around the world, as demand fell away. Investors felt they were already too full of structured products and had no appetite for any more. Spreads in the secondary market widened considerably. Indeed, at times, there was no secondary market, with plenty of sellers but no buyers at any price. This oversupply in the secondary market was exacerbated by the forced liquidation of the portfolios of the offshore SIVs. Australian RMBS were sold, not because of any intrinsic problem with them, but because the SIVs were no longer able to fund themselves. Australian RMBS thus suffered collateral damage (so to speak) on a number of fronts, even though the collateral on which they were based remained perfectly sound.”

While government economists originally opposed our calls for public intervention to vouchsafe a minimum level of liquidity in the RMBS market with hard-to-fathom statements that dismissed the RMBS illiquidity as ‘cyclical’ (even though there had been no remotely comparable cyclical precedent for such events), Debelle is refreshingly straightforward in acknowledging the severity of the market failure:

“There were some new issues during the first year of the financial crisis [in early 2008], but the market came to a complete halt late last year. Refl ecting these developments, the Government announced a support program for the industry whereby it would purchase $8 billion of new issues through the Australian Office of Financial Management (AOFM). That program has all but been completed.”

To their immense credit, Debelle and his colleagues at the RBA have been at the vanguard of efforts to shed light on the fundamental disconnects between the Australian and US housing markets, which help explain their very different trajectories. He has also repeatedly belaboured the point in various forums that investors in a rated tranche of securitised Australian home loans have never experienced a loss of principal:

“The lack of new issuance and elevated spreads in the secondary market did not reflect concerns about the credit quality of Australian RMBS. Unlike in the US, the credit quality of Australian RMBS has remained at the highest level throughout the financial crisis. An international comparison of non-performing housing loans, using on-balance sheet exposures, highlights the non-performing share in Australia, at less than 1 per cent, is extremely low. And over this year, the arrears rate for Australian RMBS has actually been declining slightly. The continued strong performance of Australian RMBS reflects both the quality and the composition of the types of loans securitised, which has been underpinned by the strength of the Australian economy, particularly the relatively low unemployment rate, robust household income growth, as well as low interest rates. The underlying sound condition of household balance sheets in Australia has helped limit the incidence of household financial difficulties during the economic downturn…

While losses (after the sale of property) on Australian RMBS have risen over the past year, they remain low as a share of loans outstanding, at less than 10 basis points per annum for prime loans Investors in rated tranches of Australian RMBS have never borne a loss of principal. In comparison, worldwide bank losses on securities’ holdings are forecast by the IMF to amount to almost $US 1 trillion, or around 6 per cent of holdings.”

Yet where Debelle has arguably added most value is in his analysis of the less-well-understood low-doc and nonconforming sectors of Australia’s mortgage market, which align more closely with the Alt-A and sub-prime segments in the US. Debelle tells us that low-doc loans account for roughly 10% of all prime securitised loans in Australia (and presumably a lower share of non-securitised assets). On the question of relative default rates he avers:

“Arrears on prime full-doc loans remain very low at around ½ per cent of outstanding loans. While arrears on prime low-doc loans are elevated compared to history, they have trended down over 2009 to be less than 2 per cent. Despite the higher arrears rate, historically losses on low-doc loans are contained by the fact that these loans have lower loan-to-valuation ratios, meaning that the borrower has a greater incentive to avoid foreclosure and in the case it does eventuate, the losses to the lender are smaller.”

Less visible are the crucial variances in the Australian and US sub-prime sectors. In 2007 the RBA estimated that ‘nonconforming’ loans accounted for less than 1% of all outstanding mortgages, which would be an even smaller figure today (in comparison to estimates of between 10-15% in the US). Of course, non-conforming assets represent a higher number of securitised loans, as Debelle explains below. While drawing attention to the much lower relative default rates on Australian non-conforming products, Debelle also points out that the originators of these assets employed different structures to their US counterparts. In particular, Australian originators often injected funds into the riskiest slices of securitised portfolios and therefore bore much of the pain in the event of default:

“Non-conforming loans are the closest equivalent to the sub-prime loans in the US, being provided to borrowers who do not satisfy the standard lending criteria of mainstream lenders such as those with impaired or incomplete credit histories. The loans are provided by a few specialist non-deposit taking lenders. This is in contrast to the US where sub-prime loans were provided by a wide range of financial institutions. Non-conforming loans make up only 3 per cent of Australian RMBS outstanding, compared to around 10 per cent of US mortgages outstanding. The arrears rate on Australian nonconforming loans is higher than for prime loans, at around 6 per cent… though it too has eased so far this year and is significantly below the arrears rate on sub-prime loans in the US (at over 25 per cent)…As well as the difference in current economic conditions, the lower arrears rate on Australian non-conforming loans compared to US sub-prime loans also reflects differences in the loans’ structural features prior to the financial crisis:

Australian non-conforming loans had a less risky structure than US sub-prime loans, evident in lower loan-to-valuation ratios.

Australian non-conforming loans did not usually feature low introductory interest rate periods (teaser rates) or high-risk repayment options (such as negative amortisation periods).

Australian lenders typically retained (and continue to retain) the lowest rated tranches of their RMBS or placed them with closely associated entities. The Australian legal system gives a lender recourse to all of the borrower’s assets in addition to the house in the event of default, which provides the borrower with a stronger incentive to repay their loan.”

On the subject of current market dynamics, Debelle emphasises that as the secondary overhang of RMBS has dissipated (given natural turnover in the underlying assets, which have a life of only around 4 years), which has seen a 40% reduction in the outstanding stock of securitised loans since the pre-crisis days, spreads have begun to naturally compress.

This has enabled around $2.3 billion worth of RMBS to be sold of late without the need for explicit government support (ie, via the AOFM). Here Debelle supplies historically-valuable data relating both to the decisive role of government during the crisis, and the decline in the need for such interventions as market confidence has recovered:

“As a cornerstone investor, the AOFM initially accounted for around 80 per cent of the investor base in those RMBS it supported. However, the AOFM’s participation has decreased to around 40 per cent in recent issues, with private investors making up the remainder. In fact, of all RMBS issued in recent months (including those in which the AOFM did not participate), the AOFM has only purchased around 25 per cent. In a further sign of broadening investor demand, there was private investment in tranches other than the senior AAA tranche in recent AOFM-sponsored issues, an outcome that was not common with earlier issues. Many recent deals have also been oversubscribed and upsized from the initial guidance…[Today t]he AOFM’s holdings amount to around 7 per cent of all Australian RMBS outstanding, and 13 per cent of the domestic market.”

As we recorded recently, it would appear that primary market spreads (ie, the cost of funding for lenders seeking to securitise new loans) have contracted to a level that is close to economic break-even. We speculated that the first of Members Equity’s recent issuances, which priced at around 140bpts over the swap rate, had converged back to commercially viable levels. Debelle confirms these statements and offers some fascinating analysis of the change in break-even pricing over time:

(Click to enlarge)

“Pricing on RMBS also suggests conditions have improved. In primary markets, the AAA rated tranches of the prime RMBS issued over recent months that have involved the AOFM as a cornerstone investor have priced at 120–130 basis points above BBSW, with deals that did not involve AOFM support pricing a little higher, at around 140–170 basis points. These latter spreads appear to be close to break-even levels. In the example [in Figure [x]], the break-even spread is around 140 basis points, which is in the ball park suggested by our market liaison, although different lenders are likely to have different cost structures. The increase in investor demand for RMBS in recent months has also been evident in a decline in secondary market spreads, which have fallen to be only a little above primary market spreads. The narrowing suggests that the market has worked through much of the overhang of supply in the secondary market created by the deleveraging of SIVs. The narrower margin between primary and secondary markets, as well as the ongoing amortisation of the existing stock of RMBS, suggests that a more broadly based pick-up in securitised issuance may not be too far off.”

In addition to the AOFM’s interventions, the government supplied liquidity to lenders in another vital way: through the RBA’s repurchase agreements, or ‘repo facilities’. As Debelle explains, there were massive repos of RMBS by banks with the RBA to the tune of around $45 billion at their height:

(Click to enlarge)

“In October 2007, shortly after the onset of the financial market turmoil, the Reserve Bank expanded the range of securities it was willing to hold under repurchase agreements to include both RMBS and ABCP. As with other private securities…the Bank was initially only willing to accept these securities from ‘unrelated’ parties. However, around the peak of the financial crisis in October 2008, the Bank relaxed the restriction on relatedness for both RMBS and ABCP as it sought to expand the range of funding options for financial institutions. In the subsequent months, the Bank purchased significant volumes of ‘internal’ securitisations under repo, with holdings peaking at around $45 billion around year-end.”

(Click to enlarge)

After positing that securitisation will continue to remain a valuable tool for dispersing risk around the financial system (which has been a view he has held on the record for some time), Debelle concludes with advice as to how the market functions could be further improved:

• In line with our recent calls for a national electronic credit register, which would substantially enhance the quality of information that regulators and investors have regarding the integrity of individual loan assets, Debelle notes that increasing, “disclosure of information to investors, such as the initial and ongoing performance of the asset pool and the creditworthiness of the borrowers of the underlying loans, is important”;

• Consistent with our arguments that Australian super funds are underweight fixed-income securities, Debelle implores issuers to redouble their efforts to explain the merits of these investments to decision-makers: “[T]he message that Australian RMBS have been, and continue to be, a strongly performing asset needs to be continually reinforced. The differentiation between Australian RMBS and US RMBS needs to be highlighted. This message…needs to be delivered to the superannuation trustees whose views may be affected by continual media exposure to the US experience that securitised assets are excessively risky. The Australian industry needs to differentiate its product from the US brand.”;

• Finally, Debelle also maintains that issuers need to be careful not to ‘oversell’ the benefits of these securities, arguing that they are not natural fits with ‘enhanced cash’ portfolios, and will remain inherently illiquid: “By their very nature, RMBS are most suited to buy and hold investors. These investors should be relatively unconcerned about the need to liquefy their investment, nor be overly worried about a temporary widening in spreads/fall in price, so long as the underlying asset continues to perform.”

All told, a very good effort, although perhaps not of the same historical import as his outstanding speech to the Brazilian central bank that offered a dissenting voice on the asset-price targeting debate.

This article derives from the October edition of the RP Data-Rismark Monthly. To subscribe to the RP Data-Rismark Monthly, please click here.