RBA's Guy Debelle: Favours Direct Investments in RMBS over Guarantees + Puzzle

The RBA's Guy Debelle is currently delivering this speech to a securitisation conference. As always, he makes a few interesting points. First, he wades into the financial services debate, and advocates keeping the AOFM initiative alive in preference to RMBS guarantees. That is, he likes the Government acting as a direct investor in the market. One can see merit to both arguments. I would also note that the RBA has never been an overly creative policy innovator--they always seem to prefer the status quo. But Guy makes some good observations, which one finds much to agree with:

"In thinking about the AOFM support for the RMBS market, I believe the AOFM program has a number of advantages relative to alternative means of support: it can be easily tailored to help specific types of institutions; it can be phased out easily; the likelihood that the Government loses money on its investment is very small; and there is no ongoing contingent liability to the Government from providing the support. If instead a government guarantee of RMBS were provided, it would be difficult to phase out, creating a commitment that could generate a large contingent liability for the Government."

The second, perhaps more interesting point, Guy raises is the pricing of AAA-rated RMBS. This might be called the RMBS pricing puzzle. In short, despite the extremely low default rates associated with RMBS, and the fact that these AAA-rated assets are much more safe than a complex AA-rated bank debt instrument, which may be unsecured, the market is nevertheless pricing them as riskier (this is even more odd given that 60% of bank assets are RMBS). Debelle comments:

"The widening of RMBS spreads was generally larger than that of other funding instruments, such as unsecured bank credit, and it has not narrowed as much from the peak (Graph 7)...It is difficult, given the very strong historical performance of Australian mortgages that provide the underlying collateral, not to view this relative pricing as somewhat anomalous. On the other hand, it is the legacy of the brand damage the crisis inflicted on mortgage-backed securities and a measure of the work still to be done by the industry and regulators to restore investor confidence and improve liquidity."

A final cool chart Debelle produces is a comparison of RMBS pricing relative to what he calls "break-even" pricing. Joshua Gans and I raised this concept in our March 2008 paper on the subject. Based on Debelle's analysis, the RMBS market should facilitate economically viable issuance (see next chart).