An investment class to not write off

14-Feb-2018

By Phil Carden

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Residential mortgage-backed securities have been viewed poorly since the global financial crisis, mainly due to their failure in the US market. Phil Carden details how the Australian market is different and why individuals should still give an allocation to these assets some thought.
Since the global financial crisis (GFC) in 2008, many Australian investors have avoided investing in residential mortgage-backed securities (RMBS). These types of investments have been categorised as high risk by many investors who do not fully understand the structure and operation of the RMBS market in Australia. This misunderstanding stems from a massive collapse in United States residential property prices, huge losses in the US residential mortgage market, several bank and insurance company insolvencies, and a period of illiquidity and money hoarding that occurred between 2007 and 2010.

The causal factors behind the crisis in property prices in the US, mortgage defaults and bank insolvencies were:

•  very poorly regulated residential mortgage lending practices in the US, coupled with:

•  a significant moral hazard contained within the structure of US bank employee remuneration schemes,
•  excessive and uncommercial mortgage lending in the US during the period 1999 to 2007 following the repeal of the Glass-Steagall legislation by Congress in 1999, and
•  having the adjustable-rate mortgage (ARM) holiday period come to an end in the US, and since the banks held most of the lower tranches, this wiped out their capital base and led to widespread panic across the sector as to how heavily each bank was exposed.

Graph 1: US residential mortgage delinquency rates (Seasonally adjusted data)

Source: Mortgage Bankers Association/Haver Analytics

Graph 2: Australian prime and sub-prime RMBS 60+ days delinquency rates

Source: Macquarie Bank

Eight important facts regarding Australian mortgages and RMBS

Since the inception of the Australian RMBS market in the early 1980s, not one RMBS note has ever gone into default, been charged off or failed to pay 100 per cent of principal and interest obligations in a timely manner.In Australia, all mortgages used to secure RMBS notes are full recourse to the mortgaged property and to the mortgagor. This is in contrast with the US where mortgagees only have recourse to the secured property and no recourse to the mortgagor.

RMBS are managed by a variety of bank and non-bank financial institutions, including Westpac, ANZ, Commonwealth Bank of Australia, National Australia Bank, AMP, credit unions, Adelaide Bank, Resimac, First Mac and Liberty, among others.

During the GFC, both RAMS Home Loans and Adelaide Bank experienced solvency issues resulting in both intuitions requiring urgent rescue action, yet their managed RMBS trust notes repaid 100 per cent of principal and interest obligations following the solvency issues.
During the GFC, then-treasurer Wayne Swan instructed Treasury’s Australian Office of Financial Management to also support non-bank financial institutions after the announcement of the guarantees on bank deposits. Swan announced $16 billion would be available to buy Australian non-bank RMBS to support this sector. 

Most mortgages used to secure Australian RMBS are insured with an Australian loan mortgage insurer regulated by the Australian Prudential Regulation Authority (APRA) in the same manner as APRA regulates Australian banks.

Under the National Consumer Credit Act 2009, it became illegal to advance funds in the Australian retail mortgage market if a lender cannot prove a borrower will be able to repay the mortgage without experiencing future financial hardship or liquidating a borrower’s principal place of residence.

In the US, ARMs offer borrowers an ‘interest-free holiday’ period upfront in exchange for higher interest rates down the line after a ‘holiday’ period of one to five years. ARMs are the mortgages that caused the GFC, because when you lend someone 100 per cent of the value of a house with a 100 per cent interest-free holiday upfront for three years and only have recourse to the house, yet don’t have recourse to the borrower, you are essentially giving the borrower a free house to live in for three years. These mortgages are unavailable in Australia, never have been available in Australia, and would now be illegal under the National Consumer Credit Protection Act.

Table 1

Data validating the credibility of Australian RMBS

In the history of the mortgage market in western economies since the great depression, the peak in default rates and mortgage losses occurred in 2010 in the US. The peak was in sub-prime ARMs when 30 per cent were in default in 2010 and the prime ARM market peak was 14 per cent in default in 2010.Graph 1 illustrates peak default rates statistics in recent years across all US mortgage categories

Graph 2 shows mortgage delinquency rates in the Australian prime and sub-prime RMBS trust mortgage sectors.

Table 1 compares prime and sub-prime delinquency rates of Australia versus the US:

When these peak mortgage delinquency rates are combined with asset recovery rates of 50 per cent, an investor can use the data to conduct ‘worst-case’ stress tests on any RMBS mortgage pool. 

The important points to observe from this analysis are:

•  The worst-case default rates in the western world occurred in the US after the GFC at the levels of 30 per cent for sub-prime and 14 per cent for prime.
•  The worst cases in Australian RMBS have been 15.36 per cent in sub-prime and 0.88 per cent in prime.
•  Then when we apply a default rate of 14 per cent to Australian RMBS while liquidating secured properties at 50 per cent of original registered valuation, a default multiple of 15.9 times Australia’s worst-case delinquency rate, the Australian RMBS can repay 100 per cent of its principal and interest obligations.

Summary

The Australian residential market has not had the extreme defaults experienced in the US caused by poorly structured loans that set the borrower up for default at the start. The Australian RMBS market is heavily regulated and the underlying pools are very diverse via state, sector, year of loan and type of loan.

There has not been one Australian RMBS note default since they launched in the early 1980s. 

If you were to apply the worst-case default rates experienced in the US and 50 per cent asset realisation rates, we still believe Australian RMBS offer an attractive investment opportunity for investors. We continue to be presented with investment opportunities offering around 6 per cent over the Australian bank bill rate fully secured. The other attractive aspect of this investment is the fact the clear majority are floating rate notes so there is minimal duration risk. 


Phil Carden is a portfolio manager with Supervised Investments.

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