Grinding to a halt

Australia's residential mortgage-backed securities market has ground to a virtual halt, creating huge funding headaches for the country's non-bank mortgage lenders. With some companies at risk of collapse, bankers claim the government needs to intervene to ensure a competitive mortgage market. By Wietske Blees

Australia's non-bank mortgage lenders are staring down the barrel. With demand for residential mortgage-backed securities (RMBSs) shrivelling, the main funding mechanism for the country's specialist mortgage companies has all but seized up. While those banks with access to retail deposits have largely been unaffected, even growing market share, those without have been forced to scale back mortgage origination. With a handful of firms already shutting up shop, lenders claim the government needs to do more to support the industry - and warn that, unless drastic action is taken to ease the liquidity shortage, there could be a significant reduction in competition.

Until the credit crisis struck in August 2007, Australia had a booming securitisation market, growing from A$10 billion ($8.7 billion) in March 1995 to reach A$175 billion by July 2007. This created the perfect conditions for non-bank mortgage lenders to grow their businesses. With no access to retail deposits, these entities either borrowed in the short-term debt market or used the securitisation market to meet their funding needs - and they took full advantage of the strong investor demand for mortgage assets. In 2006, non-bank lenders accounted for 26% of the A$60 billion of RMBS new issuance, compared with 24% for Australia's major banks, according to the Australian Securitisation Forum (ASF). Much of this paper was sold to overseas investors, particularly structured investment vehicles (SIVs) and asset-backed commercial paper (ABCP) conduits.

However, with the credit crisis stepping up a gear in the third quarter of last year, this investor base disappeared virtually overnight. "The problem is not so much that the majority of investors have tended to come from abroad. It is the fact around 50% of them were SIVs and ABCP conduits, which not only will not be around going forward, but which have also turned sellers," notes Ben McCarthy, managing director at Fitch Ratings in Sydney.

The dry-up in demand has caused spreads on RMBS paper to widen dramatically. Recent prime full-documentation AAA rated RMBS issues have priced at between 110 basis points and 150bp over the bank bill swap rate, compared to around 15bp in the first half of 2007, according to the ASF. As a result, it has become prohibitively expensive for many mortgage lenders to issue RMBSs.

"There is probably the capacity in the market to issue another A$1 billion or so of RMBSs, but the spread would be around 150bp and that is just not economical," explains Greg Medcraft, chief executive of the ASF in Sydney.

The withering of the securitisation market has hit non-bank lenders hard. One of the first casualties was Rams Home Loans, which sold its distribution business, including 99 branches, to Westpac Banking Corporation for A$140 million, after the lender had difficulty refinancing A$6.17 billion of short-term commercial paper in August 2007. The deal, which was completed in January, did not include the company's A$14.5 billion mortgage book, which Rams (now known as RHG) will run off.

Other victims include Adelaide Bank, Bluestone, Credit Union Australia, FirstMac, First Permanent, Macquarie Securitisation, Maxis Loans and Mobius Financial, all of which have been forced to either to shut up shop or scale back lending. "We have been reasonably impressed with the way the non-banks have responded to the crisis. By the end of last year, most of them had effectively gone into hibernation and had stopped the origination of new loans and moved to reduce their cost base," says McCarthy.

Those that remain are finding the going tough. "One of our biggest challenges has been to manage origination levels and create the term capacity we require to be a viable member of the industry going forward. We are very confident that is what we will be, but it is frustrating to not be able to utilise our distribution capabilities, with many capital market investors not participating for various reasons despite the significant premiums they offer. Until the capital markets return to a more functioning state, we are forced to limit our originations - which is not helping levels of competition in the market," says Andrew Twyford, general manager of treasury and securitisation at Challenger, a Sydney-headquartered financial services provider, which has a A$22.5 billion mortgage book.

Instead, the major commercial banks have been taking up the slack, winning market share in the mortgage market since last August. The share of new home loans originated by the five largest banks - ANZ, Commonwealth Bank of Australia, National Australia Bank, St George and Westpac - reached 90% in May, up from 75% prior to the credit crisis, according to the Australian Bureau of Statistics.

While these banks have been able to tap into their retail deposits, they have still had to turn to the wholesale markets to help fund at least part of this business. Unlike the smaller non-bank lenders, however, the major banks have been able to get deals out the door - albeit at higher prices. The major Australian banks were able to issue five-year bonds at a spread of around 100bp over the bank bill swap rate in June, down from around 128bp in April but up sharply from the 20bp of one year ago, according to the Reserve Bank of Australia (RBA). Issuance from banks totalled A$67 billion in the first half of 2008, well above the average A$32 billion raised in the same period between 2005 and 2007.

Meanwhile, prime full-documentation RMBS transactions were pricing at around 120bp in June, down from 145bp in May. However, the volume of new deals has taken a dramatic dive, with quarterly issuance averaging A$2 billion versus A$18 billion last year. Deal sizes have also collapsed, averaging A$375 million this year compared with A$1.6 billion in 2007. Consequently, the stock of RMBS outstanding has fallen by about 20% since the peak in mid-July to A$140 billion.

"Not only do the banks have to fund their own commitments, which are typically in the range of A$20 billion each per annum, but they also have to fund the short-term capacity they have picked up from the non-banks," says Rob Camilleri, senior income manager in the credit department at fund manager Portfolio Partners in Melbourne. "On average, their funding requirements have increased by about 50%. While the capital markets are open to these banks, they will have to do a lot of borrowing."

At the very least, bankers acknowledge the reliance of non-bank lenders on wholesale funding markets will have to change if they are to continue to be viable. Lenders had been able to achieve 100% financing on loans they originated, primarily due to the fact mortgage loans are insured, which means the insurance provider reimburses the lender for any post-sale losses incurred. This will likely have to change going forward, say analysts.

"The practice of handing a non-bank 100% financing for any loan it originates, while not forcing it to have any skin in the game when it comes to securitisation of the underlying assets, is unlikely to be accepted by investors and warehouse funders, at least in the short term. Historically, mortgage insurance has been used as the capital for prime Australian residential non-bank originators. However, the challenges faced by those entities mean that real capital is likely to be required," says McCarthy at Fitch Ratings.

Others argue non-bank lenders will have to cultivate more of a domestic investor base for their securitisation deals, rather than rely so heavily on the overseas market. "This crisis has exposed a significant structural problem in Australia, stemming from an over-reliance on the offshore investor base," says the ASF's Medcraft. "Until recently, foreign investors accounted for 70% of investor capacity. With these investors gone, we really have to focus on building a domestic investor base."

But developing a domestic investor base is easier said than done. On the plus side, there is some interest for RMBSs from superannuation funds and other real money investors, attracted by the high returns on Australian RMBSs. "We were fairly defensively positioned in RMBSs leading into 2007; but, from November onwards, we have invested in almost every primary issuance, as well as in the secondary market," says Camilleri of Portfolio Partners. "A prime pool of RMBSs today will pay between 110-130bp over swaps, up from between 15-20bp a year ago."

Camilleri points out that, unlike US subprime mortgage loans, the assets underlying Australian RMBS deals are of high quality. Although losses on loans increased in 2007, they are still relatively low as a share of outstandings, at 4bp for prime loans, according to the RBA. High subordination and the excess spread built into these structures - typically around 40-80bp after coupons - also provides a cushion against losses, he adds. In addition, loans backing prime RMBSs are almost always covered by insurance, either at the individual loan level or through a pool policy taken out by the originator when the loans are securitised - although that means investors are exposed to counterparty credit risk of the insurer.

Indeed, the two main participants in the Australian lenders' mortgage insurance market - Genworth Financial Mortgage Insurance and PMI Mortgage Insurance - have both been downgraded in the wake of the credit crisis: PMI was downgraded from AA to AA- by Standard & Poor's (S&P), while Moody's Investors Service downgraded both PMI and Genworth from Aa2 to Aa3. The changes have resulted in around 190 subordinated RMBS tranches being downgraded to an equivalent AA- from AA. However, the ratings of all AAA tranches have been affirmed by the rating agencies.

Despite this recent blip, Camilleri says Australian RMBSs have been resilient. Indeed, recent analysis by S&P showed that 59% of Australian prime RMBS notes rated AAA by number, and 39% by outstanding balance, are insensitive to changes to the ratings on the Australian lenders' mortgage insurance providers. "If you look at the structure of Australian mortgages in detail, it is clear how remote the possibilities of loss really are," adds Camilleri.

However, while some domestic investors have upped their allocations to RMBSs, others have stayed clear, restricted by their mandates from investing heavily in the asset class. "Superannuation schemes are limited in terms of how much they can allocate to RMBSs, and most cash-in-hand funds are much more sensitive to investor redemption these days and are reluctant to buy too many securitised assets," says Medcraft of the ASF. "Fixed-income managers have typically taken issue with the fact that RMBSs are not included in the benchmark UBS Australia Composite Bond Index, and investing in RMBSs would therefore result in them being mismatched against the index."

Even if issuers do manage to build a domestic investor base and interest in securitised assets returns to pre-crisis levels, the market is unlikely to be the same as it was before August 2007. "When the securitisation market recovers, I expect investors to be much more discerning between one issue and another," opines McCarthy at Fitch. "The large banks will probably be the first to benefit, followed by the more capitalised non-banks and the very last will be the undercapitalised non-banks, which may not come back at all."

With non-bank lenders under threat, the industry has appealed to the authorities to step in. Last September, the RBA announced it would widen the range of eligible assets for its repurchase operations to include bills and certificates of deposit issued by authorised deposit-taking institutions (ADIs) and Australian dollar bonds rated A3 and above issued by ADIs. In October, it added Australian dollar RMBSs rated AAA, backed by prime full-documentation domestic residential mortgages, and Australian dollar ABCP backed by prime residential mortgages and rated P-1.

However, a repo counterparty is not able to offer securities issued by itself or a related entity. As a result, bankers say this facility hasn't met the requirements of mortgage originators and needs to be extended further. "To date, only about A$3 billion has been used in repurchase agreements with the RBA. It is a tool of monetary policy and it is not something that can be relied on to provide liquidity in the short term," says Medcraft.

In fact, the relatively non-interventionist stance of the Australian government has attracted significant criticism from market participants. "A functioning securitisation market is absolutely critical for the operation of the non-bank model as it exists today, and it is very important for the government if it does not want to return to a four-bank oligopoly to play a role in the remediation of this market," says Twyford at Challenger. "The longer the securitisation market remains in a dysfunctional state, the more casualties there will be, which will be detrimental to competition and market efficiency in the pricing of residential home loans."

In response, the ASF has drawn up a list of measures designed to restore liquidity to the market. These include special liquidity measures, similar to those already in place in the UK and US, as well as extending the range of eligible collateral for repurchase agreements - in particular, allowing firms to offer securities they issued themselves. These proposals have found support from industry members.

"While the repo window is not a funding tool, it would be very helpful to see the eligibility criteria for repurchase agreements extended to include a wider variety of eligible assets, particularly when these are mortgages insured by Australian Prudential Regulatory Authority-regulated insurers," says Twyford. "I do not believe the risk on low-documentation insured loans is any higher than that on higher loan-to-value full-documentation loans, which are currently eligible. To broaden the spectrum of possible collateral would certainly help to make the traditional pool of prime insured securitised assets more attractive in the capital market."

In the longer term, the ASF recommends more direct government intervention to ensure the smooth functioning of the Australian mortgage market. For example, it is lobbying for the introduction of an agency model, similar to the Canadian Mortgage and Housing Corporation. Such a government-guaranteed vehicle would issue AAA rated mortgage-backed securities with bullet maturities, which would likely be eligible for inclusion in the UBS Australia Composite Bond Index.

"We've suggested the government could invest around A$10 billion in RMBSs through a government agency, which would contribute significantly to the demand problem. Alternatively, the government could issue more government bonds and use the money to buy RMBSs," says Medcraft, who believes the government's intention to increase issuance of Treasury bonds, announced in this year's May budget, could provide the necessary funding.

The ASF is also lobbying for the establishment of a covered bond market. The government has in the past rejected the use of these instruments in Australia, on the grounds the Banking Act prohibits the pledging of assets. However, the ASF believes there may be grounds for manoeuvre if the government was to approve depositor insurance - something currently being considered. "The covered bonds solution is one that would need regulatory change," adds Medcraft.

Given the current situation, it might not matter so much where the liquidity will come from, so long as there is some form of stimulus to avoid further casualties. In the long run, however, market participants will need to seriously rethink their models to ensure the current vulnerability becomes a thing of the past.

"If this situation is not resolved within the next 12 months, it is reasonable to expect some consolidation in the non-bank sector," says McCarthy at Fitch. "It may just mean some subtle changes to the way in which non-banks operate, such as moving from originating loans for their own books to originating loans for someone else, but something will have to change."