Aussie sub-prime mortgages are back

In a worrying development, an issuer of Australian sub-prime mortgages, Pepper Home Loans, has reportedly completed the largest issue of non-conforming (sub-prime) residential mortgage-backed securities (RMBS) since the Global Financial Crisis (GFC). From The AFR:

Global yield-seeking investors showed their faith in Australian mortgages as non-bank lender Pepper raised $500 million through the sale of non-conforming residential mortgage backed bonds, the largest of its kind since the financial crisis.

Non-conforming loans are the Australian equivalent of sub-prime loans and while there have been issues sold since the financial crisis, the Pepper issue is amongst the largest and most attractively priced since the crisis.

The $136 million of AAA rated A1 notes paid a margin of 1.10 percentage points over the bank bill rate, while the lower ranking $2.5 million A-2 notes paid a margin of 1.50 percentage points over the bank rate.

While the re-emergence of mortgage securitisation in Australia should help to boost competition in the mortgage market, it does also raise serious financial stability risks.

It was the rise of non-bank lenders using mortgage securitisation that caused an intensification of competition amongst mortgage lenders in the mid-1990s. With no formal regulator and no rules outside of regular trade practices and corporations law, they led the decline in Australian credit standards by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (sub-prime) loans just before the GFC intervened.

Faced with this new competitive threat, Australia’s banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore, much of it short-term. Gone were the days of requiring a minimum 20% housing deposit and restricting home loans to an amount that could be repaid with 30% of a household’s gross earnings. Instead, banks accepted 5% housing deposits and lent households an amount that, after loan repayments, left them with just enough money to ensure that they stayed above the Henderson poverty line.

The massive increase in the availability of credit arising from this increased competition, combined with unresponsive housing supply, is what fueled the explosion of housing values across Australia.

Indeed, evidence from the RBA seems to support my contention.

First, securitised non-performing housing loans (NPHL) were one-third higher than on-balance sheet loans at the height of the GFC:

Second, the securitisers were the main provider of non-conforming (sub-prime) loans, which had a delinquency rate far above the banks’ on-balance sheet housing loans:

Finally, in Western Sydney, where arrears on housing loans were far higher than those in other parts of Sydney or Australia, there was a disproportionately large share of housing loans sourced from non-bank lenders (mortgage securitisers):

According to the RBA in 2008:

…a disproportionately large share of the housing loans in this region was sourced from non-bank lenders. This may imply that a smaller proportion of the borrowers in the region met banks’ lending guidelines and/or that some of those marketing the non-bank loans arranged loans that were inappropriate for some people. The arrears rate on loans from non-bank lenders in this part of Sydney is running at three times that for loans on the major banks’ balance sheets….

But that is history. Now, the bank is welcoming back sub-prime. From Guy Debelle last week:

Despite the low level of foreign currency issuance in 2013, foreign investor demand for Australian RMBS has been quite high, reflecting the lack of supply of RMBS in foreign markets, the global search for yield, and confidence in the high quality of the underlying collateral of Australian RMBS. Publicly available data indicate that, on average, around 40 per cent of each deal in 2013 was placed with foreign investors, and foreign investor participation at issuance has increased significantly.

…while bank-based finance remains dominant today, in the future we may well see the Australian financial system move to more market-based sources of finance, particularly bond issuance. The regulatory changes have increased the relative cost of bank intermediation, as liquidity is now more appropriately priced and the cost of maturity transformation has increased. As a result, market-based sources of finance are now more cost effective for a wider range of companies and one would expect them to respond to this with increased bond issuance.

In short, Australia should be wary of the unintended consequences of increased mortgage securitisation, and the re-emergence of sub-prime loans in particular. Previous episodes have led to a significant loosening of credit standards and a substantial increase in the amounts that households could borrow for housing, resulting in increased debt that has been capitalised into house prices, and overall lower housing affordability.

As the RBA celebrates, it is over to APRA to prevent the punch bowl from overflowing.

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