The RBA Chris Aylmer delivered a speech today on the recovering RMBS market. It is worth a look:
Introduction
Thank you for giving me the opportunity to speak here today. My remarks are in two parts. The first part scans recent developments in the securitisation market. In the second part, I will discuss the role of asset-backed securities (ABS) in the Bank’s market operations and how we manage the risks around these securities.
Recent Developments
Let’s start with the global backdrop. While conditions in global financial markets have improved since the depths of the global financial crisis, the market for asset-backed securities has notably lagged this improvement.[1]
Issuance of private-label asset-backed securities in the US is currently equivalent to around 1½ per cent of GDP, compared with an average of around 8 per cent in the first half of the 2000s (Graph 1). Issuance of private-label residential mortgage-backed securities (RMBS) has been virtually non-existent since 2008. In contrast, issuance of auto loan-backed securities is nearing its pre-crisis level. Issuance of securities backed by student-loans and credit card receivables is also growing, though it remains well below its pre-crisis peak.
Activity in the European securitisation market remains very subdued, with annual issuance placed with investors relative to the size of the economy declining for the fourth year in a row. While the challenging economic conditions on the continent have contributed to this, European authorities have identified a number of other impediments and are developing proposals to address them.[2] In September the European Central Bank (ECB) announced that it will implement an asset-backed securities purchase program aimed at expanding the ECB’s balance sheet. While this program is not explicitly targeted at reviving the European ABS market, the ECB expects the programme to stimulate ABS issuance.
In comparison with its overseas counterparts, the Australian securitisation market, which remains predominantly an RMBS market, has experienced a strong recovery over the past couple of years, albeit not to pre global financial crisis levels. Issuance started to pick up in late 2012, reached a post-crisis high in 2013, and has remained high since then.
This mainly reflects the strong performance of Australian residential mortgages and the high quality of the collateral pools which are primarily fully documented prime mortgages. While delinquency rates on Australian prime residential mortgages increased after 2007, this increase was a lot less severe than in most other developed economies (Graph 2). Indeed, serious delinquencies in Australia, those of 90 days or longer, remained below 1 per cent and have declined since 2011 to around 0.5 per cent currently. Mortgage prepayment rates, which affect the timing of the payments to the RMBS notes, have also been relatively stable in Australia, resulting in subdued prepayment and extension risk for RMBS investors.
Issuance margins on RMBS continued to tighten throughout this year across all categories of issuers (Graph 3). Banks have been able to place their latest AAA-rated tranches in the market at weighted average spreads of80 basis points – the lowest level since late 2007. Spreads on the AAA-rated tranches of non-bank issued RMBS have also declined, to around 100 basis points. Investor demand has extended across the range of tranches, with a significant pick-up reported in demand for mezzanine notes. As a result, a number of issuers have priced their mezzanine notes at some of the tightest spreads since 2007.
Similar to last year, RMBS issuance this year has mainly originated from the major banks (Graph 4). Indeed, issuance by the major banks is on par with their issuance prior to the global financial crisis. Issuance by other banks has also been robust this year, although it is still well below pre-crisis levels when these issuers accounted for around 40 per cent of the market.[3]
Mortgage originators have been active this year, although their issuance has predominantly been of prime RMBS. Mortgage originators have issued only $1.6 billion of non-conforming RMBS in 5 transactions so far this year. The number of mortgage originators active in the market in the past two years has increased relative to the period from 2009 to 2012.
They are an important presence in the market. In the period preceding the global financial crisis, mortgage originators took advantage of innovations in the packaging and pricing of risk. In doing so, they were able to undercut bank mortgage rates. The banks responded and spreads on mortgages declined markedly. While a number of large mortgage originators have exited the market, the presence of mortgage originators promotes competition in the mortgage market.
Issuance of asset-backed securities other than RMBS has generally been in line this year with previous years. Issuance of commercial mortgage-backed securities (CMBS) and other ABS this year has been around $5 billion, compared with an average of about $6 billion over the three preceding years.
The investor base in Australian ABS has continued to evolve (Graph 5). The stock of RMBS held by non-residents has been relatively steady since late 2010 suggesting that non-residents have been net buyers of Australian ABS. The strong performance of Australian RMBS and lack of issuance elsewhere may have been an important driver behind the participation of foreign investors. There has been a pick-up in RMBS holdings by Authorised deposit-taking institutions (ADIs) – they now hold just under 40 per cent of marketed ABS outstanding – with the major banks accounting for much of the increase.
Holdings of ABS by real money domestic investors have gradually declined, to the point where these investors, in aggregate, now hold less than a quarter of what they held four years ago. The longer-term sustainability of the Australian securitisation market may well depend on increasing participation in the market by domestic real money investors.
In other words, the securitisation renaissance has been largely driven by banks buying the bonds of their competitors. This may seem counter-intuitive but the banks decided long ago that they’d rather clip the ticket on the system than hold it back and the assets are eligible as collateral for the RBA liquidity facility.
This goes to the heart of what is wrong with the Australian financial system with its few too-big-to-fail banks. Not only do they originate most of the loans, they also now fund most of their competitor’s loans as well, and if there is ever a shock large to enough to see bad loans flow back into the majors then they will also rather suddenly be pulling out of those investments.
The risk of contagion and pro-cyclical outcomes is obvious. And when the cycle turns, only the guaranteed majors will be able to borrow money and will be required to step up and buy the radically discounted mortgage books of the very entities that they have just bankrupted! It’s a particularly pernicious example of Karl Marx’s observation that capitalism tends towards monopoly.
It is interesting to note that in recent weeks RMBS spreads have begun to widen again. From Banking Day last week:
There was further evidence yesterday that margins have widened in the residential mortgage-backed securities market, when Citigroup completed a A$1.13 billion transaction.
Citi upsized the issue, Securitised Australian Mortgage Trust 2014-1, from $500 million at its launch on Monday.
Pricing on the $1.04 of A notes, which have a weighted average life of 2.7 years, was 78 basis points over the one-month bank bill swap rate.
The tightest margin paid by an issuer this year was 70 bps on the top tranche of Commonwealth Bank‘s $4 billion issue in August.
A month earlier, ME Bank had priced the top tranche of its $1.4 billion issue at 75 bps over the swap rate.
Among more recent issues, Wide Bay Australia paid 100 bps over the swap rate on the top tranche of an issue late last month and Firstmac paid a margin of 90 bps on the top tranche of an issue in September.
A similar trend is evident in the non-conforming segment of the market, with a Bluestone issue late last month priced at a wider margin than earlier non-conforming deals.
Citi did not disclose the pricing on the AB and B notes of its issue, which was its first since 2011.
This has coincided with a bounce off the bottom for bank CDS spreads, as funding costs for the majors also appear to have bottomed. That makes special kind of sense given they effectively vendor-finance RMBS!
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
