Moody’s warns on LMIs

Well, it ain’t just all things Europe under the ratings agencies searing new gaze, as I’ve pointed out numerous times, it’s Australia. And now, more to the point, it’s the Lenders Mortgage Insurers (LMI) which Moody’s has today put on negative outlook.

For those that don’t know, LMIs play a pivotal credit enhancement role in the Australian mortgage market by insuring high loan-to-value mortgages. That is, they are loss protection for the banks. The companies involved include:

The truth, however, only QBE LMI and Genworth matter that much, holding between them 75% of the market. Here is how Moody’s sees the positives:

• Strong franchise value with Genworth Australia and QMI maintaining a dominant presence in the Australian mortgage market. The sector is characterized by strong regulatory incentives for mortgage lenders to require borrowers to take out mortgage insurance, a high degree of consumer acceptance, and consequently, high penetration rates.
• Australian LMIs have a conservative underwriting profile, with low documentation products accounting for only a minor proportion of their insurance-in-force and no exposure to sub-prime loans.
• Australian LMIs remain capitalized at a level considerably above regulatory requirements. For rated companies, APRA’s solvency ratio is in the range of between 1.43x and 1.59x of minimum capital requirements, relative to a hard floor of 1.00x and APRA’s expectations of 1.20x.
• From a macroeconomic environment perspective, there is ample scope for expansionary monetary and fiscal policies to take place, if needed to stimulate the economy: the Reserve Bank maintains interest rates at a level sufficient for cuts, and Australia’s sovereign debt remains exceptionally low.

Versus a rather long list of negatives:

• All three active rated insurers reported sharp increases in loss ratios during the 2008-09 downturn. The ratios rose to nearly 50% in 2008 on average, from less than 10% in 2005. Despite some improvement in 2009-10 (to below 30%), the loss metrics indicate a high degree of sensitivity to the developments in the housing market.
• Australian mortgage insurers’ volumes declined following the financial crisis as the housing market slowed down (with credit growth declining substantially to about 5%, from about 15%), underwriting standards tightened and securitization activity declined. Lower origination volumes are likely to persist in the short-to-medium term.
• Australian LMIs have little independent presence in capital markets and their funding requirements are typically managed as part of their respective overall groups, constraining their financial flexibility. We view Genworth Australia’s recent Tier II issuance and announced partial IPO as a positive development in this respect.
• Our stress tests indicate that APRA’s capital requirements would be challenged in a severe stress scenario consistent with high investment-grade ratings. Coupled with limited access to capital markets, and, consequently, ability to raise external capital, this factor exerts downward pressure on the credit profiles of rated LMIs.
• Elevated house prices and mortgage debt levels are arguably at unsustainable levels and remain a key vulnerability for the LMI industry. The sensitivity of the mortgage insurers’ portfolio to a serious economic downturn is yet to be tested at current house prices and levels of indebtedness.
• The relative importance of resources sector investment and exports, and the dependence of the banking system on external wholesale funding, increase Australian economy’s sensitivity to exogenous shocks. At the same time, high interest rates and a strong currency are creating asset quality pressures on non-resource-related sectors of the economy.
• Whether contagion from the European sovereign crisis will drive global economic weakness and/or results in an external shock to the Australian financial sector remains uncertain.

And the housing risk:

• Capital city house prices have more than quadrupled and household debt has tripled in since 1990. Simple metrics (such as the price-to-income or price-to-rent ratio) indicate that the current levels of house prices are not sustainable.
• The market is undergoing a (to date) mild correction with a decline of approximately 4% off peak values nation-wide and up to 9.5% in Brisbane. Housing credit growth has fallen to around a third of pre-crisis levels. Our baseline expectation is that of further declines, both in the short and medium term.
• The excellent performance of Australian mortgage loans to date is beginning to be challenged with 30 days past due delinquencies reaching their highest value of 1.76% in May 2011, compared with an average of 1.28% in 2010, 1.22% in the 2005-09 period and levels generally below 1.00% prior to 2005. This is the case despite the oft-mentioned commodities boom.
• The heightened risk profile of the Australian housing market is the result of structural shifts that have developed over a number of decades, including financial liberalisation, supply constraints and stable lending standards. A material portion of the increase in house prices and indebtedness can be accounted for fundamental factors, serving to reduce – but not eliminate – any concerns over a possible severe housing market correction.

As well as the macro risk:

• We view Australian LMIs’ financial position as adequate for the current stable conditions and baseline economic scenario. At the same time, the economic outlook, particularly when considered in light of developments in the housing sector, is mixed and exposes these companies to further volume-generation and claim rate pressures.
• Moody’s base-case central range for economic growth is between 3% to 4% for 2012, although there are risks to the downside5. The economic outlook is increasingly reliant on the resources sector with the proposed new mining super tax, carbon tax, reduction in the local content of resources investment, and the strong Australian dollar expected to have only a moderate impact on the sector’s overall contribution to growth. Accordingly, Moody’s central range for unemployment rate in 2012 is around 5%, which is low by historical standards.
• However, the shift to a more resources-based economy, with the resultant strength of the Australian dollar, is putting pressure on other, trade-exposed sectors, such as tourism and retail. Should these trends persist, default and delinquency rates in the mortgage market are likely to be variable regionally and increase over the next decade.
• The Australian economy’s dependency on external wholesale funding and resources sector investment makes it vulnerable to external shocks. A sharp slowdown in East Asia, primarily, China, is a key risk. Although the probability of this scenario is low, a slowdown in China’s economy would have significant negative credit implications for the Australian economy and its financial system.
• Both the private and public sectors are (slowly) deleveraging, exerting short-term pressure on the economy: (i) the resources sector has been able to fund capital expenditure by cash generated internally, which spares it the need for borrowing; (ii) the broader corporate sector has deleveraged during the crisis and shareholder pressure to invest or pay out cash holdings remains moderate; and (iii) the household saving rate has increased and appears unlikely to fall again as long as the non-resources sector continues to face a clouded outlook.
• At the same time, the economy has sufficient built-in flexibility to mitigate the impact of an external shock. There is ample scope for expansionary monetary and fiscal policies to take place, if a need for stimulus arises: the Reserve Bank maintains interest rates at a level sufficient for cuts, and Australia’s sovereign debt remains exceptionally low. In addition, the floating Australian dollar has proven to be an effective automatic stabilizer in the past.