Chris Joye’s big short

Via Livewiremarkets:

In assessing whether to get long or short residential mortgage-backed securities (RMBS), we undertake a great deal of quantitative analysis, including revaluing the homes that protect these bonds at regular intervals and developing globally unique RMBS default and prepayment indices. (Regular readers will know that we exited most of our RMBS in February 2018.)

As house prices fall, the loan-to-value ratios underpinning an RMBS issue rise in lock-step, which reduces the equity protecting the bond. Using Bloomberg data on the current amortised value of the home loans in all Australian RMBS pools, the LVR distribution of the loans, and the geographic location of the properties, we have marked-to-market all the 2017, 2018 and 2019 issues after accounting for the amortisation or pay-down of loans through to the end of February 2019.

What we find is some huge increases in the share of an RMBS issue’s assets with LVRs over 90% compared to the leverage reported when the bond was originally sold to investors (often jumping from 5% of loans to 15% to 20% of loans).

We have also documented some recent RMBS deals where the share of loans that are underwater, or have LVRs over 100%, has increased strikingly, including one transaction where more than 1-in-10 loans appear to be underwater.

…At the same time as the equity protecting RMBS is shrinking, we have demonstrated that RMBS default rates are trending higher back to GFC peaks using our compositionally-adjusted hedonic index of RMBS arrears. This is consistent with the RBA’s data on mortgage arrears, which I have enclosed below our index chart.

There is also the problem of declining mortgage prepayment rates, which is blowing out the expected life of RMBS bonds (adversely impacting assumed credit spreads) as borrowers struggle to prepay loans at the same rate as they have done in the past.

Chris has previously noted his desire to get short Aussie RMBS in his AFR column though whether he succeeded is an open question. There are a couple of key points of note for the credit outlook here:

  • these RMBS are mostly non-bank issuance stemming from the post-2016 macroprudential slowdown in bank lending;
  • however, Aussie banks do buy these bonds so there could be feedback loops into the wider system;
  • crucially, RMBS are off balance sheet and do not have any lender of last resort. As such they are much more exposed to the underlying asset values than bank held mortgages. If they sink then spreads will widen and issuance fall, creating a doom loop, though there would likely be a fiscal response of buying the bonds directly by the AOFM;
  • finally, if you think this has echoes of the US “Big Short” then you’re spot on. The similarities are spooky. Indeed, if underlying collateral in these bonds is falling, and the LVR coverage shrinking so fast, then you have to ask where are the ratings agencies and their AAA rubber stamps? Admiring deals “structured by cows” again?

History doesn’t repeat but…you know the rest.

David Llewellyn-Smith
Latest posts by David Llewellyn-Smith (see all)


    • I don’t believe there is any way for a retail or sophisticated investor to get short.
      The best way to achieve it would be through raising a largish fund which is cash backed and then use that cash to collateralize short credit default swaps (which would require an ISDA with a couple of major banks). CDS are derivatives that payout on the default of a specified debt instrument or borrower. In this case the shitty RMBS issue generally the CDS would be referenced to a specific tranche of the RMBS issue not to the RMBS SPV itself.
      Of course you have to find a big idiot/bank to write the CDS. Having said that, at the right ‘price’ most deals can be done.
      This would be an almost exact replica of how it is done in the Big Short.
      Not rocket science but institutional grade stuff.

      • @Kodiak, how would you get short this from a retail perspective?
        I imagine you could execute short retail trades on some analogous stocks but I’ve not seen anything that would come close to a CDS.
        Keen to hear your suggestions

    • Mate, honestly if you don’t know how to short them then that is an indication that you shouldn’t get involved in shorting. That’s not intended as an insult, it’s just the way it is. You can get into all sorts of trouble with short-selling. As the saying goes, the market can remain irrational longer than you can remain solvent.

      • Agree Phil
        I’ve stopped trading
        I shorted rio a few years and got shelacked
        These banks go forever
        Their will be a day but maybe 4 years away

      • Great bcnich, I hate seeing people get stitched up so I’m glad to hear it (not shorting RMBS I meant!). As someone that looks at financial product opportunities for a living, I’m pretty sure that any fund will be some sort of derivative product that North has intimated above. Stratospherically high risk, complex (thus high fees), too late to market and probably with the Silver Donut’s name in front……

  1. thomickersMEMBER

    Can someone please decipher the duplication of names on each bar for me?
    i’m confused AF

    • I’m guessing but I believe each bar represents a single RMBS issue by a single institution, not say all non-bank RMBS issues for that year. So the first bar is an RMBS by Institution X in 2018, the second is an RMBS by Institution Y in 2018, and so on.

  2. Echoes of Big Short …not really, a faint echo if I’m being generous.

    – Aussie mortgages are full recourse ie you cant just hand your keys back to the bank if you cant make your mortgage payment as in the states. Aussie borrowers are personally liable for any shortfall if foreclosed sale price is less than mortgage.

    – Housing selloff has been huge and we might not even be halfway yet, however remember we had an approx 60% run up in prices for the 5 years preceding correction. That is a shedload of equity built into the older vintages. I would concur with article, that non bank issuance (particularly for mortgages written just prior to selloff) would need to be paying well to compensate for extra risk.

    • Mortgages in SMSFs are not full-recourse. They’re fire-walled. I’m looking for the first big blowup to occur in these as IO loans reset to P&I. No surprise then that banks have recently closed the door on these loans.

      • PlanetraderMEMBER

        Technically yes but actually no – most required external gtee as I understand

      • The mortgages themselves are full recourse to the mums and dads who are the underlying mortgagors.
        The RMBS bonds are NOT recourse to the issuer (the non-bank lender or originator) however it is customary/common for many issuers of securitised bonds to retain part of the equity layer/strip. In good markets the equity layer pays out handsomely. In bad markets, like these, the owner of the equity strip will likely dust their dough.

      • Yes a lot of SMSF lending required Trustee/Members personal guarantees as well.

        re full recourse normal home lending, this will make it more of a disaster for Aussie borrowers, a longer recovery, in the US if you could walk away from your mortgage it allowed you and the economy to recover quicker I imagine.
        The Aussie borrower and family are going to be wiped out, with social and community housing as well as charities being overrun I think.
        The governments of the day,state and federal, will have a field day building and/or buying extra social housing stock, they will need it, and it will give some people jobs.

    • Stop with the spruik:

      A study by two Federal Reserve economists debunks the notion that the US has non-recourse loans. Out of the fifty states and D.C., 11 are non-recourse. All of the remaining 39 states are recourse. On top of this, in some of the non-recourse states, the first mortgage many be non-recourse, but all proceeding mortgages are recourse. Also, it often depends on the legalities and judges’ decisions as to whether a borrower is required to pay back the full value of the loan in a non-recourse state.

      Worse yet, some of the states that experienced the largest housing bubbles have recourse loans, for instance, Florida and Nevada, whereas California and Oregon, similarly affected, have non-recourse loans. Overall, there is no real difference between states that have recourse and non-recourse loans, apart from recourse borrowers who tend, on average, to hold onto their properties longer before defaulting.

      Ireland experienced a colossal run-up in prices over the last decade, resulting in a crash and subsequent debt-deflation that has ruined the economy. What is not said is that Ireland has recourse mortgages, governed by strict rules, and non-payment may even result in imprisonment. Clearly, recourse mortgages did not prevent a bubble from forming in the housing market.

      • Thanks Geordie, good post. It seems there can be no limit to the number of reminders placed in the comments section of this blog that non-recourse mortgages existed only in a minority of states. The other point to note – not mentioned in your post – is that a non-recourse borrower who walked away from their mortgage took with them a tax obligation for the loan amount, so there’s no free lunch.

      • @Geordie fair point mate – implying full recourse to whole of US is inaccurate. That said, I dont know if you have read the report you referenced, but the conclusion reached makes it very hard to dismiss the non-recourse effect for such a large swathe of the US population. As per report’s conclusion:

        $300k to $500k properties the probability of default is 81% higher in non-recourse states than in recourse states
        $500k to $700k properties the probability of default twice as likely
        $750k to $1m , 60% more likely

        Also I am definitely not a spruiker, (remember Joye (author) is the one selling a short credit portfolio underweight RMBS here!)
        I welcome the correction as much as i do any cap gains/neg gearing reform. All long overdue IMHO.

      • Non recourse delays the default, as borrowers naturally try to keep up payments.
        Probably makes it even more disastrous.

    • reusachtigeMEMBER

      Yep totes man. You know the famous saying – “You stay the course with full recourse. You bolt on your horse with non-recourse.”

    • Problem is, Kensz0, that recourse or not, the result is the same for the banks.

      Non-recourse: The bank is lumped with the debt and holds the asset, may be able to pursue mortgagee for losses.
      Recourse: The bank is lumped with the debt and holds the asset, and can pursue the mortgagee for losses, however without a job or any prospects of getting one, the bank will get nothing from the mortgagee (personal insolvency, anyone) is still stuffed short term.

      If this happens en masse, you take down the banking system in both systems. Game over.

      Sure, we have some people who paid to shield the banks from loss via mortgage insurance, but if defaults become material it’s reasonable to assume that the stress this will put on mortgage insurers as they’re pressed to pay out will likely render them insolvent too, or at the very least unable to pay up immediately. Down goes the banking system. Game over.

      It’s hard to see a way out short of the Govt bailing people out, nationalising their mortgages (and home) or the worst of the lot, bailing out the banks to “save us”. *dry retches*

      • I wouldn’t be surprised if the Government of the day does bail out Aussie borrowers somehow.
        Probably way better then bailing out the banks, “QE for the borrowers”.
        Obviously, after saying it, that isn’t going to happen as the Banks will fight tooth and nail to stop that happening.

    • People have addressed the first point enough.
      The second point your assuming everyone bought at the bottom.
      Reality is people buy in a various points in time with volumes increasing in 2017 and 18, near or close to the top.

    • Jingle mail in the US property market is a common mis-description or over-simplification of the US resi mortgage market.
      Very few US states had laws which supported jingle mail. the overwhelming majority had full recourse lending.

    • How many times are you going to repeat the same lie about “non-recourse”? Just stop it already.

  3. And let us not forget just how much damage has been done to the Citizens of the Great U.S. of A. in pursuit of profit in free markets:

    One in five US adults now lives in households either in poverty or on the cusp of poverty, with almost 5.7m having joined the country’s lowest income ranks since the global financial crisis.

    Many of the new poor, or near-poor, have become so even amid an economic recovery that is widely expected to lead the US Federal Reserve to raise interest rates next week for the first time in almost a decade. More than 45 per cent of them — almost 2.5m adults — have joined the lowest income ranks since 2011, long after the post-crisis recession was ostensibly over.

    What is remarkable about Kevin Thomas these days is that he has what, at $13 an hour plus benefits, counts as a decent job. And that, earning the equivalent of $27,000 a year before overtime and supporting a family of four on an income just a few thousand dollars over the poverty line for such a household, he considers himself a member of the American middle class.

    It’s safe to say there was no recovery or respite from the GFC for many Americans and the legacy of the GFC continues on to ensure they remained third world labour in a first world country.

    So glad Australia is so keen to following this most excellent, ethical and equitable lead. *pukes*

  4. When ANZ talk 10 year Interest Only mortgages they are talking about existing RMBS that need to be converted to I/O so as not to implode. All the Super Funds that own these dog turds will get a cash flow but no return of capital. So lump sum payouts are history.
    That is my guess !

  5. Thank you Geordie, this “yeah, but Oz has full recourse loans” is a paper tiger. As Medio pointed out all those negative cash-flowing SMSF sure the f*ck are, and besides, whose the bank going to chase down, the fund? The only assets that are in them are now underwater non-cashflowing sh*tboxes. Also, in Oz if you can prove that your broker/banker altered your application, ex post your signature, and/or falsified expenditures (they ALL did, it was deliberate and systemic) you get the house for free. You get the deed and the mortgage is considered null and void. Wait until we get the ruling(s) from those HEM hearings. If precedent is set and the use of the HEM is declared “illegal”, BOOM!! Goes the whole thing. Can see/hear the billboard/radio adds now:. “Did your broker/banker get you in over your head? Do you have negative equity? Do you want your house for FREE!, call me, Bill Buttlicker, of Dewey, Cheating and Howe and I can get you your house for FREE!”. Put a fork in’m’, the banks are done.

    Boom! Goes the dynamite!

      • You’re right. That would require the government to act on behalf of Australians and not business (banks and other heavily vested interests), and pull the biggest asset rescue and restructure in history. See comment above regarding the cogs required for such a manoeuvre.

        Prof Cameron Murray has already suggested a mechanism to do it equitably and simply, but yeah, never going to happen even if Martin’s Iceland 2.0 scenario rolls into Sydney harbour and drops anchor.

      • Yes, they will, if you can prove that the broker/banker falsified the mortgage application through income and/or expense fraud, without your knowledge and after you signed the application, then yes you get the house. Its already been done. Google “Denise Brailey” if you don’t believe me. Why do you think the banks are shatting all over themselves about these HEM cases, they know they are f*cked. And how long do you think its going to take Mr. Institutional Investor to ring up and say, “Hey, you sold me bunch of, now known, fraudulent (they didn’t become fraudulent, they were fraudulent from origination), we want our money back, NOW!” First one gets there money out, second, third…not so much. Hello, institutional investor RMBS bank run, same sh*t as US, but with an Aussie accent. Remember it wasn’t until the money market funds started breaking the buck that things went Chernobyl.

      • You won’t get the house.

        I dislike the current system as much as anyone but there is simply no way. At best you might get the loan contract set aside and all your deposit and repayments refunded. You won’t get the asset as well.

        If you have a specific reference like a legal precedent please provide it. I am aware Denise Bradley has asserted it but that is not evidence. A legal case or some legislation might help though, if you have it?

      • Edward, in the majority of disputed cases for Westpac (before the courts) the HEM was used when it exceeded the expenses submitted by the applicant. In other words, the applicant was lying through his/her/their teeth. The case against HEM is not cut and dried, as the original judge highlighted. It’s hard to present a plea for redress when your original application was total sh1te and you, the borrower, signed off on it. In the case of falsified applications, particularly by mortgage brokers, there is an avenue. But then you have to prove that the broker did it. The whole thing will get bogged down in legals.

      • Arrow, not trying to debate but the laws are already on the books. “Responsible Lending”, all the consumer protection laws, etc. if applied could prove the fraudulent nature of all these loans. You can’t commit fraud against consumers and yes, filling out fraudulent mortgage applications, without the applicants knowledge (a BIG IF, in Oz) is against existing laws, that was proven with the Royal Commission. The bank doesn’t hold anything other than a known fraudulent mortgage, they have no claim on the property because the original claim was fraudulent in the first place. I’ve have bought and sold enough property(ies) over the years to at least have a basic understanding of the process. If you can prove that the mortgage is fraudulent and you were unaware or if you’re able to verify the fraud, ie. fraudulent pay stubs, fake signatures, etc. There is no contract, the deed gets passed to you because you’re the owner of the property, and the bank has no claim against it and the banks eat it. The banks only hold the deed as collateral on the mortgage/loan, but if the mortgage is deemed fraudulent/invalid, there is no claim against it, its yours free and clear. Might have to jump through some hoops, but that’s what lawyers are for. I’m not a lawyer, but have some friends that are, I will see if they can find me a precedent or case where the “owner” got the house for “free” after proving broker/banker fraud. Just enforcing existing consumer protection and property laws is all anyone would have to do. Why do you think the ambo chasers of Oz are wetting themselves with excitement? These HEM cases could mean billions for them. Most consumers don’t know, or most likely, don’t have the funds to fight the banks, and get scared with the first nasty letter.

        And BTW: all this broker/banker mortgage fraud was nothing more than a criminal cartel based counterfeiting scheme. The fact that they were licensed to do it by our own government makes it all the more deplorable.

  6. History doesn’t repeat but…you know the rest.
    Yes we know
    History doesn’t repeat but…we learn nothing from it

    It’s different here and now … like always and everywhere

  7. Exact same thing is pooled mortgage trusts and peer to peer lending. Reported LVR’s, even for loans being offered to market now are based on valuation reports up to 12 months old!