The active Australian mortgage-backed securities market is heading for a strong year, but the medium-term outlook is becoming clouded by developments that appear to have negative implications.
Foremost among these is the Australian Prudential Regulation Authority's take on proposed changes to the capital adequacy framework for banks: local market participants fear that APRA could implement the changes in such a way as to slow the MBS market's development. At the same time, concern for the credit quality of mortgage insurers is growing, sowing a doubt about the integrity of what many offshore investors (particularly in the U.S.) regard as a key structural component of the Australian market.
Last but not least, local investors are having to deal with a small but significant prepayments shock arising indirectly from the introduction of a goods and services tax.
Cross-border Deals
First, the good news. Mortgage-backed issuance down under during the first three quarters has overtaken that for the whole of 1999, which was a record year for the non-government bond market in Australia.
According to figures compiled by ANZ Investment Bank, year-to-date issuance totals A$7.65 billion, a 64% increase on the A$4.66 billion completed last year. Part of the upsurge can be explained by the repatriation of many deals which, under normal circumstances, would have taken place offshore.
Many of the larger issuers, which have a long track-record of overseas issuance, have been steered back to the domestic market by the historically wide A$/US$ basis swap. That said, however, issuers are discovering unprecedented levels of domestic demand. Last month, Australian Mortgage Securities (a subsidiary of ABN Amro) financed A$1.5 billion of mortgages, half through an MBS issue and half through a revolving credit facility.
Unusually, the whole of the MBS issue consisted of floating rate securities. Previously, demand for floating rate notes had run at between A$200 million and A$300 million per deal, not A$750 million.
The BIS
The news concerning proposed new capital adequacy arrangements was not all bad, either. Macquarie Bank - in a report timed to coincide with last month's central banker's conference hosted by the Bank for International Settlements in Basel, Switzerland - argued that the proposed changes could benefit the MBS market by giving banks a greater capital incentive to remove home loans from their balance sheets.
The incentive arose from the proposal to link loan risk-weightings to external credit ratings. Under the current capital adequacy framework, introduced through the 1988 Basel Capital Accord, banks set aside a notional $8 of capital for every $100 of loan face value as a buffer against default.
The actual amount set aside is weighted according to the perceived risk of a given loan category: for example, home loans are weighted at 50% and business loans at 100%. This means that $4 is set aside for every $100 of home loans, and $8 for every $100 of business loans.
Under the proposals now being discussed, loans with credit ratings from AAA to AA- would be rated at 20%, while those rated A+ to A- would be risk-weighted 50 per cent, and so on down to B+ or below, after which the full value of a loan would be deducted from the bank's capital.
As Macquarie pointed out, this template offered a credit arbitrage based on the fact that that a typical prime Australian MBS issue has no tranche rated lower than AA-: a bank can securitize a pool of loans and the whole issue will have a lower risk weighting than the original pool of assets (20% versus 50%).
In a submission to the BIS, however, APRA has argued that the template should take into account differences in risk culture and historical loss experience from one country to another. The Australian home-loan market has a risk-averse credit culture and an excellent loan default track record.
According to the regulator a home loan capital allocation of as little as 1% might be adequate. Under these circumstances, said Macquarie, the advantages of a bank diversifying its funding sources and freeing up its capital (through securitization) become less persuasive. The BIS is understood to be preparing a discussion paper for publication early next year.
Warnings For Investors
Standard & Poor's, meanwhile, has made its presence felt with the decision to put CGU Lenders Mortgage Insurance - one of the country's five major mortgage insurers - on credit-watch negative.
S&P's action was in response to a merger between the company's British parent and a third party, on the basis that the local business would be of less strategic value to the merged entity, and would therefore receive less support.
The move affected A$80 billion of subordinated MBS paper issued variously by Westpac Securitisation Trust and AIMS Resimac, much of it securitizing New Zealand assets. For various reasons, the scaling down of the ratings watch had little impact on the pricing of the paper. It served as a reminder, however, of warnings by both S&P and Moody's Investors Service that investors should carry out due diligence on the underlying mortgage insurers when buying Australian MBS.
On a lighter note, the July 1 introduction of the Federal Government's goods and services tax was held responsible for prepayment rates on some programs reaching up to 60% for that month, compared to a more normal 20 to 30%.
The reason: the GST added a 10% impost to the cost of new homes and renovations, and many homebuyers refinanced their mortgages ahead of July 1 so they could renovate and avoid the tax.
Some older MBS programs require loans to be removed from the pool once they have been topped-up or extended by homebuyers - hence the high prepayment rates. Again, there appeared to have been little disruption to the pricing on programs which had been most severely affected.
