Banks Issuing Mortgage Securities At A Loss

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This story features BENDIGO & ADELAIDE BANK LIMITED, and other companies.
For more info SHARE ANALYSIS: BEN
The company is included in ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

You could be forgiven for thinking Adelaide Bank’s ((ADB)) recent issue of $350 million in residential mortgage-backed securities (RMBS) is an indication life is returning to the previously frozen mortgage security market. However, by JP Morgan’s analysis small banks and non-banks are currently making issues at a loss.

Why would anyone issue a security at a loss?

The answer, JP Morgan believes, is probably that lenders simply need the funding, and need to prop up their regulatory capital requirements, and as such issuing at a loss is the only way to keep the business going. One presumes the lenders are hoping to ride out the storm. Even Adelaide’s $350m issue is, by comparison to the past, quite a small one, possibly suggesting the bank is trying to limit the damage.

Adelaide’s problem is that it’s a small regional bank with a very low deposit base. Adelaide’s lending business has had to rely on recycling its mortgages into packaged-up securities for investors. Now that such securities are largely poison, Adelaide has big problems. If Bendigo Bank ((BEN)) succeeds in merging with Adelaide, it will bring with it a much larger deposit base. Some analysts are still wondering why Bendigo wants to undermine that by taking on Adelaide’s business.

And that is not even to consider non-bank lenders who do not offer deposit accounts. One only has to look at RAMS Home Loans’ ((RHG)) meek capitulation to Westpac ((WBC)) to see that trying to simply maintain funding requirements on existing loan books is an everyday challenge. RAMS sold its soul (it’s future business) for a mere $140m and a vague offer of some funding assistance.

JP Morgan’s bank analysts have had a look at numbers for small banks using third party brokers on a “then and now” basis. Six months ago, lenders would profit as such:

The standard variable mortgage rate was 8.07%, and then a discount (0.80%) would be offered to win the business in what was a competitive game. The mortgage broker would be paid 0.36%, so the money was effectively lent at 6.91%. The 90-day bank bill swap rate, at which banks lend to each other, was 6.34%, and then the credit spread on the riskier mortgage security was 0.18%. Hence the bank would borrow at 6.52%. The profit margin was thus 6.91 – 6.52 = 0.39%.

Today, the standard variable rate has been pushed up to 8.32% (without an RBA cash rate hike). The discount and broker commission remain, but the bank bill rate is now 6.88% and the credit spread for risky mortgage securities is 0.40%. Lending is thus achieved at 7.16%, while funding is obtained at 7.28%. The profit margin is 7.16 – 7.28 = (0.12%). Therein is the loss.

JPM raises the obvious question: why still offer such a discount? The simple answer is it’s still needed to win the business, particularly now that the big banks are squeezing their own margins to steal back prodigal borrowers and wipe out the small bank/non-bank players for good. If you can’t win any new business you might as well pull down your shingle.

(JPM doesn’t address the issue of why mortgage brokers can maintain their commissions despite being virtual pariahs, so one can only presume they’d been running on a high volume/thin margin basis to begin with.)

So will these small lenders be able to ride out the storm, as recent issues suggest they are hoping? JPM’s analysts think not.

The situation in the US, where subprime lending may have bitten the dust but adjustable rate mortgages are yet to reach their peak volume of crippling rate jumps (June 2008), is still critical. Thus the global liquidity crunch also remains critical. This means the Australian yield curve is still steep. Not quite as steep as it was at the top of the crisis, but still steep nonetheless. Credit (risk) spreads also remain significant.

This week’s news alone out of the US financial sector is enough to make local small lenders sick to the stomach. One by one, the likes of Citigroup, Bank of America and a swathe of regional banks have been reporting their shocking third quarter results and, even worse, predicting more trouble to come. There had been a hope that Q3 would represent the nadir of the credit crisis but banks are now warning that not only will Q4 fair little better, problems will certainly continue into 2008. Last night Bank of America wondered out loud whether the credit crisis may only just be beginning, not ending.

And further jitters were brought about by the news that an IKB SIV was going to have to sell US$1.2 billion of asset-backed commercial paper.

IKB Deutsche Industriebank is a mid-sized German lender specialising in asset-backed commercial paper issuance. IKB came rapidly to the attention of the world when, within days of the US credit markets freezing, it had to run to the German central bank for a bail-out. Early this morning it was revealed that Rhinesbridge – a Structured Investment Vehicle owned by IKB – had suffered an “enforcement event”. The SIV has had its credit rating slashed, and can no longer comply with capital requirements. Its only solution is to do what banks all around the world have been dreading – actually sell its assets.

To date, asset-backed securities (and particularly mortgage-backed securities) such as collateralised debt obligations (CDO) have been sitting on books across the globe at valuations that represent only wishful thinking. The market for such securities is frozen, so there is no way to actually determine a price. Many of these SIV assets have had to be brought back onto the balance sheets of sponsoring banks, where they are still valued in the hope credit markets will soon unfreeze. The risk is that someone, somewhere, is going to break, and try to offload the assets into the market at any price before the rush. This would be self-fulfilling, as a rush would surely transpire. Who knows how little such assets might now attract?

The US Treasury and the larger US banks have foreseen this eventuality, and set up a fighting fund to try to keep a shelf under asset valuations. Whether or not this initiative will prove Canute-like is yet to be seen. But it looks like Rhinebridge may be about to test the water.

JP Morgan’s Australian bank analysts retain their Underweight recommendation on their own sector for such reasons, and suggest that for those with a mandatory bank holding, Westpac and Commonwealth ((CBA)) are preferred over ANZ ((ANZ)) and National Bank ((NAB)).

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