Australia | Aug 03 2009
By Greg Peel
The Australian Securitisation Forum has a proposal for the government on the table to address the problem of the mortgage securitisation market having been “closed” since the US subprime crisis turned the world upside-down. This involves another form of securitisation vehicle known as a “covered bond”. Full details of the proposal were outlined by our friends at banking industry e-zine The Sheet last week, available on our website (Covered Bonds An Option ).
The article prompted FNArena subscriber Liz to ask:
“Are not these sort of ‘bonds’ how the subprime mess started in the first place? Or am I missing something?”
It is a very good question and thus worthy of this open reply for the benefit of all.
The simple business model of a bank is to take in deposits and pay the depositor interest while on-lending that money to borrowers for the purpose of mortgages, investment loans, business loans, car loans and so forth. The bank charges a higher rate of interest on loans than it pays on deposits, and that margin is the bank’s profit. In carrying out this business, a bank leverages the value of the original deposit given both the depositor and the recipient of the loan can lay claim to the same parcel of money at any time.
A pool of deposits allows for a good number of loans of what is really just the same money, and provided the borrowers pay their interest on time and ultimately pay back their loans, and provided depositors don’t all one day decide to withdraw all of their money at the same time (known as a “run”), then the whole system keeps ticking over, everyone’s happy and the bank makes a profit. Without such financial leverage it is impossible for an economy to grow.
However, given the vast array of investment opportunities open to everyone today, the humble bank deposit and its low rate of interest is not as attractive an investment as it was for earlier generations. Thus to build a successful, growing business, banks need to supplement their balance sheets with other forms of funding and so provide a greater pool of funds and greater leverage potential for the purpose of lending more money. Nearly all businesses are funded on a balance of debt and equity, and banks are no different.
Australia’s listed banks obviously have a proportion of equity on their balance sheets provided by the investment community. Ordinary shares on issue and standard bank deposits make up the bulk of a bank’s “tier one” capital. To satisfy government and central bank regulations, banks must maintain tier one capital ratios at a prescribed level. Currently Australia’s Big Four banks are maintaining tier one ratios of around 8.5%. On this basis they are permitted to leverage that money by 100/8.5 or 11.8x. In very simple terms, banks are allowed to lend out your deposits/shares twelve times.
But banks also fund their lending activities by themselves borrowing money, which they do by issuing debt. The most common form of bank debt in Australia is the 90-day “bank bill” which provides short term funding for banking operations. Banks can also issue longer dated debt in the form of “corporate bonds” of maturities out to several years, which serve to provide a closer-matching maturity of borrowing for the purpose of lending on longer dated bonds such as mortgages.
These days banks prefer to issue a whole range of complex debt/equity “hybrid” bonds, but I’m keeping this simple.
You’d think that between deposits, issued shares, bank bills and corporate bonds banks would have enough funds to carry on a nice, safe, profitable little banking business, and for generations this has been the case. But in recent decades banks have been threatened by competition from smaller banks and non-bank financial institutions (NBFI).
NBFIs include co-operative credit unions and “building societies” (such as St George once was) and, most recently, mortgage specialists such as Aussie Home Loans started out as. The former two businesses follow a more traditional banking model of taking in deposits and lending on mortgages (for example) but the latter is merely a “conduit” – a means of connecting borrowers and lenders. Critical in the rapid rise of such conduits is the fact that prime mortgages offer a AAA-rating and most other forms of loan (investment, car, credit card) do not. Prime mortgages (which are issued to a home-owner on the basis of a significant cash deposit, credit history, security of salary and so forth) are among the safest form of loan for a bank to make given there is a house as collateral, house prices rise over time, salaries usually rise over time (as a borrower’s career moves along) and they are spread out typically over twenty years or more.
But a bank lends money for all sorts of purposes, and to all sorts of people. In each case the risk on such lending is evaluated and an interest rate set appropriately. The higher the risk, the higher the interest rate. That’s why mortgages attract the lowest level of bank loan interest and individual credit cards the highest, with everything else in between. Because Australia’s Big Four Banks lend on most everything and not just on mortgages, they are themselves only afforded an AA rating. A smaller bank might be a BBB, while a co-op or conduit lender would not have any credit rating.
So here’s the rub. Westpac, for example, borrows money itself on AA interest rates but issues mortgages which are AAA. Yet Westpac takes a margin and thus a profit on its business. Why should I lend Westpac money on an AA risk so they can lend on an AAA risk? Why don’t I just lend the money for a mortgage directly, cutting out the middle man and the extensive costs of its comprehensive banking operation?
And that’s how “securitisation” was born. NBFIs would package up mortgage loans into bundles, and then sell of those bundles as an AAA-rated debt asset to banks or hedge funds or other investors. The buyer of the bundled (or “securitised”) asset would have no recourse to the conduit, but would assume the default risk on the mortgages. The greater the number of mortgages, the more the default risk of the bundle is diffused.
One might recall that Aussie Home Loans was a pioneer in this new market in Australia. Aussie’s selling point was that banks were charging too high a rate of interest on mortgages to compensate for risks they took on other forms of loan, but by dealing only in mortgages Aussie could offer a cheaper rate. Australians love a bargain, and pretty soon Australia was swamped by the new mortgage securitisation market (Wizard, RAMS and everyone else in between). Such a market cut deeply into the business of traditional banks, so pretty soon the banks were also knee-deep in the securitisation game. Such a market had, however, been long established in the US.
So fierce did mortgage securitisation competition become in the US that lenders started to take bigger risks. Required deposits on houses were reduced down to zero and even beyond – to the point banks were not lending 60% of a house’s value but maybe 105%. Documentation requirements were also eased (employment and credit records, list of assets) to provide first the “lo-doc” and then the “no doc” loan. And mortgage brokers sprung up like mushrooms to join in the spoils of this new bonanza.
Then in 2004, the US Fed dropped its cash rate to 1%. Suddenly money was very cheap, making it very hard for banks and NBFIs to make profits. They needed to issue more and more mortgages and package them up into debt securities. On a greater risk banks can charge a greater interest rate (a greater spread over cash), so the trick was to issue mortgages of much higher risk – the infamous “subprime” mortgage. A combination of cheap cash, risk-hunger and eventual fraudulent practices in the heat of battle eventually led to the ultimate subprime mortgage – the NINJA loan (no income, no job, no assets).
Cheap money and easy-to-obtain mortgages fuelled the US housing bubble. But the same time, there was another problem. These new riskier mortgages were obviously not rated AAA, and indeed subprime mortgages were granted no credit rating at all. Many investment funds, who had been quite willing to provide bank funding by buying up AAA prime mortgage securities, were either unwilling to or not permitted by their own mandates to buy anything other than AAA, or at least certainly not unrated securities. The sell-side was very willing (prospective homeowners) but the buy-side was not forthcoming (ultimate debt security investors). Then someone very clever had an idea.
So was born the “collateralised debt obligation” (CDO). These are extremely complex instruments and I won’t go into all the detail here, but suffice to say by packaging up mostly prime, a bit of medium-prime, and a tincture of subprime mortgages into one mortgage security, sold off in tranches of varying default risk, CDO issuers were able to issue an AAA-rated security that contained unrated credit risk. The unrated credit risk element was only tiny, but just as the fabled butterfly causes a tsunami, so can one small default at the subprime end ultimately bring down the entire mortgage package. The risk of such foreclosure was nevertheless very small, provided there wasn’t a collapse in house prices. But of course, the CDO market fuelled its own bubble.
And that bubble burst. The rest is now history. CDOs collapsed in value, hedge funds went broke, large investment houses were brought down as a result and the subprime crisis became the credit crunch became the GFC. Commercial banks had offered lines of credit to investment banks to package up mortgages and sell them to hedge funds which paid with money borrowed from the same investment bank. It was a totally opaque, “over-the-counter” market. A hedge fund investor in Luxembourg would have had no idea his risk lay with an unemployed mortgage-holder in Florida. The whole system was so interwoven that the subprime butterfly caused the GFC tsunami, and no one could stop it.
Since the subprime crisis began in 2007, the mortgage securitisation market has been ostensibly shut.
This proved to be bad news for smaller Australian banks, NBFIs and even subsidiaries of international banks. They had lost their major source of funding. Many mortgage brokers and NBFIs have now vanished, international banks have sold up and moved on, regional banks have merged, and smaller banks such as St George and BankWest have been swallowed. The Big Four have also suffered as a result of the GFC. But given their market capitalisation, their capacity to raise fresh capital, their capacity to increase their already substantial deposit bases and their ability to exploit an AA rating to attract offshore funding (albeit at a wider credit spread), the Big Four have survived. And because their competition relied so heavily on securitisation, the death of securitisation has not been so much as a setback but a boon. Australians have raced back into the safety of the big banks.
Nor did Australian banks stoop to subprime levels as low as the US had reached. Indeed, while “lo-doc”, “no-doc” and high loan-to-value ratio mortgages were offered by Australian banks, none could seriously be labelled as “subprime” in the US sense. Nor did Australian banks carry excessive exposure to investments in CDOs and other “toxic” securities.
But mortgage securitisation was indeed rife in Australia. There’s nothing wrong with securitisation at all, as long as inherent risks are correctly identified and priced accordingly. It was not securitisation per se which caused the GFC. All asset-backed securities were nevertheless tainted by the same brush as far as the global investment market was concerned, forcing the Australian government to step in as a buyer of existing securities and prevent the local market’s collapse-by-association. But such support is soon to come to an end.
In order to prevent the gap left in bank funding by a frozen securitisation market becoming permanently so (thus adding to impediments to a return to normal economic growth), the Australian Securitisation Forum (ASF) has been attempting to come up with ways to reintroduce securitisation in a safer form. One suggestion is for banks to issue what are known as “covered bonds”.
Covered bonds have long been popular in Europe as a variation on the asset-backed security. Asset-backed securities such as residential mortgage-backed securities (RMBS) are packaged up by banks and on-sold as a debt investment alternative. The buyer of the security takes a risk on those mortgages defaulting and the issuing bank offers no guarantee. Debt investors can also choose to simply buy the issued debt of the bank itself, via a bank bill or corporate bond for example, thus investing in the bank that issues the mortgages rather than the mortgages themselves. In this case the risk is of the whole bank defaulting, not just a number of mortgages.
But as previously noted Australia’s big banks offer interest rates on their debt based on a AA rating while “prime” mortgages are individually AAA rated. A covered bond is a bond issued by the bank which is “covered” by a specific set of mortgages. The bond can thus be offered as a lower risk instrument at a lower interest rate. They are basically an RMBS with a bank guarantee. For the investor to lose his money the whole bank would have to go down, not just the mortgage bundle.
The Australian Prudential Regulation Authority (APRA) has not allowed covered bonds in Australia in the past because as a form of secured debt, a covered bond would rank above a deposit in the event a bank went into liquidation. APRA decided this was not commercially fair to deposit holders. But in light of the GFC, the Australian government has since guaranteed deposits to a certain value, thus providing insurance for deposit holders. The argument thus is with this new legislation in place, covered bonds now become viable.
The ASF has also suggested alternatively the government could act as guarantor to RMBS directly, but how much financial risk can the taxpayer ultimately be subjected to? The government became a buyer of RMBS post-GFC to insure against the ramifications of cascading local mortgage and banking collapse, but now that the dust has settled somewhat the government would like to withdraw its support and let the private sector reassume control. Covered bonds are a way of achieving that.
So to answer the question, Liz, a covered bond issued by Australian banks would be “covered” by “prime” mortgages which are undeniably AAA-rated, and not by “subprime”, unrated, high-risk mortgages, nor by toxic, misleadingly rated concoctions like CDOs. In one sense, covered bonds are a way of returning the Australian mortgage securitisation market to that which was originally intended – a means of providing more affordable mortgages for Australians by passing the risk on to willing investors via the conduit of a guarantor bank.
As interest rates begin to rise again, such mortgage relief – properly regulated and tracked – will be welcomed by prospective home buyers. On the other side, AAA-rated bonds based on hundreds of mortgages should be a popular debt security investment for those worried about sovereign AAA alternatives such as Aussie bonds or (heaven forbid) state-issued debt which are beholden to fiscal and monetary policy decisions.
No – we are not going back there. Not for a long time anyway.