17 September 2018
David Hanna – Senior Portfolio Manager, Global Fixed Income
There’s certainly been no shortage of headlines recently around the Australian housing market, mortgage lending, and supposed impending credit crunch.
While headlines can draw attention to important matters, they can also be sensationalised to capture the reader’s attention; distracting and creating confusion around what is really happening.
With this in mind however, and after several years of positive momentum, is it now time to be worried about Australian mortgages? And should those concerns extend to Residential Mortgage Backed Securities (RMBS)?
What house price crash?
Anyone reading the news recently could be forgiven for believing that the housing market is in free fall.
While it’s true property prices have moderated from the highs posted last year, and the Royal Commission is also reducing the banks’ appetite for providing more marginal loans, at a national level house prices have declined by only -2.0% from last year according to CoreLogic data. This is far less than the -6.5% decline experienced in 2010/11.
In Sydney, the decline has been a more meaningful -5.6%, though this is not uniform across all properties. High priced properties have fallen more than low priced properties, with properties at the more affordable end of the spectrum attracting a wider range of buyers.
Australian house price Year on Year change
Source: CoreLogic – August 2018
What about RMBS?
RMBS are financial instruments that pool residential mortgages together, allowing institutional investors to gain exposure to those mortgages.
RMBS performance is predominantly linked to the ability of borrowers to repay the loans. While movements in house prices can influence borrower behaviour, falling house prices is not a primary factor for borrowers to miss repayments. The big three reasons for borrowers to fall behind on mortgage repayments, also referred to as arrears, are unemployment, health, and divorce.
Over the years we have developed a Safety Factor Model that allows us to go one step further than most RMBS investors. It allows us to rank RMBS based on the quality of the underlying mortgages relative to the protections offered through the structure of the RMBS. This means we can break up AAA rated securities and adjust our holdings. So, when most investors consider AAA RMBS homogenous, our model allows us to ensure we identify and avoid those with deteriorating mortgages, and overweight RMBS able to withstand a softening housing and mortgage market.
Loans in arrears – why the devil is in the detail
Overall, given the current low unemployment rate and historically low interest rates, we do not expect to see arrears rising significantly anytime soon - but the devil is in the detail.
S&P publish RMBS arrears rates in its monthly SPIN index, which gives a good indication of the overall health of the mortgage market. As expected, this indicator is currently showing very benign conditions with only 1.0% of borrowers behind by one or more payments.
While this is a useful indicator, we believe it can be influenced by new loan issuances, and hide underlying stress in smaller segments of the market such as investors, self-employed borrowers, or high loan-to-value loans.
After analysing our database containing over 306,000 individual home loans, from September 2017 to September 2018, we found:
- high loan-to-value loans (more than 80% leverage) increased to 2.4%, up 0.6%
- loans to the self-employed increased to 1.1%, up 0.2%
- investor loans increased to 0.7%, up 0.1%.
We believe it’s important to note that two of the more cashflow-sensitive segments, high loan-to-value, and self-employed, may start responding to tighter lending standards. We are not yet ready to call this the canary in the coal mine movement, but it does warrant additional scrutiny going forward.
Interest-only loans – an imminent threat?
Due to macroprudential restrictions, interest-only loans are getting a lot of media attention.
By tracking individual loans over time, we have been able to identify those which have converted to principal and interest from interest-only. Our findings showed loans converting from interest-only to principal and interest, underperformed the broader market, but also showed signs they may normalise after a period of adjustment.
Our research also shows a wall of interest-only loan expiries coming up in 2020. Given the longer time-horizon, we have this on our radar, but do not see it as an immediate concern.
Percentage of interest only loans expiring each year
Our view remains broadly positive on the RMBS market.
However, given the softer housing market, and potential for weaker arrears performance, we have reduced our already limited exposure to the riskiest parts of the market even further. This reduction is a step towards a more cautionary stance and locking in gains from strong performance of subordinated securities. Given their strong performance, these securities are now offering limited value versus shorter dated and more senior RMBS.
Shrinking excess return in riskier RMBS