Notwithstanding we are 10 years beyond the global financial crisis which was largely precipitated by reckless mortgage lending in the United States, I’m often confronted by negativity for Australian RMBS which often is confused with CDOs. In addition to RMBS’ guilt by association with CDOs, the current deflationary environment in housing is also causing consternation with mortgage-backed-securities. But, forget the noise, the facts are RMBS provide great relative value on a risk adjusted basis.
RMBS and house prices
RMBS are structured to withstand a deflationary house price environment. At its simplest, AAA bonds are structured to assume a 45% market value decline in house prices while a single B-rated bond assumes a 30% decline. While it is ideal for house prices to rise during the term of the subject RMBS, it is of secondary importance to the risk of a borrower defaulting. The logic behind this is that an RMBS is only exposed to the market risk on a house if the mortgagor/borrower default. For the most part, owing to the mortgage being recourse to the individual, Australians continue to service their mortgage provided they remain employed - even if their house drops in value.
Accordingly, when modelling potential losses in RMBS, the greater risk is an increase in the cumulative default frequency curve rather than house prices falling in isolation. Of course, housing activity has a large multiplier on the economy and when house prices decline the wealth effect is negative for discretionary components of the system.
The differences between CDOs and RMBS
The essential difference between RMBS and CDOs is the collateral that backs the issuance. In the case of RMBS, as the name suggests, they are always backed by registered first mortgages over Australian real properties. CDOs on the other hand is a generic term and they can be backed by a variety of assets such as bonds, loans or any other asset that pays a yield, like credit default swaps or mortgage-backed securities. Further CDO structures pre global financial crisis became exotic, such as the issuance of CDO squared. This is the practice of one CDO structure investing in another CDO structure, therefore magnifying financial leverage.
The other difference beyond the standardisation of the collateral backing RMBS is that they are not actively managed. An RMBS provides investors with a static pool of individual mortgages which can be scored and credit assessed. This allows the structure to de-risk over time as the majority of underlying mortgages pay principal and interest. When mortgagors sell or refinance their property this pays off the AAA rated notes and increases the level of subordination in the structure. This is an important feature of RMBS vis a vis CDOs and even corporate bonds, neither of which de-risk over time. On balance, a BB rated RMBS will become BBB rated in about 18 months after issue.
CDOs generally take sub-investment grade bonds (or colloquially known as “junk bonds”) with assumptions around diversification and correlation. Truncating turns those ‘risky’ bonds into a portion of safe AAA rated securities. Unfortunately, this does not turn risky bonds into safe bonds, they always remain risky. Another difference between CDOs and Australian RMBS is that they are one step removed from the security of a first registered mortgage over property. CDOs may buy RMBS, hence there is leverage on leverage. Further, CDO structures are not buying the safer bonds, but are buying the sub-investment grade bonds and issuing a portion of AAA rated securities.
Funding mechanism (“RMBS”) versus fee generation vehicle (“CDOs”)
The issuance of Australian RMBS is a method of funding for the originator of the underlying mortgage and they always maintain an economic interest in the structure, via receiving the net-interest-margin and ordinarily holding the most subordinated note in the capital stack. Accordingly, the originator is incentivised to be prudent in both writing new mortgages and with the ongoing management of the structure. Conversely, the originator of CDOs is essentially an asset management business with the CDO originator earning asset management fees and not holding a ‘paid-up’ economic risk in the structure. For example, Lehman Brothers would simply buy bonds in the secondary market, bundle them into a special purpose vehicle, and that vehicle would issue CDOs truncated into AAA, AA, A, BBB, BB and equity. Lehman Brothers would earn management fees for actively managing the CDO, therefore they were incentivised to continue grow the pool of issuance, and unlike RMBS, CDOs have little connection to the real economy.
The structure superiority of RMBS
Banks can largely be considered a large residential structured finance vehicle, with around 70% of the banks' balance sheet composed of residential mortgages. In effect, holding equity and hybrids in the banks equates to being structurally subordinated in the capital structure with no underlying security backing the obligation. RMBS on the other hand are secured obligations with a first ranking claim on Australian properties with no senior ranking obligations ranking ahead.
Figure 1
Conclusion
While I understand negative news attracts greater readership then a positive or balanced view, the facts are, RMBS are secured obligations whereby investors assume systemic rather than idiosyncratic risks. Further, they are structured to withstand a deflationary housing environment. Financial market commentators often in isolation comment about household indebtedness at unprecedented highs, but what is not often quoted is interest rates are at unprecedented lows. Moreover, household debt needs to be considered in light of household assets. In Australia, the value of housing stock to the outstanding value of mortgage debt is around 3.8x or residential mortgage debt is around $1.8tn while the total value residential dwellings are around $6.9tn (source: ABS).