Housing turns from threat to opportunity

Christopher Joye

Coolabah Capital

Today I argue that Australia is behaving like the indulgent and entitled child of a billionaire, quote my own 8 year old's analysis of what the two political parties have to offer (even I was surprised), and explain why we are not residential-mortgage-backed securities (RMBS) haters and arguably one of the few unconflicted parties running the numbers on the sector (click on that link to read or AFR subs can click here). Excerpt only:

Now there is one silly view that I am a huge RMBS hater, even though I helped convince the government to invest $15 billion into RMBS during the crisis. The fact is that we were large buyers of RMBS between 2012 and 2016 when: house prices were booming at double-digit rates; mortgage arrears were falling; borrowers were repaying loans faster than normal; the new issuance, or supply, of RMBS was weak; and, most importantly, credit spreads offered on these securities were historically high.

When every single one of these variables changed for the worse in 2017 and 2018, we rationally exited the sector: house prices started falling (registering their largest declines ever), destroying the value of the collateral protecting RMBS; mortgage default rates rose to the same levels experienced during the crisis (and may now be higher); home loan prepayment rates dropped like a stone, blowing out the expected life of these bonds; new RMBS supply soared to the largest levels since 2007; and the credit spreads offered on the bonds tightened to the skinniest margins in over a decade.

For the last year and a half we have felt like a lonely voice highlighting these risks, and published novel research to verify them. For example, we developed the world’s first “hedonic”, or compositionally-adjusted, index of RMBS arrears that showed they were climbing in contrast to Standard & Poors’ index that implied they were moving sideways (the S&P index was being artificially suppressed by the surge in new RMBS issues that are default free).

Indeed, since almost every bank in Australia is loaded-up to the gills with RMBS that they buy for their “liquidity books" and most fund managers have large allocations, often to the riskiest tranches with the highest yields, there has been an enormous amount of “book-talking” defending these positions.

While we tried to get short the sector, or profit from price falls, and were definitely shadow-short relative to peers, we were not able to do so for a bunch of complex reasons that would ruffle far too many feathers were they were revealed.

We have, therefore, been one of the few unconflicted participants when it comes to objectively evaluating the pros and cons of RMBS vis-à-vis other alternatives. Pretty much everyone else issues it, buys it, rates it, and/or clips the ticket advising on it.

In 2019 it has been the worst performing sector in Aussie fixed-income with primary, or new issue, credit spreads moving consistently wider since mid 2018. In the last week alone there have been an extraordinary 7 new deals in the market and this supply pipeline is unlikely to abate, which means spreads should push wider still.

But if the RBA cuts, the housing market turns, and Westpac prevails in its responsible lending case with ASIC in the Federal Court, we will consider buying fresh RMBS pools (not existing issues) over the next 1 to 2 years if they are priced correctly.

I generally like the secured (asset-backed) and self-amortising (where principal is constantly repaid) nature of RMBS and other asset-backed products, and the exposure you typically get to thousands of nationally diversified loans. But these are complex assets to understand and price, and the huge “long-only axe" in the market means most commentary and research tends to be biased and seriously understate the risks.

For example, we have regularly marked-to-market RMBS deals priced since 2017 with low levels of loan seasoning (ie, low weighted-average loan lives) using CoreLogic’s hedonic house price indices. This analysis reveals a striking increase in risk in many recent RMBS portfolios as a function of falling house prices and rising arrears. We can find deals where the share of loans with less than 10 per cent equity protecting them appears to have leapt from below 5 per cent to over 20 per cent. Indeed, one transaction looks to have 12 per cent of all its assets underwater, or in negative equity. This unambiguously increases the probability of rating downgrades and should, at the very least, demand greater compensation in the form of superior spreads.

Disclaimer: This information has been prepared by Smarter Money Investments Pty Ltd. It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Past performance is not an indicator of nor assures any future returns or risks. Smarter Money Investments Pty Limited (ACN 153 555 867) is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd, which holds Australian Financial Services Licence No. 482238 and authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited that holds Australian Financial Services Licence No. 255016. 

Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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