Non-Conforming Loans : The risk is in the detail

Clive Smith

The recent growth in the non-conforming mortgage market has provided increased opportunities for investors to boost returns without the appearance of taking on much in the way of additional risk. But appearances can be deceiving and investors need to remember that there is no such thing as a “free lunch”.

What are non-conforming loans?

A non-conforming loan is one where the borrower has either an impaired credit history or is unable to supply full documentation when applying for a loan. As either of these conditions prevents the lender from taking out mortgage insurance on the loan the borrowers are viewed as being “non-prime” or more commonly referred to as “non-conforming”. Though often compared to US subprime loans, non-conforming loans in Australia are quite different. Australia regulators require that lenders have a “duty of care” to ensure that a borrower can meet loan repayments at not only current but also materially higher levels of interest rates. Accordingly, non-conforming borrowers in Australia, unlike their US counterparts, can still represent relative low risk borrowers.

This is not to say that there aren’t additional risks associated with lending to non-conforming borrowers. Several key points which raise the overall risk profile of such loans are:

  • Income streams for many borrowers may be more volatile and exhibit heightened sensitivity to economic downturns.
  • Absence of full documentation can make assessing the borrower’s ability to meet loan repayments more problematic and potentially open to more optimistic loan serviceability assessments.

There is no ‘free lunch’

As the accessing of exposures to non-conforming loans are likely to be via Mortgage Backed Securities (“MBS”), for most investors there are two main risks they need to focus on. The first is default risk which is the risk that investors lose money when borrowers are unable to service the underlying loans. Though the individual non-conforming loans exhibit higher risk characteristics this additional risk is often compensated for within the structures of the MBS themselves. By creating tranches with different priorities to the cash flows from the underlying loans, the default risks associated with investing in the more senior tranches remain quite low. As a result there appears to be little difference in the effective default risk associated with investing in the more senior tranches for conforming or non-conforming MBS. Given the additional yield available on non-conforming MBS, it may appear to provide a “free lunch” for investors.

Unfortunately, there is no “free lunch” once you consider refinancing risk, which has been increasing due to changes in bank regulations. Refinancing risk arises as the nature of mortgages means that :

(a) technically the legal maturity can be very long dated at around 25 years and

(b) the ability for the borrower to alter repayments results in the effective term of the mortgage being highly variable.

To provide greater certainty when mortgages are bundled up into MBS, and thereby make the issues more attractive to investors, the originators incorporate a call option within the MBS structure. This call option allows the originator to repay the investors in the MBS at a pre-set date, providing investors with greater clarity as to the timing of cashflows. The key point is that the ability of the originator to exercise the shorter dated call option depends on them being able to refinance the underlying mortgages. Such refinancing risk is not a material issue for large banks which maintain portfolios of mortgages on their balance sheets and have access to a range of funding sources.

Increasing the refinancing risk associated with non-conforming loans has been a range of regulatory changes for banks which has seen them take steps to reduce their exposures to this market. As banks have reduced exposures, more borrowers wanting non-conforming loans are having to go to smaller more specialist non-bank financial institutions (NBFI). The increased participation by NBFI’s increases the level of refinancing risk as they tend to have fewer sources of funding. Unlike banks they are much more dependent on their ongoing ability to issue new MBS to fund the repayment of existing MBS at the predefined call dates. The growing risk now is that any event which reduces investor demand for new non-conforming MBS has the potential to reduce the value and liquidity of existing MBS by preventing the originators from repaying the outstanding securities on the call date. To make matters worse this is most likely to occur at a time that the underlying financial conditions for non-conforming borrowers making up the collateral pool are deteriorating. The risk is therefore increased that a more modest deterioration in funding access for the NBFIs may be exacerbated by the development of a negative feedback loop within the non-conforming loan market.

The major risk lies increasingly with the financial institution

The evolution of the market has meant that the key risk associated with non-conforming mortgages is refinancing risk. Going forward there are reasons for believing that funding conditions will become less favourable as major domestic banks tighten lending standards and central banks move to less accommodative settings for monetary policy. Against such a backdrop it is increasingly important that investors be selective about the credit exposures they include within their portfolios. In non-conforming loan space this means not only checking the quality of the underlying loans but increasingly the quality of the financial institutions that are originating the MBS.

Clive Smith

Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...


Non Conforming Loans


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