Residential Mortgage Obligations in New Zealand – A new investment opportunity for investors
The existence of Residential Mortgage Obligations (RMO) isn’t new. It was only in 2017 the Reserve Bank of New Zealand started taking steps to develop a private traded market. The private market, which is expected to start developing post 1st July 2020, represents the introduction of a new high quality security for investors in New Zealand.
Background to RMOs in New Zealand
The initial RMO market came into existence in 2008/2009, in response to the liquidity issues faced by the banking system in New Zealand during the Global Financial Crisis of 2008 (GFC). Faced with issues around accessing global funds, the Reserve Bank of New Zealand (RBNZ), in order to provide liquidity to the banking system, allowed banks to package residential mortgages into securities. These were referred to as Residential Mortgage Obligations (RMOs), which could then be discounted back to the RBNZ. Although RMOs have existed for over a decade, the only trading has been between the banks and the RBNZ.
Why the change?
The catalyst for evolving the RMO market has been the desire of the RBNZ, along with central banks globally, to progressively reduce the contingent liabilities faced by governments and their banking systems. As part of this process, the RBNZ has decided that bank risk should, where possible, be increasingly shared with the private market. The RMO market, as it currently operates, serves as a case in point regarding contingent liabilities faced by governments. Not only is the RBNZ providing banks with relatively cheap funding but it is also assuming the full liquidity risk associated with the New Zealand banking system. It’s against this backdrop of reducing the contingent liabilities faced by governments that the RBNZ has begun the process of developing a liquid RMO market in NZ. Though the RBNZ has stated that the development of an RMO market is “to address the shortage of High Quality Liquid Assets in the New Zealand markets; offer mortgage lenders an additional funding tool; and support developing deeper private label mortgage bond markets”*, the overarching objective remains to reduce the contingent liabilities faced by the government and the RBNZ with respect to the banking system.
RMOs will be high quality and quite standardised
An important objective from the RBNZ’s perspective is that the final framework around the structuring of RMOs should result in high grade securities which satisfy a range of requirements. As set out by the RBNZ, the structure of RMOs should be that “The subordination and risk retention provided in support of RMO senior notes … keep RMO holders confident in the underlying credit risk profile and rating stability, in the underlying credit risk profile and to allow to treat RMO as primary liquidity assets for regulatory purposes on a permanent basis”. The dual requirements of ratings stability and treatment of liquid assets from a regulatory perspective means that RMOs need not only be low risk but also quite standardised. It’s these characteristics, particularly standardisation, which largely serves to differentiate RMOs from other securitised vehicles such as covered bonds and Residential Mortgage Backed Securities (RMBS). To achieve the dual requirements of high quality and standardisation the RBNZ has set out a series of rules regarding the structure of RMOs. Some of the key features are that at the pool level:
- Must comprise NZ residential mortgages.
- Minimum number of loans 500 with the top 50 obligators comprising less than 10%.
- Maximum weighted average Loan to Value Ratio of 60%.
- Investment or interest only loans allowed but only up to a maximum of 25%.
- Issuers will have the option to replenish mortgages for up to 2 years after the close date after which the mortgage loan portfolio will be closed.
- Minimum subordination of 10%, where one subordination note is issued, which is materially higher than that required by ratings agencies.
- Originator can have the option to call any time after 5 years.
- Originators need to retain around 10% of the issue (most likely the subordinated tranche) and be exposed in a first loss position.
- Priority of payments (waterfall) shall be strictly sequential and shall run in strictly reverse order for any write down.
Importantly, for the banks as a source of funding and further encouraging the development of the private market, the RBNZ has stated that RMO senior notes will be:
(a) fully repo-eligible and
(b) accepted as regular collateral in its market operations.
While RMO senior notes become an important tool for accessing private funds their current role as a potential means of accessing RBNZ liquidity remains unchanged.
Why issue them?
This raises the interesting question that ‘If the market doesn’t want to roll over RMOs won’t the banks just repo them back to the RBNZ as they do now?’ In this situation the RBNZ will still be on the hook for providing liquidity for the banking system. The key to understanding the rationale for the desire to develop a private RMO market is that the RBNZ is not trying to avoid responsibility for acting as liquidity provider of last resort to the banking system but rather to control and share that risk. Furthering the achievement of these objectives RMOs assist in:
- Longer duration of RMOs spreads out liquidity risk.
- Unlikely that, in other than the most extreme events, 100% of RMOs wouldn’t be rolled over by private investors so reducing the call on RBNZ to provide liquidity.
- Provide a liquidity buffer which requires more extreme events to occur before the RBNZ needs to step in as a liquidity provider.
- Pushes risk back onto shareholders and bond holders. This occurs as the balance sheets of NZ banks will, admittedly at the margin, become riskier as higher quality residential loans are transferred to bankruptcy remote RMOs.
While low risk uncertainties will remain
Though there is no doubting the quality of the collateral in RMOs, uncertainties still exist regarding certain characteristics of the market. Firstly, until the market has had time to mature, it’s unclear the pricing structure, or level of margin, that will be applied to RMOs. This uncertainty is compounded by them differing materially from existing securities such as covered bonds and RMBS. Secondly, the level of liquidity within the market is an unknown and may be adversely impacted if investors adopt a ‘buy and hold’ attitude to RMOs. This risk is increased as the higher degree of standardisation reduces the extent to which there will be differences in characteristics and hence pricing between comparable RMO issues. Standardisation may also adversely impact liquidity by reducing the extent to which there is trading within the secondary market in response to new issuance.
The anticipated development of a private RMO market post 1st July 2020 is positive for New Zealand investors as it will provide access to a new class of high quality securities. It will assist the RBNZ by reducing the extent to which it needs to act as a liquidity provider of last resort to the banking system. With that said, the desire of the RBNZ to ensure not only high quality but a higher degree of standardisation may weigh on the liquidity of the market and the extent to which secondary trading occurs. Despite this potential reservation it’s hard to see the evolution of a private market in RMOs as being anything but a positive for the New Zealand fixed income markets.
* All RBNZ quotes are taken from Residential Mortgage Obligations (Exposure Draft November 2018) : Reserve Bank of New Zealand
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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...