Wednesday, December 15, 2010

Our "Responsible" Lending Standards

How many times have you heard the robotic mantra that Australian banks are the model of probity and have not engaged in any of the risky practices seen in the USA and other countries where housing bubbles have burst? An article by Tim Colebatch in The Age nicely encapsulates this standard narrative of the Australian housing market, which is accepted as gospel by almost the entire mainstream media.
...unlike most in the West, Australia's banking system did not collapse in the global financial crisis. That's partly because the Australian Prudential Regulation Authority did an outstanding job as our watchdog before the crisis. It's partly because the government moved in the heart of the crisis to guarantee the banks' debts and deposits. But it's also because our banks were prudent and sensible lenders, when their overseas counterparts were not.
The global financial crisis began when this market was poisoned by American banks filling their securitised bundles with bad mortgages. As they went bad, the market for securitisation collapsed - even for Australian lenders, whose bundles remain good. And as it collapsed, so did the new lenders...
Is this indeed the case? Or is it just that the chickens haven't yet come home to roost? From a macro viewpoint, the amount of mortgage debt in the Australian economy is at unprecedented levels. In fact, it is higher than the USA, as the chart below from Steven Keen shows.


Is it really plausible that all of this lending has been responsible? And is there an Australian version of the Mexican strawberry picker in California on a $14,000 salary who was given a $724,000 mortgage? (see The Big Short by Michael Lewis).

Maybe not, but let's take a peek inside a recent large RMBS deal. Last week Bendigo and Adelaide Bank priced a $1 billion issue, in which our very own AOFM invested more than $400 million of taxpayer money. The deal structure is below. Now, I don't intend to do a full primer on how RMBS works here, but a little explanation is in order.
Class A1 AAA $250m
Class A2 AAA $150m
Class A3 AAA $130m
Class A5 AAA $395m
Class AB AAA $45m
Class B1 AA- $20m
Class B2 n/a $10m

Essentially what Bendigo and Adelaide Bank have done is bundle together around 4,000 mortgage loans and slice and dice them into several classes of residential mortgage-backed securities (RMBS), which are collateralised by the loan assets. The interest and principal payments on the underlying bonds flow through to the investors in the securities. You can see that the top 5 classes of bonds are rated AAA by the ratings agencies, indicating that they are the very safest of investments. But in fact, these five classes all have very different risk profiles.

The top rated AAA note, class A1, has first priority on any cashflows -- therefore it is the safest investment and carries the lowest yield. The cashflows flow down the structure in a typical "waterfall" fashion, next to the A2, then the A3, etc etc. If there are any defaults in the pool, then losses are absorbed by the LOWEST noteholders first. In this case, just $10m of loan losses -- or 1% of the total mortgage pool -- would be enough to wipe out the entire investment of the B2 noteholders.

Now, the AOFM invested $395m in the Class A5 Notes and $20m in the Class AB Notes. As you can see, these are the two lowest rated AAA tranches. In fact, the AB notes have just $30 million in notes beneath them in the capital structure, meaning that a 3% loss in the pool and they are starting to suffer losses. So how the hell are these lower tranches still rated AAA? And why the hell is the AOFM investing taxpayer money in them?

Ratings agency S&P, which has an impeccable record and has never been wrong about anything, says its ratings on these notes are based on the following:
-- Our view of the credit risk of the underlying collateral portfolio;
-- Our view that the credit support for each class of notes, which comprises both note subordination and mortgage insurance covering 100% of face value of all loans, accrued interest, and reasonable costs of enforcement, is sufficient to withstand the stresses we apply;
So there are two parts to this. Firstly, S&P is judging that the underlying portfolio of loans is of very low risk. According to this source, the average "seasoning" of the loans is 43 months and the LVR of the pool is 64.9%.  So far so good. However, it should be noted that low LVRs tend to give a false sense of comfort during property booms, since the denominator in the calculation is inflated due to overvalued house prices. If prices were to collapse, LVRs will shoot through the roof.

Nevertheless, the most interesting thing here is that an astonishing 27.4% of this portfolio is concentrated in interest-only loans of up to 10 years (ie are not repaying any principal at all). For an excellent account of the kind of disaster that likely awaits many of these borrowers when house prices fall, read this article in the New York Times. And if you think this Bendigo/Adelaide Bank deal is an anomaly, see the chart below from Westpac. It shows that close to 40% of owner occupier loans in Australia are interest only, low-doc or nonconforming. Amazingly, half of investor loans are interest only. As many others have noted, this is nothing more than a giant ponzi scheme based on the notion that prices can only go in one direction -- up.

Source: Westpac

But I digress. Let's return to S&P's view of the Bendigo/Adelaide Bank mortgage pool. The key here is the statement in bold. Essentially, S&P (and Moody's) is comfortable rating these bonds AAA because the principal and interest payments on the loans are 100% insured -- in this case, by Genworth Financial and QBE.

Now this is very curious, because some of you may recall an American company called AMBAC. Or another one called MBIA. But more on that and the dark art of bond insurance in my next post some time soon...


  1. great post! Would really be interested in seeing your take on the mortgage insurers.

  2. Cheers. The mortgage insurers are still on my list -- need to do a bit of research first!