RMBS retail door finally opens

Residential mortgage-backed securities have been off-limits to smaller investors, until now.

Summary: The residential mortgage-backed securities market appears to be opening up, with some boutique managers offering exposure to retail clients.

Key take-out: RMBS offer exposure to a pool of secured mortgages, with most paying interest monthly and many returning incremental principal payments monthly.
Key beneficiaries: General investors. Category: Portfolio management.

Our banks have defied all odds in recent years.

Despite subdued business confidence and the lowest growth in home lending in 36 years, they’ve notched up a stellar run of record earnings and delivered enormous yields to shareholders that have sparked a bull run on the Australian equities market.

But the sudden resurgence of the Residential Mortgage-Backed Securities (RMBS) market threatens a return of good old-fashioned competition to the Australian banking scene.

It is a development that potentially has ramifications for bank earnings growth while possibly throwing up valuable opportunities for investors desperately hunting for reliable yield.

A RMBS essentially is a slice of a large package of home loans, a financial innovation that revolutionised home lending in the 1990s and broke the monopoly of the banks. It has a fixed-interest rate for the life of the security, which typically lasts for about five years.

Until recently, RMBS were confined to the institutional market and to professional investors. With parcel sizes of around $500,000, there was little access available to retail clients. But the market appears to be opening up, with some boutique managers offering exposure to retail clients.

RMBS were the instruments that allowed non-bank lenders such as Aussie, Wizard and RAMS to independently raise cash and undercut mortgage rates offered by the established banks, allowing them to steal a sizeable chunk of the home lending market.

But the funding method was severely curtailed by the meltdown on global financial markets five years ago, which all but crippled the non-bank lenders, particularly RAMs, which collapsed spectacularly just weeks after it listed on the stock exchange.

Australia’s RMBS market never completely dried up. But it shrank alarmingly from its 2007 peak when more than $25 billion in securities were issued. By 2012, less than half of that was being raised, despite initiatives by the Treasurer Wayne Swan to inject up to $20 billion into the moribund market through the Australian Office of Financial Management.

The first signs of change occurred in March last year. As credit conditions eased, the AOFM became a seller for the first time in three years, offloading an initial $50 million of securities.

That since has accelerated. Between November and now, it has sold almost $270 million of RMBS on to the secondary market at between 90 and 205 basis points over the bank bill swap rate, currently sitting at about 4.55%.

The longer the date to maturity, the greater the premium to the swap rate. Securities with 2.1 years left to maturity were sold at 90 points above swap, three years to maturity gathered a 126 basis points premium, with securities lasting another 4.5 years attracting the 205 basis points premium.

In recent weeks, the cost of raising cash through the RMBS markets has fallen, prompting Bendigo and Adelaide Bank to issue $850 million worth of new securities at around 100 basis points over 90-day bank bill rates while Westpac plans a $1 billion raising at an even slimmer premium.

Investment opportunities

The Australian RMBS market is a large and liquid market of around $100 billion. That’s about twice the size of the corporate bond market.

Most securities pay interest monthly and many return incremental principal payments monthly. So towards the end of the life of a loan, the principal can be quite small. For instance, if 90% of the principal has been repaid on a $500,000 RMBS, then the tradeable price could be as little as $50,000.

The only catch is that many market players refuse to deal with such small parcels.

Laminar Group executive director Chris Black says that since June last year, credit spreads have tightened considerably in many areas of the fixed-interest market and particularly corporate bonds.

But, he says, RMBS were slow to move initially and have not tightened anywhere near the degree of other fixed-interest instruments.

“We still see excellent relative value in RMBS and have been able to provide access to these types of securities to our wholesale clients, directly and in relatively small parcels, and to our retail clients through the Laminar Credit Opportunities Fund.”

A relatively small fund, the Credit Opportunities Fund, so far has raised around $19 million and is aiming to cap at about $150 million with more than half its portfolio in RMBS and the remainder in a spread of fixed-interest securities.

With a minimum application of $25,000, it is well within reach of many retail investors who previously would have been denied access.

According to Black, many investors are happy to invest in either bank shares or bank corporate bonds and notes, which deliver only indirect exposure to residential property debt.

“They are effectively taking an unsecured position with exposure to residential mortgages. RMBS provides similar exposure but can add several levels of protection including security over a specified pool of loans, excess spread within the structure and a level of subordination that protects them from the first amount of losses in the pool of mortgages,” he explains.

Black says that is why senior tranches of RMBS carry a AAA rating, at least three notches higher than any Australian bank.

Corporate moves

There has been some interesting moves in recent weeks in the mortgage market that point to significant changes that could occur in the home lending market.

In particular, Resimac – a wholesale non-bank lender created in 1985 and the first Australian institution to issue RMBS – has made overtures to RHG Mortgage Corp, which has the old RAMS loan book.

RHG is the rump of the old RAMS and is in wind-down after Westpac bought the RAMS name and all rights to future loans. In addition to its $2.5 billion loan book, RHG has retail systems in place that could be extremely valuable to an organisation wanting to enter the home loan market.

In recent months, Mark Bouris’s new venture Yellow Brick Road formed an alliance with Macquarie Group to take on the big four banks in the residential home loan market.

These developments are a direct result of the resurgence of the RMBS market and could spell the end of the cosy market conditions that have kept competition out of the residential home loan market.

Just last week, CBA chief executive Ian Narev dropped a tantalising hint that out-of-cycle cuts to mortgage rates may be in the wings. It also signals renewed competition for market share and perhaps a stalling in bank earnings in the future.