Siphoning signals from Genworth

Hysterical housing doomsayers got very excited by the delay of Genworth Australia's IPO on the back of a modest first quarter loss. It was said by some that this might be the 'canary in the coal mine' and presage deep gloom for Australia's much-maligned housing market.

To compound matters, Moody's Australia, which has occasionally expressed reservations about local housing valuations, promptly placed the company on "ratings watch negative”.

Unfortunately for those salivating at the prospect of an Aussie housing blow-up, Genworth's first quarter results merely reveal a company prudently building internal reserves, and cleaning up a backlog of claims. They show that the share of Genworth's bad loans actually declined between December 2011 and March 2012. I will say that again: delinquencies fell – they did not rise – after a spike following the first quarter east coast floods (and a double hike in lending rates at the end of the preceding year).

The results highlight that this is an Australian business with virtually no debt, and significant capital above and beyond that which is required by its regulator, APRA. In recognition of this, Standard & Poor's yesterday announced that it was actually "affirming our financial strength and issuer credit ratings on Genworth Australia at 'AA-'” with a "stable” outlook.

Moody's move nevertheless has broader ramifications for Australia's financial system. As Sydney University's Dr Elvis Jarnecic explained, the two duopoly lenders mortgage loss insurers in Australia, QBE LMI and Genworth Australia, are, relatively speaking, better capitalised than the major banks. They have stand-alone S&P ratings of "AA-" in comparison to the majors' single "A” stand-alone ratings, and possess arguably significantly lower catastrophic risk. (Recall that the four majors alone amongst all banks get a "two notch” ratings upgrade to "AA-" because S&P assume they will get a taxpayer bailout in a crisis.) And in contrast to the majors, they have one business, focused on one relatively easy to understand industry: housing.

More importantly in the case of Genworth Australia, it effectively has no leverage, with incredibly low circa 4 per cent gearing that has been mostly generated by APRA requirements that Genworth Australia issue bonds. In a recent report, S&P assessed that Genworth Australia had about $3.3 billion of total capital excluding its bonds, and tier one capital well in excess of what is mandated by APRA. The only real link to Genworth Australia's struggling parent is through reinsurance contracts that cover excess losses. However, in giving Genworth its coveted AA- rating, S&P assumes the parent's reinsurance is of zero value. And the parent only provides a minority of Genworth Australia's reinsurance with at least 13 other reinsurers used. After reviewing the March quarter results, S&P concluded:

"As at March 31, 2012, the company's $2 billion of total shareholders equity translated to a very strong risk-based Standard & Poor's capital model score at the 'AA' category level, and a regulatory multiple of 1.53 times. We expect low credit growth in the Australian mortgage market to allow the company to build up excess capital over the year to maintain its very strong capital metrics and increase capacity to issue dividends to shareholders.”

Now contrast this with a major bank. The banks are typically geared 15-20 times their shareholders equity. They face the risk of retail depositors withdrawing their money via a 'bank run'. They deal with the periodic hazard of wholesale funders not "rolling-over” their institutional bonds.

So they confront two tremendous funding risks that are simply not problems for the Aussie LMIs. Yet to make the banks' business models even more precarious, they run large 'asset-liability mismatches', which basically means that the average life of their funding (ie, retail deposits and wholesale bonds) is significantly less than the average life of the loans they make (eg, home loans). Unless they can guarantee access to future liquidity, they risk trading insolvent. This is exactly why the RBA lends to the banks, and has developed a generous 'committed liquidity facility' to assist them comply with the new global banking regulations known as Basel III.

Beyond these structural funding vulnerabilities, the major banks also take on a much more diverse (yet correlated) array of credit risks. Whereas the LMIs only supply insurance for the purposes of protecting defaults against secured, full recourse home loans, the major banks also lend to unsecured individuals, small businesses, corporate borrowers, and commercial real estate owners. These four categories of credit have historically had much higher default rates than fully secured, residential home loans, as the banks themselves have been keen to point out.

Some argue that this gives a bank the benefit of more diversified earnings. This is true during the good times. But the only reason diversification is regarded as being valuable from a risk perspective is because it is assumed to afford protection during the bad times.

Contextualised against Australia's two LMIs, the major banks' exposures to personal, corporate, and commercial property credits have historically generated much more pro-cyclical and volatile earnings, and amplified the risk of catastrophic loss.

This assessment was clearly borne out during the 1991 recession and the more recent GFC where the vast bulk of major bank losses crystallised in their non-housing credit portfolios.

So what did Genworth Australia's first quarter financial results actually reveal? Was it a harbinger of housing Armageddon? As it turned out, the 90 day default rate across its 1.4 million insured home loans actually declined slightly from an already low 0.55 per cent to 0.54 per cent between the December and March quarters. This compares to the Australia-wide 90 day default rate of 0.60 per cent documented by the Reserve Bank at the end of December 2011.

As a general observation, Genworth Australia's lower-than-industry-average default rate is somewhat surprising giving LMI is normally only applied to borrowers with loan-to-value ratios greater than 80 per cent. Having said that, Genworth Australia's average LVR is only around 63 per cent in part because one of its main insurance activities is covering entire loan portfolios that comprise many lower LVR borrowers.

The modest first quarter loss of $21 million was primarily driven by a very conservative increase in reserves (which rose by $53 million) in anticipation of faster foreclosures by banks cleaning up a backlog of aged arrears. This was reflected by a doubling in paid claims in the first quarter to $69 million, from $32 million in the fourth quarter, despite the fact that delinquencies declined over this period.

S&P comments: "Genworth Australia reported a loss ratio of 154 per cent for the first quarter of 2012 – significantly exceeding the prior quarter's loss ratio of 46 per cent... The company cited reserve strengthening... for the spike in the loss ratio, driven by actions by lenders – in partnership with Genworth Australia – accelerating claims to address aged arrears in late 2011. This resulted in an above-average volume of claims processed in the first quarter of 2012, which was compounded by continued pressure from regions and sub-segments of the book that we previously highlighted as weaknesses.

"Many of the aged arrears were concentrated in tourism-reliant parts of Queensland… that have been negatively affected by the strong Australian dollar. In addition, Genworth Australia cited ongoing stress from sub-segments of the 2007 and 2008 books – small business owners and self-employed borrowers – which were written at the peak of the origination and property cycles. The impact of the significant reserve strengthening on bottom line results was largely offset by strong investment earnings.”

Looking ahead, we believe this should be a cyclically favourable environment for the two Australian LMIs: stabilising house prices, a large decline in interest rates and, therefore, material improvements in affordability, historically low unemployment, and (likely) declining default rates.

On this note, a blogger for The Sydney Morning Herald dismissed the Reserve Bank's recent report of a 0.1 per cent decline in Australia's 90-day default rate in the final quarter of 2011, which, incidentally, was also confirmed by Genworth's data. He seemed confused by the seemingly small 0.1 per cent number. In isolation, this self-evidently sounds tiny. But relative to the previous level of 0.7 per cent, this actually represents a 14 per cent decline in delinquencies.

We believe housing conditions will continue to improve as the year passes, and 2012 will be another very profitable one for Australia's LMIs. Moody's may downgrade Genworth, but if it does so one would think it will also be downgrading QBE LMI and the major banks.

Christopher Joye is a leading financial economist and a director of Yellow Brick Road Funds Management and Rismark. The author may have an economic interest in any of the items discussed in this article. These are the author's personal views and do not represent the opinions of any other individual or institution. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations.