The credit rating agency Moody’s is reviewing the ratings issued by PMI Australia, one of the biggest providers of mortgage insurance in this market, in the wake of the losses experienced by its US parent. While the Australian business is solidly profitable and exposed purely to an Australasian market that bears no resemblance to the US sub-prime mortgage market, it would be unusual – although not unprecedented – for it to retain a higher rating than its parent. It's probable that it will suffer a one-notch downgrade from AA to AA-.
While some say a downgrade would threaten up to $83 billion in bonds backed by Australian mortgages, in fact only a small proportion would be affected – the subordinated tranches that probably constitute three or four per cent of the market.
An AA- rating wouldn’t affect PMI’s ability to write new business but in a residential mortgage backed securities (RMBS) market already suffering from illiquidity investors in new issues would presumably seek greater comfort from greater subordination and higher yields to reflect the slightly reduced quality of the credit enhancement.
That wouldn’t be good news for existing investors in the RMBS market nor for new issuers or home loan borrowers.
PMI could respond to the threatened downgrade by raising more capital but that in turn would have to be serviced and would presumably mean a rise in the cost of mortgage insurance.
The Australian mortgage market bears no resemblance to US sub-prime. In the US the normal default rate on sub-prime mortgages (as opposed to the bloodbath now occurring) is about 3 per cent, whereas the normal default rate on Australian mortgages is about 0.3 per cent.
A concern is that successive interest rate increases are having an impact on default rates, which were as low as 0.15 per cent only three years ago but are now around 0.4 per cent and rising. While that’s within historical norms, and focused in regional pockets like the south-western suburbs of Sydney, the correlation between rising rates and default rates is obvious.
Default rates on mortgages have never been a general issue in this market, even when periods of economic distress have created regional stresses – as occurred in Victoria during the recession in the early 1990s. Whether the unprecedented leveraging of households over the past decade and a half produces outcomes outside historical norms remains to be seen, although with unemployment at minimal levels there wouldn’t appear to be a significant threat of abnormal default rates.
Nevertheless, an obvious response by the banks and the mortgage insurers to the adverse changes in conditions in the RMBS market and to increases in defaults is to try to improve the quality of exposures or to re-price risk.
The banks, and more particularly the non-bank lenders whose business models are being tested by their lack of access to funding, had been prepared to lend on quite high loan-to-valuation ratios, with the risk being passed onto the mortgage insurers. As the pressure on households from higher rates intensifies, one would expect either mortgage insurance premiums to rise or loan-to-valuation ratios to fall, or both, to reflect increased caution in the system.
In the RMBS market, one would expect investors to seek not only greater protection through greater levels of subordination, but higher returns because of the volatile and liquidity-constrained market conditions, increased default risks and a weakening in mortgage insurers’ credit ratings.
In a market where housing affordability is a hot button issue the prospect of higher rates, lower loan-to-valuation ratios and potentially higher mortgage insurance premiums isn’t an encouraging one.