By George Whittle
Moody’s recently published their latest ‘Sector Comment’ regarding Australian Residential Mortgage Backed Securities (RMBS) and drew several conclusions about the pools of mortgages they rate. We profile the Liberty 2014 -2 and test an extreme scenario
Moody’s recently published their latest ‘Sector Comment’ into Australian Residential Mortgage Backed Securities and drew several conclusions about the pools of mortgages they rate:
- Rising house prices have added an average of 14% equity to mortgages since they were originated which will absorb losses if loans default
- House price appreciation has varied substantially across states and territories with NSW and Victoria exhibiting the highest “additional equity cushions” and Western Australia experiencing depreciation
- Some exposures in mining areas may now have negative equity, but the exposure to these loans within RMBS is low
Most RMBS pools are geographically diverse, although regional bank and non bank lenders may have more concentrated pools. With the exception of Western Australia, all states have benefited to some degree by rising prices as reflected by Loan-To-Value ratios.
Indexed LTVs are adjusted by Moody’s to a regional house price index
Source: CoreLogic, Moody’s loan by loan database
While typically RMBS investors will look at the original valuation of the underlying properties, this analysis adjusts those values for average house price movements since the loans were established. The outcome of this is that investors in RMBS secured over well seasoned pools may have substantially different buffers against loss than as reported by ‘current LTV’. In every state apart from Western Australia, movements in house prices have on average improved borrowers’ equity positions.
One RMBS pool highlighted by Moody’s as a result of their indexed LTV analysis is Liberty 2014-2. Below we will work through the implications of this analysis, and how this compares to the features in the transaction that protect noteholders against losses.
Loan by loan database – Liberty 2014-2
Source: CoreLogic RP Data Regional House Price Indices, Moody’s
According to Moody’s indexed LTV measure, 7.9% of this pool of loans has a balance greater than the value of the property security. This doesn’t necessarily mean that these particular borrowers are in arrears or are incapable of servicing their loans - it just refers to the amount they owe versus the value of their security. On the left hand side of the chart, we see that indexation almost doubles the number of properties with LTVs less than 50%.
Overall, weighted average LTV is going in the right direction for this pool, and with weighted average seasoning at more than 4 years, the additional equity buffer available for most of the loans is not insignificant – weighted average indexed LTV is nearly 8% lower at 62.7%.
Weighted average LTV (current) – Liberty 2014-2
Source: Moody’s
However, the level of arrears as a percentage of the portfolio has risen since the transaction issued.
Delinquency by current LTV- Liberty 2014-2
Source: Moody’s
It is important to cross reference the indexed LTV of loans with the level of arrears to determine pockets of concern, as displayed in the table below.
Loan amount and delinquency rates by LTV as a percentage of deal current balance (CB) – Liberty 2014-2
Source: Moody’s
If every loan in arrears by more than 30 days and with an indexed LTV greater than 80% were foreclosed upon immediately, our estimate is that there would be a loss of $1.22m, assuming that the costs of sale (inclusive of selling commissions, maintenance and unpaid interest) would equal 20% of the value of the property.
Source: FIIG Securities
While senior note holders gain security from an appreciation in overall pool quality, deterioration in the riskiest parts of the pool can be important for junior note holders. In a given period, losses on foreclosed properties are initially covered by excess spread, and if this is not sufficient it falls to cash reserves and then to more junior notes to provide protection. In the case of Liberty 2014-2, F Note holders have the buffers of excess spread, a $1.5m cash reserve, and more junior G Notes totalling $2.5m. As a percentage of the transaction, the size of these buffers has more than tripled from 0.50% on issue to 1.62% today. To date, there have been cumulative losses of $1,477 on the pool of $500m and this has been wholly covered by excess spread.
In the extreme stress scenario outlined previously, which assumes that every single borrower currently in arrears with an indexed LTV of greater than 80% defaults, we projected a loss of $1.22m. In the absence of any excess spread, this would reduce the $1.5m cash reserve and not affect a charge-off to either G or F Note holders. Absent further losses, these buffers would then be replenished by incremental excess spread earned on the portfolio each month.
Indeed, this additional credit enhancement and the performance of the underlying pool of loans led to an upgrade in credit rating on the F Notes in July last year by Moody’s. Coincidentally, the F Notes were upgraded again while this article was being written, as a result of “an increase in credit enhancement (from note subordination and the Guarantee Fee Reserve Account) available for the affected notes.”
Junior RMBS are not without risk; however, deterioration in quality of some of the underlying mortgages is protected against by the buffers that accrue underneath. These buffers lead to continuous credit enhancement which is sometimes recognised by the credit ratings agencies and almost always makes the notes safer over time.
Note: Clients who have questions about investing in RMBS should contact their dealer.
Glossary
Loan to value (LTV)
The ratio of the total loan to the value of the property securing the loan. For example, if $400,000 is lent to acquire a property valued at $500,000, LTV would be 80%. The lower the LTV, the lower the risk to the lender.
Excess spread
The interest income to RMBS transactions which is in excess of the cash required to meet interest payments and tax and management charges, and which replenishes any previously incurred losses and charge offs. Excess spread may then be returned as equity.
Bibliography
1. Liberty Financial Pty Ltd. Liberty Funding Series 2014-2: January 2017. [Online] January 3, 2017.
2. Moody's Investors Service, Inc. Moody's upgrades ratings on notes from three Liberty Series RMBS. [Online] February 9, 2017.
3. —. RMBS: Rising Housing Prices Provide Equity Cushion To Absorb Losses. [Online] January 19, 2017.
4. —. Moody's upgrades ratings of notes issued by Liberty Series. [Online] July 14, 2016.