Tuesday 29 November 2016 by George Whittle Trade opportunities

Moody’s updates its residential mortgage backed securities outlook

Global credit rating agency Moody’s recently provided an updated structured finance outlook for 2017 that considered asset backed securities (ABS), covered bonds, and residential mortgage backed securities (RMBS)

house on a hill

The ratings agency stated (emphasis ours):

We expect RMBS delinquencies to increase moderately in 2017 from their current low levels. Weaker economic conditions in states reliant on the mining industry, rising underemployment, weak wage growth, and less favourable housing market conditions will drive delinquencies higher. However, RMBS losses will remain low in 2017, because house price appreciation and deleveraging have increased the amount of home equity available to absorb losses if loans default. The credit quality of mortgages backing new RMBS issued in 2017 will be weaker than that of mortgages backing 2016 deals, owing to the inclusion of a greater proportion of riskier loans originated since 2013.”

Our senior economist Craig Swanger has written extensively about the impact of underemployment on Australian growth prospects, with Moody’s also seeing this as having an adverse effect on homeowners being able to service their mortgages as shown in Figure 1.

RMBS graph
Figure 1
Source: Moody's, Australian Bureau of Statistics

There is a clear link between higher employment and the level of mortgage arrears, which in turn increases the risk of default. However, loans originated over the last several years have benefited substantially from property appreciation. Recovery rates on those loans that default within underlying mortgage pools should be strong as a result. This has been a theme in our assessment of mortgage pools and why we emphasis ‘seasoning’, that is the age of loans.

Moody’s also raises the possibility of higher interest rates, and therefore loan serviceability as a concern – with several lenders reportedly having begun raising their rates this week by as much as 60 basis points.

In evaluating upcoming RMBS deals we will continue to look for:

  • A high level of seasoning
  • Low average loan to value ratio (LVR) pools, with few large loans
  • Geographic diversity, but limited exposure to Western Australia, Tasmania, and rural Queensland
  • Limited exposure to units and apartments
  • Attractive structural features, including more junior notes, reserves, and accelerated principal return

RMBS continue to offer more attractive rates of return than equivalently rated corporate bonds, allowing exposure to a specific pool of assets at a specific level of risk.

To learn more about RMBS, please contact your local dealer or call 1800 010 181.


Glossary

Basis points

Basis points are commonly used for calculating changes in interest rates, equity indices and the yield of a fixed income security. The relationship between percentage changes and basis points is that where 1.00% is equal to 100 basis points. For example, a bond whose yield increases from 6.50% to 7.00% is said to increase by 50 basis points; or interest rates that have dropped by 1.00% are said to have dropped by 100 basis points.

LVR

Loan to value ratio (LVR) is the ratio of the total loan to the value of the property securing the loan. For example, if you are lending $400,000 to acquire a property valued at $500,000, your LVR would be 80%. The lower the LVR, the lower the risk to the lender.

RMBS

Residential mortgage backed securities (RMBS) are a pool of residential mortgages. More specifically, it is a type of asset backed security or debt obligation that is secured by a mortgage or collection of mortgages. These loans are combined to form pooled investments. Instead of paying investors fixed coupons and principal, it pays out cashflows from the pool of mortgages, The bank acts as a middleman between the home buyer and the investment markets.

Seasoning

The number of months since the loans or bonds were first issued. All loans in residential mortgage backed securities (RMBS) have been seasoned one month (i.e. have received one mortgage payment) to avoid including any fraudulent applications. All things being equal, securities which are more seasoned will have paid down principal, reducing risk.

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