Like the broader corporate bond market, RMBS is also responding to market uncertainty. Structural support features and government assistance for borrowers will provide short-term support for the asset class.
Background
In this note we provide an update on how Covid-19 is likely to affect Australian RMBS and the mitigating measures in place to support these transactions.
The wide reaching implications from mandatory shutdowns on job losses and incomes are already having an impact on the property market and the flow of housing credit. However, it is important to remember that this is a temporary shock and government assistance for households has been deployed to cushion borrowers against an earnings shock. Lenders have also announced support measures for mortgage holders during this period.
RMBS structures include various protection features to cover for a shortfall in mortgage repayments, which would help to offset the increased stress faced by borrowers in the short term.
Response from lenders and regulators to provide near-term relief
Loss of income due to Covid-19 is putting stress on mortgages, which represent the underlying collateral in a RMBS transaction. Lenders have announced mortgage assistance packages to help borrowers in hardship, which include a temporary deferral of mortgage payments (generally up to six months) or an option to move the mortgage from principal & interest to an interest only loan. This does not mean that the borrower’s obligation to the bank is vanquished, it is simply a deferral of payment i.e. the mortgage is required to be repaid in whole at a later date.
The banking regulator, APRA, has announced that where a borrower who has been meeting their repayment obligations until recently chooses to take up the offer not to make repayments as part of a Covid-19 support package, the bank need not treat the period of the repayment holiday as a period of arrears. As such, while we expect RMBS arrears to rise, this amendment to the reporting standards mean that arrears in RMBS transactions are unlikely to be too elevated.
The Government has also thrown its support behind RMBS
In late March the Government announced that it will invest up to $15bn in wholesale funding markets via the Australian Office of Financial Management (AOFM). The AOFM enacted a similar measure from 2008- 2012 by investing in AAA traches of RMBS transactions.
However, unlike last time, this time around the AOFM’s purchases will not be limited to senior RMBS tranches only. The Government is stepping in to support the whole structure as well as different asset classes. In order to assist the secondary market, the AOFM has noted that it will be purchasing secondary market securities from investors who commit to purchasing primary market transactions.
This facility is primarily expected to support non-bank issuers such as Firstmac, Resimac, Liberty, Pepper and Bluestone to name a few. It is expected that banks will support their RMBS transactions by utilising the RBA’s term funding facility.
Together these measures will allow lenders to provide support to their customers. The AOFM has already made its first major investments under this new authority where it participated in 6 tranches of the Firstmac 2020-1 RMBS transaction to a total of $189.14m. The Firstmac 2020-1 RMBS was the first public market deal to price since the onset of the Covid-19 crisis.
RMBS structures provide noteholders with protection from cashflow disruptions
Given that deferred mortgages have to be repaid in full and with interest, the risk of actual losses in RMBS is relatively low at this stage. The primary risk for most transactions at this stage is extension risk (longer weighted average lives or “WALs”), which will be introduced through a slowdown in principal repayments as well as the potential for some near term date based calls being missed. The latter of these two should be somewhat mitigated with the support of the AOFM and RBA funding facilities.
While the deferral of mortgages should not result in widespread losses, it will result in a direct reduction in cash flow available to an issuer, however the issuer remains obliged to make timely interest payments on the notes of RMBS. Transactions often have the ability to build cash reserves and access to liquidity facilities to allow them to bridge this funding mismatch.
The ratings agency S&P has estimated that most prime Australian RMBS transactions have liquidity reserves or facilities that would cover an average of around nine months of senior expenses and note coupons at current interest rates, even if cash inflows to the transaction fell to zero. For Australian nonconforming transactions this figure is estimated to be around 11 months on average if cash inflows to the transactions fell to zero.
The majority of the RMBS transactions have low loan to value (LVR) ratios and can withstand significant property price declines. To illustrate this, we can take the example of a RMBS tranche with 5% subordination. If this transaction has weighed average LVR of 75%, then the tranche is able to withstand a 50% decline in property prices and 20% defaults. It is very unlikely that we will see such extreme conditions, even as a result of this current crisis.
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RMBS performance will come under pressure, but structural features and response from various agencies provide short-term support
We believe performance of Australian RMBS will come under pressure due to the cashflow stress faced by borrowers. At this stage it is difficult to predict the impact of payment deferrals on individual RMBS transactions. It is fair to assume that arrears will rise, however the changes to reporting announced by APRA will make it difficult to ascertain the actual underlying delinquencies. It is important to keep in mind that payment deferrals will continue to accrue and borrowers will have to repay their whole mortgage in full albeit at a later date. As discussed above, structural support features and government assistance for borrowers should provide short-term support for RMBS.
While we expect WALs of most transactions to lengthen, based on the data at hand we do not expect there will be losses in the investment grade rated tranches of RMBS.
The AOFM will continue to support new transactions providing additional comfort to investors wanting to participate in RMBS. In the near term, we expect there will be good opportunities for investors to participate in high grade tranches of RMBS with attractive returns as bank balance sheets and credit investment funds may be forced to sell these for liquidity purposes (e.g. to meet redemptions).
We will keep investors updated with any material news affecting the RMBS market. In the meantime, please speak to your Relationship Manager or email me with queries relating to specific RMBS transactions.