Last week we had an excellent question from a client
I have the three “non conforming” subprime lenders – Liberty, Pepper and La Trobe in my portfolio. I realise sub-prime” is a toxic word in the US, which is not the Australian market. Can you please explain how some tranches can be rated the same as conforming RMBS?
In the context of Australian RMBS, non conforming and subprime mean the same thing. Non conforming lenders are mortgage originators that lend to borrowers that do not conform to a bank’s lending criteria. This might be because the borrowers don’t have a perfect credit history, may not have a stable job, might have had a credit event in the past, may not have a deposit or have received a deposit as a gift. This list is by no means exhaustive but it highlights that these borrowers would generally be considered riskier than prime, bank quality borrowers.
RMBS issuance by these non conforming lenders can indeed be rated as high as AAA, however, the credit enhancement required to achieve a certain rating for a non conforming transaction is significantly higher than that for a prime transaction. This reflects the fact that the underlying mortgages in a non conforming pool are riskier and are likely to have higher arrears and defaults. As such, the additional credit enhancement for each tranche of a non conforming RMBS is sized to provide the same level of ‘protection’ as an equivalent rated prime RMBS.
For example, the credit enhancement for the AAA tranche of the Apollo 2018-1 RMBS was 8.0% (Apollo is a prime RMBS issued by Suncorp), whereas the AAA tranche of an upcoming Liberty 2018-1 transaction has 35.0% credit enhancement. The AA and A tranches of Apollo 2018-1 have 2.65% and 1.61% credit enhancement, respectively, and the AA and A tranches of Liberty 2018-1 have 6.5% and 4.6% credit enhancement, respectively.
So, while the issuer can be non conforming, the transactions can achieve higher ratings by structuring the tranches to provide additional support and protection to reflect higher risk in these mortgages.
Finally, I should add that Australian non conforming loans are nowhere near as risky as the US subprime loans, which can have limited or no recourse to the borrower. All mortgages in Australia have full recourse to the borrower in the event of a default.
If you have any more questions, please email me on asmita.kulkarni@fiig.com.au
Asmita Kulkarni
Director - Portfolio Strategy 
Asmita has over 14 years of experience in financial markets. Prior to joining FIIG, Asmita worked at Westpac Institutional Bank and Macquarie Funds as a credit analyst for large global banks, non bank financial institutions securitised products, and later as a credit officer at UBS AG, with responsibility for credit and complex financial product approvals for hedge fund and financial institution counterparties.
Her area of expertise is analysis of financial institutions and structured products such as Residential Mortgage Backed Securities and Asset Backed Securities. Asmita has broad risk management experience and is well versed in documentation negotiation.
She graduated with a double degree in Actuarial Studies and Finance from the University of New South Wales and is also a CFA charterholder.