Securitisation is one of the oldest forms of secured financing techniques. It is as old as banking, and it is a simple form of financing. It is the financial practice of pooling contractual debt and a straightforward way to take an illiquid mortgage and make it tradable by using the security of the cash flows of a large pool of similar mortgages as collateral. Securitisation works to protect the bond holders by the diversity of the underlying loans and structure.
This type of financing allows the bank to fund itself, and manage its capital. When considered closely, a bank’s balance sheet is very similar to a securitisation funding structure. Banks borrow money, either through deposits or the issuance of bonds. These funds can be lent to household borrowers with a mortgage on a house as security. The bank lends these funds on the premise that the chance of them re-paying the loan is very high. Whilst the value of the collateral is a feature banks are generally motivated by the credit quality of the borrower before such considerations are made.
The physical collateral, the property, is a credit enhancement feature of a Residential Mortgage Backed Securities (RMBS) pool. Ownership of the property does not pass to the security. The security consists of obligations to repay loans. If a borrower is in default, the proceeds from the sale of this asset may be used to fulfil the obligations to the security holders.
Banks fund thousands of loans like an RMBS structure, they have equity, subordinated debt and senior funding. Why do banks use securitisation to fund mortgages? Securitisation offers banks an opportunity to improve the utilisation of their balance sheet and manage the risks they are exposed to. It is a very simple funding solution to finance very large amounts of their balance sheets and retain the potential to use these loans as security if liquidity is required. There is a capital benefit if they choose to sell all the repayment risk to the market. Alternatively, they can retain this risk. In both instances the subordination (representing the repayment risk) in these structures is designed to absorb losses as they arise in a cyclical downturn. Investors can choose the extent to which they wish to be exposed to the risk by determining which tranches of an RMBS to acquire.
Product design is really important and the Australian Sub Prime Crisis of the late 80s put Australia into a great position to survive the US Sub Prime Crisis of 2008, which was product design driven. In the US, the credit markets found ways to make loans to progressively weaker borrowers, in a quantum of size to create a cluster of risk that had the potential to overwhelm the system. These were key ingredients to a cliff event in the housing market.
Loan data sometimes masks the real risk of pools, LVR blending, renovation medium price uplifts, bank balance offsets and cohorts of multiple loan single obligor risks. This further illustrates the expertise and sophistication required to successfully play the game in this asset class.
Full Recourse can be an incentive or a deterrence, competing motivations from lenders to determine if arrears temporary or permanent is key consideration of special services. The equity model in lending is like a put option, and lenders expect rational defaults when borrowers are in a negative equity position. Alternatively, when compared to the ability to pay model which uses recourse as a deterrent rather than a means, this drives behaviour. The facts are, borrowers default all of the time and we can for the best part forecast this through the cycle. What cannot be forecast are many things such as factors around personal relationship breakdown, a household member withdrawing from the labour market due to illness or pregnancy or death. What does drive an increase in the probability of missed payments is small business failure, high indebtedness and financial over-commitment, a sudden loss of income resulting from losing or changing jobs or a, loss of overtime. If a sharp increase in missed payments does arise the dominant reason is loss of employment or long-term unemployment.
On the question of a bubble, house prices appreciate and depreciate for very specific reasons, and to simplify this into one specific drive, is the imbalance between Demand and Supply fundamentals. The price of a house will behave differently to other assets because of the large transaction costs, relatively thin market and heterogeneous environment. Demand will change faster than supply and the price will need to adjust temporarily, unless vacant housing can absorb the change in demand. Supply takes longer to adjust, due to the lead time to create new stock i.e. construction. There is amble RBA and independent research around Australian property price movements. At Realm Investment House we have built a proprietary model to model house price depreciation probabilities through the cycle, utilising factors that make up Demand and Supply dynamics. Should you be worried about a property crash, serviceability issues, or just the cycle? This model forecasts a floor in property prices at any point in the cycle.
The research paper concludes that property crashes need a catalyst, tight credit conditions and rising unemployment. In addition, property crashes are not all the same. Specific ingredients are required for an out of cycle crash, non-cyclical events for example need specific ingredients which drive and increases the speed of a crash and also increases the depth of such an event.