Nonbanks: the sector summit
In September, KangaNews hosted representatives of Australia’s most significant nonbank lenders at the first-ever sector roundtable discussion. On the agenda were funding markets and investor relations, the outlook for the Australian housing market and regulatory oversight of the sector.
Davison It has been an extremely positive year for Australian securitisation of almost all types, and the issuers around this table are a major part of what looks well set to be record volume from the nonbank sector by year end. Can the issuers describe their experience of funding market conditions in 2017, with a focus on liquidity and pricing?
Demand has also been steady and the consistency with which investors have engaged has been very positive indeed. The macroeconomic environment has remained relatively stable relative to recent years, with a lack of global unrest which has caused widespread volatility in the past.
Spreads have tightened somewhat across the capital structure but it doesn’t seem to have been a price-driven market. What has been noticeable for us is the consistency of demand, which has allowed us to issue frequently. We appreciate the support investors have provided us this year and we hope the markets in 2018 will continue as they have in 2017.
It is noticeable that investors have been happy to engage well before the deal process, which makes the deal backdrop very constructive and enables issuers to build and structure transactions to meet investor appetite.
We’ve observed pricing tightening throughout the year and this dynamic has also been supportive of issuance. We priced the super-senior tranche of our recent RMBS at 114 basis points over one-month bank bills in September, which is well inside the 130 basis points over bills we paid on our last public deal – Firstmac 2016-3 – completed in September last year.
It feels like a purple patch and of course this may prove to be the case. But right now the environment feels like it has never been better for our business and its settings.
Today it feels like we’re in a comfortable spot where what we can offer to the market appeals to a broad base of investors. Our investors can invest in multiple products, depending on their mandates, and it feels like what we have is attractive and competitive compared with other products on a relative-value basis.
The other big change we have seen is a degree of confidence from offshore investors in Australian nonbanks that hasn’t always previously been there. Accounts from the US and Europe – and Asia, possibly to a lesser extent for the nonbanks – are investing consistently and in size.
Australia certainly stands out as a consistent issuance market. A couple of investors with a strong understanding of Australian securitised product are now looking at Australian nonbanks when two or three years ago they were insistent they would not buy. This demand is coming through even in Australian dollars. This is all very positive for local nonbank issuers, because at the end of the day the domestic investor market has an overall volume cap in my view.
In fact, one of the biggest developments for us in the last 12 months is that we are increasingly attracting new investors into our deals that have previously been constrained by mandates that only allow them to buy ADI paper. We provide a day-one, 15 per cent credit enhancement and our arrears are best-in-market. This means our offering is very much major-bank comparable and it is driving investors to alter their mandates to include Firstmac bonds.
The key point is relative value. On the back of QE continuing in other parts of the world, investors are recognising that Australian assets are performing while still offering attractive yield pickup.
Nonbanks are among the largest and most consistent issuers of foreign-currency securitisation in Australia. Deal flow remains patchy, however – although issuers would love to be more active.
RIEDEL A positive confluence of events clearly helped. QE was one factor while the cross-currency basis swap tightened significantly in June and July, which made the euro and Australian dollar tranches cost the same from an overall perspective. This situation has not prevailed for quite some time. We had also just met with euro investors at the global asset-backed securities conference in Barcelona, so to some extent it was really a perfect storm for timing.
European demand for Australian assets is high, although the reality is it is hard to say with any certainty what effect QE tapering might have. Keeping in close contact with investors will help us get a clear sense of this.
The overarching factor, though, is investors continue to seek diversification. Even if more product becomes available in Europe, I don’t think this will reduce the demand for Australian assets.
CRAIG What feedback do you hear from international investors about the Australian housing market? Are they concerned about a correction?
Davison Are investors emerging from a post-crisis sensibility in the sense of recognising there can be a change in cycle in Australia without necessarily having a housing crisis?
The question is still there, though. It is very important that we remain vigilant and honest as an industry. If we start to become concerned that any element of the lending market is overheating we need to call it out and demonstrate how we’re mitigating it. Even so, it does feel like people are used to and comfortable with the answers we are giving. Our market’s track record speaks for itself and every year it is a bit easier to discuss.
Investors want to know whether our portfolios are exposed to concentrations in regions or postcodes, borrower types like foreigners, or security types like high-rise apartments.
In other words, negative macro views have actually opened up investors’ minds and made them more pointed in their questions, and therefore in the end given more comfort around the various processes we are using.
What is less available is information on potential emerging borrower stress from an affordability and serviceability perspective. Added to this, there has been substantial rhetoric in the media around high and growing debt-to-value ratios and question marks over borrowers’ ability to service loans.
We receive more enquiry about serviceability and affordability stresses than questions about the performance of the property market.
Nonbanks' lending appetite
The challenges facing the Australian housing market, particularly around soaring prices in the key locales of Sydney and Melbourne, are no secret. Nonbanks say their lending practices are calibrated appropriately.
RIEDEL I imagine each nonbank lender has its own specific risk appetite. At Liberty Financial we have always been bearish on high-rise and inner-city apartments, and we don’t lend to foreign borrowers. Serviceability is still very strong in our view and our delinquency performance is the lowest it’s ever been. The reality of the low interest-rate environment is that affordability and serviceability have been very strong.
Now we are moving into an interest-rate-increasing cycle we are receiving more questions around performance. We watch regional areas very carefully in relation to affordability, more so than anywhere else. But we are not seeing signs of stress across the country that are sufficient to concern us and which might therefore affect our appetite to lend to and service our consumers.
PLOUGHMAN Our biggest focus for investor conversations is the underlying Australian economy. The unemployment rate is a much bigger driver of performance than property prices. The way Australians tend to approach their debt responsibilities is to repay if they can, rather than taking the view that the house has diminished in value. Investors often ask us what we are concerned about, and for us it is also regional areas where unemployment can be a bigger issue.
BARRY We are stress-testing things like irregular income and checking the sustainability of this income. We echo all the concerns about regional lending and inner-city apartments.
I would also make the point that we are all in the business of building diversified loan portfolios. Lending ‘speed limits’ have been imposed on the banks and one suggestion to us has been that nonbanks are taking up the slack. But this isn’t true, because our funding models require diversified asset portfolios in just the same way as the banks.
Davison If there is a cloud on the horizon for the funding outlook, it is the concern that European demand in particular may be driven more by a shortage of competing assets than a strategic allocation to Australian securitisation. How confident are the nonbanks about their ability to retain a critical mass of the demand they have uncovered as and when European QE scales back?
Also, the asset quality of Australian mortgages relative to what else is available – in Europe in particular, where there is a higher percentage of nonperforming loans – strongly suggests Australian assets will remain in demand for some time.
We have long been of the view that while pockets of supply can challenge our funding objectives from time to time, having a broader array of RMBS in various jurisdictions – particularly in the US – gives greater validity to the product itself in the eyes of investors.
We used to face challenges based on investors’ inability to determine relative value because of a lack of comparable non-US supply. For the broader health of securitised product on a global basis, the more issuers we see from traditional jurisdictions, like the UK, the better the opportunities for the Australian nonbanks over time.
Liberty’s euro transaction has reinforced to Australian investors that they can’t expect solely to dictate terms going forward as they have done in the past, because there is a solid European bid. Having said this, the nonbanks still have considerable reliance on the domestic market and very strong support from Australian investors. We wish there were more, because those that do buy are very engaged indeed.
Craig Europe seems to be the big story in offshore demand for nonbank securitisation. How are issuers viewing Asian, including Japanese, demand dynamics and also those from the US?
It feels to me that there are many more Japanese accounts that are ready to invest and that some of these are on the cusp of doing so. I would say the most productive development in our programme for a long time has been the awakening of Japanese demand.
We consider all foreign-currency issuance from a cost perspective and at the moment we observe US issuance opportunities to be broadly similar to those that have been uncovered in Europe, albeit marginally more favourable from a cross-currency swap perspective.
It’s the same story as with European and US investors: it hasn’t just happened overnight – it is a long, constant, ongoing engagement process.
Even given our early engagement with US accounts we only saw incremental change: one year we attracted two or three investors into our deals, the next we saw five or six investors and the one after that, 10 or 12.
Our progress with Japanese investors has been even slower and for a long time we didn’t feel we were making any headway at all. But now we know the interest is there we will continue to put the work in. This is because we know the payoff is worth it: like Japanese investment into UK master trusts, we know that once accounts start buying Australian dollar assets they will be extremely committed to them.
What would be considered a large fund in Australia – say A$20 billion – is small in US terms. We don’t need a big proportion of the trillions of US dollars of liquidity to make a difference to our funding programme, so getting a dozen or so investors interested in a transaction makes it relatively easy to fill a tranche.
Price is obviously important in funding, but sustainability, depth and reliability are equally important. This is why we made the decision when we entered the US market more than five years ago to commit to supporting our US investors with regular issuance.
The change in US money-market regulation hasn’t affected our appetite for the US because we haven’t historically sold our short-term paper to many 2-a7 funds.
In 2017, we managed to extend the duration of our US issuance to include a four-year weighted-average life (WAL) tranche. This came into existence because Australian investors typically prefer a two- or three-year WAL while a large proportion of US investors prefer less than two or more than four years, and many want no call risk. So we have produced a structure which includes a tranche with no call risk and another with a four-year WAL. It’s important to note that the investors buying into these tranches are very different from those that have participated in our money-market offerings.
We find US investors to be more resilient to macro and credit issues. Once they understand the Australian and the issuer stories their ability to price and execute transactions in various issuance markets is fundamentally different from other jurisdictions – which is why we place such a high degree of importance on the US.
Securitisation demand has been particularly strong for lower-rated tranches in 2017. Nonbank issuers discuss the significance of – and robustness of – the mezzanine market.
BARRY The level of demand has been outstanding. We have seen new mezzanine investors come into every transaction we have done, as they get increasingly comfortable with the assets and the performance.
Their business models have changed as well. In the lower-rate environment they have grown funds under management and are looking to deploy capital to stable fixed-income product. Residential mortgage-backed securities (RMBS) comfortably meet these requirements.
We see new demand coming from a combination of family offices, boutiques and larger industry players that continue to grow through superannuation year on year.
Davison The biggest development in 2017 has been the way the regulatory spotlight seems to have shifted to the non-ADI sector. Four nonbanks – Firstmac, Liberty, Pepper and Resimac – prepared a joint submission to Australia’s federal Treasury on this issue. Can you outline the background to the submission?
We know an individual voice is often received as self-serving but our aim is to ensure the government understands the nonbank industry is aligned. I sit as deputy chair of the ASF but, as Peter Riedel rightly points out, the ASF has a notable ‘bank tone’ to its voice. We needed to make sure our views would be fully and accurately represented as they are.
As it happens, the banks don’t appear to have had a contrary view. But even so, having multiple submissions that say similar things is very powerful. From the discussions we have had with government, the fact that the four of us came together had value.
Davison What was the key message of the submission?
We may have created a rod for our own backs in some ways, because there hasn’t been a consistent level of public reporting around the size of the nonbank market. We think it’s important first to understand the extent and nature of non-ADI lending compared with the overall mortgage market and only then assess whether aggregate lending by non-ADIs is at a level that could affect financial-system stability.
Our analysis suggests that prior to the financial crisis the non-ADI market had about a 12 per cent market share, whereas the number today is more like 5 per cent. This is in an environment in which everyone is very concerned about debt-to-income ratios and an overheated housing market, but the non-ADI market has declined. So clearly if the housing market is overheated it’s not as a consequence of the small proportion of lending by non-ADIs.
We collectively believe it is important to make the market as resilient as possible, but it’s unclear which activities of nonbank lenders will materially contribute to risks of financial instability. On this basis the legislation is an overreach, which will bring with it unintended consequences for consumers. The point we sought to make was while the regulator should collect and analyse the data from non-ADIs, it should only be given powers to intervene where there is evidence of risk to financial stability.
There is also a good level of transparency around the business we are writing. It is easy to understand what the underlying assets are just by a quick examination of the transactions.
Davison Being devil’s advocate for a moment, I have to ask why, if you don’t have anything to worry about, it was necessary to make a submission at all?
We have asked APRA to define when and why it would make any sort of move because this has been where the issue comes into play. More than anything else it’s about the undefined power.
Going forward there will likely be an increased reporting and compliance burden for our businesses. We are not afraid of compliance – we have built our business models to comply – but what we’d like is to minimise the levels and layers of institutions that we have to report to.
Davison APRA has said it expects to take a light-touch approach with new powers over nonbank lenders. How positive a development is this?
Initially, my concern was that APRA would bundle us in with the banks and treat us with the same regulation, which would make no sense whatsoever. One is about protecting depositors, whereas we only talk to sophisticated investors about wholesale instruments.
These are very different goals, so I take some comfort that APRA won’t extend its powers unreasonably. But I also believe APRA has seen that nonbanks really are incapable of creating systemic risk in the overall housing market.
Having said this, it is incumbent on the nonbanks to continue to be vigilant about our lending practices so we know we are treating borrowers appropriately when we approve loans.
We are an important part of the system and we are only as good as our weakest link, so we certainly wouldn’t want a maverick lender in the market. The government says APRA will not be a prudential regulator for us in the sense that there won’t be a requirement for regulatory capital. Quite frankly, though, and despite what people expect will happen right now, the problem with a reserve power is it is very much an unknown.
Craig Do offshore investors ask about your regulatory status?
Australian nonbanks have enjoyed growth in their opportunity set as banks have pulled back from less vanilla lending. The potential for growth remains, they say, even as the regulatory landscape continues to shift.
AUSTIN We have remained relatively self-regulated in originations. We reprice our back-book loans in line with the average of the four major banks and, as a result, as they tighten up on investor and interest-only lending this has a natural knock-on effect on our book. But as we are less than 30 per cent interest-only and investor loans, our portfolio is not one that should cause any regulator any concern.
PLOUGHMAN The point I’d like to make clear from the outset is that it is not that the banks are not comfortable to lend. What they are not doing is buying market share. This is a massive market so even a tiny shift makes a very significant difference.
In regard to this continuum and where market players sit on it, the major banks have clearly moved away from the areas where they probably shouldn’t have been lending in the first place. Initially a large volume of this business went to the second-tier banks. It has now filtered down to the nonbanks.
With strong funding markets, we have been able to achieve a competitive advantage without sacrificing credit or price. All we have done is continue to be there, and the banks haven’t undercut us.
investing with impact Yearbook 2017
KangaNews's first-ever supplement focusing on sustainability in the Australian fixed-income market.