Nonbanks’ local buy-in

The success of these issuers in continuing to find homes for their local-currency securitisation is shown by the accelerating pace of issuance in the past half-decade. Following the maintenance mode of the immediate post-crisis years, nonbank securitisation in Australian dollars picked up in 2013 before hitting a new record level in 2016 and again this year (see chart on right). The four biggest nonbank names continue to account for around two-thirds of the total volume.

Domestic investors remain critical to this growth. The largest nonbank issuers see international buyers as their main funding growth driver, but to date issuance in foreign currencies has provided only a small component of total securitisation issuance since the financial crisis. Offshore buyers are taking a bigger share of nonbank-originated paper denominated in Australian dollars, but the domestic component is still dominant.

Nonbank securitisation offers investors an interesting value proposition. The product is diverse in credit profile. Residential mortgage-backed securities (RMBS) based on pools exclusively or partly comprising nonconforming loans are arguably the sector’s stock in trade. But nonbanks also offer consistent supply of prime RMBS as well as asset-backed securities (ABS) comprising consumer, auto and equipment or SME loans, and occasionally commercial mortgage-backed securities.

This degree of diversity is part of the appeal to sophisticated credit investors. Fund managers willing to back their credit analysis say they can find value in different collateral and throughout the securitisation capital stack.

On the other hand, perhaps the biggest question for potential investors in nonbank securitisation is whether the investment in detailed credit analysis they have to make in order to gain sufficient understanding of nonbank pools and issuers can be rewarded in scalable investments. This is more than just deal-by-deal analysis, too.

With nonbanks not having access to deposit bases or – in most cases – alternative forms of wholesale funding, fund managers say being satisfied with the sustainability of these issuers’ business models is almost as important to the credit process as detailed analysis of specific securitisation pools.

KangaNews speaks to a clutch of Australian institutional investors that have developed comfort with at least some of the local nonbank sector’s issuers and securitisation product.

Fund managers say even analysis of assets being securitised on a standalone basis requires some degree of understanding of the originator. However, those most engaged with the nonbank sector say this is because of the diversity of the Australian securitisation-originator landscape rather than because nonbank collateral inherently demands additional scrutiny.

“When it comes to the specific loan pool, the analysis and stress-testing we do is virtually identical for bank and nonbank RMBS issuers,” says Steve Martin, portfolio manager at Challenger Investment Partners (Challenger) in Sydney. “We focus on maintaining consistency in our credit process in this respect and not automatically assuming a loan written by a major bank is of better credit quality than a loan written by a nonbank. Each should be judged on its merits.”

Rob Camilleri, Melbourne-based investment manager at Realm Investment House (Realm), adds: “We don’t discriminate between prime and nonconforming mortgages or between major bank, regional bank and nonbank originators. Everything is processed through a risk-for-value model and we assess each pool on its own merits.”

Investors refer to two important considerations when it comes to nonbank mortgage collateral. The first is that not all nonbank mortgages are nonconforming. Firstmac alone issued nearly A$4.5 billion (US$3.5 billion) of prime RMBS between the start of 2016 and the end of Q3 2017. Fund managers are also keen to counter any stigma about nonconforming product. Taken on its own merits – with appropriate credit analysis and pricing for risk – the Australian nonconforming mortgage can be an appealing investment choice.

“It’s important to be clear about what nonconforming means in an Australian context, because we aren’t talking about US subprime or ‘liar loans’,” comments Scott Barker, regional head, Asia Pacific at IFM Investors (IFM) in Melbourne. “There is a lot of lending that doesn’t meet the traditional underwriting standards for lenders’ mortgage insurance – which tends to be what the major banks are originating – but is still perfectly mainstream mortgage product.”

The post-crisis regulatory process has provided a catalyst for increased prominence of ‘near-prime’ mortgage assets in Australia. With capital deployment at a premium in the bank sector, certain types of lending – for instance to self-employed borrowers – has become less appealing to banks and therefore made them less willing to chase this market segment via aggressive pricing regimes.

Dylan Bourke, Sydney-based portfolio manager at Kapstream Capital (Kapstream), says tighter lenders’ mortgage insurance criteria and the Australian Prudential Regulation Authority’s desire to manage house-price inflation and financial-system risk have significantly expanded the pool of technically nonconforming loans that have a performance profile very close to prime.

“We are pretty constructive on nonconforming assets at present,” Bourke confirms. “Partly this is simply because collateral performance has been consistently good since the introduction of the National Consumer Credit Protection Act in 2010. This applies to all mortgage collateral, but nonconforming in particular has done exceptionally well. We are seeing arrears typically in the 3-5 per cent range where pre-crisis they might have been close to double-digit levels at some points.”

Nonconforming RMBS does require a degree of intensity in the credit analysis, investors say – the point is simply that buyers do not start from a perspective of assuming all nonconforming pools must inherently comprise bad credit. In fact, the range of considerations relating to any securitisation pool can appear dizzyingly broad, and doubly so when it comes to the inherently diverse nonconforming product.

Martin explains: “It’s not totally unreasonable to say a lot of prime loans are competing in a similar space – their customers are seeing a range of similar loans and selecting based on a relatively limited group of criteria. By contrast, the reasons why a borrower ends up in a nonconforming portfolio can be extremely varied. On a nonconforming deal it’s vital to understand exactly what type of portfolio we are looking at, and to arrive at an assessment of default and recovery based on bottom-up, loan-level analysis.”

The starting point for many investors is establishing exactly how and why nonconforming loans in any RMBS pool do not qualify as prime and thus what market sector the originator is targeting. From there, the fund manager conducts in-depth, loan-level analysis of each pool.

For some deals, the gap between prime and nonconforming – and bank and nonbank – can be relatively small. “The heterogeneity of nonconforming pools means we need to continue to check the makeup and credit characteristics in depth on every occasion. We run the same process for prime pools but they tend to be quite highly correlated with each other, aside from regional concentrations which we generally prefer to avoid,” Martin tells KangaNews.

Bourke agrees specific credit work around the nature of nonconforming assets is crucial. In this respect, he draws comfort from two developments in particular. One is the evolution of deal structures in the past decade. Coming out of the financial crisis, investors were highly cautious around securitisation in general and nonconforming assets in particular.

Structures have had to change to woo the buy side back into the fold, Bourke says – and by doing so they have become much more robust. He points to such factors as initial credit enhancement that is often 30-40 per cent for the top tranches of sequentially paying nonconforming deals, and the fact that these transactions tend to have significantly larger liquidity pools than bank RMBS. This could mean a 3-6 month liquidity pool.

Features like this afford significant investor protection against issuer failure or asset underperformance, Bourke says – especially given the asset quality that often underlies such RMBS offerings.

Martin suggests nonbank securitisation structures can often be better calibrated with investor preferences. For instance, although he says major-bank RMBS may feature a notional coupon step-up if not called this is often only available on the senior notes – which he tends not to regard as a genuine economic alignment between investor and issuer in the event of changed market conditions at call date.

By contrast, Martin says nonconforming, nonbank RMBS will be more likely to offer excess spread diversion post-call, more punitive step ups and other structural features giving investors more comfort around alignment of interest with the originator.

The other factor Bourke points to is the resilient business performance of the bulk of securitisation-originating nonbank lenders in Australia. He explains: “Fortunately for us, the major lenders in the nonbank space have come through the financial crisis with their business models intact. Once we have reviewed the players in the sector it becomes easier to keep up to date with the credit profiles of their specific lending.”

Barker says IFM strives to be sure a mortgage originator or servicer is set up to handle the nonstandard characteristics of its loans. For this reason, his firm also reviews mortgage originators’ standards and systems, including site tours and management meetings, to help it develop appropriate understanding of underwriting processes in detail.

Taking a credit view on nonbanks as corporate entities and having a clear picture of their business models is vital, investors say, even though the assets they are buying are standalone securitisations issued by special-purpose vehicles – and therefore remote from the originator of the underlying loans.

The issue is the potential for securitisation pools to be orphaned by originator failure. Investors want to be confident issuers will call securities voluntarily and that extension risk is minimised. In the worst-case scenario, a missed RMBS interest payment is an event of technical default – though the liquidity pools Bourke mentions insulate against this risk to some extent.

Regardless, fund managers say issuer creditworthiness and funding behaviour is critical even in the securitisation space. In this respect, the nature of nonbank lenders means additional scrutiny is required – including keeping a keen eye on the developing regulatory picture (see box below).

Realm’s Camilleri explains: “We model the balance sheets of the main nonbank securitisers and assign an internal credit rating to them. When we invest in RMBS we take mortgage assets that are held in trust, but there is also always the additional factor of refinancing or call risk. This is inevitably greater in the nonbank sector, simply because these issuers don’t generally have access to a diverse range of funding options.”

Although most of Australia’s nonbanks are not rated in their own names – with the exception of Liberty Financial, which holds a BBB- rating from S&P Global Ratings and has twice issued senior-unsecured bonds – investors say the credit process they conduct on nonbanks is similar to what they would deploy on a rated, own-name bond issuer.

In this sense, success is its own reward – because Australian fund managers say they look most favourably on the nonbanks that have established a track record of resilience and positive investor relations over time. Good assets have survived in Australia even when their originators have not, but the issuer-investor relationship runs deeper than this.

Camilleri notes: “A lot of Australia’s nonbanks have been around for a long time and have some very smart, strategic thinkers involved in running them. It’s not all about taking the cheapest funding available at any given moment for them – they are clear about wanting to have a strong, stable investor base that is supportive through the cycle.”

While investors acknowledge the nonbank sector brings special considerations around the nature of the loans its constituents write and their ongoing business prospects, their main message is that none of these make the sector uninvestable. As ever, the question is whether the buy side believes it is being adequately compensated in a holistic sense – from risk profile, to the credit work required to reach an informed view, to liquidity and consistency of supply.

Martin says Challenger takes a more nuanced view than a blanket yes or no on nonbank names or adding a standard spread increment to reflect additional risk in these issuers’ business models. However, there are “red flags” that would lead the firm away from participating in a specific issuer’s transactions and cannot be solved by price. These could be related to structural features of deals, market segment or reputation, and Martin says they are “non-negotiable”.

But in general the discussion is about appropriate pricing. Unsurprisingly, nonbank securitisation traditionally comes to market in Australia with a small but significant margin premium attached – typically in the range 10-25 basis points above bank deals for prime mortgages (see chart on right). Bourke says this range is relatively well established, and where relative pricing sits at any specific point in time is a major component of Kapstream’s view on the sector.

He comments: “In my view, we are being adequately compensated for the fact that nonbanks may have to keep issuing during sell-offs and their spreads are therefore at risk of blowing out. Nonbanks offer extremely high credit enhancement relative to bank deals, so we’re covered from a default perspective. They also add a pickup of around 15 basis points of credit spread on their most senior notes and attractive investment opportunities throughout deal structures.”