01 Jun 2008, Risk magazine
The decision by the Reserve Bank of Australia (RBA) in April to leave interest rates unchanged has calmed more than a few antipodean nerves. While counterparts in the US, Canada and the UK have cut interest rates to cushion their domestic economies from the global credit crunch, Australia, by contrast, has made four back-to-back monthly interest rate increases to battle domestic inflationary pressures, adding 100 basis points to the benchmark rate since August, up to 7.25%.
"Banks are under a lot of pressure at the moment in this hothouse rates environment," says Craig Saalmann, a credit strategist at JP Morgan in Sydney. "It's costing them a lot more to fund themselves."
The interest rate rises have come amid the largest sell-off in a quarter for Australian stocks in 20 years, with declines spearheaded by the financial sector. Most notably, Commonwealth Bank of Australia (CBA) has seen its share price fall 29% in the first three months of the year.
But the situation is even worse for non-bank mortgage lenders. While banks enjoy the benefit of cheap retail deposits, non-bank lenders either borrow in the short-term debt market or use the securitisation market to meet their funding needs. The credit crisis has virtually shut both of these markets.
Rams Home Loans, now known as RHG was the first casualty when it was forced to sell its 91 branches and all its future business to Australia's fourth-largest bank by assets, Westpac, in October last year for what many saw as a bargain-basement price of A$140 million ($129 million).
As part of the deal, Rams kept its existing A$14.5 billion mortgage book but that will go into run-off because Rams signed a non-compete agreement with Westpac. Sydney-based Westpac also agreed to provide Rams with A$1.5 billion to help it refinance the A$6 billion it had previously funded from the US commercial paper markets.
Another casualty was Mobius, a mortgage provider owned by Sydney-based asset manager Allco Finance Group. In its heyday, Mobius claimed to have a 20% share of the non-conforming mortgage market - a market estimated to be worth A$20 billion compared with the A$230 billion Australian mortgage market - but, today, its portfolio of A$1.5 billion mortgages is up for sale, with Allco shares trading down 92% since February to 48 cents at the start of April.
And in March, Macquarie, Australia's top investment bank, which has relied heavily on the securitisation market to fund mortgage activities, said it would scale back its domestic lending because of the difficult credit conditions.
This was followed by Australia's largest mutual society, Credit Union Australia, which said it was winding back its mortgage origination activities from brokers due to higher funding costs.
"It's not a total surprise that non-bank lenders such as (Macquarie's) Puma, Rams, Liberty (Financial) and others would see a drop off in appetite for writing loans when funding costs through securitisation market have risen," says Saalmann. "The winners will be the four majors and those banks who could fund on balance sheet using deposits."
With the short-term funding market and securitisation market both virtually shut, non-bank lenders have had to turn to the more expensive interbank lending markets to stay in business.
And the big four Australian banks - National Australian Bank (NAB), CBA, Westpac and the ANZ - have received criticism for making the most of the situation to tighten the screws on their more vulnerable competitors.
March saw banks hoarding cash and forcing interbank rates to their highest in thirteen years, leaving borrowers scrambling for funds. The three-month bank bill futures rose to as high as 8.15% almost 90 bp higher than the central bank's overnight cash rate of 7.25%.
"The big banks are clearly the beneficiaries when there is such heated competition for funds," says Saalmann. "While they may be citing increased funding challenges that are pressuring their stock prices, they are also reporting asset growth. There's only one place, given the slowdown in the local mortgage markets, that growth can be coming from - they're taking the business away from the non-bank lenders."
He adds that, while the big banks have to cry poor in a rising interest rate environment for fear of offending stricken mortgage borrowers, "secretly they are rubbing their hands with glee".
"Competition from the non-banks is fading away," Saalmann says. "The non-bank lenders are having to turn to the banks and their warehouse lending facilities to survive. By hiking their own rates in addition to the RBA increases, the big four can really pile on the pressure. Non-bank lenders have been a thorn in their side for years." Not everyone agrees.
Steve Ferguson, a financial services partner and head of banking and capital markets for Australia at Ernst & Young in Sydney, says the interbank rate rises reflect the true cost of funding.
"For one thing, it's not just the big four that are raising rates in excess of the RBA rate," Ferguson says. "All the banks are reacting the same way."
But Australian non-bank lenders have been losing mortgage market share to banks since the start of the credit crisis in August and analysts have questioned the future of many businesses in the wake of rising credit costs.
But Ferguson says: "This is not an effort to crush the competition. It's not in the financial sector's interests to see, let alone, perpetuate more bad news in these kinds of market conditions. Admittedly, they are in a good position to improve their market share. But I do not agree that they are actively seeking to manipulate interbank rates in order to push non-bank lenders out of business."
Ferguson also points out that the current squeeze is no death knell for non-bank lenders in Australia. "Non-bank lenders have a future," he says. "They may have to revisit their business model and find a way to compete on a different level other than on just price. But they will survive."
And Andrew Chick, head of structured capital markets at RBS in Sydney, adds that respite for non-bank lenders may be nearer in sight than some imagine.
"Basically, the Australian mortgage market is still in pretty good shape," he explains. "The quality of assets here is far better than most countries because the economy has been growing well for 17 years, unemployment is very low and people are in a better position to repay."
The problem, he says, comes from a sheer lack of demand for any kind of securitised issue, as opposed to the quality of the paper.
"European structured investment vehicles (SIVs) were big buyers of Australian issues but now they've fallen away," he says. "But I'm more optimistic than most about the future. Once the global securitisation markets come back on track, non-bank lenders will very much be back in business."
Chick concedes that banks may have been quick to exploit their non-banking competitors in the immediate aftermath of the credit crisis. But, he says that attitude has fallen by the wayside somewhat as the crisis has worsened.
"I don't think any banks are particularly focused on growing the balance sheet and winning market share at the moment," he says. "The primary focus today for everyone is how to best manage and fund their existing operations. Things have moved a long way on from rivalry in such a chronic funding environment."
While raising interest rates, the RBA has tried to alleviate pressure with a series of money market initiatives.
In September last year it said it would accept more types of assets for repurchase in its money market operations. Most notably, the RBA said it would accept domestically issued certificates of deposit, as well as top-rated residential mortgage backed securities (RMBSs) and asset-backed commercial paper (ABCP) for repurchase.
When the reforms were unveiled, Patrick Eng, a director of fixed income at Credit Suisse in Sydney, said: "The RBA announcement effectively adds another dimension to liquidity. If liquidity is tight and there are no avenues to sell, prices go crazy. But this repo facility gives sellers another option. It also means that a clear pricing floor is set since everyone knows at what level the RBA will repo."
In addition to RMBSs backed by prime, fully documented mortgages, the RBA said it would also accept issues with pools of low-documentation, or 'low-doc' residential mortgages up to a maximum equivalent of 10% of the value of all underlying assets.
For example, in a $100 RMBS, comprising $85 of eligible full-doc mortgages and $15 of eligible low-doc mortgages, the valued assets for repurchase would be $95 ($85 in full-doc mortgages plus $10 of the low-doc mortgages). Mortgages in the pool underlying a RMBS that do not meet the requirements for valued assets are fully discounted by the RBA.
The RBA repo facility had an immediately beneficial effect with Macquarie utilising the repo facility for its P-13 securitisation issue in September.
And, in February, Westpac engineered a 'crisis liquidity' facility, with an A$10.6 billion self-led, self-owned RMBS that was repo-able with the RBA.
Westpac now has access to a war chest should the capital markets become even choppier. Should Westpac find itself short of money, the RBA will provide short-term funding on those securitised assets at bills plus 25 bp.
At the moment Westpac has a market capitalisation of A$45 billion and assets on its balance sheet of around A$365 billion. The ability to have ready access to around 3% of its assets was described admiringly by one Sydney-based banker as "a handy little option".
In other ways it is a win-win situation for Westpac. Quite apart from a financial 'get out of jail free card', the bank also has A$10bn of mortgages securitised, rated and ready to go should the sun break out in the capital markets.
Although Westpac's move is innovative within the Asia-Pacific region, it is not new to Europe. It has long been a favoured liquidity play, particularly by Spanish and Dutch banks.
Most recently, in December, Rabobank, one of the largest banks in the Netherlands, issued a EUR30 billion ($45.5 billion) RMBS that it could post as repo collateral with the European Central Bank.
Other Australian banks are now rumoured to be looking at similar measures. And, given that the credit crisis has revealed itself to be like the mythological Hydra, sprouting new heads almost each time a central bank initiative is unveiled to deal with a specific problem, some parties say it might be prudent idea for banks to build their war chests.
Of course, that still leaves the issue of non-bank lenders and what might happen to them in the ongoing storm. But at this point, it seems, only the strongest survive.