Mutual Limited manages $2.6 billion on behalf of investors across four retail funds and a range of individual wholesale mandates. The firm’s core focus is debt or credit securities that have contractual payment profiles.
These securities include principally floating rate notes (FRNs), which are a debt obligation like a typical bond used by banks to fund their lending activities to mainly households or small businesses. FRNs represent a contractual requirement for the banks to pay the coupon when they fall due as well as the balance at maturity.
Senior rated major bank FRN’s provide investors with a prevailing yield of 5.2% - 5.3% for a 5-year maturing note (as at the time of this report). Subordinated notes, which rank below senior notes, offer yields of 6.3% - 6.4% for a similar maturity.
An alternative FRN asset class that isn’t as well known by retail investors is Residential Mortgage Backed Securities or ‘RMBS’, which are structured vehicles used by banks and non-bank lenders to help fund their mortgage lending activities. The market for RMBS is meaningful, with $22 billion issued year to date and annual issuance over the past five-years around $43 – $49 billion per annum. Through its funds and on behalf of its clients, Mutual Limited holds close to $250 million in RMBS. A ‘BBB’ rated RMBS note is currently offering yields of 8.8% - 9.0%.
In this piece we answer frequently asked questions investors often have with regard to RMBS.
What are RMBS (Residential Mortgage-Backed Securities)?
Securitisation is the process of converting a pool of cash flows, i.e. mortgages, into tradable securities, in this instance, Residential Mortgage Backed Securities, or RMBS. The RMBS securitisation process involves a mortgage originator, such as a bank or non-bank lender, selling a pool of loans into a special purpose vehicle (aka SPV). In turn, the SPV issues debt securities (‘RMBS’) to investors (such as Mutual Limited) to fund the purchase of these loans. The SPV has no other purpose. The interest and principal from the underlying mortgages loans are used to pay interest and repay principal on the underlying securities, or the RMBS.
What types of loans are used in securitized structures?
Securitisation is most commonly used with home loans – at least in a volume sense, which is what RMBS are populated with. ABS, or Asset Backed Securities, are structures backed by loans to fund cars, trucks, office equipment, business receivables and even solar panels to name a few. Lastly there is CMBS or Commercial Mortgage-Backed Securities, which are populated with loans to fund commercial property purchases. In 2022, annual volume of RMBS issuance was $35.1 billion, while ABS accounted for $6.2 billion and CMBS $1.5 billion.
What is mezzanine financing and how do tranches work?
A typical RMBS structure ranges from $500 million to $1 billion in size, with average loan size around $250,000 - $450,000. Each RMBS structure is divided up into 6 or 7 ‘tranches’, sometimes as many as 10. The word tranche is French for slice, series or portion. The transaction documents usually define tranches as different "classes" of notes, each identified by letter (e.g. the Class A, Class B, Class C notes) with different rights. RMBS structures are rated by rating agency firms such as S&P, Moody's and Fitch, with each tranche allocated a rating based on its position in the capital stack, and layers of support below it.
Investors with a lower risk appetite might focus on Class A tranches, which are usually rated ‘AAA’ and represents circa 80% - 85% of the structure by dollar value (proportion varies depending on quality of underlying loans). At the time of writing, ‘AAA’ rated RMBS are offering yields of ~5.7% - 5.9%, or +160 – 180 basis points above the prevailing cash rate. On the other hand, an investor with higher risk appetite might invest in the Class D tranche, which is typically rated 'BBB', and offering yields of ~8.5% - 9.0% at the time of writing (+440 – 490 basis points above cash).
Higher tranches earn less interest income but they're more insulated from the risk of default of the underlying mortgages. Any losses from defaulted mortgages are absorbed firstly by equity in the structure and then lower ranked tranches, moving up the tranches if and when defaults intensify.
Anything below Class A is typically referred to as a “mezzanine” tranche. The following is a simplified schematic depicting a typical RMBS structure.
What are the main risks associated with RMBS?
Very broadly there are two core risks that determine the underlying fundamental strength of RMBS, and in turn performance as an investment. The first is default risk, whereby one or more of the underlying mortgages default because of non-payment of the loan interest and principal as and when due. The second is loss given default, that is once a borrower has defaulted and the secured property is sold, there remains a shortfall relative to the outstanding loan balance.
What are the historical default rates and performance of RMBS?
For the sake of this question, default rates refer to default of the rated tranches in the structure, and not the underlying mortgages. And, to answer the question, zero. In the 25+ years that RMBS has been used as a funding source, the number and percentage of rated tranches that have default is close enough to zero to be zero. Put another way, no rated tranche has ever incurred an uncured capital loss.
Performance is difficult to quantify given the evolution of RMBS structures post the global financial crisis and lack of publicly available data. There is no RMBS index.
How liquid is RMBS investments?
Like government bonds or vanilla bank bonds, RMBS are over the counter securities. Under normal trading conditions, most major banks make markets in ‘AAA’ rated RMBS tranches, in that they will buy such paper onto their books / balance sheets and on sell it to other investors as and when opportunities arise. Anything rated ‘AA’ and below is typically traded on a best endeavours basis, i.e. banks will try and find buyers if you’re a seller and so on.
In Australia there are approximately $2.2 trillion of outstanding residential mortgages, written by banks and non-banks, across both investor and owner-occupied borrowers. Of this volume, around 5% -10% is funded through RMBS. Year to date, RMBS issuance has totalled $15 billion versus last year’s full year issuance of $35 billion. Average annual issuance over the past ten-years has been $20 - $25 billion per annum, a meaningful number.
If we apply a standard 80% - 85% AAA rated tranche ratio to these figures, that suggests AAA rated tranches total $16 - $20 billion. During periods of meaningful market dysfunction, the RBA and AOFM have actively supported RMBS market liquidity. The RBA recognises that RMBS markets are a core element of credit creation, particularly for borrowers who traditionally do not meet normal eligibility requirements of the mainstream lenders (ie. banks).
What are the costs and fees associated with investing in RMBS?
There are no direct costs or fees to investing in RMBS. However, retail investors are typically unable to invest directly in RMBS as it is generally an institutional investor market with minimum traded parcel size of $500,000. Accordingly, for investors to gain access to the asset class they need to go through a professionally managed fund. Such funds typically charge a fee.
Mutual Limited offers two funds that invest in RMBS, including the Mutual Credit Fund, which is permitted to hold up to 30% of assets under management in RMBS or ABS securities. This fund targets returns of the bank bill swap rate +2.20% net of fees. The fee on this fund is 0.48%, or $48 per $10,000 invested. The fund has no exit or entry fees and does not charge performance fees. As at the date of this paper, the fund is yielding 7.50%.
The other fund is the Mutual High Yield Fund, which can invest up to 100% in RMBS or ABS, this fund targets a higher return of the bank bill swap rate +420 bps net of fees. As at the date of this paper the fund was yielding 10.31%. As with the Mutual Credit Fund, the High Yield Fund has no performance fee, no entry free, but a modest 0.25% exit fee.
Are there any regulations specific to RMBS?
Non-bank originators or lenders are not regulated by the same authorities as banks, i.e. APRA, however they voluntarily adhere to APRA’s minimum underwriting standards. Lenders are required to be licensed under the National Consumer Credit Protection Regulations 2010, with licensee’s obligation to meet minimum ongoing requirements in order to continue lending. With regard the RMBS structures, specifically their legal form, they are covered under the Corporations Act 2001.
What happens if borrowers’ default on their mortgages?
If a borrower defaults on their mortgage, and assuming the documented cure process is adhered to, and assuming there is no likelihood the borrower could continue to service the loan, the underlying property is repossessed and sold. Proceeds are used to repay the loan with capital returned to the RMBS structure. If there is any shortfall, the lender would look toward the borrower’s other assets to recoup any losses.
What happens if housing prices decline?
RMBS structures typically have a weighted average loan to value ratio of 65% - 70%, with some mortgages as high as 90% and others as low as 40%, for example. Most investors will avoid any structure with more than 10% of mortgages with LVR’s greater than 80%, accordingly such structures are rare. Nevertheless, all mortgages are added to the pool with positive equity when originally underwritten (or lent).
Once an RMBS is launched, the underlying collateral – properties – will move in value according to market forces. Declining property prices only become a problem if and when a mortgage is foreclosed upon and sold at a price below the outstanding loan amount. If this occurs, the RMBS structure incurs a capital loss, which is initially covered by any excess spread reserves (credit enhancements) and after that any losses are charged off against the equity tranche.
Using the example structure above, this deal had an equity tranche of $16 million and another 0.5% - 1.0% of credit enhancements below the equity tranche. Accordingly, there is $21 - $26 million of loss absorption protection below the first rated tranche, the Class F notes (rated ‘B’). This loss piece is not utilised unless the fall in house price is greater than the borrower’s equity built up in the property. With regard to this example, the structure in question had a weighted LVR of 64%, 2,000 mortgages and average loan balance of $484,000. So, at the average, the structure could withstand a 36% decline in house prices and assuming the average mortgage defaulted, none of the rated notes would incur a capital loss. Historically, since the recession of the early 1990’s, the worst peak to trough decline in house prices has been 10.0%.
Is Australian RMBS similar to offshore securitized products (i.e., in the US)
Australian mortgages are materially different to US mortgages. The two main differences are loan recourse and tax treatment. Another consideration is the strength and stability of the Australian banking and non-bank lending market versus the US, a core difference, at the bank level at least, is the strength and quality of regulatory oversight.
Loan Recourse: US mortgages are generally non-recourse loans. Australian mortgages on the other hand are full-recourse. Australian mortgages include a personal guarantee from the borrower, which allows banks and lenders to a borrower’s other assets in order to pay any mortgage balance outstanding post foreclosure and sale of the property. A US mortgages typically do not include personal guarantees and as such lender do not have the same avenues available to then to recoup any losses.
Tax Treatment: interest on US mortgages is tax deductible, yet any capital gain made on the sale of the property is taxed – for both investment property and prime residence. This incentivises borrowers to keep their loan to value ratio (LVR) high. In Australia, mortgages on a borrower’s primary residences are not tax deductible and any capital gains made on the sale of the property is tax free. Therefore, Australians are incentivised to reduce their LVR’s as quickly and as much as possible.
Are RMBS investments safe?
As with any investment, there are risks to investing in RMBS. As per previous questions and answers in this piece, no RMBS structure has ever incurred an uncured capital loss. However, that is not to say haven’t incurred losses. As with any traded security, underlying price can and does vary. Under normal trading conditions, RMBS securities can be expected to trade around $97.5 -$102.50 up and down the capital stack, with par and issue price being $100.00. However, there have been periods of market ‘dysfunction’, such as the global financial crisis or COVID pandemic. This can impact pricing.
Example: at the height of the global financial crisis local RMBS investors sought to sell their RMBS positions on fear of contagion from US markets (where RMBS structures were defaulting as inflated house prices plunged). Now, while Australian mortgages differ materially from US mortgages, investors still panicked. Consequently, there were more sellers than buyers. At the time, around late 2008, early 2009, I observed AAA rated RMBS tranches trading at $60.00, or 60 cents in the dollar vs an issue price of $100.00. The underlying pool of mortgages was performing to expectations, with arrears manageable and none of the rated tranches at loss of loss. Shortly after, as the RMBS structure amortised, these securities repaid at par, $100.00.
Coming back to the original question, we would highlight that historically no rated RMBS tranche within the Australian dollar RMBS market has ever defaulted. This includes during the global financial crisis, the European sovereign crisis and more recently the COVID pandemic and resulting economic shut-down.
How are RMBS investments rated?
Most RMBS notes are assigned ratings by one or more ratings agencies (S&P, Moody’s or Fitch). The rating agency will stress test the overall pool of loans and assign a rating to each RMBS tranche. Higher RMBS tranches are designed to withstand more severe economic environments than lower rated tranches. Under S&P’s RMBS rating methodology, AAA-rated RMBS tranches are stress-tested to withstand a great depression like scenario.
Importantly, all noteholders within an RMBS trust share the same pool of loans despite being in different tranches within the mezzanine structure. The ranking of higher tranches and lower tranches is only relevant when distributing the aggregate income, principal or losses from the pool of loans at each payment period – all loans are shared by all noteholders and all tranches.
What is a non-conforming loan?
Broadly speaking there are two types of mortgages or loans used to populate RMBS structures. “Prime” loans and “Non-Conforming” loans. The Reserve Bank of Australia defines the two as follows…”Prime mortgage loans are those made by mainstream mortgage lenders (banks and other deposit-taking institutions and mortgage originators). Non-conforming mortgage loans are those made to borrowers who do not meet the normal eligibility requirements of the mainstream lenders.”
An example of a non-conforming borrower is someone who may be self-employed with an irregular income stream, i.e. tradesman, doctors, dentists etc. Non-conforming borrowers could also be borrowers with a few dents in their credit record.