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The squeeze on mortgage provider costs

By Greg Medcraft - posted Wednesday, 30 April 2008

The global credit squeeze and resulting pressure on mortgage provider cost of funds has highlighted fundamental weaknesses in the Australian mortgage market. As policy makers develop the financial services reform agenda, the Australian Securitisation Forum (ASF) is proposing the Federal Government enhance the mortgage-backed securities (MBS) model for prime owner-occupied residential mortgages. The proposal has received strong support from key industry participants and was identified as a recommended action at the recent 2020 Summit.

The current environment

Arguing the case for market reform starts with a review of the current environment in Australian credit markets. The credit turmoil is increasing Australian bank and non-bank lenders’ cost of funds, which is driving up mortgage rates. On balance sheet funding for major banks is currently about 100 basis points over bank bill swap rates (BBSW) for a five-year maturity. Given a swap/bond differential of 60 basis points and cost of capital of 50 basis points, bank cost of funds is 210 basis points over treasuries.

The Australian residential mortgage-backed securities (RMBS) market, which is an alternative source of capital, is at a standstill. Cost of funds for major bank RMBS is currently trading at over 150 basis points over BBSW. In addition, any major debt or equity raising by a bank could increase these levels further depending on investor demand.


According the Reserve Bank of Australia’s 2008 Financial Stability Review, issuance of RMBS has been extremely limited in recent months following a sustained period of steady growth. In the last six months of 2007, issuance totalled less than A$6 billion, compared with A$45 billion in the first half of the year. No capital has been raised in this market during 2008.

Learning from the Canadian experience

After reviewing a number of agency MBS models around the world, the ASF has concluded the Canadian MBS model has significant benefits to offer the Australian market.

The Canadian Mortgage and Housing Corporation (CMHC) introduced the National Housing Act Mortgage-Backed Securities (NHA MBS) program in 1985 in response to rising mortgage costs. The program aimed to improve competition in mortgage markets and strengthen the solvency of the financial system while lowering mortgage costs and deepening the fixed income investment market.

The model involves a government agency issuing Canadian Mortgage Bonds (CMB) as a three or five-year semi-annual coupon fixed or quarterly coupon floating rate bullet maturity bond. CMBs are secured against pools of high quality, eligible mortgages and supported by mortgage insurance. The principle and interest payment of CMBs are guaranteed by the CMHC, which means the securities have the characteristics inherent in government bonds with a higher yield. CMBs are also included in the major fixed income index (Universal Fixed Income Index), by which many money managers’ performance is measured.

The approved issuers (currently in excess of 50) include banks, life insurance companies, credit unions and dealers. Approved issuers must have the relevant experience, management capability and facilities to ensure they can underwrite and service the mortgages. The CMHC requires approved issuers to also have a minimum net worth of CAD$3 million (A$3.2 million) plus 2 per cent of the aggregate principle amount of securities issued, as well as amounts for any proposed issues.

The CMHC sets eligible mortgage criteria that help to reduce the risk of default. As a result, underlying mortgages are all high quality, prime mortgages. Among other things, they must be owner-occupied property, mortgage insured with an 80 per cent loan to value ratio.


Benefits of the Canadian MBS model

The Canadian experience demonstrates that enhancing the Australian MBS model has the potential to improve home loan affordability. Canadian mortgage provider cost of funds is 60 basis points over Canadian five-year treasuries. That’s a 150-basis point differential with current comparable Australian bank cost of funds.

Investment hungry institutional investors are also expected to benefit from an enhanced model that would deliver a new source of government guaranteed, fixed income securities that are included in the major fixed income index. The bonds are issued quarterly with single maturities, creating large liquid issues for fixed income investors. By contrast, Australian MBS are generally monthly pass through of principal, not included in the major fixed income index and have a wide range of maturities from a broad number of issuers.

Australia would also benefit from improved liquidity in the MBS market. While other markets are frozen with the credit crisis, the CMHC priced CAD$11 billion of CMBs during March 2008 - its largest ever quarterly issue. This follows a CAD$9.5 billion issue in December. This compares to the Australian MBS market, which is currently frozen.

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About the Author

Greg Medcraft is the Executive Director and Chief Executive Officer of the Australian Securitisation Forum, the peak body representing the securitisation market in Australia.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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