Executive Summary
The Australian securitisation market has evolved significantly over the years. Once an obscure corner of debt security issuance, securitisation has become an important part of Australia’s financial fabric with a public market size of ~$160bn, compared to the combined market capitalisation of all stocks on the ASX of ~$2,300bn. Our paper outlines exactly what securitisation is, how it works and the underlying structure of a standard offering. Using the example of residential mortgage backed securities (RMBS), the most common securitisation transaction in the Australian market, the paper also explores how some of the structural features within these assets offer diversification and protection to investors.
What is Securitisation?
Securitisation refers to the process of converting a pool of individually illiquid assets, and their associated cash flows, into a tradeable security. The performance of the securities is directly linked to the performance of the underlying assets. It has become an important component of modern financial markets and helps improve liquidity, increase stability and mitigate risks for both investors and issuers. While securitisation can take various forms, this paper focuses on residential mortgage backed securities (RMBS) which is the most common structure in the Australian market.
The underlying assets of a securitisation transaction typically have the following features: 1) known cashflow profile 2) transparent asset value and 3) illiquid or difficult to trade individually. As you can imagine, the combination of the above factors creates a funding dilemma as the two former qualities make for an appealing asset for investors, but the latter deters capital from being allocated to these assets.
While a range of pooled assets can be securitised, the most common example of securitised assets in the Australian market are residential mortgages, which neatly meet the criteria for securitisation. Mortgages generate consistent and known cashflows in the form of mortgage repayments, while the outstanding loan amount means there is a clear and transparent value of the underlying asset. However, despite these desirable attributes, an individual mortgage is not an easily tradeable asset. Houses are bought and sold every day in Australia and the securitisation process plays an important role in ensuring purchasers have access to a range of competitive home lending products.
How Securitisation Works
The process of securitisation allows an originator, such as a mortgage lender, to take a large quantity of individual loan assets, package them together and sell them to a Special Purpose Vehicle (SPV). To pay for these assets, the SPV issues securities backed by the underlying assets which are then sold to investors. In most securitisation structures, the securities are in a hierarchical tranche structure, with each tranche having its own risk and return profile and credit rating. There is generally a senior class of notes which has a priority right to repayment, and one or more junior classes which rank behind the more senior classes, with funds distributed in accordance with a “payment waterfall”.
Importantly, the originator is required to retain the lowest, most risky tranche, referred to as the Seller notes (sometimes also known as the Equity notes) which is exposed to the first losses in the event of a repayment shortfall. This ensures the lender has a vested interest in the quality of the loans in the pool and the ongoing servicing of these loans.
A Servicer is appointed (generally the originator) to collect payments and monitor the assets and plays a critical role managing the cash flows of the structure and recoveries of the underlying loans.
The securitisation process provides several benefits to participants involved. Originators can more readily access wholesale funding through capital markets which frees up their balance sheets and allows them to focus on writing loans and managing borrowers. This is most important for non-bank lenders who, in comparison to authorised deposit-taking institutions (ADIs), cannot accept deposits to support their lending activities. Meanwhile, for investors, securitisation provides access to an asset class that delivers significant diversification benefits, consistent income and the benefit of secured investments backed by assets with contractual obligations. They also have the opportunity to invest in different tranches of securities which suit their particular risk/return appetite. Lastly, for the underlying borrower, the existence of a securitisation market means a ready source of capital to meet their various funding needs.
What does a Securitisation Structure look like?
A securitisation SPV is a bankruptcy-remote trust or company which holds the asset pool and issues the securities. It has no direct credit exposure to the originator. It has a balance sheet, which is made up of the underlying pool of assets, and liabilities, represented by the securities it has issued to investors. It also has a P&L, of which the primary source of income is the repayments of principal and interest received from the underlying borrowers while its expenses are the coupons paid to investors, as well as the costs associated with operating the SPV to the Trust Manager and Servicer (and other parties). Where the originator is also the Servicer for the SPVs, a back-up Servicer (which is an independent third party) is usually also appointed to ensure no direct credit exposure to the originator. Finally, the net profit generated by the SPV, often referred to as the “excess spread”, is paid to the originator.
As mentioned earlier, in a securitisation structure, the securities issued to investors are “tranched” into classes of notes in a hierarchy representing their priority in the payment waterfall . In a public securitisation deal, these notes are rated by independent rating agencies, such as S&P, Fitch or Moody’s. At the top of this capital stack are the senior notes, which receive the highest rating. The ratings then notch down with each tranche of the capital stack. While all notes are backed by the same underlying pool of assets the different risk ratings reflect the levels of subordination of each class of notes.
So, what determines the risk rating? The ratings agencies will assess a range of factors including the credit quality of the asset pool, the integrity of the legal structure, and quality of the servicer. The risk rating for each class of notes is determined by their level in the payment waterfall and the dollar value of the tranches that sit above and below a specific tranche in the capital stack. Each subordinated tranche buffers the tranches above it against potential losses. Losses from the underlying pool of assets flow upwards, starting from the equity note at the bottom of the structure. Due to this, the more junior notes with a lower credit rating, command a higher return compared to the notes above. In a similar vein, all income from the pool of assets flows downwards, paying the coupon of the senior notes at the top of the structure first.
While the underlying assets themselves are easily understood, investors would be forgiven for having difficulty in understanding the structure of a securitisation deal. The complex structures create a raft of legal protections for investors to allow them to participate in an otherwise inaccessible asset class while giving them the ability to invest in a way which fits their risk/return appetite.
Risk Mitigants in Securitisation Structures – RMBS
In the Australian RMBS market, no rated securitisation note has ever had a permanent capital loss – that is a remarkable statistic considering the 30+ year history of the market. This means these securitised assets have weathered the storms of the COVID pandemic, the GFC and the 1990s recession.
This impressive track record is due in part to the contractual protections awarded to investors in securitised notes and the obligations on the servicer to manage the assets in the pool. These protective features are present on an individual loan level, as well as an SPV level.
Loan Level Protections
At an individual loan level, the trigger for a mortgage to become non-performing is that the loan enters arrears: that is, the borrower stops paying their mortgage. Job loss is the main cause of arrears and once any amounts of prepayments and additional savings are used up, and regular mortgage repayments are missed, the mortgage then enters arrears. However, where the borrower can find employment again and start repaying their mortgage again, the loan will exit arrears and return to performing status. This is the most common outcome for mortgages that do enter arrears.
Where the borrower remains in arrears for more than 3 months, the lender may recognise the loan as being in default. At this stage, the lender can begin the process of repossessing the property and selling it, the proceeds of which are then used to pay off the outstanding loan. If the borrower has any Lenders Mortgage Insurance (LMI), a common occurrence for mortgages with a loan-to-value ratio above 80%, then any shortfalls in the sales proceeds may be covered by a successful LMI claim. If there is no LMI and there is a shortfall between the property sale and the mortgage amount, the lender may then claim against the borrower or any guarantors to the mortgage.
Australian mortgages are structured as full recourse. This is a critical difference in the Australian mortgage market when compared to the US as, in Australia, the lender has access to the other personal assets of a borrower when they are in default. This means that, if the proceeds from the sale of the house do not fully repay the loan, the lender may also take legal action against the borrower and any guarantors to recoup the shortfall (including through bankruptcy proceedings). This unique feature also disincentivises borrowers from abandoning their homes where the value of the property has materially fallen and the loan is in negative LVR.
If, after these first five steps, there is any losses still remaining, these are then allocated against the SPV which offer further layers of protection.
SPV Level Protections
At an SPV level, any losses are first allocated against the excess spread. As explained previously, the excess spread is similar to the “net profits” of the SPV which are paid to the lender. This provides an incentive for the originator to ensure they are packaging high quality assets into the SPV as their profits take the first hit after all loan level protections are exhausted. If the losses of the mortgage exceed the excess spread, many SPVs will also have a Principal Loss Facility that will also reduce the impact of any losses on investors. These facilities are typically funded by the originator and offer yet another layer of protection to the noteholders.
Finally, if any losses still remain, these are allocated against the securitised notes, starting with the Seller note held by the lender. Once the Seller note is reduced to zero, then the class of notes next above in the stack is impacted. This process continues until all losses have been allocated.
Even at this point, any class of notes that incur a capital loss will have a claim against all future excess spread of the SPV until they are repaid the full amount of the write down. Therefore, it is possible for an initial loss to be recovered over the life of the note.
Conclusion
In summary, Australia’s large and mature securitisation marketplace plays an important role in our financial system. This process not only facilitates liquidity in the market, but also offers investors with access to an asset class that benefits from a number of contracted protections. These securitised assets are not simple, however, for those that can overcome their inherent complexities, they can be an attractive investment.
Disclaimer
This report is prepared by Aquasia Pty Ltd ABN 20 136 522 051, AFSL 337872 (Aquasia) as trustee and investment manager of the Aquasia managed investment funds (Funds) for information purposes to wholesale clients (as defined in the Corporations Act 2001). It contains general information and does not constitute personal financial or investment advice or recommendation or an offer to buy or sell any financial product. It does not take into consideration any person’s objectives, financial situation or needs and should not be used as the basis for any investment or financial decision. Past performance is not a reliable indicator of future performance. Aquasia does not guarantee repayment of capital or any particular rate of return from the Fund. Recipients interested in investing in an Aquasia Fund should refer to that Fund’s Information Memorandum and seek independent financial advice and input from accounting, tax, legal and other professional advisors.
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