CNN Money reported on a paper by Standard & Poors that critiqued our Aussie Mac proposal. We have seen the S&P paper but it contains a number of errors, misunderstandings and/or mischaracterisations. We think that debate and dissent is healthy. With this in mind, over the fold, we have outlined our assessment of the flaws in S&P’s critique.
1) S&P open up by claiming that, “the proposal is predicated on the closure of the primary market for Australian RMBS and the assumption that it will not return.” They continue, “But to say that the market for RMBS is dead and will not return is a big call.”
S&P’s claim that we have said the RMBS market is dead and will never return, which serves as the foundation for the overall critique, is completely false.
As any reader of our paper will see, the AussieMac initiative is based on the observation that the primary RMBS market has closed for a period of time with potentially irreversible consequences for the composition and structure of the Australian mortgage market and, indeed, other industries (eg, the SME lender sector, which suffers from a high risk-weighting). Importantly, this market failure has materialized for reasons that are completely unrelated to the performance of Australian mortgage borrowers, the institutions the lend to then, or the health of our economy: it has occurred because of an external liquidity shock brought about by the US sub-prime crisis that has propagated a dramatic global increase in investor risk-aversion to levels that most central banks consider to be irrational. As we note in our paper, less than 1% of Australian loans are sub-prime, while the default rates on our prime loans are a fraction of US equivalents.
Our observations that the primary RMBS market has closed and that this has had major ramifications for the industry are statements of fact: there have already been significant withdrawals from the market (eg, three of the securitization pioneers in Macquarie, RAMS, and ANZ’s Origin) combined with severe credit rationing by other players (eg, Adelaide Bank, Wizard Home Loans, Resimac, Heritage Building Society, Credit Union Australia, etc). This is borne out by the fact that the market share of the Big-5 majors has increased dramatically with a commensurate reduction in competition.
To say that we’ve claimed that the RMBS market is “dead” and would not return is highly misleading. In fact, on page 9 of our paper, we note “Most experts expect very thin primary market liquidity to persist for another 6-12 months. When demand does eventually return, participants project that it will do so in limited form and on materially more expensive terms.”
As you will see, S&P have, for one reason or another, created a “straw-man”: they are criticizing a proposal and a set of assumptions that have never existed.
It should have been clear to S&P that our central argument is simply that markets irregularly fail, and are subject to significant liquidity shocks oftentimes for reasons that are external or unrelated to the market in question. When markets do fail there are potentially catastrophic consequences. In order to prevent or mitigate these effects, many economists accept that there is a strong rationale for governments to intervene and provide participants with the public goods of “liquidity” and “price discovery”. The actions of central banks around the world, who are providing liquidity to banks (and in some cases non-banks), clearly validates this view.
Our point is simply that in Australia these liquidity and price discovery services should be provided on a systematic and non-discriminatory basis. While the RBA is currently furnishing liquidity on a temporary basis to ADIs, this is clearly inadequate for the securitisation markets (here S&P have tried to argue to us that “surely the role of temporary liquidity provider belongs to the RBA”): in particular, the RBA only offers to repo AAA-rated home loans for a very short period of time (up until recently, overnight, although this has now been extended to 90 days); it does not acquire these loans as one would in a securitisation (although there is talk of the Fed doing this in the US); it only lends 90 cents in the dollar against these loans; and, perhaps most importantly, it does not offer such liquidity to non-ADIs. In short, the RBA is providing liquidity to those who least need it. This is understandable, since all the RBA cares about is financial system stability, and with this in mind all you have to do is protect the banks.
Our AussieMac solution is motivated by the growing frequency with which extreme financial market dislocations appear to be occurring in our increasingly integrated world. This is likely to be a result of the tendency of investors to systematically overreact to positive (eg, the tech boom) and negative (eg, the tech wreck) events. These “behavioural biases” in the actions of investors, which can persist for relatively prolonged periods of time, have become increasingly well-documented in the academic literature over the last 10 years and undermine traditional notions of investor rationality and market efficiency.
2) One tenuous argument S&P make for the return of the primary RMBS market is the fact that St George recently sold some asset-backed securities. While we believe that the primary RMBS market will eventually return, it will almost certainly do so with less depth and the damage to the industry will likely already have been done. More importantly, however, S&P forget in their analysis to tell us that the St George transaction was a securitisation of car-loan receivables. Since the global credit crunch has focused most intensively on the mortgage market, we fail to see how securitising a tranche of car loans is directly related.
3) S&P spend several paragraphs explaining how the closure of the primary market “is hardly surprising… Investors can buy as much RMBS as they want in the secondary market at yields that have never been seen before. Investors would buy primary issues of RMBS if the yields offered matched those available in the secondary market but this is, of course, uneconomic for the mortgage originators.”
The reader is given the impression that this is something that we have overlooked. On the contrary, we go to some lengths on page 10 of our paper to explain exactly this point: ie, that secondary market pricing of RMBS has, because of the surfeit of sellers, blown out to up to 10 times historical pricing at around 200 basis points above bank bills. In fact, S&P has repeated exactly what we noted: “With no current primary market demand for Australian RMBS…and typical secondary market pricing at late 100 basis points to early 200 basis points above bills (ie, up to 10 times higher than pre sub-prime pricing), one can see why primary liquidity has disappeared. Local institutions, such as super funds, are also much more likely to acquire RMBS assets in the secondary market since the pricing offered is far cheaper than any primary issue. However, even the secondary market trading activity is highly illiquid.”
4) S&P confidently claim that “there is a natural solution that will exert itself relatively quickly.” This is based on the view that since RMBS has an amortization life of 3 years, and the weighted average life of secondary RMBS being sold in the market is even shorter, investors will have to eventually look for new RMBS to replace the old.
However, this argument contains two issues:
(a) if the weighted average life of secondary RMBS is, say, half of the primary life of 3 years, then there is still, say, a good 12 months of secondary assets still available. This then implies that the duration of the closure of the primary RMBS market, which has been effectively shut for 6 months now, could persist for at least another 6 months and possibly longer. The current market collapse has already had major consequences for competition in the mortgage market—the longer the market remains shut, the greater those consequences will become; and
(b) the S&P argument presumes that liquidity will return in a manner that is sufficient to restore the primary RMBS market back to its previous form. There is, as yet, no indication of that: liquidity in the secondary market is still extremely thin, despite the extraordinarily cheap pricing available to investors.
5) Perhaps the three most important arguments S&P uses to critique our AussieMac proposal are as follows:
(a) AussieMac will completely dominate the primary RMBS market and disintermediate private sector activity with adverse consequences;
(b) By the time you establish AussieMac, the problem will likely have gone away. Specifically, they comment, “By the time it is operational the market for RMBS may have returned to normal. What purpose would AussieMac serve then?”; and
(c) AussieMac is just a “”back to the future” solution, recalling predecessors to the development of the RMBS market such as Fanmac and National Mortgage Market Corporation.”
Let us respond to each of these in turn:
As we note in our paper, AussieMac should be deliberately constrained from disintermediating private sector activity. These restrictions would be quite easy to impose. For example, except during periods of demonstrable market stress, you could limit AussieMac to supplying no more than, say, 5%-10% of the market liquidity (and note that this would be liquidity only for the purposes of acquiring prime RMBS that conformed with AussieMac’ strict credit criteria). This should ameliorate any artificial distortions brought about by AussieMac’s participation in the RMBS market during the ordinary function of that market. It would also minimise day-to-day operating costs, notwithstanding that AussieMac should be a cash-flow positive concern with no direct government subsidies (eg, like CMHC in Canada). AussieMac’s chief mandate would be to serve as a liquidity provider of last resort to a key component of the financial system (ie, the securitised RMBS market) in the event of these once-every-ten-years external shocks–that result in the closure of critical economic markets for extended periods of time to the potentially irreversible detriment of Australian financial institutions and the households they service.
B. By the time AussieMac exists, the problem will not have gone away.
The motivation for AussieMac is not just to solve the current credit crisis. On the contrary, it would be a permanent infrastructure that could help protect against all future crises. As in the past, we expect these irregular liquidity shocks to reappear in the future: as capital markets become increasingly well connected, and investor sentiment can be transmitted rapidly around the world, markets will at some point in the future fail again. At this time, there will once again be a need for government to intervene and provide the public goods of price discovery and liquidity.
We have this infrastructure in place for the banking sector with the RBA, and our view is that it should be reinforced and extended to cover the non-banking market
3. AussieMac is not just a “back to the future” solution, recalling predecessors to the development of the RMBS market such as Fanmac and National Mortgage Market Corporation.”
We went to some lengths in our paper to highlight the fact that any comparison with FANMAC is entirely inappropriate. In this context, S&P’s reference to FANMAC is quite bizarre. In footnote 7, we commented:
“It is critical to note that our AussieMac proposal has nothing to do with the NSW Government mortgage financing agency, FANMAC, and the Government mortgage originator, HomeFund, which suffered significant difficulties in the early 1990s. These organisations ran into trouble because HomeFund was providing home loans to incredibly high risk borrowers who could not meet their repayments. One of the principal reasons for the problems was that HomeFund was misleading borrowers about the terms and conditions of their loans and aggressively targeting low-income or poorly-equipped households that could not service their repayments. For example, in 1993 Auditor General’s report showed that 11% of HomeFund’s unsubsidised borrowers and an amazing 35% of HomeFund’s subsidized borrowers were in default, the latter of which more than twice as high as US sub-prime default rates. By way of contrast, average 30 day default rates on prime Australian home loans are just 0.84% according to S&P data. Importantly, it is categorically not proposed that AussieMac would be an originator of home loans, like HomeFund. Rather, the originators would be the mainstream private sector lenders that operate today. Even more importantly, AussieMac would only acquire high credit quality ‘prime’ mortgages sourced in accordance with its credit criteria just like the Canadian and US GSEs. Another issue with FANMAC and HomeFund was that their specially designed products involved steep increases in repayments made by borrowers after a certain period of time had elapsed much like the way the US adjustable rate mortgages that have caused so many problems work (ie, get a big reduction in repayments for a few years then get slammed by a huge increase down the road). As the NSW Ombudsmen said at the time, HomeFund was ill-considered, badly advised and poorly understood, even by the Government. Since inception, the overseas GSEs have generally had a hugely positive influence on the formation of the mortgage markets in the countries in question. One should not, therefore, extrapolate out from the sub-prime-like HomeFund experience.”
Finally, in S&P’s paper, and in subsequent correspondence, they argue that this is a market problem and the market should, therefore, be left to remedy itself.
Our response is that markets fail all of the time when “public goods” are not provided. One of the reasons we have intellectual property laws is to protect inventors who deliver important technical innovations. Without such a government-supplied infrastructure in place, there would be few incentives for people to engineer these technologies and the market for innovation would almost certainly fail. Similarly, without the confidence imbued by an implicit government guarantee of deposit-taking taking institutions we would likely face the spectre of bank-runs, as was recently seen in the UK (where the government had to remind citizens that this implicit guarantee was in fact in place). Few credible economists today believe that markets are as “efficient” as was once believed.
Even if deep liquidity were to magically reappear next week the case for an AussieMac-style agency, or modifications to the RBA’s mandate to allow it to fulfill such a role, would, we believe, remain compelling.