Insecuritisation

From this morning's SMH comes a report about developments in a less well known dimension of the great Australian bank bailout, the securitisation market:

REGIONAL banks and other small lenders have begun talks with the Gillard government seeking a third extension to the $16 billion residential mortgage-backed securitisation program that forms a key funding support for the sector.

The smaller banks are hoping to capitalise on recent concerns raised by the Treasurer, Wayne Swan, about the state of competition in the market, amid speculation some of the bigger banks might try an out-of-cycle interest rate rise.

So far the federal government has invested $11.3 billion in low-risk mortgage securities and has been a cornerstone investor in several big transactions in a bid to boost investor confidence after the securitisation market stalled in late 2008.

The initial $8 billion program in late 2008 was extended by $8 billion last November.

It is understood several lenders have approached Mr Swan to continue the program, with a $3.4 billion standing facility to support securitisation issuance from five smaller operators due to expire on December 15.

This blog bets they would like to continue the program. Why bother running a business when you can get a continuous handout?

Whilst it was perhaps understandable that the AOFM began the purchase program in the heat of the GFC with banks threatening wholesale collapse, like so many other bailouts structures, it has since crystallised into permanent and utterly distorted new 'market' rules.

But the securitisation process was not some innocent roadkill in the crisis. It's mediation of investor funds for mortgages, as well as clever shifting and repackaging of risk was the crisis. The many structures that sought to move loans from bank balance sheets into securities vehicles proved hopelessly inadequate under pressure. Indeed, they were subject to the same confidence collapse phenomenon that plagued banks for centuries before the creation of a central bank lender-of-last-resort system.

This blog can hear Australian securitisers and their defenders railing in response that Australia is different. Our Residential Mortgage Backed Securities (RMBS) were better managed and throughout the crisis maintained very low default rates. No Australian RMBS has ever suffered a loss, don't you know!

But let's take a moment to look back at the history of securitisation in Australia.

First, it arose largely after the 1991 recession so it hadn't faced a stern test until the GFC. When it did face such a test from an offshore shock, it totally collapsed and the non-banks disappeared into the banks for chump change quicker than you could say "bust", as did two leading mid-tier banks dependent upon the same process. Is this robust and sustainable competition?

Second, securitisers led the decline of lending standards in Australia. It was they that first issued low doc loans, then no doc loans.

Third, securitisation began by issuing domestic securities but by 2007 was issuing well over half of them offshore, a higher percentage of international funding than even the big banks pursued. They increased the nation's already obscene liquidity risk and was central to the creation of an offshore funded housing bubble.

Fourth, there was widespread abuse of lending rules and required documentation by securitisers. Most of the documented cases are in the non-bank sector. For instance this Boby Dazzler:, "In 2007, the Federal Court ordered Skeers to pay former client Aj Biega $32,000 in compensation after the broker falsified documents to arrange a $365,000 mortgage in 2004 for the then 20-year-old unemployed, dyslexic and homeless man."

Yet it is also widely known that certain mid-tier banks were involved in very aggressive use of securitisation in both their business and business models. The parallels with the dynamics around "Foreclosuregate" are noteworthy.

Back to the SMH:

The government's funding arm, the Australian Office of Financial Management, has bought about a quarter of residential mortgage-backed security issuance this year and its holdings represent about 15 per cent of the domestic market.

While there are signs the market for the securities is slowly improving, it is still fragile, says the Australian Securitisation Forum chief executive, Chris Dalton. ''There needs to be further support,'' he said.

Mr Dalton also called on the Office of Financial Management to broaden its scope and invest in the so-called ''B-class notes'', or subordinated debt, which is part of a securitisation issue. This will avoid crowding out the senior debt where demand is becoming more robust.

The gall of this request is not immediately apparent to the uninitiated. Remember that securitisation shifts risk, is doesn't eliminate it. It does this by breaking a pool of mortgages into "tranches". Each tranche has different rules pertaining to the cash flow of the underlying mortgages. The high risk ones are the first to absorb losses resulting from defaults in the mortgages.

Dissatisfied with the current level of tax payer subsidy, the ASF is calling for the government to buy the securities that are sold from the high risk tranches. You, the tax payer, are being asked not only to subsidise the securitisation but to take all the risk too. We should just cut out the middle man and get the AOFM to write the investors a cheque each month.

This blogger is exersised by the need for increased bank competition as much as the next analyst, but that does not mean securitsation is the answer. The bailout of the Australian financial system was so comprehensive that evidence of the shortcomings of securitisation has either been swept away in a wave of liquidity or absorbed and hidden on bigger balance sheets.

It may be that the rules around Australian securitisation mean it is a less egregious corruption of the credit creation process than those in the US.

But this blogger wouldn't bet on it, and neither should the AOFM.