Active management in the debt market can help avoid issues, explains Warwick Boys.
Some interesting news arrived recently with the bail-out of SNS Bank by the Dutch Government, causing Fitch Ratings to downgrade the country’s outlook from stable to negative (whilst maintaining it’s AAA status).
It was widely reported just over a week ago that the Dutch Government nationalised SNS Reaal in a §10 billion rescue.
According to ministers, the bailout was needed to prevent the banking and insurance group’s collapse from property loan losses and to shore up confidence after a private investor-led rescue had failed.
The Times newspaper reported that the move has highlighted the fact that some European banks are still struggling to recover five years after the economic crisis began, and has emphasised how Europe’s debt-laden governments and their taxpayers remain ultimately liable for corporate banking failure.
SNS Bank did have some AUD sub-debt (final maturity date 2017), but we shared the same view as the Dutch Government that SNS is a strategically important and good banking business.
However we were uncomfortable with the sub-debt, so we don’t hold any of their AUD paper.
Unfortunately for tier one and lower-tier two debt holders, they have lost their investment.
Lessons
Portfolio manager Greg Stock said the two lessons from this are:
- The benefits of active management and how, although once upon a time SNS sub-debt risk was an acceptable exposure, circumstances and banking regulations have since changed and so too did our view of that risk.
- Understanding the risk-reward characteristics of different parts of the capital structure.
Here is another example of active management at work.
Recently the press reported that Fitch Ratings’ latest release of home loan delinquencies showed that overall, across Australia, delinquencies decreased to 1.2 per cent at the end of September 2012, from 1.6 per cent, at the end of March 2012.
The current rate of delinquencies is below the five-year average of 1.6 per cent.
Fitch said that the easier monetary policy in Australia since last year had a positive impact on borrowers’ ability to service loans over the year to the end of September 2012. Fitch said its study analysed the performance of 1.1 million loans with a value of $A211 billion.
This gives portfolio managers more confidence with the underlying collateral for Residential Mortgage Backed Securities (RMBS) issues and in turn will most likely support liquidity in the secondary market and potentially places further downward pressure on margins (ie upward pressure on price).
Another interesting move in the RMBS market
Moody’s Investor Services have just concluded their review of the Australian lenders’ mortgage insurance (LMI) sector, and downgraded the ratings of three LMI companies.
In pre-GFC days, the RMBS market reigned supreme and issuers were typically over $1 billion in size, held AAA tranches and priced at margins of just 15bps over bank bills.
During this time it was common practice for credit fund managers to completely ignore the underlying collateral of an RMBS issue, so long as there was lender’s mortgage insurance in place.
Their assumption was that it didn’t really matter what the quality of the collateral was nor the obvious slender subordination under them (which took the first loss piece), because the LMI would protect their capital.
With the almost total decimation of AAA-rated mono-line insurers during the GFC and the subsequent stress placed on the ability of insurers to support the vast number of RMBS deals they had underwritten globally, underlying collateral became a very important issue and the spreads finally begin to reflect that in a truly meaningful way.
Deals with poor collateral and minuscule subordination suffered incredible spread-widening and poor liquidity (although there was almost always a price, it just wasn’t anywhere near par¨try 40 cents in the dollar).
In contrast, deals with strong collateral and subordination traded in a much more sensible fashion.
At Perpetual, we never valued the LMI as anything but a “nice to have”. To us, it was always about the underlying collateral and the amount of subordination.
What I find fascinating is that despite this always being our process, all fund managers now treat LMI as something akin to a hygiene factor and focus on collateral and subordination to the extent that standard subordination has moved from 0.5 per cent pre-GFC to now being in a 6-10 per cent range.
So, a downgrade to LMI’s these days is nothing more than a discussion point for credit researchers¨for the smart investors, it is now and always has been about bottom-up lending.
Warwick Boys is the general manager of Perpetual Investment.
