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Melbourne APEC Finance Quarterly

Issue 1, November 2007

 
   
 

 

APEC Secretariat

APEC Study Centre at Monash

Victorian Government

 

Welcome to the newsletter of the Melbourne APEC Finance Centre.

MAFC at Monash University is a facility sponsored by the Victorian Government's Department of Innovation, Industry and Regional Development. The Centre's mission is to promote Victoria's knowledge and expertise in financial services in the Asia-Pacific region through the provision of training, symposia and research.

The Melbourne APEC Finance Quarterly will advise readers of the work of the Centre and issues of contemporary experience in finance. We welcome your comments and feedback by email.

In this inaugural edition, we provide you with executive level insights from leading industry participants - Ernst & Young, ANZ Bank and Standard & Poor’s - on the highly topical issues of the sub-prime fall out, as well as the progress being made in Australia on the implementation of the Basel II Banking accord, plus more.

 

US SUB-PRIME - IMPLICATIONS FOR FINANCIAL SUPERVISORS AND REGULATORS

Paul Braddick is Head of Financial System Analysis at ANZ

Image of Paul Braddick

A steady deterioration of credit quality in the US sub-prime mortgage sector came to a head in August when several global hedge funds including Bear Stearns and Blackstone Group announced substantial losses on sub-prime mortgage securities and derivatives. The ensuing market crisis saw global credit spreads widen sharply and liquidity in asset backed commercial paper markets all but evaporate. 

Rising interest rates and a slump in the US housing market were catalysts but at its core rising delinquencies and foreclosures in the sub-prime mortgage market reflect a significant lowering of lending standards. Large numbers of marginal customers facing a high risk of default were sold loans that they often did not fully comprehend. Widespread allegations of predatory lending, fraud and ineffective prudential supervision have led to the inevitable calls for a tightening of supervisory standards.  

US epicentre with global implications

A sustained period of low official interest rates led a surge in financial market liquidity, boosted asset prices and increased the risk appetite of borrowers, lenders and investors. A booming US economy and rising house prices saw lenders competing for market share by relaxing loan criteria and targeting buyers with weak credit.

Housing boom buoyed by very loose policy

 

US INTEREST RATES

graph 1

Sources:  Thomson Financial Datastream, Economics@ANZ

‘Piggyback’ loans where borrowers took out a second loan for their mortgage deposit *  became commonplace, loan to valuation ratios increased and lending to buyers with weak credit rose exponentially. Sub-prime 2/28 loans which offered a low introductory ‘teaser’ rate for two years, then adjusted to a rate often three percentage points more than a prime customer would pay for the remaining 28 years became very popular. Sub-prime mortgages surged from around 3% of the mortgage market at the turn of the decade to more than 15% (over US$1trillion) in June 2007.  Reduced lending standards and a boom in the housing and structured finance markets left borrowers and investors highly exposed.

The music eventually stopped in 2006 when rising interest rates and a housing ‘bust’ saw many borrowers left in a negative equity position and unable to meet rising repayments^. Mortgage delinquencies and foreclosures have risen sharply and the demand for (and value of) mortgage backed securities has plummeted. 

Sub-prime delinquencies are rising sharply

 

SUB-PRIME MORTGAGE DELIQUENCIES

graph 2

Sources:  Thomson Financial Datastream, Economics@ANZ

The securitisation of such loans spread the pain throughout the global financial system resulting in a crisis of investor confidence.  The earlier global appetite for high yielding mortgage backed commercial paper has seen institutional investors as far away as Germany Australia hit by significant losses as the value of such investments collapsed. 

Australia is far less exposed

In contrast to the US where 80% of mortgages are sold on to investors, in Australia securitisation represents just 20% of the mortgage market with the majority of mortgages remaining on lenders’ balance sheets. Moreover, sub-prime (or non-conforming) loans account for just 1% of total home loan outstandings and loan underwriting standards, while declining, remain relatively tight in Australia. 

Nonetheless, despite a buoyant (ex-NSW) economy and booming housing prices, loan delinquencies have risen, particularly in the non-bank originator segment. Credit quality in the banking sector remains high suggesting the deterioration of credit quality is not a systemic issue but reflects a lowering of lending standards and a rise of predatory lending practices.

Delinquencies confined to certain channels

 

graphs 3 & 4

graphs 5 & 6

Sources:  S&P, Economics@ANZ

High loan to valuation ratio and adjustable rate loans are far less prominent in Australia, but have become increasingly available in recent years. So while we have little cause for concern regarding credit quality in the broader Australian mortgage market, the US sub-prime mortgage crisis is a timely wake-up call for regulators, lenders and borrowers. 

Conclusion

The crisis has highlighted the need for increased consumer protection against predatory lending practices. This will require greater scrutiny of the lending market by prudential supervisors and consumer protection agencies, including investment products that currently fall outside the scope of ASIC regulations. The existing model in which mortgages are sold to marginal borrowers for up-front fee income with the default risk subsequently passed on to investors in mortgage backed securities is already being reassessed. Once the dust from the current crisis has settled, demand for mortgage backed commercial paper may recover, but for this to happen, investors will need to be convinced that lending standards have been tightened and credit ratings provide an accurate reflection of underlying risk. 

While the crisis has resulted in the loss of billions of dollars and caused heartache for homeowners and investors alike, the eventual outcome will hopefully be a significantly more robust financial system.

Annotations:

* Often without mortgage insurance: and in the prevailing market conditions in 2000, 'piggyback loans' were regarded by some in the credit ratings industry as no more likely to default than a standard mortgage.

^ Particularly those facing upward interest rate resets on adjustable rate mortgages.

 

LESSONS LEARNED FROM SUB-PRIME

Ian Thompson is Managing Director, Chief Credit Officer and Head of Research & Training Asia-Pacific Rating at Standard & Poor's

Image of Ian Thompson

Recent difficulties in the U.S. subprime mortgage market provide a variety of lessons for rating agencies – lessons we are eager to learn from and act on.

The extraordinary behavior of subprime loans made since late 2005 – including the unprecedented level of very early payment defaults – has required us to look long and hard at the assumptions underlying our ratings of securities backed by these mortgages. Data on mortgage performance that we have used in our rating analysis – including data that sometimes went back as far as the Great Depression – have proved no longer to be as useful or reliable for these recent subprime mortgages as in the past.

Downgrading

We have responded by downgrading our ratings on a number of U.S. residential mortgage-backed securities (RMBS), in anticipation of higher losses to come in the subprime loans backing these securities. It is important to note that these downgrades have predominantly impacted weaker RMBS tranches that were originally rated BBB or below.

As important, we have embarked on a series of initiatives to enhance our analytics and process, as part of our commitment to continuous improvement. We are tightening our criteria, increasing the frequency of our reviews, modifying our analytical models, and looking for ways to enhance the quantity and quality of data available to us.

This is not a one-off exercise. We are continually seeking to improve our rating opinions, and the assumptions supporting them, so that they remain current and analytically sound in light of shifting market circumstances. And we will continue to listen carefully to investors and other users of our ratings to respond to market conditions.

More generally, recent events have highlighted that our ratings may be misunderstood. We aim to learn from this and are working closely with the market and regulators to improve the understanding of what our ratings mean, how we arrive at them and how they perform.

Defining credit ratings

A Standard & Poor’s credit rating has an important, but very precise, role - it is an opinion about the probability of a security or debt issuer defaulting. It does not speak to the market value of the rated security, and it is not a promise or guarantee of market performance. In practice, a rating is one of many factors that an investor considers when making an investment decision.

The credit crunch and falling market valuations we have witnessed recently are very real. But at the same time we have not witnessed widespread defaults of mortgage-backed securities, which is what our ratings specifically address.

Ratings, while inherently more stable than market prices, can and do change. As the performance and outlook of the economy, sectors or an individual issuer change, so may our views of underlying creditworthiness.  Sometimes the reasons for these changes are difficult to predict.  The performance of U.S. subprime mortgages made since late 2005, for example, is unlike anything we have seen before for loans with similar credit characteristics.

Concern also has been raised about rating agencies being paid by the issuers of bonds they rate. This model was introduced approximately 30 years ago at the behest of the market, because it enables us to make our ratings widely available for free, which enhances the transparency of our criteria and our opinions. Rating agencies that use a subscription-only model do not typically make their ratings public.

The ratings process

We have well established policies and procedures to protect the integrity of our rating process from any potential conflict of interest:

  • Ratings are assigned by committee, not by individual analysts;
  • Our analysts are prohibited from negotiating fees and other commercial activities;
  • And we specifically structure our analysts' compensation so that it is not dependent upon the fees related to the ratings they assign.

Most important, our reputation and integrity are our most valuable long-term assets, making it self-defeating for S&P to provide anything other than fair and independent ratings opinions. A study by two Federal Reserve Board economists found that rating agencies’ reputation interests trump any conflict of interest. Numerous other studies have come to similar conclusions.

The acid test of our integrity, of course, is our track record, which is open for all to see in its entirety. It shows an extremely close historical correlation between our ratings and defaults. Since 1978, the average five-year default rate for investment grade structured securities is less than 1%; for speculative grade securities it is over 15%. By comparison, the five-year default rate for investment grade corporate issuers is just over 1% and around 20% for speculative grade issuers.

Our reputation is our business, so when it comes into question, we listen carefully, we learn and we improve. To that end, we are introducing a number of enhancements in light of the subprime experience, and we believe these will help us maintain our strong track record into the future. It is this empirical track record – the correlation between ratings and defaults – on which we hope to be judged.

 

CHINA AUSTRALIA GOVERNANCE PROGRAM DIALOGUE

Ken Waller is Director of MAFC at Monash University

Image of Ken Waller

The inaugural China Australia Governance Program (CAGP) in risk management and governance was held in Melbourne in July 2007 as a collaboration between the Asia Pacific Finance and Development Centre, Shanghai (AFDC) and the Melbourne APEC Finance Centre (MAFC). The program was funded by the Australian government under the CAGP format, with the support of the Chinese Ministries of Commerce and Finance, the Australian APEC Study Centre and the Australian Treasury.

Objectives

The specific objectives of the program were to build durable relations between Australian and Chinese institutions; to identify capacity building needs that might be useful in supporting the implementation of Basel II in China; and to develop a five-year program for capacity building training. As a result of the program, a report has been presented to the Australian and Chinese governments with proposals on how to meet these objectives.

A key proposal was that the AFDC and the MAFC jointly agree to cooperate on work on mutually beneficial training projects, subject to appropriate funding sources. Some of the joint projects may include high level dialogues, risk management and/or governance training programs, joint research on key issues of common interest to support training in the banking sectors of both China and Australia, and an effective alumni network to promote exchanges.

These ideas came about after the participants in the dialogue from both sides developed a deeper understanding of the issues involved in improving governance and risk management. Participants also shared their experiences of successes and challenges in implementing Basel II, and examined strategic options that could be pursued in building capacities.

A full suite of presentations from the dialogue are available for downloading here.

Outcomes

Three areas in particular were discussed and debated in greater detail. The first of these was the issue of Risk Management with regard to capital allocation and changes that may be needed in banks’ culture and practices during the implementation of Basel II. The second was Corporate Governance, including the roles and relationships between Boards of Directors, supervisors and management, and the responsibility of Board committees. The third was Capacity Building, and its long-term focus. During the site visits, the Chinese delegation discussed issues like operational frameworks, privatisation, the development of China’s and Australia’s banking systems, regulatory policies and practices, and transition issues relating to Basel II.

Having identified key issues for Chinese bankers and regulators in risk management and governance, the development of a framework to build institutional capacity through executive training has been realized and marks the start of the next phase for MAFC’s China program.

 

THE BASEL PROCESSION. . .

Tim Coyne is Partner Financial Services at Ernst & Young

Image of Tim Coyne

The relevance of the Basel II Accord marked a further step in refining the measurement and management of capital by global regulators. A move to a more refined risk measurement process was welcomed away from the Basel I “one size fits all” approach.

In Australia, the prudential regulator APRA moved quickly to settle on the application of Basel II to Authorised Deposit-taking Institutions (ADI). The Australian banks are moving towards staged accreditation as determined by APRA, with effect 1 January 2008, following a number of years of solid effort.

So how are Australian banks going?

It is fair to say there has been a ground swell of work required to accommodate Basel II by Australian banks, particularly at this juncture by the majors. Not only has it required long tailed project plans, it has also placed demands on each of the majors’ systems, knowledge, practices and financial resources.

Anticipated savings in capital are unclear at this stage due to relatively fundamental issues, primarily the timely finalisation of regulator requirements and then the task of addressing data integrity, aging legacy architecture, sheer size and complexity of the ADIs and resource availability. Many banks in Australia and globally are still counting the costs, in anticipation of eventual savings via the level of capital expected to be maintained post Basel II. It is fair to say that the combination of adopting economic capital as the primary decision making tool; underlying data integrity challenges, ability to integrate into old systems and embedding the ‘new’ thinking into banks’ line management will take many years to fully operationalise.

Managing data

In this regard, particularly in the area of data management. the industry sought APRA’s views, and the result was the recent Data Management Principles release. Interestingly, these principles are not isolated to Basel II, but span the operation of any banking institution or for that matter, any institution. 

As a result, this has provided additional impetus to review and challenge current management information systems, functionality and useability. Many institutions are realising the impact of data integrity and identifying both efficiency and anticipated benefits in re-designing and re-engineering their core processes, capital management, governance and quantification of risk in the institution’s own risk appetite. In fact, a number of institutions are now actively utilising the advanced approaches to credit in comparison to operational risk where global regulators and banks are still ‘finding their way’.

Capital versus risk

A further challenge to emerge is to ‘re-educate’ bankers in managing capital and the managing risk/return equation in the front line. The corollary to this aspect is the critical role incentive schemes and performance measurement of bankers plays. The delicate balance between appropriate growth and remuneration for achieving that growth becomes a business imperative to ensure the sustainability of returns.

Now as the banks prepare to operate with a more sophisticated approach to risk and capital management, the regulator is also keen to observe the ultimate capital impact in the banking system. Indeed, because of the issues that have emerged relating to data gaps, data history and pervasiveness of system impacts on day to day operations, the regulator has had to acknowledge and consider this outcome on the overall implementation of Basel II. In fact, it has meant the regulator has been heavily engaged to work with ADIs through the demands of this new system of risk measurement and management.

Overall, the path to completion will continue to be demanding through into 2008 and the ADIs will continue to refine their systems, methodologies and processes as experience from banks and regulators globally emerges. It will be watching brief to see to what extent the banks can leverage this investment quickly to the benefit of their shareholders.

 


The Melbourne APEC Finance Quarterly is edited & published by MAFC at Monash University.