RMBS liquidity: the tide finally turns

It was ten years' ago that the GFC turned dangerous with the meltdown of the US mortgage market. Realm Investment House’s Robert Camilleri reviews how this killed the local RMBS market, which is only now showing signs of life.

There has been a marked change in secondary liquidity within the RMBS market, when compared to the last decade. Post the GFC, Australia saw a mass exodus of market participants.

Overnight issuers went from being flush with options, to having their availability of credit heavily rationed, meanwhile RMBS went from a generally accepted and tradeable fixed income product, to an illiquid one. In many instances, this wasn’t simply an Australian phenomenon as cornerstone supporters walked away.

It was a surreal environment, traders literally went from moving $50 million-dollar lines on 1 basis point spreads, to markets going no bid. This initially hit the cash funds after the government guaranteed deposits saw mass redemptions and at the same time a sharp decrease in prices occurred because of the European selling of high quality Australia RMBS assets.

This bled into other fixed income products, like high yield funds, which were not as liquid and vulnerable to a run on funds. And many non-bank lending programs effectively hit the wall as the foreign banks left.

This forced the survivors to go cap in hand to the investment community. The few traders that were still around at that stage, effectively decided which non-banks would continue as going concerns.

Gentle thawing

In the post GFC period, the market became almost dysfunctional - through the period of 2009 to 2011 the RMBS market effectively fell into a state of hibernation. We hardly saw public transactions, until a gentle thawing finally took place into the end of 2011.

Those that had survived, however, were still in care and maintenance mode. With debt capital markets for securitised credit still effectively frozen, non-banks and regional banks lost a significant plank of their funding; in the case of the non-banks their only plank.

During this period, Australian Office of Financial Management (AOFM), the financial management arm of the Australian Government, decided to invest $20 billion of taxpayer’s money into the RMBS market for new loans, to maintain competition, and to buy time so primary markets could re-establish themselves.

Through this period, repo eligibility rules were advocated by the ASF to further bolster the asset class. This had a meaningful impact on the asset class as it was a precursor to AOFM now having an ongoing mandate to invest within RMBS markets.

This was in many ways an ideal period for investors. An absence of any significant liquidity - coupled with the fact that issuers went out of their way to forge pristine pools to lure investors - saw the RMBS market deliver a value for risk that was superior to most other risk markets.

That said, the aversion to the asset class was also at its highest, due to the exodus of the cash funds and trustees and investment committees being led by the stigma of US headlines. The RMBS acronym was enough to scare asset allocators into their shell, no amount of pleading to common sense or judgement helped dissipate misplaced falsehoods around the asset class.

Question of market liquidity

For most of the market between 2012 and 2016 RMBS was still a taboo of sorts. Investors were mired in a bias created by the post-traumatic stress of the GFC and the contributions to popular culture in the form of “The Big Short” and “Margin call”.

That said, for investors who understand the asset class and the fact that RMBS ultimately exposes the investor to the same diversified systemic risk as bank debt, this was an excellent period to put money to work, particularly for hold to maturity investors. At Realm, we started to see a gentle increase in secondary market activity as smaller brokers began to actively broke to family office and high-net-worth markets.

And here we are, where we started. Japanese, European and American banks are once again actively seeking to re-enter the market to fund non-banks and regionals. This current year is on track to eclipse any in the post crisis period for total issuance, stock is being gazumped here at home and abroad as foreign investors muscle in and swallow whole loan pools.

In addition - and this goes directly to the question of market liquidity - we have once again seen the re-entry of several participants into market making. Hundreds of millions of dollars’ worth of foreign investment bank balance sheets has been earmarked and has been allocated to support the RMBS market.

This is on balance a positive for our market, while a good portion of this cash is touristy, absent another tail event a lot of this market making capacity will remain. In our opinion, this will have a meaningful permanent impact on the liquidity dynamics of this market. This poses the question to many researchers and participants who have written RMBS off as a fringe asset class on how they perceive these assets going forward.

Tide turning

As liquidity conditions improve RMBS will only become a more meaningful part of allocations in the fixed income market. While this trend reversal plays out, we will see the liquidity premium dissipate, as bid offers tighten to reflect increased market acceptance and contestability. The ability to trade will allow skilled participants to better reflect their own value based and thematic conviction.

The tide seems to have turned. As such we expect that increased supply in this market, and from major banks in particular, APRA’s standard on securitisation (APS 120) has paved a clear road for regulatory capital transactions, couple this with funding run-offs, capital benefits and a bank levy, more off-balance sheet capital transactions are expected to hit the market.

We are not surprised to see investors soaking up this risk. It is common at the end of a cycle for investors to become price takers because of the fear of missing out. Our experience is that there is always another deal, the economy never stops needing to be funded. It is important to remember this, especially in times like now, where investors are starting to increase their risk seeking behavior to get set and deliver returns.

Much of this paper will be absorbed by the market, especially the senior tranches. However, the junior parts of issuance will steepen as big banks crowd out the non-banks in the foreseeable future due to sheer volume.

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