The Australian residential mortgage-backed securities (RMBS) sector has fared well amid the COVID-19 pandemic. However, the true effects on debt serviceability are yet to be revealed.

Borrowers have been affected by the economic effects of lockdowns and restrictions. These effects have been mitigated by enormous fiscal stimulus measures for the household sector and a competitive refinancing environment, which are helping many borrowers to better manage their financial situations.

The full effect on arrears is unlikely to surface until the first quarter of 2021, by which time most mortgage-relief periods expire and fiscal stimulus measures taper off. Many borrowers have enhanced their repayment buffers in recent months. More highly leveraged borrowers, particularly those who are less seasoned, and the self-employed are likely to face greater debt-serviceability pressures in the months ahead.

We expect most of our ratings on RMBS to be relatively resilient to rising unemployment and a general contraction in economic activity. However, some of the lower-rated tranches in nonconforming transactions will be more exposed to rating downgrades in the next 12-18 months as mortgage relief periods and fiscal stimulus measures come to an end.

The ongoing reopening of the economy will help borrowers to transition off mortgage deferral schemes and fiscal stimulus schemes in the months ahead.

Table 1

Key Influences On Australian RMBS
Influences	Current outlook
Australia's economic fundamentals	S&P Global Ratings forecasts GDP growth to rise to 4.0% in 2021 (% year-on-year growth). An economic recovery is underway, with good progress on the health front enabling the reopening of most state economies and lifting of state borders. Economic recovery will be uneven across industry sectors, regions, and firm sizes due to variations in lockdown durations and their effects on business cash flows.
Demographic trends	Net overseas migration, a key driver of population growth, has ground to a halt due to COVID-19-imposed travel restrictions. Population growth is forecast to reach 0.2% in 2020-2021 and 0.4% in 2021-2022. This will have flow-on effects on property market demand dynamics and temper a potential resurgence in property price growth, given the historically low interest-rate environment.
Interest-rate trends and mortgage arrears	Central banks around the world have lowered policy rates to help stimulate economic growth in the wake of COVID-19-induced recessionary pressures. Australia has followed suit with the cash rate at a historically low level of 0.1% and unlikely to be increased until the employment landscape improves. Given the sensitivity of variable mortgage rates to interest rates, historically low interest rates will help to offset debt serviceability pressures. We expect arrears to rise in 2021 as employment subsidies taper off and mortgage-relief periods expire. Increases in arrears will be tempered by the support to household income provided by enormous fiscal stimulus measures, in addition to the ability to access superannuation balances, enabling borrowers to build repayment buffers.
State of the housing market	Property prices are recovering in most parts of the country. We expect modest growth in housing prices to resume, on the back of economic recovery. Travel restrictions continue to impede immigration-driven population growth, and business and consumer sentiment is cautious but improving. These factors should deter a runaway spike in house prices in the next few months. Nevertheless, low interest rates, potential easing of responsible lending rules, and housing supply shortages could reignite strong growth in prices in the next two years.
Household indebtedness	Australia's household indebtedness has continued to rise, though the rate of increase has moderated. Low interest rates historically have been a catalyst for strong property price growth in Australia. This could lead to further pressure on household indebtedness in the years ahead. Record-low interest rates have reduced the debt-servicing burdens of many households and high loan-to-value ratio lending has been in retreat for some time, tempering the risk of a highly indebted household sector's increased sensitivity to future economic shocks.
Mortgage market dynamics	Housing credit growth is a tale of two markets. Owner-occupier housing credit growth has gained momentum, with banks keen to provide housing finance to borrowers of a sound credit quality at phenomenally low interest rates. Investor housing credit growth is yet to stage a comeback, reflecting cautiousness given high vacancy rates and reduced rental yields in some property markets, but this could shift with recent rate cuts. Competitive lending is likely to persist in the current interest-rate environment as banks seek to build market share in a post-COVID-19 mortgage market.
Role of lenders' mortgage insurance (LMI)	The use of LMI in the Australian RMBS sector continues to decline. Underwriting standards are now increasingly being influenced by regulatory guidelines, though there is still a close alignment between LMI guidelines and lending policies. The low level of LMI claims-adjustment rates in the Australian RMBS sector reflects this historically close alignment.
Product variations	Discretionary variable-rate mortgages are the predominant loan type in Australia, but fixed-rate loans are fast becoming a larger share of new lending because borrowers are keen to lock in rock-bottom interest rates. Recent RMBS transactions have been predominantly issued by nonbanks because banks have a clear funding advantage over nonbanks, given their ability to access the RBA's Term Funding Facility. The credit profile of recent issuance also reflects this trend, with a higher proportion of investor and interest-only loans than prior vintages.
Regulatory and legal framework	The regulatory landscape is under review, with the proposed easing in responsible lending rules. While proposed reforms could shift the focus from "lender beware" to "borrower responsibility," banks (and nonbanks under the proposal) will still be subject to APRA's prudential practice guidelines. If needed, regulators likely would use macroprudential tools to temper any economic imbalances that may surface, given the current interest-rate settings and search for yield.

This article on the market's operating environment, structure, and performance provides an overview of:

• Australia's economy and demographic trends.
• The Australian housing market.
• The Australian residential mortgage loan market.
• The role of lenders' mortgage insurance in Australian RMBS.
• Australian housing loan product types.
• The Australian legal and regulatory systems applicable to RMBS.
• The key structural issues of offshore RMBS issuance.
• The performance history of Australian RMBS.

To enhance market transparency, S&P Global Ratings also publishes its rating methodology and assumptions, periodic RMBS performance updates, commentary articles, scenario analysis, and presale reports detailing its analytical rationales supporting the ratings assigned (see references under Related Research).

Economic And Demographic Trends

Economic fundamentals

Australia is a democratic country, with a diverse, open, and resilient economy. The sovereign credit ratings on Australia benefit from the country's strong institutional settings, its wealthy and resilient economy, monetary policy flexibility, and low government debt.

Table 2

S&P Global Ratings' Economic Indicators
	2020	2021F	Effect on collateral
Real GDP growth (%)	-3.4	4.0	Negative but improving. The economy is rebounding faster than we initially expected. Policies protecting jobs, supporting household incomes, and easing access to retirement savings have been effective.
Unemployment rate (%)	6.6	6.5	Negative but improving. Jobs growth is recovering faster than we expected due to the effect of wage subsidies and the flexibility of part-time and temporary workers, many of whom bore the brunt of job losses. Labor markets will take time to return to normal but recovery momentum is good news for future jobs growth.
CPI (%)	0.7	1.4	Negative. Weak wage growth is likely to persist for some time with many people looking for work and consumption recovering gradually.
Policy rate (%; EOP)	0.10	0.10	Favorable. Falling interest rates are closely correlated with decreasing arrears because most mortgages are variable rate.
F--Forecast. Source: S&P Global Ratings. EOP--End of period – Q4 values.

Australia's enviable track record of almost 30 years of uninterrupted economic growth ended in the second quarter of 2020, when the economy contracted 7%. Economic recovery will be uneven across industry sectors, regions, and firm sizes. Continued progress on the economic front will be dependent on management of the virus as well as success in developing and distributing vaccines and antiviral treatments.

The economic recovery to date has been better than we initially expected. This is due to early and effective policy intervention, including generous wage subsidies and swift reductions in official interest rates. Underpinning the recovery is state economies' ability to gradually reopen after containing the virus.

While uncertainty remains high, there is a growing probability of a safe and effective vaccine rolling out earlier than our baseline assumption of the second half of 2021. All the logistical challenges remain. Still, an early rollout would mean faster normalization, with less permanent damage to labor markets and balance sheets (see "Asia-Pacific Forecasts Stabilize, Risks Now Balanced," published Nov. 30, 2020).

Interest-rate trends

The Reserve Bank of Australia (RBA) is responsible for the country's monetary policy, historically with the primary objective of maintaining inflation within a target range of 2% to 3% during the course of the economic cycle. It has kept inflation within this target band on average, through adjustments to the overnight cash rate.

Chart 1 shows the target cash rate from 1997 to 2020.

Like many central banks around the world, the RBA acted swiftly at the onset of COVID-19, cutting the cash rate twice in March to 0.25%. On Nov. 3, the RBA cut the cash rate again, to a historical low of 0.1%. Since the onset of the pandemic, the RBA has repeatedly communicated that the board will "not increase the cash rate target until progress is being made towards full employment and it is confident that inflation will be sustainably within the 2%–3% target band." The RBA said it does not expect to increase the cash rate for at least three years, based on its current economic outlook.

As many home loans in Australia are variable-rate mortgages, there is a reasonably strong correlation between arrears and interest-rate movements. A prolonged period of low interest rates will help ease debt-serviceability pressures in a weaker economic environment.

In addition to traditional monetary policy levers, the RBA has been purchasing government bonds, and established the Term Funding Facility to provide low-cost funding to banks and support the supply of credit to the economy.

Population demographics

Australia has an estimated population of about 25 million, and is divided into six states and two mainland territories. Most of Australia's population is concentrated in coastal regions, particularly in the southeast and east. Most people in these regions live in urban centers, mainly in and around the capital cities (chart 2).

Australian Population Distribution
State/Territory	Local currency rating as of Oct. 2020	Population as of March 2019	Population as of March 2020
New South Wales (NSW)	AA+/Stable	8,071,071	8,157,735
Victoria (VIC)	AA/Stable	6,566,170	6,689,377
Queensland (QLD)	AA+/Stable	5,076,512	5,160,023
South Australia (SA)	AA+/Negative	1,748,630	1,767,247
Western Australia (WA)	AA+/Stable	2,615,794	2,656,156
Tasmania (TAS)	AA+/Stable	533,308	539,590
Australian Capital Territory (ACT)	AAA/Negative	425,706	429,834
Northern Territory (NT)	Not Rated	245,562	245,353
Total		25,282,753	25,645,315
Source: Australian Bureau of Statistics.

Before the outbreak of COVID-19, Australia's population was growing at an average rate of about 1.6% during the previous 10 years (chart 3). The population growth rate has been slowing since 2012 due to lower net overseas migration (chart 4), reaching 1.4% as of March 2020. Population growth has been significantly reduced since the onset of the pandemic and the sudden halt to international migration. Net overseas migration is a large contributor to population growth in Australia. Population growth is forecast to reach 0.2% in 2020-2021 and 0.4% in 2021-2022, the lowest growth rate in more than 100 years.

This has flow-on effects on property markets, given population growth historically has been a strong demand factor for property. Low interest rates and returning expatriates are tempering these pressures, though.

Population migration analysis

Interstate and overseas migration rates are key drivers in the demand for residential properties and housing finance in Australia. People move between states and territories for reasons such as employment, lifestyle, and the cost of housing. Table 3 shows interstate and overseas migration by state for the year ended March 31, 2020.

Table 3

Interstate And Overseas Migration By State
	Net overseas migration	Net interstate migration	Net population gain (including natural increases)
New South Wales	67,569	-22,301	87,811
Victoria	73,484	7,721	116,538
Queensland	32,105	24,021	84,995
South Australia	16,121	--3,176	17,882
Western Australia	24,826	-3,206	39,628
Tasmania	3,668	1,254	5,991
Northern Territory	576	-3,387	407
Australian Capital Territory	2,141	-926	4,563
Australia	220,510	0	357,018
Note: Data are as of March 31, 2020. Source: Australian Bureau of Statistics. N/A--Not applicable.

Strong net overseas migration until recently had underpinned the relatively strong demand for housing. In terms of net overseas migration, the most common states for immigrants to enter Australia are New South Wales and Victoria. This is significant because the point of entry has a big impact on where migrants decide to reside permanently.

COVID-19 could alter these trends. Structural shifts such as remote working, housing affordability, and lifestyle preferences could see increased interstate migration to states like Queensland, particularly to coastal areas on the fringe of capital cities.

These trends are also supporting property prices in regional markets, where the spread of COVID-19 has been more limited than in the more populous capital cities.

This could alter the geographic distribution profiles of RMBS loan pools in the years ahead, with an increasing proportion of loans located in regional areas outside of capital cities.

Urbanization

Australia's population historically has been concentrated in suburban, urban fringe, and inner-city regions, particularly in state capital cities.

COVID could alter the long-term trend of greater urbanization in Australia. Population centers traditionally have been largely based on proximity to physical work spaces. The ability to work remotely on a longer-term basis might see some shift in population distribution as more affordable housing and less commuting make the "tree change" or "sea change": phenomena an attractive proposition for many households.

Employment trends

Employment is the most important factor underpinning debt serviceability; loss of income is a key cause of mortgage default in Australia.

Australia's relatively long period of uninterrupted economic growth pre-COVID-19 contributed to robust employment growth in most parts of the country. Chart 6 shows Australia's historical unemployment and underemployment rates between 1978 and October 2020.

S&P Global Ratings forecasts unemployment to reach a year average of 6.6% in 2020, decreasing to 6.5 % in 2021. While COVID-19's has had a significant effect on unemployment, the unemployment rate has not reached the levels observed during the 1990s recession, when it peaked at above 11%. Significant fiscal stimulus, including wage subsidies, and a prolonged period of low interest rates have helped cushion the blow of the economic fallout, and job losses, caused by COVID-19.

Jobs are easily lost but hard to win back, as demonstrated in previous recessions. History might repeat, with the unemployment rate unlikely to return to pre-COVID-19 levels until at least 2023, under our economic forecasts.

We expect unemployment levels to remain high in industry sectors that are more constrained by social-distancing measures, including the leisure, hospitality, and arts sectors. These sectors typically have a higher proportion of part-time and casual workers in younger age cohorts and are less represented in home ownership. An early vaccine rollout would speed up domestic normalization by reopening affected sectors and reducing voluntary social distancing. This would help jobs growth in these sectors.

Structural shifts, including the increasing contractualization of work and growth in part-time jobs, are likely to persist in a post-COVID-19 world as firms seek to utilize a lower-cost and more flexible workforce. This could add to future debt-serviceability pressures for certain borrower cohorts. This is because full-time employment provides a level of stability to borrowers' incomes and their ability to repay debt obligations.

According to the Australian Bureau of Statistics, about 83% of workers in Australian are employees, of whom around 67% work full time. Australian RMBS transactions' exposure to casual and part-time employees is low, at less than 3%. These longer-term structural shifts may see these percentages rise over time, though.

Credit Culture And Household Balance Sheets

Consumer credit culture

There are a range of consumer credit options in Australia, including housing loans, personal loans, and continuing credit arrangements such as overdrafts and credit cards. Housing-loan products incorporate features that allow consumers to redraw prepaid principal, which may be used for any reasonable purpose. Some housing-loan products also allow consumers to conduct transaction banking through their loan accounts. Check and credit card transactions may be cleared through a consumer's housing-loan account.

Personal bankruptcies

The level of personal bankruptcies in Australia has been consistently lower than in the U.S. and Canada (chart 7).

Underpinning Australia's historically low level of personal bankruptcies are the:

• Traditionally strong willingness of Australians to repay debt;
• Severe consequences of bankruptcy under Australian law;
• Stigma in Australia associated with bankruptcy; and
• Difficulty in accessing finance after bankruptcy.

Even in bankruptcy, housing-loan lenders continue to have recourse to borrowers to pursue outstanding debts alongside a borrower's other creditors after the security property is sold.

The level of personal bankruptcies in many jurisdictions is being masked by the different stimulus measures aimed at helping borrowers to stay afloat during lockdown periods. As these measures are wound back, we expect personal bankruptcies to rise in the next 12 months.

Household indebtedness

Household debt as a percentage of net household disposable income in Australia is high compared with many other Organization for Economic Cooperation and Development (OECD) countries (chart 8). The most indebted households tend to be those in developed countries, owing to their superior average earning capacity compared with households in most emerging markets (see "A Double-Digit Rebound Has Begun, But It's No Time To Celebrate," Oct. 6, 2020).

Australia's household debt did not increase dramatically until interest rates and inflation reached low levels in the 1990s, improving consumer confidence (chart 9).

Most of the increase in household debt was used to buy assets, namely property. Chart 9 shows the increases in household debt as a proportion of household disposable income and housing debt as a proportion of household disposable income from 1998 to 2020. Falling interest rates have coincided with rising household debt, of which the majority is housing related.

Australian household debt is also elevated because the housing rental stock, and hence the debt used to fund it, is owned by the household sector, as recently outlined by the RBA. In most other countries, a significant share of rental properties, and the associated debt, belongs to the government or corporate sectors.

Households in higher-income quartiles typically are more highly represented in higher household-debt-to-income quartiles.

Ultralow interest rates have reduced many households' debt-servicing burdens, but they could increase household indebtedness by reigniting property price growth. Strong property price growth has improved many households' net wealth, with the value of their assets increasing at a faster rate than their debt, improving their equity position.

The Australian Housing Market

Dwelling types and locations

According to the Australian Bureau of Statistics,76% of all Australian dwellings were standalone, detached houses. The remainder are semidetached or duplex houses, row or terrace houses townhouses (11.4%), or flats and apartments (11.8%). The percentage share of higher-density accommodation has grown in recent years. This is particularly the case in larger cities such as Sydney, where 18.8% of dwellings are flats or apartments. This reflects the finite supply and higher cost of housing in these markets relative to peoples' incomes.

In RMBS pools, property locations are identified by a postcode, which is a four-digit number that identifies each of the postal service's delivery areas. In metropolitan areas, a single postcode can cover several suburbs. In very remote areas, a single postcode can cover many thousands of kilometers due to the much lower population densities. S&P Global Ratings separates postcodes into inner-city, metropolitan, and nonmetropolitan locations to analyze the elements of RMBS pools that are likely to be affected by a location's characteristics.

Home ownership

Home ownership is an important goal for many Australians. Many Australians consider it important to retain their own homes and, therefore, meet their obligations under housing loans, even if they are experiencing financial stress. This predilection makes housing affordability a politically sensitive issue.

More than 66% of Australian households live in owner-occupied dwellings. Of these homeowners, 44% own their properties outright (29.5% of all households), without a mortgage loan. The proportion of homeowners without a mortgage has fallen in the past 10 years, while the proportion of households with a mortgage has risen, as has the proportion of renters as a percentage of total households. These changes, albeit incremental, reflect the effects of a prolonged period of strong property price growth, which has affected housing affordability. This has forced more people to rent for longer and increased household indebtedness. The composition of Australian households by home ownership, as determined by the Australian Bureau of Statistics, is summarized in chart 10. The latest available data are from the Housing Occupancy and Costs Survey of 2017-2018, produced by the Australian Bureau of Statistics.

Historical house price trends

Australia's housing market reflects rises and falls in the country's economic cycles. The house price increases of the late 1980s were the result of a variety of factors, including the deregulation of the financial services sector that led to a relaxation in interest-rate controls on housing loans, which were previously capped at 13.5%. This had the effect of increasing the amount of housing finance available. Other key factors were a rise in demand for investment properties after the 1987 stock market correction, higher overseas immigration, the trend toward smaller households, and housing demand by children of the baby-boomer generation.

While the 1991-1992 economic recession was the most severe economic downturn in Australia in many years, residential property values have experienced more severe declines in other periods. Chart 12 maps the annual percentage change in the Australian Bureau of Statistics' Established House Price Index for each capital city. Housing cycles in Australia reflect the different supply and demand dynamics at play and can be exacerbated by timing lags, most notably construction. The most recent housing cycle in Australia followed an uptick in population growth in the mid-2000s, which increased demand for housing. Construction did not respond to this demand until 2012.

Supply of new housing, the decline in foreign demand, and tightening in lending standards contributed to a downturn in property prices beginning in 2017. Macroprudential limits on investor and interest-only lending reduced the supply of credit to investors, which had a flow on effect on property prices. Low interest rates and an easing of APRA's debt-serviceability requirements via the removal of interest-rate floors helped property price momentum, and property price growth in Sydney and Melbourne was back on track by late 2019.

Recent house price trends and outlook

House price growth has resumed in many capital cities, thanks to low interest rates and improving confidence as state economies gradually reopen. Travel restrictions continue to impede immigration-driven population growth. These factors should deter a runaway spike in house prices in the next few months. Nevertheless, low interest rates, potential easing of responsible lending rules, and housing supply shortages could reignite a rise in prices in the next two years.

Recent property price data show that the decline in property prices in the past few months has largely abated. Most capital cities are reporting month-on-month growth in property prices as of November.

We have not yet observed signs of widespread distressed property sales nor do they appear imminent. We believe lenders will not want to rush into foreclosure processes at the end of mortgage-relief periods, choosing instead to work with borrowers by restructuring loans and moving them into formal hardship programs. Inevitably there will be a cohort of borrowers who will be unable to repay their mortgages due to permanently lost income and who will likely move into formal foreclosure proceedings in the coming months; however, we do not believe exposure to these borrowers is significant enough to exert material downward pressure on property prices.

We expect property price trends to vary according to geography and dwelling type. Cities and regional destinations that achieved early success in suppressing or eliminating the virus, thereby enabling local economies to open earlier, are likely to see greater property price momentum as confidence returns. We expect house price growth to pick up more quickly than for units. Demand for units will continue to be suppressed by an oversupply in some markets. This is due to higher rental vacancy rates, particularly in inner-city areas, and a potential contraction in population centers in more urbanized areas, where traditionally there is a greater supply of units.

Investor impact:   Periods of lower interest rates historically have been a catalyst for strong property price appreciation.

Investors have been a large contributor to strong property price growth in prior housing cycles. This reflects their greater propensity to take on higher debt levels due to their often-higher income, the tax advantages for investors in negatively gearing investment properties, and their existing footprint in the property market enabling them to borrow more.

Investors so far have been sitting on the sidelines during the COVID-19 outbreak, as evidenced by the lackluster growth in investor lending. Rental yield pressure and high vacancy rates in some areas are contributing to this cautious behavior. As the economy continues to open up and confidence returns, we believe investors could be lured back into the property market, given historically low interest rates and the enduring attractiveness of property as a long-term investment option.

Supply side factors:   On the supply side, dwelling approvals for houses and units have contracted since late 2017 (chart 13). Dwelling approvals as of September 2020 were up 21% year on year for houses and down 12% for units. This reflects the short-term boost to construction from government grants aimed at first-home owners.

Fundamental supply and demand imbalances exist in some markets. The supply-demand balance varies by state, city, and region, but these structural factors will influence the magnitude of property price movements in property markets.

Australian RMBS portfolios are well diversified geographically. Around 32% of loans are secured by properties in New South Wales, followed by Victoria at 26%, and Queensland at 24%. These proportions have been relatively constant for the past 10 years. Around 68% of loan exposures are in metropolitan locations. Exposure to inner-city postcodes--the location of many high-density unit developments--is minimal, at slightly more than 1.0%. Furthermore, the weighted-average loan-to-value (LTV) ratio of the Australian RMBS portfolio of around 60% means that most borrowers have built up a degree of insulation against depreciation in property prices, particularly for well-seasoned loans in Sydney and Melbourne, which have benefited from the strong appreciation in property prices for the past 10 years. Loans with higher LTV ratios are more exposed to changes in property prices. Around 11% of total RMBS loans outstanding have an LTV ratio in excess of 80%.

The rise of the first-home owner

The presence of first-home owners (FHOs) is heavily influenced by property price dynamics. Periods of property price decline normally precipitate an increase in FHO lending activity as housing affordability pressures are eased.

Most states and territories offer first-home owner grants (FHOGs). Eligibility varies by jurisdiction, but most criteria stipulate that the prospective FHOs must either purchase an existing dwelling that has not been occupied previously or construct a new dwelling.

National grants programs available to FHOs include the Australian government's First Home Loan Deposit Scheme, which helps a defined number of FHOs to purchase by acting as guarantor for the difference between the normal 20% deposit required and the amount contributed by the borrower (subject to minimum deposit provided of 5%). As part of the 2020-2021 Federal budget, the Australian government announced an additional 10,000 places for the scheme; however, the additional places only apply to new dwellings or the purchase of newly built dwellings.

In response to COVID-19, the government also announced the HomeBuilder program, which provides eligible owner-occupiers with a grant of $25,000 to build a new home or substantially renovate their existing home.

An initial easing in property prices and the rollout of various government schemes to assist FHOs has led to an uptick in lending to FHOs. Growth in lending to FHOs has increased to 34.5% of total owner-occupier residential mortgage lending as of September 2020 from around 20.6% in August 2016.

S&P Global Ratings considers FHOs to be more likely to default than non-FHOs in the archetypical pool due to a lack of a home loan payment history. To reflect this higher risk, we apply a higher default multiple to FHOs until they have established a payment history of at least 18 months.

The Australian Residential Mortgage Loan Market

Despite the risks in the broader operating environment, we believe the Australian mortgage market has a number of features that increase its resilience to an economic slowdown, including:

• A majority of Australian housing loans are based on discretionary variable-rate loans, which can subject borrowers to payment shocks should interest rates increase rapidly. As such, borrowers generally prefer to repay home loans as fast as possible to reduce the potential exposure. Furthermore, the variable-rate feature enhances the effectiveness of expansionary monetary policy.
• In Australia, unlike loans to investors, loans to owner occupiers do not benefit from tax deductions to offset interest payments on their mortgage loans. As a result, owner occupiers have an incentive to pay down their loans rapidly, creating further borrower equity in the security properties.
• Current mortgage interest rates are at historically low levels.
• A range of structural features in the Australian housing market likely have helped to make borrowers and lenders more conservative. For example, there is a strong social stigma attached to default and limited options for credit-impaired borrowers.
• Regulators continue to reinforce prudent lending standards.

Market size

There are now more than A$1.84 trillion worth of home loans outstanding in Australia, of which about 7.7% are securitized. The percentage of home loans securitized has decreased from a high of 24% in 2007 due to the amortization of RMBS issued before June 2007, and the much smaller volumes of RMBS issued since then. Chart 14 shows the value of Australian housing finance--securitized and nonsecuritized--and the percentage of loans securitized from 1990 to 2020.

Lenders

Banks continue to be the main providers of housing finance in Australia. After falling to 77% in 2002, banks now account for 96% of housing finance commitments.

The four large major commercial banks dominate Australia's banking sector. Regional and other banks building societies, and credit unions have traditionally made up the remainder of the market. The major Australian banks use securitization to varying degrees, mainly as a source of funding diversification and liquidity. Australia's regional banks, which were common issuers of RMBS, tap securitization markets for funding and funding diversification, liquidity, and regulatory capital relief.

Issuance from nonbank originators has gained momentum in recent years, reflecting their increased lending volumes as banks have retreated from certain loan segments. New issuance from nonbanks made up around 68% of total RMBS new issuance as of Oct. 31, 20120, compared with 6.4% in 2011.

RMBS new issuance

New issuance has been dampened by COVID-19, with new issuance rated by S&P Global Ratings in 2020 around 70% of 2019 levels, as of October 2020. Since the onset of the crisis, spreads have narrowed and new issuance has picked up, due in part to support provided by the Australian Office of Financial Management's (AOFM) A$15 billion Structured Finance Support Fund. The purpose of the program is to provide support primarily to the non-ADI market to complement the RBA's Term Funding Facility (TFF).

Most RMBS new issuance this year has been issued by nonbank originators. We expect new issuance to be dominated by nonbank originators in the next 12 months because banks are likely to continue to utilize the TFF and deposit inflows to fulfil their funding requirements. The ongoing search for yield is also likely to facilitate demand for more bespoke transactions, including nonresident and self-managed super fund (SMSF) transactions, as investors become more familiar and comfortable with alternate asset classes.

Loan lifecycle

A typical Australian housing loan will follow a similar course during its lifecycle. Broadly, the stages of a typical loan would include documentation verification, debt-serviceability assessment, property valuation checks, LMI checks, and loan settlement (chart 16).

Mortgage arrears process

For loans that fall into arrears, and are unable to become current, the following steps may also become a feature of the loan life cycle (chart 17).

Underwriting standards

Increased regulatory scrutiny of mortgage lending standards since late 2014 has resulted in a general lowering of LTV ratios and improved debt-serviceability standards in recent years.

The underwriting policies and procedures of bank and nonbank lenders for residential mortgages are of a relatively uniform and high standard throughout Australia. This is primarily due to Australia's prudential regulatory framework, consumer credit legislation, the nature and maturity of Australia's mortgage market, and the extensive use of lenders' mortgage insurance, though this is declining. The standards mainly focus on establishing a borrower's capacity and willingness to pay, and the quality and value of the underlying security.

On Sept. 25, 2020, the government announced proposed changes to responsible lending requirements. If the legislation is passed by parliament, ADIs will no longer be required to comply with the Australian Security and Investment Commissions' (ASIC's) consumer lending requirements. They will still be required to comply with the Australian Prudential Regulation Authority's (APRA's) lending guidance. Under the proposed reforms, non-ADIs (nonbank originators) will also have to comply with key elements of APRA's ADI lending standards, but ASIC will be responsible for administering the obligations of non-ADIs, not APRA.

Debt serviceability

Serviceability is typically determined by one of two methods. One method involves ensuring that debt commitments do not exceed a certain percentage of a borrower's gross monthly income. The other method involves calculating surplus income by deducting living expenses and debt repayments from monthly income net of tax.

S&P Global Ratings has observed a general convergence in lending standards in the RMBS sector, in line with APRA's expectations, as articulated in "Prudential Practice Guide 223." This has occurred in the bank and nonbank sectors.

We do not expect the proposed changes to responsible lending requirements to result in a material deterioration in underwriting standards. Under the proposal, banks are still required to comply with APRA's extensive prudential mortgage guidelines. Nonbanks will also have to comply with key elements of APRA's guidance under the proposal, leading to even greater convergence in lending standards across the bank and nonbank sectors, in our opinion.

We believe the authorities would use macro prudential tools if needed to prevent a rapid buildup of economic imbalances through the reoccurrence of strong growth in property prices or private-sector debt.

Third-party originations

One distribution channel used in the market is mortgage originators, also known as mortgage brokers or mortgage managers. These are companies or individuals who refer borrowers to lenders in exchange for a commission from the lender. Third-party originated loans make up around 52% of total bank lending in Australia.

The involvement of brokers and third-party originators in the RMBS sector is limited to the referral of borrowers to lenders, with brokers performing more of an intermediary role between the lender and borrower. Credit decisions generally are made centrally, and third parties are not involved. However, third parties can provide borrower information to lenders, leading to a risk of broker fraud if appropriate procedures are not in place to verify the accuracy and completeness of the information provided. Some lenders have processes to verify the information they receive from brokers, but practices vary.

Proposed changes to responsible lending laws to stimulate subdued lending growth in the wake of COVID-19 will place a greater onus on information provided by borrowers. Given the high share of broker-originated mortgages in Australia, information-verification processes need to be robust to ensure that the information provided by third parties cannot be falsified.

Technology will facilitate greater visibility over borrowers' spending and expense patterns in an era of "open banking," in our opinion. This will reduce reliance on labor-intensive expense-verification processes and help to improve debt-serviceability assessments by providing deeper insights into borrowers' spending behavior in real time.

Savings verification

Australian lenders traditionally required borrowers to prove that they have a regular savings pattern. S&P Global Ratings believes that it would be prudent for a lender to review a borrower's savings history because this indicates a borrower's ability to forego a portion of net income and decreases the likelihood of payment shock when mortgage repayments are required. Such standards across the industry are changing; mortgage insurers currently require genuine savings for loans at certain LTV ratios.

Credit reporting

The ability to access the historical credit performance of a borrower is generally an integral part of the decision to extend credit. Most Australian lenders conduct a credit check on each potential borrower as part of their underwriting processes.

Credit-reporting agency subscribers include banks, financial institutions, other credit providers, telecommunication companies, utilities, and parties with an interest in the payment patterns of nonperforming customers. Subscribers provide credit-reporting agencies with details of any application for credit, loans repaid, and accounts overdue by 60 days or more.

The integrity of the credit-reporting agency's database depends on diligent reporting of relevant information by subscribers.

Reforms to the Privacy Act came into effect in March 2014, moving Australia from a negative credit-reporting environment to one of comprehensive credit-reporting, in line with many other OECD countries.

Other ADIs not subject to CCR are incentivized to supply credit information to credit-reporting bodies because they will not receive information unless they also provide credit data. This is the "principle of reciprocity" under CCR. The Australian Securities and Investments Commission (ASIC) is responsible for monitoring compliance with CCR and it has authority to expand the content required to be supplied.

Property-valuation methods

When underwriting a mortgage loan, Australian lenders will value a property using one of several methods. For loans with primary lenders' mortgage insurance (LMI), the minimum valuation requirements will be determined by the LMI provider. When loans are originated without primary LMI, such as loans that are ultimately covered by a pool insurance policy when the loan is securitized, the valuation method initially will be at the discretion of the lender, and reviewed by the LMI provider if pool cover is requested.

Full property inspections by a qualified valuer tend to be undertaken for riskier loans or properties. A full valuation gives a valuer the best opportunity to understand the specific conditions of the property that may affect the future sale value. Some lenders also rely on "curb-side" or "drive-by" valuations, which involve a valuer estimating the value of a property by viewing it from the street. This is less comprehensive than a full valuation. Automated valuations are now also in use with a variety of valuation models and approaches available to lenders. They include using a statistically based valuation through to a registered valuer utilizing satellite photos, site photos, and street maps to value the property from a desktop, with the option of conducting a full onsite valuation if this information does not provide sufficient clarity.

Some lenders have "no valuation" policies that rely on other methods to determine the realizable value of a security property for loans with lower LTV ratios. These include relying on the contract of sale for "arms-length" transactions, valuer-general assessments, council rate notices, or databases of historical sale prices to substantiate borrower estimates of property values.

Residential mortgage loan servicing

In the Australian market, servicing is generally undertaken by the originator of the mortgage loans, though outsourcing some or all of the servicing functions to third parties is becoming more common.

Servicing in Australia is generally of a high quality, by global standards. The extensive application of technology and electronic funds transfer arrangements are features of the Australian market.

Servicer evaluations performed by S&P Global Ratings indicate that most servicers involved in securitization transactions maintain a relatively high standard. All six residential servicers with S&P Global Ratings public rankings are ranked STRONG.

The Role Of Lenders' Mortgage Insurance

Most prime residential mortgages securitized through the RMBS market in Australia until recently were fully mortgage insured under a primary or pool mortgage insurance policy. Under the primary policy, LMI providers typically underwrite each loan individually. A pool policy is a policy taken out mainly for securitization purposes and, as the name suggests, is underwritten on a pool basis, generally when the loans have LTV ratios below 80%.

A limited number of lenders may have delegated authority to underwrite in accordance to LMI providers' guidelines under an open policy; LMI providers do a sample audit of the underwriting of such policies. Almost all policies are provided by an insurer with a financial strength rating of at least 'A', such as Genworth Financial Mortgage Insurance Pty Ltd. (Genworth Australia) and QBE Lenders' Mortgage Insurance Ltd. (QBE LMI). The underwriting and servicing standards imposed by the mortgage insurers traditionally have had a strong bearing on the policies and procedures of lenders using the RMBS market, particularly for the nonbank lenders who rely on securitization for funding. The ratings on Genworth Australia and QBE LMI remain higher than their parents' core operating companies' ratings as we consider them to be partly insulated subsidiaries. This view is largely supported by Australia's robust regulatory regime, which we believe affords these entities with a degree of protection from financial deterioration at the group level.

LMI was introduced in Australia in 1965 to cover lenders against losses on loans secured by mortgages. This type of insurance became popular because lenders were often unwilling to provide home loans with an LTV ratio exceeding 80%, and due to the APRA prudential framework that includes lower capital requirements for insured mortgages of smaller financial institutions. The availability of insurance to cover the additional risk of lending to this level allowed lenders to be less restricted in determining acceptable loan profiles, thereby giving residential property buyers greater access to the housing-loan market. The Australian LMI experience initially mirrored the U.S. practice, in which cover was restricted to the top 20% of the principal loan balance applying only to owner-occupied residential lending. The industry has since diversified, and 100% insurance coverage for the residential market, including residential investment, is standard practice in Australia today.

Mortgage insurers' product suites include reduced or low documentation loans, high LTV ratio loans, large loans, and loans to borrowers with minor credit impairments. However, LMI providers were quick to alter criteria and reduce their exposures to risky loans under slowing economic conditions, such as by reducing LTV ratios for some products, particularly low-doc lending.

LMI use is declining in the Australian RMBS sector

The prevalence of LMI in Australian RMBS transactions has declined in recent years. The decline reflects the reduced appetite for high LTV ratio lending, which has slowed in response to regulatory requirements such as higher risk weightings.

LMI covers about 34% of loans, by outstanding balance, in Australian RMBS transactions. Around 85% of Australian RMBS transactions have LMI coverage, but an increasing number have only partial coverage.

Housing-Loan Product Types

The home-lending market has been subject to high levels of competition, and product innovation has become one of its key features. Most lenders offer standard housing-loan products with a wide range of options.

Standard housing loan

The standard housing loan in Australia is a fully amortizing principal-and-interest loan, with a term of 25 to 30 years, secured by a first-ranking registered mortgage over the borrower's home. The interest rate on a standard housing loan is typically a variable rate that can be altered at any time, at the lender's discretion. Fixed-rate lending has become more popular during the pandemic. While historically many lenders only adjust interest rates when the RBA adjusts monetary policy and announces an adjustment to the overnight cash rate, in recent years we have seen more lenders adjusting interest rates out of step with the RBA due to the tight funding markets.

The common features of a standard housing loan in Australia are outlined in table 4.

Table 4

Standard Loan Product Options
Loan type
Prime loans	Loans made to borrowers with a clean credit history. Prime loans traditionally are eligible for LMI.
Nonconforming loans	Loans made to borrowers who typically would not qualify for a residential mortgage from a traditional prime lender and are generally ineligible for LMI. Borrowers are not necessarily credit impaired but might not be able to provide standard loan documentation or their loan size could be larger than standard limits, for example.
Subprime loans	Borrowers who are typically credit impaired.
Loan purpose
Purchase a home
Refinance	Refinance an existing home loan
Debt consolidation
Equity take out	Use equity in a property to release cash for investment and consumer purposes
Construction loan
Property occupancy
Owner-occupier	Loan is for home purchase
Investor	Loan is not for the primary place of residence. The investor property classification includes holiday/second homes.
Payment features
Redraw	Redraws permit borrowers to redraw any funds paid ahead of the scheduled amortized balance of the loan.
Further advance	Further advance allows a borrower to request additional funds through a variation of the mortgage. Lender usually undertakes a full credit assessment at the time of the further advance.
Line of credit	Borrowers receive a line of credit secured against their homes. The limit is generally fixed and borrowers can draw up and down against the limit as they please. Repayments are less regular.
Interest-offset accounts*	Noninterest-bearing deposit account directly linked to the loan. The lender notionally reduces the balance of the loan account by the amount of funds held in the offset account for the purpose of calculating interest payments.
Interest rate types
Fixed	Interest rates on fixed loans are usually fixed for a period of up to five years. Loan rate switches to variable after this point.
Variable rate	Discretionary variable-rate loans. Lending practices in Australia recognize and account for borrower exposure to interest-rate changes through the incorporation of interest-rate buffers in debt serviceability assessments.
Split rate	The loan is split into two or more accounts and the rate on each account may be either fixed or variable.
Repayment options
Amortizing	Both principal and interest repayments are made over the remaining term of the loan.
	Both principal and interest repayments are made during the remaining term of the loan.
Interest only	The interest-only period normally ranges between five and 10 years.
Bullet loans	The borrower is required to pay all or a significant portion of principal by loan maturity date.
Documentation type
Full documentation	Loans for which the borrower's income has been fully verified by the lender through reference to relevant source documents such as payslips or tax returns.
Limited documentation	Loans for which the borrower's income has not been fully verified by the lender. Limited-documentation loans are often referred to by a variety of terms, including self-certified and stated-income loans.
*In RMBS transactions, the seller usually pays the interest-offset amount into the trust during each payment period. If this arrangement is not in place, increased liquidity support and interest-rate mechanisms may be used to mitigate liquidity and yield risks.

Documentation standards

Documentation standards in RMBS are generally classified as either full or limited (income partially verified). S&P Global Ratings classifies low- and alternative-documentation loans as "limited." Low-documentation product standards differ, and in Australia include an element of supporting evidence of income, and are not solely reliant on a stated income. Such products are targeted at self-employed borrowers. While they are considered lower documentation, they are not written on a stated income or no income verification basis.

We see higher residual risk for low-documentation loans than for full-documentation loans. The primary risk is that the borrower's income may be overstated.

Some originators historically only required a signed statement from the borrower that the borrower could afford the loan repayments. Since the global financial crisis, changes in the Responsible Lending Conduct Obligations of the National Consumer Credit Protection Act require credit providers to make reasonable inquiries and take reasonable steps to verify information, and make a final assessment as to whether the consumer has the capacity to repay the loan without experiencing financial hardship. As a result, the standards for verifying information and assessing borrower capacity have generally been raised for reduced-documentation loans.

Underwriting requirements vary from lender to lender, but they typically impose lower maximum LTV ratios. Exposure to low-documentation loans in the Australian prime RMBS sector is low, at 0.68%. The exposure is higher in the nonconforming sector, at 50%.

Table 5 provides examples of the common income-verification documentation standards in the Australian residential mortgage market.

Table 5

Australian Mortgage Documentation Standards
	Full-doc PAYG	Full-doc self-employed	Low-doc	No doc*
Income documentation required	Last two pay slips, and letter of employment, tax assessments, three months' bank statements or similar	Last two years' tax returns and last two years' tax assessment notices	ABN/GST registration for 12 or six months, declaration of financial position, and six months' business bank statement, six months' BAS or similar	Declaration of affordability
*No longer a feature of the Australian residential mortgage lending market

Nonstandard Housing Loans

Reverse-mortgage loans

Reverse mortgage loans enable borrowers to access equity in a property by borrowing against the value of the house. Repayment of the loan is not required until the property is sold. Sale of the property will occur at the earlier of the death of the homeowner, when the owner ceases to occupy the home, or a contractual breach.

Typically, these loans are offered to retirees as lump sums, periodic payments, or lines of credit, and are secured by a first-registered mortgage over residential property. There remains no publicly rated reverse-mortgage securitization in the Australian market.

Reverse-mortgage loans are not included in a typical RMBS transaction.

Loans to self-managed super funds

Loans to SMSFs are limited-recourse borrowing arrangements, whereby an independent trustee holds legal title of the property on trust. Income sources available to service SMSF loans are limited due to the legislation surrounding SMSFs. Income sources include mandatory and voluntary superannuation contributions, rental income from the mortgaged property, and income from other investments in the fund. The lender's rigor in serviceability assessment is an important consideration in our analysis.

Although SMSF loans are limited-recourse lending, the risk of this affecting borrowers' payment behavior could be somewhat mitigated by features such as personal guarantees provided by SMSF members. A strong, well-documented personal guarantee contains features that create the full-recourse characteristics that are typically exhibited in a first-registered, full-recourse residential mortgage. Compliance with the relevant legislation is crucial to our analysis of these loan products.

Several bank lenders have ceased originating SMSF loans, particularly in the wake of the Banking Royal Commission. Several nonbank lenders still originate these loan products. The level of SMSF loans under mortgage deferral arrangements is low, at less than 1% across the Australian RMBS sector.

Arrears levels for these loans also remain low. Some anecdotal observations on why mortgage-relief levels are lower for this borrower type include the presence of meaningful superannuation buffers pre-COVID-19, the presence of rental income in addition to regular superannuation contributions to assist with debt serviceability, and lower LTV ratio exposures because lenders typically take into account superannuation guarantee and rental income only in debt-serviceability assessments, as opposed to gross/net income less estimated living expenses.

Australian Legal And Regulatory Systems Applicable To RMBS

Generally speaking, the Australian legal system is a common-law system similar to the U.K., comprising statutory law and case-law components. Property and consumer-lending laws regulate the rights and obligations of borrowers and lenders. Despite recent consumer-friendly reforms, the law generally favors lenders because it provides a conclusive registration process for real property and a prescriptive but efficient enforcement process.

Land title and registration

Most privately owned land in Australia is recorded on a comprehensive, state-based register with a unique title registration number assigned to each parcel of land known as the Torrens Title system.

All dealings with land, such as the transferring or granting of a mortgage should be noted on the title. A registered interest can only be defeated if it was registered with fraudulent intent. The priority between competing interests in land typically will be determined by referring to when they were registered. In most cases, the first interest to be registered will prevail.

The title-registration process ensures a low-risk environment for purchasers and lenders, providing basic due diligence is undertaken. In most cases, the due diligence process is performed by an approved solicitor, the lender's staff, or a title insurer. Due diligence primarily involves obtaining and checking the registrar's copy of the certificate of title and other publicly available information.

The property exchange settlement process until recently was paper based. The process has moved online. Property Exchange Australia is Australia's first online property exchange network. Through its digital platform, members, such as lawyers, conveyancers, and financial institutions, can lodge documents with Land Registries and complete financial settlements electronically. Transactions conducted on the exchange include property transfers, caveats, new mortgages, settlement notices, mortgage discharges, and refinances.

Most residential properties are held on freehold title except in the Australian Capital Territory, which has long-term leasehold interests. Different forms of titles, such as strata and leasehold titles, also can be included in securitized pools. Strata titles are similar to the U.S. condominium titles. When they are included in securitization pools, leasehold titles typically have terms that are at least 15 years in excess of the term of the securitized mortgage.

Enforcement process

Australian real property legislation prescribes a process for enforcement and recovery of defaulted mortgages. This involves the issuance of written default notices and giving the borrower a maximum timeframe to remedy the default. If the default is not remedied within the prescribed time, the lender is entitled to sell the property and recover the debt. S&P Global Ratings assumes that the entire recovery process will take no longer than 12 to 24 months for a weighted-average pool. The Australian process has some stringent procedural requirements, but is generally more favorable to the lender than the equivalent U.S. process.

Personal Property Security Act (PPSA)

In Australian securitizations, a special-purpose entity (SPE) typically grants a security for the benefit of the holders of the rated security. This security previously was by way of a fixed and floating charge. When the Personal Property Securities Act came into force in January 2012, fixed and floating charges were essentially replaced with general security agreements that also require registration to perfect the security.

Personal recourse

In Australia, lenders have personal recourse or "full" recourse against borrowers for any shortfalls in their recoveries of mortgage loans. Lenders have the right to obtain court orders to access any of a borrower's other assets or to have the borrower declared bankrupt.

Set-off

In the context of residential mortgage lending, set-off can occur in two ways:

• Equitable set-off, which may be exercised at any time; or
• Insolvency set-off, which may be exercised on the insolvency of one of the parties.

Most mortgage loans seek to avoid the risk of equitable set-off by including a term whereby the borrower agrees not to set off any payments due under the loan against any amounts due by the lender to the borrower. The transaction parties obtain confirmation from their legal representative--a copy of which is usually provided to S&P Global Ratings--that such an agreement is effective and mitigates set-off risk in a securitization transaction. Generally, we understand a well-drafted clause will be effective unless the borrower maintains an account with the lender that is in some way connected to the loan, and a clean legal opinion about the set-off risk of a transaction cannot be given.

In the absence of a waiver of set-off clause in the loan documentation, the transaction may seek to mitigate this risk. A borrower's equitable right to a set-off crystallizes when the borrower is notified that his or her loan has been assigned to a third party. This means that the borrower remains entitled to exercise an equitable right to set off deposits up to the time of notice, but is not entitled to set off amounts deposited after receiving the assignment notice. Typically, these accounts are transaction accounts that have high turnover rates that quickly reduce set-off exposures.

Insolvency set-off can occur when a deposit-taking institution lends money to a borrower who has funds deposited with that institution. If the lender becomes insolvent, the borrower may set off his or her deposit against the outstanding loan. However, a borrower's right to insolvency set-off will be eliminated on assignment of the loan to a special-purpose entity. The assignment breaks the required mutuality between the borrower and the lender.

Taxation issues

Stamp duty:  Depending on the states and territories involved, purchases and sales of real estate in Australia may be subject to stamp duty. The rate of stamp duty varies among states and territories, but in most cases it is levied on the gross purchase price. Recent changes to stamp duty during the pandemic include an increase in the threshold for stamp duty exemption for first-home buyers in New South Wales, and a stamp duty discount of up to 50% on the purchase of residential property in Victoria.

Interest deductibility:  Interest on mortgage loans used to finance owner-occupied properties in Australia is not tax deductible. This increases the incentive to repay home loans faster. In contrast, interest paid on loans used to finance investment properties that generate rental income are tax deductible, and this may lead to a slower rate of repayment. Empirical data collected by S&P Global Ratings on portfolios indicate that this distinction does not significantly affect the default frequency.

Capital-gains tax:  Any gains realized on the sale of a borrower's primary place of residence are free from tax. However, any gain realized on the sale of an investment property is subject to capital gains tax. The costs associated with transferring property, including stamp duty and capital-gains tax, mitigate the risk of widespread speculative activities.

Key regulations governing the Australian mortgage market and RMBS

National consumer credit regime:  Consumer credit law reforms have resulted in a single national consumer credit regime governed by the National Credit Protection Act 2009 (Cth) (NCCP) administered by ASIC.

The NCCP includes the National Credit Code (NCC), which applies to Australian credit license holders with respect to credit contracts entered into on or after July 1, 2010. The NCC replaces previous state-based consumer credit codes and the Uniform Consumer Credit Code (UCCC), but largely replicates the previous UCCC. It applies to all contracts for the supply of credit to individuals or strata corporations for the following:

• Personal, domestic, or household purposes;
• To purchase, renovate or improve residential property for investment purposes; or
• To refinance such debt.

The NCC imposes a code of conduct on lenders, which dictates a range of conditions, such as minimum disclosure requirements. Other conditions cover interest-rate charging and adjustment mechanisms; procedures for contract variations, including on the basis of financial hardship as a result of illness, unemployment or other reasonable causes; and enforcement procedures.

Unfair contract terms:  Under the NCC, the terms of an "unjust" contract may be reassessed by a court in certain circumstances, such as when a lender has used unfair tactics, or when a lender knew or failed to determine that the borrower could not afford to repay the loan. An unfair contract term will be void, but the contract will continue if it is capable of operating without that term.

Hardship provisions:  In 2009 the Australian government established a set of principles to assist borrowers experiencing financial difficulty. The principles provide guidance for consumers and the retail banks, credit unions, and building societies that have adopted them.

Hardship concessions can include a reduction in the interest rate or payment, lengthening of loan maturity, or full or partial deferral of interest for a temporary period.

Under APRA's prudential practice guidance for hardship loan arrears reporting, arrears would continue to accrue, based on the original scheduled payments, until the loan is brought back into performing status.

A breach of any of the key requirements of the NCC may lead to criminal sanctions and severe civil penalties. However, a contravention of the legislation will generally not affect the validity of the credit contract or related mortgage or guarantee.

Regulatory developments in securitization

Domestic regulations governing securitization are increasingly influenced by international regulatory developments, and Australian securitization new issuance has not been immune to these developments. Among the international securitization developments significant to the Australian market are the publication of the final criteria for identifying simple, transparent, and comparable securitizations, and the Basel Committee on Banking Supervision guidance and framework around the capital treatment of securitization exposures.

Banking regulation - APS 120:  The Australian Prudential Regulation Authority (APRA) regulates securitization activities of ADIs through its Prudential Standard APS 120. The Prudential Standard requires ADIs to adopt prudent practices to manage the risks related to securitization and to ensure that appropriate capital is held against that risk.

APRA in November 2016 released its final revised Prudential Standard APS 120 Securitization (APS 120). The revised APS 120 became effective in January 2018.

The key features of the revised standard include:

• Explicit recognition of securitization for funding purposes in addition to regulatory capital relief securitizations.
• Removal of the use of advanced modeling approaches to determine regulatory capital requirements for securitization exposures.
• Ability to use standardized approaches for capital treatment to assign a risk weight for nonsenior securitization exposures.
• Warehouses with availability periods might qualify for capital relief, provided the renegotiation of terms and conditions relates to funding rates only.
• Allowance of ADIs (originators and nonoriginators) to apply a risk weight cap for senior exposures which are not resecuritization exposures.

APRA said it has seen no immediate need to implement the STC standard. It said it would consider later the merit of amending APS 120 to incorporate STC criteria.

Key Structural Issues Of Offshore RMBS Issuance

Cross-jurisdictional issues

Any securitization that issues into the U.S. or European markets also must address numerous cross-border issues, such as sovereign risk, foreign-currency risk, and cross-border taxes, all of which are not present in a domestic transaction.

Sovereign risk

Australia currently has foreign and local currency unsolicited ratings of AAA/Negative/A-1+.

Cross-currency swap

Australian RMBS transactions issue securities denominated in currencies other than Australian dollars. Cross-currency swaps are entered into to hedge the obligations on the notes and the Australian-dollar cash flows on the underlying mortgages. In an adverse credit cycle, the counterparty risk becomes a more prominent factor in influencing the credit quality of a transaction. For example, global RMBS transactions with multicurrency obligations expose all noteholders, including Australian dollar-denominated obligations, to currency-swap counterparty risk.

Withholding tax

An Australian resident issuer may be required to deduct withholding tax from payments of interest to a foreign-resident investor unless the specific exemptions provided for in section 128F of the "Income Tax Assessment Act 1936" (and subsequent amendments) apply to the payments. Satisfaction of the exemption requirements is relatively straightforward, and most transactions are structured to include them, with the result that offshore investors receive all payments free and clear of Australia-levied taxes.

Trustee roles

Most transactions use a separate trustee for the trust and security trustee. For offshore transactions, an additional note trustee may be appointed because the investors may be located offshore while the supporting collateral is in Australia. The security trustee is generally concerned with the maintenance and exercise of the secured assets, and usually will be based in Australia. The trustee is generally concerned with ensuring compliance with the note terms and conditions on behalf of the investors. If a separate note trustee is appointed, they fulfill some of these responsibilities and are likely to be domiciled in the U.S. or Europe to better coordinate with investors. Reporting lines between the trustees are typically documented. The note trustee typically provides instruction to the security trustee to take action under the security when required.

Performance Of Australian RMBS

Performance of Australian residential mortgage loans

The Australian RMBS sector has been a strong performer globally, as evidenced by low arrears and losses. Higher unemployment in the wake of COVID-19 is yet to have any meaningful effect on arrears. We do not expect to see such effects until at the least the first quarter of 2021, and any losses in the second half of 2021.

Lower interest rates and boosts to household income have helped to keep arrears low. Arrears movements during 2020 also reflect reporting nuances, including the treatment of "restructured loans" that have exited mortgage-relief arrangements. We expect these reporting nuances will continue for several months. Loans for which payment holidays have been granted to due COVID-19 mostly are not included among loans in arrears.

Despite the large shock to the economy, household income has been well supported by fiscal stimulus measures, including wage-subsidy payments and the ability to access superannuation balances. This has enabled many borrowers to build up repayment buffers and pay down debt or cure prior arrears positions. Historically low interest rates have also helped ease debt-serviceability pressures and have contributed to a decline in arrears in recent months (chart 18a).

The SPIN measures weighted-average arrears that are 30 or more days past due.

We expect arrears to start to increase as mortgage-relief measures expire, though they will be coming off low levels. According to the RBA's October Financial Stability Review, banks have assessed that about 15% of deferred loans are at greatest risk of not being able to resume repayments when mortgage-deferral periods end.

While arrears are likely to rise in the months ahead, it would be off a low level. Job losses have been higher in sectors such as tourism and leisure. This could temper increases in arrears because workers in these sectors are more likely to rent. Nonconforming transactions have a higher exposure to self-employed borrowers, who are more sensitive to cash-flow pressure arising from a drop in business activity.

As outlined by the RBA, some borrowers may be able to restructure their debt, such as by extending the term or temporarily switching to interest-only payments, and lower their repayments. However, some borrowers may need to sell their property to repay their debt.

The level of mortgage-deferral arrangements across the broader RMBS sector continues to decline from the May-June peaks, consistent with the broader mortgage market. Mortgage-deferral levels are around 3%-4% in the prime RMBS sector and around 5% in the nonconforming sector as of October, having declined consistently since their peaks. A large proportion of mortgage-deferral arrangements expired in October so we expect the level of mortgage deferrals to significantly drop off after November. Most borrowers who have already exited mortgage-deferral arrangements have resumed repaying their mortgages.

The higher level of mortgage-deferral arrangements across the nonconforming sector reflects the greater exposure to borrowers who are credit impaired, more highly leveraged, and self-employed. Mortgage-deferral levels have declined more quickly across the nonconforming sector, reflecting the shorter duration of mortgage-relief periods at inception.

Nonconforming transactions generally have a weaker credit profile than those in the prime sector. Consequently, we expect arrears increases flowing from weaker economic conditions to be higher in the nonconforming sector and to surface earlier than in the prime sector. Recent performance confirms these trends (Chart 18b).

The stronger arrears performance in the nonconforming sector since the 2008 financial crisis reflects the sector's improved collateral profile. More nonconforming pools now have a mixture of full-documentation loans made to prime borrowers, low-documentation loans, and more traditional subprime loans.

S&P Global Ratings each month publishes a suite of arrears charts, which are available at https://www.spglobal.com/sfsurveillance.

Management and measurement of arrears

The two most common ways of measuring and managing arrears in Australia are the "scheduled-balance" approach--also known as the "Australian arrears method"--and the "missed-payments" approach. The scheduled-balance approach is used by most banks, credit unions, and building societies. The missed-payments approach historically has been used by nonbank lenders that want to establish regular cash inflows to match their payment obligations to investors who hold securities issued under their RMBS programs. This is changing, however, because many nonbank lenders are increasingly using the scheduled-balance approach.

There can be considerable differences between the levels of arrears measured under the two approaches. This can often result in significant variances in the reported arrears position of a mortgage portfolio. Investors should be aware of the distinction between the two measures. The missed-payments approach produces a higher but more conservative measure of arrears.

The scheduled-balance approach involves measuring and managing arrears by reference to the scheduled amortization curve of each loan. A loan is only deemed to be delinquent when the outstanding balance of the loan exceeds the scheduled amortization balance. A loan will not be delinquent simply because a number of scheduled payments may have been missed. This approach gives borrowers the flexibility to manage repayments to suit their needs on the condition that the balance of the loan remains at or less than the scheduled amortization balance. Failure to make a loan repayment when the scheduled amortization curve is above the current loan balance is referred to as a "payment holiday."

The missed-payments approach deems a loan to be delinquent when a scheduled payment is not made, even though a borrower may be substantially ahead of the scheduled amortization balance. This approach is designed to ensure that borrowers establish a regular payment pattern, and it can provide an early warning of borrower credit issues, such as unemployment or marriage breakdown, which may affect a borrower's ability to meet loan repayments. This early warning provides the lender and borrower with more time to develop strategies to make losses less severe than they would be otherwise.

During the pandemic, most lenders did not include loans under mortgage-deferral arrangements in their arrears reporting. This was based on an exemption granted by regulators, consistent with other jurisdictions. Most mortgage deferrals were due to expire in October; however, lenders can grant an extension to borrowers beyond the original six-month period. Criteria for extensions will be lender specific. Beginning in March 2021, lenders will be required to include in their arrears reporting any loans that are still under some form of hardship arrangement.

Characteristics of Australia's residential mortgage market

Some of the fundamental characteristics of the Australian market that underpin the credit quality of residential mortgage loans are:

• The full-recourse nature of loans to borrowers, which promotes borrower accountability.
• The consumer credit legislation promotes lender accountability, with recent amendment to Commonwealth and state legislation to further emphasize responsible lending obligations.
• The uniformity and generally high standards of the underwriting policies and procedures of bank and nonbank lenders for residential mortgages. This is primarily due to Australia's prudential regulatory framework, consumer credit legislation, the nature and maturity of Australia's mortgage market, and the extensive use of lenders' mortgage insurance.
• A strong home-ownership ethos and a high free-and-clear ownership rate.
• The rarity of severe downturns in nominal property prices across the country.
• The taxation system, which encourages rapid repayment of housing loans and acts as a disincentive to speculative behavior; for example, a high entry cost through stamp duty and capital gains tax.

Causes of default

We generally consider the major causes of default in Australia to be:

• Personal crisis, most commonly, marital disputes, illness, and death;
• Loss of income, commonly caused by job loss, a decrease in paid overtime, decrease in commissions, or the loss of a second job; and
• Loan affordability, predominantly due to interest-rate increases or other commitments.

Losses on Australian RMBS pools

The performance of Australian prime RMBS transactions has been robust to date. All losses as a result of foreclosures on properties secured by defaulted loans have been met by lenders' mortgage insurance, the seller (as damages under its representation and warranties), or excess spread.

Chart 19a and chart 19b show the cumulative gross loss experiences by vintage.

The absolute level of gross losses on loans in Australian prime RMBS pools has been extremely low compared with the volume of loans that have been securitized.

Chart 19c and chart 19d show the cumulative gross loss experience by vintage for nonconforming transactions.

Although higher than before the downturn, the loss experience remained low through the 2007-2009 economic slowdown.

We do not expect losses to significantly increase in most transaction vintages as a result of COVID-19. While we forecast arrears and defaults to rise, we expect losses to be tempered by the modest LTV ratio profile of the RMBS sector, with limited exposure to high LTV loans. A recovery in property prices in recent weeks has further mitigated the risk of higher losses in the event of borrower default.

Mortgage insurance claims payout ratio experiences

A close alignment between lending policies and LMI guidelines has contributed to low claims adjustment rates in the Australian RMBS sector, reinforced by a general tightening in lending standards since late 2014. The high claims adjustment categorizations we assign to most RMBS originators in this market reflect the close alignment between LMI guidelines and lenders' underwriting policies. The average claims adjustment rate across prime RMBS originators is around 8%.

Around 34% of loan balances in Australian RMBS transactions have LMI coverage. More recent vintages of prime RMBS transactions have partial LMI coverage, reflecting a decline in the utilization of LMI since the financial crisis. Genworth Financial Mortgage Insurance Pty Ltd. and QBE Lenders' Mortgage Insurance Ltd. provide around 98% of LMI coverage in the Australian RMBS sector. A few lenders insure through captive insurers.

LMI claims frequency rates might rise in the next 12-18 months, given the expected increases in borrower defaults, but we do not expect LMI claims adjustment rates--the difference between a claim made and the claim payout--to deteriorate. This reflects the strong claims payout ratio levels we have observed in the sector.

Loss curves

Prime amortizing mortgage loan pools display a typical loss curve, which is represented in chart 20.

If nominal house prices begin to appreciate more slowly, the risk period could become longer because equity in the property would not accumulate as rapidly as when nominal prices were increasing quickly. The faster payoff rate in Australia, which is due to factors such as there being no tax deductions for interest payments on owner-occupier loans, could partly counter the effect of lower nominal property price inflation on the loss-curve horizon.

The default curves for nonconforming loans are noticeably different compared with the prime assumed default curve, showing higher defaults earlier in the life of the transaction. Based on the performance data of nonconforming transactions that it rates, S&P Global Ratings has observed that higher prepayment rates and more front-end defaults occur in such transactions.

Prepayment behaviors of RMBS pools

By global standards, Australian RMBS pools tend to have relatively high prepayment speeds. The main reasons for this are the rate of refinancing, the existence of a mobile workforce, and the fact that interest on housing loans is not tax deductible. Refinancing rates are influenced by the strength of residential property markets, mobility within the workforce, interstate migration, and competition between lenders.

Conditional prepayment rates vary from program to program. The variation can be caused by high levels of refinancing away from a lender or by the structural features of a transaction that require a lender to repurchase loans in certain circumstances. A common example of this occurs in RMBS programs in which a loan is repurchased from the pool if the borrower seeks an additional loan advance beyond his or her scheduled balance. Another example is when borrowers change loan products after the commencement of a securitization program and their loans are repurchased from the collateral pool by the lender. These structural features vary by transaction.

S&P Global Ratings has developed indices representing the weighted-average annualized quarterly prepayment rates for rated prime and nonconforming RMBS transactions, known as the Standard & Poor's Prepayment Index (SPPI). The SPPI is available on a quarterly basis in the S&P Global Ratings publication "RMBS Performance Watch: Australia and New Zealand" (chart 21).

Nonconforming pools tend to have higher conditional prepayment rates than prime pools due to the high level of refinancing activity because borrowers either become eligible for prime loans with lower interest rates or they default and foreclose on the property to repay the loan.

Prepayment rates in the prime RMBS sector have held up well during the pandemic (chart 21). This reflects the strong refinancing activity that was at play before the spread of COVID-19, and has continued throughout the pandemic. Strong competition for good credit quality borrowers is underpinning this momentum. This is in addition to the increased presence of new players, including the financial technology industry and online "neobanks" that have been building market share.

Nonconforming prepayment rates have started to slow, given refinancing prospects for nonconforming borrowers are expected to be more difficult in the current environment.

Counterparty risk in RMBS

The key reason for rating movements in the Australian RMBS sector historically has been rating transitions in key transaction counterparties, namely LMI providers and swap providers.

Counterparty risk has increased for the Australian RMBS sector during the pandemic. Key counterparties, including the four major banks and key LMI provider Genworth Financial Mortgage Insurance Pty Ltd., are on negative outlook.

Related Criteria

• Criteria: Methodology For Assessing Mortgage Insurance And Similar Guarantees And Supports In Structured And Public Sector Finance And Covered Bonds, Dec. 7, 2014
• Criteria: Australian RMBS Rating Methodology And Assumptions, Sept. 1, 2011

Related Research

• Asia-Pacific Forecasts Stabilize, Risks Now Balanced, Nov. 30, 2020
• Banking Industry Country Risk Assessment: Australia, Nov. 26, 2020
• Australian Structured Finance Mostly Resilient In Face Of Protracted Recovery, Oct. 14, 2020
• Credit FAQ: How Will COVID-19 Affect Australian RMBS Ratings? May 25, 2020

Useful Links

• The Australian government provides detailed reporting and operational notices at http://www.aofm.gov.au/content/rmbs.asp?NavID=60
• The Australian Bureau of Statistics provided a range of statistics utilized in this report (see http://www.abs.gov.au)

Primary Credit Analyst:	Erin Kitson, Melbourne + 61 3 9631 2166; erin.kitson@spglobal.com
Secondary Contact:	Kate J Thomson, Melbourne + 61 3 9631 2104; kate.thomson@spglobal.com