The resilience of Australia's RMBS sector is about to be tested. Borrowers already saddled with large household debt and high exposure to variable rates have a fresh burden: monetary tightening.

Borrowers' sensitivity to rising interest rates varies across the Australian structured finance sector. In this analysis, we look at the fundamental credit attributes of borrower cohorts, average loan balances, fixed-rate exposures, leverage levels, and historical drivers of arrears movements to provide some insights on the Australian RMBS sector's likely resilience to rising interest rates.

The RMBS Arrears Story

Arrears performance is closely correlated to interest rate movements

The Australian RMBS sector's high variable-rate exposure, at more than 80% total loan outstandings, means changes to interest rates are transmitted relatively swiftly to arrears performance (chart 1). This is in contrast to mortgage markets such as the United States, for example, where mortgage rates are predominantly fixed rate. A high exposure to variable rates increases the speed with which interest rate increases have an effect. This is because the variable-rate mechanism means lenders can pass through rate rises immediately to borrowers. Australia's high household indebtedness also increases borrowers' sensitivity to interest rate rises.

Chart 1

Arrears are at historical lows after a prolonged period of low interest rates

Arrears in the prime and nonconforming sectors are at historically low levels, given a prolonged period of low interest rates, low unemployment and, for many borrowers, a build-up in repayment buffers. Because arrears will be rising off low bases, we don't expect a recurrence of the peaks that followed the 2008 global financial crisis, when the economic backdrop was more subdued and lending standards leading into the financial crisis were less prescriptive.

Significant increases in defaults are unlikely during periods of low unemployment

Mortgage defaults are correlated with unemployment. Increased job mobility lowers the risk of mortgage default because borrowers have more options to find higher paying jobs to help alleviate potential mortgage stress. For borrowers who also have equity built up in their homes, this provides options to self-manage out of potential arrears pressure because they can sell their properties voluntarily without realizing a loss. We forecast unemployment to remain below 5% in 2023, 2024, and 2025 (see "Asia Pacific Economic Risks, Thy Name Is Inflation," March 27, 2022). This underpins our stable outlook for the RMBS sector, despite increased risks for certain borrower cohorts due to rising interest rates and cost of living.

What's Different This Time?

Average loan sizes have crept up

Average loan sizes in the broader mortgage market increased during the pandemic, aided by ultra-low home loan rates that enabled people to borrow more (chart 2). An increase in average loan sizes has also pushed up debt-to-income (DTI) levels in new lending volumes. A higher proportion of new loans were underwritten during the pandemic at higher DTI levels than before the pandemic, according to Australian Prudential Regulation Authority (APRA) statistics. Until recently, wage growth has not followed suit. Labor shortages and a declining unemployment rate have helped lift wage growth in recent quarters from pandemic lows to a current level of around 2.4%. Despite these modest gains, inflationary pressures and rising interest rates will add pressure to household budgets, particularly for more highly leveraged borrowers and lower-income households, thereby eroding real income.

Chart 2

Household balance sheets are mostly in good shape

An antidote to the bracket creep in loan sizes during the pandemic is a buildup in household savings, including balances in offset accounts (chart 3). This has enabled many borrowers to build repayment buffers to help offset rising mortgage repayments and living costs. The median excess payment buffer for owner-occupiers with a variable-rate loan was equivalent to around 21 months' worth of scheduled payments in February 2022, according to the Reserve Bank of Australia's "Financial Stability Review," published in April 2022. While savings buffers have been declining from their pandemic highs as the economy has reopened, they remain above the long-term average of 5%.

Chart 3

Scenario Analysis: Borrower Sensitivity To Interest Rate Rises

Borrower sensitivity to interest rates is a function of loan sizes and prevailing interest rates relative to household income. In this theoretical sensitivity analysis, we explore the sensitivity of household income to increases in mortgage repayments across the various prime and nonconforming RMBS transaction vintages. We use current loan balances and weighted-average mortgage rates from the securitization data for the prime and nonconforming sectors.

Hypothetical scenario

Base case:   Monthly repayments as a proportion of average household income using average loan balances and weighted-average mortgage interest rates for each transaction vintage. We have used the Australian Bureau of Statistics' (ABS's) December 2019-2020 mean weekly gross household income as a proxy for household income (A$121,108). Weighted-average loan balances and weighted-average mortgage interest rates for each transaction vintage are based on RMBS securitization data.

Scenarios 1-3: 1.5%, 2%, and 3% interest rate increase.   Under the scenarios, we used annualized monthly repayments, under rising interest rate scenarios, as a proportion of average household income.

Results

• The prime sector is less sensitive to interest rate rises, given the lower average loan balances across most vintages compared with the nonconforming sector.
• Even under higher interest rate scenarios, mortgage repayments account for less than 30% of average annualized household income, a common measure of mortgage stress, across most RMBS vintages.
• More recent vintages display a higher sensitivity to interest rate rises. This reflects the lower seasoning of more recent vintages and higher average loan balances.

Table 1

Chart 4

Table 2

Chart 5

The scenario analysis is a conservative assessment of borrowers' sensitivity to interest rate rises, in our opinion. It doesn't factor in household savings, including offset balances, which could be substantial for some borrowers. When interest rates are rising, prime-quality borrowers with stronger refinancing prospects are also likely to search for a better rate to minimize increases in mortgage repayments. There are higher mortgage rates on existing loans in many prime RMBS transactions relative to the competitive variable rates currently on offer (table 1). As such, we expect stressed prime borrowers with modest LTV ratios to be able to refinance to a lower mortgage rate in the current competitive lending environment.

Why is the nonconforming sector more exposed to interest rate rises?

Higher exposure to self-employed borrowers.   The average exposure to self-employed borrowers across nonconforming transactions is around 59%. Self-employed borrowers are more likely to have more variable income streams than salaried employees. This increases their cashflow sensitivity to inflationary cost pressures, slower economic growth, business disruption, and rising interest rates. This is often why arrears surface earlier in transactions with higher exposures to self-employed borrowers. Due to the greater complexity involved in originating loans to such borrowers, this type of lending is more prevalent among specialist nonconforming lenders. The documentation standards of self-employed borrowers have also influenced the arrears performance of this subset of borrowers historically. During the financial crisis, arrears increases were more pronounced for low-documentation loans than for full-documentation loans. Low-documentation loans were more common among self-employed borrowers. Income-verification standards in the nonconforming sector have generally improved since the financial crisis, with low-documentation products substantially stronger and no-documentation products largely unavailable in the market. We apply higher default multiples to self-employed borrowers and low-documentation loans in our credit analysis.

Higher exposure to credit-impaired borrowers.   Nonconforming transactions include borrowers with prior credit events. Exposure to borrowers with prior credit events is around 16% (on a weighted-average basis) across the nonconforming sector, but exposures in individual transactions range from 4% to 38% in some cases. This reflects the different lending focus of the originators that operate in this segment. Some originators have a greater focus on "near prime" loans that fall outside of banks' lending criteria due to features such as loan size or alternate documentation standards. Others lend across the borrower spectrum and will differentiate transactions issued by borrower type and credit risk. Borrowers with prior credit events are more sensitive to increased borrowing costs due to their generally more vulnerable credit strength and attract higher default multiples in our credit analysis.

Higher exposure to larger loans.   The nonconforming sector has a higher exposure to larger loans than the prime RMBS sector (table 2). This reflects the more specialist nature of nonconforming lending that typically falls outside of standard bank lending criteria due to features such as loan size.

Lower seasoning and repayment buffers.   The nonconforming sector's weighted-average seasoning of around 28 months is less than half of the prime RMBS sector's 62 months. This will limit the amount of repayment build up. Higher repayment buffers provide borrowers with additional protection when interest rates rise. The average repayment buffer--calculated by the difference between current versus scheduled balance/monthly instalments--is around six months for the nonconforming sector. This is a conservative estimate because it doesn't factor in any balances in offset or savings accounts.

Despite lower seasoning and repayment buffers for the nonconforming sector, most borrowers across a number of nonconforming transactions have net surplus ratios (NSRs) between 1 times and 1.5 times (chart 6) at loan origination. NSR calculations differ by lender, depending on what credit is given to different income sources, including bonus, commission, overtime, serviceability buffer used, and expenses included. Nonconforming lenders typically give more credit to variable income sources such as bonus, commission, and overtime than bank lenders.

Chart 6

Refinancing prospects diminish in a tighter lending environment.   The heightened credit risk profile of many nonconforming borrowers, including larger loan sizes and leverage levels, can diminish their refinancing prospects when lending conditions tighten. Because refinancing is a common way for borrowers to self-manage their way out of financial stress, this can lead to higher arrears for this borrower cohort.

Nonconforming loans comprise a small subset of the broader mortgage market.   Nonbank originations comprise around 6% of total mortgage lending. Nonconforming lending comprises a smaller portion of this total because several nonbank originators lend in the prime and nonconforming sectors. This means that the overall influence of nonconforming residential exposures on the broader mortgage market is insignificant and unlikely to cause any systemic risk issues. While arrears increases are likely to surface first in this loan segment, they will be rising off historically low levels. The sector's ratings performance to date has also been sound, with upgrades exceeding downgrades in recent years due to the strong buildup in credit support in many transactions.

Nonconforming loans comprise around 11% of total loans outstanding across the Australian RMBS sector.

Credit attributes of different borrower profiles influence interest rate sensitivity

The credit attributes of different borrower cohorts will influence their sensitivity to interest rate rises. Table 3 provides a breakdown of the major borrower groups across the Australian structured finance sector and their sensitivity to interest rate rises.

Table 3

The Fixed-Rate Phenomenon

Fixed-rate exposures are not material across the broader RMBS sector. While fixed-rate lending increased significantly during the pandemic, exposures across the broader Australian RMBS sector remain relatively modest, at around 16%. This varies by originator and vintage (chart 7). Bank-originated transactions' higher exposure to fixed-rate loans reflect the cheap funding available to banks during the pandemic through the Reserve Bank of Australia's now expired Term Funding Facility. As structured finance issuance from banks was fairly limited during the pandemic, more recent vintages have a higher proportion of nonbank-originated loans, which are more likely to be variable rate.

Chart 7

Upcoming fixed-rate maturities could exacerbate arrears pressures, but not materially.   Most ultra-low fixed-rate loans in the prime RMBS sector that were originated during the pandemic are in the 2020 and 2021 vintages and are due to roll into variable rates in 2023 and 2024 (chart 8). Upcoming fixed-rate maturities do not comprise a significant proportion of total loans outstanding, at less than 5.0% of total RMBS loans outstanding.

Chart 8

The risk of repayment shock for mortgages converting from fixed to variable rates will be tempered by key factors.   While some borrowers will experience a reasonable jump in mortgage repayments, we believe several mitigants to repayment shock will limit the flow of loans from short-term into more advanced arrears categories. These include:

• The inclusion of interest rate buffers in debt-serviceability calculations across lenders.
• Many borrowers' ability to draw on built-up household savings.
• Many prime borrowers being ahead in their repayments.
• Many borrowers' ability to self-manage their way out arrears through refinancing, given a competitive lending environment, or voluntary property sales, given the buildup in equity in many home loans.
• Strong employment conditions that increase job mobility.
• Owner-occupier borrowers' historical predisposition to prioritize spending commitments in times of uncertainty to avoid foreclosure.

Lenders are likely to work with borrowers to minimize repayment shocks.   Many lenders are likely to proactively manage interest rate rises and work with borrowers who face upcoming fixed-rate expiry dates to smooth their transition to higher mortgage repayments. This occurred during the transition of many loans from interest-only periods to amortizing periods leading up to 2020, when a large proportion of interest-only loans underwritten in 2015 were rolling onto amortization repayment schedules. Lenders' proactive outreach minimized the potential repayment shock and flow-on effects on arrears.

What Happens to Prepayment Rates When Interest Rates Rise?

Refinancing activity might rise for prime borrowers on less competitive mortgage rates in the short term.   Lenders typically discount rates on new lending more aggressively than existing loans to increase market share and preserve yield. This reflects the tendency of many borrowers to stick with their current lender rather than switching lenders to take advantage of cheaper mortgage rates. This is illustrated across the prime RMBS sector, where the weighted-average interest rate of transactions is higher than the current mortgage rates on offer across the wider residential market for new residential home loans. (table 1 shows weighted-average interest rates across different vintages). With rising interest rates, this is likely to result in some short-term refinancing activity as prime borrowers take advantage of more competitive interest rates. This may flow through to short-term rises in prepayment rates for the prime RMBS sector.

Rising interest rates will slow refinancing activity in the nonconforming sector.   Lending conditions are more competitive when interest rates are falling. This means falling interest rates typically drive up refinancing activity and, by extension, prepayment rates (chart 9). Rising interest rates are more likely to slow prepayment behavior in the longer term, particularly if they are accompanied by a tightening in lending conditions. Nonconforming borrowers are more likely to experience tougher refinancing conditions in such an environment. This can lead to larger falls in prepayment rates, which have been at elevated levels for the past 12 months, given strong competition in this loan segment.

Chart 9

High mortgage repayments and inflationary pressures will ultimately constrain prepayment behavior.   Many borrowers are less able to make additional mortgage repayments during times of rising interest rates and strong inflationary pressures. This will flow through to reduced prepayment activity over the medium to longer term.

Property Price Cooling Is A Second-Order Risk for The RMBS Sector

Modest leverage in the Australian RMBS sector tempers the risk of property price declines.   The Australian RMBS sector has a relatively limited exposure to high LTV ratio loans (chart 10). The prime exposure benefits from high levels of seasoning, which has enabled many borrowers to build up equity in their home loans. This reduces the risk of property price declines and aids refinancing prospects for many borrowers. Lenders look more favorably on borrowers with more conservative LTV ratios and typically offer such loans at more competitive rates. Loans originated in the past 12 months at the peak of the property cycle at higher LTV ratios are more at risk. We estimate the exposure to loans with less than 12 months seasoning and LTV ratios greater than 80% to be less than 1% across the prime RMBS sector and less than 6% in the nonconforming sector as of February 2022.

Chart 10

Default risk is more closely tied to borrower employment than property price declines.   A decline in property values does not affect borrowers' repayment behavior if there is no change to their employment and income. Property price declines can exacerbate existing mortgage pressures by restricting borrowers' options to self-manage their way out of arrears by selling their property or refinancing an existing home loan. More highly leveraged loans are more likely to experience arrears. Faced with lower property prices, such borrowers could have more difficulty in refinancing. This means arrears could increase more for this cohort than for others. We factor this higher LTV ratio into our credit analysis by applying higher default multiples for higher LTV ratio loans, in addition to our property market value decline stresses.

Property prices and arrears are inversely correlated.   We have observed an inverse correlation between property price movements and arrears. Periods of property price declines typically coincide with rising arrears (chart 11). This reflects more limited refinance options when property values are falling, particularly for more leveraged borrowers. Refinancing is a common way for borrowers under financial stress to self-manage their way out of arrears. Lower property valuations when refinancing can constrain a borrower's ability to self-manage their way out of any financial stress by refinancing their home loan or selling their property.

Chart 11

A rapid rise in interest rates could trigger a sharp fall in property prices due to lower demand and increased supply on the market.   In our base case, however, we expect falls of up to 15% in national house prices over the coming 12 to 18 months (under our 'B' rating stress, we apply a 30% market value decline stress, rising to 45% under our 'AAA' rating stress.) We expect housing demand to be bolstered in the medium term by the resumption of immigration, low unemployment, and persistent demand-supply gaps that are likely to be exacerbated by labor shortages and supply chain constraints affecting the construction sector. Demographic shifts will also influence housing demand, including many millennials nearing home-buying years.

Strong geographic diversity across most RMBS transactions mitigates the risk of localized property downturns.   Property market dynamics are typically idiosyncratic, influenced by local supply and demand factors. This historically was the case in Australia until the onset of the pandemic, when most property markets across the country experienced large gains, driven by low interest rates and a universal desire for more living space. Now that the economy has reopened, we expect property price dynamics to diverge in cities and regions as immigration returns and property purchasing decisions are increasingly influenced by affordability concerns. Strong geographic diversity across most RMBS transactions limits the exposure to localized property price downturns.

Debt serviceability analysis in RMBS

Operational review assessments are a key part of our credit analysis.   As part of the operational review process in our credit assessment, we look at originators' debt serviceability components, including:

• Use of interest rate buffers and floors.
• Credit given to different income sources, including variable income sources.
• Household expense measurement practices.
• Net surplus ratio calculations and thresholds.

Debt to income vs. net surplus ratios.   While the use of DTI multiples is more common among bank lenders, the NSR measure is the most common approach to measuring surplus income across the broader RMBS sector. Although the various approaches may be relatively uniform, in principle, the composition and derivation of income and expenses and the maximum or minimum limits (whichever is applicable) often vary across originators. Based on this review, we assign a specific originator multiple to default frequency for assessment of borrowers' repayment capacity that ranges from 0.95 to 1.15. This multiple is part of our credit analysis (chart 12).

Chart 12

Originators who include in their assessment a large interest-rate buffer over prevailing mortgage rates and require income assessed to be greater than a material multiple of the calculated borrower costs likely attract an adjustment factor at the low end of the range. Those originators requiring a smaller interest-rate buffer and lower levels of income coverage over assessed costs most likely attract an adjustment factor at the higher end of the range. Banks lifted their interest rate serviceability buffers to 3.0% following APRA's updated prudential guidance in October 2021. However, several nonbanks are still applying a buffer of 2.5% in debt-serviceability assessments.

Lending standards are relatively uniform across the RMBS sector.   Most Australian RMBS originators attract a multiple of 1.05 times (a neutral score is 1.0) (chart 12). The large number of lenders in a similar band reflects the relative uniformity of Australian lending practices and debt-serviceability assessments. This demonstrates strong adherence historically to lenders' mortgage insurance standards and, in more recent years, the increasing regulatory scrutiny on lending standards that has resulted in more prescriptive prudential guidelines.

Arrears Frontrunners

Arrears pressures typically surface first in unsecured consumer lending asset classes.   Loan type also influences borrower sensitivity to interest rates. Across the structured finance sector globally, asset classes like subprime auto ABS and unsecured consumer lending typically have exhibited the first signs of increasing debt serviceability pressures, given their high exposure to borrowers of lower credit quality. Borrowers are also more likely to prioritize home loan repayments than personal loan commitments and credit card receivables, given housing is a fundamental necessity.

Higher exposure to lower-income contractual workers will increase arrears sensitivity.   Transactions such as buy now, pay later securitizations that have a higher exposure to millennials and lower-income borrowers with fewer alternate income sources or more variable-income sources (i.e., contractual/casual work) are more sensitive to rising inflation and its effect on household finances. This trend may become more pronounced in these transactions now that the government's income support scheme to compensate for lost employment hours due to lockdowns has ended.

Because the underlying loan contracts in auto ABS transactions in Australia are mostly fixed rate, they are more insulated from arrears pressure caused by rising interest rates.

Strong Credit Support Available In Most Transactions Will Limit Ratings Pressure

Our positive ratings bias for the RMBS sector reflects a buildup in credit support.   Ratings upgrades have exceeded ratings downgrades across the broader RMBS sector for the past five years, reflecting a buildup in credit support in many transactions. This is partly due to solid prepayment rates, with pronounced increases during the pandemic, and transaction structures in which principal payments are made on a sequential basis for defined periods while credit support is building up. Strong collateral performance for many transactions with minimal losses to date has also enhanced the sector's rating performance.

Lower-rated tranches of nonconforming transactions are more exposed to rising arrears.   Nonconforming transactions have a higher likelihood of loss than prime transactions. This means that the lower-rated tranches of nonconforming transactions are more vulnerable to rising arrears. Nonconforming transactions typically have more structural features, including loss and yield reserves, to provide additional support to transaction structures that help cover any back-ended losses. The initial credit sizing for these transactions will also reflect the higher credit risk profile.

Heightened uncertainty increases headwinds.   A longer monetary tightening cycle will result in higher arrears for a longer period. This is unlikely to lead to ratings pressure for most tranches of RMBS notes, given the strong employment outlook, the support available in many transaction structures, and the equity build up in many underlying home loans that will limit losses in the event of borrower defaults.