The Australian residential mortgage-backed securities sector faces fresh challenges as rising interest rates and cost of living pressures weigh on debt serviceability. Many households are entering this phase from a position of strength, with savings and repayment buffers available as cash flow pressures emerge. However, not all borrowers benefit from these safeguards, and debt serviceability pressures will mount as pressures on cost of living continue to rise quickly.

These challenges may lead to a divergence in collateral performance across transactions in the coming year. Arrears increases are likely to be more pronounced for recently issued transactions with higher exposures to borrowers entering the property market at the peak of the cycle, some nonconforming borrowers, and those borrowers with low fixed-rate loans with approaching maturity dates. Offsetting these challenges are Australia's strong job market and improving wage growth.

Despite the headwinds, we expect Australian RMBS ratings to be broadly stable in 2023 and lending standards to remain mostly prudent. All in all, we think the Australian residential mortgage-backed securities (RMBS) sector is well placed to navigate this turbulence and will come through this period relatively unscathed.

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

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

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's economy is holding up better than many other developed economies in the face of swift monetary policy tightening and growing inflationary pressures. The overall economy is yet to feel the flow-on effects from these trends, with consumer spending still holding up, wages growing, and unemployment at an all-time low.

This is in part due to the resilience of the household sector. Household savings are partially offsetting rising costs. Rising wages are bolstering incomes, as labor shortages improve job mobility and wage outcomes in many sectors.

Table 1

S&P Global Ratings' Economic Indicators
	2022	2023f	Effect on collateral
Real GDP growth (%, year average)	3.9	1.7	Negative. Higher interest rates and rising inflation will drag on the economy, with consumer spending likely to be dampened by constrained household budgets.
Unemployment rate (%, year average)	3.7	4.2	Positive. Strong labor market conditions persist, keeping unemployment low. A slow resumption of immigration should alleviate some of the tightness in the labor market.
CPI (%, year average)	6.6	5.9	Negative. Inflation is likely to remain high before falling back toward 2%-3% in 2025. Persistent inflation will add to financial pressures for lower-income households, with flow-on effects likely for prepayment rates. Offsetting this is a pickup in wage growth.
Policy rate (%; EOP)	3.10	3.60	Negative. Further rate rises are likely to be implemented to try and tame inflation over the next 12 months. Rising interest rates will drive up arrears, given the high proportion of variable-rate loans in the RMBS sector. Low unemployment will temper the transition from arrears to defaults.
f--Forecast. EOP--End of period – Q4 values. Source: S&P Global Ratings.

S&P Global Ratings forecasts GDP growth will slow to 1.7% in 2023 and unemployment will rise to 4.2% in 2023, from its current level of 3.4% in October 2022. The forecast rise in unemployment is still below pre-pandemic levels and is unlikely to cause any material pressure on RMBS collateral or pose downside risks for ratings.

Interest-rate trends

The Reserve Bank of Australia has increased the cash rate every month since May this year to its current level of 2.85% as at November. While the rate of increases has slowed, further rate hikes are likely, in our view, in order to tame rising inflation. Though the outright level of interest rates is not significant by historical comparisons, the ratcheting up of interest rates in such a compressed timeframe is unprecedented in recent times. The last time rates rose so quickly was in 1994 when the cash rate increased by around 2.75% in six months.

As many home loans in Australia are variable-rate mortgages, there is a reasonably strong correlation between arrears and interest-rate movements. Most lenders have passed through cash rate increases to borrowers. Official cash rate rises can take around three to four months to be transmitted to underlying mortgage rates.

The pace and quantum of interest rate increases will be uncharted territory for many borrowers. This is likely to cause some pronounced increases in early arrears while borrowers readjust spending commitments in response to higher mortgage repayments. The use of household savings built up in recent years may delay a rise in arrears for many borrowers. We expect to see early signs of debt serviceability pressures from higher interest rates later in 2022, but higher levels of arrears are unlikely to surface until the second half of 2023.

The transition of many ultra-low fixed rate loans originated during the pandemic to variable rates over the next 12 months will likely cause some level of payment shock, in our assessment. Higher exposure to fixed-rate loans will delay the impact of interest rate rises on arrears. A higher proportion of variable-rate loans across many RMBS transactions will temper the impact of this transition across the sector.

Population demographics

Immigration plays an important role in Australia's population growth, which is recovering from a lull during the pandemic (see chart 3). About 60% of Australia's population growth over the past 15 years was due to immigration.

With borders now open, we expect a gradual pickup in migration and population growth over the next two years. There is currently a backlog of offshore visa applications. International students have started returning, and this will add to the pipeline of potential property buyers and renters over the next few years. As immigration resumes, this will also ease pressure on labor shortages.

Table 2

Australian Population Distribution
State/territory	Exposure across Australian RMBS October 2021 (%)	Population as of March 2021	Population as of March 2022
New South Wales (AA+/Stable)	32	8,176,368	8,130,100
Victoria (AA/Stable)	26	6,648,564	6,593,300
Queensland (AA+/Stable)	23	5,206,400	5,296,100
South Australia (AA+/Negative)	6	1,771,703	1,815,500
Western Australia (AAA/Stable)	9	2,675,797	2,773,400
Tasmania (AA+/Stable)	1	541,965	571,200
Australian Capital Territory (AAA/Negative)	2	431,826	455,900
Northern Territory (Not rated)	1	247,023	250,400
Total		25,645,315	25,890,800
Source: Australian Bureau of Statistics.

Lower population growth has caused labor shortages in certain industry sectors during the pandemic due to restrictions on international migration. Before the pandemic, Australia ran a skilled migration program targeting immigration for sectors with shortages in specific skills or labor. The pandemic effectively shut these programs, creating labor shortages, particularly in the tourism, agriculture, and hospitality sectors.

To help address this, the Australian government increased the planning level for the 2022-2023 permanent migration program to 195,000 from 160,000 places. This will help ease labor pressures, but acute short-term imbalances between the supply and demand of labor are likely to persist until the backlog of visa applications is cleared.

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, 2022.

Table 3

Interstate And Overseas Migration By State
	Net overseas migration	Net interstate migration	Net population gain (including natural increases)
New South Wales	47,095	(40,057)	44,447
Victoria	33,691	(17,997)	41,543
Queensland	11,981	53,984	92,075
South Australia	8,167	673	15,422
Western Australia	2,634	9,571	32,184
Tasmania	2,518	(413)	4,079
Northern Territory	1,669	(3,330)	958
Australian Capital Territory	(1,817)	(2,431)	3,381
Australia	10,9608	N/A	243,143
Note: Data as of March 31, 2022. N/A--Not applicable. Source: Australian Bureau of Statistics.

Strong net migration from overseas has historically underpinned the relatively strong demand for housing in Australia. In terms of net overseas migration, New South Wales and Victoria are the most common states for immigrants to enter the country. This is significant because the point of entry has a strong correlation with where migrants decide to reside.

Net interstate migration is stronger in states with more affordable housing like Queensland, and lifestyle attractions. This trend accelerated during the pandemic, underpinned by structural shifts in the market such as remote working and demand for more space in desirable lifestyle locations near coastal areas. Queensland was the top destination for interstate migration during the pandemic and has retained this spot as the pandemic has shifted to the endemic phase.

The extent to which this becomes a longer-term structural shift will depend on remote-working models and employment opportunities outside of capital cities. Job prospects are an important determinant of dwelling locations. The Australian RMBS sector's exposure to nonmetropolitan areas (i.e., areas outside of capital cities) is around 30%.

Employment trends

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

S&P Global Ratings forecasts unemployment will average 3.7% in 2022, increasing to 4.2% in 2023. The unemployment rate is at historical lows because labor shortages in many sectors have pressured the unemployment and underemployment rate (see chart 6).

We believe the unemployment rate will rise as the impact of higher interest rates weighs on demand and economic growth. Increases in the number of places on migration programs will help address acute labor shortages in some sectors. Low unemployment is helping to keep arrears low and will also temper the shift of rising arrears to defaults amid higher interest rates. Our forecast unemployment rate in 2023 is still below pre pandemic levels and unlikely to cause any material pressure on defaults.

According to the Australian Bureau of Statistics, about 83% of workers in the country 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%.

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, credit cards and Buy Now Pay Later (BNPL). 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.

Personal bankruptcies

The level of personal bankruptcies in Australia has been consistently lower than in the U.S. and Canada (see 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 local law;
• Stigma 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 collateral property is sold.

The level of personal bankruptcies in many jurisdictions was masked by the different stimulus measures aimed at helping borrowers stay afloat during lockdown periods. Australian personal bankruptcies in December 2020 were at the lowest level since current records began in the early 2000s. As stimulus measures have been wound back, personal bankruptcies have increased, but are still below long-term averages.

Household indebtedness

Household debt as a percentage of net household disposable income in Australia is high compared with many other Organisation for Economic Co-operation and Development (OECD) countries (see chart 8).

Most of the increase in household debt was used to buy assets--namely property (see chart 9).

Australian household debt is also elevated because the household sector owns the housing rental stock, and hence the debt used to fund it. In most other countries, a significant share of rental properties and the associated debt belongs to the government or corporate sectors. Household indebtedness has different facets, depending on the borrower profile (see chart 10).

High household indebtedness increases systemic risk and can amplify economic shocks. The Australian Prudential Regulation Authority (APRA) has recently released its macroprudential policy framework that is aimed at limiting the buildup of high risk loans in the financial system. This comes off the back of an increase in new lending at higher debt-to-income (DTI) levels during the pandemic that has levelled off in recent months (see chart 11).

Under APRA requirements, authorized deposit-taking institutions (ADIs) must be operationally prepared to implement certain macroprudential measures, for example, limits on high debt-to-income lending (DTI)or loan-to-value (LTV) lending. This would require ADIs to have systems in place to record and track this type of lending to implement limits in a timely manner, if required by APRA.

The Australian Housing Market

Dwelling types and locations

According to the Australian Bureau of Statistics, 70% of all Australian dwellings were standalone, detached houses. The remainder are semidetached or duplex houses, row or terrace houses, townhouses (13%), or flats and apartments (16%). The percentage share of higher-density accommodation has grown in recent years.

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 square kilometers due to the much lower population densities. S&P Global Ratings separates postcodes into inner-city, metropolitan, and nonmetropolitan locations. We do this to analyze the elements of RMBS pools that are likely to be affected by a location's characteristics. It also reflects likely property price volatility in economic-downturn scenarios.

Home ownership

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 tendency 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 (30% of all households), without a mortgage loan (see chart 12). 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 trend has forced more people to rent for longer, and increased household indebtedness.

House price trends

At this point in the property cycle, national dwelling values have fallen by 4.1% in the three months to Oct. 31, 2022, according to CoreLogic data (CoreLogic is property data and analytics provider). On an annual basis, dwelling values were 0.9% lower at the end of October, but the property downturn has become more broad-based, led by larger falls in Sydney and Melbourne. This is consistent with prior property cycles where the more expensive cities of Sydney and Melbourne tended to lead the property boom, and the subsequent correction as house price growth unwinds (see chart 13). Around 50% of loans in Australian RMBS transactions are domiciled in Sydney and Melbourne.

A spectacular rise in property prices during the pandemic, fueled primarily by ultra-low interest rates, is being reversed as rate rises continue apace while inflationary pressures persist. An ongoing orderly correction in house prices should alleviate risks of a possible sharp fall, and consequent blow to the economy and financial system. We expect property prices to fall by 15%-20% from their peaks over the next 12-18 months, reversing most of the gains made during the pandemic.

Property price falls will be buffered by low unemployment, the resumption of immigration, and supply shortfalls in some markets, particularly units where dwelling approvals are below long-term averages (see chart 14). Adding to supply pressures is a backlog of work under construction due to labor shortages and supply chain issues. These pressures have been exacerbated by the collapse of several construction companies this year.

Supply-demand balance varies by state, city, and region, but these structural factors will also influence the magnitude of property price movements in property markets (chart 15).

The Australian Residential Mortgage Loan Market

The Australian mortgage market has a number of features that increase its resilience to an economic slowdown:

• Most Australian housing loans are based on discretionary variable-rate loans. As such, borrowers generally prefer to repay home loans as fast as possible to reduce the potential exposure.
• Owner-occupiers are incentivized to pay down their loans rapidly, creating borrower equity in the security properties because they do not benefit from tax deductions to offset interest payments on their mortgage loans.
• Strong social stigma attached to defaulting, and limited options for credit-impaired borrowers.
• Regulators continue to reinforce prudent lending standards.

Market size

There are now more than A$2.1 trillion worth of home loans outstanding in Australia, of which about 7% are securitized (see chart 16).

Lenders

Banks continue to be the main providers of housing finance in Australia.

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. Nonbank lending comprises around 5% of total residential mortgage lending.

In recent years, nonbank issuance has dominated structured finance issuance. Issuance in the second half of the year has been constrained by volatility in capital markets forcing many issuers to sit on the sidelines until funding costs move to more opportunistic levels. This has necessitated a degree of fine tuning in capital structures and flexibility to meet changing investor demand and shifting costs. This contrasts with the first half of 2022, where issuance was very strong, reflecting existing momentum in housing markets and desire for yield (see chart 17).

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, lenders' mortgage insurance (LMI_ checks, and loan settlement (see chart 18).

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 (see chart 19).

The mortgage loan originator generally undertakes mortgage servicing in the Australian market. Outsourcing some or all of the servicing functions to third parties is becoming more common, however. Servicing in Australia is generally high quality by global standards. The extensive application of technology and electronic funds transfer arrangements are features of the Australian market.

Underwriting standards

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.

Nonbanks are not directly regulated by the APRA. Their lending activities have to be in compliance with the National Consumer Credit Code that is overseen by the Australian Securities & Investments Commission. In addition, APRA's reserve powers allow it to regulate the lending activities of nonbank lenders if they become large enough to pose a material risk to the financial system.

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. Debt repayments are typically assessed based on an interest rate above the prevailing rates and also based on a borrower being able to fully repay the loan over the term.

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 59% 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. Most lenders have processes to verify the information they receive from brokers, though practices vary.

Savings verification

Australian lenders traditionally required borrowers to prove that they have a regular savings pattern.

Credit reporting

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.

Comprehensive credit reporting allows lenders to share borrower data, including credit limits on cards, the dates when accounts were opened and closed, and repayment history with credit bureaus.

The rollout of comprehensive credit reporting should facilitate more advanced risk-based pricing among lenders, given the wider range of data points.

Property-valuation methods

Property valuation methods are typically based on the associated credit risk of the loan. More automated methods are used for lower LTV loans. When underwriting a mortgage loan, Australian lenders will value a property using one of several methods, including:

• Full valuations – Undertaken by qualified valuer. Generally used for riskier loans.
• Curb-side or drive-by valuations – Valuations based on an estimate of the property by viewing it from the street.
• Automated valuations – Statistically based valuations derived through a registered valuer utilizing satellite photos, site photos, and street maps to value the property from a desktop.
• Contract of sale, valuer-general assessments, council rate notices, historical sales price data – Used only for lower LTV loans to substantiate borrowers' estimate of property.

Many lenders will identify which valuation type was used for the specific property in their loan level data. S&P Global Ratings applies higher default multiples to less-comprehensive valuation methods.

The Role Of Lenders' Mortgage Insurance

Most prime residential mortgages securitized through the RMBS market in Australia historically 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%.

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.

The Australian LMI experience historically mirrored the U.S. practice, in which cover was restricted to the top 20% of the principal loan balance.

LMI use is declining in the Australian RMBS sector

LMI covers about 24% of loans, by outstanding balance, in Australian RMBS transactions, having declined in recent years for the RMBS sector. Around 85% of Australian prime RMBS transactions have LMI coverage, but an increasing number have only partial coverage. LMI coverage is less prevalent in nonconforming RMBS transactions.

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 25-30 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.

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. For example, borrowers that 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.
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	Not permitted in structured finance transactions.
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. This is not a common loan type in Australia.
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 pay slips 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, they 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.

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 0.55%. The exposure in the nonconforming sector is 54%.

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
*Not 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.

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

Loans to self-managed super funds (SMSFs)

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.

Nonresident loans

Underlying borrowers are nonresidents of Australia. The properties securing the loans are domiciled in Australia. This exposes a portfolio to macroeconomic events and policies that affect the borrowers' countries of residence. For nonresident transactions, we apply a higher default frequency adjustment to reflect the wider macroeconomic exposure beyond Australia and the limited performance record of a portfolio that predominantly comprises nonresidents.

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 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, provided 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.

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.

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 12-24 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 and by the purpose of the property. In most cases, however, it is levied on the gross purchase price.

Land Tax  Investment properties are subject to land tax which is an annual or quarterly tax owners pay to state and territory governments based on the value of the land they own. Owner occupiers are generally exempt from this tax if the property is their principal place of residence. Assessment rates vary across jurisdictions. This tax applies to freehold land everywhere in Australia, except the Northern Territory.

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 for such loans.

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.

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. 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:  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.

Banking regulation - APS 120:  The 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.

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/Stable/A-1+.

Cross-currency swap

Australian RMBS transactions sometimes 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.

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 act under the security when required.

Performance Of Australian RMBS

The Australian RMBS sector has been a strong performer globally, as indicated by low arrears and losses. 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, which promotes lender accountability.
• The uniformity and generally high standards of the underwriting policies and procedures of bank and nonbank lenders for residential mortgages.
• 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 and a prolonged period of relatively benign economic conditions.

Arrears Performance

We forecast nonconforming Australian RMBS arrears will rise at the end of the third quarter, and prime Australian RMBS arrears during the first quarter of 2023, due to the effects of successive interest rate hikes. We do not expect more advanced arrears to surface until at least the second half of 2023. Arrears typically rise in January and February following Christmas and the Summer holiday period in Australia. Arrears increases will likely be more pronounced during this period, as savings buffers are progressively drawn down and cost-of-living pressures continue to rise. These increases could be more pronounced in flood-affected areas. Despite the forecast increase in arrears, we anticipate that low unemployment will temper the transition from arrears to default. Arrears movements in earlier arrears categories will reflect borrowers' readjusting spending to prioritize mortgage repayments.

Nonconforming transactions generally have a weaker credit profile than those in the prime sector, given the former's higher exposure to credit impaired and self-employed borrowers. Consequently, we expect arrears increases flowing from higher interest rates and cost of living pressures to be higher in the nonconforming sector and to surface earlier than in the prime sector. Recent performance confirms these trends. Nonconforming loans comprise around 10% of total RMBS loans outstanding.

The credit profile of the nonconforming sector has changed since the financial crisis; more recent transactions include a broader credit spectrum of borrowers, from weaker, credit-impaired borrowers to "near prime" lending.

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

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

Arrears Reporting Methods

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 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. 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.

Defaults

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

• Personal crises, 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.
• Loan affordability, predominantly due to interest-rate increases or other commitments.

Across the prime RMBS sector, we assume most defaults will occur within the first five years from loan origination. For nonconforming transactions, we assume higher defaults earlier in the life of the transaction. Higher prepayment rates and more front-end defaults occur in nonconforming transactions, based on the performance data of nonconforming transactions that we rate.

Losses

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.

Based on June 2022 performance data, all losses as a result of foreclosures on properties secured by defaulted loans have been met by LMI, the seller (as damages under its representation and warranties), or excess spread in the Australian RMBS sector.

Given the lower exposure to higher LTV loans, we do not expect forecast property price declines to increase losses in most RMBS transactions. The weighted average exposure to loans with an LTV greater than 80% is 8% for prime RMBS transactions and 11% for nonconforming RMBS transactions. Under our criteria, we apply a 30% market value decline stress to properties at the 'B' rating level, rising to 45% under our 'AAA' rating stress.

Mortgage insurance claims payout ratios

The average claims-adjustment rate is around 6% for prime RMBS originators. 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.

Prepayment rates

By global standards, Australian RMBS pools tend to have relatively high prepayment speeds. The main reasons for this are the rate of refinancing, the predisposition to pay down loans quickly, 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.

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 are around long-term averages. We expect a short-term uptick in prime prepayment rates as many borrowers search for better deals on their mortgages, driving up refinancing activity. Over the medium to longer term, prepayment rates will likely fall as borrowers' ability to make additional repayments is constrained by cost-of-living pressures and higher mortgage repayments. We anticipate further declines in nonconforming prepayment rates, given the more limited refinancing options for these types of borrowers under current economic conditions.

Counterparty risk

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 subsided for the Australian RMBS sector during the pandemic. Our ratings on the major banks are no longer on negative outlook.

Charts 20-27 show performance trends for key credit metrics for the Australian RMBS sector.

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 Sector Roundup Q1 2023: Cracks In The Wall, Nov. 14, 2022
• How Will Australian RMBS Weather The Recent Victorian Floods? Oct. 18, 2022.
• Economic Research: Economic Outlook Asia-Pacific Q4 2022: Dealing With Higher Rates, Sept. 25. 2022
• Monetary Tightening To Test Australian RMBS, Jun. 15, 2022

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