The Australian residential mortgage-backed securities sector has remained resilient to date, in the face of macroeconomic challenges. While rising interest rates and cost-of-living pressures are credit negative, they haven't materially affected asset performance. New issuance is rebounding as demand for Australian residential mortgage-backed securities (RMBS) and auto asset-backed securities gathers pace domestically and offshore.

Increasing global uncertainty and the lagging effects of monetary policy tightening will tilt risks to the downside over the coming year. But RMBS performance should remain mostly stable if the labor market remains mostly robust.

Economic And Demographic Trends

"Higher for longer" is hurting some households. Australia's economy has been robust despite macroeconomic headwinds, particularly on the employment front. While the economy is slowing as the rising cost of living weighs on consumer demand, the general resilience of many households and the business sector has kept things ticking along.

We predicate our economic forecasts for Australia (table 1) on the assumption that inflation will take time to return to its target range, while the economy and labor markets continue to grow, albeit at a slower pace.

Table 1

Low unemployment a bulwark against rising defaults

Despite the pain caused by monetary policy, labor markets have remained resilient, with the unemployment rate still at historically low levels (chart 1).

Unemployment is a lagging indicator, so we haven't yet seen the full impact of consecutive interest rate rises on the labor market. Job market tightness will abate as higher interest rates weigh on the broader economy and immigration helps alleviate labor shortages. S&P Global Ratings forecasts unemployment will increase to 4.1% in 2024, peaking at 4.3% in 2025. This is still below pre-pandemic levels.

Low unemployment has kept arrears modest and tempered the transition from arrears to defaults amid higher interest rates. Loss of income, caused by unemployment, is a key reason for mortgage defaults.

Rising interest rates test indebted households

The transmission effects of monetary policy decisions are relatively swift in Australia, given its high proportion of variable-rate mortgages. This feature increases the correlation between interest rates and early arrears. Official cash rate rises can take around 3-4 months to be passed on to borrowers.

The transition of ultralow fixed rates, underwritten during the pandemic, to higher variable rates is ongoing. It has been well managed so far, with minimal evidence of payment shock in arrears and loss reporting. Because the Australian RMBS sector has a quite modest exposure to fixed-rate loans of around 10%, the transition has had little effect on RMBS collateral performance.

There is a high proportion of borrowers in the broader mortgage market who are transitioning from low fixed-rate loans to higher variable rates. This has heightened refinancing competition among lenders for borrowers seeking competitive refinancing rates to reduce their debt-serviceability burdens.

We expect refinancing conditions to remain competitive, but not as frenetic, until the end of the first half of 2024, when most cheap fixed-rate mortgages will have rolled over to variable rates.

Population demographics

Immigration plays an important role in Australia's population growth. Migration contributed about 60% of Australia's 1.6% annual population growth between fiscal years 2005 and 2020.

Net migration has returned strongly after turning negative for the first time since 1946 (chart 2) during the onset of the COVID-19 pandemic.

Net overseas immigration will remain an important contributor to Australia's population growth, given forecast declines in fertility rates and an aging population.

International student arrivals have contributed significantly to Australia's migration intake and future net overseas migration will be sensitive to these trends. This population cohort will also add to the pipeline of renters and potential property buyers in coming years.

Millennials on the cusp of home ownership

Millennials, defined as people currently aged between 25 and 39 years of age, make up around 21.5% of Australia's total population, according to the latest Census. Their stage in life, income profile, and employment trajectory has economic and housing implications. According to Australian Bureau of Statistics data, approximately 40% of people aged between 25 and 34 are in home ownership versus around 60% nationally (chart 3). Housing affordability pressures could delay home ownership aspirations for many millennials, given the high price barrier to entry. This cohort of prospective borrowers is also likely to be more highly leveraged, given property's high price tags in many of the capital cities, adding to household indebtedness.

Housing affordability and lifestyle preferences influence intrastate migration

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.

In terms of net overseas migration, New South Wales and Victoria are the most common states for immigrants to enter the country (chart 4). This is significant because the point of entry has a strong correlation with where migrants decide to reside.

According to Federal Government Budget forecasts, Victoria will be the fastest-growing state over the next decade (chart 5). The data projects New South Wales to grow more slowly than the other eastern states, while remaining the most populous state.

Stronger population growth will add to housing demand pressures. The different population growth trajectories across the states will also influence property price dynamics.

The Australian Housing Market

Home ownership is less affordable for new entrants to the property market

Australians have an enduring relationship with home ownership. More than two-thirds of Australian households live in owner-occupied dwellings, but the rate is declining (chart 6).

The changes reflect a prolonged period of strong property price growth that has reduced housing affordability. Higher interest rates and strong population growth will add to such pressures for prospective homeowners. This trend has forced more people to rent for longer and has increased household indebtedness.

Private ownership of rental stock is also high in Australia. According to statistics from the Australian Bureau of Statistics (ABS), about 21% of Australian households own a residential property other than their primary place of residence. Homeowners who own multiple properties are more likely to reside in New South Wales and Victoria and are more highly represented in higher income quartiles. Greater private-sector ownership of rental stock also increases overall household indebtedness because many households have both owner-occupier and investor loans.

Detached housing is still the most desirable dwelling type for most Australians

According to the Australian Bureau of Statistics, 70% of all Australian dwellings are 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. It is likely to continue to grow, given medium- to high-density accommodation is typically more affordable than detached dwellings. Medium- and high-density dwellings have longer lead times than detached housing, though. This can add to housing supply and demand imbalances.

Constrained housing supply is putting a floor under property prices

Property price growth has resumed in Australia after a brief period of decline, driven by an imbalance between housing supply and demand (chart 7).

Higher interest rates are raising hurdles for new housing finance. But this pressure is being offset by rising immigration and its associated housing needs, low advertised housing supply, and low vacancy rates in the rental market. Labor shortages, high construction costs, and bad weather are constraining housing supply, with dwelling approvals below long-term averages, particularly for medium- to high-density housing. This is creating a demand/supply imbalance that is putting a floor under property prices, despite rising interest rates.

We expect property price growth to moderate in 2024 to around 4%, as the expected slowdown in the broader economy weighs on housing sentiment. The higher for longer interest-rate environment is also likely to constrain housing finance for prospective borrowers, particularly owner-occupiers.

Property tailwinds include the recent surge in migration that will add to rental pressures because migrants typically rent before purchasing a property. Low vacancy rates and high rentals may heighten the appeal of home ownership. But the high price tags on properties might force prospective homeowners toward medium- and high-density accommodation, given their lower pricing points. However, the longer lead times involved in this type of construction mean short-term rental pressures are more likely to be eased through increases in household formation. Tightness in the rental market may also incentivize more investor participation. The recent pick up in investor lending, despite higher interest rates, may reflect renewed confidence, by investors, that interest rates have nearly peaked and supply-demand imbalances will enhance capital gains.

Rising property prices are generally credit positive for existing homeowners as they enhance refinancing prospects, a common way for borrowers to self-manage their way out of financial pressure, by improving current loan-to-value (LTV) ratios. They enable some borrowers the ability to voluntarily sell properties without realizing a loss. Given the low exposure to high LTV ratio loans across the Australian RMBS sector, the risk of loss in the event of borrower default is quite low.

Rising property prices increase housing affordability pressures for prospective homeowners and can add to household indebtedness by increasing the amount of debt required to purchase a property. Higher household indebtedness adds to systemic risks by elevating economic imbalances. While property prices are not directly managed by regulators, the increasing use of macroprudential measures can indirectly affect property price dynamics by altering the supply and demand of housing credit.

The key factors affecting supply and demand are outlined in chart 8.

Household Balance Sheets

Household indebtedness increases systemic risks

Household debt as a percentage of net household disposable income is high in Australia compared with many other Organisation for Economic Co-operation and Development (OECD) countries (chart 9).

Most of Australia's household debt is tied up in property assets (chart 10).

Australian household debt is also elevated because the household sector owns the 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 (chart 11).

A growing share of savings held in offset accounts is offsetting these liabilities. According to Reserve Bank of Australia data, around 40% of housing loan accounts have an offset account where surplus funds are invested, and interest repayments offset by interest earned on funds invested. This has aided debt serviceability by reducing interest burdens and bolstering household balance sheets.

Despite Australia's high household indebtedness, personal bankruptcies in Australia are low by international comparisons. Underpinning this is:

• Australians' traditionally strong willingness to repay debt.
• The severe consequences of bankruptcy under local law.
• The stigma associated with bankruptcy.
• The 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.

Lending standards are broadly similar across most RMBS lenders

Bank and nonbank lenders' underwriting policies and procedures for residential mortgages are of a relatively uniform and high standard throughout Australia (table 2). This is primarily due to Australia's prudential regulatory framework, consumer credit legislation, the nature and maturity of the 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.

Table 2

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 one 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.

The Australian Residential Mortgage Loan Market

There are now more than A$2.3 trillion worth of home loans outstanding in Australia, of which about 5% are securitized (chart 12).

Banks continue to be the main providers of housing finance in Australia. Nonbank lenders comprise around 4% of total mortgage lending in Australia. Nonbanks are not directly regulated by the Australian Prudential Regulation Authority (APRA). Their lending activities have to be in compliance with the National Consumer Credit Code, which 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.

Competition for prime mortgage borrowers has been intense. Larger lenders dominate, given their funding cost advantages, forcing many nonbanks to pivot to new lending segments. Many nonbanks have diversified their product offerings to include higher credit risk borrowers, auto lending, and more esoteric lending such as to self-managed superannuation funds (SMSFs) and nonresidents.

This has led to a greater volume of asset-backed securities issuance in 2023, particularly from nonbanks. We expect this to continue in 2024 because larger bank lenders prefer lower-credit-risk prime borrowers.

Performance Of Australian RMBS

The Australian RMBS sector has exhibited strong collateral performance over a long period, as evidenced 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.
• A strong home-ownership ethos.
• The rarity of severe downturns in nominal property prices across the country and a prolonged period of relatively benign economic conditions.

Relatively low unemployment levels and most loans' modest LTV ratio exposures have limited defaults and losses in the event of borrower default. Low unemployment is pivotal to strong collateral performance. This is because the major causes of default in Australia are typically:

• 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.

A close alignment between lending policies and LMI guidelines has also contributed to low claims adjustment rates in the Australian RMBS sector, reinforced by a general tightening in lending standards since late 2014.

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

The Standard & Poor's Performance Index (SPIN) measures weighted-average arrears that are 30 or more days past due.

Charts 14-19 show performance trends for key credit metrics for the Australian RMBS sector.

APPENDIX

Loan lifecycle

A typical Australian housing loan will follow a similar course during its lifecycle (chart 20).

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 lifecycle (chart 21).

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.

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 and generally used for riskier loans.
• Curbside 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.
• Contract of sale, valuer-general assessments, council rate notices, historical sales price data: Used only for lower LTV ratio loans to substantiate borrowers' estimate of property value.

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

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 3.

Table 3

Nonstandard housing loan

Table 4

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. 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.

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

Table 5

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.

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.

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.

Personal Property Security Act (PPSA)

In Australian securitizations, a special-purpose entity typically grants a security for the benefit of the holders of the rated security. Under the Personal Property Securities Act, general security agreements require registration to perfect the security.

Personal recourse

Lenders in Australia 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.
• 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.

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.

Interest deductibility:  Interest on mortgage loans used to finance owner-occupied properties in Australia is not tax deductible. In contrast, interest paid on loans used to finance investment properties that generate rental income are tax deductible.

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.

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.
• To refinance such debt.

The National Credit Code 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 code, 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.

Banking regulation - APS 120:  APRA regulates securitization activities of authorized deposit-taking institutions (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.

Related Criteria

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

Related Research

• Economic Outlook Asia-Pacific Q1 2024: Emerging Markets Lead The Way, Nov. 26, 2023
• How Resilient Are Australian RMBS Ratings To Rising Arrears? June 5, 2023
• Why Servicer Transition Risk Is Low In The Australian Structured Finance Sector, April 30, 2023