Why the "Big Short" doesn’t work on Australian RMBS

When Paramount acquired the film rights to Michael Lewis’ nonfiction financial thriller The Big Short, it is unlikely they knew the impact they would have on the public's understanding of finance. The 2010 blockbuster of the same name used an all-star cast and a scathing sense of humour to educate the masses on the origins of the Global Financial Crisis. Applauded for its historical accuracy, the film left many with a severely sour taste in their mouth at the protagonists’ priority of profit.

No punches are pulled during its explanation of subprime lending, collateralised debt obligations and credit default swaps. Of particular concern were mortgage-backed securities, which lay at the epicentre of the collapse. In the movie, their structures are likened to toppling Jenga towers and their contents to stews of rotting fish.

The disparaging approach is understandable given the economic, social and political cost of the Crisis. A study by the Federal Reserve Bank of San Francisco in 2018 found that the financial cost amounted to $70,000 for every single American[1], while another study by the Federal Reserve Bank of Cleveland estimated that over 3.8 million Americans lost their homes as a result[2].

No rated Australian mortgage bond in history has ever suffered a permanent loss of capital.

By comparison, the Australian residential mortgage-backed security (RMBS) market weathered the storm of the Financial Crisis incredibly well. No rated mortgage bond suffered a permanent loss of capital. In fact, this is true for the Asian Financial Crisis, the Dotcom Bubble and the COVID Pandemic. No rated Australian mortgage bond in history has ever suffered a permanent loss of capital.

The legal frameworks and lending standards supporting securitised assets in Australia are particularly stringent and onerous when compared to other jurisdictions. This is to the benefit of investors and is a key reason why Australian RMBS should not be compared to the GFC mortgage bonds of the United States.

However, with a shift in central bank policy settings, it is reasonable to question what it would take to break an Australian RMBS. What would Michael Burry be looking for if he were to set his sights on the Australian RMBS market?

As a reminder, an RMBS is a type of financial instrument that is created by pooling together a large number of residential mortgage loans and then selling the rights to receive the cash flows from those loans to investors in the form of bonds or other securities. In essence, an RMBS is a way for investors to gain exposure to a diversified portfolio of loans secured by first-ranking mortgages, with the income generated from the mortgage payments being used to pay interest and principal on the bonds.

The right to repayment of the loans and the mortgaged properties form the security for the holders of the RMBS. In the event of default on a loan, the mortgaged property can be repossessed and sold, with the proceeds paying off any outstanding amounts owed.

Therefore, two factors that can determine the probability and severity of loss in an RMBS are mortgage defaults and house price declines.

Understanding the Impact of Mortgage Defaults and House Price Declines

Credit rating agencies, such as S&P Global Ratings, use sophisticated, individual loan-level data models to calculate standardised ratings for RMBS assets. By reverse engineering these models, it is possible to back solve for the assumed level of defaults and house price declines that these rated bonds can withstand before their capital begins to be eroded.

What’s interesting about our results is the joint nature of these two factors. House price declines alone are not enough to result in RMBS losses. If house prices fall, borrowers can opt to service their mortgage and await a recovery in asset prices instead of crystallising a loss. Similarly, if default rates increase while house prices fall only modestly, then the underlying properties can be sold for amounts in excess of the outstanding loans, albeit at the expense of the homeowner’s equity.

Mortgage defaults or house price declines in isolation do not cause a loss in an RMBS, you need significant levels of both.