Forget big deals such as the A$200 million (US$148 million) Eurobond issue from National Australia Bank (NAB) or the syndicated loan for Telstra Corporation worth A$3 billion, the truly ground-breaking Australian deal of the past 12 months was an issue arranged by JP Morgan worth only A$30 million. This is the deal that has allowed a new generation of mortgage providers to challenge the near monopoly of Australian banks in the home loan mortgage market. The consequence may be one of the most dramatic upheavals yet seen in Australian retail banking.
Years ago the main non-bank mortgage providers were building societies, which lent at rates usually a few points above bank loans. The most successful building societies eventually turned into banks and much of the differentiation between loan products disappeared.
Over the past few years new mortgage providers have emerged with a fresh marketing edge: they offered loans priced below the most competitive bank loans. With no branch networks to maintain and tiny overheads, the mortgage providers have prised a small but significant proportion of new lending business away from the banks.
While able to generate adequate funding from the burgeoning domestic mortgage-backed securities market, leading non-bank mortgage providers were limited by the availability of competitively priced capital. By contrast, the banks had significant capital resources.
Enter JP Morgan Australia in December last year with a benchmark deal for the RAMS Mortgage group to raise A$18.4 million, increased by two subsequent transactions to A$30 million. This issue, although small in size, showed the way to other mortgage originators and enabled them as a group to wrest at least 13% of the mortgage market away from the banks.
Thomas Dunn, vice-president of JP Morgan, says the deal was significant for two principal reasons. "It represented the first-ever securitization of the net interest spread on a floating-rate mortgage portfolio that had been achieved anywhere in the world," he says. "So it was not only an Australian first but a world first in terms of that securitization. Secondly ... it has opened the way for the non-bank originators to raise attractively priced capital."
Dunn says the issue resolved the perennial problem facing all mortgage originators that money put in to originate new mortgages can only be recouped over the life of the mortgage.
"They have the sunk-capital costs up front and, not having the deep capital pockets that the major banks have, it has always been a competitive disadvantage for them," Dunn explains. "Since then, all of the non-bank originators, but particularly RAMS and Puma, have moved to materially higher levels of origination because they have been able to raise capital in this fashion."
Strengthened financial muscle has enabled these mortgage providers to establish a strong beachhead in the new mortgage market. The banks have responded by reducing the interest costs of their mortgages with a variety of no-frills products and with so-called honeymoon mortgages, which have a guaranteed maximum rate for the period of the honeymoon.
At the same time, the banks have either raised or imposed charges on other retail transactions. It has been argued that by putting up these charges the banks are tacitly acknowledging that home mortgages have subsidized some other retail transactions.
The success of the mortgage providers has helped squeeze bank lending margins, which in 1996 were more than 4% above banks' average cost of funds. Nowadays these margins are about 3% or lower, "now more in line with comparable overseas countries", as the Reserve Bank of Australia's semi-annual statement comments.
Just what gains the new mortgage providers have achieved is somewhat masked in official statistics, but Dunn sums it up: "At the time this transaction was done, RAMS was probably [originating new mortgages] at A$60 to A$70 million a month and now is running at well over A$100 million."
The innovative nature of the issue required some careful marketing. The first step was to secure an investment rating for which JP Morgan worked closely with Standard and Poor's. The issue gained an A minus, which, in Dunn's words, "provided an important platform for its sale to a group of major institutions in Australia. It was sold on the basis of a very limited roadshow which took it to six institutions. All six put in bids but four took it at prices of bills plus 65".
For investors the issue had a different significance. Dunn explains: "This transaction required them to take an element of pre-payment risk that they had never previously taken. The servicing for the obligations under the RAMS net interest margin issue is provided by the excess margin that is earned on the mortgage portfolio."
The risk here is that mortgages might be repaid early, leaving less available on which excess margin is earned. So, to support this transaction, JP Morgan published a volume of pre-payment analysis on the Australian mortgage market.
The key was in creating a structure that met the requirements of the rating agency, Standard and Poor's, and one that suited investors and provided them with some comfort about the pre-payment risks.
Eurobond innovation
At the same time, competition in the primary Euro-Australian-dollar market is becoming fiercer. With the European single currency just a few deep breaths away, European portfolio managers have begun hunting for currency diversification and in many instances seizing upon Australian-dollar issues.
"The take-up by a broad spectrum of investors in many countries indicates that Australian-dollar product is an important, albeit small, part of the fixed-income portfolios held by the international investor community," says Jonathan Stebbins, a director of Hambros Bank.
The competition for Australian-dollar debt product, coupled with a prolonged cycle of monetary easing, has culminated in rates for Australian-dollar issues being lower than those for US dollar issues for maturities up to five years. Rates for Australian-dollar Eurobonds are lower across the entire yield curve than issues in New Zealand dollars.
The Australian-dollar Eurobond market has matured and has reached what Stebbins regards as desirable critical mass. "Currently, there is approximately A$40 billion outstanding," says Stebbins. "Since 1990 the market has grown about A$2 billion a year."