Australian nonbank trajectory still pointing up

Second, the regulators worked in unison to impose macroprudential regulatory policies such as lending speed limits to cool ostensibly overheated housing markets in Sydney and Melbourne. The speed limits have been reversed out but credit standards remain at the higher water mark.

Third, and most dramatically, was the Hayne royal commission, the recommendations of which are still being worked through.

All of these have contributed to an aggregate market shock of a degree not experienced for many years. There has been a clear retracement in overall credit formation as banks have been forced to tighten their lending standards.

One consequence has been the creation of a funding gap of around A$75 billion (US$50.5 billion) per year for residential lending and around A$41 billion for commercial lending – both of which are more than 20 per cent of total annual market volume in these sectors.

This gap, or under-served market, has in part been forgone entirely – reflected in lower credit-system-growth numbers. But in part it has been picked up by the nonmajor banks, credit unions, foreign banks and nonbank lenders. All of these segments have experienced growth rates in mortgage volumes above the lacklustre 2.9 per cent system growth rate for FY2019.

An important point for investors, however, is that this market tilt away from the majors is simply a reversion back to the long-term average. Nonbank market share, for example, has traditionally – even as far back as the 1970s and 1980s – sat at around 20 per cent. It was as high as 30 per cent prior to the financial crisis. Its current level, of less than 10 per cent, is well below the natural level and we expect it to mean revert over time, in a measured way.

At La Trobe Financial, we have not changed credit jaws and have barely changed our pricing. We are essentially delivering the same product set – and this has been good for our investors. We have adopted a disciplined investment approach to underlying assets rather than chasing growth for growth’s sake.

After the financial crisis, the nonbanks’ market share shrunk to a level which was not representative of what the players could offer. There was a normalisation stage and then a rebalancing between the banks and the nonbanks.

We have not really seen any material changes in the tiering of wholesale funding cost for authorised deposit-taking institutions (ADIs) and nonbanks. Risk-capital weights have offered our sector some additional opportunities in the prime space since 2015 but there are effective parameters that regulate nonbank growth.

Things have become more competitive in the nonbank space. But the fact remains that all issuers are different in the way they approach lending – which is good for investors. For instance, some have focused more on prime lending and thus going head-to-head with the banks. Pepper has grown the prime share of its book as the near-prime portion of the industry grew.

We had a very strong year in originations in 2018. Whereas 2019 has been a year of consolidating this position, with the banks returning to the market. Overall, if we were to predict the market three years ago we would have been hoping to drive ahead with opportunities as and when they arose. I think it’s fair to say we have done this and more.

We have also worked hard to show our investor base that our originations process remains robust despite the growth. Everything we originate must be something we can securitise. This transparency has been rewarded: our growth in 2018 was strongly supported by investors.

It is this focus on good customer outcomes that has allowed us constantly to outgrow the system over the past three years. We have always focused on service as a differentiator and on continually innovating so we can deliver improved outcomes year-on-year.

The opportunity for growth persists because we engage customers with an effective service proposition that is superior to the banks.

However, we do expect price competition to emerge from banks – particularly in fixed-rate loans. In a low interest-rate environment, banks make less money from their deposit books and will find it much harder to grow revenue. I expect banks will increase their offering of fixed-rate loans to lock in NIM [net-interest margin]. However, this competition shouldn’t affect us materially as fixed-rate loans is a very small component of our customer value proposition.

At the same time, we have seen some other nonbanks expand their own offerings. This has created some competition in certain segments we are focused on. The way I see it, 2019 has a different market dynamic than what we experienced in 2018.

We also recently had ASIC [the Australian Securities and Investments Commission] in court with one of the major banks. The regulator lost that case but has announced an appeal. It will be interesting to see the next move of ASIC and government. This will probably play out over the next 2-3 years.

All these factors could continue to create opportunities for the more nimble nonbanks. Our house view remains that the changes present and coming will distract major banks for some time to come.

This can have a large effect on our origination volume. I agree that the nonbanks need to offer an attractive proposition to people who would typically be bank borrowers.

We haven’t found any material challenges in the market of late, though of course at the same time we can never take anything for granted. I recently visited the UK, for example, and it provides a classic example of how events beyond your control can affect markets.

It’s fair to say that the political environment in the UK has had an impact on our investor base, some of which is UK-based. UK investors have varied views ranging from not wanting to add more local risk to being quite pragmatic around the political environment. The real positive is that, broadly speaking, they still like our assets and asset classes. Those investors not wanting to add UK risk are potentially more supportive of Australia.

Despite some broader geopolitical uncertainty and the softness in the Australian property market up until recently, the situation has played out quite well for Australian issuers. Save for a little bit of pullback from very key investors in Asia, which is going to happen from time to time, market conditions have consistently been quite strong. I should add that this is only possible because of the consistent hard work and support we all put into fostering our investor bases.

The reality for capital markets generally – but particularly this year – is that geopolitical issues have an effect. We are coming up to another Brexit deadline on 31 October and how European investors respond to this will be interesting.

As issuers, we need to be aware of what is happening globally and ensure we meet investors’ needs within this context. When we did this in the second quarter we were very successful.

We set an issuance strategy in response to the anticipated environment, but we had a very good run with our recent August trade. If we were having this conversation in November or December last year it would have been much more negative. The Australian federal election outcome in 2019 improved housing-market sentiment and some of the issues around global trade have been digested well by markets so far, although there is still downside risk.

What I think has underpinned the securitisation market, domestically and offshore, is the global search for higher-yielding opportunities. The underlying Australian product is still very strong. There has been some softness in parts of the domestic economy but we still have a very strong story to tell to domestic and offshore investors.

The domestic market is working fine and has been able to absorb much larger volumes than many people, including me, would have thought – while maintaining prices.

Japan is a different story. These investors had massive Australian dollar pockets, albeit mainly for prime securities, which are now shrinking. They probably still need more education on exactly what nonconforming means.

In the US, it is a long process but issuers that have stuck at it for four or five years are starting to find that their efforts are paying off. Those that can issue in US dollars will have very sticky investors.

In Europe, everything is driven by the central bank. All prices went up dramatically the moment the central bank stopped buying. This was particularly the case at the end of last year when there were rumours of a major crisis or credit crunch. Now the central bank is buying again massively, which opens opportunities.

It is then a question of currency. Some European investors are agnostic on currency because they manage currency risk themselves. But there are also quite a few investors that cannot buy outside of euros. It is a question of cost, opportunities and long-term planning.

Issuers that are willing to pay a small premium initially and to commit to being programmatic reap the rewards. At the same time, what we see at the moment is that when an issuer increases yield by 5-10 basis points it suddenly finds a lot more bid, including from investors who focus more on relative value than the underlying story.

This is a good parachute to have, particularly given where we have been able to price our US dollar tranches. We offered a 30-40 basis points pickup to where other nonagency US dollar deals would price.

It is pleasing that issuers are still getting deals away and we are still sourcing new investors into our A$5 billion term-debt programme. We have many repeat investors who know and trust our stewardship of their capital. Investors require regularity, so being programmatic with issuance is important.

There is a hunt for yield in Japan, too, but I like to think demand has been driven by nonbank issuers going there frequently and being consistent with their stories. Whether or not they issue to Japanese investors is a similar story to the US and Europe in that it can take a while to get traction. But it is incumbent on issuers to keep investors updated.

The reality is that CLOs are the benchmark and Japanese investors are quite focused on them. But this offers an opportunity, too, in the sense that RMBS is a diversity play.

Then there is currency. There are large pockets of demand in yen, while Australian dollar demand from Japan is not what it used to be.

We have commented previously that a fundamental, structural change is probably needed in the financial products that are offered throughout the Australian market. There is quite a strong incentive for ‘mum and dad’ investors to buy equities. Until this changes, I don’t think we will see massive changes to allocations.

There is an argument which says the increasing amount of self-funded retirees and the proportion of the population with some form of superannuation means there will be a greater requirement for annuity-style investments. This could bring some benefit to triple-A structured product in the future. But we have a fairly limited outlook for increasing depth in the Australian market at the moment.

Andrew Marsden is right that there is no more credit risk in any of our structures than there is in a bank RMBS deal. Investors recognise this, but they say it is about liquidity compared with senior-unsecured bonds. Liquidity should improve if we can get 40-50 investors in our deals, though.

If issuers become programmatic and pay a bit of a premium at first, the next deal will price a bit tighter and the first investors will be incentivised to sell, take profit and come back. This is a dynamic we have seen play out globally but which I have not seen much of in Australia.

We then have to nurture investors to keep them growing with us and make sure they feel comfortable maximising capacity of allocations to the Pepper name.

These are questions we expect to get, and should get, every time we issue. I have not encountered property-market concern being a reason for investors not to participate in deals for many years now.

Investors understand the measured retracement in house prices. The myth of a collapse has been busted. Average house prices saw their largest drop at the end of 2018 and momentum has clearly been shifting since then. On top of this, there was a material uplift in sentiment following the federal election.

Over the past few years, there have been times when the housing market was growing so strongly that there was more concern from investors. They wanted to know how it was all going to play out. The fact that it has progressed in a logical, letting the air out of a balloon, kind of way was positive as opposed to negative.

However, the basic principle is that you are not lending against a house as your ultimate protection. You are lending against the capacity of the borrower to repay their debt. It is not real-estate exposure you are taking but the debt of an Australian citizen who is working, has regular income and should enable NIM to pay off the debt.

The fundamentals were always there. Vacancy rates remained low, unemployment has been near record lows and the dynamic of the economy has been good. This is what should be taken into consideration, and this is what we keep telling investors.

There is a good story on house prices as well. There were concerns around house prices overheating, which were met by a regulatory attempt to slow down certain products.

There has now been a retracement of house prices, a positive election result for the housing market and now a more sustainable path for house prices is ahead. Investors are comforted by this and spreads are holding even though there is more supply coming from nonbanks.

The process of educating investors, regulators and banks is ongoing. We also need to keep servicing existing investors as well as searching for new pockets of demand.

This is another reason I am interested in PPs [private placements]. When investors look at a PP they can have a real due-diligence process where they go onsite and assess the whole underwriting process. This creates an extra layer in the relationship, compared with a roadshow where investor and issuer might meet for two hours at most.