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One of the reasons why the Reserve Bank of Australia did not ease rates in March is because of the reaction of our unusually interest-rate-elastic housing market to recent reductions in borrowing costs. Importantly for investors, this is creating short-term opportunities to arbitrage the central bank’s easy money policies via residential mortgage-backed securities.

For better or worse Australia’s housing boom is racing away like an out-of-control freight train. So-called “macroprudential” constraints on bank lending, which place a soft limit on credit growth at four times current wages growth, have had zero impact to date.

And contrary to new Treasury secretary John Fraser’s claim, Sydney’s soaring house prices are not a “global phenomenon”. They are exclusively an artefact of the RBA’s decision to slash borrowing rates to the lowest levels in history.

People forget that Sydney prices fell by a record margin between late 2010 and mid-2012. It was only after the RBA cut its cash rate from 4.75 per cent in October 2011 to a “crisis-level” 2.5 per cent in August 2014 that the great east coast housing boom was truly ignited.

In contrast to the United States and Britain, where fixed-rate mortgages are much more popular, the vast bulk of local borrowers have loan costs determined by the overnight cash rate. This makes their investment decisions extremely sensitive to monetary policy movements.

In 2014 many dismissed The Australian Financial Review ‘s forecast that the rate cuts would fuel double-digit house price appreciation and force regulators to introduce macroprudential regulations to throw sand in the wheels of new lending.

Back then the conventional wisdom was that because Australian households had already leveraged-up before the global financial crisis, we could not possibly get another debt-led boom.

Yet since the market bottomed at the end of May 2012, home values across the five biggest capital cities have leapt 23 per cent, with Sydney prices jumping 35 per cent. Silver linings

In July 2014 RBA governor Glenn Stevens warned that it “would in my opinion be good, for a range of reasons” if the “slower pace of growth in dwelling prices” observed in May and June, which proved to be a temporary blip, “did persist for a while”.

Stevens said he hoped for “unremarkable performance on [house] prices” for the “next couple of years”. I rebutted that “he must be a preternaturally optimistic character”.

Since Stevens’ July 2014 warning Sydney property prices have inflated at a 14.4 per cent annualised pace.

There are three silver linings to this leveraged asset price inflation. First, capital is pouring into new construction, which will give a much needed boost to historically inert housing supply that has not been keeping up with underlying demand.

Second, Australia’s housing debt-to-assets ratio has been declining as prices outpace credit growth. This means the value of the collateral protecting bank balance sheets has been improving, as have default rates, which are benign despite a modest increase in the jobless rate.

The third point is that these dynamics are positive for investors in highly rated residential mortgage-backed securities (RMBSs) issued by Australian banks. There would barely be a single fixed-income fund in Australia that doesn’t hold some of these. Investors of some means could access them directly through a private banker or adviser.

The best RMBS assets are portfolios of very low risk and well-seasoned home loans. RMBSs directly benefit from cheaper money and higher house prices through a rise in the value of the equity protecting the underlying loans, lower arrears and faster repayment speeds.

In February some banks were offering AAA-rated RMBSs, paying 1.75 percentage points above the one-month bank bill rate, or 4 per cent in total. These assets have better ratings than a deposit in a major bank and can be traded in the wholesale markets daily or sold in an emergency to the RBA through its so-called “repurchase facilities”.

In a world where you will struggle to find an unsecured bank deposit paying more than 3 per cent, a secured, RBA repo-eligible RMBS portfolio that provides daily liquidity and an AAA rating seems pretty attractive. And I would venture that these assets will remain in demand as house prices continue to appreciate and interest rates slide.


Posted by Christopher Joye – AFR on 6th March, 2015