- The unique risks of nonresident lending in Australia are reflected in nonresident RMBS transactions' higher credit support levels.
- Local obstacles as well as offshore ones such as China's "zero-COVID" policy and its slowing economy are likely to weigh on new lending volumes.
- We expect collateral performance to remain stable due to the sector's conservative LTV profile and strong performance observed to date.
Australia's nonresident lending sector is facing several challenges. Travel restrictions, domestic policy, and a slowing Chinese economy are dampening lending volumes. Nonresident RMBS transactions nevertheless continue to perform within our expectations.
This primer on the nonresident lending sector covers the market's fundamentals and key features as well as our analytical approach to this nuanced asset class. It also looks at the current obstacles facing the sector and how this may influence performance and new issuance trends in the months ahead.
The Unique Risks Of Nonresident Lending
Nonresident lending has several unique risks compared with the archetypical loan pool on which we base our Australian criteria. Most of the loans in the loan portfolios that make up nonresident RMBS transactions are to borrowers who are not permanent residents or citizens of Australia. This necessitates several lender-level adjustments to reflect the higher credit risk profile of nonresident portfolios. The key risks are as follows.
Exposure to macroeconomic events in other countries. Nonresident lending portfolios are not only exposed to macroeconomic events and policies that affect Australia, but also to those that affect borrowers' countries of residence. These include that country's economic growth, unemployment rate, government, and foreign-exchange policies. S&P Global Ratings applies a higher default frequency adjustment to nonresident transactions to reflect the wider macroeconomic exposure beyond Australia and the limited performance record of mortgage loan portfolios predominantly made up of nonresident borrowers and/or borrowers reliant on offshore income.
A high concentration of a single country, such as China, exposes transactions to potential disruptions in cash flows due to events or policies affecting the flow of funds between countries. In our cash-flow analysis, we apply additional compressed default curves to simulate a possible concentrated disruption in cash flows to the trust due to events or policies affecting the flow of funds between countries.
Less homogeneity in underwriting of loans. Because most borrowers in nonresident portfolios reside outside of Australia and borrower income is therefore derived offshore, there is greater complexity in the underwriting of such loans compared with that of borrowers who are residents of Australia. The challenges include less certainty in income verification, living expense determination, serviceability assessment, credit history checks, and differing standards in verification documents. Specialist lenders operating in this space typically have dedicated multilingual staff, operations, infrastructure, and, in some cases, offshore offices to conduct loan origination and verification checks designed specifically for nonresident lending.
S&P Global Ratings applies lender-level adjustments to account for the greater heterogeneity of underwriting loans to nonresidents.
Elevated concentrations of specific geographic areas and dwelling types. Nonresident portfolios typically have a higher exposure to high-rise and midrise apartment and units. Foreign investment in residential properties can also be concentrated in inner-city areas where high-rise towers have been constructed with foreign investors in mind. Geographic concentrations also reflect Foreign Investment Review Board (FIRB) restrictions on the types of properties that nonresidents can purchase. Nonresidents are typically restricted to purchasing newly constructed properties. This is in contrast to resident borrower loan pools, which usually have a much lower exposure to inner-city areas. Under our Australian RMBS criteria, we apply higher default frequency and market value decline assumptions for loans secured for inner-city units and apartments.
Higher market value decline risk. Properties purchased by nonresidents tend to be bought "off the plan," which means the buyer enters into a contract of sale before the property is completed. The value might be lower if the property is resold on the market. That's because the property is then an established dwelling and can only be sold to Australian residents, who may not pay the same price as the contract of sale. Properties built for a specific target market might not appeal to a broader market and could be viewed as overvalued by domestic buyers. We consequently adjust the market value decline assumptions for nonresident pools to reflect the risk of greater declines in value during periods of economic stress.
Higher exposure to specific property developments. Nonresident portfolios can have higher exposures to specific property developments. This necessitates adjustments to the standard market value decline assumptions that we apply to an archetypical pool because a higher correlation in security values could have a compounding effect on the portfolio. We expect a change in the valuation of a unit to influence the valuation of another unit more strongly within the same development than a comparable unit in another development.
Higher risk of fraud. Lenders can find it more difficult to satisfactorily verify borrowers' information. Underwriting expertise is crucial in mitigating this risk. To help mitigate the risk, lenders rely on the language skills and knowledge of staff employed in offshore and domestic offices.
Increased servicing complexity. Servicing nonresident portfolios is more operationally intensive than servicing resident portfolios. There could also be difficulty in managing the arrears or recovery processes should a nonresident borrower default. Given the increased servicing complexity, replaceability of the servicer is a key rating consideration. The nonresident RMBS transactions that we rate have a standby servicing agreement in place to help mitigate this risk. While there is no contractual requirement for borrowers to make mortgage repayments in advance, nonresident borrowers often do so voluntarily, based on anecdotal findings from operational reviews of lenders.
Enforcement risk is higher. Loans in Australia have recourse under Australian law. Loans to nonresidents are meanwhile more akin to loans with no recourse beyond the security property if the borrower is out of the country, making enforcement more challenging. Foreclosure periods are typically longer for nonresident transactions. Anecdotal reports from lenders suggest that the maximum delay, where the property is not vacant, is around six to eight weeks if the borrower avoids service (i.e., cannot be contacted) in most states. From our operational review findings, the number of foreclosures has been low to date. Each state has different rules and processes around possession proceedings against nonresidential borrowers. Once in possession, the foreclosure process is likely to take the same time as a resident loan.
The various lender-level adjustments to our standard RMBS criteria result in significantly higher default frequency, loss severity, and credit support levels for nonresident RMBS transactions compared with prime and nonconforming RMBS transactions (chart 2). Minimum credit support levels for nonresident RMBS transactions will be influenced by the proportion of nonresident loans in relation to resident loans.
The Specialist Lender
Banks largely retreated from nonresident lending. Nonresident lending accounts for a small share of total residential bank exposures (chart 3). Since 2016, Australian banks, including the majors, have curbed lending to foreign investors and temporary residents of Australia.
Nonresident lending is mostly a nonbank affair. The scant presence of banks in this sector since 2016 has allowed several nonbank lenders in Australia to become major players in lending to nonresidents. The banks' more restrictive lending criteria have pushed many foreign investors to look to nonbank lenders, thereby increasing their market share in this sector in recent years. Several nonbank lenders in Australia, such as Columbus Capital Pty Ltd., BC Securities Pty Ltd., and Brighten Home Loans Pty Ltd., have established themselves as specialist nonbank lenders that target nonresident borrowers. These specialist lenders have dedicated multilingual staff, operations, and infrastructure to conduct loan origination and verification checks designed specifically for nonresident lending.
Underwriting standards need to reflect increased risks. Although the origination and underwriting processes for nonresident lending are similar to resident lending, there are additional measures and processes due to the increased complexity. These challenges include more complexity and the risk of opaqueness in income verification, living expense determination, serviceability assessment, credit history checks, risk of fraud, and differing standards in verification documents.
In addition, nonresident borrowers are usually required to front a larger deposit for a property and are charged a higher interest rate relative to resident borrowers. Although loans to nonresidents are assessed at a higher interest rate, the risk of foreign-currency fluctuations and capital controls are not mitigated.
Key Attributes Of Nonresident Lending Policies
Nonresident lending policies are, in principle, like standard resident lending policies, with more checks and balances in specific areas due to the increased risks. The key features of nonresident lending policies are as follows:
- Foreign income is typically converted to Australian dollars and discounted by a fixed percentage for currency fluctuation. The percentage of foreign income recognized varies by lender.
- Expense calculations are based on the higher of declared living expenses plus the household expenditure measure, which is adjusted for international living expenses. Some lenders will apply an additional buffer to calculated living expenses.
- Lenders apply interest-rate buffers and floors in calculations, and these vary by lender.
- Evidence of FIRB approval is required.
- Lenders obtain credit history checks for Australia and a borrower's country of residence.
- Lenders generally require a full property valuation.
The maximum loan size and loan-to-value (LTV) ratio restrictions for nonresidents are typically more conservative than those for resident borrowers, given the greater complexity in underwriting and the increased risks (chart 4).
Collateral Performance Has Been Stable To Date
Arrears performance is within our expectations. Arrears performance across nonresident RMBS transactions has been within our expectations, with most transactions' arrears performance to date tracking below the Standard & Poor's Performance Index (SPIN) for Australian prime mortgages (chart 5). Historical performance for this sector is limited, though, given the first transaction was only issued in 2019. The sector's small size also makes arrears performance more volatile in percentage terms. Because most loans in nonresident transactions are variable rate, we expect arrears to increase in the months ahead as lenders pass interest-rate rises on to borrowers as per resident portfolios. And because nonresident borrowers often have higher incomes, given their financial ability to purchase overseas investment properties, their financial resilience to rising interest rates is likely to be greater than some resident borrower cohorts such as first-home owners.
Prepayment rates are more volatile. Prepayment activity across the nonresident sector has been more erratic, with some transactions reaching lofty highs of above 30%, while others report levels of around 10%-12% (chart 6). Given the limited number of lenders operating in this space, refinancing options are more limited for nonresident borrowers. Also, the ability to make prepayments is limited by the foreign-exchange restrictions that are imposed on nonresident borrowers from China; Chinese borrowers comprise the lion's share of nonresident borrower exposures in this niche segment. Across the broader RMBS sector, prepayment rates have been elevated over the past 18 months due to strong refinancing activity and increased competition. This is likely to have affected nonresident RMBS transactions as well, though the refinancing opportunities for these borrowers would be more limited than prime, resident borrowers. We expect refinancing activity to pick up as all borrowers--resident and nonresident--shop around for better mortgage rates in the face of rising interest rates. This may keep prepayment rates elevated in the months ahead. Offsetting this will be potential debt serviceability pressures caused by China's economic slowdown.
No losses recorded in rated trusts. To date, there have been no losses in any of the RMBS transactions backed by nonresident loans. The loan segment's conservative LTV ratio profile helps to mitigate the likelihood of loss in the event of borrower default. Further, many properties securing loans in these transactions will have benefited from equity build up, given the strong growth in property prices in recent years.
Local And Offshore Hurdles Ahead
The nonresident lending sector faces several local and offshore hurdles. While we don't expect these obstacles to materially affect transaction performance, new issuance volumes are likely to plateau in the short term. Some of the more notable challenges affecting the sector are as follows.
Heightened exposure to Chinese borrowers. Rated nonresident RMBS transactions' exposure to Chinese resident borrowers is high, at around 80% in most transactions (chart 7). Australia has been an attractive location for Chinese investment due to its stable political climate, robust regulatory environment, advanced-economy status, reliable investment returns, and proximity to China. Ties to the Australian Chinese community, given the large Chinese diaspora in Australia, also increase the appeal of Australia as an investment destination. In addition, the ability to have freehold ownership of property, as opposed to leasehold ownership (as is typically the case in China), has held strong appeal to many Chinese investors. Elevated exposures to borrowers from one country increase the exposure to macroeconomic and political events affecting that country. This can affect demand for nonresident lending.
China's "zero-COVID" policy. China's stringent travel restrictions and quarantine requirements under its "zero-COVID" policy have all but halted travel for study or business purposes. This has curtailed demand for Australian property because many Chinese borrowers purchase overseas properties to house children studying at universities or for accommodation purposes while conducting business overseas.
Weaker economic growth and its effect on debt serviceability. China's "zero-COVID" policy has weighed on economic growth through subdued consumption, weaker employment, and supply-chain implications. We've revised down our growth expectations for China in 2022 to 3.3% from 4.2% (see "Credit Conditions Asia-Pacific Q3 2022: Costs Heighten, China Growth Tightens," June 28, 2022). Credit pressures for small to medium-size enterprises, particularly in the services sector, could intensify, resulting in a prolonged rise in unemployment in China's slowing economy. This could cause debt-serviceability pressures for some borrowers, leading to higher arrears in some transactions. Nonresident RMBS transactions' exposure to self-employed borrowers ranges from 2% to 25%.
Declining FIRB approvals. The FIRB recently increased its applications fees under the newly elected Labour government. This is likely to lead to further declines in FIRB approvals--a prerequisite for overseas investors to purchase an Australian residential property. Foreign investment in Australian residential real estate has fluctuated over the past 10 years (chart 8).
According to the FIRB, approvals have declined significantly since 2015-2016 due to a tightening of domestic credit and increased restrictions on capital transfers in home countries, state taxes, and progressive increases in foreign investment application fees and stamp duties. Chinese borrowers currently can convert up to US$50,000 or equivalent per year into foreign currency.
Downturn in local property markets. Property markets in Australia have passed their pandemic peaks; they're now on a downward trajectory as rising interest rates constrain borrowing capacity and declining confidence dampen property demand. We forecast dwelling prices in Australia to fall in an orderly manner, dropping about 15% from peak to trough. We believe a persistent supply gap in the Australian housing market will limit the fall. Nonresident RMBS portfolios have elevated exposures to medium- and high-density dwellings in inner city areas of Sydney, Brisbane, and Melbourne. This is due to restrictions on the types of properties nonresidents can purchase and the construction of specific property developments targeted at foreign investors. This increases transactions' risk to property declines in these geographic areas and property subsets, given the lower geographic diversity in these portfolios compared with resident RMBS transactions (chart 9).
Despite falling property prices, low vacancy rates are helping investors to offset rising interest costs. Rents can be increased, to a point, given high demand for rentals in the current market. Most nonresident borrowers are investors. As international borders reopen and skilled labor immigration and international students return, we expect demand for apartments will continue to rise because most migrants typically rent for a period before purchasing a property. In addition, younger demographics typically prefer to live in inner-city locations, close to key amenities and public transport. This should support demand for high- and medium density apartments in the medium term.
Delays in delivery of housing projects. Labor shortages and global supply chain disruptions affecting the supply and cost of building materials are weighing on construction times for housing projects. Adding to these pressures is the collapse of several construction companies in the wake of COVID-19-induced labor, contractor, and material cost increases. This is likely to weigh on loan origination volumes, given the decreased supply of new housing, because nonresident borrowers are restricted to purchasing newly constructed properties.
Slow return of international students. A key reason foreign investors buy Australian residential properties is to house children studying overseas. Student inflows to Australia are slowly resuming after nearly two years of border closure but remain below prepandemic levels (chart 8). Early data on international commencement demographics hint at a demand shift away from Chinese students. Australia-China geopolitical tensions and current COVID-19 lockdowns in China could be factors moderating these flows. We see Australia-China tensions as a key downside risk that could structurally weaken Chinese student demand (see "Slow Burn For Australia Student Return," April 12, 2022). These shifts could lead to fewer Chinese investors buying Australian properties to house dependents studying here.
Structural defects and cladding risk. Building defects are a key concern for overexposure to a single property development. We have not been made aware of any exposure to building defects at the time of rating each RMBS. Some originators in this sector have dedicated teams that review the developer, builder, property amenities, and lending locations to assess settlement risk. The teams can reject specific properties and locations, based on their risk assessments. Other lenders do deeper dives on any cladding issues for loans with LTV ratios above a particular threshold.
Lenders are likely to pivot toward resident borrowers. We expect the current challenges facing nonresident lending to lead to lower new issuance in the short-term. Most specialist lenders operating in this space lend to residents and nonresidents. In the current climate, we expect these lenders to pivot toward resident lending and niche areas such as self-managed superannuation funds lending, where they already have a footprint. This could lead to more mixed transactions as some nonresident lenders seek to diversify their portfolios. Nevertheless, we don't expect collateral performance to deteriorate, given the sector's conservative LTV ratios and the strong collateral performance we've observed to date.
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
|Primary Credit Analysts:||Erin Kitson, Melbourne + 61 3 9631 2166;|
|Paul Prajogo, Melbourne + 61 3 9631 2069;|
|Secondary Contacts:||Kate J Thomson, Melbourne + 61 3 9631 2104;|
|Narelle Coneybeare, Sydney + 61 2 9255 9838;|
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