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State of the Mortgage Fund Space. Capstone PD Day December 2008 Presented by: Rob Stewart Head of Challenger Howard Mortgage Fund. Agenda. Suspension of redemptions Banks and non-banks Funding options Commercial finance fundamentals Property market Mortgage funds Characteristics
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State of the Mortgage Fund Space Capstone PD Day December 2008 Presented by: Rob Stewart Head of Challenger Howard Mortgage Fund
Agenda • Suspension of redemptions • Banks and non-banks • Funding options • Commercial finance fundamentals • Property market • Mortgage funds • Characteristics • Fundamentals • Performance
Why amend withdrawal process? • The Fund has maintained a prudent level of liquidity to meet redemptions as required • Federal Government guarantee only covers bank deposits and not managed funds (such as CMT’s and mortgage funds) • Speed of redemptions following the announcement of the Government guarantee was immediate and growing, and overwhelmed the ability to manage through the natural liquidity of mortgage discharges
Why amend withdrawal process? (cont’d) • Not able to sell or securitise mortgages in the current credit crisis environment (not reflective of quality of loans) • The only course of action was to amend the withdrawal process and to then make withdrawal offers based on the liquidity available at the time • Where we make a withdrawal offer, if withdrawal requests exceed the total amount available for that offer, requests will be satisfied proportionally • As announced we currently intend to make quarterly withdrawal offers
Were there other sources of liquidity? • Fund has a $500m liquidity facility to meet short term cash flow needs for redemptions • Facility was not employed given the scale of redemptions following the Federal Government’s guarantee of bank deposits • Did not want to rapidly fully draw down on this facility, and potentially put remaining unitholders in a worse position • RE has an obligation to act in the best interests of ALL investors • Requirement to repay facility within 12 months could not have been ensured given the illiquidity in credit markets (i.e. higher levels of borrowers are failing to discharge in an environment where refinance is scarce) • Wanted to avoid a situation where the facility provider would rank ahead of investors
What are the implications for distributions? • Distributions continue to be paid normally and remain highly competitive
Banks and non-banks Funding options • Financial firms rely upon the ‘velocity of capital’ – that is the ability to accept/raise funds and lend those funds out quickly • With banks this is a combination of three key funding sources: • Deposits (CMA’s, CMT’s, online accounts and TD’s) • Debt through the issuing of commercial paper (CP) • Securitisation of residential and commercial (i.e. corporate) mortgage books (RMBS and CMBS respectively) • Non banks do not necessarily have a deposit base to use, so funding is sourced primarily through a combination of debt (CP) and securitisation • Risk in borrowing short and lending long: • Works when short term debt is cheap • Fails when there is a mismatch between assets / liabilities and liquidity is not available (eg. RAMS)
Banks and non-banks Funding options • Cost of funding has dramatically altered in the last twelve months • Deposits have moved from being priced at 300bp below cash rates to 100bp below cash rates • Short term debt for AA rated banks has been re-priced from 10-15bp over bills to as much as 65bp over bills • Long term debt for AA rated banks has been re-priced from 25bp over bills to as much as 175bp over bills • Securitisation markets in Australia remain open, but on much reduced volumes and more expensive pricing • Securitisation of RMBS market was running at about $60b prior to Aug 07 • Pricing has moved from 50bp over bills for RMBS to as much as 375bp over bills • Implications: • Funding sources are constrained and more expensive • Leads to reduced lending volumes and higher margins being applied
Banks and non-banks Funding options • Funding volume has also altered in last twelve months • Traditionally banks would raise 1/3rd of funds from deposits, 1/3rd from commercial paper and 1/3rd from securitisation • With issuing commercial paper and securitization expensive and unable to provide required volumes the only significant source of funding has been deposits and term deposits • Banks did not want to fully pass on any increases in deposit rates because they will be mindful of the impact this has on the back book (i.e. existing customers savings accounts) • Term deposits have been selectively used to bolster funding • TD tap has been turned on and off as banks needed capital • TD offerings expensive for banks so rates were always going to be temporary • TD rates halved once RBA started cutting official rates • Term deposits have been the major competitor for mortgage funds over the last year
Commercial finance fundamentals • Commercial finance commitments total more than $500b annually, with commercial finance for real property totaling more than $85b annually as at Aug 08 (source: ABS) • Long term system growth of 15%-16%pa, but this has rapidly slowed during 2008 due to disconnect between: • Supply of finance: providers of commercial finance have seen funding sources constrained • Demand for finance: potential borrowers have delayed investment decisions due to property market uncertainty and high interest rate environment • Excess demand for finance has allowed those entities with available funds to achieve far superior margins on new loans and a re-pricing of back books
Commercial finance fundamentals • Sources of commercial finance dominated by banks with between 85%-95% market share over the long term • Mortgage funds historically have represented an estimated $5.0-7.5b in commercial loans annually (source: ABS and Challenger) • Mortgage fund suspensions will see the supply of commercial finance reduced (mortgage funds in the process of increasing cash balances) • Banks remain only major source of commercial finance and as a result will build market share (i.e. lack of competition allows banks to dominate sector and pricing) • Underlying security dominated by residential property – primary driver for commercial finance • Demand for commercial finance remains ‘solid’ but requires easing of supply constraints and lower interest rates to flow through to borrower confidence
Property marketsResidential • Positives • Supply • Local and state governments have made development of new stock difficult with insufficient land releases, excessive infrastructure costs and taxes • Demand • Strong immigration and population growth (averaging between 1%-2% pa growth; equivalent to 300k people) • Low vacancy rates (sub 2% represents 30 year lows) • Solid rental growth (5%-10% pa growth) • Conducive monetary policy (2% cut in official rates and further rate cuts in the near term) • For investors and owner/occupiers the cuts to official rates has narrowed the gap between cost of funding (7%) and rental yields (5% gross)
Property marketsResidential • Negatives • Unemployment concerns • 4.3% just off 30 year lows • Market commentary suggests potential for 200k to lose jobs which would put unemployment rates at 6.3% - equivalent to levels in 2001 • Buyer confidence • Forced sellers at upper end of market • Buyers delaying purchasing decisions due to uncertainty
Property marketsNon-residential • Commercial • Underlying demand remains strong, although white collar employment slowed from mid-2007 • Nationally CBD office vacancy rates at 3.9% • Valuation capitalisation rates not necessarily fully reflected in market values • Retail • Population growth, tax cuts, real wage increases and strong dollar have contributed to strong performance from retail property • Expect slowing of retail property in light of falling consumer confidence, retail sales and capitalisation rates • Investors will discriminate on basis of location, management, demographics • Industrial • Logistics and location around transport hubs and proximity to markets key themes • Recent import growth and infrastructure investment likely ongoing drivers for industrial property
Mortgage fundsCharacteristics • Mortgage fund characteristics • Provide a consistent and regular income and capital stability • Exposure to commercial mortgages on a first mortgage basis only • Underlying loan exposure is real property (residential, commercial, industrial and retail) • Terms are typically 5 years or less • Loan purpose may be for investment or business purposes • Lending practices are principally full doc in nature • Important to differentiate mortgage funds from fixed interest products and perception that products have exposure to US sub-prime • Mortgage funds do not operate in the US and have no direct exposure to US sub prime • Mortgage funds may have a small indirect exposure to US sub prime through exposure to fixed interest securities
Mortgage fundsCharacteristics • Important to differentiate between conservative, true to label mortgage funds, and products sold as mortgage funds that have: • Higher return and significantly higher risk • High management fees structures • Different legal structures (eg. debentures and unsecured notes) • Exposure to development and / or mezzanine finance • Potential related party transactions • Single product offering
Mortgage fundsFundamentals • Fundamentals improving for mortgage funds with both benchmark and margin expansion • Loan portfolios are benchmarked against official cash rates and / or bank bills • RBA cash rate increases of 100bp in year to June 08 • Bank bills increased 120bp in year to June 08 • Flows through immediately to improved returns for investors • The credit crunch has seen the availability of commercial finance become scarce • Disconnect between the supply and demand for commercial finance • Allows for improved margins to be achieved on existing loan books • Re-pricing of credit has seen margins on existing loans increase • Margin expansion 160bp on existing loan book (with room for further improvement) • Loans are being refinanced and are being done on margins of 4% plus • Flows through mortgage books and investor returns
Mortgage fundsFundamentals Past performance is not a reliable indicator of future performance
Mortgage fundsFundamentals • Arrears and loss provisioning • In previous interest rate cycles - higher interest rates flowed through to higher arrears ratios, albeit with a lag factor of 6-12 months • When interest rates decreased then arrears levels also gradually trended down • Arrears book adds value as borrowers incur penalty interest (positive for unit holders) • Real focus should be on loss provisioning which drag on potential investor returns • Liquidity • Seek to manage liquidity through cash flow and loan maturity profile • Commercial mortgages are not easily sold or securitised • Suspension of redemption by mortgage funds is not a reflection of the assets of the products or the fundamentals • Direct result of the federal governments guarantee for bank deposits • Panic amongst investors
Mortgage fundsFundamentals • Stress testing of loan portfolio • Conducted every quarter to understand the downside risk of property markets impacting the underlying assets of the loan book • Determine a loss on the Fund as: • Inability to pay a monthly distribution (equivalent to about $19m) • Impact on capital value of portfolio • Requires every borrower in the portfolio to cease making interest repayments, CHMF takes possession and underlying assets disposed of in an orderly fashion • Under scenario 1. would require property markets to fall 28% before an impact on being able to pay the monthly distribution • Under scenario 2. would require property markets to fall 38% before an impact on capital value of portfolio
Mortgage fundsFundamentals • Other considerations • Exposure to construction / development or mezzanine finance – higher return does not always compensate for the additional risk • Products that have related party exposures – clear conflict of interest • Large exposures to fixed interest or high yield securities being re priced – mark to market issues will impact investor returns • Management and corporate strength
Mortgage fundsPerformance • Long term performance (after fees) versus benchmarks: • 50-150bp above official cash • 50-100bp above bank bill rates • Performance versus benchmarks: • Mortgage funds typically under-perform benchmarks in a rising interest rate environment • Reflects the delay in loan re-pricing flowing through the loan book and to fund returns • Mortgage funds typically out-perform in a falling rate environment • Product of loan re-pricing • Margin expansion
Mortgage fundsPerformance Past performance is not a reliable indicator of future performance
Mortgage fundsPerformance • Long term performance (after fees) versus alternative yield based investments: • 300-400bp above cash management accounts (CMA’s) • 100-200bp above cash management trusts (CMT’s) • 100-200bp above term deposits (TD’s) • Alternative yield products have been aggressively priced over the last year as banks have relied upon the ‘deposit base’ as the primary means of funding • Pricing for alternative yield based products has dramatically altered in the last two months in response to: • Easing of monetary policy • Improvement from the wholesale money market • Federal government guarantee on bank deposits
Mortgage fundsPerformance Past performance is not a reliable indicator of future performance. A mortgage fund is not a bank deposit.
Mortgage fundsPerformance Past performance is not a reliable indicator of future performance. A mortgage fund is not a bank deposit.
Mortgage fundsPerformance • Mortgage funds also compete against ‘fixed interest’ investments • Fixed interest products are inherently different from mortgage funds: • Asset exposure • Fixed interest funds have an exposure to a range of govt. debt, corporate debt, RMBS, CMBS, CDO’s etc • Mortgage funds provide commercial loans secured against real property • Pricing • Fixed interest funds asset base is ‘marked to market’ • Mortgage funds are ‘marked to book’, hence a stable $1.00 unit price • Returns • Marked to market pricing creates unit price volatility with both capital gains and losses • Mortgage fund returns reflect underlying yield from asset base
Summary • The mortgage sector requires consideration of three key elements: • Competition for funding • Competition for commercial finance • Property market dynamics • Fundamentals for mortgage funds represent decade high returns relative to competing products • Suspension of mortgage funds is not a reflection of the assets or the fundamentals of the sector – but a liquidity issue as a result of federal government guarantee for bank deposits
Disclaimer The information contained in this presentation is current as at 20 November 2008 unless otherwise specified and is provided by Challenger Managed Investments Limited ABN 94 002 835 592, AFSL 234 668 (Challenger). It is intended solely for holders of an Australian financial services license or other wholesale clients (as defined in the Corporations Act 2001 (Cth)). It must not be passed on to retail clients except where it is included as part of the financial adviser’s own advice to their client and is not accredited to Challenger. It should be regarded as general information only, rather than advice. It has been prepared without taking account of any person’s objectives, financial situation or needs. Because of that, each person should, before acting on any such information, consider its appropriateness, having regard to their objectives, financial situation an needs. All mortgage funds carry some investment risk. They are not bank deposits. Past performance is not a reliable indicator of future performance. Challenger is the issuer of interests in the Challenger Howard Mortgage Fund ARSN 090 464 074 and the Challenger Howard Wholesale Mortgage Fund ARSN 093 720 159 (Funds). Offers of interests in the Funds are contained in the current relevant product disclosure statements (PDS) issued by Challenger which are available on our website www.challenger.com.au. The relevant PDS should be considered before making any decision whether to acquire or continue to hold units in the Fund. In preparing this presentation, Challenger has relied on publicly available information and sources believed to be reliable, however, the information has not been independently verified by Challenger. While due care and attention has been exercised in the preparation of the presentation, Challenger gives no representation, warranty (express or implied) as to the accuracy, completeness or reliability of the information. The information in this presentation is also not intended to be a complete statement or summary of the industry, markets, securities or developments referred to in the presentation. Any opinions expressed in this presentation, including as to future matters, may be subject to change. Opinions as to future matters are predictive in nature and may be affected by inaccurate assumptions or by known or unknown risks and uncertainties and may differ materially from results ultimately achieved.
