Shares in the “Big 4” banks have been important investments for Australians both pre and post retirement for a long time. Table 1 shows the extent to which self-managed super funds (SMSF) hold bank shares, highlighting the overweight exposure to these names.
People often justify their exposure to these shares for two key reasons. Firstly, since the recession of the early 1990s until the Global Financial Crisis (GFC), the Big 4 provided shareholders with significant capital growth. Secondly, these shares deliver a very healthy dividend stream, which is further enhanced by the generous Australian franking credits system.
Still, investing in these shares is not risk free by any means, as investors are exposed to both market and stock-specific risks. The former is generally referred to as equity Beta and reflects how the value of a share will rise and fall in lock step with the overall share market. Since the GFC investors have been hit by this risk more than once; their retirement savings set back by years.
In terms of stock-specific risk, as you can see in Figure 1, the Big 4 have had a mixed share price performance over the past few years. This reduced share price performance is the result of a combination of poor lending and business practices and the absence of earnings growth required to sustain their valuation multiples. Also, in an attempt to fix their bad business practices, the major banks have exited several lending markets, a topic which will be discussed again shortly.
Despite the poor share price performance, shareholders have been compensated with dividends (see Figure 1). However, these dividends have come under pressure in recent years, and will not be immune to further decreases if economic conditions tighten and new entrants in niche segments erode profit margins. To illustrate this point, in FY12 Westpac paid a total of $5,028m in dividends, yet by FY21 this had fallen to $2.846m. This change represents a decline in dividend per share of 0.55c since FY12 ($1.73 vs $1.18 per share).
The increasing risk around the total returns of the banks raises a crucial question for investors, “how can I generate a strong income stream without risking the loss of my capital?”
Growth in the Non-Bank Lending Market
There are many options for investing that could give you income streams similar to bank shares – and without the risk to capital that comes with sharemarkets. Still, many of these options are not well known or are challenging for Australian investors to access. One possibility is gaining exposure to securities linked to the increasing funding demands from the Australian non-bank lending sector. This sector continues to experience strong growth for a variety of reasons, including:
- changes to bank regulations after the GFC that have made it harder for traditional banks to lend to certain market sectors, either by increased capital requirements or outright limitations
- improvements in machine learning which speed up loan processing and make it easier to assess creditworthiness.
Essentially, without the old technology systems of a big bank holding them back, new non-bank lenders have been able to make a name for themselves across the whole of Australia’s lending market by giving their customers more efficient service.
A prime example of a lending sector that has been targeted by the non-banks space is small to medium (SME) lending. In recent years banks have shifted away from SME lending as they have deemed it too difficult, and the returns do not meet the required cost benefit hurdles for the banks.
Driving the banks’ reluctance to lend to certain sectors are the new Basel III capital rules, which penalise business loans over home loans. Regarding the size of the market opportunity in this space, the SME sector contains approximately two million companies. Of these, one in four struggle to obtain credit from Australian banks. The unwillingness of the banks to address this market has created a ‘funding gap’ of more than $90 billion.
Given non-bank lenders do not have access to a deposit base and often limited access to capital markets versus a bank, their primary source of funding is via the process of securitisation. Securitisation can be used to create securities that are readily tradeable in a public debt market (generally labelled as RMBS or ABS) or in bespoke, privately negotiated vehicles generally referred to as “Warehouses”.
Outside of the ability to trade in secondary markets, one of the key differences between RMBS/ABS and Warehouses is the former contains a fixed pool of loans, while a Warehouse acts as a revolving facility.
In effect, a Warehouse acts as the first home for new loans issued by a non-bank lender. Once the loan portfolio in the Warehouse reaches a certain size, they are then transferred into a RMBS/ABS security, which in turn creates more capacity in the Warehouse to house new loans. Figure 2 provides a stylized illustration of this process.
Over the past 10 years, the RMBS/ABS markets have continued to grow (see Figure 3) to help the non-bank sector obtain the funding it requires. As this market has grown, so has the number of potential investors.
Demand for Warehouse funding has also grown, but given the specialised expertise required to assess, establish and monitor a Warehouse, the number of potential lenders into this market has not grown to the same extent. This, in turn, creates an opportunity for investors who are resourced to find and manage a warehouse, since the demand for their money is higher than the supply.
As a result, the returns on the Warehouse market are much higher than those on the RMBS and ABS markets, even accounting for the fact that the secondary market isn’t as liquid.
Figure 5 illustrates the basic structure of a Warehouse, as well as the standard parties that are involved. Basically, the non-bank lender (“originator”) will send loans into the Warehouse that meet a set of agreed-upon criteria, and the investor (“noteholders”) will send money into the Warehouse to pay for these loans. Importantly, the Warehouse is bankruptcy remote, meaning that the originator is separated by the Warehouse from the noteholders.
The Warehouse, which is a separate entity, then becomes the legal owner of those loans. So, if the originator goes out of business, the loans still belong to the trust, and a back-up servicer will take over to make sure the borrowers keep repaying their loans and making the necessary interest payments.
Each individual Warehouse will be specific to one non-bank lender, though a single non-bank lender may have multiple Warehouses in its funding structure. The specific details of each Warehouse will be the result of commercial negotiation between the non-bank lender and Warehouse’s noteholder(s).
Once an agreement is reached, an investment into a Warehouse will result in a legal commitment to fund that Warehouse up to an agreed amount. Key commercial parameters in any Warehouse negotiation include:
- Portfolio Parameters: Key conditions for the loan portfolio that must be consistently met, including type of loan, geography of loans, industry profile of loans, arrears performance and average return of the loan portfolio
- Credit Enhancement: This is basically the warehouse’s loan-to-value ratio. Larger warehouses will likely have more than one layer of Notes available for investment. Notes with lower credit enhancement are riskier, but they pay a higher rate of return.
- Performance Triggers: Investors into a Warehouse will make their decision based on expectations of loan book performance. Any deviation away from that performance will often be covered by performance triggers. These triggers can support the Warehouse investor through several ways, including diverting cash away from the non-bank lender, stopping any funding of new lending and in extreme circumstances, take operational control of the loan pool.
Investors in a Warehouse are protected through the assignment of key roles. Specifically, an independent trustee is appointed to act in the best interests of the trust, not the originator. This trustee makes sure that the Warehouse performs within the limits of its portfolio parameters, that incoming payments are enough to cover outgoing costs, and that the trust has enough collateral.
Investors are compensated for investing in a Warehouse by receiving a regular interest coupon. The yields of these coupons are generally floating in nature, and based on a spread over a benchmark rate like the one-month or three-month bank bill swap rate (BBSW). The spread is relative to the risk of the note, while the BBSW rate is a proxy for official cash rate. The benefit of a floating rate note is that the investment has no interest rate risk, meaning that if rates increase so too will the coupon payments. Therefore, investors do not need to worry about predicting movements in official interest rates.
Key advantages
For a non-bank lender, the main benefit of using Warehouses is that it gives them the ability to fund their lending at a much cheaper rate and with significantly more volume than if they used debt held directly on the balance sheet or by raising more equity. In reality, a non-bank lender that doesn’t use Warehouse funding is unlikely to ever reach the scale and cost of funds that are needed to become profitable.
For investors, a Warehouse that is set up correctly is a very good way to balance risk and reward. There are important ways that the Warehouse reduces risk:
- If a non-bank lender goes bankrupt, the Warehouse’s pool of loans remains separate.
- The Warehouse’s governing documentation have strong covenants that offer meaningful protection to investors.
- Warehouses are typically structured to last between one and two years. This feature limits an investor’s ongoing risk exposure and gives them a way out or a chance to renegotiate if they become uncomfortable with their investment or the price is no longer competitive. On the other hand, if both parties are happy when the time is up, the facility can be extended.
Not to be dismissed is the fact that Warehouses offer a regular coupon payment with a variable rate that is much higher than what an investor receives from RMBS/ABS or corporate bonds with similar credit risk.
Challenges and barriers
Although there are significant benefits to Warehouses for investors, there are some drawbacks. An investor may be comfortable with moving away from bank shares, but actually doing so may prove difficult to achieve because:
- The financial barrier to entry is extremely high, with most Warehouse structures priced in the millions of dollars.
- The structures are more complex than that of listed assets and require a level of expertise and resourcing that most individual investors don’t have.
- Sourcing Warehouses can be difficult and time consuming as they are generally negotiated privately and under non-disclosure agreements.
The way most investors navigate these challenges is to engage the services of a credit fund manager. These fund managers offer investment in managed funds, often with minimum investment thresholds in the thousands rather than the millions. They employ a team of data analyst and lawyers to navigate the origination and negotiation of Warehouses terms, and they have a network of contacts to seek out new potential opportunities.
An added benefit of accessing Warehouse investments via a managed fund is diversification, with many of these investments having exposure to multiple Warehouses at any given time.
Conclusion
Australian investors have benefitted from using bank shares as an income generator in their portfolios for the last 30 years, despite the higher level of price volatility inherent in any share investment. The focus on bank shares has in turn left the opportunity to invest in true income alternatives ignored because they are difficult to access or not well understood. The Warehouse market is once such opportunity, with demand for investment supported by the secular growth of non-bank lenders across the entire Australian lending market and a growing pool of investment opportunities for retail investors.