Homeside Sale Fails To Lift Cloud Over Nab Executives
The Age
Thursday December 13, 2001
In an ideal world, National Australia Bank would have announced a clean exit from its United States mortgage processing and servicing business yesterday. As NAB and the rest of the market discovered through the course of this year, however, when it comes to the HomeSide operation, nothing is straightforward.
The sale of HomeSide's operating platform to Washington Mutual for $3.7 billion was the best deal NAB could do in the circumstances, even though it leaves the bank with an exposure to HomeSide's $5.2 billion of mortgage servicing rights (MSR).
Those rights - the present value of the future income streams from servicing mortgages HomeSide has originated and securitised - are the source of the $4 billion of writedowns NAB has made against the value of HomeSide this year.
It is conceivable NAB could have sold those rights but the backdrop - the announcement of the 11th cut in official US interest rates this year - underscores the reality that this may be the worst point in the history of the sector to be offloading MSR even if anyone were prepared to buy it. HomeSide has been ravaged by the impact of tumbling US interest rates this year. US mortgages are fixed rate with no locking in of the borrowers. As rates fall, the rate of refinancings rises and the value of the future income streams from the mortgages being serviced shrinks.
As NAB's chief executive, Frank Cicutto, pointed out yesterday, while that may make this the worst time to sell MSR, it also makes it the perfect time to sell a mortgage production business because of the sharp increase in origination volumes.
Conversely, a rising interest rate environment, which slow the rate of refinancings and generates more predictable behaviour by the borrowers, makes MSR more valuable (although, self-evidently, not valuable enough to convince anyone to offer NAB its current, heavily written down book value).
NAB is hoping that it can get its timing right, not just in terms of the business it has sold, but the MSR it hopes to eventually sell.
Despite the latest fall in official rates, mortgage rates bottomed last month and are starting to creep up. Refinancing volumes, which were at historically unprecedented levels, are slowing. If those trends continue, the value of the MSR will rise and the rights will become more easily traded.
NAB isn't the only mortgage service group to have been caught out by the steepness of the shift in US rates and the acceleration in refinancing activity. MSR has become untradeable because of the market circumstances but, as the rate of refinancing drops and future income streams become more predictable and valuable, it will be easier for the bank to liquidate the portfolio on reasonable terms.
The sale of the operating platform helps simplify NAB's residual exposure to US mortgage markets and will make it easier in future for it to reduce that exposure.
The HomeSide platform is scale and volume-driven, needing a minimum of $US150 billion ($A291billion) of mortgages to operate efficiently. It now services about $US187 billion of mortgages.
As long as NAB owned the platform, it needed to keep volumes up by originating new mortgages and generating new customers, whose behaviour was inherently less predictable than those who had been on its books for any length of time. It also meant that it couldn't sell MSR without undermining the platform's economics.
Now it will be able to let the portfolio run off and, if conditions improve, will be able to sell MSR without any concern about maintaining volume.
Simply allowing the MSR to shrink as borrowers refinance will steadily reduce the exposure and make the remaining MSR more valuable, although some of the mortgages have 30-year terms. NAB said yesterday the portfolio had a ``half life" of about four years.
With the MSR, NAB has retained the financial hedges that are supposed to protect it against the consequences of adverse movements in rates. It was an unprecedented blowout in spreads between mortgage rates and the 30-year US treasuries used to hedge MSR risk that first alerted the market to the risks in HomeSide.
Since those hedges were re-jigged (after NAB was forced to provide $865 million against HomeSide's value earlier this year) the bank has claimed they have stood up under the pressure of further rate cuts, providing a 99 per cent correlation with mortgage rates.
The other problem within HomeSide that emerged subsequently and caused a further $3 billion of writedowns was an input error in the models used to calculate the value of the MSR. That has been remedied.
Thus, while there is still risk in the exposures retained by NAB, it is better understood, the responses have been tested and as the US rate curve shifts, the level of risk will recede further.
The sale, for a modest premium ($111 million) to the book value of the operating business, also significantly reduces the degree of leverage in the NAB exposure to MSR (which itself contains intrinsic leverage).
Before the sale, HomeSide had $US6.2 billion of total assets supported by $US1.2 billion of equity after all the writedowns and subsequent capital injections. After the sale it will have $US4.3 billion of assets and $US1.3 billion of equity, with NAB using the sale proceeds to pay down HomeSide debt.
The market will remain uncomfortable with the residual exposure to a non-core and potentially volatile asset in the US until it is completely run off or sold, although the MSR generates about $250 million of cash each year.
It was, however, reasonably enthusiastic about the level of the sales proceeds and the knowledge that, having sold its production platform, NAB will be reducing rather than increasing the level of exposure.
While it is likely to be a while before NAB rids itself of the HomeSide legacy, the other issue ahead of it will be the board-directed review of the disaster. The review's findings had been expected this month but NAB revealed yesterday it was now unlikely they would be available until next year.
A number of NAB's most senior executives, including Cicutto, chief financial officer Richard McKinnon and executive general manager Bob Prowse (who's had the responsibility for cleaning up the mess) have had, at various stages, involvement with the HomeSide.
The failure of the bank to properly recognise and control the risks inherent in the business, and the breakdown in what ought to be the bank's core competency, raises the issue of whether any of the current management carries real responsibility for what has occurred.
Until the review is completed and its findings, hopefully, made public, it would be premature and unfair to leap to any conclusions. Clearly, however, the HomeSide debacle has destabilised and cast a cloud over key NAB executives that can't and won't be dispelled until that review is completed.
bartho@theage.com.au
© 2001 The Age