National Ready For Possible Us Exit
The Age
Friday July 6, 2001
The circumstances that led to National Australia Bank's decision to create a $865 million provision against the value of its US mortgage servicing business are interesting in their own right. Just as interesting, however, is what the provision implies about the future of the $2 billion HomeSide group.
The provision, about $568 million after tax, flows from the turmoil in US interest-rate markets that has flowed from the US Federal Reserve's series of interest-rate cuts - six in six months.
The rate cuts have triggered unprecedented refinancing volumes in the US mortgage market and the volatility in the various rate markets has undermined the value of HomeSide's future income stream from its mortgage market activities.
The US mortgage market is not like ours. Typically, borrowers take out loans for relatively long terms -15 to 30 years. The loans are fixed-rate and there is no penalty for early repayment.
Historically, the average life of a mortgage in the US has been about 7.5 years.
When rates are falling rapidly, as has happened over the past six months, there is constant churn in the market as borrowers refinance to grab the benefit of lower rates.
The average maturity of the loans that underpin HomeSide's operations would have fallen sharply in recent months.
The mortgage-service businesses originate, service and securitise loans.
Their core income stream is the average of about 30 basis points that they retain of the borrower's interest payments as they flow through to the investors in the pools of mortgages. That margin is described as mortgage servicing rights, or MSR.
The MSR is a tradeable security - its value is simply the present value of the future income streams that will be generated from the mortgage book being serviced - whose value is obviously affected by movements in rates and prepayment rates that vary from the norm.
MSR values are inherently volatile and have the potential to have a leveraged impact on the value of the actual mortgage servicing business.
NAB's MSR before the provisioning was $US5.1 billion ($A9.8 billion) - a 1 per cent movement in its value would add or cut $US50 million off the bottom line of a business whose average earnings over the past three years has been $US88million.
To protect themselves, the mortgage service groups had traditionally taken out hedge positions. While there isn't a perfect hedge for MSR, the 90per cent-plus historical correlation between mortgage rates and 30-year treasuries has made them an effective instrument.
That is, until this year. The historical spreads between mortgages and treasuries blew out, and what the players describe as their ``net ineffectiveness" - effectively the uncovered position created by the fact that treasuries don't provide a perfect hedge - blew out with them. In the wrong direction.
The problem for HomeSide was compounded by the consolidation that has occurred among the mortgage service providers.
That's partly just the evolution of the industry and its pursuit of scale, but also a consequence of a new US accounting standard that has forced the companies to bring changes in their MSR values through their profit-and-loss statements. In Australia, the MSR is capitalised and amortised.
Effectively, marking the value of the MSR to market has driven the smaller players out of the sector - they can't tolerate the volatility in reported earnings.
That reduced the market for MSR, and therefore muddied the pricing signals the market has traditionally sent, but also left a small group of large institutions - some of them much larger than HomeSide - all following the same hedging strategies at the same time and distorting the markets for the hedge instruments.
NAB could have regarded the big swing in the value of its MSR as a temporary phenomenon. What goes down in these circumstances can just as easily go back up.
``Net ineffectiveness" could become positive just as easily as it turned negative. Using a provision, of course, means that NAB could write back the value in future.
NAB is a conservative institution, and the creation of the provision is a conservative act. It does, however, also provide NAB with greater flexibility.
HomeSide has been regarded as a core NAB business, partly because former chief executive Don Argus saw it as a core platform that could be rolled out globally.
Current CEO Frank Cicutto, while shifting his Australian mortgage business on to the HomeSide platform, doesn't apparently see HomeSide in quite the same light. Plans to introduce HomeSide to NAB's UK operations have been shelved.
There has been speculation in the US media that NAB may be a seller of HomeSide. NAB doesn't respond to that kind of speculation, but yesterday's announcement would certainly make it easier to sell HomeSide in future if the bank decided to completely exit the US.
Having already sold its Michigan National operation (for a $1.6 billion profit, which will more than absorb the impact of the HomeSide provision) and having decided against deploying HomeSide in the UK, HomeSide looks like a stand-alone US business and not a particularly high-returning one at that.
An average annual profit of $US88million from a business that cost $US1.2 billion when acquired in 1998 doesn't compare well with the returns NAB generates in its more conventional financial service operations.
It is, nevertheless, quite a strategic and valuable asset in a sector that is, as discussed, consolidating rapidly. HomeSide is the sixth-largest player in the sector.
The mortgage service providers tend to trade at quite high multiples of earnings. In a sale to a competitor, HomeSide's value would probably underscore NAB's conservatism on carrying values. If it didn't, Cicutto has at least created the room to move.
With Cicutto still very focused on a major expansion of NAB's UK operations, and the chances of something becoming available in the UK looking more promising as the Lloyds bid for Abbey National meets regulatory resistance, a couple of billion dollars more of cash released from the US might be quite useful at some point in the not too distant future.
NAB's likely future exit from the US is another indication that Cicutto's vision for the bank is quite different to that of his predecessor, and also that Cicutto, while he takes his time to come to a decision, can make the tough ones.
Selling National Michigan and, perhaps, HomeSide will, however, only look good with hindsight if Cicutto is able to deploy those funds to give the UK and Ireland beachhead that his predecessors built over the past decade the scale and relevance it needs to survive long-term in another fast-consolidating market.
bartho@theage.fairfax.com.au
© 2001 The Age