 My name's Elizabeth Moran. I'm Director of Education and Research here at FIG. Unfortunately today, Tony Perkins wasn't able to be with us. So we have Henry Stewart, Associate Director of Investment Strategy, stepping in for Tony. Henry has a wide background in RMBS and has been an RMBS analyst in the past. He's worked at FIG for three years and works closely with our Regeneration team, which I'm sure that you know. But welcome, Henry. Thank you for joining us. I'll now hand over to you and we'll commence the presentation. Good morning, Liz and everyone else on the call. Thanks very much for that introduction. I suppose I'd mentioned that the most relevant part of what my role has been at FIG is that for the last two and a half years I've been the primary RMBS analyst, putting together all the sort of sales collateral that you would have seen from the desk when they're presenting RMBS opportunities to you. And so it's very much in that mind that we've got this presentation today and it's going to look to achieve a couple of things. Firstly, it's going to go through a little bit of what the market for RMBS looks like and its importance within our economy, if you like. And it's then going to talk through the basic technology that allows for RMBS structures to work. And what we see is that while they're hindered by expectations of them being overly complicated and opaque and not transparent, what we see is that once you get down to the underlying structure, they're quite simple and I think particularly appropriate for a high net worth or self-managed super fund investor who has a genuine view on Australian property markets to be investing in. We then talk about some of the more technical features of how these transactions fit together, how the ratings agencies look at these transactions because that's often one of the easiest ways where you can identify what sort of RMBS you're looking at is to have a look at the ratings agencies analysis. And finally we're going to walk through a case study of, it's actually a real offer that we showed to our clients on Monday or Tuesday this week. And we're going to step you through that so you can have a look at first how we present that and then secondly exactly how to read the sort of information that we will provide to you when we're showing RMBS opportunities to you. And so I think we can kick forward. And if we just jump to the next slide as well. But broadly speaking when we look at RMBS we see that they provide a real opportunity for wholesale investors and we should say right up at the top of the call that these are products which we do only make available to wholesale investors due to the level of sophistication and complexity that's perceived to be associated with them. And there are a few reasons why we think they provide a real opportunity. Firstly they offer a true spectrum of risk. You can access RMBS which are rated anywhere from AAA for the most senior lines, the most senior pieces in an RMBS transaction. That's the same rating for example as the Commonwealth of Australia that's a higher rating for example than the United States of America or the state of Queensland. You can access AA minus rated for the junior notes in prime transactions. So that's the same rating as Australia's four major banks. It's also incidentally the same rating as the senior rating on Genworth Financial Mortgage Insurance and QBE, Lenders Mortgage Insurance which are the two main providers of mortgage insurance in Australia and that's how those notes get that rating. And then for non-conforming transactions or transactions which aren't covered by mortgage insurance you'll have them seeing ratings between single A all the way down to single B. And this means that if you're an investor and you're looking at these structures you can clearly define the level of risk which you want to take on and target that part of the RMBS structure. The second thing or the second reason why we think that there are compelling opportunity for investors to look at is because they offer quite compelling relative value and a high yield in compared to what you'd see as comparably rated securities. For example, if I'm looking at a five year senior bank paper from a AA minus rated institution I'd expect to get a yield well south of 100 basis points over the relevant swap rate for that. If I'm looking at a AA minus rated junior RMBS note in a prime transaction so the same rating as a senior piece of bank paper you'd be looking at getting almost 6.5% call that 300 basis points over the relevant swap rate. When we start looking lower than those AA minus rated pieces we start looking at the single A through the single B rated pieces which are more junior in the structure. We find that even in today's current low yielding environment yields of up to an even over 10% available for investors. We think that for investors who are willing to do the work and learn how these structures work and get comfortable with the underlying risk that they're taking that this offers a really compelling relative value opportunity within the fixed income space. And that's really why for the last several years since the middle of 2011 FIGS really been wanting to educate our wholesale investors regarding the benefits of RMBS. We accept that they are structurally complex however we believe that if we can bring investors along with us on a journey and educate them about how these structures work so that they truly understand it and understand the risks that are associated with it and it really does create a compelling opportunity as part of a balanced portfolio. So I suppose what we're going to step through here is just a broad analysis of what the market for RMBS is like in Australia and why that's important. So here we've got four graphs and we're going to step through each of them in turn. These are all produced by the RBA in association with a variety of other groups and they're regularly updated by the RBA as a representation of the fact that this is quite an important part of the market. So in the top left-hand corner we see a graph titled Funding Composition of Banks in Australia and what we see is that you have two trends which you can really view there. The one is the fact that as we were leading towards the GFC up until 2008 we had a strong ramp up in the amount of securitization. Let's use securitization as another word for RMBS in this instance in the share of total funding for Australian banks. That's the pink line at the bottom when we saw that it almost reached 10% of the total amount of funding. Now since the GFC you initially had markets close off which is why you had that sharp drop off and you had banks turn substantially more to funding themselves through domestic deposits. Since then however particularly in the last 12 months we've seen the Australian securitization market really pick up with multi-billion dollars of issuance in the first half this year. If we step to the second graph there titled Australian RMBS in the top right we can again see that story which I was describing there where in the lead up to the GFC you had a substantial amount of issuance north of 20 billion in 2007 now and then as we go forward it dropped off almost entirely and as we move forward through to today we see it increasingly being tapped more and more. Now the other important thing to note in that graph is the bottom half of it and that shows the pricing. So here we can see that before the GFC you had incredibly tight pricing. Just last week I was looking at a transaction where the most junior note in the transaction was paying a coupon of the bank bill swap rate plus 36 basis points. That's incredibly tight. What we've seen is that that gapped out pretty substantially around the time of the GFC and it's now starting to come back in. The resting point presently for senior paper in RMBS transactions is around about 90 to 100 basis points over the bank bill swap rate keeping in mind that all RMBS do tend to prices will be structured as floating rate notes and not big straight notes. Jumping to the bottom left we have a look at the outstanding volume of RMBS and this is further reinforcing the story we've been hearing a fair bit which is that you had substantial issuance which led to a large corpus of RMBS outstanding pre-GFC which slowly rolled off and now it's rested at a new sort of natural level which makes the issuing into again. The other interesting thing to note in that graph is the yellow portion, the middle mark, the LFM. What that represents is where the Australian government directed the Australian Office of Financial Management who's responsible for all of Australia's debt issuance and a variety of other responsibilities to actually go out and insure that it was purchasing senior RMBS to help kick competition alive in mortgage-backed markets. Now that tells us a couple of things. That tells us that the government doesn't just believe in this market, it's willing to put its money on the line and it's believed in this market. It also shows you how the securitisation market is essential for the correct functioning of Australia's residential property financing and it's really enables additional competition in that sector by allowing for non-bank lenders to have access to funding and be able to provide compellingly priced alternatives to the mortgages which you can go and get from the major banks. Finally, we have a look at the graph on the bottom right-hand corner, Australian banks wholesale issuance and this is if you ignore deposits and equity in how the banks are funding themselves, how that breaks down. Obviously in 2009 you had a lot of unsecured issuance which was also benefited from a government guarantee which is why that amount is so high there, a lot that was done at the start of 2009 near the end of 2008. We've seen in the last few years the beginning of a covered bond market which is slightly taking away from the RMBS market as it's another way of moving residential mortgages which sits on bank balance sheets, off balance sheet and allow them to be funded at compelling rates but we again see the volumes of securitisation in the lead up to the GFC which is the light blue or purple part of the graph. It was quite high, 2008 through 2011 it was recovering and then in 2013 we saw a really strong figure. We've seen that reflected again in 2014 and we're on track to have even higher levels of issuance this year. I think what we see from this is that RMBS despite predominantly not being in front of Australian mum and dad high net worth self-managed super fund type investors is a really genuine and large part of the Australian fixed income market. It's traditionally wholly been the province of the institutional investor however what these graphs show is that it genuinely is substantial and to the extent that it provides compelling relative value and can pay you a yield that makes you think that it's appealing to you but this is definitely a credible market that you can be comfortable investing in. I suppose if we're looking to expand that idea of credibility let's have a look at some of the issuers who issue into this market and we see that they include all the big four. They include all of our next tier of banks includes the substantial number of regional lenders and then it also includes two other groups that I've mentioned includes prime non-bake lenders and these are people like Rezimac and First Back who operate on a model similar to the one you're probably most familiar with was Rams back during the mid-2000s to late-2000s. They offer products that compete with the banks and they fund them through securitisation markets. Now it also includes several other lenders who write both prime and non-conforming or subprime loans. They include the Bluestone Group, Liberty Financial and Pepper. Now Liberty and Pepper also write prime loans but their real expertise sort of sits in that subprime area. What we see is that this is a market that's tapped by a wide variety of participants from household names to very specialist lenders. The fact that you have the CBA all the way through to Liberty Financial issuing into this market is further indication of its depth and its breadth, not to mention its credibility. So I suppose what we're going to do through these next few slides is just briefly talk about exactly what these products look like. And on this slide you see a quite simple diagram. What we have is we have a bank or a non-bank lender take a variety of home loans, a substantial number and a new transaction let's call it 2000 and they transfer those into a special purpose trust which now owns them. In return the special purpose trust pays the bank full face value of those loans. Now where does this trust get that money from? Well what it does is it issues ROBS notes to investors and investors pay for those. So you've now got a situation where before you had mortgages sitting on a bank balance sheet. They've been transferred into a special purpose trust and in order to fund that they've issued ROBS notes to investors who've paid for that. The proceeds of those payments are used to fund the purchase of this pool of mortgages. Now if we think about a bank and how it runs its business, how it runs its residential mortgage business, obviously there are a whole heap of things that have to go on. Now a lot of that exists in the process of originating the mortgages. That's having mortgage brokers out there, it's having branches on street corners where people can go in and inquire about a branch and that's a lot of the cost that's associated with it. But then even once you've got the mortgage has been established the borrower has signed up, he's bought his house. You've got a whole heap of things which need to continue to happen on an ongoing basis. You need to send that person monthly bills saying what interest and principle is due. You need to set the interest rate on that. If someone goes into arrears you need to be able to manage that, remind them that they are and if things don't get resolved then start to begin a foreclosure process. You need to to the extent that you offer any fixed rate loans or a fixed rate portion of a loan you need to be able to swap that out into a floating rate. These are all things which banks do on a daily basis to manage the mortgages that they have originated. And this special purpose trust by virtue of the fact that it owns a large number of mortgages it needs to be able to do all those things as well. And so you have a variety of different service providers providing those services to the special purpose trust. You also need a few additional things to service or to deal with the fact that you do have notes on issue and you need to manage your relationship with investors as well. But they're quite typically what you'd see with the normal bond transaction. You're going to have trustees of the like of perpetual, the largest trustee in Australia, Bank of New York, Mel and the largest trustee in the world tend to be the two who get used for RBS transactions. And we see that all of the other roles in this transaction tend to be the sponsoring bank themselves or a related entity of that sponsoring bank. The point of this slide if you like is to show that the various roles that are played within a normal bank scenario, the people who service the loans, the people who service loans that are in trouble that are in arrears, the provision of bank accounts where money's come into and out of. In an RMS structure, all of those roles are still played by the exact same people. And so all the same technology that sits behind a major bank in Australia running its mortgage servicing operation sits behind the way that RMS trusts run their mortgage servicing operation. And that gives you comfort in the degree of quality and competence of the various steps in the process between the end holder of the mortgage, the borrower and you as a note investor being paid. And so we get to really the heart of what an RMS transaction is. And the easiest way to begin to think about this is to know that the underlying assets that that trust owns is a variety, a large number of mortgages. Now, what are some features of mortgages in Australia that we know? Well, the vast majority of them are variable rate mortgages and as a result of that, the RMS which spit out of the other side of the trust are floating rate, prepayable FRNs. And they need to be prepayable by virtue of the fact that if you think about your normal Australian mortgage product, it's a 30-year principle and interest loan. And each payment that you make on your mortgage, I'm sure you're all familiar with, will include an interest portion and it will also include a small repayment of principle. Now then the next thing to keep in mind is that it's very unusual in the Australian market for someone to actually keep a mortgage for 30 years and just slowly pay it down at the scheduled amounts. People tend to either move houses in which they'll wholly refinance their mortgage. They will pay it down more quickly if they receive a pay rise or a bonus or an inheritance. There are a variety of reasons why people would pay their loan down more quickly and then also a variety of reasons why people would refinance their loan entirely. In all of those instances, the RMBS transaction needs to be able to, when principal is repaid on the underlying loans, use that money to repay principal on the RMBS notes themselves, the liabilities of this trust. So the other important concept which is described on this slide is the idea of over-claderalization in the actual underlying pool of mortgages. And this is pretty easy to understand if you think about the fact that if I want to go to, let's call it the CVA today and get a loan, it's going to be substantially easier for me to do so if I'm willing to put 20% of the cost of the property I wish to purchase up front. So what we see is that in the Australian RMBS market, if you look at the average pool of mortgages, you tend to have a weighted average LVR. LVR there stands for Loan to Value Ratio. It's essentially the proportion of the value of the property that you're purchasing that you're borrowing. You tend to have a weighted average LVR of about 60% to 70% on new transactions. Obviously, as those transactions age in time, borrowers tend to pay down their mortgages, the principle on their mortgages further, better improving your security position because you've got further over-claderalization on those underlying loans. So essentially what that trust does is it takes all of the principle and interest income that's coming off those underlying loans and it uses those to pay down the various obligations that it has on the RMBS notes. And it actually segregates the cash that it receives into two very clear pools. It separates into principle and it separates it into interest. It uses the interest that is earned on the underlying mortgages to pay interest on the RMBS notes and it uses principle that's earned on the underlying mortgages to pay down principle on the underlying RMBS notes. In this way we refer to them as pass-through notes because they do pass through all the cash flows that they receive to investors in the liability side of the trust, the RMBS note investors. The final important concept to appreciate from this slide is the final dash point there on the left, the idea of subordination. Now what that means, if you look at the quite simplified RMBS structure that we have on the right, we've got 95% of the transaction which is triple A rated senior RMBS and we've got 5% of the transaction is double A minus rated junior RMBS. What we do when we take all the interest that we've received from those underlying mortgages is we first pay the interest on the senior notes and we second pay interest on those junior notes. So those junior notes only get paid interest if there's sufficient cash left over after paying interest on the senior notes in order to pay them. And then to the extent that there's anything left over, we call that excess spread and the sponsor of the transactions or the originating bank. In the example we've kind of been using, it'll be the CBA, each period to the extent that there's excess income that actually gets paid to them and that's their profit for having originated all these loans if you like. And now if we jump to the next slide, we're going to see quite explicitly what happens with income. So I talked about the waterfall there being used to pay interest on the senior notes before the junior notes. There are a few extra things that happen in there. Obviously you need to pay tax, you need to pay those various parties who are part of the transaction like the servicer, the trustee, parties like that. Although those expenditures do tend to be reasonably de minimis, you then pay your senior note interest, your junior note interest to the extent that there are any losses that have been experienced in the current period. So principal losses on loans which you've been forced to foreclose upon, income would be used to cover them. To the extent that there were any losses in prior periods which weren't able to be covered by income in that prior period, you'd use income in this period to pay them. And only after you've covered all of those things does that excess spread get returned to the sponsoring bank. And that will happen depending on the transaction on either a monthly or a quarterly basis. Principle is a little bit more simple. The important concept to grasp is that we do wholly separate amounts received by way of principal from amounts received by way of income in the cash receipts that we get from the underlying borrowers in the pool. And we take that principle and we use that to repay the body of notes on offer. And we do it in such a way to ensure that if the loan balance of the mortgages that I own goes down by $10 million, then I'll also ensure that the total amount of debt that the structure has, so the total amount of RMBS notes that are on offer from the trust also goes down by $10 million and this ensures that the amount of income that's being generated on the underlying mortgages will always be sufficient to service the RMBS notes because as the principal balance of the mortgages goes down, the principal balance of the RMBS notes goes down accordingly. Okay, Henry, it's Liz here. I've got a question from Carol. She just wants to know if you have a $10 million repayment of principal, is it shared equally between the AAA RMBS note holders and the AA minus RMBS note holders or is it like a capital structure where the whole 10 million would go to the AAA tranche first? So that's a really good question. We're going to get to a concrete example of how that specifically applies later on. But as a general rule, what happens is that in the early periods of the transaction, all that principal will be used to repay the most senior note holders. What we see is that after usually 50% of the transactions paid down, you'll actually start using that principal to equally repay both the senior note holders and the junior note holders. The logic behind why you do that is because obviously you're paying a higher coupon or a higher rate of interest on those junior notes because they have a relatively riskier position. And so if I'm just paying down all the senior notes, then actually my weighted average cost of capital of this transaction is increasing every period. Proportionally, I've got less of the senior notes and I've got more of the junior notes and the junior notes have a higher interest amount. So the agreement that was reached in the way that RMBS structures are operated in Australia is that once the transaction is paid down by 50%, then you start sharing the principal amongst both the senior note holders and the junior note holders. Why do senior note holders agree to this after the transaction is paid down by 50%? Well, let's imagine that on day one, the junior note represented 5% of the total transaction. Imagine we're dealing with a billion-dollar transaction. The junior note would represent $50 million of that. By the time half of the principal on the underlying loans is paid down, then you've got a total of $500 million of RMBS notes outstanding. You've got a total of $500 million of underlying mortgages which is servicing those RMBS notes and you've still got $50 million of junior notes which provide hard equity to absorb any losses before the senior note holders have to take a hit if losses do happen which can't be covered by excess spread. So it seems reasonable to argue that because proportionately or proportionately the amount of support you're getting from that junior note has increased from 5% of the transaction to 10% of the transaction that the senior note holders are willing to start sharing that principal with the junior RMBS note holders in order to have the ultimate benefit of keeping the total interest cost that you're paying on your RMBS notes as low and manageable as possible. Thanks very much, Henry. We'll move on to the next slide. So we've talked about the concept of as principal gets repaid on the underlying mortgages, it gets used to repay the RMBS notes which have been issued to fund their purchase. And this, because it happens as and when principal gets repaid on the mortgages you can imagine that this creates a bit of a problem because I don't necessarily know with the same degree of certainty as I would with a regular fixed income investment when those payments are going to happen. Now as it turns out I do know with a reasonably high degree of certainty how that's going to happen because I've got a lot of historical data and I know how Australian borrowers tend to pay down, or we know how Australian borrowers tend to pay down their mortgages. What we see is a broad rule that differs from transaction to transaction a little bit and it differs from issuer to issuer or originator to originator a little bit but as a broad rule of thumb we see that of every dollar of mortgages outstanding in Australia over the course of a given year, 20 cents of that will get repaid. Now that sounds at first brush really, really high because we know that if you're paying off a mortgage, principal and interest then of every check that you send into the bank substantially less of that is principal than it is interest and it's very unlikely that you'd be paying off 20% of your mortgage balance in a year. These are 30-year mortgages after all. Now what we see is there are a couple of different ways that you can have principal get repaid. It's not just the small amount that you make in your monthly payment. So the other ways include people prepaying their mortgage balance and that can happen when they've received an inheritance, a bonus, an increase in pay or most importantly when people refinance their entire loan which essentially represents them repaying all the principal at once. Now they can refinance their loan for a couple of reasons. They can refinance their loan because they're moving to a new house. I don't know about you but I don't know many people who've been living in the same property for 30 years or they can refinance it simply because they are able to get a better rate from another financial institution. If you combine all those factors together what you see is that on average you see about 20% of the principal balance of a given mortgage repay over the course of a 12-month period. Let's have a look at that in aggregate because you have in the first year you go from let's say 100 cents to 80 cents. You then have 20% of 80 cents repay in the second year so you go from 80 cents to it's going to be minus 16 cents which is going to get you to 64 cents and that's going to continue down. It's not like you're going to expect it to be wholly repaid within five years. This is sort of an example of exponential decay but what we see is that you're going to have about 5% of that transaction left within six years but 10% of the transaction left around about the 4.5 to 5.5 year period depending on whether it's 20% or it's 21% or it's 19%. It's normally going to be around that area and that's how we see these principal amounts being repaid. Now if you would never have the transaction to get called if you would just have principal get repaid to the RMBS notes as and when it got repaid on the underlying mortgages then what you'd see is that you'd have an incredibly long tail on these notes because there are going to be the few exceptions, the people who do keep their mortgage for the full 30 years and those people's mortgages have to be funded and the RMBS notes would do that. However what we see is that in reality and if we jump to the next slide in order to guard against that problem we have the issuing institutions agree that once the transaction reach either a certain date for example it might be three years into the transaction or it reaches a certain amount of the transaction that's still outstanding for example it might be there's 10% of the transaction left then the issuing institutions or the originating bank the CBA and the example we've been using as we go along they'll call the transaction so they'll buy all the mortgages back and pay out the RMBS note investments. Obviously that's something that is at the option of the sponsoring bank and it's not an obligation of theirs it's a call option they have and I'm sure you're familiar with call risks from other fixed income products but what we see is that in Australia issuers have been very good with calling their transactions the first available opportunity. As far as the distinction between that 10% based outstanding call and the date based calls we tend to see that if the sponsoring organisation is an ADI that's to say they're a bank and they're regulated by APRA then they're only allowed to do those outstanding based calls at 10%. APRA won't let them call it before that. One of the key benefits actually of investing in transactions which are sponsored by non-bank lenders like Resinac or Pepper or Bluestone or Liberty is that they have the ability to hit date based calls so they can commit to I will, you know, I have the option to call this transaction on the 17th of July 2017 and so you know that there's a certain final end date there. Well of course there is the risk that they won't choose to exercise that call one sort of key offender in that area probably has been the Bluestone Group which after the GFC failed to call several transactions when they were first able to and knowledge of what various issuers call history is like that's one of the key things which FIGS are able to help educate you on whenever we provide you with a specific RMBS investment opportunity. Okay, Henry have a quick question from Han and he's asked do you get notice of possible impending early calls? So on the concept of an early call I think is an interesting concept to deal with so what we see is that the vast majority of issuers have called every single transaction that they've had outstanding at the first available opportunity and so we know when that first available opportunity is coming because either a date-based call in which case it tells you this is able to be called from for example the 13th of July 2017 or it's an outstanding space call and I know how much is outstanding because I can look at the fact that this was a billion dollar transaction when it first issued it's now got 110 million dollars left alright it's coming up close to that 10% threshold it's going to be eligible to be called. When you're dealing with issuers who haven't called all their transactions on the first available opportunity it becomes slightly trickier. First Mac for example is I think a notorious for not being particularly transparent with when they're going to call their transactions. Bluestone as I mentioned failed to call transactions for several years and then came out and did call it. Unfortunately you have to make sort of an educated, I'm not going to say guess but you have to take an educated position on what you think the call behaviour of various issuers is going to be because they're not able to disclose specifically that they're going to call a transaction in advance because that would be material price sensitive information if they were to release that. They tend to tell you when they're going to call a transaction a month before they're going to call it. There's normally a 30 day notice period they have to give and apart from that you have to work from your experience with the issuer. So we talked about how you have income being applied from the top of the transaction, gets paid to the senior notes first before it gets paid to the junior notes. Now the other thing that makes the senior notes more safe is the fact that losses can only be applied to them after they've gone through a fair few other lines of defence first. Now the first line of defence against losses is I'm going to disagree with this slide a tiny bit and apologies for that but actually the over collateralisation that you have on the underlying loan so the idea that the LVR of the loan is probably only 70% which makes it difficult to realise a loss. If you only need to get 70% of the value of that property when you foreclose upon it that reduces the chance that you get a loss. The second line of defence that exists in a lot of RMBS transactions particularly a lot of prime RMBS transactions in Australia is lenders mortgage insurance. This is essentially an insurance policy the borrower pays for but actually benefits the bank or the lending institution. This says that if the bank forecloses on this property and can't get the full value of the mortgage back then the insurer will pay out that amount. The next line of defence you've got is that periodic excess spread that we talked about so the extra income that's been charged on all the underlying mortgages that is in excess of the amount that's required to pay senior trust expenses and then interest on the senior and junior notes. Now if you have a loss and doesn't get covered by any of those things then the next thing you do is you write down the value of the junior notes and the only way that you can have a loss impact a more senior class of note is if the junior class of note has been wholly written off. And there's one final thing that helps improve your security position. It's the fact that even once you've written off a junior note for either a portion or in its entirety to the extent that there is any excess spread profit in future periods that amount gets used to replenish the value of those junior notes. So what you see is that you do have a particularly strong security position within these structures ensuring that losses are allocated first to several features that are outside of the transaction wholly and then even within the transaction they go through excess spread first and then they go through any junior note which might sit beneath you. So we're going to have a brief discussion about the ratings agencies because they are important in securitization markets because they do some pretty rigorous analysis. We actually have an article run in a wire this week which talks through exactly and explicitly how ratings agencies do rate RMBS transactions and I think if you listen to this and you find that you didn't wholly get everything that I was saying or you want a bit more detail about it I highly recommend having a look at that article but broadly speaking their attitude to rating RMBS transactions comes down to this fundamental idea. They say that the only way you have losses that have to be levied against RMBS notes is if you have losses under the underlying mortgages. If I want to measure the quantum of losses that I'll have on the underlying mortgages well there are two things that I really care about. One is how many of these mortgages do I think are going to default and the second is when they default how much money do I think I'm going to lose on each of those mortgages. So we call the first one the weighted average foreclosure frequencies that's how many of them are going to default. We're going to call the second one the weighted average loss severity on average how much money are they going to lose on each of those mortgages. And then what they do is that for each different level of rating they apply a stress scenario for the lower ratings like a single B rating it's not particularly hectic and then for the higher ratings a triple A rating for example you really start talking about disaster scenarios. If we're to look at standard reports by way of example if you're looking at the triple A level of mortgage market stress that they apply in determining their weight average foreclosure frequency and the weight average loss severity they look at what they call average mortgage. So this is for between 200 grand and 500 grand it's in a metro area it's not in the city it's not in the country. It's a standalone house it's not a unit it's not a townhouse it's not a villa. It's occupied by someone who is full-time employed. They're full dock they've got prime credit history and they look at a pool of 10,000 loans that look like that so very vanilla very sort of normal very usual. And they say that in my triple A level of triple A stress scenario I think one in ten of them is going to default on their mortgage so let's just like imagine one in ten mortgage borrowers in Australia defaulting on their mortgage we're looking at a pretty dire scenario and I think the property prices are going to decline by 45% from when the loans were originated. So what we see is that they're applying a really quite hectic and stressful level of stress to the underlying assets to the extent that the actual borrowers differ in a meaningful way from that idealized borrower than they adjust. So they say for example if you didn't have a perfect credit history then I'm going to assume it's not a 10% likelihood that you're going to default it's going to be a 14% likelihood. If you live in the country if you live in an apartment in the inner city they're going to say well I don't think there's going to be a 45% defined property I'm going to see what this would look like if there was a 52% decline in property and they go through and by looking at the entire pool they can generate an expected level of loss under each of those stress scenarios. If we jump to the next slide we can see hypothetically what that would look like. So here this gives an example for a non-conforming transaction where under a AAA level of stress the ratings agencies would expect for a 16.7% for closure frequency. That's to say that 16.7% of the borrowers in the pool would be expected to default under that AAA scenario of stress and the dollar value that you'd lose on each of those mortgages would be 49% of what you'd lent to them. So they'd say if you've got that happen which is just like a hectic disaster scenario then you'd require 8.2% of the transaction to be sitting underneath you to absorb those losses. And then it goes through and that table shows what those numbers look like at various other ratings levels of less hectic stress scenarios if you like. And what we see is that this means that in order to put a AAA rating on a trunch in an RMBS structure with these underlying loans you'd have to have at least 8.21% of the transaction providing equity. The important thing to think about here is that this analysis wholly ignores any benefit that you might have on an incremental basis from excess spread going forward. And so I suppose we can take this a step further and we can look at how this works out on the next slide. There's a graph which shows that obviously to the extent that you had a lower level of loss severity then you'd be able to withstand a higher level or foreclosure frequency for a given level of subordination. So that light blue line on the top right-hand side which is my AAA. Imagine that's the instance where you've got the 8.21% subordination or equity sitting beneath you that can get burnt up before you have to wear any losses. Well, that means that if you have a loss severity of 49%, then you could have up to around about 15% of the transaction default. However, if the loss severity would be lower, if you were to have a loss severity of only say 25%, then you'd be able to deal with substantially more of the pool defaulting. So you'd be able to deal with from this graph you'd see about 23%. It's worth pointing out that this graph is reasonably approximate. But it shows the robustness that having subordinated notes sitting underneath you which can absorb losses before they hit you provides to your security position within an RMBS structure. Now that's the fundamental work that ratings agencies do and as we go through to the next slide, we can just see the other things that they cover off on. Now obviously there's a reasonably complex and long legal structure that sits behind these transactions. They sort of ensure that that's going to do what it says it's going to do. They kick its tires if you like. They go through and have a look at all those participants in the structure that we talked about before and they ensure that they're all up to scratch and they often will provide explicit ratings on some of those underlying service providers to the trust. They ensure that the cash flow waterfall design is robust. That's the idea that income firstly gets used to pay tax and next gets used to pay trust expenses and next gets used to pay senior interest and on and on and on. They ensure that they stress the transactions for liquidity purposes to ensure that even if you were to have a stress event with a severe number of mortgages going into arrears for a short period of time it would still be able to cope with that and maybe request that the issuer of the transaction actually includes some special reserve accounts to help account for issues like that and they make sure that any hedge counterparties are appropriately rated so that you don't have any dependencies on then which could hurt you and what this means is that the ratings that we see coming out of structured products in Australia in particular are really robust. And I think the other thing that's important to mention is that RMBS after or Instructured Products in general after the GFC were often considered a bit of a dirty word if you like. However, since then you've had the ratings agencies really tighten up their standards and make the ratings they give substantially more conservative. And I think when you look through to what individual ratings are actually saying about the explicit assets that sit behind them and the sort of levels of stress that they'd be able to withstand, I think you can derive a high degree of confidence from their validity. And so I suppose having talked through all of that before we open it up to more questions we're going to just step you through a brief example of a transaction that we've done recently. Now, as I mentioned at the start, this is actually almost word for word an email that I wrote to dealers at FIG or the salesman at FIG on Monday or Tuesday this week about an offer that we had available for them to show to their clients and it's going to track pretty closely to what you're going to see get offered to you as we go forward and the sort of things that I tend to tell you about a transaction or that we tend to tell you about a transaction. And we're just going to walk through so we can have a look at exactly what's important here when you're reading these sorts of notes. So we'll let you know the rating of it pretty upfront. Obviously that's important and gives you a quick way to calibrate exactly what I'm looking at. Am I looking at a junior note in a prime transaction? Am I looking at a subordinate note in a non-conforming transaction? You tend to be able to tell pretty well what you're looking at by having a look at the rating. This is double A rated and it says that it's from a non-conforming transaction so what this means is that it's going to be quite near the top of the capital structure in a non-conforming transaction. That means it's non-prime as it turns out this is from the Sapphire 2007-1 transaction which was bought by Bluestone mortgages who specialized in subprime mortgages or non-conforming mortgages as we sort of prefer to call them. And then we identified the transfer. It's the MA tranche and you tend to have a pretty generic set of names that you call each tranche in a prime transaction. The most seen tranche will be the A note. You'll then have a mez tranche which is also triple A rated which is called an AB note and then you'll have the junior note which will be called a B note often split into two different sub tranches, a B1 and a B2. With non-conforming transactions they tend to just go A, B, C, D, E, F, G and then interestingly some of the originators have their own sort of naming conventions. For Bluestone an MA tranche sits towards the top of the middle, if you like. Now they benefit from $28.1 million of subordination equaling 26.7% of the deal. So that tells me that there's a little more than $100 million of mortgages left in this transaction and that underneath the MA tranche there's $28.1 million worth of other tranches that can absorb losses before me as the MA note would ever be subjected to having to have any of them levied against me and myself. This is up from 9.7% when the transaction was, I think that should read, originated. This is to say that when the transaction was first brought in 2007 that $28.1 million of subordination represented a little under 10% of the transaction because of how the transaction has paid down since then, it now represents 26.7% of the transaction. So proportionally the amount of loss buffer that you have there supporting your credit position has times by two and a half. And interestingly the ratings agencies haven't improved the rating on this which would suggest that it's AA rated which is a really strong rating to start with but even that soft, I suggest that this would be AA plus or even an equivalent of a AA rated credit. Now the next line is the really important one where it says that given the current LBR profile at the pool this means that if every property defaulted and you could sell the properties for 41% of what they were worth in 2007 then the MA notes would get all their money back. And this is a pretty common sort of scenario that I'll put in front of investors. So we talk about every single one of the properties defaulting. Obviously that's a pretty outrageous assumption. We touched briefly earlier on the fact that if you were to have even 10% of properties defaulted that would be a disaster scenario. Here we go just for the purpose of showing how incredibly robust the security position is here. If you had every single property default we're going to show you what would have to happen in order for you to lose money. And what would have to happen is that you'd have to have the amount that you could sell the property for decrease by over 59% from where these properties were valued in 2007. Obviously that's a huge, almost unthinkable decline in property prices particularly considering what's happened to property prices between 2007 and today with an increase substantially. Finally, not just as a broads of average statistics, the weighted average fridge loan to value ratio of the portfolio is 64.1%. So the average mortgage has 35% money down on what they paid for it which is pretty substantial skin of the game for any borrowers. Now we then go through and tell you a little bit about the issuer and things specific to this transaction. So we talk about the fact that Bluestone failed to call its RMS issues after the GFC. However it started issuing a new transaction at the end of 2013 which allowed for it to clean up a few legacy transactions and then we give you some scenario analysis. So we say if this transaction were never to get called, if it were just to pay down naturally then that scenario, if you were to buy these notes at the price that they're available you'd generate a return of BBSW plus 1.5% and you'd have a 3.6 year weighted average life of the transaction. So some of the principles are going to get repaid to you tomorrow, some of your principles are going to get repaid to you longer than 3.6 years because it's going to work out at 3.6 years on average. And then the second scenario we present to you is if you were to get called in one year's time then this transaction would generate your return of BBSW plus 4.32% with a weighted average life of under a year. So that's obviously a substantially more compelling risk return sort of opportunity and that gives you an opportunity to sit back, have a look at those two different scenarios and make a judgment call as to how comfortable you are of the likelihood of Bluestone who's got a sketchy call history calling this transaction within the next year or two years or three years or never and what that's going to mean for your return and whether you're comfortable to invest given the sort of risk metrics that we've got at the top. And then we just have a little bit reinforcing the risk, the transaction because we're really not sort of that interested in overselling these. I want to make sure that everyone who invests in these transactions are fully aware of what they're getting into. When we send notes like this around we tend to attach a couple of things. We tend to attach the latest investor report and that'll give you a whole bit of pool statistics that'll tell you where the mortgages are located, it'll tell you what the interest rates they're charging on various products are. It'll tell you how many of these people are full-dock borrowers, how many are low-dock borrowers, how many of them have perfect credit histories, what their arrears levels on the transaction are, etc. We'll also send you the full program documentations like the information memoranda that actually underlies it for those of you who are interested in digging in and getting into all the mechanics of the transaction. And finally we'll send you some sort of idealized cash flows. So here are two screen grabs of the cash flows that we sent round with this note on Tuesday. At the top you see the cash flows if it were to get called in a year and at the bottom you see the start of the cash flows for if it weren't to get called in a year and it would just stay outstanding. So let's walk through these a little bit and have a look at what they show us. Capital price, obviously that's what you're going to have to pay for. Accrued interest is how much interest is accrued on these bonds since the last coupon payment date and you've sort of got to pay for that up front and that gives you your total gross price. We talked about the original face value of the bond. In this instance we had $1.411 million of it on offer. However because principal repays over the life of the transaction as we've discussed, you've actually had the vast majority that about a little over a million dollars already be repaid to you. So the only principal that's left is $365,000 here. And so the amount that you pay for this is $96.50 plus the accrued interest on the $365,000 remaining principal balance. In this instance that works out at $353,990.36. In the top right hand corner we get a couple of return statistics. That's the IRR that would generate the spread. That's the margin over BBSW that is expected to return. The wall is that weighted average life that we talked about. So it's like the equivalent of an average maturity date for the principal in the transaction. And then the annual CPR is an assumption which sort of heavily predicates the cash flows that are generated. So that's the amount of principal that we forecast to be repaid in a given 12, unrolling 12 month period. So we talked about 20% being the average. You're buying this at a discount. So the faster principal comes back to you, the better. That's why I've used 18.5% because we always try to make it look a little less good than we think it actually will be. We sort of would prefer to under promise and over deliver with the return metrics that we show clients here. Underneath there you actually see what the predicted forward cash flows are. The various components, what we forecast the interest rate to be, and that's a function of today's swap markets. How much principal we expect to get repaid in a period, how much interest we expect to get paid in a period, and then your net cash flow. Finally, for those of you who like doing your own NPV maths, we include the figures there for you to check our numbers. The bottom you've got all those same things repeated, but it's just assuming that the transaction isn't going to get called in a year and it remains outstanding. Go Henry, we have a question actually from Gary and he says that he notes it's normal to quote the IRR return. And he is wanting if you can just explain that a little bit better how that's calculated. Right. So I'd suggest that when you're looking at RMBS, I would caution against looking at an IRR. I'd depend substantially more on that spread metric because this is an FRN and so that's just more relevant. But in order to generate that IRR, we take today's swap rates and we use that to forecast what the market's telling us. It expects for forward BBSW rates to be. So what the market expects for the 30-day BBSW or the 90-day BBSW rate in this instance to be in nine months time. Using that, we add the coupon margin on these notes. In this case, it's 36 basis points. So if you look in the period that ends on the 14th of January 2015, we forecast that the 90-day forward BBSW rate for that period will be 2.675%. You add the 36 basis point coupon margin and you're getting a coupon of 3.04%. You're having that paid on $307,133.33 of remaining principal and that works out at $2,489 of interest being paid. We've got an 18.5% CPR which would lead to an expectation that $18,185.87 of principal would get repaid, giving you a total net cash flow of a little over $20,000. Now by forecasting all of these cash flows from the dates that we're going to be receiving them on, we're able to calculate an IRR. The simplest way to tell you how we calculate an IRR would be to say that it's the discount rate at which the net present value of the sum of the net present value of all the cash flows associated with the transaction is equal to zero. What we see here in this instance is that in the top example where it gets called within a year, you'd have an expected IRR of 7.19%. In the bottom scenario where it never gets called, you'd have an expected IRR of 4.99%. So it's simply a matter of predicting the future cash flows which we'd expect to receive and then combining that with the price that we're being asked to pay for it today, being able to quite intuitively figure out what return that cash flow profile would generate. Okay, Henry, we have another question from Han. He wants to know, how does a potential investor gauge the relative value of RMBS issues given the absence of price transparency and because of low market liquidity and also the uncertainty of when you're actually going to be repaying? I do like me a nine-part question. I suppose there are a couple of different ways we can approach this. When we're talking about how an investor can get confidence in the relative value of RMBS opportunities, you can look at that in two different ways. You can say, how can I compare the relative value of an RMBS opportunity to other fixed income opportunities or other investment opportunities that are being shown? And then you can have a look at how can I identify relative value opportunities within the RMBS space. Let's touch on the first one first because that seems logical. I think what we've talked through today is some of the ways that you can begin to assess the credit quality of RMBS transactions and what I'd argue is that they're extremely robust and if you look at where these trade, I think they trade wide for the credit quality that they offer. And so you can get a feel for what you believe the credit quality of any of these RMBS transactions to be and you can have a look at the returns on offer and you can compare that to things that offer a similar return and what the credit quality of those are. I would suggest that if I'm looking at something with a, if I'm looking at a brand new transaction that comes, you know, that came two weeks ago, you had a AAA rated note, so an AB note priced at 160 basis points over swap. It had a weighted average life of five years. A AAA rated five years is paying 160 points over swap. If I go and look at ALE Finance, they're a triple B rated owner and sort of roll-up operator of pumps around the country. They just issued six year paper at 170 over and they're triple B rated. So if I'm looking at AAA rated 150 over five year, triple B rated, six year, 170 over, that sounds like a compelling relative value story to me. Now within the RMBS space, it's sort of substantially easier to compare one credit to another because you've got the same underlying fundamentals and so identifying relative value within the RMBS space I think becomes easier. With respect to price transparency, I'd say the market does tend to price substantially off the new issue market whether it's substantial price transparency because A, they're printing a large transaction and B, they're getting price tension and volume. And you can have a look at the notes that you hold or considering purchasing and looking at the returns that are offered on them relative to the primary market and get a pretty good feel for what your relative value is within the RMBS space. Now there was a final comment that was part of the question which was, this is challenging in a context that I don't know when this is going to mature. And yes, I think that's a thing you need to be comfortable with with RMBS. In the same way with other callable securities, you do have the right to call being at the option of the issuer. With RMBS or a lot of RMBS, those issued by any ADIs, authorized deposit taking institutions with banks and credit unions, you don't even have a hard data on which it's callable. You've got it dependent on the transaction paying down to only having 10% of its original value outstanding. That is a difficulty that's inherent with RMBS and it's a level of uncertainty that you have to get comfortable with as an investor if you're wanting to come in here. I'd say that it's reasonably minor. Okay, Henry, we've got a couple of other questions and I think it's a good time to ask them. So Peter has asked, to participate in this particular note, was it necessary to invest the $353,990.36 or does it come in smaller parcels? Right, so I regret that the answer to this question is yes and no. What we do with RMBS is if we have good supply in a particular line that we think offers compelling relative value, then we will go to the effort of making that a direct bond. Usually available in parcels of $50,000 or $100,000 is where I tend to cap it out just because they do tend to be quite intensive with, you know, we give investors who invest in RMBS the opportunity to, as home owner, ask me and other RMBS analysts here at FIG, you know, pretty extensive questions do have any about it. Because of that, we sort of try to avoid taking them down to $10,000 parcels and leave it at $50,000 or $100,000. In the instance of these sapphire notes, we've got a pretty strong following within some of our legacy clients here at FIG in sapphire transactions. People who understand them very well and are able to respond to these sort of offers quite quickly and they tend to act in a pretty substantial volume. So in this instance, we didn't go to the effort of breaking it down into smaller parcels because I was pretty confident that it was going to move even as a $360,000 or $355,000 parcel pretty quickly as it turned out it went in about six minutes. Okay, I think that's a pretty interesting point, Henry, because really this demand inherent within FIG within our existing investor base. So if you're new to RMBS and you're interested, it's definitely worth registering with your dealer saying, I'm interested. Please let me know when some of this becomes available because it is fairly tightly held, isn't it? Yeah, I'd say the instance of it moving as quickly as that would be quite rare, but an entire line moving within the space of an afternoon or a few hours even isn't particularly unusual to the extent that this is an area that you're interested in. I'd definitely make sure that you let your FIG representative, your fixed income salesman, know of your interest to make sure that when any notes about prospective transactions that are available get sent out across the desk, he knows that you want that to be forwarded along as soon as possible so that you've got an opportunity to consider it. Okay, great. I've got a couple of other questions. One from George and he asks, are RMBS traded at all or does the investor need to hold until they're called? And a secondary sort of question that ties in a little bit from Han asking, is there any kind of secondary market in RMBS and are the spreads very wide? So not quite the nine point question, but there's a few points there for you, Henry. Yeah, so like I think almost all products that FIG offers, yes, there's a secondary market. When we're able to offer these to you, we're sourcing them from the secondary market and selling them to you. With respect to liquidity, I'd say if you were to look at RMBS, particularly junior notes of RMBS, as an asset class, you would not be able to say that it's a particularly liquid one. However, at the same time, I'd argue that FIG has a particular knack at providing liquidity as and when it's required. With respect to the spreads, FIG has a broad and ongoing quest to make the spreads that we charge as transparent as possible. These sort of transactions are reported in our transparency report. I'd say given the high level of individual analysis and sort of high level of customer service that we provide in answering investors' questions when it comes to RMBS, we do tend to charge a slightly higher spread than for regular bonds. However, not necessarily materially so. The actual spread that's going to be charged is going to vary based on a variety of factors, how esoteric the transaction is, how long the transaction's got to go, etc. So there are a variety of factors that feed into that ultimate amount. The final thing I'd say is that when we offer you an investment in anything at FIG and this is also the case in RMBS, the price that you see in the return metrics that you see there are a net of any spread that we're taking. So you don't have to pay anything in additional to that amount. Okay, great, Henry. Still got some more questions coming in. And here's one from Gary again, just wanting to talk about how he compares and what are the main things he should look at when he's assessing a deal. And he's saying, so would you actually be looking more at spread and rating as opposed to that internal rate of return if you're assessing a new issue or a new deal? Yeah, so the internal rate of return is not a hugely useful metric in comparing various products which have different terms to maturity, just because you've got a base level of risk for interest rates which sits underneath that. That's why a spread metric I think is substantially more valuable if you're comparing anything that has a different maturity date. And I'd argue that's probably true across all of your fixed income holdings. As far as what you want to be looking for when you're considering investing in a transaction, I think we'll highlight it pretty well to you in the summary information that we send you about the transaction. Here are the key positive things about this transaction and here are the key risks and where it can go wrong. What you're really looking for is what sort of transaction it is. Is it non-conforming? Is it a prime transaction? Looking for whether it has any benefit from mortgage insurance. You want to ensure that it's well diversified. You want to make sure that you've got an appreciation of the arrears history of that transaction and whether there have been any losses which have been incurred and how well they've been dealt with. I'd say they're the key things. You then probably want to have a look at the fact that you want to be very aware of whether you're buying this at a discount or a premium given the prepayment risk. The real risk is that if you buy something at a discount and it repays more slowly than you expect, then obviously that's going to be dilutive to your return. You want to avoid that the opposite of the case if you're buying something at a premium. I suppose the one other thing I didn't mention there that is quite important is you want to be aware of who the sponsor of the transaction is. So who was that originating bank who sits behind it? And that's for a variety of reasons. One is you have higher confidence in certain originators and the quality of the mortgages that they write. You also have higher confidence in their ability to call the transaction or better knowledge of what their call behavior is going to be like. If you know who the issuer is and feel free to, if you get shown something like this, ask questions if you don't think you're being given everything that you need. If you were to get sent this and didn't know who Bluestone was, go back to your dealer and say, who's Bluestone? What's their story? What's their history like? Tell me a bit about them. That dealer is going to come through to me or Tony who's the head of this part of the business and will give you a response. And we pride ourselves on having a pretty personal level of service when it comes to RMDS. Okay, fantastic. Henry, thank you so much for the comprehensive answers. Now, we're running down on our timer here. And if it does stop on us, thank you for joining us today. I did want to try and slip in one last question from Larry. In fact, some very good questions. And he's wondering why the sapphire notes become available and do you know how much is available and why weren't the original investors staying in? Right, in this instance, really simple answer. It's a fund who bought them when they were pretty distressed asset in 2009 at a substantial discount and he's cleaning up his accounts pre-30 June because that's where you land at the end of the year is an important thing for a fund. And things like that can drive supply. In reality, this is a special instance why that supply is available. In general, when these become available in the secondary market, it can be for a whole heap of reasons. It can be mandate changes within funds. It can be the house view within that fund has changed on this type of RMBs. And so they now want to change the way they hold it. There are a whole variety of reasons. It may be that it's an existing fig holder who's a high net worth or a self-managed super fund and they need to buy a boat or a house or go on a holiday. And they need to liquidate some of their stock. There are a variety of reasons why people can sell them in this particular instance with these sapphires. This was a credit fund that's trying to book some profits pre-30 June. Okay, great. Do you want to just wind up now, Henry, please? Yeah, I think here's a nice final slide which tells you things that we've said a few times already. But I think if there are two things that I'd like for everyone to take away from this presentation, it's one, I generally do believe that they offer a compelling relative value proposition and if you look at what equivalently rated products, the margins that they trade out and compare that to RMBs, it just stacks up really aggressively. And then the second thing is just to remember what the things are that improve your security position. And you've got credit enhancement coming from four key sources. One, you've got the fact that the underlying loans, the borrowers haven't borrowed the full value of their property. Two, you've got mortgage insurance on a lot of RMBs transactions which cover any losses which arise from those underlying loans. Three, you've got ongoing excess spread which is being generated in the transaction which can cover any losses that don't get knocked out by those first two. And finally, in a lot of instances, you'll have junior notes which sit underneath you which effectively act as equity to absorb any losses before you get hit. That's a lot of security that you have improving your position. And I think when you combine really strong credit metrics of a lot of RMBs transactions with the margins that they're paying and you compare it to other things in the market, they look very attractive. Henry, thank you very much for stepping in and presenting on behalf of Tony today. I think you've done an excellent job, clearly. You're very knowledgeable on RMBs and there were some difficult questions which you answered extremely well. And I'm sure some of our listeners would like to hear more from you and a bit more in-depth analysis. But I want to say thank you very much for presenting today. And equally, thank you very much to all the listeners. Please, if you have any questions, call your local dealer or in fact you can call and speak to Henry, our expert. Thank you very much. This now concludes the presentation. Good afternoon.