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BFCSA: Explaining Residential Mortgage Backed Securities - The issue of debt securities by trustee companies is unique to Australian RMBS programs.

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Rajapakse, Pelma Jacinth --- "Issuance of Residential Mortgage-Backed Securities in Australia - Legal and Regulatory Aspects" [2006] UNSWLawJl 42; (2006) 29(3) University of New South Wales Law Journal 173

In Australia, the term ‘residential mortgage-backed securities’ (‘RMBSs’) denotes debt securities, which are secured, in respect of the principal and interest, on a pool of residential mortgages. A public trustee company specially established solely for this purpose, known as a ‘special purpose vehicle’ (‘SPV’), issues the RMBSs.

The issue of debt securities by trustee companies is unique to Australian RMBS programs.[1]

In a typical residential mortgage securitisation program, a housing loan provider, generally referred to as the originating bank or the mortgage originator, ‘pools’ selected housing loans[2] and – for a price – transfers its rights under the loan agreements to the trustee.

This public trustee company then issues the RMBSs. The RMBSs are typically issued in the form of bonds or notes to investors. These RMBSs are, in practice, invariably characterised as ‘debentures’ for the purpose of the Corporations Act 2001 (Cth) (‘Corporations Act’),[3] the requirements of which mandate a trust structure for SPVs that issue RMBSs in Australia. The income received by the SPV, from the loan repayments made by the initial housing loan borrowers, acts as a cash inflow against which the trustee issuer’s obligations under the RMBS issue are offset. A structure of a typical RMBS program in Australia is illustrated in Figure 1 below.

 

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RMBSs first attracted widespread attention in Australia in December 1986, with a $50 million issue by the New South Wales (‘NSW’) government agency First Australian National Mortgage Acceptance Corporation (‘FANMAC’), which was used to purchase residential mortgages originated by cooperative housing societies.[4] Since then, the value of the issues of RMBSs has grown considerably, with the amount outstanding in 1996 being $3 billion and reaching a peak of $126 billion in December 2005.[5] RMBSs currently account for more than half the value of all asset-backed securities issued in Australia as at 30 June 2006.[6] The share of the residential mortgage loans that have been securitised through the issue of RMBSs has increased from 2 per cent to 17 per cent between 1996 and 2005.[7]........

 

In Australia, the most significant investors in RMBSs are authorised deposit-taking institutions (‘ADIs’) and insurance and superannuation funds[9] seeking short- to long-term debt investments. These investors are plainly sophisticated in their knowledge of such investments, relative to the average small individual investor. Because of their greater experience and expertise, issuers of securities to sophisticated investors are not subject to the same onerous disclosure requirements under the Corporations Act as are issuers of securities to ‘average’ individual investors.[10]

 

The purpose of this article is to examine the impact of the Corporations Act, the Australian Securities and

Investment Act 2001 (Cth) (‘ASIC Act’), financial services regulation, and the contractual issues surrounding the

issue of RMBSs in Australia.

 

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To rule out the risk that promoters may market their debt instruments legalistically as ‘debentures’ to unsophisticated investors who assume that the instruments are secured when they are not

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The only equity issue in Australia, to date, has been the FANMAC Trusts issue[24] in the early 1990s,

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(a) Sophisticated Investors

Sophisticated investors, as defined by section 708(8), are deemed not to need the protection of the disclosure requirements because they are experienced,[56] financially sophisticated[57] or wealthy investors. Judging from the wording of these provisions of the Corporations Act, Parliament has taken the view that such investors have sufficient means to obtain the relevant information themselves, and that mandating disclosure would be unnecessary.[58]

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It is not beyond the realms of possibility that, if the market for RMBSs in Australia expands substantially in the foreseeable future, RMBS issues of securities of less than $500 000 could be sold to retail ‘mum and dad’ investors, as distinct from the higher face value securities currently marketed to ‘sophisticated’ institutional investors. If this were to become the case, new provisions in the Corporations Act, or possibly an entirely separate new regulatory regime embodied in ‘stand-alone’ legislation, may become necessary.

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A housing loan is, at its most fundamental level, a contract between lender and borrower

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Securitisation via RMBS programs involves the risk that borrowers might find their homes sold by downstream

financial intermediaries who have ‘purchased’ their bank’s or independent mortgage provider’s (‘IMP’s’)[123]

mortgagee rights. This is not because of a failure to pay on the part of the borrowers, but as a result of some act or omission by one of the financial intermediaries in the supply chain or the insolvency of the intermediary.[124]

This begs the question of whether most home loan borrowers are aware of this risk at the time of taking out their loans. Experience would indicate that most are not, nor is it specifically brought to their attention.............

..........If the banks are to take mortgage security over residential properties, they can and should be expected to explain, at least, the major clauses in their mortgage documents to borrowers. The steps that are reasonably required to bring the clause to the attention of the other party (in this context, the mortgagor) must be taken before or at the time the contract is entered into.

A clause brought to the attention of a party after the contract has been entered into will not be effective.[128]

Banks can and should advise their customers to obtain independent legal advice about the effects of clauses in their mortgage documents. The problem with banks relying completely on advising customers to obtain independent legal advice is that currently, in practice, solicitors are not commenting on assignment programs in mortgages

because they do not fully understand them, and sometimes have continuing conflicts of interest from acting on

behalf of banks or other parties in past transactions...........

The risk that the banks and IMPs run, if they do not bring the risks of their participation in RMBS programs to the

attention of home loan borrowers, is that they could ultimately face a wave of litigation similar to that

precipitated by the foreign currency loan scandals of the mid-to-late 1980s.[129]

In essence, all of that litigation arose, not from the complicated nature of the (then) ‘novel’ financing arrangements, but from the banks’ failures to notify borrowers of the risks involved. In those cases, the risk was that borrowers could ultimately have their mortgaged properties sold not through any conscious default on their part,

 

The risk to housing loan borrowers that they might lose their homes through no fault of their own; the uncertainty of whether, at common law, the banks and IMPs even owe a duty to explain that risk and other technical aspects of RMBSs to their home loan borrowers; and the risk that many, or even most, bank managers, loans officers and independent lawyers are themselves unaware of that risk, are compounded by the fact that, at present, there is no specific legislation requiring the banks or IMPs to bring those risks to the attention of home loan borrowers. While it is true that borrowers may be protected by section 52 of the Trade Practices Act, and equivalent provisions in the Corporations Act, this is by no means clear and unequivocal.[136]

In the longer term, there remains the risk of moral hazard, and appropriate regulation may be needed to correct this.

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