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The Eureka Report: October 5, 2007

Rams’ tempting loan book
By Ian Rogers (Ian Rogers edits the banking newsletter The Sheet.)


PORTFOLIO POINT: It’s loan book of $14 billion means Rams’ share price is unlikely to remain heavily discounted for long.


The trashing of the share price of Rams Home Loans Group this week was an understandable reaction to news on Tuesday, October 2, of the separation of the company – with the franchise and brand sold to Westpac and the residual listed entity left to earn whatever profits it can from a $14 billion loan book.

The announcement of the sale to Westpac, followed by market briefings by Westpac and Rams that day, still left most outsiders in the dark over the earnings prospects for the non-bank lender's stock.

From now Rams’ profits derive solely from management of this residual portfolio, equal to about 1.6% of the Australian mortgage market.

To put that in context, that’s a home loan book equal to that of all building societies combined, and larger than the loan portfolios of Citibank, Bendigo Bank and Bank of Queensland.

The profit of any mortgage loan – once on the books – is a function of the life of the loan, the spread and fees.

Let’s start with the fees. The key fee to think about is the break fee (known inside banking circles as the “deferred establishment fee”). This is really part of the up-front origination cost incurred but not recovered and deferred until later in the life of the loan.

The reason these fees exist is mainly so banks can fib about the notional interest rate, more commonly known as the “comparison rate” – the calculation of which is dictated by law. Lenders keep this advertised rate low by having a hefty fee when someone refinances within five years (by which stage the profit from the interest spread should be worth the trouble the lender has taken).

In the case of Rams, these fees are in the order of 2%. These fees are at the high end of the range, according to data compiled by InfoChoice.

The spread Rams might earn from managing its loan book is hard to estimate in the current market. Few investors are willing to buy asset-backed securities of any description in any corner of the global capital market just now, and the size, structure and pricing of Rams’ $300 million bond sold to eight investors a few days ago wasn’t too encouraging.

And while Rams is facing some problems refinancing the $6 billion worth of commercial paper with a February deadline, and several billion more now funded through bank warehouses, it's hard to conclude they are terminally unprofitable.

Credit markets will reopen, although slowly, and a market price will emerge for all lenders hoping to make use of the machinery of securitisation.

With a portfolio in “run off”, the Rams loans will, by definition, become highly seasoned and are likely to improve in quality.

The upshot is that, despite the pessimism, Rams management will refinance the loan and while investors today can only guess at the terms, the better hunch is that those terms will leave some profit on the table.



Then there’s the question of the life of the loans. There are some tricky issues here.

Rams has had to increase interest rates on low-doc loans and prime loans, with the rate rise in prime loans in line with actions of other lenders dependent on wholesale markets but out of line with major bank pricing for now.

There’s also a question mark over the extent to which brokers and, to a lesser extent Rams franchisees, will encourage borrowers to refinance (whether with Westpac or elsewhere).

Rams, as manager of the portfolio, will have every incentive to hinder attempts by customers to refinance and enforce contractual terms in whatever fashion maximises returns. If this proves to be the case, some customers may find Rams’ conduct annoying, but investors can expect the managers of this portfolio to take a hard-headed approach.

And if Rams doesn’t take a tough stance in managing the residuals, some other more natural owner of mortgage portfolios will step forward to do so. A financial institution or financial investor will, more than likely, emerge once the credit markets clear and take over the Rams portfolio.

That’s probably unlikely before the first quarter of 2008. It seems less likely that owners of the Rams residual assets would have to wait until 2009 for such an offer.

Rams is now trading about 50¢, which is only 11¢ more than the value, per share, of the cash that Rams will receive from Westpac. Estimates are floating around from investment banks of the pre-crisis value of the Rams residual of 50-something cents per share, stretching anywhere up to a dollar.

There are plenty of unknowns to keep the cautious out of Rams at these discounted prices.

For anyone who thinks Rams is more likely to hit a buck rather than have the company’s value expire altogether, now may be the time to buy.