Musings of a Fintech: The Amazon Moment for Mortgage Brokers

My good friend Sharon Lu seeded an idea into my mind and now it is time to discuss!

Regardless of your views of Amazon, as a company it has caused some momentous shifts across multiple industries. I am calling these shifts an Amazon Moment and believe the same thing will happen to the Australian mortgage broking industry. Although Amazon hasn’t fully arrived in Australia, across the world it has changed many things:

  1. It forced many retail shops to close or change their business models
  2. It revolutionized online retail along with a small select group of firms
  3. It made books cheaper for the everyday consumer
  4. It allows people to buy thousands of items online with next or same day delivery from the comfort of their own home

The major problem with retail in the modern day is that there are natural mismatches that lead to obvious inefficiency:

  1. A large physical store where the consumer is only interested in a small selection of products (size, colour, use, brand are just some of the factors)
  2. A poor matching of supply and demand (shops open in the day, people’s free time is generally in the evenings) and seasonality.
  3. An inventory and working capital problem. People want to buy from a physical store if it is in stock, otherwise they see no advantage against ordering online (so physical stores need to hold more stock).

The overall result is that physical stores represent a form of sales and marketing but have limitations in that they are expensive and inefficient. The result is that a consumer will pay more to visit a physical store when they don’t know what they want to buy (spur of the moment), need deeper inspection (quality control) or want the product immediately (coffee).

Amazon did well as it identified a few things:

  1. People might have an idea of what book they want to buy: the latest trends (Harry Potter), the top ranked, the life-related (I’m currently reading about fatherhood)
  2. Physical quality inspection for books isn’t required in most cases: they are paperback (or were, digital is now here)
  3. They are not needed immediately (except the airport purchases). You can’t read a book in a day, so you can buy ahead of time in many cases.

The result was that a market for online or automated sales of books was there and consumers would buy it. Amazon won. Once it was able to achieve scale, the ability to cross into other areas made sense by reinvesting the money saved on physical stores into improving the supply chain: Faster delivery and better stock management.

The overall result: Traditional bookshops who were unable to add value where Amazon played soon lost out. Not every bookshop closed but they had to offer more – better spur of the moment locations and products, better research into what is a good read (quality advice) and older or rarer books (need physical inspection). This is creative destruction: a better service is offered by a new entrant and existing players also need to improve to keep up.

So how does this translate into an Amazon Moment for Mortgage Brokers?

Firstly, some basic facts about mortgage brokers:

  1. They sell a widely viewed commoditised product (although this is questionable for reasons below)
  2. They have a high cost of use at 1.3% on average of the loan balance (relatively high sales and marketing cost)
  3. Supply doesn’t match demand: it suffers from seasonality as well as poor conversion rates
  4. High salary/cash commission costs

So what would happen if the 1.3% cash commission (which is a sales cost similar to the physical store above) is used for something else: a better credit supply chain in the same way Amazon changed the physical product supply chain.

Supply chains in finance are less obvious. In the most simplistic form, someone somewhere usually has some cash. They invest it (buy shares) or save it (deposits). This feeds through the financial system into a bank and then gets loaned in the form of a residential mortgage.

The bank can make a few choices here. What a deposit holder wants is 100% certainty of their money back, whilst the home loan borrower has some risk: they may default. The bank equity usually holds the difference (is a risk bearer). However a number of other risks also exist and are simply not managed by the expert (the bank): interest rates change when a central bank alters rates or market sentiment changes them. These fluctuations are extra risks and are shoved onto the borrower, who doesn’t have the capability to manage the complex risk.

So what happens in Australia with these extra risks?

Australian loans are either variable rate or fixed for a period. There are very small but hugely significant differences in these loans to the rest of the world:

  1. Variable loans in Australia allow a bank to re-price loans at their discretion. Recent examples of new capital charges to banks leading to price increases straight away. Consumers get a bad deal.
  2. Fixed loans in Australia have only a limited fixed period (mostly up to 5 years). They also have high break costs if a borrower wants to repay early and interest rates have dropped (and banks won’t reward people who repay earlier if rates go up, so this is unfair!). Overall, borrowers face interest rate risk: they either get stuck in mortgage, have to pay to get out and the fixed period isn’t long enough to protect them for the life of the loan, say 20 years, if interest rates increase over the long term..

Both of these loans are then pretty risky to a borrower if something harsh was to happen to the economy: banks would shovel costs onto borrowers or their fixed periods would lapse (and you can’t lock-in rates before the expiry of old fixed periods as you would need to pay extra costs!).

The simple solutions: make loans better by redesigning the supply chain and adding in extra features that make these above risks disappear. The loans themselves aren’t a new invention either:

  1. A Tracker loan, which is defined as the central bank cash rate plus a fixed margin is a better floating rate loan for the borrower. Tracker loans exist in the UK.
  2. Longer fixed periods without break fees. 25-year fixed loans without prepayment fees exist in the United States and Japan.

So how is Huffle going to create the Amazon Moment for Mortgage Brokers?

We are looking to take that 1.3% cash commission and use it to creatively bring new, customer-centric mortgages to the Australian market.

We hope that the end result is not dissimilar to Amazon and traditional bookshops – with a more customer-focused and cost effective alternative that drives the traditional brokers to adapt and enhance their service for the benefit of all Australians.

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Musings of a FinTech: Will my bank screw me?

Inspiration for this comes from the statement “Australian Banks are unquestionably strong and much of this is due to their ability to screw the Australian punter”. I won’t say who said it.

Any bank can be unquestionably strong if a few conditions are met:

  1. It holds vast amounts of capital (global top quartile)
  2. It can borrow for virtually nothing (pay no interest on deposits)
  3. Shunt any increases in costs onto customers with the type of loans it offers (e.g. variable rate home loans)
  4. Generally price loans at higher levels as there is an overall lack of competition (oligopoly, a hint of price coordination)

In short: 0% deposits, generally high interest rates and shoving capital costs and other price increases directly onto customers as they appear. The banks will remain strong for a long time and the customer will lose out. The benefit: strong banks. The cost: a weak customer.

What does a weak customer mean and is it offset by a stronger economy?

A weak customer has weak returns on their savings, so retires with less. One response to this is that a saver should also buy bank shares. Win-win. I still haven’t come up with a reply to this but market forces should help: rubbish deposit returns should lead to people moving away until the deposit offering improves.

A weak customer might not get borrowing at the right rate. This one is trickier. It might prevent a business from being created or lead someone into financial hardship. But a strong bank has a healthier economy. This means more overall lending and no recession. So again I find this hard to dispute.

Does the customer face more risks?

So my last chance is to look at risk. What if a recession comes due to an external reason, say a China crisis or a severe commodity shock (both of which have potential)? Banks may face higher costs and interest rates could go up. Then what? In the hope of keeping banks strong, they can pass on a number of costs straight to consumers: higher variable interest rates. This would happen at the time of a weaker economy, so the debt might not be serviceable.

Now this might not happen. Banks may realise a spike in defaults at a time of a contracting economy may lead to higher losses.

So give a little back to the public and maintain their margins? This I find hard to believe: competition should reduce during a recession, so there are fewer alternatives. My gut tells me the punter would get squeezed and this is a type of manufactured bailout: customers will pay for their lender’s mistakes.

In short: if you want to have certainty in the future you need to find a way to detach the ability of your lender to screw you.

Much like my previous post, a recession may trigger a huge amount of innovation: punters will know what it is like to get screwed, opportunities will appear on the efficient frontier and the public will realise that bank employees have made off like bandits for decades. Just look at the unquestionably strong Royal Bank of Scotland circa 2006. However, until that recession, punters might never know and the opportunities may never appear.

What are Huffle doing?

We don’t want anyone to get screwed. We aim to bring better home loans to Australia, which will reduce the risks that borrowers face over the long term. Watch this space in 2016!


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Musings of A FinTech: Lending on the Efficient Frontier

Motivation for this post comes from a number of sources, including a conversation with a close friend on auto-leases and how new lenders have historically entered the market.

Entering lending markets is never easy. Established players have data, can price loans and generally deliver a solution to a set of borrowers. At the prime end of the market, assets with low probability of default and high asset coverage or security, it is virtually impossible to come in and disrupt: the game is about capital and funding. Large banks have both a capital advantage (lower risk weights, higher amount) and funding (e.g. deposit funding). A FinTech cannot win.

Strong and established lenders will naturally land on the efficient frontier of lending: low risk (volatility, capital) and reasonable return to get an optimal return per unit of capital. This can be viewed as either a point in time (where regulatory capital is determined as a through the cycle forecast) or as a through-the-cycle prediction: pick the stable annuity like returns and stay clear of the cyclical stuff. In other words, lend prime, ignore the sub-prime.

If a new entrant cannot win in the prime space (insufficient capital and funding), then all it can do is lend to those who don’t normally get loans (if you play on the efficient frontier, the established banks will out-scale you). This means lending to high default probability, low asset security, highly cyclical borrowers and you hope the credit cycle is long enough that you can establish yourself and diversify before the usually default cycle begins.

This has been achieved by a few FinTechs and new lenders:

Funding Circle entered the lending space at a time where nobody lent to small businesses as it was in the depths of the financial crisis but also the opinion that SME lending didn’t really make money through-the-cycle. Funding Circle identified a number of established businesses where banks refused to lend to: they couldn’t refinance easily as banks didn’t have the capital to lend to the riskier subset but were used to managing debt and had a good chance of survival. Next thing you know, they’re the 5th largest business lender in the UK.

Bear Stearns, for all its failings, really grew strongly from sub-prime and near-prime mortgage lending to become the world’s 5th largest investment bank. Its final failings were that is didn’t diversify away before the credit cycle blew it up: it was able to enter prime lending markets but had its deep exposers to its humble beginnings.

Dozens of other examples exist – from payday lenders, most peer-to-peer platforms (consumer loans with high stressed probability of defaults for those with interest of regulatory capital) all the way through to private equity or hedge fund owned non-bank lending platforms

Peer-to-peer also gives an interesting take: the initial losses are not an impact to the P2P platform. However, people will stop using a platform with high loss rates, so the platform would collapse in any case. But is the real play to hope the business cycle is long enough going to work for them? A recession now might also be a great thing for FinTech lending: it would provide an estimated longer time before the next cycle ends and open up more areas of lending the incumbents don’t want to lend. Timing is everything.

One final twist is lending itself: if incumbents lend in higher amounts and/or at lower interest rates, the business cycle will be longer (greater investment) and there will be fewer gaps on the efficient frontier. This means fewer FinTech lenders able to launch

Is this a problem? No, the consumer wouldn’t mind: they would be getting lower interest rates and more loans.

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