Musings of a Fintech: Australian House Affordability

Over the last few weeks we have been running an affordability analysis on Australian property. Our framework was as follows:

  1. Obtain Median Household Incomes (ABS), e.g. $51,896 in 2014.
  2. Define a reasonable expectation of a deposit
    • assuming households save 40% of income for 5 years
    • this is aggressive but caters for both those willing to save to own and might be living with parents and if they had other savings or hand-me-downs.
    • Result: a deposit equal to 2 years household net income
  3. Determine required mortgage from the above deposit and observed median house price (ABS), i.e. 2014: 100% less 18% deposit = 82% of median house price. Median House Price 2014: $571,700. 2014 Required Mortgage: $467,908.
  4. Consider achievable serviceable mortgage from observed variable rate mortgages (plus serviceability buffer) and household net income. Say 4.5x Household Net Income, but driven by a slightly more complex equation. 2014: $231,937.
  5. Look at how many multiples the required mortgage is above the achievable serviceable mortgage. 2014: 2.02x. Average: 1.69.

There are a few things to note:

  1. Median Income does not buy median house. Top earners will have multiple properties whilst lower earners will never own. However this analysis serves 2 purposes:
    • how has this relationship evolved
    • which percentile of household income can actually afford the median house
  2. Achievable mortgage is calculated from inputs and factors that we will not discuss but is roughly derived from:
    • interest rate + 3%
    • 40% of household net income to service that debt
    • hence a median current household income of $51,896 would have an achievable mortgage of $231,937 (about 4.5x net household income) if the current interest rate (SVR) is 5.95%

Resulting Observations:

A. Households cannot save as much of a deposit. In 1994, households could achieve a 29% deposit under our hypothesis. It has declined to 18%. Note: this is a major constraint for first time buyers whilst existing property stock holders can release equity in their property for further purchases.

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B. The ratio of required mortgage to achievable mortgage has been increasing, meaning the median household is further away from being able to afford the median house. Note: the dip into 1998 is a function of interest rates declining but house prices remaining relatively static. Screen Shot 2016-06-10 at 13.12.25

C. The Percentile of Household income required to buy the average house has trended heavily upwards and now you need to be in the 90th percentile of household income to buy the Median (50th percentile) house.

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We draw several conclusions from this:

  1. We can use #B to suggest Australian property is about 20% overvalued on an affordability basis. We note the risk of averaging here.
  2. The ability to raise deposits has become difficult (#A) but LMI and lower deposit requirements have solved this problem in some ways.
  3. If you need to be in the 90th percentile to buy the media house price, based on this simple analysis, we see 2 things:
    • The average person is leveraging too aggressively to buy property in such a way that they are acquiring a mortgage they may struggle to service (ie the 70-80th percentiles are still buying a median house that is only affordable by the 90th percentile). We note the average borrower is taking 5.3x net household income in Australia from Macquarie via Clancy Yeates, or
    • The 90th percentile and above are accumulating more property, possibly distorting household income with negative gearing, and that pocket of what is ultimately investment property, is deeply over leveraged.

Any potential solutions?

  1. 20% price downward correction, although this will impact those who are over leveraged but support those who are under-leveraged.
  2. If borrowers can lock in lower interest rates for longer periods (such as the Huffle 10-Year Fixed), then the serviceability issue may reduce and households with lower percentile incomes can confidently borrow more.
  3. There is potential need for the severe reduction of property investment if we want average Australians to be able to own the average house.

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FinTech Sandbox: My Words Introducing The Treasurer, The Hon. Scott Morrison

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Australian Treasurer, Scott Morrison, today made an announcement regarding the creation of a Regulatory Sandbox for Finance Start-ups. Below is my speech introducing the Treasurer at Tyro FinTech Hub.

Good regulatory frameworks are incredibly important for well-functioning financial systems and the Regulatory Sandbox is an important piece that helps start-ups, regulators and consumers work together to allow the formation of new products and services.

Attempting a finance start-up is a daunting experience. Not only do you need to develop significant advantages over existing well-resourced businesses, the layers of regulation make it almost impossible to get going and test hypotheses. The Sandbox should lower the very early stage constraints so that we can have a huge wave of innovative businesses delivering better outcomes for Australians and overseas.

Sandbox pictureFor those who don’t know me, my name is Damian Horton and I’m the co-founder of Huffle. We’re an early stage FinTech with the ambitious aim of introducing a new type of home loan to Australia and beyond.

As co-founder of a young finance start-up, we welcome the Government and Treasurer’s announcement of a FinTech Sandbox and I’d like to spend a few minutes explaining  its importance from our perspective.

Finance, as a sector, is now playing catch-up to the ever increasing influence of technology on our lives. Hence the recent growth in FinTechs.

The major underlying trend is that we are moving away from physical bank branches on our streets and into the mobile phones in our pockets. And the entire economy needs to keep up.

Up until today, we have only seen an initial wave of financial technology start-ups. And while many of these companies have been great trailblazers, we’d expect to see many more companies offering new products and services that haven’t even been considered yet. Much of this will occur as the cost of using technology continues to fall, talented and energetic people leave the comfort of the corporate world and consuming finance via your phone expands from about 10% towards 100% of the population.

And this is what brings us to the importance of the Fintech Sandbox.

In the case of my start-up, Huffle, where we are aiming to bring long-term fixed rate home loans to Australia which significantly reduce borrower risk, the complexity of being a start-up, primary lender, derivatives business and with a bank-like appearance all at once from day one creates a number of challenges.

As with all leading global financial centres, a strong regulatory framework is crucial, particularly for consumer protection, but these protections often present barriers for start-ups that are simply too expensive to overcome.

A start-up might not initially be able to tick all of the required boxes for regulatory approval. So they then can’t determine if a new business idea would work. The opportunity to create something new and potentially of major benefit has been lost as the cost of trying is too prohibitive.

In Huffle’s case, the initial barrier to ticking all of the boxes was driven by overseas founder experience not counting towards the required Australian experience under the consumer protection act.

Other fintechs face challenges such as the high cost of obtaining a financial services licence, which is required if they are offering investment and savings products.

Another challenge is the heavy reliance on incumbents to provide early stage services.

If there’s a market for a product and a start-up gains traction, this then becomes the right stage to invest in additional people to meet full regulatory approval.

The next step is nurturing.

The sandbox will provide a controlled environment in which start-ups, their customers and the regulators can explore and understand the new product and associated risks. Feedback from these multiple stakeholders can then help to refine and improve the initial products and nurture the new businesses to transform them into tomorrow’s banks and financial services businesses.

I congratulate the treasurer, the government, FinTech Australia and ASIC in the work they have done to put together the framework for this Sandbox and look forward to seeing many new fintech businesses and the jobs it will help create.

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Technical Notes: Dissecting P2P Securitizations

A couple of unrelated things popped up in the last few weeks that got the team at Huffle thinking. Firstly, the LendingClub issues over asset quality, which we believe is a specific case and not an industry risk.

The second, which I will discuss here, is regarding the securitization of peer-to-peer loans originated by Funding Circle in the UK.

TRanching

As with all securitization, Funding Circle’s has a pretty obscure name. The transaction is called SBOLT 2016-1, which stands for Small Business Origination Loan Trust. Having structured CLOs earlier in my career, the securitization on small business loans is not only interesting from a market demand perspective but also an intellectual one. How have unsecured assets been packaged and presented to the rating agencies?

Pricing:

securitization are commonly opaque in terms of pricing, often due to the discount on issuance that may increase the attainable yields or spreads. Luckily, the prospectus was available to me, so I can investigate a little further.

Pricing of CLOs is driven by the attainable credit ratings but also by an assessment of cashflow and scenario analysis. Here we have multiple tranches of increasing risk, with the senior piece getting a BBB rating and a spread of 2.2% over UK Libor.

It is interesting to see how the BBB has tightened in Europe. Locally to Australia, Commonwealth Bank priced AUD RMBS Medallion 2016-1 AAA at +140bps around the same time as SBOLT. Currency risk aside, I would certainly prefer to take on AAA RMBS risk and I also expect traditional CLO paper might also offer better value and liquidity.

Looking at this transaction against an underlying portfolio that is yielding 9.57%, it might be better to simply buy the underlying portfolio rather than the tranched transaction. Further, Class E seems to make no sense, particularly as Class D looks to have a higher IRR. Be aware that fee side-letters may exist and other mechanisms to make the transaction more attractive for investors.

collateral

Tranche Sizing:

Six tranches on a small deal appear to be a little tight: how much loss protection will the Class E offer the Class D in a stressed scenario?

Multiple tranching is possible as the underlying collateral is pretty granular, with over 2400 loans. For this quick assessment, Classes C to Z are of less interest to me. The B Class has obviously caused some discrepancy between Moody’s and S&P as Moody’s has given it a lower rating than the Class A.

So how secure is the Class A?

On inspection, the senior note is pretty secure. BBB rated assets have an annual default probability of around 0.2% and the 67% and 72% attachment points for the Class A and Class B fall comfortably inside the stressed scenario distributions required to meet the 99.8% pass rate (1 minus 0.2%).

A simpler way to recreate the credit rating agency analysis is to adapt the Advanced IRB framework for the given risk profile and asset class. The unexpected loss can be used as an indicator for senior tranching, although the final credit rating agency models are different.

Could we ever see this ever become AAA?

There is always potential to make AAA senior Classes. In this instance, the attachment point would need to be closer to 50%, which is too small and the transaction will struggle to sell. The reason for this is that the unsecured aspect of the underlying assets is a really high downside loss-given default (assume 80%-90%) and a probability of default of 5% to 10% (implied backwards given the high interest rate charged). The Advanced IRB framework can show you how much you can lose in downside scenarios needed to attain a AAA.

Different asset classes make the ability to create AAA rated securitization harder or easier. Secured assets, such as residential mortgages or auto-leases, are much easier for this asset class, which it ultimately about creating additional security rather than funding arbitrage. Unsecured loans are usually the hardest.

Verdict on SBOLT:

The senior tranching appears to make sense versus where the portfolio risk comes out. If we think the securitization mathematics are wrong, we should also assume the entire Basel framework on bank capital is wrong. As such, the transaction, structurally, is pretty well aligned to globally accepted risk frameworks and the securitization should be seen as a valid investment for regulated entities such as banks and insurance companies.

I am less concerned about the lower tranches as they are smaller fractions, speculative and more sensitive to the underlying portfolio for which I don’t have granular data.

How should we view this deal in Australia?

Overall, I am optimistic for the transaction. Wholesale funding is an important piece to peer-to-peer lending on the basis that not all investors want loan specific risk or equal risk that the borrower offers.

Caution should be taken that CLO securitization and subsequent layers of intermediation (such as fixed income portfolio managers, risk processes and rating agencies) add layers of costs that is worn, ultimately, in higher borrowing costs or reduced returns for investors. Direct lending by hedge fund-owned CLO platforms has been around for over decade. Can FinTech offer an advantage here?

In some cases they can, if they have a specialized team, but they need to ensure they have strong compliance procedures and the ability to perform the analysis and risk management process for risk transformation, which is where LendingClub recently faltered. Unlike vanilla funds without structuring overlays, the underlying collateral in securitization becomes ever more important in the resulting investment performance, particularly if there is a stressed market event.

As FinTechs evolve from new entrants and upstarts into more established businesses, these are the type of specific processes that are likely to be taken on.

Note: I have tried to simplify this blog so that more people can follow the analysis. Credit rating agency models have a number of different mechanisms and methodologies to the Basel II framework.

 

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