Never Pay Your Bills: Negative Rates

A lot of noise has appeared in the last few weeks on the effectiveness of recent central bank policy, namely quantitative easing. Whilst this has been an important part of the recovery since the banking systems near collapse, the benefits of continuing this policy look to now be outweighed by the costs.

Here are a few interesting snapshots on negative rates.

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  1. Swiss local authorities want the public to delay paying their tax

As a consequence of negative interest rates on the cash held in Swiss bank accounts, local authorities (cantons) prefer that the public delay paying. It costs the cantons money if people pay at the start of the tax window.

Interestingly, everyone wants to pay tax as early as possible.

We wonder how this could go further. If you were a business with invoices due, would you prefer customers delay paying? If you trust their credit rating and don’t have a cash flow constraint, you might.

It also presents an interesting issue for invoice financing start-ups. Will they need to pay companies for the privilege of getting people paid faster?

We note that credit spreads (default risk) should still keep SME lending rates positive but negative rates do reduce margins in some way.

  1. Danish couple paid to have a mortgage

Coming to all home owners soon! I expect a few people have similar mortgages in the UK. I remember a friend obtaining a mortgage 30 basis points lower than the BoE base rate in 2006, which would be negative now if she hasn’t refinanced.

As central bank cash rates and even long-term bond yields go negative, you are essentially rewarded for taking on leverage and house-price risk. Seems a bit odd that the result of trying to repair leveraged speculation on house prices is to reward people with cash payments for taking speculative leverage on house prices.

  1. Private equity metrics shift

The ECB’s CSPP (buying corporate bonds) has had a few words of warning from Bank of America analysts. As BB rated bonds, which are below investment grade, have increasingly negative yields we see a shift in borrowing and acquisition metrics.

Screen Shot 2016-09-12 at 10.20.37Firstly, gaming any interest coverage test becomes easy. You no longer need to care about Interest/EBIT multiples as you will be paid for the leverage. Existing buyouts then have more room to increase leverage and new LBO opportunities become available.

Companies will look to acquire more targets, ideally with strong collateral values, as owning a liability on collateral (in the same way as the Danish couple with a mortgage) is a money earner. You are rewarding those who believe in future price increases or stability.

In the ECB’s case, this makes sense: the fear of deflation is creating opportunities for those who are willing and able to help the ECB fight all deflationary pressures.

Sadly, many of these problems might be due to prior price increases being brought forward by earlier monetary policy: central banks might be chasing growth that has already been taken through lower interest rates and earlier rounds of quantitative easing.

In the meantime, enjoy the free leverage. Just make sure you can run to the door when the music stops playing.

Notes:

Thanks to Bruegel and Bloomberg/BofA for the charts.

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How Fixed Rate Mortgages Transform Affordability

A previous blog discussed overall housing affordability in Australia. Using a simplified version of serviceability we determined that the median house was only affordable by the top 10 percent (90th percentile) of household incomes (under a set of conservative assumptions). This has been the status quo for a while, with lower interest rates being counteracted by higher house prices.

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Of course, this affordability isn’t broadly true even if it feels like it. We note that many households will resort to interest only mortgages, which reduce the payment burden but do increase the risk overall. Other mechanisms also exist so that a wider portion of the population can still buy the median house.

However, the trend – where the income band increased from top 30% in 1998 to just the top 10% by 2014 is worrying. The trend exists under all circumstances even if the exact percentile brackets are different. The extra risk via interest only and the overall interest risk taken by borrowers in variable rate products is a large systemic risk Australia and the RBA needs to contend with.

Revisiting the model

If we take a 3.75% variable rate and apply it to our last data point, we observe that the top 15% can now afford the average home as the mortgage is more serviceable due to the lower interest payment (note: the house price data is not up to date). Housing gets more affordable based on our conservative affordability assumptions. One would expect an increase in house prices to close up this shift.

Taking the analysis further: what happens to house prices and affordability when our 10-year mortgage is launched?

Further assumptions:

  1. The current expected interest rate for our 10-year is at 4.5% and this is allowed to be applied for the life of the loan.
  2. We are able to deliver our mortgage going backwards using similar observed metrics plus other wholesale pricing observations (we cannot disclose this here, sorry).
  3. Serviceability can then be determined using the interest rate for the fixed rate and not via a 3% upwards stress.

Fixed is lower risk for the borrower

The subtle difference in the serviceability assessment means what the borrower is able to take on as debt is higher for fixed rate (vs. variable) as the borrower has less overall interest rate risk. Alternatively, a borrower can take on the same amount of debt but with lower risk versus a variable loan. Using our assumed mortgage rates, we obtain the following results:

  1. A Principal and Interest Variable Rate Mortgage at 3.75% using the above methodology suggests the median house is affordable to the top 15% of the population (85th percentile).  Note: the house pricing data is on a lag.
  2. For the Fixed Rate home loan, even though it has a higher fixed rate, the affordability is to a wider audience. The top 20% of earners (80th Percentile household income) can afford the median house and historically an additional 5% to 10% of the total population would be able to buy the median house.

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Now a few key pieces to add

  1. Fixed rate debt can be taken on with more confidence knowing the rate cannot increase. Most importantly here, borrowers can have greater confidence in their repayment certainty. The cost is a higher interest rates compared to variable loans.
  2. Lower systemic risk: fixed rate home loans have lower systemic risk as interest rate increases will not impact home owners and damage retail consumption – it will impact the wholesale funding portion of the financial system. In other words, a fixed loan with repayment optionality shifts all of the interest rate risk from the borrower into the financial system.
  3. Housing hasn’t been affordable for a while, however it is more affordable to Fixed Rate borrowers on a consistent basis, meaning a wider set of customers for a similar quantum of risk. It just depends on the method and product the lending is delivered.

Look forward to comments and discussion.

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