Building Tracker Loans

Thought piece from last week’s Bank Inquiry.

Brian Hartzer, CEO Westpac:

“When your cost of funds spike dramatically and yet you’re unable to reprice your loan book, that’s a serious for problem for the bank.

We could put that product out there but the premium involved in managing all the risks inherent in doing that … make that product really unattractive for a customer.”

Is this really true? Does a bank face an existential risk from offering Tracker Loans? How much more would they cost and what strategy would you use to deliver them.

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Firstly, banks have the full right to offer whatever loans they wish. It is their risk management and ultimately banks offer 2 services: maturity transformation and risk transformation.

What we want to know, however, is why don’t banks offer Tracker Products right now, how could they do it and how much would they cost but still make similar returns.

Step 1: Defining a Tracker

A Tracker Mortgage is different to a variable rate loan in that the Tracker is legally linked to a premium above a reference rate, be it Libor, base rates, cash rates or in the Australian context, BBSW. A variable loan is usually defined as a discount to a bank defined standard variable rate (with discounts up to 1.75%).

For example, with the Australian cash rate at 1.5%, a Tracker could have a premium of say 2.5% above the cash rate and currently have an interest rate of 4.0%. As the RBA moves the cash rate, the borrower will pay the bank a higher interest but it will always be 2.5% above the cash rate.

Step 2: Understanding the Risks

The main risk with a Tracker is that a bank cannot manage the loan re-pricing, meaning it must make up front decisions on the Tracker’s premium above the reference rate. This is difficult as a bank needs to manage maturity transformation – balancing deposits, debt funding and securitisation programs. As those costs change, a bank usually changes the variable rate.

The variable rate works really well if a bank prices the variable aggressively – attempting to pass on wholesale cost savings to borrowers and then recoup them as costs increase. This is the cheapest way to offer home owners value at the lowest possible rate.

The problem builds when rather than passing on all the rate savings, banks pocket too much of the wholesale cost savings, either for profit or to cover costs. However, borrowers should also have some partial blame here – if they were willing to switch to those passing more on then the behaviour would subside. But human nature is difficult and the cost of switching isn’t zero. The result is that borrowers are potentially willing to pay a premium to make sure banks can’t take too much of the change in wholesale pricing.

Trust Banks: Go Variable. Don’t Trust Banks: Go Tracker.

The clear risk with a Tracker is that cost of funding increases more than 1% and a bank has to swallow that entire cost if the bank’s lenders (such as deposit holders) refuse to absorb higher costs (banks could manipulate the deposit rate). This leads to a profitable loan turning into a loss making one the bank cannot rectify unless it can reduce its funding cost.

Step 3: Tactics

Firstly, a bank can offer a Tracker product without too much risk as long as that loan is only a small portion of its loan book.

If tracker loans were 10% of the mortgage loan book, the risk of that loan being loss making still exists but it won’t be a systemic risk for the bank. It would mean the loan book becomes less profitable if funding costs widen. The bank could also have a Tracker period for the first 2 or 3 years only, as happens in the UK.

Key point though: as a response, a bank would need to charge a premium for the Tracker mortgage as its own risks do increase and a bank’s main function is risk management.

It can decide on the loan interest rate by using probability-based pricing via an economic capital framework. What are the chances of the rise in wholesale funding and the likely cost? Assuming this has a 50% probability and a 1% per annum cost: 0.5% additional charge could be levied on the consumer.

An alternative is using wholesale funding, like many banks do. However, RMBS funding costs are currently higher than deposit and other funding sources. CBA priced a Medallion RMBS early this year at about 0.5% higher than a blended cost of funding and that is a Tier 1 issuer.

Either way, this suggests the tracker would be 0.5% higher in interest rate than the median discounted variable rate. Note: this is a very basic assessment and ignores regulatory capital constraints.

Step 4: Interim Risk

A bank would also need to consider interim risk if it were holding a tracker mortgage on balance sheet. Interesting here, a bank coming to market with a Tracker is likely to have some demand and reduced sales costs: it would be, for a period of time, the only lender offering the product.

Alternative options also exist. If mortgage brokers are being paid upfront 1.5% per mortgage on average, a similar quantum to the potential loss on a tracker is paid out upfront by a bank to a 3rd party for 52% of all loans (mortgage broker share of sales). Admittedly, mortgages brokers are effective at the distribution of home loans.

If, instead, a bank decides to sell exclusively online, then it may be able to offer a Tracker at a closer rate to the variable product whilst still maintaining the current profitability.

Step 5: Mass Adoption

As Tracker loan volumes increase, the wholesale mechanisms behind them may also change and improve. Investors themselves may prefer the guaranteed headroom on loan interest rates rather than a bank’s ability to reduce them to meet their own needs. This may lead to an uptake and system-wide improvement in Tracker mortgages.

Step 6: First Mover

So who will be first mover?

For us, it is important to determine how much demand there is right now for a Tracker Loan at 4.00% to 4.25%. If there is strong demand and a bank is struggling to make a good return on equity at the moment, this product could be launched pretty quickly and have an immediate increase to ROE (as higher funding costs are not present at the moment).

We look to the smaller lenders to move first here, particularly ones looking to increase their digital distribution and reduce their cost of sales. The main problem they face is the wholesale solution. However they can easily finance an exploration phase via direct online options and the associated cost savings.

Other Options?

For banks looking for more creative options, there is potential scope in using FinTechs to bridge the gap, particularly if they have improved the process of selling online. This also introduces the scope for venture capital to fund the interim risk: will venture capital invest in Start-ups on the basis of transferring borrowers to the digital universe via improved mortgage products at prices that are attractive for the customer.

Our opinion: A Tracker Mortgage at 4.0% (cash rate + 2.5%) is possible right now and high demand would exist for it.

 Note: Thanks to the AFR.

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Smart Contracts and Helping First Time Home Owners

One graph should scare everyone: First Time Buyers are being priced out of the Australian housing market. They made up 25% of property buyers in 2009 but this has declined to sit closer to 10%. On top of this, up to 50% Australians get help from their parent to buy their first home (versus just 3% 6 years ago), so technically the pure first time buyer portion is even lower. The Australian property market stakeholders, which includes real estate agents, government, the RBA, retail banks, ASIC and APRA, are underserving our younger generation.

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From an economic stability point of view, we should want the population to have access to being owner-occupiers, particularly as they start to have young families and become the driving power of the workforce.

Why Has First Time Buyer Percentage Declined?

Former Bank of England Governor, Mervyn King, in his book The End of Alchemy wrote about the intergenerational wealth transfer from the young to the old. In short, the global reduction in interest rates – the RBA has reduced interest rates 18 times and 5.75% in the last 10 years, down to an all-time low of 1.5% – is a major contributing factor.

Lower interest rates provide a huge help to those already with debt loads and assets: lower interest rates mean people are able to borrow more and this inflates asset prices. Lower interest rates are also a direct assistance to those paying off mortgages as the cost of debt declines. Mortgages are given out to those able to service them and most importantly have deposits to hand.

Older generations (Baby Boomers) benefitted from selling houses at high prices to mid-life adults (Gen X), who have been helped with lower interest rates. Millennials, unfortunately, then miss out as the house prices increased too quickly and too far. With the required deposit now mostly unattainable and a huge quantum of debt now a major inhibiting factor (Gen X typically has a deposit from their own prior homes and have been upgrading).

With strong price increases driven by lower interest rates, those with property portfolios can access equity in their property to be the deposit for the next house purchase. Investment property owners have the double-whammy of great returns and reduced competition from owner-occupiers.

First-Time Buyer Constraints

Simply, they don’t have access to a deposit to leverage into a new purchase. They need to save a minimum 10% of the house price value. And if they want to buy anything near a major city CBD, that will be something around $50k for a $500k apartment. Want a 3-bed house and the deposit requirement could be north of $100k.

To save the $50k or $100k, assuming aggressive joint household income of $150k (which puts the first time buyers in the top quartile of household incomes), and assuming they are able to save 30% of net income (after rental payments), the deposit could take up to 3 years to build ($100k * 30% = $30k, 3x $30k plus interest/investment gains = $100k). And this is being incredibly aggressive – very few people are lucky enough to “go and get a well paid job” as Joe Hockey said.

However, in those 3 years, house prices have roared further away and the required deposit has increased further, leading to the view of an unattainable dream. First time buyers will need even more deposit when the time comes (in Sydney, it is another 60%, or $30k on the $50k).

How Can Millennials Fight Back? (Hint: By Doing Something Different).

Whilst Gen X may have received a huge boost, technology and communications has been a major benefit to Millennials. Our view is that trying to harness that in the correct way may allow Millennials to fight back and get a footing. Obviously as a consequence, some form of behavioural change may be required.

Our view: They should buy together.

Consider that stage in life where you are renting with 2 or 3 close friends. You are paying away rent whilst still not having certainty on where you will be. You choose to either;

  1. Not buy but pay rent to someone else, or;
  2. Rent-vest (buy an investment property somewhere that is affordable and choose to rent where you want to live).

Neither Of These Options Help:

Not having a stake in property whilst prices roar ahead is an issue and as prices rise, the risk of falling further behind is a problem. Hoping for a correction is another danger – the entire system is set up for price increases and don’t think for a minute that the RBA, the government or APRA really want to take the flack for sinking house prices and risking a recession. Best bet is that they try to manufacture 3% annual price increases but this is difficult.

Rent-vesting has its own problems. In finance speak we would refer to it as basis risk. You have a desire to save towards owning in a popular suburb in Melbourne like Elsternwick but you have invested in Perth or Brisbane where house prices are lower. Your investment property can easily fall (as commodity prices decline) whilst Melbourne prices increase. Buying a CBD apartment to rent is probably the riskiest investment available as huge oversupply is about to arrive.

Fractional Ownership:

This is a recently tabled option. However:

  1. You are not really investing in property and still face that basis/rent-vesting risk
  2. Fractional models can’t get a normal residential mortgage, so the mechanics are completely different. In many ways you are better off buying shares in a real estate business
  3. You will may struggle to sell the fractional ownership and the costs associated with it may be very high

Buying With Friends:

We believe the best option is the simplest and removes costs you are already facing: buy with your housemates.

You are already paying rent – a commitment with friends. Why not go one step further, combine your purchasing power and buy where you want to live. And most likely, if it is in a popular area, the price will appreciate at a better rate than a CBD apartment. This also helps those with unpredictable incomes, such as freelancers.

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Technology To Make This Easy:

The next steps are to work out the best ways to manage the relationship with your friends and newly made investment partners. Legal contracts and making sure you square off over and under payments you each make is really important. This is what technology can deliver and I certainly don’t think Gen X will be thinking the same thing.

Taking this into the future, the home may no longer become a directly owned asset. People may choose to have their primary residence but have it part owned by other people – either in the form of intergenerational ownership or something owned with friends and rental payments paid on portions of the asset.

This complex web of ownership becomes a necessity as younger generations look to blend ownership with high debt loads that may take longer to pay off. Having sophisticated and secure methods for tracking who owns and owes what becomes a reality for the financial system and a solution that sits on distributed ledgers via smart contracts could be an obvious starting point.

Introducing coHome:

And this is what we have been working on. Our new offering, coHome, enables people a selection of tools to manage buying with friends and family.

We have launched with a small selection of services and will sequentially release more tools as requests come in for those services. We have designed out prototype smart contracts and ledgers but do require mass adoption before we start revealing how we achieve this.

For more information, please visit www.cohome.co

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Ensuring Long-Term Mortgage Affordability Via Optionality & Liability Management

Our widely quoted statistic is that 85% of Australian home loans are variable rate, with just 15% having any sort of fixed rate (mostly 2 & 3 years) and virtually no product offering beyond 5 year fixed. This is in huge contrast to the US and UK Mortgage markets, where 90% and 78% are fixed respectively. 90% of the US mortgage market is fixed for 15 or 30 years.

Market structure, including the regulations that govern banking, insurance and retirement systems are influencing factors in the US and UK. In Australia’s case, the dominance of a variable rate product allows banks to maintain strong pricing mechanisms over their home loan portfolios, which in effect ensures a strong level of profitability and stable banking system from their perspective.

However, this isn’t necessarily the best result for customers or the most profitable option for banks. More importantly, borrowers are left without the flexibility or certainty to manage their financial liabilities and exposure to interest rate risk – services banks should be offering. These products need to exist and our primary research suggests 25% of the entire mortgage market will move to these products within 3 years of launch.

Is Variable any different to short-term borrowing?

Borrowing short-term comes in various forms but having an interest rate that floats and can re-price is a risky consideration for the borrower. Consider this: if interest rates increase by 1%, how exposed would a variable rate borrower be? For a $500k loan that is an extra $5k per annum in payments, which is absorbing an extra 10% from the median gross household income ($80k) once you consider tax.

This is one reason why banks are required to measure serviceability on loans with a 2 or 3% increase in the variable rate. But do borrowers really pay attention to this and does the wider financial system understand what risk this will lead to? Can better customer solutions be developed?

We should assume 1% increase over the next decade will happen:

Nobody truly knows where interest rates will go but forward rates and the yield curve can give an indication. Extrapolating this, we can expect a cash rate of 2% within 7 years and 2.5% within 10-years.

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For borrowers, we might see lower rates but how much lower can they go? They certainly will never go zero. In terms of how high they can go, increases of 0.25% per annum wouldn’t be unheard of. At this rate, by year 7, a variable home loan rate could be as high as 5.25% – a rate seen less than 3 years ago.

I have mapped out the various future home loan interest rate paths on the chart.

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All borrowers will also have an unaffordable line – the extent to which they can no longer service their debt. I have put this at 1% above variable rates to show that what is affordable today may not be affordable by year 2023, leading to a spike in defaults to the segments that become overexposed (the RBA would have to allocate pain to somebody if they need to raise rates).

Fixing at 4.49% now for 10-years with the option to leave anytime:

Consider this option – fixing for 10 years but with the ability to leave anytime.

As a borrower, you take out the risk of higher rates straight away. You also can bring in the ability to take advantage if a rate drop occurs: optionality gives a borrower the basis for fixing at a rate they can definitely currently afford and plan towards but the option to take advantage if rates do decline.

This optionality then reduces the variability borrowers face: they will have a maximum of 4.49% interest rate but may be able to fix it to an even lower amount (I assume 3.50% appears n 2019). Further, if the affordability line moves upwards, they can take higher risk and return to a variable rate with full confidence they are no longer the segment that would feel the RBA pain if interest rates need to rapidly increase.

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This is a potential optimal answer and a financial product driven solution for borrowers. Even though it looks complex, the borrower use is simple: fix a rate but maintain the flexibility to move to a lower rate as it becomes available. No wonder why these types of products are popular overseas.

The US financial system has figured this out. Now is the time for the Australian financial system to figure it out too.

 

 

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