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.
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.
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.