Why Fitch Can Be Wrong (Again)

We should think about statements like this:

“[First Time Buyers] considered the highest risk borrower in the [Bank] portfolios”

Few comments on this:

  1. Fitch has been wrong on mortgages in a big way in recent memory, so don’t take everything they say as gospel.
  2. First time buyers usually have much higher loan-to-value ratios than other buyers. Less buffer to absorb loss given default, so if house prices fall there obviously a higher credit risk potential.
  3. Investment property is potentially a higher risk.
  4. First time buyers with higher risk is a product of incredibly poor innovation by banks and a total unwillingness to invest in new lending products that would reduce risks to first time buyers.

Going through these comments:

Fitch has got things wrong before and is probably wrong again:

We are aware of huge miscalculations in mortgage securitisation (e.g US subprime mortgages), of which the assumption of ever increasing house prices led to a misunderstanding of risk.

In the Australian context, the error here is assuming first time buyers are more risky than investment loans. Here is why:

Investment loans, particularly where the investor has high leverage across multiple properties with reasonably high leverage has a risk driven from multiple reasons:

  1. The rental yield doesn’t cover the mortgage finance cost (interest rate). The investor may be reliant on tax deductions and ultimately price appreciation for a positive return. Momentum will eventually slow or reverse.
  2. The correlation across investment properties is high. The investor would be hit with price declines, potential negative equity and further net negative rental yields all at the same time.
  3. Many renters, in a recession, are likely to move to find new work or move in with parents if they lose their jobs. What is worse than negative net rent? No rent or a significantly higher vacancy rate which may be increased by higher apartment supply and an investor’s inability to cover the investment loan.

In short: investment property lending is more risky than lending to first time buyer owner-occupiers who will have a desire to live in the property over the long-term and protect their full recourse debt position.

Banks are not helping or showing any innovation to help first time buyers or those who need to take on additional debt to buy a home.

Australia has the highest OECD exposure to housing debt (home loans) but is 85% financed by variable rate loans. The remaining 15% is short-term fixed (less than 5 years). Banks are not innovating on lending products – and clear overseas examples exist as the US mortgage market is 90% fixed for 15 or more years yet no products exist here. This would reduce the risk to first time buyers proportionally more than other borrowers.

We can also show, this is our business proposal, how it is possible to offer these mortgages products with the correct features and still make 20%-30% return on equity for a bank.

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We can keep writing about housing risks as to whether they will or will not appear but with very little being done about it protecting against the risk. Who is ultimately responsible and who is innovating?

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Australia: The Land of the Undiversified

Researchers from MIT Sloan have come up with new findings that the GFC (2008 Financial Crisis) was not caused by subprime mortgages.

MIT Sloan may be a little late on this one as most major market participants are aware of “Correlation Equals 1” and how the reliance on cheaper short term borrowing and overnight liquidity drove the entire financial system before its near-collapse. Much of this has also been covered with increased liquidity requirements, such as higher reliance on sticky deposit funding and leverage limits via the 3% equity to asset ratio.

This additional regulation has attempted to plug one potential weakness in the financial system. Do other risks exist, particularly in Australia?

Looking more deeply at the construction of assets across Australia, it faces its own “Correlation Equals 1” problem in that the entire economy has gone long on housing, is reliant on variable rate financing (prices can adjust upwards quickly and at a bank’s choosing), has become over-exposed to Australian equities and Australian financial services. We explain this via 3 charts

Chart 1 via OECD: Super Fund Asset Allocation (Shortage of Non-bank Fixed Income)

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Chart 2 via OECD: Household Debt to GDP, Leading Nations (Over-exposure to Mortgage Debt)

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Chart 3 via S&P: Industry Weighting to Financials (Over-weight Financials)

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Australia has created for itself one of the most correlated economies on the globe that could be exposed to deep risk if any of the following happens:

  1. A need to significantly increase interest rates, most likely due to imported inflation
  2. One of the 4 Majors banks comes under pressure
  3. The momentum in house price growth or credit supply slows

Alternatively, 44% (35% Financials + 9% Real Estate) is based mostly on the well-being of the real estate market in Australia. The financial reward from real estate is tied to the ability for the future to pay higher prices, so well functioning financial markets assist this reward and hence lead to the high correlation (from a mathematical risk perspective, there is only really a time delay between the outcomes).

I am less pessimistic on the housing market but a number of products need to be created to reduce the risk to the system and ultimately leave households in much better financial positions.

  1. Where are the Fixed Income Investment Products:

Australian deeply suffers from a lack of high quality non-bank investments that can complement the equity exposure in super fund portfolios. Moving the weighting of Non-Bank Fixed Income asset weighting from 8.8% to 20% will increase portfolio Sharpe ratios, reduce downside risk and may even offer high lifetime returns even in optimistic scenarios (as well as downside scenarios). The ultimate goal is to ensure retirees will be able to cover their retirement needs in as many future economic scenarios as possible.

This is also a fantastic way for the banking industry to diversify its funding sources further, leading to a more secure financial system (note: there would need to be deconsolidation processes to create non-bank exposures).

  1. The housing market needs to move away from variable rate financing:

Over exposure to the RBA cash rate means that the economy is reliant on what the RBA does and how banks pass those movements on (remember, banks can independently change the interest rates on the variable home loans that make up 85% of the house financing in Australia). Short-term fixed rates, such as 2, 3 or 5 years, do protect for a short period but they quickly move to either variable products or borrowers need to find a new fixed rate. Those newly fixed rates could also increase, as happened in Australia in the last few weeks:

If we can achieve these 2 things, we may be on the path to reducing the overall high correlation the Australian economy currently faces.

This is the biggest opportunity in Australian Financial Services and we are working with banks to make this a reality.

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Mortgage Rate Forecasting, November 2016

Since the US Election we have had a substantial increase in bond yields and inflation expectations. The result is significantly higher expected future interest rates, including for Australian Home Loans.

Based upon maintaining a margin above where the cash rate is expected to be (2.25% premium), the lowest discounted variable rates are, on average, expected to reach 5.60% within 10 years.

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The key point here are that this may be the turning point in the Australian interest rate cycle. For borrowers who are unable to reduce the principal amounts on their mortgages and do not expect good wage growth, this potentially introduces future mortgage stress risk. 5.60% comes close to being a 2% increase on where the loans can be obtained at the moment and 2% rate increases is a critical point in many loan serviceability tests.

We believe the best way to mitigate this risk is by opting for one of our 10-year FlexiFix mortgages. The interest rate is fixed for 10 years but borrowers can repay, refinance anytime without break fees after 3 years. If rates don’t go up, they go down or you feel more comfortable in being able to manage interest rate rises, then you can switch without facing any further costs.

This can be done with a straight mortgage or with a split loan (part FlexiFix, part variable).

Other Forecast:

We have assigned a 50% probability on the 4 Major banks increasing their Variable Rates over the next month.

2, 3 and 5-year fixed rate mortgages have already seen their offered rates increase and further pressure on wholesale markets will lead to costs being passed onto existing borrowers who have variable rate products.

To find out more and be the first to obtain the loan when we launch, visit www.huffle.com.au

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