Housing Deposit Call Options

One of the main features about US mortgages leading up to the GFC and subprime crisis was that borrowers were able to hand back the keys of their property. As prices fell and negative equity appeared, to many it was seen as better to default on your mortgage than pay off a debt that was more than the house’s market value.

Arguing the merits and risks of a “hand-back-the-keys” model is tough. Whilst it looks like a riskier lending option, it allows borrowers to default and move on to look for work elsewhere, in a severe recession without being locked into a debt they cannot afford. In any case, liquidity and commercial real estate is what kills banks.

In the US, the 100% or even 120% mortgage existed. A 100% mortgage essentially offered the home buyer the property in exchange for debt. As the borrower could walk away, this was then latterly described as giving borrowers a “free call option” on property prices. The 120% mortgage took this a little further as the property purchase had costs: taxes, decoration & refurbishment and advertising for a tenant (in some cases). You could describe the 120% mortgage as somewhere between a free call option on property prices or being paid for a free call option (you could argue being paid was a reflection that the property was overpriced).

And ultimately everyone loved a free call option and this led to large price increases and financial instability as people handed back the keys and homes to the the banks.

The question that needs to be asked: are free call options available today and is the “free” the problem?

What is a Free Call Option?

Firstly, there needs to be a definition: What is a true free call option vs. what someone perceives as a free call option?

Given the negative gearing and capital gains tax incentives, the shortage of land and appropriate new housing supply, being a property investor to many is seen as having a free call option on property:

  1. rent roughly covers the cost of mortgage (particularly after tax deductions)
  2. the downside risk is mostly not a factor

So investors are so positive that they believe they have the right to accept the gains in house prices but don’t face any cost. This is a natural part of credit and business cycles and the last quarter of a century has helped remove any perception of risk. Regular recessions and keeping price appreciation in check are good mechanisms here, but micro management of private asset prices is not seen as desirable (though I believe that price appreciation should form part of inflation measurement!).

In the case of investors, they are simply owning the asset and don’t have the ability to pass the asset back to the lender without consequence. So it isn’t a financial derivative.

Free Call Options:

This is where is gets technical, there is no free option as there are no 100% loans now that loopholes with personal loans have closed. What we do have is a potential paid call option in the off-the-plan market that may have the same risk profile. This is also where it gets mathematical.

Assume:

  • S = Current Property Price = $250k
  • Deposit = 10% = $25k (what was paid)
  • t = Completion & Settlement date = 2 years
  • r = Risk Free Rate (Bank deposit Rate) = 3%
  • K = Strike Price = $225k

call price

Making various assumptions we obtain a call option price of between $25k and $40k, which is either equal to the deposit (very low volatility and setting yield = risk free rate) or that the buyer has bought an option worth $40k for $25k.

This isn’t a disaster and there is likelihood that the development profits easily cover the lost value in selling the option. However, options are more than value: where does the physical asset go?

Delivery of Asset

The key piece to all this is that in option trading you can end up being exposed to the underlying physical asset (taking delivery). This occurs if you cannot find a buyer to take the market price.

In the apartment market, the scenario where the would-be buyers don’t use their option is when the current market price falls below the strike price (a 10% price decline to below $225k in our example). At this point, the developer/seller needs to find another buyer. However, this may not occur as many would-be buyers may take the same option strategy and compound the price declines. The developer is then left holding the underlying properties, is unable to repay its bank loans (for the development) and the banks themselves might need to claim the collateral (the apartments).

If the banks themselves had short-term borrowings, then the collateral might also be a problem for them (liquidity squeeze).

So whilst we do see developers and banks (indirectly) selling call options at below market values, it is the potential delivery of the asset that causes the risk.

And this has more similarities with the US mortgage bust in 2006-2009 than we might think.

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Gypsy Banking: Future of Finance

Are “Gypsy Banks” the future of Australian finance?

For 5 minutes, let’s forget about our banking oligopoly and look at another Australian industry which could also be considered oligopolistic.

The Beer Industry

With CUB and Lion Nathan dominating the beer industry, we can be certain that it isn’t as competitive as it should be. However, consumer trends have pushed back against the mainstream and enabled microbrewing to blossom. A small part of this trend is called Gypsy Brewing.

Brewer_top

What is “Gypsy Brewing”?

Gypsy Brewing is when a small group of people hire out the facilities of a larger brewer to make their own batch of beer, usually because the larger brewer is not running at capacity. This could be due to:

  1. Demand for the beer made by a specific piece of machinery is down.
  2. Maximum utilisation is impossible with seasonality, so pockets of downtime periodically emerge.

The Gypsy Brewers get access to infrastructure they could not afford at such an early stage, test their recipes, manufacturing skills and sales and distribution of the new brews. People drink their beer and the beer industry evolves, with happy taste buds in the consumer, major breweries with a new revenue stream, and smaller brewers getting access to equipment they can’t yet afford.

And this isn’t limited to beer. A friend of mine at Pacific Ice Creams was testing his IP protected process for making UHT Ice Cream, using a major ice cream manufacturer’s facilities. With this he also got access to their expertise for ensuring the food passes consumption laws and regulations.

Why can’t we create Gypsy Banks?

So why is this limited to beer and food when a financial services equivalent would provide a huge amount of value? If this approach works to improve customer choice and deliver to different niches in beer and food, the same can surely be done for banking.

Our current banks could then be described in another way: Infrastructure Banks. They have the licensing and most importantly deposit financing (the two biggest barriers to a new entrant), but they are not operating at capacity.

We know the banks are not good at manufacturing new financial products, and in recent years have been more focused on product rationalisation. Their Legal, Risk, Operations and Compliance teams have seasonality, so staff won’t always be at full capacity. Other staff in the bank, may not be completely engaged, but giving them new and varied work may help keep them satisfied. And finally, as market conditions change, the banks will be looking for new revenue streams outside the core business.

So what would a Gypsy Bank look like?

This needs to be about manufacturing new products and services, which is not where banks are going with their innovation teams (who are focused on improving digital infrastructure and the customer experience). That excess seasonality in product compliance needs to be linked up with Gypsy Banks (FinTech) who have a product vision and want to sell it themselves. The existing banks should focus on providing their infrastructure at a price, be it 10, 15, 20 or even 30% return on capital. This needs to be efficient and transparent. 

So a FinTech needs to be in a position to say to a bank, “I have a product with a recipe (costs, risks, structure etc.)”. Then work with an Infrastructure Bank to agree a timeframe for product development, ideally around the downtime in Legal, Risk and Compliance (this shouldn’t be a marketing or business unit decision).

The Infrastructure Bank then needs to:

  1. Be able to agree to commercial terms for product development/prototype and medium-term manufacturing
  2. Look at contingency options if the Gypsy Bank proves a hit: is this an acquisition, is this a joint venture, are their extra services to offer (for example FX, hedging, complementary products).

Does this work overseas?

We are seeing this evolve in many forms. Tide is an example of a white-label small business bank run by Barclays. Other white-label products are further options but they are usually paid for upfront by the would-be Gypsy provider. Technically, they are not new businesses and in many cases are add-ons, such as mortgage broker group’s white-label home loans that have no distinguishing features to existing products.

The goal is to improve financial products and services so they provide the best possible outcome for consumers, including lower risk. People want or need different flavours.

brew_variety

Why banks should support this kind of structure and the competition it will bring?

This one is simple: local Australian FinTech are not a threat. FinTech globally are not a major threat. The major threat for our banks is coming from Google, Apple and Amazon from the US and the unknown quantity emerging from China by the likes of Tencent and Alibaba. After all, CUB and Lion Nathan aren’t worried about the threat of smaller craft brewers. They’re worried about other global giants or non-beer options coming to Australia to eat their lunch.

If we can then create a competitive market in Gypsy Banks and Infrastructure Banks, Australian consumers might be able to sample financial services that don’t leave a bitter taste in their mouth. And our banks will have access to a wider range of tools to compete with new entrants locally and offer to overseas markets.

I’ll drink to that.

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