Australian Investor Loans: How Much More Will They Cost?

rate delta

You don’t need to look far to see that property investor loan interest rates have increased significantly above owner-occupier home loans in the last year. Investor loans currently have interest rates 0.3% higher than owner-occupier rates.

Before APRA took initial action to limit year-on-year investor loan growth in 2014, investors and owner-occupiers were paying the same interest rate and with some bank preference to even charge investors less. This is at odds with overseas, where buy-to-let mortgage (investors loan) interest rates are approximately 1% higher per annum.

Part of this Australian market attribute is driven by the perception that investor loans have less risk: if the renter loses their job then you can replace them with someone else. If an owner-occupier loses their job, they might default on the loan. No recessions helps reinforce this.

Wrong Assessment

From my perspective, this is the wrong assessment and overseas banks clearly agree with me – hence the higher interest rate for buy-to-let mortgages.

For owner-occupiers, the 4 Major banks hold approximately 2.5% credit risk capital on home loans (APRA average). When offering home loans at 3.8% they make around a 30% return on regulatory capital.

The 2.5% credit risk capital is driven by the probability of default (PD) and loss given default (LGD). This falls into the ranges of 0.2% to 0.3% for PD and 10% to 25% for LGD. I expect the Major banks are on the aggressive end here.

For investor loans, there is a similar analysis with similar PD and LGD assessment. I also expect that the price increases are more of a supply/demand consideration given that the year-on-year limit is within sight – so there is a little else a bank can do except raise prices.

The Credit Risk Assessment is Potentially Wrong:

Key Question: Should investor loan credit risk be measured by Basel 2’s PD & LGD formula? Possibly not.

The main risk I see in these portfolios is the assumption that new renters will be available rather than the property investors’ ability to service the loan. So the 99% downside financial stress needs to be driven by 2 things:

  1. What will the renter vacancy rate increase to in a 99% downside scenario
  2. If there is rental income contraction, does that influence the likelihood of investor default.

These 2 items should be additive. Note: for credit risk capital we assume a fully diversified portfolio, so can use broad averages.

Renter Vacancy Rate:

As a broad estimate, the vacancy rate could increase by 10%. This will be driven by renters losing their jobs and/or downsizing and/or moving in with others for an interim during a deep recession. Unemployment rates could potentially rise by 10%, so I have mimicked this for the increase in rental vacancy rate.

I make no judgment on in investors themselves lose their jobs – but I would presume this would could to default. I will assume everyone who loses their job is a renter. If a property is not rented out for 6+ months, I assume the investor will default as property price declines will not bail them out (they will be in negative equity, on average). As unemployment rates will rise for more than 6 months, the vacancy and hence default rate will hit the 10% level.

Rental Income:

This one is harder as it is a sensitive supply & demand problem and the serviceability is a 2nd order impact. I will simply assume that there is not impact at this stage.

99% Stressed PD

Based on this, the 1-Year 99% downside Stressed PD (SPD) could be 5%-10%, depending on the increase in jobless rate, with a preference to selecting 10% and assuming a severe stress to the mining or financial sector.

The 10% SPD in this instance is also the stressed PD required for capital calculations. Using this in a loan capital & pricing model, I obtain an investor mortgage rate of 4.4%, which is 0.6% higher than owner-occupier.

Why is the UK 1% higher?

The calibration of loss-given-default might be important. Whilst broad market LGD could be assumed to be 20% (derived from a 35% decline in property prices plus 10% collection costs on an 75% LVR property), specific property investment stressed house prices could be considered to fall much further. If this is in the 50% to 70% range then the LGD is 40%+. If we then revisit our pricing, we can get a difference between owner-occupier and investors to match that 1%.

So What Happens Next?

Australia has a lack of recession-based data, so cannot really make an assessment of investor loan risk based on observed defaults and losses. The main concern is the divergence from countries and banks that have better data sets that have led to higher pricing for higher risk in investor loan markets. This higher pricing is also driven by stricter regulatory intervention which is also derived from a view on risk.

Given the regulatory hurdles in place, increasing risks for high rise apartments and the above analysis, we are forecasting that most Australian banks will have investor loans with interest rates 0.6% higher than equivalent owner-occupier. This is a further 0.3% increase on the current situation. Shame investors didn’t get a FlexiFix loan.

Watch this space!

 

 

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Australia’s Major Problem: The 4 Major Banks Are Stuffed Full

hamster

One key attribute of the Australian financial system that people need to know about is the reliance on the 4 Major Banks to fund the economy. The lack of wholesale markets, driven by local insurance and local superannuation funds desire to invest sub-investment grade credit or equity portfolios (as opposed to investment grade and AAA/AA/A securitisations), has led to a reliance on the 4 Major Banks to fund the economy.

This is most easily seen in the following tables:

Total Assets $AUDm as Per Annual Reports
30/06/04 30/06/05 30/06/15 30/06/16
CBA 305,995 329,035 903,075 933,078
WP 237,036 254,355 812,156 839,202
NAB 411,309 419,588 955,052 777,622
ANZ 259,345 293,185 889,900 914,900
4 Major Total 1,213,685 1,296,163 3,560,183 3,464,802
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 101.99% 105.46% 220.17% 208.97%

 

Lending Liabilities $AUDm As Per Annual Reports
  30/06/04 30/06/05 30/06/15 30/06/16
CBA 205,946 235,849 674,466 700,547
WP 170,863 188,073 623,316 661,926
NAB 247,836 260,053 532,784 510,045
ANZ 204,962 230,952 570,200 575,900
4 Major Total 829,607 914,927 2,400,766 2,448,418
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 69.71% 74.44% 148.47% 147.67%

For the past decade, Major Bank balance sheets (both total assets and total loans) have grown, on average, at 10% CAGR (except NAB, which has been impacted by overseas businesses). These assets and loans are mostly domestic.

At the same time, GDP has grown at 3% CAGR in nominal terms, leading to approximately 7% higher bank balance sheet growth than GDP each year. The 4 Majors used to have total assets/loans at 100%/70% of GDP but now have 220%/148%.

Stuffed!

At what point do the 4 Major Banks get full? How can the economy continue to grow at a strong level if the bank balance sheets can no longer grow credit above GDP growth as either deposit growth struggles to keep up or financial stability reduces given the high concentration risk of funding via such a narrow channel. Can this lead to a credit crunch? My view is that they may already be sufficiently full to prevent new lending at anything close to the rate experienced in the last decade (noting the below trend YoY growth in 2015/2016, albeit with NAB’s Clydsdale disposal making an impact).

Possible Mitigation

As a response, only a few alternative strategies are really available:

  1. Overseas Wholesale
  2. Local Wholesale
  3. Interest Rate Reduction
  4. RBA Funding (QE)

The 4 Major banks need to tactically grow overseas and local wholesale markets. Overseas distribution of securitisations, particularly the US market, has continued to be an available option but banks may need to consider how the pass fully desonsolidated deals into this market and what return requirements they are willing to take to facilitate this. Even if the 4 Major Banks don’t take the bulk of the spoils, the overall support this gives to the wider economy will lead to better outcomes for the 4 Majors. This may require supporting non-ADI Australian lenders, including FinTech, and identifying high-value opportunities in assisting these business. This may also lead to the development of broader local wholesale options.

Local wholesale potential is split between expanding the lending performed by insurance companies – which could be enhanced by regulatory changes – or by encouraging superannuation to take on a higher percentage of fixed income assets in their portfolios, particularly senior tranches of asset-backed securities. The obvious rationale: if super funds don’t support lending in Australia, there will be detrimental impacts to equity returns that make up the majority of their portfolios as net new lending is an input to economic growth.

Screen Shot 2016-11-16 at 13.54.22

An alternative approach will be for the RBA to buy financial assets. If a local securitisation market does expand, this could be supported by a form of QE. This would be inline with actions the US Fed took in buying agency RMBS or the ECB in corporate bonds.

The last option will be lower interest rates that may be linked with QE. Lower interest rates will support further credit growth and help banks manage a higher balance sheet level versus GDP. But note that interest rates are already low for an economy where the banks have mostly been well-run and capitalised.

Something has to happen

Without a system-oriented movement into addressing the runaway growth of the 4 Major Bank balance sheets, I would expect a major debt-driven problem to emerge in Australia within 5 years. This doesn’t imply a crisis at this point in time but does suggest an eventual fall in the rate that the economy can grow. If house price growth has been driven by credit expansion, this trend simply cannot continue without the financial system becoming top-heavy due to the 4 Major Banks’ balance sheets.

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offset ripoff

Offset Home Loan: Is it worth it?

offset ripoff

One of the sacrifices we have to make when building a long-term fixed rate home loan is a reduced ability to add some extra features, such as an offset account to the loan. Whilst we don’t see this as a major issue (which we will show below) it was a sticking point with one bank we  talked to. They told us “the offset account is important in case borrowers want to buy a boat!”.

Seriously.

This drives us to offer value in other areas, with features like no break fees, freedom to repay a fixed loan anytime and a fixed rate for 10 years. These all form part of our key value: borrowers get to fix the interest rate for 10 years but can switch or pay off any amount when they choose. This has a huge amount of value.

The Offset

The history of the offset account is interesting and its use does make sense. Banks started offering offset accounts as a good way to combat non-bank lenders. An offset account, which is a deposit account and you need to be a bank or ADI to offer it, sits there and reduces your home loan exposure. If you have a salary being paid in, then the mortgage interest paid is reduced by the offset. More importantly, any savings you hold in deposit effectively attract the mortgage interest rate and are tax exempt (awesome).

For example (which we also use in our analysis later):

Home Loan Interest Rate = 4.0%

Best bank account savings rate = 2.5%

Tax Rate = 30%

If you didn’t have an offset, you would only save at 2.5% and be due to pay tax on those earnings, lowering the effective post-tax interest rate to 1.75% (2.5% * (1 – 30%)) for a 30% marginal tax rate payer.

Compare this to earning 4.0% with the offset account and looks like a good idea. But this is only a partial view.

Different Approaches

We need to be careful: the borrower could simply just pay off some of the mortgage with those savings and then refinance to release the savings at a later date.

Alternatively, the borrower could invest those savings into other assets and earn a higher return, albeit with some investment risk. Finally, banks may charge higher interest rates to get access to offset accounts.

What we want to know: how much is an offset worth and does it make sense to go for one?

To do this analysis, the impact of the Offset is measured across 2 fields: the Salary Impact and the Savings Impact.

Salary Impact

The first part to this is paying a salary into the offset account at the start of the month to reduce the loan balance. To make things easy, I will simply assume this salary is paid at the start of the month to give the largest possible impact. In practice, we would expect perhaps only 60% of the economic impact due to the loan balance reducing over the month – for example to pay off credit card and other bills.

We looked at 4 sets of households: low and high earners (in household terms) and each using an offset or not.

Household Household Income Mortgage Offset Account Estimated CPR Tax Rate
Low Earnings with Offset $60,000 300,000 YES 15% 25%
Low Earnings $60,000 300,000 NO 15% 25%
High Earnings with Offset $150,000 900,000 YES 15% 35%
High Earnings $150,000 900,000 NO 15% 35%

In addition, we also assume the non-offset household puts their salary into a savings account (at 2.5%) but pay tax on the interest earned.

To make a comparison, we reduce the interest rate of the non-offset household until the interest payments between the offset and non-offset households are essentially equal.

What we observe in these cases is the net benefit to the offset households is approximately 0.05% (5bps). If just savings methodology are applied, a household is 0.05% better off, each year, by using an offset account.

[To estimate this, consider $4000 paid in each month in salary. This equates to lowering the loan balance by $4000 for the life of the loan and saving 2.25% on that balance (4.0% minus 1.75%).  Assuming $300,000 loan balance, this is a $90 saving per year on $300,000 = 0.03%. We used a more complex model that considered inflation to assess the impact, hence the higher value of 0.05%.]

CPR made little impact over observable ranges.

If we assume only 60% of the economic impact, the annual economic impact is reduced to around 0.03%.

Savings Impact

The secondary impact is how savings influence the borrower and note that this is additional to the Salary Impact.

Assessment is harder as households could invest savings into non-cash assets. Cash in bank accounts is typically low earning as it is deemed to have very low risk whereas stocks and shares have higher risk but higher returns (and average to about 4-6% higher per year). Property has also increased significantly recently: should a borrower have savings or an investment property.

For our assessment, we will simply assume the borrower has savings in cash. For the offset account, there is a single approach as the mortgage balance reduces and the savings earn 4.0% without any tax implications (as 4% is the mortgage interest rate).

The non-offset borrow has 2 approaches:

  1. Pay off the mortgage and then redraw or refinance at a later stage as required
  2. Keep the savings in a separate account, get a lower interest rate (2.5%) and pay tax on the earnings

Within this, there are a few things to note. Paying off the mortgage is a good use of money if you have no desire to take additional investment risk in the short to medium term. If you do need to get access to the higher equity balance in your property, refinancing usually costs about $1500. You might get a free redraw access from some lenders (if you are not changing lender, the costs will be lower), so looking for redraw rather than offset is another option.

Keeping a separate savings account only makes sense if you want access to that money in the short term – notably within 2 years.

Combining the 2, if you know your approach, then we can find a maximum impact from not having an offset. If you need complete flexibility in the savings then there could be a far higher cost which we can then assess but do note: wanting full access and flexibility but not knowing how or when you will use it is possibly a poor approach – similar to leaving a large cash balance in your checking account.

Pay-off Mortgage and Re-Draw

The cost of this approach is based upon how often you re-draw/refinance and what the loan balance is. We assume each redraw $1500. We have set it out in years (how many years until the refinance/redraw is required):

Time (Years) 1 2 3 4 5 6
Cost ($) 1,500 1,500 1,500 1,500 1,500 1,500
Loan Balance ($) 500,000 500,000 500,000 500,000 500,000 500,000
Cost 0.30% 0.15% 0.10% 0.08% 0.06% 0.05%

We can then apply this across a range of values – with years along the top and the amount borrowed along the side.

1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6 YEAR
$125,000 1.20% 0.60% 0.40% 0.30% 0.24% 0.20%
$250,000 0.60% 0.30% 0.20% 0.15% 0.12% 0.10%
$375,000 0.40% 0.20% 0.13% 0.10% 0.08% 0.07%
$500,000 0.30% 0.15% 0.10% 0.08% 0.06% 0.05%
$625,000 0.24% 0.12% 0.08% 0.06% 0.05% 0.04%
$750,000 0.20% 0.10% 0.07% 0.05% 0.04% 0.03%
$875,000 0.17% 0.09% 0.06% 0.04% 0.03% 0.03%
$1.0m 0.15% 0.08% 0.05% 0.04% 0.03% 0.03%
$1.125 0.13% 0.07% 0.04% 0.03% 0.03% 0.02%
$1.25m 0.12% 0.06% 0.04% 0.03% 0.02% 0.02%

I will revisit the results after Approach 2. Any borrower should take this approach as a maximum they should be willing to forgo for Approach 2: having flexibility costs money and this table shows you how much it should cost. It costs $1,500 to refinance and if the loan balance is higher or you plan to redraw very infrequently, simply wait until you need to redraw and pay the $1,500 – certainly if you save money elsewhere.

Keep Savings Separate, Pay the Taxes

Here, we assume you have savings as a percentage of the total loan balance, ranging from 1 to 20% and that borrowers will redraw every 2 years.

% of mortgage held as cash 1% 2% 4% 5% 10% 20%
Cash Balance ($) 5,000 10,000 20,000 25,000 50,000 100,000
Mortgage Rate 4.00% 4.00% 4.00% 4.00% 4.00% 4.00%
Savings Rate 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%
Mortgage Cost ($) 200 400 800 1,000 2,000 4,000
Interest Earned ($) 125.00 250.00 500.00 625.00 1,250.00 2,500.00
Tax 30% 30% 30% 30% 30% 30%
After Tax Earnings 87.5 175 350 437.5 875 1750
Net Cost 113 225 450 563 1,125 2,250
Years 2 2 2 2 2 2
Total ($) 225 450 900 1,125 2,250 4,500
Cost per annum 0.05% 0.09% 0.18% 0.23% 0.45% 0.90%

These tables present a lot of data but it can be simplified into 3 sections:

If you have a very low savings balance (1-2%), using the offset has less value as you are not saving much money. We assume this is at best 0.1% per annum benefit in having an offset.

If you have reasonable savings, which comes to about 5% of your outstanding mortgage, the potential cost of this approach is 0.18% to 0.23% per annum (18bps to 23bps). From this point onwards, the decision is then a matter if the redraw will be made in Year 1 versus later. If you expect to redraw within a year, Approach 2 (savings & tax), otherwise Approach 1 (redraw/refinance). This caps the cost at about 0.15% (from Approach 1) as the 1-Year cost for Keep Savings in this second bracket is 0.1% and the maximum cost for Approach 1 is 0.15% if over 2 years (less if longer).

Generally, if one has a very large savings balance (10-20%) then there is limited point in borrowing. You are essentially giving the bank money by receiving 2.5% and paying 4%. Here, the best approach will be to use the redraw strategy (Approach 1) as the total cost is $1,500 and we expect the cost to be around 15bps as a maximum and reduce if you infrequently need access to the savings.

Drawing Conclusions

Offsets do add value to a borrower in that the tax benefit of reducing a liability is better than receiving interest and that interest us a lower rate than you pay.

By combining our assessment of Salary and Savings Impact, the offset puts a borrower in approximately 0.2% per annum better off: a borrower should be willing to pay up to this for the product.

There are several caveats around this:

If the savings balance is very low, the impact is reduced to about 10bps.

If the savings balance is proportionally higher, the borrower needs to consider what they are going to do with their savings: keeping large savings in cash deposits is not an optimal choice. If these savings are put into equities and earn 7% per annum, then the value of an offset account is reduced but the borrower is taking on a different financial risk that we cannot easily compare.

If you are a conservative borrower who doesn’t plan to redraw, the offset benefit may reduce to less than 10bps.

If you have other types of debt, you are better paying them off than reducing a mortgage, which typically has the lowest interest rate.

You may get access to free redraws in some home loans. Then benefit of an offset versus these is then reduced to 0.03%- 0.05% as we can use Approach 1 without facing the $1,500 cost.

Applying to a Family

Consider a family with household income of $150,000, 35% tax rate, $625,000 mortgage, $35,000 of savings and refinance frequency of 3-years.

An offset will save them:

Salary Impact: $2,264 or 0.05%

Savings Impact: Approach 1 is 0.08% (note: Approach 2 is 0.40%)

Total Impact is 0.13%, so they should only choose an Offset if the interest rate is less than 0.13% higher than a non-offset account.

What are banks charging?

The cost of an offset account ranges from 10bps to 40bps, so you need to consider if it is worthwhile versus going for the more simplified product. If a bank is charging more than 0.15% it is likely to be a financially negative decision to choose an Offset account (banks are known to gauge customers) as the bank is charging more than the likely benefit. We think most banks are charging 0.2% to 0.25% extra for offsets, so see them as being a pointless exercise unless combined with a split loan (we’ll save this for a separate blog).

Like many things, the borrowers view on how often they need to draw money is key and if the standard non-offset product allows the occasional redraw, this will help answer the question.

It may also be worth picking other loan products with no offset feature at all if they offer features that outweigh the offset’s value. The easiest example is a fixed rate product: if you think interest rates will increase, then a fixed offers potential value as those interest rates won’t go up during the fixed period.

Huffle’s FlexiFix home loan product goes beyond this. We offer the certainty of payments and the flexibility to pay off and refinance without any break costs. We believe this has substantially more value to a borrower than an offset account.

 

 

 

 

 

 

 

 

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Mortgage Rate Forecasting, January 2017 (Pre-Trump)

With the clock winding down to the Inauguration of US President Elect, Donald Trump, a quick update on Australian mortgage rate forecasting.

In the last 2 months we have seen most Australian lenders increase their home loan rates across their fixed products (2, 3 and 5-year fixed rates) and well as increases to variable rate products. This is inline with our prior forecast in November. Investor loans have had a higher hit, in part due to higher systemic risk, the APRA 10% annual volume increase limit (banks using price to temper strong demand), and simply less sensitivity to rate increases (it’s not going to stop investors given high house price growth and the ability to negative gear away some of the higher increase).

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 5.70% within 10 years. This is an average case forecast with variation possibly up to 2% higher.

Screen Shot 2017-01-18 at 09.44.45

As we have discusses before, now is a great time to borrow with fixed terms for as long as possible as rates are low, the RBA is expected to consider interest rate increases (1 in 3 chance of a rate hike this year) and incumbent banks are increasing interest rates even without RBA rate changes. The cheapest variable home loans have already increased about 0.2% in the last 2 months.

We believe the best way to mitigate the risk of higher interest rates 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, go down or you feel more comfortable in being able to manage interest rate rises, then you can switch without facing any finance related costs from our side.

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

Other Forecast:

We will look at what happens to expected rates after the Presidential Inauguration. Many experts expect to see a few interesting changes over the next few weeks.

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

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Capital Floor Impact: Wholesale versus Retail

WayneByres

The latest thoughts on new bank capital rules are that risk-weight floors are introduced so that advanced banks are no longer able to significantly deviate from regulatory views on capital adequacy for credit exposures based on internal models.

Banks that have internal models have shown large discrepancies between institutions in how they view the same type of risk. So international regulators are considering making a few adjustments that cover this:

  1. Should large banks have a huge capital advantage over small ones? Diversification across much larger pools is a justification but there should be a limit.
  2. Should the maximum deviation be contained? For better prudential risk management would suggest yes. And this is most easily delivered by having a minimum limit on how little capital a bank would hold against a specific risk.

Minimum Levels: A Floor

This brings us to IRB Floors. Any internal ratings base bank will potentially be subject to holding capital based on the higher of:

  1. The internal view on risk
  2. A minimum percentage of the regulator’s view on the risk via standardised rules.

Advanced IRB banks show evidence to regulators as to why IRB models should apply – receiving regulatory approval for the probability of default and loss-given default based on historical evidence compared to the bank’s credit scoring methodology.

The Floor would then say that is OK as long as the bank isn’t stretching the capital too far from aggregate data gathered by regulators that forms part of its standardised one-size-fits-all view.

Statistical Error versus Conservatism

A bank may have experienced lower losses based on sampling rather than the real risk but someone has to be wrong or too conservative: just because a borrower takes a loan from a smaller bank rather than a Major bank shouldn’t mean they become vastly different in risk.

Minimum thresholds already exist in some cases and one was introduced by APRA for residential mortgages as a response to the Financial System Inquiry. This also happens in other cases, particularly for banks in FIRB status (halfway from being considered eligible for full internal ratings based status).

Back to Basel

Credit Rating

APS 112 (Standardised) IRB Capital 60% Floor 75% Floor 90% Floor

A

5.00% 2.12% 3.00% 3.75% 4.50%

BBB

10.00% 3.46% 6.00% 7.50%

9.00%

BB 10.0% 6.27% 6.00% 7.50%

9.00%

B 15.00% 9.91% 9.00% 11.25%

13.50%

Returning to the Basel committee, there are 3 potential numbers being suggested for the Risk-Weight Floor: 60%, 75% and 90%.

Using 30% LGD and a 3-Year maturity, this suggests the following impact to corporate credit:

Basel III with a 75% RW Floor on Corporate Loans (LGD = 30%, Maturity = 3) increases the required capital on A and BBB loans significantly. If a bank cannot adjust the loan spread, then the return on capital will drop dramatically.

Given the 4 Major Australian banks hold $575bn in corporate credit exposures and assuming this is realised as an upfront loss of 1% (averaging the implied loss across all credit ratings), this will equate to destroyed value of $5.75bn if banks had to mark-to-market. Of course, as banks are hold-to-maturity this will be reflected in lower return on equity but the overall impact will be the same over time.

Credit Rating

Expected Spread @ 25% RoRC New Required Spread New RoRC (was 25%) Implied Loss of Value on Loan

A

2.06% 2.47% 14.13% 1.22%

BBB

2.44% 3.45% 11.53%

3.03%

BB 3.37% 3.68% 20.92%

0.92%

B 5.48% 5.81% 22.03%

1.00%

Importantly: banks will have to absorb the cost for loans made in the past and new loans will have higher interest rates.

Residential Mortgages:

Within consumer lending, the 4 Majors continue to have a major pricing advantage due to the capital they hold versus all other banks. Standardised banks hold 35% risk-weight against sub-70% LVR loans (APS 112), whereas the 4 Majors are holding an average of 25% across the entire loan book.

Screen Shot 2017-01-06 at 09.31.02

The originally proposed and retracted 25% Risk weight floor would represent a 71% risk weight floor versus the standardized level (35% RW).

Clearly, we expect 60% to have limited impact whereas 90% would lead to a higher capital charge. Working through the 90% example:

A Standardised bank has an approximate risk weighting of 37%, as some loans carry a higher risk weight (LVR above 80% and 90%, defaulting loans, non-standard, no LMI etc…).

If the 90% Floor comes in, this would force the 4 Majors to hold 33.3% Risk Weight. This is 8.3% higher than the 25% average Risk Weight allowed by APRA.

Mortgages are different as banks can re-price:

8.3% on 10% capital ratio and 30% current return on regulatory capital across the residential mortgage portfolio suggests banks will raise rates by 0.25% to maintain profitability (8.3% * 10% * 30%) – an equivalent to an RBA rate increase. Banks can do this for variable loans made in the past by adjusting their standard variable rate upwards. New and old loans will have higher interest rates and consumers pay for Basel’s actions, not the banks, if banks choose to pass on the cost and they seem to be very active in doing this.

The major difference here is that banks can re-price their variable rate mortgages. Perhaps corporates are smarter than consumers but one should think that consumers should look for better risk protection and not continually subsidise major bank profits,

So watch out for Basel, especially if your bank can re-price your debt.

Note: Photo of Wayne Byres from Louise Kennerley via smh. 

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Helping Home Owners: Building Better Loan Products

At Huffle, our mission is to help home owners get onto the housing ladder and then have a happier, lower risk way to look after the financial burden that comes with a home loan.

Joining forces with others or having a larger deposit does lower the risk and cost – but what is being done by banks to actually help reduce the risk in the loan product? We think very little and it is a great shame. It isn’t even that difficult to look at what potential answers would be and here is a simple example.

How much can we borrow?

Lenders assess what is called serviceability: can you make all the due payments on a home loan. This is done by looking at your income and expenses and assuming that interest rates will rise 2% or 3% from current levels. This means that lenders will assume an interest rate on a variable mortgage may be as high as 7%. Can you afford to pay this? Obviously 7% interest rates will have higher monthly payments that 4% or 5%, so the total amount you can borrow may not be enough to buy the right home.

Easy solution: Long-Term Fixed Rates

There is a huge shortage of long-term fixed rate home loans in Australia. No lender offers an appropriate product: fixed for long enough so that interest rate increases are not a problem and with the flexibility to leave early if you move home. Compare this to the United States, where 90% of all home loans are of this type: borrowers get a much better deal on the other side of the Pacific.

If your home loan was fixed, say at 5% for 10 years, then you can say that there is only a very small risk of interest rate increases and an assessment on the borrower can be how much can you borrow at just 5% interest rate.

Ignoring the deposit requirement, you can lend between 10% and 25% more if it is long-term fixed rate than a variable rate for the same serviceability assessment. Having a long-term fixed rate reduces borrower risk to interest rate increases, meaning a lender can offer a larger loan.

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What about 2,3 or 5 Year Fixed Rate Home Loans?

This simply isn’t long enough: you will have a mortgage for over 10 years, with the average mortgage taking 17 years to fully pay off. 10 years or longer is the required fixed period so that enough of the mortgage is paid off before you need to refinance to another fixed  or variable rate or move home – and at that point interest rates could be higher or lower.

What if I want to move before year 10?

Simply put – lenders need to offer fixed rate loans without early break fees and with no repayment and refinancing restrictions. Then you can move home with cost or burden and obtain a new fixed rate mortgage.

This would be a real piece of customer innovation and is one of the products we are bringing to Australia. This can help Millennials onto the housing ladder and those already on it that are a little concerned about interest rate increases. 

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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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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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