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.

cohome floor copy

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

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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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Never Pay Your Bills: Negative Rates

A lot of noise has appeared in the last few weeks on the effectiveness of recent central bank policy, namely quantitative easing. Whilst this has been an important part of the recovery since the banking systems near collapse, the benefits of continuing this policy look to now be outweighed by the costs.

Here are a few interesting snapshots on negative rates.

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  1. Swiss local authorities want the public to delay paying their tax

As a consequence of negative interest rates on the cash held in Swiss bank accounts, local authorities (cantons) prefer that the public delay paying. It costs the cantons money if people pay at the start of the tax window.

Interestingly, everyone wants to pay tax as early as possible.

We wonder how this could go further. If you were a business with invoices due, would you prefer customers delay paying? If you trust their credit rating and don’t have a cash flow constraint, you might.

It also presents an interesting issue for invoice financing start-ups. Will they need to pay companies for the privilege of getting people paid faster?

We note that credit spreads (default risk) should still keep SME lending rates positive but negative rates do reduce margins in some way.

  1. Danish couple paid to have a mortgage

Coming to all home owners soon! I expect a few people have similar mortgages in the UK. I remember a friend obtaining a mortgage 30 basis points lower than the BoE base rate in 2006, which would be negative now if she hasn’t refinanced.

As central bank cash rates and even long-term bond yields go negative, you are essentially rewarded for taking on leverage and house-price risk. Seems a bit odd that the result of trying to repair leveraged speculation on house prices is to reward people with cash payments for taking speculative leverage on house prices.

  1. Private equity metrics shift

The ECB’s CSPP (buying corporate bonds) has had a few words of warning from Bank of America analysts. As BB rated bonds, which are below investment grade, have increasingly negative yields we see a shift in borrowing and acquisition metrics.

Screen Shot 2016-09-12 at 10.20.37Firstly, gaming any interest coverage test becomes easy. You no longer need to care about Interest/EBIT multiples as you will be paid for the leverage. Existing buyouts then have more room to increase leverage and new LBO opportunities become available.

Companies will look to acquire more targets, ideally with strong collateral values, as owning a liability on collateral (in the same way as the Danish couple with a mortgage) is a money earner. You are rewarding those who believe in future price increases or stability.

In the ECB’s case, this makes sense: the fear of deflation is creating opportunities for those who are willing and able to help the ECB fight all deflationary pressures.

Sadly, many of these problems might be due to prior price increases being brought forward by earlier monetary policy: central banks might be chasing growth that has already been taken through lower interest rates and earlier rounds of quantitative easing.

In the meantime, enjoy the free leverage. Just make sure you can run to the door when the music stops playing.


Thanks to Bruegel and Bloomberg/BofA for the charts.

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How Fixed Rate Mortgages Transform Affordability

A previous blog discussed overall housing affordability in Australia. Using a simplified version of serviceability we determined that the median house was only affordable by the top 10 percent (90th percentile) of household incomes (under a set of conservative assumptions). This has been the status quo for a while, with lower interest rates being counteracted by higher house prices.

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Of course, this affordability isn’t broadly true even if it feels like it. We note that many households will resort to interest only mortgages, which reduce the payment burden but do increase the risk overall. Other mechanisms also exist so that a wider portion of the population can still buy the median house.

However, the trend – where the income band increased from top 30% in 1998 to just the top 10% by 2014 is worrying. The trend exists under all circumstances even if the exact percentile brackets are different. The extra risk via interest only and the overall interest risk taken by borrowers in variable rate products is a large systemic risk Australia and the RBA needs to contend with.

Revisiting the model

If we take a 3.75% variable rate and apply it to our last data point, we observe that the top 15% can now afford the average home as the mortgage is more serviceable due to the lower interest payment (note: the house price data is not up to date). Housing gets more affordable based on our conservative affordability assumptions. One would expect an increase in house prices to close up this shift.

Taking the analysis further: what happens to house prices and affordability when our 10-year mortgage is launched?

Further assumptions:

  1. The current expected interest rate for our 10-year is at 4.5% and this is allowed to be applied for the life of the loan.
  2. We are able to deliver our mortgage going backwards using similar observed metrics plus other wholesale pricing observations (we cannot disclose this here, sorry).
  3. Serviceability can then be determined using the interest rate for the fixed rate and not via a 3% upwards stress.

Fixed is lower risk for the borrower

The subtle difference in the serviceability assessment means what the borrower is able to take on as debt is higher for fixed rate (vs. variable) as the borrower has less overall interest rate risk. Alternatively, a borrower can take on the same amount of debt but with lower risk versus a variable loan. Using our assumed mortgage rates, we obtain the following results:

  1. A Principal and Interest Variable Rate Mortgage at 3.75% using the above methodology suggests the median house is affordable to the top 15% of the population (85th percentile).  Note: the house pricing data is on a lag.
  2. For the Fixed Rate home loan, even though it has a higher fixed rate, the affordability is to a wider audience. The top 20% of earners (80th Percentile household income) can afford the median house and historically an additional 5% to 10% of the total population would be able to buy the median house.

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Now a few key pieces to add

  1. Fixed rate debt can be taken on with more confidence knowing the rate cannot increase. Most importantly here, borrowers can have greater confidence in their repayment certainty. The cost is a higher interest rates compared to variable loans.
  2. Lower systemic risk: fixed rate home loans have lower systemic risk as interest rate increases will not impact home owners and damage retail consumption – it will impact the wholesale funding portion of the financial system. In other words, a fixed loan with repayment optionality shifts all of the interest rate risk from the borrower into the financial system.
  3. Housing hasn’t been affordable for a while, however it is more affordable to Fixed Rate borrowers on a consistent basis, meaning a wider set of customers for a similar quantum of risk. It just depends on the method and product the lending is delivered.

Look forward to comments and discussion.

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10-Year Fixed Getting Cheaper

For those who are not tracking the developments in Australian yields, the following will be an interest as Huffle’s 10-year mortgage nears launch.

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Since July 2015, we have seen 2 cuts by the RBA to the cash rate. However, the yield curve has flattened a further 47bps on the 10-year. The 10-2 spread is now just 36bps.

It’s getting cheaper to borrow longer.

Hint hint home owners. Sign up at

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Musings of a Fintech: Australian House Affordability

Over the last few weeks we have been running an affordability analysis on Australian property. Our framework was as follows:

  1. Obtain Median Household Incomes (ABS), e.g. $51,896 in 2014.
  2. Define a reasonable expectation of a deposit
    • assuming households save 40% of income for 5 years
    • this is aggressive but caters for both those willing to save to own and might be living with parents and if they had other savings or hand-me-downs.
    • Result: a deposit equal to 2 years household net income
  3. Determine required mortgage from the above deposit and observed median house price (ABS), i.e. 2014: 100% less 18% deposit = 82% of median house price. Median House Price 2014: $571,700. 2014 Required Mortgage: $467,908.
  4. Consider achievable serviceable mortgage from observed variable rate mortgages (plus serviceability buffer) and household net income. Say 4.5x Household Net Income, but driven by a slightly more complex equation. 2014: $231,937.
  5. Look at how many multiples the required mortgage is above the achievable serviceable mortgage. 2014: 2.02x. Average: 1.69.

There are a few things to note:

  1. Median Income does not buy median house. Top earners will have multiple properties whilst lower earners will never own. However this analysis serves 2 purposes:
    • how has this relationship evolved
    • which percentile of household income can actually afford the median house
  2. Achievable mortgage is calculated from inputs and factors that we will not discuss but is roughly derived from:
    • interest rate + 3%
    • 40% of household net income to service that debt
    • hence a median current household income of $51,896 would have an achievable mortgage of $231,937 (about 4.5x net household income) if the current interest rate (SVR) is 5.95%

Resulting Observations:

A. Households cannot save as much of a deposit. In 1994, households could achieve a 29% deposit under our hypothesis. It has declined to 18%. Note: this is a major constraint for first time buyers whilst existing property stock holders can release equity in their property for further purchases.

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B. The ratio of required mortgage to achievable mortgage has been increasing, meaning the median household is further away from being able to afford the median house. Note: the dip into 1998 is a function of interest rates declining but house prices remaining relatively static. Screen Shot 2016-06-10 at 13.12.25

C. The Percentile of Household income required to buy the average house has trended heavily upwards and now you need to be in the 90th percentile of household income to buy the Median (50th percentile) house.

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We draw several conclusions from this:

  1. We can use #B to suggest Australian property is about 20% overvalued on an affordability basis. We note the risk of averaging here.
  2. The ability to raise deposits has become difficult (#A) but LMI and lower deposit requirements have solved this problem in some ways.
  3. If you need to be in the 90th percentile to buy the media house price, based on this simple analysis, we see 2 things:
    • The average person is leveraging too aggressively to buy property in such a way that they are acquiring a mortgage they may struggle to service (ie the 70-80th percentiles are still buying a median house that is only affordable by the 90th percentile). We note the average borrower is taking 5.3x net household income in Australia from Macquarie via Clancy Yeates, or
    • The 90th percentile and above are accumulating more property, possibly distorting household income with negative gearing, and that pocket of what is ultimately investment property, is deeply over leveraged.

Any potential solutions?

  1. 20% price downward correction, although this will impact those who are over leveraged but support those who are under-leveraged.
  2. If borrowers can lock in lower interest rates for longer periods (such as the Huffle 10-Year Fixed), then the serviceability issue may reduce and households with lower percentile incomes can confidently borrow more.
  3. There is potential need for the severe reduction of property investment if we want average Australians to be able to own the average house.

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FinTech Sandbox: My Words Introducing The Treasurer, The Hon. Scott Morrison


Australian Treasurer, Scott Morrison, today made an announcement regarding the creation of a Regulatory Sandbox for Finance Start-ups. Below is my speech introducing the Treasurer at Tyro FinTech Hub.

Good regulatory frameworks are incredibly important for well-functioning financial systems and the Regulatory Sandbox is an important piece that helps start-ups, regulators and consumers work together to allow the formation of new products and services.

Attempting a finance start-up is a daunting experience. Not only do you need to develop significant advantages over existing well-resourced businesses, the layers of regulation make it almost impossible to get going and test hypotheses. The Sandbox should lower the very early stage constraints so that we can have a huge wave of innovative businesses delivering better outcomes for Australians and overseas.

Sandbox pictureFor those who don’t know me, my name is Damian Horton and I’m the co-founder of Huffle. We’re an early stage FinTech with the ambitious aim of introducing a new type of home loan to Australia and beyond.

As co-founder of a young finance start-up, we welcome the Government and Treasurer’s announcement of a FinTech Sandbox and I’d like to spend a few minutes explaining  its importance from our perspective.

Finance, as a sector, is now playing catch-up to the ever increasing influence of technology on our lives. Hence the recent growth in FinTechs.

The major underlying trend is that we are moving away from physical bank branches on our streets and into the mobile phones in our pockets. And the entire economy needs to keep up.

Up until today, we have only seen an initial wave of financial technology start-ups. And while many of these companies have been great trailblazers, we’d expect to see many more companies offering new products and services that haven’t even been considered yet. Much of this will occur as the cost of using technology continues to fall, talented and energetic people leave the comfort of the corporate world and consuming finance via your phone expands from about 10% towards 100% of the population.

And this is what brings us to the importance of the Fintech Sandbox.

In the case of my start-up, Huffle, where we are aiming to bring long-term fixed rate home loans to Australia which significantly reduce borrower risk, the complexity of being a start-up, primary lender, derivatives business and with a bank-like appearance all at once from day one creates a number of challenges.

As with all leading global financial centres, a strong regulatory framework is crucial, particularly for consumer protection, but these protections often present barriers for start-ups that are simply too expensive to overcome.

A start-up might not initially be able to tick all of the required boxes for regulatory approval. So they then can’t determine if a new business idea would work. The opportunity to create something new and potentially of major benefit has been lost as the cost of trying is too prohibitive.

In Huffle’s case, the initial barrier to ticking all of the boxes was driven by overseas founder experience not counting towards the required Australian experience under the consumer protection act.

Other fintechs face challenges such as the high cost of obtaining a financial services licence, which is required if they are offering investment and savings products.

Another challenge is the heavy reliance on incumbents to provide early stage services.

If there’s a market for a product and a start-up gains traction, this then becomes the right stage to invest in additional people to meet full regulatory approval.

The next step is nurturing.

The sandbox will provide a controlled environment in which start-ups, their customers and the regulators can explore and understand the new product and associated risks. Feedback from these multiple stakeholders can then help to refine and improve the initial products and nurture the new businesses to transform them into tomorrow’s banks and financial services businesses.

I congratulate the treasurer, the government, FinTech Australia and ASIC in the work they have done to put together the framework for this Sandbox and look forward to seeing many new fintech businesses and the jobs it will help create.

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Technical Notes: Dissecting P2P Securitizations

A couple of unrelated things popped up in the last few weeks that got the team at Huffle thinking. Firstly, the LendingClub issues over asset quality, which we believe is a specific case and not an industry risk.

The second, which I will discuss here, is regarding the securitization of peer-to-peer loans originated by Funding Circle in the UK.


As with all securitization, Funding Circle’s has a pretty obscure name. The transaction is called SBOLT 2016-1, which stands for Small Business Origination Loan Trust. Having structured CLOs earlier in my career, the securitization on small business loans is not only interesting from a market demand perspective but also an intellectual one. How have unsecured assets been packaged and presented to the rating agencies?


securitization are commonly opaque in terms of pricing, often due to the discount on issuance that may increase the attainable yields or spreads. Luckily, the prospectus was available to me, so I can investigate a little further.

Pricing of CLOs is driven by the attainable credit ratings but also by an assessment of cashflow and scenario analysis. Here we have multiple tranches of increasing risk, with the senior piece getting a BBB rating and a spread of 2.2% over UK Libor.

It is interesting to see how the BBB has tightened in Europe. Locally to Australia, Commonwealth Bank priced AUD RMBS Medallion 2016-1 AAA at +140bps around the same time as SBOLT. Currency risk aside, I would certainly prefer to take on AAA RMBS risk and I also expect traditional CLO paper might also offer better value and liquidity.

Looking at this transaction against an underlying portfolio that is yielding 9.57%, it might be better to simply buy the underlying portfolio rather than the tranched transaction. Further, Class E seems to make no sense, particularly as Class D looks to have a higher IRR. Be aware that fee side-letters may exist and other mechanisms to make the transaction more attractive for investors.


Tranche Sizing:

Six tranches on a small deal appear to be a little tight: how much loss protection will the Class E offer the Class D in a stressed scenario?

Multiple tranching is possible as the underlying collateral is pretty granular, with over 2400 loans. For this quick assessment, Classes C to Z are of less interest to me. The B Class has obviously caused some discrepancy between Moody’s and S&P as Moody’s has given it a lower rating than the Class A.

So how secure is the Class A?

On inspection, the senior note is pretty secure. BBB rated assets have an annual default probability of around 0.2% and the 67% and 72% attachment points for the Class A and Class B fall comfortably inside the stressed scenario distributions required to meet the 99.8% pass rate (1 minus 0.2%).

A simpler way to recreate the credit rating agency analysis is to adapt the Advanced IRB framework for the given risk profile and asset class. The unexpected loss can be used as an indicator for senior tranching, although the final credit rating agency models are different.

Could we ever see this ever become AAA?

There is always potential to make AAA senior Classes. In this instance, the attachment point would need to be closer to 50%, which is too small and the transaction will struggle to sell. The reason for this is that the unsecured aspect of the underlying assets is a really high downside loss-given default (assume 80%-90%) and a probability of default of 5% to 10% (implied backwards given the high interest rate charged). The Advanced IRB framework can show you how much you can lose in downside scenarios needed to attain a AAA.

Different asset classes make the ability to create AAA rated securitization harder or easier. Secured assets, such as residential mortgages or auto-leases, are much easier for this asset class, which it ultimately about creating additional security rather than funding arbitrage. Unsecured loans are usually the hardest.

Verdict on SBOLT:

The senior tranching appears to make sense versus where the portfolio risk comes out. If we think the securitization mathematics are wrong, we should also assume the entire Basel framework on bank capital is wrong. As such, the transaction, structurally, is pretty well aligned to globally accepted risk frameworks and the securitization should be seen as a valid investment for regulated entities such as banks and insurance companies.

I am less concerned about the lower tranches as they are smaller fractions, speculative and more sensitive to the underlying portfolio for which I don’t have granular data.

How should we view this deal in Australia?

Overall, I am optimistic for the transaction. Wholesale funding is an important piece to peer-to-peer lending on the basis that not all investors want loan specific risk or equal risk that the borrower offers.

Caution should be taken that CLO securitization and subsequent layers of intermediation (such as fixed income portfolio managers, risk processes and rating agencies) add layers of costs that is worn, ultimately, in higher borrowing costs or reduced returns for investors. Direct lending by hedge fund-owned CLO platforms has been around for over decade. Can FinTech offer an advantage here?

In some cases they can, if they have a specialized team, but they need to ensure they have strong compliance procedures and the ability to perform the analysis and risk management process for risk transformation, which is where LendingClub recently faltered. Unlike vanilla funds without structuring overlays, the underlying collateral in securitization becomes ever more important in the resulting investment performance, particularly if there is a stressed market event.

As FinTechs evolve from new entrants and upstarts into more established businesses, these are the type of specific processes that are likely to be taken on.

Note: I have tried to simplify this blog so that more people can follow the analysis. Credit rating agency models have a number of different mechanisms and methodologies to the Basel II framework.


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Musings of a Fintech: Huffle 10 Year Fixed Target Pricing Drops to 4.49%


The RBA cut the cash rate to 1.75% this week and further rate cuts are expected. This sent the team at Huffle back to the loan lab to tinker with our model. Adjustments are required in our modeling, not only in the yield curve but also the pricing of interest rate derivatives.

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The daily feed of Aussie government bonds show the recent decline in borrowing costs but also a slight increase in steepness in yield curve. This is indicated by the 2-10 Spread, which currently sits around 72bps. On a very simplistic level, this indicates that our expected pricing for a fixed rate, hedging and capital aside, is likely to be 72bs higher than where the variable rate home loan market is.

Updating our models and with a Return on Equity hurdle at 20%, we have reduced our expected pricing down from 4.99% to 4.49%. The main gains are due to the current derivative pricing and volatility.

Why is this the case?

As rates compress towards zero, the embedded call option in fixed rate prepayables has a reduced upside value to the borrower. The result is that this has a reduced sale value that would naturally be added into the price of the mortgage. The overall impact is a bigger reduction in the expected fixed rate loan price compared to the observed rate cut and decline in the yield curve.

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Musings of a Fintech: Single-Product Single-Brand Strategy

One of my guilty pleasures is watching Gordon Ramsay blow off steam. It recently occurred to me that his TV show, Kitchen Nightmares, has a nice insight into bank product offerings, marketing and product development.

In Gordon Ramsay’s Kitchen Nightmares there is one specific action he takes in almost every episode. He looks at their huge menus, usually multiple pages of every option possibly available, and culls it to a 1-page daily menu of the best items. He does this for a few reasons:

  1. Customers can’t decide, it is too hard, and then they pick something they don’t really want or the most popular default item.
  2. The restaurant needs to keep a lot more ingredients and perishables. This has a substantially higher cost in terms of wastage and inability to bulk buy.
  3. The restaurant doesn’t have a clear identity. Does it sell pasta, pizza, fish and chips, burgers or a sub-set of them.

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On the opposite end of the spectrum a great example is one of my favourite eateries in London, Burger & Lobster (no Ramsay link, as far as I know). As evidenced by their name, they only serve 2 things. This offers a great advantage:

  1. They clearly show what they do. Customers understand this. When they want burger or lobster, guess who is the first choice restaurant.
  2. They can buy in bulk. Lots of lobster and beef. This means they can offer more competitive pricing and their staff can become specialized at cooking specific dishes. Margins increase.

Pr. Mark Ritson of Melbourne Business School and advisor to many world leading brands, also believes killing brands or items is more important that creating them. It becomes harder to sell so many products under a house of brands or branded house and also to keep them all relevant. It is also a headache on stocking and matching demand and supply. Large businesses need to reduce first.

So what does this mean for banks and Fintech? We suggest a few key points:

  1. Whilst large banks should be culling SKUs (financial products), FinTechs should fill the void and be product specific. We call this “Single-Product Single-Brand” strategy.
  2. Single brand for a single product: the Fintech becomes specialist in a specific area and customers who want a product go to that fintech first. This creates marketing and sales efficiency as the brand becomes synonymous with that product.
  3. Navigating through most bank websites is like the old restaurant menus. See for yourself – try to find CUA’s credit card products from their home page (hint: you’ll probably have to use the search function as they aren’t there!).
  4. Lack of product differentiation between the banks means customers simply can’t decide. So in the case for home loans, they defer to a mortgage broker for fulfillment – creating an unnecessary expensive cost to acquire new customers.

So where does that leave us? If a bank had to pick what its single product would be, I expect it is going to be deposits. This is the item they are regulated on and have strong risk systems in place, particularly over capital and liquidity. One way this could go is the concept of “utility” banks, which sit as the underlying layer of financial services. On top of this core utility layer there could be a number of “single brand, single product” FinTechs acting as satellites with unique products and customer experience tailored to specific segments.

The major challenge to banks specializing in core deposits? This is the areas that Google, Apple and the large tech giants are likely to go after in coming years, but we’ll save that for another blog.

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