Capital Floor Impact: Wholesale versus Retail


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


5.00% 2.12% 3.00% 3.75% 4.50%


10.00% 3.46% 6.00% 7.50%


BB 10.0% 6.27% 6.00% 7.50%


B 15.00% 9.91% 9.00% 11.25%


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


2.06% 2.47% 14.13% 1.22%


2.44% 3.45% 11.53%


BB 3.37% 3.68% 20.92%


B 5.48% 5.81% 22.03%


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.

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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)

Screen Shot 2016-11-18 at 09.50.42

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

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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.

Screen Shot 2016-10-10 at 12.24.32

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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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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