Loan Denied: Tightening Loan Serviceability

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We have written a few blogs on our view of residential investor mortgages and want to reinforce a few further points:

  1. Many banks view investor loans as lower risk than owner-occupier. This is wrong.
  2. Serviceability criteria will slow lending dramatically. ASIC is as much in-play as APRA.
  3. Serviceability is a yes/no result, meaning many investors will soon be blocked out from the market.

Investors loans have higher risk:

Most secured loan products for IRB banks follow the Basel PD, LGD formula to determine an unexpected loss value that is then a direct input into regulatory capital. The PD in this case is seen to be a through-the-cycle probability of default (TTC PD), which is then scaled up to a 1-in-1000 year stressed probability of default.

Australia has had benign lending environments in the last 2 decades, in effect no true credit cycle. So the first point to make is the TTC PD estimation is potentially a little low. In this data set, investor loans are showing a lower TTC PD than owner-occupiers*. One rationale banks believe is that rental properties have a replaceable occupant, so if one tenant loses his job, you can find another with a job.

However, the PD/LGD model is probably the wrong assessment for this asset class. Investment properties are revenue producing real estate, so you must wonder why residential properties get less stress than commercial property that gets put into Specialised Lending.

The PD scale-up is missing a systemic risk component that is not a spike in landlord defaults. It is an increase in rental property vacancy ratios.

Look at vacancy rates:

If an investment property is reliant on a tenant to cover the mortgage, usually interest-only, and the landlord doesn’t have a high capacity to cover the full mortgage payments themselves, then empty properties may lead to defaults.

So rather than looking at TTC PD, we should look at potential increases in rental property vacancy rates. Does a national movement from 2.5% to 12.5% seem appropriate for a 1-in-1000 risk event? We have seen unemployment rates move from 6% to 16%, so there is scope for at least a 10% increase in vacancy rates.

There is potential further stress in that a country-specific recession will have lower inbound migrants seeking work and expat communities might decline. Vacancy rates could increase further.

Added to this, rental prices will need to fall, due to excess supply of rental properties over demand. This is an unknown factor but will lead to further stress. As most investment property rental yields are below the mortgage interest rate, this is a dollar cost to the landlord’s income.

The owners of empty rental properties then face a dilemma. If they have a mortgage or higher loss to service, how will they pay for it? Relying on selling the property is not appropriate as 10% of other rental properties may be performing the same process at the same time.

Instinctively, 20% of investment properties becoming under severe stress feels about right. This is double the implied stress currently assumed on investor loans.

Serviceability is everything:

The above methodology is appropriate if the landlord is reliant on the tenant to cover the mortgage. If the landlord has a diversified source of other income, notably not just investment property, then you can assume they have the capacity to cover a single empty property.

The major issue with current serviceability calculations is they haircut the attainable rent by 20%. But as we described above, there could be an extra 10% of properties with no tenant and this is where the systemic risk is.

We expect ASIC and APRA to realise this risk at some point and tighten up the serviceability calculations so that investors reliant on filling a property will either not pass the serviceability assessment or they will be classified as Specialised Lending, which will have risk-weights 2 or 3 times higher and a mortgage rate several percentage points higher than owner-occupier home loans.

We look forward to these changes.

 

*Those that suggest this means there is lower risk in investor loans are incorrect. If expected losses do not appear, this is really a higher net income history rather than lower risk. Unexpected losses are the risk factor.

 

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Why Is There Regulator Panic?

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Panic is probably a little strong but APRA and ASIC are now appearing to take a much more vocal and active position on Australian housing risk. The RBA is also ready but whilst upward interest rate movement would reduce overheating Sydney and Melbourne markets, other aspects of the economy don’t need a rate hike.

Is there a bubble?

More people are saying there might be in Sydney and Melbourne, with another year of mid-teens house price increases. However, other fundamentals that should be a factor in house prices, namely wages, are at very low levels of growth.

There is a risk that this is credit driven price growth and we now believe there is a much higher risk of a large price correction.

Are interest rates to blame?

In part, yes. People base their ability to pay off a home loan by seeing a monthly mortgage payment. If they can pay that or cover it with rent from tenants, then it looks affordable. Interest rates are at an all time low, so unsurprisingly prices are at an all time high as affordability will always be stretched by those who want a house the most.

However, there are 3 things that make this a cyclical risk:

  1. Most of the debt is floating. Interest rates may and will increase due to the RBA or banks.
  2. A big proportion of the debt is interest only: the loan risk is staying there longer and borrowers are planning to not pay down debt in an orderly way (principal repayments might not be affordable in their eyes, be spent on other things).
  3. Rent isn’t covering the mortgage’s interest rates.

If we start to unpick these, we see that the regulators have allowed the proliferation of higher-risk borrowing.

Fixed is better than floating

There is no current long-term fixed rate mortgage market in Australia. The longest fixed period most banks offer is 5-years. This is not a long enough period for borrowers to pay down mortgage debt before the loan resets to a floating rate, meaning the borrower is still exposed to interest rate increases.

We need a 10-year fixed. We need longer. It’s a shame that the banking sector doesn’t understand the risk that not having this loan creates: banks believe they can just pass on interest rate increases to consumers without either higher defaults or a huge slump in consumer spending, which will lead to mortgage defaults as unemployment increases. This was one of the findings from APRA’s 2014 stress tests.

Interest Only is Subprime

The major problem with US subprime was that it relied on house-price appreciation to work. As soon as prices stopped increasing and teaser periods on Adjustable Rate Mortgages ended, there was a spike in defaults.

Interest-only investor loans are a similar risk. The borrowers have a negative rental yield as the mortgage rate is higher than the rental yield, so they only make money due to tax concessions and price appreciation. At 18.9% annual rate of increase, Sydney doesn’t have to wait too long before anyone living in their own home wouldn’t be able to afford their property if they were buying it today. Prices can’t increase forever

When prices stop rising, the trade unwinds or rental rates need to increase, leading to higher vacancy rates (people can’t afford the rent) or a diversion of money from consumer spending. Higher vacancy rates are what would lead to a huge correction in investor property portfolios. Higher rents, which cause consumer spending diversion, will lead to higher unemployment.

Serviceability is the key

We have no idea who is doing the serviceability assessment at the lenders but they clearly have an aggressive view on serviceability that is now a major driver for housing risks.

Providing floating rate debt with a buffer for 2 or 3% interest increases is simply not enough when we have seen interest rate cycles with 3, 4 or 5% overall increases in interest rates (look at the US Fed Funds Rate from 2004 to 2006 at +4.25%).

The key ingredient to a long-term fixed is that the serviceability risk is taken off the table: the interest rate can’t change. The risk with the loan can only reduce whereas floating or interest only loans can have higher risk as interest rates climb or the interest only period ends.

Will the RBA join the party:

In the long run, the RBA will have to assist in the unwinding of all-time low interest rates. However, it can’t increase interest rates with the all-time high debt load unless something happens:

  1. High inflation and high wage growth
  2. It actively tries to shift the floating rate debt to long-term fixed debt

And it is this second item that will eventually appear: the RBA will have to create a mechanism to control the longer part of the yield curve. However, the RBA, ASIC and APRA need to support the creation of a much broader wholesale market before this can happen and the banking system needs to understand the lower risk attributes of long-term fixed rate mortgages. We also need to hope that the non-bank sector doesn’t load up on the same risk and blow itself up in the process.

This also means regulators may have to actively support greater competition in the retail banking sector and ultimately reduce the sensitivity of consumers to interest rate increases.

 

 

 

 

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Housing Deposit Call Options

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

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

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

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

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

What is a Free Call Option?

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

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

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

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

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

Free Call Options:

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

Assume:

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

call price

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

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

Delivery of Asset

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

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

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

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

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

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Australian Investor Loans: How Much More Will They Cost?

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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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Offset Home Loan: Is it worth it?

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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, 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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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.

Screen Shot 2016-10-03 at 11.57.22

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.

Screen Shot 2016-10-03 at 11.33.34

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.

Screen Shot 2016-10-03 at 11.32.52

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.

Screen Shot 2016-09-12 at 10.25.44

  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.

Notes:

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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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.

Screen Shot 2016-06-10 at 13.35.22

 

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.

Screen Shot 2016-06-10 at 13.13.41

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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