Small Amount Credit Review Recommends Tighter Controls

The final report of the Review of Small Amount Credit Contracts (SACCs) has been released. A range of recommendations tighten regulation of short term small loans and consumer leases. Of note is the need to disclose the actual APR of the transaction, be it a small amount credit contract or consumer lease. In the latter case, the cost of the relevant household good must be disclosed.

The review panel provided the Final Report to the Government on 3 March 2016.

The review was silent on mandating better collection of transaction data so  the true volume of loans could be recorded. As highlighted in the report accurate data is an issue.

Small Amount Credit Contracts (SACCs)

Recommendation 1 – Affordability – Extend the protected earnings amount regulation to cover SACCs provided to all consumers.
Reduce the cap on the total amount of all SACC repayments (including under the proposed SACC) from 20 per cent of the consumer’s gross income to 10 per cent of the consumer’s net (that is, after tax) income. Subject to these changes being accepted, retain the existing 20 per cent establishment fee and 4 per cent monthly fee maximums.
Recommendation 2 – Suitability – Remove the rebuttable presumption that a loan is presumed to be unsuitable if either the consumer is in default under another SACC, or in the 90-day period before the assessment, the consumer has had two or more other SACCs.
This recommendation is made on the condition that it is implemented together with Recommendation 1.
Recommendation 3 – Short term credit contracts – Maintain the existing ban on credit contracts with terms less than 15 days.
Recommendation 4 – Direct debit fees – Direct debit fees should be incorporated into the existing SACC fee cap.
Recommendation 5 – Equal repayments and sanction – In order to meet the definition of a SACC, the credit contract must have equal repayments over the life of the loan (noting that there may need to be limited exceptions to this rule). Where a contract does not meet this requirement the credit provider cannot charge more than an annual precent rate (APR) of 48 per cent.
Recommendation 6 – SACC database – A national database of SACCs should not be introduced at this stage. The major banks should be encouraged to participate in the comprehensive credit reporting regime at the earliest date.
Recommendation 7 – Early repayment –  No 4 per cent monthly fee can be charged for a month after the SACC is discharged by its early repayment. If a consumer repays a SACC early, the credit provider under the SACC cannot charge the monthly fee in respect of any outstanding months of the original term of the SACC after the consumer has repaid the outstanding balance and those amounts should be deducted from the outstanding balance at the time it is paid.
Recommendation 8 – Unsolicited offers – SACC providers should be prevented from making unsolicited SACC offers to current or previous consumers.
Recommendation 9 – Referrals to other SACC providers – SACC providers should not receive a payment or any other benefit for a referral made to another SACC provider.
Recommendation 10 – Default fees – SACC providers should only be permitted to charge a default fee that represents their actual costs arising from a consumer defaulting on a SACC up to a maximum of $10 per week. The existing limitation of the amount recoverable in the event of default to twice the adjusted credit amount should be retained.

Consumer Leases

Recommendation 11 – Cap on cost to consumers – A cap on the total amount of the payments to be made under a consumer lease of household goods should be introduced. The cap should be a multiple of the Base Price of the goods, determined by adding 4 per cent of the Base Price for each whole month of the lease term to the amount of the Base Price. For a lease with a term of greater than 48 months, the term should be deemed to be 48 months for the purposes of the calculation of the cap.
Recommendation 12 – Base Price of goods – The Base Price for new goods should be the recommended retail price or the price agreed in store, where this price is below the recommended retail price. Further work should be done to define the Base Price for second hand goods.
Recommendation 13 – Add-on services and features – The cost (if any) of add-on services and features, apart from delivery, should be included in the cap. A separate one-off delivery fee should be permitted. That fee should be limited to the reasonable costs of delivery of the leased good which appropriately account for any cost savings if there is a bulk delivery of goods to an area.
Recommendation 14 – Consumer leases to which the cap applies – The cap should apply to all leases of household goods including electronic goods.
Further consultation should take place on whether the cap should apply to consumer leases of motor vehicles.
Recommendation 15 –Affordability – A protected earnings amount requirement be introduced for leases of household goods, whereby lessors cannot require consumers to pay more than 10 per cent of their net income in rental payments under consumer leases of household goods, so that the total amount of all rental payments (including under the proposed lease) cannot exceed 10 per cent of their net income in each payment period.
Recommendation 16 – Centrepay implementation – The Department of Human Services consider making the caps in Recommendations 11 and 15 mandatory as soon as practicable for lessors who utilise or seek to utilise the Centrepay system.
Recommendation 17 – Early termination fees – The maximum amount that a lessor can charge on termination of a consumer lease should be imposed by way of a formula or principles that provide an appropriate and reasonable estimate of the lessors’ losses from early repayment.
Recommendation 18 – Ban on the unsolicited marketing of consumer leases – There should be a prohibition on the unsolicited selling of consumer leases of household goods, addressing current unfair practices used to market these goods.

Combined recommendations

Recommendation 19 – Bank statements – Retain the obligation for SACC providers to obtain and consider 90 days of bank statements before providing a SACC, and introduce an equivalent obligation for lessors of household goods. Introduce a prohibition on using information obtained from bank statements for purposes other than compliance with responsible lending obligations. ASIC should continue its discussions with software providers, banking institutions and SACC providers with a view to ensuring that ePayment Code protections are retained where consumers provide their bank account log-in details in order for a SACC provider to comply with their obligation to obtain 90 days of bank statements, for responsible lending purposes.
Recommendation 20 – Documenting suitability assessments – Introduce a requirement that SACC providers and lessors under a consumer lease are required at the time the assessment is made to document in writing their assessment that a proposed contract or lease is suitable.
Recommendation 21 – Warning statements – Introduce a requirement for lessors under consumer leases of household goods to provide consumers with a warning statement, designed to assist consumers to make better decisions as to whether to enter into a consumer lease, including by informing consumers of the availability of alternatives to these leases. In relation to both the proposed warning statement for consumer leases of household goods and the current warning statement in respect of SACCs, provide ASIC with the power to modify the requirements for the statement (including the content and when the warning statement has to be provided) to maximise the impact on consumers.
Recommendation 22 – Disclosure – Introduce a requirement that SACC providers and lessors under a consumer lease of household goods be required to disclose the cost of their products as an APR. Introduce a requirement that lessors under a consumer lease of household goods be required to disclose the Base Price of the goods being leased, and the difference between the Base Price and the total payments under the lease.

The Government is also consulting on whether the recommendations relating to consumer leases should apply to all regulated consumer leases (including motor vehicles) rather than only leases of household goods, and how second hand goods should be treated.

Macroprudential stable funding requirement and monetary policy

The Reserve Bank NZ, just released a paper “A macroprudential stable funding requirement and monetary policy in a small open economy” which considers the impact of the Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of long-term wholesale funding and deposits to fund their assets.

Central banks act as lenders of last resort to prevent liquidity pressures from becoming solvency problems. Liquidity provision by central banks, however, can lead to the problem of moral hazard. The availability of public liquidity reduces the incentive for banks to raise relatively expensive ‘stable’ funding such as retail deposits and long-term bonds, and leads banks to underinsure against refinancing risk. In periods when credit has grown rapidly, retail deposits have tended to grow more slowly, and banks have shifted toward less stable funding from short-term wholesale markets. The shift toward short- term wholesale funding increases the exposure of the banking system to refinancing risk, both by increasing rollover requirements and by lengthening intermediation chains through funding from other financial institutions. In response to the systemic liquidity stress experienced during the recent global financial crisis, extensive liquidity support was provided to banks, reinforcing incentives for moral hazard. Hence, stronger liquidity regulation has been proposed to increase banks’ self-insurance against liquidity risk.

The Basel III net stable funding requirement, scheduled for adoption in 2018, requires banks to use a minimum share of stable funding, in the form of long-term wholesale funding and deposits, to fund their assets. We introduce a stable funding requirement (SFR) into a small open economy model featuring a banking sector with richly-specified liabilities; deposits as well as short-term and long-term bonds. The SFR regulates the proportion of loans financed by the ‘stable’ component of the bank’s liabilities. The model is estimated for New Zealand, where a similar policy, the Core Funding Requirement, was adopted in 2010. A distinctive feature of the model is that it allows banks to issue short-term and long-term home currency-denominated debt overseas, in order to make loans in the small open economy.

We evaluate how the presence of the SFR alters monetary policy trade-offs between the volatility in inflation, and volatility in other variables such as output, interest rates and exchange rates. A higher SFR raises the share of long term foreign bonds on the banks’ balance-sheet and hence increases the economy’s exposure to shocks to the interest rate spread on long-term foreign debt. This in turn leads to macroeconomic volatility and hence worsens monetary policy trade-offs. However, since the SFR mainly affects the composition of bank funding rather than the cost, the SFR does not affect the transmission of other macroeconomic disturbances that do not affect the bank funding spread. Since bank funding spread disturbances have a negligible influence on the business cycle, the operation of monetary policy is little changed in the presence of the SFR. The additional macroeconomic volatility generated by the presence of the SFR can be diminished and monetary policy trade-offs can be improved if: (i) the central bank raises the interest rate to react systematically to increases in measures of credit growth in the economy and (ii) the SFR policy is varied over time to respond to credit  growth.

 

Marketplace Lender Enthusiasm Confronts Market Realities – Fitch

After an extended period of rapid growth and increasing acceptance for marketplace lenders globally, several market dynamics are testing the business model’s long-term viability, Fitch Ratings says. These changes are forcing marketplace lenders to seek alternative funding sources, expand their product offerings, modify their underwriting approaches and address heightened regulatory scrutiny.

The challenges underscore the unproven nature of the marketplace lender business model – which was originally premised on funding loans primarily via retail investor demand – through the economic cycle. The extent to which marketplace lenders can navigate these challenges without adversely impacting their risk profiles and profitability will determine the sector’s long-term success.

A sustained period of historically low interest rates prompted an increased funding appetite among banks and other institutional investors for marketplace loans. As institutional demand waned in recent months, marketplace lenders began to seek alternative funding sources to sustain loan originations. For example, Social Finance (SoFi) recently launched a quasi-captive hedge fund purposed with investing in loans originated by SoFi as well as other marketplace lenders.

Some marketplace lenders also responded to reduced funding availability by raising loan pricing to attract funding; however, this reduces the competiveness of marketplace lenders’ lending rate (if the cost is passed to the borrower) or adversely impacts profitability (if the lender absorbs the cost). Passing higher funding costs through to borrowers is also harder to implement for lenders targeting higher quality borrowers.

The marketplace lender business model has yet to endure either a full interest rate cycle or credit cycle, so the resilience of current models under rising interest rates and/or rising credit losses is uncertain. Pockets of recent credit underperformance beyond initial expectations have likely contributed to the ongoing refinement of underwriting models, including further de-emphasizing of the use of traditional FICO scores in certain instances. Marketplace lenders are also exploring product expansion into adjacent lending products such as mortgages, small business loans, and autos, which Fitch views as tacit acknowledgement that business models, as currently constituted, may not have the diversity to flourish if core product growth is constrained.

Marketplace lenders’ rapid growth has attracted heightened regulation and legal risk (Madden v. Midland), which may force changes to loan pricing and risk sharing, as evidenced by recent changes implemented at Lending Club with respect to its relationship with WebBank. In this case, LendingClub gave up a portion of its revenue to WebBank in an effort to preserve its exemption from state-specific usury rate caps.

Fitch considers greater regulatory oversight to be inevitable with the distinctions between marketplace lenders and traditional lenders continuing to blur as marketplace lenders adapt their funding models to economic realities.

Several US federal and state regulators have begun to seek more information about the marketplace lending industry with the expectation of producing a more formal regulatory framework. LendingClub, Prosper Marketplace and Funding Circle established an industry trade group, the Marketplace Lending Association, to respond to regulatory scrutiny and establish certain industry operating standards.

Likewise, the regulatory environment has begun to evolve outside of the US. For example, regulators in China seem poised to tighten oversight of the industry given the rapid growth in loans originated in that region over the past few years and the degradation in credit performance that has ensued, driving some lenders out of business.

RBA Financial Stability Review Released Today; And All Is Well…ish

The RBA released the latest edition of the Financial Stability Review. Whilst they highlight the risks in emerging markets and higher bank funding costs, they argue local banks have limited exposure to these issues, households and business are financially sound and banks have tightened lending standards (as shown by lower LVRs and bigger affordability buffers) so predicted losses remain low, whilst profitability is strong. They are not concerned about high household debt ratios. The RBA also highlights the capital improvements which are in train. So overall they argue the financial sector is well positioned (though with a few issues to work though, for example, exposures to New Zealand Dairy and Property, Resource sector, property development, Insurance sector).  They also say the tighter access to credit for households could pose near-term challenges in some medium- and high-density construction markets given the large volume of building activity that was started several years ago. They also suggest some foreign banks operating here could be under more pressure.

They examined Chinese buyers in the Australian Property Market.

Chinese investment in Australian residential and commercial property has increased significantly in recent years. This interest in property from Chinese households, institutional investors and developers is not unique to Australia; they are also active in the property markets of other countries, such as the United States, the United Kingdom, Canada and New Zealand.

The Australian banking system’s direct exposure to Chinese property investors and developers appears to be small. However, if Chinese demand were to decline significantly, that could weigh on domestic property prices and so lead to losses on the banks’ broader property-related exposures. Non-resident Chinese buyers own only a small portion of the Australian housing stock, but industry contacts suggest that they account for a significant and increasing share of purchases. These purchases are largely concentrated in off-the-plan apartments (especially in Sydney and Melbourne), in part because all foreign buyers, other than temporary residents, are generally restricted to purchasing newly constructed dwellings. Consistent with observations by industry contacts, the limited and partial data available from the Foreign Investment Review Board (FIRB) suggest that approvals for all non-residents applying to purchase residential property have increased substantially of late. The majority of these approvals are for new dwellings in New South Wales and Victoria. China is the largest source of approved investment in (residential and commercial) real estate and its share of total approvals is growing, but it still only accounts for a small fraction of overall market activity.

Nonetheless, if a significant subset of buyers reduce their demand sharply, this can weigh on housing prices, and Chinese buyers are no exception to this given their growing importance in segments of the Australian market. Such a reduction in housing demand could result from a number of sources, including:

  • A sharp economic slowdown in China that lowers Chinese households’ income and wealth. Any accompanying depreciation of the renminbi against the Australian dollar could further reduce their capacity to invest in Australian housing. In the extreme, Chinese investors may need to sell some of their existing holdings of Australian property to cover a deteriorating financial position at home. A macroeconomic downturn in China could also be expected to have knock-on effects on other countries in the region, which could also affect those countries’ residents’ capacity and appetite to invest in Australian property. On the other hand, if economic prospects in China deteriorate this could make investment abroad, including in Australia, more attractive and result in an increase in demand for Australian property.
  • A further tightening of capital controls by the Chinese authorities that restricts the ability of Chinese households to invest abroad.
  • A domestic policy action or other event that lessens Australia’s appeal or accessibility as a migration destination, including for study purposes. Industry contacts suggest that in addition to wealth diversification, many Chinese purchases are dwellings for possible future migration, housing for children studying in Australia or rental accommodation targeted at foreign students. If so, this demand could be expected to be fairly resilient to shorterterm fluctuations in conditions in China or developments in the domestic property market, but more sensitive to changes in migration or education policy.

A substantial reduction in Chinese demand would likely weigh most heavily on the apartment markets of inner-city Melbourne and parts of Sydney, not only because Chinese buyers are particularly prevalent in these segments but also because other factors would reinforce any initial fall in prices. These include the large recent expansion in supply in these areas as well as the practice of buying off the-plan, which increases the risk of price declines should a large volume of apartments return to the market if the original purchases fail to settle.

The Australian banking system has little direct exposure to Chinese investors. Australian owned banks engage in some lending to foreign households to purchase Australian property, but the amounts are small relative to their mortgage books. Australian-owned banks also have tighter lending standards for non-residents than domestic borrowers, such as lower maximum loan-to-valuation ratios, because it is harder to verify these borrowers’ income and other details, and because the banks have less recourse to these borrowers’ other assets should they default on the mortgage.

Australian branches of Chinese-owned banks appear to be more willing to lend to Chinese investors because they are often in a better position to assess these borrowers’  creditworthiness, particularly where they have an existing relationship. Nonetheless, although the direct exposures are small, if a reduction in Chinese demand did weigh on housing prices this could affect banks’ broader mortgage books to some extent.

Whats Really Going On With Investment Housing Lending?

The ABS data on lending finance was issued on Wednesday, and the seasonally adjusted numbers caught the headlines. Housing finance was up 1.7% month on month, and commercial finance was up 5.6%. However, the seasonally adjusted numbers have lots of noise in the data, we we think they obscure what is really going on. So, first we look at the trend data. Overall credit flows fell by 0.9% in the month.  Within that secured housing fell 0.6%, whilst secured lending for alternations and additions rose 0.5%.  Revolving credit (mainly credit cards) fell 1.7% as households continues to pay off the Christmas binge, but fixed loans rose 0.5%. Commercial fixed loans (which include housing investment loans), fell 1.6%. However, the value of housing investment loans were line ball from last month, so the fall was from other commercial sectors, which is not good.

As a result, we see from the summary chart that the proportion of fix commercial lending NET of housing investment fell, from 28.7% to 28.2%, so in trend terms, lending for commercial purposes continued to fall. Assuming that lending is correlated to prospective economic growth, this is bad news.

On the other hand, lending for investment housing was still very present, and lifted to 35.3% of all secured housing loans. Investment lending still has momentum. Also, now we are seeing more households deciding to stay put and renovate. We expect lending demand for renovations to be strong in coming months.

ABD-Feb-2016-All-Lenidng

The other piece of data which is important is the state lending footprint. Some made much of the apparent fall in investment lending in NSW, but taking the original data (there are no trend or seasonally adjusted series), and using a rolling average over 3 months, we see a different story. The best way to look at this is to compare lending for investment housing (sum of new construction and purchase of existing dwellings for rental), compared with all commercial lending. When we look at the series, we do see a small fall in NSW, though with an upward inflection in the latest data. But we see that NSW has a lower relative share of housing investment loans compared with QLD and WA. In fact relatively there has been a greater proportion of investment loans written in these states for since 2011. VIC is also lower, though above NSW. So, the story about the great fall in housing investment momentum in NSW is over done. On the other hand, we should be more concerned about the ongoing investment momentum in QLD and WA, where house prices are set to ease, and mining re-balancing is most at work. We think the risks are higher here.

State-Inv-Lending-Feb-2016 We are still not seeing sustained commercial investments which are required to drive true economic growth. Housing is still doing too much of the heavy lifting, with household debt as high as it has ever been.

Bendigo and Adelaide Bank Update

In their business strategy and trading update today, they recapped on lending growth which  has been below system, and that they have a cost to income ratio which is still high (~2% above Suncorp).

Ben4NIM is under some pressure.

Ben6However, the bank is quite well positioned from a funding perspective. 81% is deposit funded, could go higher, this is significant because RMBS market funding pricing is line ball at the moment. They have moved from 20% to 6% RMBS, and this has created a capital headwind, so they will most likely focus on senior funding.

Ben7In terms of Strategy, Bendigo and Adelaide Bank, describes its aim to build around customer engagement and staff engagement, with an expectation that digital channels and customer centricity will out.

Ben3They are driving towards 24/7 digital platform, underpinned by their core banking system. Their vision is to be the most customer connected bank with a focus on customer service and the strengthening of core relationships.

Ben5However it is clear they are banking on benefits of moving from standard to advanced IRB capital model. Whilst they may wish to move to this basis, and this may be a phased implementation, it will be APRA who is holding the implementation cards. There is a benefit as their current mortgage risk weighting is about 39 basis points, whereas the major banks have a 25 basis point target by July 2016.

Homesafe will continue to be a drag on the business if property valuations in the major centres fall as the portfolios have to be marked to market, they of course had upside in the good times! 3Q16 Homesafe contribution was -$1.6m pre-tax. There are 2,500 contracts in the portfolio, average $125,000 funded.

Ben8Lending will be important and they wish to grow their books, with a focus on mortgages and small business (both highly contested areas). Arrears on mortgages and business seem under control.

Ben9Ben10They have a significant investment path in order to build the digital platform and IRB models. Restructure costs will be $2m or more in the half. The question will be whether the benefits out way the costs. You cannot really argue with the strategy, (though, it is not really a mobile first strategy), but its all about effective execution in a highly contested environment. The high customer satisfaction ratings will certainly assist.

 

Where Did The 10% Investor Mortgage Growth Speed Limit Come From?

An interesting FOI disclosure from the RBA tells us something about the discussions which went on within the regulators in 2014 and beyond, as they considered the impact of the rise in investor loans. Eventually of course APRA set a 10% speed limit, and we have see the growth in investment loans slow significantly and underwriting standards tightened.

Back then, they discussed the risks of investment lending rising, especially in Melbourne.

Macroeconomic: Extra speculative demand can amplify the property price cycle and increase the potential for prices to fall later. Such a fall would affect household spending and wealth. This effect is likely to be spread across a broader range of households than the investors that contributed to the heightened activity.

Concentration risk: Lending has been concentrated in Sydney and Melbourne, creating a concentrated exposure in these cities. The risk could come from a state-based economic shock, or if the speculative upswing in demand brings forth an increase in construction on a scale that leads to a future overhang of supply. In Sydney, the risk of oversupply appears limited because of the pick-up in construction follows a period of limited new supply and it has been spread geographically and by dwelling type. While the unemployment rate has picked up a little over the past 18 months, the overall economic environment in NSW is in a fairly good state. In Melbourne, there has been a greater geographic concentration of higher-density construction in inner-city areas. Some developments have a concentration of smaller-sized apartments that may only appeal to some renters, or purchasers in the secondary market. Economic conditions are not as favourable in Victoria and the unemployment rate is 6.8%.

Low interest rate environment: While a pick-up in risk appetite of households is to some extent an expected outcome given the low interest rate environment, their revealed preference is to direct investment into the housing market.  Historically low interest rates (combined with rising housing prices and strong price competition in the mortgage market) means that some households may attempt to take out loans that they would not be able to comfortably service in a higher interest rate environment. APRA’s draft Prudential Practice Guide (PPG) emphasises that ADIs should apply an interest rate add-on to the mortgage rate, in conjunction with an interest rate floor in assessing a borrower’s capacity to service the loan. In order to maintain the risk profile of borrowers when interest rates are declining, the size of the add-on needs to increase (or the floor needs to be sufficiently high).

Lending standards: In aggregate, banks’ lending standards have been holding fairly steady overall; lending in some loan segments has eased a little, while lending in some other segments has tightened up a bit. The main lending standard of concern is the share of interest-only lending, both to owner-occupiers and investors. For investors, 64% of banks’ new lending is interest-only loans and for owner-occupiers the share is 31%. The typical interest-only period is 5 years, but some banks allow the interest-only period to extend to 15 years. During this period, the loan is amortising more slowly than a loan that requires principal and interest (P&I) payments. If housing prices should fall, this increases the risk that the loan balance may exceed the property value (negative equity). There is some risk that the borrower could face difficulty servicing the higher P&I payments when the interest-only period ends, although this is typically mitigated by banks assessing interest-only borrowers on their ability to make P&I payments.

Of course the regulators found underwriting standards were more generous than they thought, at times in 2015 more than half of all new loans were investment loans, and recently banks have reclassified loans, causing the absolute proportion of investment loans to rise. Things were whose than they thought.

Next they discussed how to set the “right” growth rate:

How to calibrate the benchmark growth rate?  Household debt has been broadly stable as a share of income for about a decade. National aggregate ratios are not robust indicators of a sector’s resilience because the distribution of debt and income can change over time. But as a first pass, it is reasonable to expect that the current level of the indebtedness ratio is sustainable in a range of macroeconomic circumstances. Therefore there does not seem to be a case to set the benchmark growth rate significantly below the rate of growth of household income, in order to achieve a material decline in the indebtedness ratio. With growth in nominal household disposable income running at a little above 3 per cent, this sets a lower bound for possible benchmarks at around 3 per cent. Current growth in investor credit, at nearly 10 per cent, suggests an upper bound around 8 per cent to achieve
some comfort about the leverage in this market. Within this range, there are several options for the preferred benchmark rate for investor housing credit growth (including securitised credit).

a) Around 4½ per cent, based on projected household disposable income growth over calendar 2015. This could be justified as being consistent with stabilising the indebtedness ratio. However, it would be procyclical, in that it would be responding to a period of slow income growth by insisting that credit growth also slow. It would also be materially slower than the current rate of owner-occupier credit growth, which so far has not raised systemic concerns.

b) Around 6 per cent, based on a reasonable expectation of trend growth in disposable income, once the effects of the decline in the terms of trade have washed through. It is also broadly consistent with current growth in owner-occupier housing credit, which as noted above has not been seen as adding materially to systemic risk.

c) 7 per cent, consistent with the system profile for residential mortgage lending already agreed as part of the LCR/CLF process. Unless owner-occupier lending actually picks up from its current rate, however, the growth in investor housing credit implied by the CLF projections would be stronger than this. It is therefore not clear that these projections should be the basis for the preferred benchmark.

Staff projections suggest that only a moderate decline in system investor loan approvals would be required to meet a benchmark growth rate for investor housing credit in the 5–7 per cent range for calendar 2015. The exact size of the decline depends partly on assumptions about repayments through churn, refinancing and amortisation in the investor housing book. For a reasonable range of values for this implied repayment rate, and assuming that investor housing credit growth remains at its current rate for the remainder of 2014, the required decline in investor approvals is of the order of 10–20 per cent. This would take the level of investor housing loan approvals back to that seen a year ago. It is worth noting that investor loan approvals would have to increase noticeably from here to sustain the current growth rate of investor housing credit, even though the implied repayment rate is a little below its historical average. Since credit is not available at a state level, the benchmark can only be expressed as a national growth rate. The flow of loan approvals at a state level can be used as a cross-check to ensure that the benchmark incentive has had its greatest effects in the markets that have been strongest recently.

When the 10% cap (note this is higher than those bands discussed above) was announced, some Q&A’s provide some insights into their thinking.

Isn’t 10 per cent a bit soft?  We are not trying to kill the market stone dead. Investor housing credit is currently running at a bit under 10 per cent. Some lenders will have investor credit growth well below this benchmark anyway, so if all lenders do end up at least a little under this benchmark, which we hope they will, then aggregate growth in investor credit will be noticeably below 10 per cent. Setting a benchmark for individual institutions is not the same thing as setting it for an aggregate, and APRA has allowed for that.

Where did the 10 per cent benchmark come from?  This was a collective assessment by the Council agencies. We took the view that we did not want to clamp down on the market excessively. We also took the view that in the long run, household credit can expand sustainably at a rate something like the rate of trend nominal household income growth, maybe a bit more or less in shorter periods. Trend income growth is below 10 per cent, more like 6 per cent or thereabouts. But it was important to make an allowance for the fact that some lenders will undershoot the benchmark, so the aggregate result will likely be slower than that.

But isn’t household income growth likely to be below average in the next few years, because of the end of the mining boom?  Maybe, but we don’t want to be procyclical and clamp down on credit supply more when the economy growing below trend.

This of course confirms the regulators were wanting to use household debt as an economic growth engine (interesting, see the recent post “Why more-finance-is-the-wrong-medicine-for-our-growth-problem” )

We also see a significant slow down in household income growth, yet credit growth, especially housing has been stronger, creating higher risks if interest rates or unemployment was to rise. Raises the question, were the regulators too slow to act, and did they calibrate their interventions correctly? We will see.

 

Risks to Global Financials Stability Have Increased – IMF

The IMF just released the latest edition of its Global Financial Stability Report.  It’s 118 pages makes grim reading. They highlight a number of elevated risks, and advocate more proactive policies, including the adoption of macroprudential measures. They highlight elevated funding risks to banks, risks to banking models from the ultra low interest rates, and disruption to global asset markets. Significantly, the indicators are that interest rates are likely to fall, not rise.

IMF-GFS-2016-1Risks to global financial stability have increased since the October 2015 Global Financial Stability Report. In advanced economies, the outlook has deteriorated because of heightened uncertainty and setbacks to growth and confidence.

Disruptions to global asset markets have added to these pressures. Declines in oil and commodity prices have kept risks elevated in emerging market economies, while greater uncertainty about China’s growth transition has increased spillovers to global markets. These developments tightened financial conditions, reduced risk appetite, raised credit risks, and stymied balance sheet repair, undermining financial stability.

Many market prices dropped dramatically during the turmoil in January and February, moving asset valuations to levels below those consistent with macroeconomic fundamentals that suggest a steady but slowly improving growth path (see the April 2016 World Economic Outlook). Instead, heightened market volatility and risk aversion may have reflected rising economic, financial, and political risks as well as weakened confidence in policies. The recovery in asset prices since February has reversed much of these losses and lowered volatility. Market sentiment has been supported by higher oil and commodity prices, stronger data out of the United States, and supportive actions by central banks. But the net impact of the turmoil has been a shock to confidence, with negative repercussions for financial stability.

The main message of this report is that additional measures are needed to deliver a more balanced and potent policy mix for improving the growth and inflation outlook and securing financial stability. In the absence of such measures, market turmoil may recur. In such circumstances, rising risk premiums may tighten financial conditions further, creating a pernicious feedback loop of fragile confidence, weaker growth, lower inflation, and rising debt burdens. Disruptions to global asset markets could increase the risks of tipping into a more serious and prolonged slowdown marked by financial and economic stagnation. In a situation of financial stagnation, financial institutions responsible for the allocation of capital and mobilization of savings might struggle with impaired balance sheets for an extended period of time. Financial soundness could become eroded to such an extent that both economic growth and financial stability are adversely affected in the medium term. In such a scenario, world output could fall by 3.9 percent relative to the baseline by 2021.

Policymakers need to build on the current economic recovery and deliver a stronger path for growth and financial stability by tackling a triad of global challenges—legacy challenges in advanced economies, elevated vulnerabilities in emerging markets, and greater systemic market liquidity risks. Progress along this path will enable the world’s economies to make a decisive break toward a strong and healthy financial system and a sustained recovery. In such a scenario, world output could expand by 1.7 percent relative to the baseline by 2018.

Advanced economies must deal with crisis legacy issues. Banks in advanced economies have become safer in recent years, with stronger capital and liquidity buffers and progress in repairing balance sheets. Despite these gains, banks came under market pressure at the start of the year, reflecting concerns about the profitability of banks’ business models in a weak economic environment. Approximately 15 percent of banks in advanced economies (by assets) face significant challenges in attaining sustainable profitability without reform.

IMF-GFS-2016-2 In the euro area, market pressures also highlighted long-standing legacy issues, indicating that a more complete solution to European banks’ problems cannot be further postponed. Elevated nonperforming loans urgently need to be tackled using a comprehensive strategy, and excess capacity in the euro area banking system will have to be addressed over time. In the United States, mortgage markets—which were at the epicenter of the 2008–09 crisis—continue to benefit from significant government support. Authorities should reinvigorate efforts to reduce the dominance of Fannie Mae and Freddie Mac and continue with reforms of these institutions.

Chapter 3 shows that across advanced economies, the contribution of the insurance sector—particularly life insurers—to systemic risk has increased, although not yet to the level of the banking sector. This increase is largely a result of growing common exposures to aggregate risk, partly because insurers’ interest rate sensitivity has risen and partly because of higher correlations across asset classes. In the event of an adverse shock, therefore, insurers are unlikely to fulfill their role as financial intermediaries at a time when other parts of the financial system are also struggling to do so. These findings suggest that a more macroprudential approach to supervision and regulation of insurance companies should be taken. Measures could include regular macroprudential stress testing or the adoption of countercyclical capital buffers. Steps that would complement a push for stronger macroprudential policies include the international adoption of capital and transparency standards for the sector. In addition, the different behavior of smaller and weaker insurers warrants attention by supervisors.

Emerging markets need to bolster their resilience to global headwinds. Emerging market economies are faced with a difficult combination of slower growth, weaker commodity prices, and tighter credit conditions, amid more volatile portfolio flows. This mixture has kept financial and economic risks elevated. So far, many economies have shown remarkable resilience to this more difficult domestic and external environment, as policymakers have made judicious use of buffers in strengthened policy frameworks.

Commodity-related firms are cutting capital expenditures sharply as high private debt burdens reinforce risks to credit and banks. Commodity exporting countries and those in the Middle East and the Caucasus are particularly exposed to strains across the real economy and the financial sector. The nexus between state-owned enterprises (SOEs) and sovereigns has intensified, and could increase fiscal and financial stability risks in countries with repayment pressures. More broadly, debt belonging to nonfinancial corporations with reduced ability to repay have risen to $650 billion, or 12 percent of total corporate debt of listed firms considered in this report. Bank capital buffers are generally adequate, but will likely be tested by weaker earnings and the downturn in the credit cycle.

Emerging market economies generally have the tools to boost their resilience and counter the effects of lower commodity prices and the slowdown in growth and capital flows. Authorities in emerging market economies should continue to use their buffers and policy space, where available, to smooth adjustment and strengthen sovereign and bank balance sheets. This includes using external buffers, fiscal and monetary policy, and macroprudential and supervisory frameworks, among other tools. Countries with insufficient buffers and limited policy space should act early by adjusting macroeconomic policies to address their vulnerabilities, including by seeking external support.

China’s economic rebalancing is gaining traction. The country has made notable progress in rebalancing its economy toward new sources of growth and addressing some financial sector risks. In addition, stricter regulation of shadow banking activities has helped steer the composition of financing toward bank loans and bond issuance. Nevertheless, China’s rebalancing is inherently complex, and commitment to a more ambitious and comprehensive policy agenda is urgently needed to stay ahead of rising vulnerabilities.

Slowing growth has eroded corporate sector health, with falling profitability undermining the debt servicing capacity of firms holding some 14 percent of the debt of listed companies, adding to balance sheet stresses across the system. A comprehensive plan to address the corporate debt overhang would assist a steady deleveraging process. Corporate deleveraging should be accompanied by a strengthening of banks and social safety nets, especially for displaced workers in overcapacity sectors. A comprehensive restructuring program to deal with bad assets and strengthen banks should be developed swiftly, along with a sound legal and institutional framework for facilitating bankruptcy and debt-workout processes.

Chapter 2 finds that spillovers of emerging market shocks to equity prices and exchange rates have risen substantially, and now explain more than a third of the variation in asset returns. This underscores the importance for policymakers in both advanced economies and emerging markets of taking account of economic and policy developments in emerging market economies when assessing domestic macro-financial conditions.

Financial integration, more than economic size and trade integration, is key to an emerging market economy’s role as receiver and emitter of financial spillovers. The level of integration explains, for example, why purely financial contagion from China remains less significant even as the impact of Chinese growth shocks is increasingly important for equity returns in both emerging market and advanced economies. As China’s role in the global financial system continues to grow, clear and timely communication of its policy decisions and transparency about its policy goals and strategies consistent with their achievement will be ever more important. Given the evident relevance of corporate leverage and mutual fund flows in amplifying spillovers of shocks, shaping macroprudential surveillance and policies to contain systemic risks arising from these channels will be vital.

The resilience of market liquidity should be enhanced. As discussed in previous reports, a comprehensive approach to reducing risks of liquidity runs on mutual funds and strengthening the provision of market liquidity services is needed to avoid the risk of amplifying market shocks.

The stakes are high. First, rising risks of weakening growth and more instability must be avoided. Then, growth must be strengthened and financial stability improved beyond the baseline. An ambitious policy agenda is required, comprising a more balanced and potent policy mix, including stronger financial reforms together with continuing monetary accommodation. Increased confidence in policies will help reduce vulnerabilities, remove uncertainties, and touch off a virtuous feedback loop between financial markets and the real economy.

Why it is good policy, not bad politics, to ignore bad modelling on negative gearing

From The Conversation.

Negative gearing and capital gains tax are a looming battleground in the federal election. The debate was heightened last month by the release of modelling by consultants BIS Shrapnel purporting to show that reforms would lead to rent increases of between 4% and 10%. If correct, this would scare any political party.

An article in The Australian on Tuesday revealed that the ALP had seen this modelling before it released its policy to wind back the tax breaks on negative gearing and capital gains,

The ALP should be applauded for proceeding nevertheless. The report was clearly going to be inconvenient. But it was also not worth the paper on which it was printed.

The report implied that a $2 billion increase in tax would reduce economic activity by $19 billion a year. The report’s model also suggested that every additional house or apartment would increase the size of the Australian economy by $2.6 million.

None of this is remotely plausible, and consequently, it is difficult to believe anything else that the modelling or the report has to say.

Nonetheless, this report is still being discussed a month later – so it clearly needs some more critical analysis.

Tax changes will clearly reduce the after tax benefits for property investors. The key question is whether the market responds by reducing the price of housing, or by increasing rents, or by absorbing a reduction in returns.

Most likely, the price of housing will fall somewhat, investor returns will reduce a little, and rents will barely move. This is why.

Changes to negative gearing and capital gains tax will increase taxes for investors and lower their returns. Normally this would lead to lower asset prices.

But the outlook for home-buyers is different. The benefits for a home-buyer (of living in the home) won’t change. The price of the home will be a little lower due to the changes in negative gearing and capital gains tax. Therefore the return on assets (the benefits divided by the price) will be a little higher for home-buyers.

Combining the effects of the changes for investors and home-owners leads to an average after tax return on housing that is about the same as today. There will be more home-owners and correspondingly fewer investors – but higher rates of home ownership are the political goal.

The outcome might be different if the supply of new housing dried up. If there were fewer incentives to develop new homes, then eventually rents would increase.

However, our best guess is that tax changes will have little effect on housing construction. The supply of new housing is mainly restricted by planning rules rather than a lack of returns. In any case, reforms to negative gearing are likely to reduce the price of developable land, but they won’t change the returns on development.

BIS Shrapnel assume otherwise. They believe that changes to negative gearing rules will reduce the price and therefore the profitability of property developments, but not the price of developable land. And so they assert that tax changes will lead to less residential development, and therefore higher rents in the long run. Their report assumed that the price of developable land wouldn’t change based on three claims.

First claim: if the price of developable housing land fell, sites would instead be used for commercial purposes. But as a firm that advises clients on property development, BIS Shrapnel should know that in most localities land provides a much higher return per square metre when turned into residences than when used for commercial purposes. Indeed, there are concerns that too much of the Melbourne and Sydney CBDs is being converted to residential rather than commercial uses. There isn’t much evidence of enormous pent-up demand for commercial development.

Second claim: landholders will be reluctant to sell at lower prices. This is simply wishful thinking. Prices don’t rise just because sellers would like them to do so.

Third claim: it will be more expensive to aggregate sites for development. But lower prices as a result of negative gearing reform will affect all residential properties, irrespective of whether they have already been developed, or have potential to be aggregated further.

Instead of assuming that tax changes will only affect the price of development, it is much more plausible that changes in after tax returns to investors will primarily lead to lower land prices. This won’t hurt the profitability of development, the supply of rental property will continue, and the impacts on rents will be minimal.

Even if tax changes did affect the profitability of development, it’s all small beer. Quick sanity checks (the kind of things that property developers do to ensure that their modellers don’t lose them a fortune) show that the effect of negative gearing changes on property prices will be less than 2 per cent across the Australian market.

One way to think about it is that negative gearing and capital gains tax provide investors in real estate with a tax benefit of about $3 billion a year; that annual benefit converts to an asset value of about $55 billion; and all Australian residential property is worth a little over $5 trillion. If negative gearing were abolished entirely the lost value would be $55 billion, just over 1 per cent of $5 trillion of property value.

Another way to crunch the numbers shows that negative gearing and capital gains tax changes would reduce the after tax returns on real estate investment assets by about 7 per cent. But this wouldn’t affect all housing assets – only 30 per cent are investment properties, and the rest are owner occupied. So across the market, return on assets – and therefore asset values –would fall by about 2 per cent. Or in the unlikely event that investors succeed in passing on tax costs, rents would rise by at most 2 per cent.

BIS Shrapnel presented the ALP with a claim that tax changes would increase rents by 4 to 10 per cent. But that claim was several times larger than fundamentals would suggest. It used a model that was not publicly available. It was allied with a series of manifestly ridiculous economic results. And it all rested on an unjustifiable assumption that tax changes won’t affect land prices.

The ALP was right to ignore such flawed analysis. It is a relief to discover that – sometimes – a political party’s policy cannot be bought off just by commissioning a flawed report with scary numbers.

Author: John Daley, Chief Executive Officer , Grattan Institute

Real Estate Investment In Australia From China Doubled Last Year – FIRB

China foreign investment in real estate in Australia doubled that last year, according to the Foreign Investment Review Board (FIRB) in their annual report for the year 2014-2015. Total foreign investment approvals across all categories were worth $194.6 billion. No applications were rejected last year, though some were approved only with conditions.

Looking at the real estate sector, we see significant growth in applications compared with previous years.

FIRB-2014-1Approved investment in real estate (comprising commercial and residential proposals) was $96.9 billion in 2014-15 (compared with $74.6 billion in 2013-14). Residential approvals rose from $34.7 billion in 2013-14 to $60.75, of which $49.25 billion were for development.

Looking at the state analysis, VIC leads the way in terms of the number and value of approvals. For example VIC had $20.6 billion of developments for approval, compared with $16.24 billion in NSW.

FIRB-2014-2The FIRB report includes a state analysis by type of development

FIRB-2014-3Our analysis shows the largest proportion of new dwelling approvals in NSW, compared with VIC and QLD. On the other hand, VIC had the highest proportion of existing property and vacant land approvals.

FIRB-2014-4The Country data provided by the FIRB report does not separate residential real estate from commercial property. That said, the data shows China as the largest investor, based on number of approvals and value. In the previous year, China originated 14,716 approvals, compared with 25,431 in 2014-15 overall, whilst real estate was worth $12.4 billion in 2013-14 compared with $24.3 billion in 2014-15.

FIRB-2014-5