ASIC publishes a review of reverse mortgage lending

ASIC’s review of the reverse mortgage industry highlights that some taking a reverse mortgage could face financial difficulty later in life. This despite the fact that borrowers can never owe the bank more than the value of their property, and can remain in their home until they pass away or decide to move out

Thus, while this type of finance may assist older home owners (70% aged 55-85 own their own home), they face the dual risks of compounding effects on the original loan value as interest is rolled up…

… and significant risks should home prices fall, leading to loss of all or most capital.  63% of borrowers may end up with less equity than the average upfront cost of aged care for one person by the time they reach 84.

Plus there is limited competition, as just 2 credit licensees wrote 80% of the dollar value of new loans from 2013 to 2017.

A review by ASIC has found that reverse mortgages are allowing older Australians to achieve their immediate financial goals – improving their lifestyles in retirement – but longer-term challenges exist.

For older Australians who own their home with few other assets, a reverse mortgage can allow them to draw on the wealth locked up in their homes, while they continue to live in their property.

ASIC reviewed data on 17,000 reverse mortgages, 111 consumer loan files, lender policies, procedures, and complaints. We also commissioned in-depth interviews with 30 borrowers and consulted over 30 industry and consumer stakeholders.

The review found borrowers had a poor understanding of the risks and future costs of their loan, and generally failed to consider how their loan could impact their ability to afford their possible future needs. Lenders have a clear role to play here and need to do more: for nearly all of the loan files we reviewed, the borrower’s long term needs or financial objectives were not adequately documented.

Importantly, under legal protections in place since 2012, borrowers can never owe the bank more than the value of their property, and can remain in their home until they pass away or decide to move out. However, depending on when a borrower obtains their loan, how much they borrow, and economic conditions (property prices and interest rates), they may not have enough equity remaining in the home for longer term needs (e.g. aged care).

ASIC Deputy Chair Peter Kell said “Reverse mortgage products can help many Australians achieve a better quality of life in retirement.”

“But our review shows that lenders and brokers need to make inquiries that would lead to a genuine conversation with customers about their possible future needs, not just a set of tick boxes on a form.”

ASIC’s report also finds that there is an opportunity for lenders to reduce the risk of elder abuse. Under the new Code of Banking Practice, recently approved by ASIC, banks will be required to take extra care with customers who may be vulnerable, including those who are experiencing elder abuse.

Consumers also had limited choices for finding a reverse mortgage. Several providers withdrew from the market after the global financial crisis. From 2013 to 2017, two credit licensees provided 80% of the dollar value of new loans from 2013 to 2017.

Background

Reverse mortgages are a credit product that allows older Australians to borrow using the equity in their home. The loan does not need to be repaid until a later time, typically when the borrower has vacated the property or passed away. They are a more expensive form of credit compared to standard variable owner occupier home loans; the interest rates are typically 2% higher and, as there are no repayments required, interest compounds.

Consumer demand for reverse mortgages has grown gradually since the global financial crisis, with the total exposure of ADIs to reverse mortgages increasing from $1.3 billion in March 2008 to $2.5 billion by December 2017.

ASIC commenced a review of lending practices and consumer outcomes in the reverse mortgage market to proactively examine issues that might emerge for older Australians.

As part of this review, we evaluated the effectiveness of enhanced responsible lending obligations for reverse mortgages which were introduced five years ago into the National Consumer Credit Protection Act 2009 (National Credit Act).

This review examined five brands, who collectively lent 99% of the dollar value of approved reverse mortgage loans in 2013-17. These brands were: Bankwest, Commonwealth Bank, Heartland Seniors Finance, Macquarie Bank and Westpac (comprising St George Bank, the Bank of Melbourne and BankSA). As of late 2017, Macquarie Bank and Westpac are no longer providing new reverse mortgages.

This project forms part of ASIC’s broader work for older Australians to help bring about positive changes for these consumers in credit and financial services: see REP 537 Building seniors’ financial capability report 2017 and REP 550 ASIC’s work for older Australians.

ASIC’s MoneySmart website has information for consumers about reverse mortgages. Consumers can also use MoneySmart’s reverse mortgage calculator to see how a reverse mortgage can impact the equity in their home.

CIF to propose ‘customer first duty’ for brokers

The Combined Industry Forum has agreed “in principle” to extend its good consumer outcomes requirement to incorporate a “conflicts priority rule” as a “customer first duty”, via The Adviser.

In its interim report, released on Monday (27 August), the Combined Industry Forum (CIF) stated that throughout 2018, it has been considering ways to build upon its good customer outcomes reforms published in its response to the Australian Securities and Investments Commission’s (ASIC) review into mortgage broker remuneration.

In its review, ASIC noted that a broker would satisfy the requirement if the “customer has obtained a loan which is appropriate [in terms of size and structure], is affordable, applied for in a compliant manner and meets the customer’s set of objectives at the time of seeking the loan.”

However, the CIF has proposed that the provision could be extended to include a “conflicts priority rule”.

“The ‘conflict priority rule’ could be formulated as a requirement for the customer’s interests to be placed above the providers, or those of their organisation, based on the information reasonably known to the provider, at the time of providing the service,” the CIF noted.

“The effect of this approach would be a requirement to place the customer’s interests first. The combination of the good customer outcome definition and a customer first duty allows both an easy to follow principle – put the customer’s interests first – and structure to follow for brokers when assessing loan suitability.”

The CIF added that further governance metrics could be built for “monitoring and oversight”.

However, the CIF acknowledged that the development and application of the customer first duty is “multifaceted and complex”, noting that “there may be unknown impacts”.

“These include the potential for limiting access to credit, and a disproportionate impact on smaller and regional lenders if lender panels require rationalisation,” the CIF continued.

The CIF noted that it had “not yet settled on a final position”, but claimed that the reform should be underpinned by the following principles:

  • placing the customer first, and having ‘good’ consumer outcomes at the centre of its approach
  • fit-for-purpose for the mortgage broking industry, considering the nature of services provided, the form of conflicts of interests inherent to the industry, the current evidence of risks to customer outcomes, and considering the current regulatory framework
  • promoting competition, and ensuring that no part of the value chain is unfairly disadvantaged
  • all parts of the value chain will have a role to play to support the implementation and monitoring the customer duty
  • providing transparency for all participants, and
  • promoting simple, achievable solutions. Finally, the CIF is aware that there is merit in moving a customer first principle from an implicit expectation, to an explicit statement that a customer and mortgage advice provider can easily understand.

The CIF concluded that it is “aware that there is merit in moving a customer first principle from an implicit expectation, to an explicit statement that a customer and mortgage advice provider can easily understand”.

The report also outlined CIF’s progress in implementing other reforms proposed in its response to ASIC, which include the standardisation of commission payments, the removal of bonus commissions, the removal of “soft dollar payments”, and the drafting of the “Mortgage Broking Industry Code”.

Are Icebergs Fluffy? … A Conversation With Steve Keen

Steve Keen, the controversial economist, and I discuss the nature of debt, why home prices will fall and why the regulators and authorities are unable to disassemble the debt bomb.

You can watch the video, or listen to the podcast:

 

Support Steve via his Patreon Channel

His book: Can We Avoid Another Financial Crisis? (The Future of Capitalism)

“The Great Financial Crash had cataclysmic effects on the global economy, and took conventional economists completely by surprise. Many leading commentators declared shortly before the crisis that the magical recipe for eternal stability had been found. Less than a year later, the biggest economic crisis since the Great Depression erupted.

In this explosive book, Steve Keen, one of the very few economists who anticipated the crash, shows why the self-declared experts were wrong and how ever–rising levels of private debt make another financial crisis almost inevitable unless politicians tackle the real dynamics causing financial instability. He also identifies the economies that have become ‘The Walking Dead of Debt’, and those that are next in line – including Australia, Belgium, China, Canada and South Korea.

A major intervention by a fearlessly iconoclastic figure, this book is essential reading for anyone who wants to understand the true nature of the global economic system”.

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Please share this post to help to spread the word about the state of things….

Royal Commission Moves On To Insurance

The Royal Commission in Financial Services Misconduct has announced that the sixth round of public hearings will focus on the Insurance Industry and will be held in Melbourne from Monday 10 September to Friday 21 September.   AMP, CommInsure, IAG and Youi are among the case studies to be considered. More grief for the industry we suspect as more bad behaviour is uncovered!

The sixth round of public hearings will consider issues associated with the sale and design of life insurance and general insurance products, the handling of claims under life insurance and general insurance policies, and the administration of life insurance by superannuation trustees. The hearings will also consider the appropriateness of the current regulatory regime for the insurance industry.

The Commission presently intends to deal with these issues for the purposes of the public hearings by reference to the case studies set out below. These include the natural disaster case studies that were originally to have been examined in the fourth round of public hearings. Entities are named in alphabetical order and not in the order in which the evidence of those entities will be heard.

  Topic Case Studies
1. Life insurance
  • AMP
  • ClearView
  • CommInsure
  • Freedom Insurance
  • REST
  • TAL
2. General insurance
  • AAI (Suncorp)
  • Allianz
  • IAG
  • Youi
3. Regulatory regime
  • Code Governance Committee
  • Financial Services Council
  • Insurance Council of Australia

During the hearings, evidence will also be given by consumers of their particular experiences. The entities that are the subject of consumer evidence will be informed by the Commission.

Fintech Tic:Toc Announces Reductions In Its Fixed Home Loan

Australian fintech Tic:Toc, has today announced a reduction in its fixed home loan (live-in) rates by up to 0.10%, bringing their headline 1-year fixed rate to 3.59% (comparison rate 3.64%).

I discussed this rate price move and the current dynamics of the mortgage industry with Founder and CEO Anthony Baum today. See my earlier post on their business model.

 

Tic:Toc’s 2-year fixed home loan (live-in) will match their standard variable rate at 3.64% (comparison rate 3.65%).

The rate cut increases Tic:Toc’s standing as holding the lowest 1 and 2 year fixed rates in the market (27 August, https://www.finder.com.au/home-loans/fixed-rate-home-loans), possible due to the cost efficiencies in Tic:Toc’s automated assessment and approval platform.

Tic:Toc founder and CEO, Anthony Baum, said the decision to reduce fixed rates was great news for home loan customers and new home buyers looking for stability for the foreseeable future.

“We recognised there is a lot of confusion in today’s market; with slumps in house prices; out of cycle rate changes; and erratic predictions around interest rate rises.

“Helping Australians better manage their home loan repayments, or move into home ownership, is our priority, and we want to do so with full transparency.”

Since its launch, Tic:Toc has received over $1.3billion in value of submitted home loan applications.

The home loans originated by Tic:Toc and backed by Australia’s fifth largest retail bank, Bendigo and Adelaide Bank, are available throughout Australia at tictochomeloans.com; with the latest fixed rates advertised at www.tictochomeloans.com/instant-fix.

Bank Australia sells its first sustainability bonds

On 20 August, according to Moody’s, Bank Australia Limited sold AUD125 million of three-year sustainability bonds, its first issuance of environment, social and governance (ESG) themed bonds. The bank plans to use the proceeds to finance, or refinance, green and social projects. Bank Australia’s ability to tap the growing demand for ESG investments is credit positive because it adds diversity to its funding sources and allows it to lengthen the overall maturity of its funding portfolio.

Bank Australia is a mutually owned bank that is primarily deposit-funded and must compete with larger commercial banks at a time when deposit growth has been slowing, but new liquidity regulations have incentivised banks to gather stable customer deposits. This has caused average deposit spreads to remain high.

The ability to diversify funding to include wholesale sources is therefore attractive. However, Bank Australia is a small mutually owned bank with a market share of 0.2%. Its limited scale means that, inevitably, investors will not have the same familiarity with its credit profile as Australia’s major banks, such as the Commonwealth Bank of Australia. This makes it more challenging and costly for Bank Australia to raise long-term funding in the senior unsecured market.

However, increasing investor interest in environmental and socially responsible investing has provided an opportunity for issuers like Bank Australia to tap longer-tenor wholesale funding in meaningful amounts.

A total of 60% of Bank Austalia’s AUD125 million sustainability bond issuance was allocated to investors with socially responsible investing (SRI) mandates or an ESG framework (Exhibit 2). The scale of investor demand also allowed the bank to increase its final issuance by 25% over the initial offer and to improve its pricing.

Other Australian issuers have also gained traction with bonds providing environmental and social benefits. Teachers Mutual Bank Limited, another small mutual bank, sold an ethical bond in June 2018. Demand has driven Australia’s issuance of green, social and sustainability bonds in the past four years at competitive spreads compared with regular issuance.

Following its sustainability bond issue, Bank Australia’s wholesale funding will increase to 12% from 10% of total funding, on a pro forma basis. Importantly, the sustainability bond, which has a tenor of three years, will lengthen the bank’s overall funding maturity profile.

Bank Australia will likely be able to issue further sustainability bonds in future, because of its involvement in social and environmental projects. For example, it makes loans for affordable housing, community housing, and disability housing.

We expect issuers’ increasing awareness of the benefits of issuing green, social and sustainability bonds to spur additional supply. There is some risk that issuance by larger banks may crowd out some small issuers like Bank Australia. However, any increase in issuance will build on a low base since these notes comprise only 2% of total issuance so far in 2018, according to financial market data collector Dealogic. Investor demand is also growing and is likely to absorb more supply.

 

More Clues To Home Price Falls Ahead

DFA research was featured in a number of the weekend papers, discussing the rising number of mortgage loan applications which are being rejected by lenders due to tighter lending standards, meaning that many households are unable to access the low refinance rates currently on offer.

NEARLY half of all homeowners are now shackled to their mortgage, with refinance rejections up significantly cent in less than a year as banks rattled by the royal commission drastically tighten borrowing rules.

 

Loan sizes are being slashed by 30 per cent, trapping many financially stressed customers including some who have been slugged with “out of cycle” interest rate rises. House hunters are also being hit by the credit crunch, with dramatic implications for property markets. The crunch stems from two big shifts in the way banks judge borrowers.

Expense estimates have been raised substantially — the minimum outgoings for an average household are now assumed to be a third higher, according to bank analysts UBS.

On top of this, granular cost breakdowns must be provided. After the royal commission revealed in March that expense checks were so lax as to be borderline illegal, new tests have been imposed requiring in some cases detail of weekly, fortnightly, monthly, quarterly and annual spending in as many as 37 categories from alcohol and haircare to shoes and pets, as well as doctor visits.

As a result, we think that now four in 10 households would now have difficulty refinancing.  That means you are basically a prisoner in the loan you’ve currently go. This is based on our 52,000 household surveys plus data from a range of official sources. We estimate that 31,000 households’ refinance applications were rejected in July versus 2,300 in August last year.

Comparison service Mozo’s lending expert Steve Jovcevsk said . “There’s such a huge pool of people who are in that boat.” The most common motivation among those seeking to refinance was to save money by finding a better deal. Many were feeling the pinch because living costs were rising faster than wages and rates on interest-only or investment loans had increased.

The main issue these households are facing in seeking a new deal was banks’ definition of a “suitable loan now is different to six months ago because of the royal commission” and a clampdown by the Australian Prudential Regulation Authority. So there has been a big rise in loan rejections, particularly refinancing.

The borrowing power of hosueholds are being crimped, as shown on the banks website mortgage calculators. Those calculators, compared to a year or 18 months ago, are now on average showing a 30 per cent lower number. For some, the reduction in borrowing power is even greater. The head of UBS’s bank analysis team Jon Mott said that for a household with pre-tax income of $80,000 would get 42 per cent less from a bank; for a $150,000-a-year household, would get 34 per cent less.

Mozo’s Mr Jovcevski said in one example he was personally aware of, a person pre-approved to borrow $630,000 last year was recently offered just $480,000. The would-be borrower’s job and income hadn’t changed.

The implications for property markets were severe, Mr Jovcevski said. “There are fewer qualified buyers,” Reduced borrowing power would drag down selling prices and eventually cut valuations.

“It’s a double whammy for those mortgage prisoners,” Mr Jovcevski said. “Their valuations come in lower so their equity may end up being less than 20 per cents so they have to pay lenders mortgage insurance again” if they refinance.

Australian Banking Association CEO Anna Bligh said banks had to make reasonable inquiries to satisfy APRA’s strengthened mortgage lending standards but she said the term ‘home loan prisoners’ does not represent the facts of a fiercely competitive home loan market where everyday banks are seeking to attract new customers.

Mozo’ Jovcevski said homeowners seeking to give themselves the best chance of successfully refinancing should reduce their expenses in the months prior to applying and ensure all bills have been paid on time.

Mark Hewitt — general manager of broker and residential at AFG which arranges 10,000 home loans a month — said would-be borrowers whose budgets were at breaking point or beyond could still get a loan if they had equity, a clean repayments history and the ability to ditch key expenses such as fees for private school if under the pump.

Some people seeking their first home loan are signing documents in which they promise to cut their spending if a new loan is approved.

“When you get a mortgage you make sacrifices — you continue some of your discretionary spending but not all of it,” said Brett Spencer, head of Opica Group, which sells software to brokers that works out how much a prospective customer can cut back.

A figure is agreed between the broker and the would-be borrower which is then provided to the bank, which would otherwise rely on the higher, raw expense figures.

This makes in interesting point, mortgage brokers will be diving into household expenses more than ever before, but of course, household saying they will cut their expenses to get a loan is not the same a clear cash flow.

Thus even in this tighter market, the industry is still trying to find ways to bend the affordability rules. And it’s worth remembering that according to the latest figures from APRA more than 5% of new loans currently being written are outside standard assessment criteria.

This suggests that even now; bank lending standards are still too lose.  All this points to more home prices falls ahead. This is reinforced by the latest Domain auction clearance rate data which was released yesterday, and shows that the final auction clearance rate last week in Sydney, Melbourne and Nationally ended up below 50% way lower on both volume and clearance rates than a year ago.

Yet despite all this, some are still sprooking the market, saying it’s a great time to buy. We do not agree.

The Bears Are In Town – The Property Imperative Weekly 25 August 2018

Welcome to the Property Imperative weekly to 25th August 2018, our digest of the latest finance and property news with a distinctively Australian flavour.    And what a week it was…

By the way, if you value the content we produce please do consider joining our Patreon programme, where you can support our ability to continue to make great content.

Watch the video, listen to the podcast or read the transcript.

 

Scott Morrison, the new PM must carry much of the burden for our current economic situation, which to my mind is sliding by the day. Booming debt and flat wages have combined to drag way too high home prices lower, as the number of SME’s feeling the pressure continue to rise. Sprooking high jobs growth (measured on a simplistic basis which does not report underemployment, accurately) and in an environment where the cpi for real households is much higher than the quoted number means the GDP is likely to flag, as the Aussie continues to slide against the US. The bears are it seems out in force now.  You can watch my discussion with John Adams, recorded before the spill “Is Parliament Fiddling While Rome Burns” for the political context.

We expect some unnatural acts from the new man, perhaps with first time buyers offered the chance to tap into super to “buy now” and probably overt attempts to trim migration ahead of the election ahead. Remember Morrison spent time at the Property Council, so he is so to speak, pro-property, and pro-property investment – thus the debt bubble may grow further and investors enticed back, at least to some extent. This means a harder fall if or when Labor sweeps to power as the property market turns to custard, what a nice incoming present.

And analysts seem to agree the bears are out. For example, Damien Boey at Credit Suisse says that in the year-to-2017, the Australian population grew by 388,056 people to 24,782,303 residents. According to the 2016 Census, the average number of people per household is 2.57894. Assuming this number remained steady throughout 2017 (an optimistic assumption), household formation was about 150,471 (388,056 divided by 2.57894). Now it is possible for replacement housing demand to rise as high as 25,000 per annum. Therefore, an optimistic estimate of underlying housing demand is around 175,000 per annum. This is below the current level of dwelling completions of around 210,000 per annum. In other words, Australia is in a situation of marginal housing oversupply to the tune of 35,000 per annum. Consistent with this state, house prices are falling moderately.     However, it is now possible that marginal oversupply could become worse, due to changes in the political climate. For example, former Prime Minister Abbott, representing the shadow conservative wing of the ruling Liberal Party, has advocated in the past that he would like to cut immigration by up to 80,000 per annum. If the immigration intake is cut by 80,000 per annum, household formation would fall to 119,451 per annum, and underlying housing demand would fall to 144,450 per annum. At the current level of dwelling completions, this would increase marginal housing oversupply to 65,549 per annum, consistent with much faster house price declines. A 40,000 per annum cut to the immigration intake result in a 50,039 per annum housing glut.  On top of all of this, we need to consider the risk that if the Liberal Party loses the next election, and the Labour government wins a majority, the new government would attempt to grandfather out negative gearing provisions for investment properties.

Boey does not include the tighter credit environment and high debt which is, as we discussed in this week’s live stream event, crimping households’ ability to borrow. In fact, this is the strongest negative impact on home prices, which is why we revised down our four economic scenarios, such that we think there is only a 5% probability of the RBA’s forecast for the economy playing out. All our other scenarios are more bearish. You can watch the full event on YouTube, including the chat during the session, we had more than 300 watch live on Tuesday.  Our next event will be on the 18th September at 20:00 Sydney, and its already scheduled on the channel if you want to set a reminder.

We expect the next RBA rate move to be down, not up, whilst both Barclays and RBS this week pushed out their expectation of a potential cash rate rise from the RBA, due to weaker economic conditions to late 2019 or 2020.

Home prices continue to run lower, as the latest data from CoreLogic shows, with year to date falls of 3.44% in Sydney, and 3.29% in Melbourne, plus a fall of 1.95% in Perth. But also of note is that prices are now falling faster in Melbourne, down 0.59% this month so far, compared with 0.23% in Sydney. And auction clearance rates continue to languish, as more properties remain on the books for sale.

Of course, values are still up 35.3% since the 2010 peak at the 5-city level, driven overwhelmingly by exceptionally strong gains in Sydney at 58.5% and Melbourne 40.4%. But there has been little movement elsewhere (and in fact down in inflation-adjusted terms).   And remember the CoreLogic index is driven by settlement data which is weeks behind transactions themselves.

CoreLogic also showed that as well as fewer seven-figure sales occurring now as values decline, the volume of more affordable homes selling is also falling. Their analysis shows that the share of sales under $400,000 homes has continued to decline over the past year. Nationally, 29.2% of all houses and 34.6% of all units sold over the 2017-18 financial year transacted for less than $400,000. The share of sales below this price point has fallen from 30.7% for houses and 35.4% for units a year earlier. The share of sales below $400,000 has increased slightly over the past few months for both houses and units.

An historic low 13.9% of combined capital city house sales and 25.8% of capital city unit sales were under $400,000 over the 2017-18 financial year. The share of sales below $400,000 has fallen over the year from 16.2% of houses and 27.1% of units. Although capital city dwelling values are falling, there continues to be fewer sales occurring below the $400,000 threshold.

The share of sales below $400,000 is predictably much larger across regional areas of the country than within the capital cities. Over the latest financial year, 49.6% of all regional house sales and 57.3% of all unit sales were for less than $400,000. House sales under $400,000 were at a record low and down from 51.6% the previous year while unit sales under $400,000 have increased over recent months but are lower than the 58.0% a year earlier.

Then consider falling rental yields. The AFR reported that Andreas Lundberg from Montgomery Investment Management believes that the sagging yield on residential rental properties in Sydney could drive prices lower if investors seek higher yields without an increase in rents.  Sluggish rental growth is weakening the income-generating prospects of property, giving buyers another reason to avoid the asset class and potentially forcing prices to fall further. Such a “de-rating” of residential property is not out of the realm of possibility. “In a rational market, rental yield should drift higher but don’t think it’s a rational market.  Mr Lundberg said official data showed property rental yields in Sydney are about 2.7 per cent – well below the long-term average of 4 per cent. “In an environment where rates are no longer falling and indebtedness is very high, rental yields should become a more important consideration in where you should invest your money,” he said.

If you look at Sydney, the annual fall in rental rates is significant, according to CoreLogic data. This is one reason why property investors are, and will continue to head for the exits.  Rental yields remain the lowest in Melbourne (3.04%) and Sydney (3.21%) which, given the dim prospects for capital growth and tougher credit conditions, is likely to act as a further disincentive to investors in these markets and help push prices even lower. Labor’s proposed negative gearing and capital gains tax reforms will also add to the downward pressures.

We discussed the state of the property market in a prerecord for Nines’ Sixty Minutes to be broadcast in a few weeks. You can see my video blog which tells the story of the days filming “Talking Finance and Property On Channel Nine”.

Building Company Lend Lease, in their results, which were strong, specifically called out that they were preparing for Australia’s housing slowdown. “We have been participating in a slowdown for some time and most markets are past their peak,” The Group Chief Executive Steve McCann said. Presold lots in its big residential communities slowed to 3,231 lots in financial 2018 from 3,896 in the previous corresponding period. Their sales were down -17% year on year. Their share price is off its highs but up 24% over the past year. As building approvals are still pretty strong, perhaps Lend Lease market share is lower here now. That said, they are still holding a huge land bank and have diversified from residential building.  They can afford to wait for the next property boom, down the track.

Westpac’s quarterly update was a salutary lesson in what’s happening in their mortgage book. The biggest property investor lender in the country reported that its net interest margin in June quarter 2018 was 2.06% compared to 2.17% in First Half. The 11bp decline mostly reflected higher funding costs and a lower contribution from the Group’s Treasury. We discussed this in more detail in our post “Through The Westpac Looking Glass” but the primary source of higher funding costs has been the rise in short term wholesale funding costs as the bank bill swap rate (BBSW) increased sharply since February. Every 5bp movement in BBSW impacts the Group’s margins by around 1bp and compared to 1H18, BBSW was on average 24bps higher in 3Q18, reducing the Group’s net interest margin by 5bps. As well as reduced Treasury activity of 4 basis points, 2 basis points came from the ongoing changes in the mix of the mortgage portfolio (less interest only lending) along with lower rates on new mortgages. Deposit pricing changes only had a small impact on margins in 3Q18. And finally, while overall credit quality was fine, mortgage 90+ day delinquencies in Australia were up 3bps over the three months ended June 2018 with most States recording some increase.

So we see the pincer movements at work, deep discounting to try to attract new business, a switch from interest only loans, reducing interest take, a hike in funding costs and higher delinquencies. Combined these forces are enough to put considerable pressure on the bank, as well as others in the sector. Their share price fell 2.43% on Friday to 27.66, just above their 12-month low of 27.30 in June. We see more downside than upside in the banking sector and remember the Royal Commission is still grinding away.

In comparison CBA, the largest owner occupied lender was up 0.2% to 70.89 on Friday.  The ASX 200 ended the week at 6,247, up a little on Friday after the ructions in Canberra this week, but below its recent highs. Again, we see more downside than upside.

The Aussie against the US Doller ended at 73.26, up 1.08% on Friday. Looking at the daily chart, AUD/USD was at one-point climbing back into its familiar consolidation range from June. By the close of play, it remains right on the May 2017 low. That was also its largest daily gain since June 4th. From a bigger picture, its dominant downtrend since February still remains in play. But for now, the pair may consolidate between near-term resistance and support. The former is around 73.82 or the August 21st high. A push above that exposes a descending resistance line composed of the July and August highs. This line also intersects the February trend, making for a potentially stubborn area of resistance. In the event Aussie Dollar pushes above that and potentially reverses its significant progress to the downside, we may eventually get to the June 6th high at 76.77.

On the other hand, immediate support is at 72.38 which is the low set on Friday. A descent under that then exposes the current 2018 low at 72.03. Continuation of AUD/USD’s dominant downtrend would then involve getting beyond the December/May 2016 lows between 71.60 and 71.45. We think the longer term trajectory will be lower as the local economy slows further.  The risk is there to go below 70 cents ahead.

Across to the US markets, where the bull market is still running. The Dow Jones Industrial ended up 0.52% to 25,790, up 0.52% on Friday, still below its February highs. But the Benchmark S&P 500 stock index clinched its longest bull-market run on Friday, closing above its previous January high, as Federal Reserve Chairman Jerome Powell affirmed the U.S. central bank’s current pace of rate hikes.

The S&P had last reached a new closing high on Jan. 26, then retreated more than 10 percent, a correction that lasted until Feb. 8. Friday’s new closing high confirmed that the index’s bull run remained intact. Speaking at a research symposium in Jackson Hole, Wyoming, Powell said the Fed’s gradual interest rate hikes were the best way to protect the economic recovery, maintain strong job growth and keep inflation under control. His comments did little to change market expectations of a rate hike in September and perhaps again in December. Investors said they were reassured that Powell’s comments stayed in line with previous commentary from the Fed regarding policy. Economic data also boosted sentiment. New orders for key U.S.-made capital goods increased more than expected in July and shipments growth held firm, the Commerce Department said. The index was up 0.62% to 2,875.

However, Housing numbers continue to give the market pause. It’s recently been the part of the economy waving the most red flags. Data on existing home sales released by the National Association of Realtors on Wednesday showed a surprise drop. Existing home sales fell 0.7% in July from the previous month to an annualized pace of 5.34 million units. Economists had forecast a 0.6% increase to an annualized pace of 5.44 million.  Sales are now 1.5% below a year ago and have fallen on an annual basis for five-straight months, according to NAR, especially at the lower end of the market. The report also showed that the median existing-home price for all housing types in July was $269,600, up 4.5% from July 2017 ($258,100). July’s price increase marks the 77th straight month of year-over-year gains. In addition, new home sales fell short, dropping to a nine-month low in July. New home sales fell 1.7% last month to an adjusted annual rate of 627,000 units. Economists expected a rise to 645,000 units.

And Moody’s highlighted that once again at the late stage of a cyclical boom, there are signs of excessive risk taking. This time, the most serious developing threat to the current cycle is lending to highly leveraged nonfinancial businesses. While businesses appear to be in good shape in aggregate, a significant number of highly leveraged companies are taking on sizable amounts of debt. This is evident in the rapid growth of so called leveraged loans—loans extended to companies that already have considerable debt. These loans tend to have floating rates—typically Libor plus a spread—with a below-investment-grade (Baa or less) rating.

Leveraged loan volumes are setting records, and loans outstanding have increased at a double-digit pace over the past five years to nearly $1.4 trillion. Businesses use the loans to finance mergers, acquisitions and leveraged buyouts, followed by refinancing, and to pay for dividends, share repurchases and general expenses.

Powering leveraged lending is demand from the collateralized loan obligation market. CLOs are leveraged loans that have been securitized, and global investors can’t seem to get enough of them. This is clear from the thin spreads between CLO yields and comparable risk-free Treasuries.

Approximately one-half of leveraged loans currently being originated are packaged into CLOs, with CLO outstandings approaching $550 billion.

To meet the strong demand for leveraged loans from the CLO market, lenders are easing their underwriting standards. According to the Federal Reserve’s survey of senior loan officers at commercial banks, a net 15% of respondents say they lowered their standards on commercial and industrial loans to large and medium-size companies this quarter compared with the previous quarter. The only other time loan officers eased as aggressively on a consistent basis was at the height of the euphoria leading up the financial crisis in the mid-2000s. Standards for loans to small companies have not eased nearly as much, since they are much less likely to be bundled into a CLO.

Considering the leveraged loan and junk corporate bond market together, highly indebted nonfinancial companies owe about $2.7 trillion. Their debts have been accumulating quickly as creditors have significantly eased underwriting standards. As interest rates rise, so too will financial pressure on these borrowers. Despite all this, global investors appear sanguine, as credit spreads in the CLO and junk corporate bond market are narrow by any historical standard.

Regulators are undoubtedly nervous—they issued guidance to banks to rein in their leveraged lending in 2013—but an increasing amount of the most aggressive lending is being done by private equity, mezzanine debt, and other institutions outside the banking system and regulators’ purview.

Now consider that subprime mortgage debt outstanding was close to $3 trillion at its peak prior to the financial crisis. Insatiable demand by global investors for residential mortgage securities drove the demand for subprime mortgages, inducing lenders to steadily lower their underwriting standards.

Subprime loans were adjustable rate, which became a problem in a rising rate environment as borrowers didn’t have the wherewithal to make their growing mortgage payments. Regulators were slow to respond, in part because they didn’t have jurisdiction over the more egregious players.

It is much too early to conclude that nonfinancial businesses will end the current cycle in the way subprime mortgage borrowers did the previous one. Even so, while there are significant differences between leveraged lending and subprime mortgage lending, the similarities are eerie.

We will make a longer post later on this important issue, but it does highlight that even amid the booming US markets, the bears are stalking their prey.

Finally, to round out our review, the fear index – the VIX was lower, down 3.38% to 11.99 on Friday, Gold was higher, up 1.53% to 1,213, though still well down across the year and Bitcoin ended the week at a slightly higher 6,722, up 3.5% on Friday though just one day after the U.S. Securities and Exchange Commission (SEC) rejected proposed rule changes for nine bitcoin ETFs, the Commission initiated a review of all related decisions. As a result, three rejection orders made on August 22 are now stayed pending the review by the SEC Chairman and the Commissioners. This is the first time the SEC initiated a review of its staff decisions on bitcoin ETFs. Their initial rejections were driven by concerns about the underlying markets so this just might indicate a change of view. Bitcoin of course is way off its highs of more than 18,000, but this might just signal a change in sentiment. We will see.

So in summary, the Bears are in town!

SME Insolvencies On The Rise

New data from one of Australia’s biggest insolvency firms has revealed there are nearly 10,000 small to medium businesses on the brink of collapse, and experts says business strength is unlikely to improve, via SmartCompany.

The SV Partners Commercial Risk Outlook Report for August 2018 shows there are 9,948 businesses with annual turnover of less than $50 million that are at “high risk” of insolvency in the next 12 months, with political uncertainty and a downturn in property markets pinned as the main contributing factors.

Those SMEs make up 80% of the total 12,464 businesses the insolvency firm detected as being high risk, with SV Partners managing director Terry van der Velde recommending SMEs have a “rigorous” approach to risk management to try and prevent insolvency where possible.

“SMEs often struggle more with solvency than larger businesses, as their smaller income streams, tighter margins and difficulties sourcing finance can make dealing with short-term shocks more challenging,” van de Velde said in a statement.

“That’s why small and medium-sized business owners need a rigorous approach to risk management, to ensure that their business has a plan to deal with unexpected situations.”

A number of high-profile businesses, particularly in the retail space, have entered administration throughout the end of 2017 and into 2018. These include Toys ‘R’ Us, a selection of Adriano Zumbo’s patisseries, SumoSalad, and Oliver Brown.

Speaking to SmartCompany, Patrick Coghlan, managing director of credit reporting agency CreditorWatch, says there’s definitely been a significant increase in the number of insolvencies for both incorporated and unincorporated businesses.

CreditorWatch’s own research shows the number of unincorporated businesses that have gone from active to inactive between March 2017 to March 2018 is up 60%, suggesting the businesses being hit the hardest are also the smallest.

“We’re seeing people really struggle from a cash flow point of view, and we know from our research that it’s pretty much a 50/50 split between SMEs that are running cash flow positive and those that aren’t,” he says.

Coghlan puts this down to the ever-present issue of payment times, saying a lot of SMEs are still finding it hard to get payments from suppliers on time.

However, he also attributes some insolvencies to a “general softening” of the economy overall.

U.S. Non-Bank Mortgage Lender Margins May Fall Further

U.S. non-bank mortgage lenders may face further margin pressure as interest rates continue to rise owing to higher funding costs relative to banks with lower-cost, stable depository funding, Fitch Ratings says.

Profitability metrics for non-bank mortgage lenders are generally weak, with expenses outstripping net revenues by approximately 21% across the five public non-bank mortgage companies for the 4.5-year period ending June 30, 2018.

We expect consolidation to continue as a result of weak profitability, with non-bank lenders seeking scale efficiencies to combat rising rates, persistently high technology and regulatory compliance costs, and declining refinancing activity. That said, non-bank lenders with multiple origination channels and established mortgage servicing platforms that generate higher fee income and more sustainable earnings should be better positioned for the shifting trends of the interest rate and economic cycles. These lenders are generally less exposed to cyclical swings in the mortgage market, as the complementary nature of origination and servicing businesses can serve as a natural hedge, reducing earnings volatility.

Aside from driving funding costs higher, Fitch also sees rising interest rates as a headwind to origination volumes, which could further pressure profitability in the medium term. Forecasts by the Mortgage Bankers Association (MBA) call for originations of $1.6 trillion annually from 2018-2020, down 6% from 2017 levels. Refinancings should drop to 24% of originations by 2020, down from 49% in 2016, in the face of rising rates, according the MBA.

Positively, mortgage servicing right (MSR) valuations generally increase with rising rates and economic growth, as prepayments fall and default risk lessens. Reflecting these dynamics, MSR valuations have increased in recent years, averaging 104bps of the unpaid principal balance of servicing portfolios for the five public non-bank mortgage companies.

Ratings assigned to non-bank mortgage servicers are typically in the ‘B’ to ‘BB’ rating categories, reflecting the highly cyclical and monoline nature of the business, valuation volatility associated with MSRs, elevated legislative and regulatory scrutiny, weak earnings profiles and reliance on short-term wholesale funding sources.