Mortgage arrears to increase in 2018: Moody’s

According to Moody’s “RMBS, ABS and covered bonds – Australia, 2018 outlook – Delinquencies will increase moderately from low levels, report”, delinquencies underlying Australian residential mortgage-backed securities (RMBS) are expected to “moderately” increase in 2018 from their current low levels.

The housing market is expected to ease, and household finances remain under pressure.

Of note is the rise in the relative share of non-bank lending (who are not under the same regulatory control as the banks) and the continued impact from the mining downturn, especially in WA.

We expect mortgage delinquencies in outstanding RMBS deals  to increase moderately from their low levels because of the continued after-effects of weaker conditions in states reliant on the mining industry and less favourable housing market and income dynamics.

With Western Australia and other states reliant on mining pushing up delinquencies this year, this will continue in 2018,

The balance of risks in new RMBS deals will also change, as bank-sponsored RMBS issued in 2018 will include a lower proportion of interest-only, high loan-to-value ratio (LVR) and housing investment loans, following regulatory measures to curb the origination of riskier mortgages.

RMBS issued by the non-banks will include a greater percentage of interest-only and investment loans than has been recorded in the past as these lenders have fallen outside of APRA’s regulatory remit thus far.

China’s Tightens Regulation of Internet-based Consumer Finance

Last Friday, the People’s Bank of China and China Banking Regulatory Commission issued a regulation to rectify excesses in internet-based consumer finance says Moody’s.

The regulation is credit positive for banks because it will help prevent a rapid increase in consumer leverage, strengthen banks’ risk management and limit disorderly competition. Exhibit 1 shows that outstanding internet-based person-to-person (P2P) loans were RMB1.2 trillion ($181.8 billion) at November 2017, 13.4x the amount three years earlier and far outstripping the growth of traditional micro-credit companies (MCCs).


With immediate effect, the regulation stops any unlicensed firms or individuals from making loans. The regulation also temporarily bans internet-based platform companies from making general-purpose unsecured consumer loans and permanently bans loans to finance down payments of housing purchases and loans for purchases of stocks and futures. The permanent ban on affected loans is in line with the authorities’ policy priority of deleveraging the financial system and the real economy.

The regulation curtails funding available to all MCCs, either online platforms or offline traditional entities. MCCs can no longer sell their loans through internet-based or local trading platforms and MCCs must consolidate on their balance sheets loans that have been sold or securitized.

P2P platform companies are particularly prone to liquidity and solvency stresses, as shown in Exhibit 2. The improved risk management of MCCs will help improve the asset quality of banks that lend to MCCs, which would reduce the systemic transmission of risks. The regulation prohibits banks from investing either their on-balance-sheet funds or off-balance-sheet wealth-management products in structured products with underlying assets sourced from the affected loans.

In addition, the regulation prohibits banks’ outsourcing of credit underwriting and risk management functions to internet-based credit service platforms. Banks must validate consumer credit information against centralized databases maintained by the People’s Bank of China and National Internet Finance Association of China. This will discipline banks to strengthen their internal process of managing the use of consumer credit information in originating consumer loans.

Larger banks are likely to benefit most because their brand recognition is more attractive to customers as the regulation reforms the sector. For the 16 listed banks, which account for more than 70% of the country’s commercial banking-sector assets, new retail loans were 54.3% of the increase of the total loan balance in the first half of 2017.


UK’s reduction of stamp duty for first-time homebuyers will benefit RMBS

From Moody’s

On 22 November, the UK government announced a number of measures in its Autumn Budget, including a stamp duty reduction that will benefit 95% of first-time homebuyers, with a maximum saving of £5,000 per buyer. For purchases completed on or after 22 November 2017, first-time buyers do not have to pay stamp duty on properties worth up to £300,000, while for properties worth up to £500,000 they pay £5,000 less. The stamp duty for purchases above £500,000 is unchanged. Such measures will be credit positive for residential mortgage-backed securities (RMBS), allowing first-time buyers to amass the down payment they need to take out a loan faster or allow them to borrow a larger amount, strengthening both housing demand and property prices and lowering market-implied loan-to-value ratios on existing loans.

The stamp duty reduction will help alleviate some of the financial burden on first-time buyers amid stagnant wage growth, proportionally more household cost expenditures, and rising rents (rental price inflation in the UK has slowed recently, but was up 0.9% in October 2017 versus a year ago, according to HomeLet). Nevertheless, first-time buyers, especially in London and surrounding counties, still face relatively high equity layouts compared with other regions. Our recent RMBS pool analysis also showed that compared with non-first-time buyers, first-time buyers start with up to 15% less equity in the property (see exhibit).

The budget also confirmed additional funding under the help-to-buy equity loan scheme, another credit positive because it increases the availability of loans for borrowers, while supporting house prices, which overall we expect will remain flat in 2018. Under the scheme, borrowers can purchase a newly built property with just a 5% deposit. Since its launch, borrowers have purchased 120,864 properties, with 81% of the sales attributable to first-time buyers. In 2017, Halifax Ltd. estimated that first-time buyers accounted for almost half of all mortgage-financed house purchases, an important driver of housing demand.

China to tighten regulations on financial firms’ shareholding

From Moodys

On 16 November, the China Banking Regulatory Commission published for public comment a draft regulation on commercial banks’ shareholding. The draft regulation raises the bar for investor qualification, demands the long-term commitment of significant shareholders’ (those owning a 5% or greater stake) investment, and requires annual disclosures of significant shareholders and related parties. The proposed regulation is credit positive for China’s financial firms because it will limit the systemic transmission of financial risks, improve the quality of the firms’ capital and strengthen their corporate governance.

The draft regulation will serve as a benchmark for regulating non-bank financial institutions including rural credit cooperatives, trust companies, financial leasing companies, automobile and consumer finance companies, and financial asset management companies, which are a type of specialist firm that works out nonperforming financial assets. More stringent investor qualifications include a ban on leveraged acquisition of shares, in line with the authorities’ policy priority of deleveraging the financial system and the real economy. In addition, the draft regulation will limit system interconnectedness by restricting any investor from becoming a significant shareholder of more than two banks or a majority shareholder of more than one bank.

The draft regulation also raises the entry barrier for significant shareholders by setting up a prior-approval process to screen out investors that have overdue bank debts or outstanding court judgments against defaults. Investment pools such as funds, insurance asset-management plans or trust plans cannot own more than 5% of a bank if they are ultimately controlled by a single entity. The higher barrier will diversify the investor base for banks and reduce system interconnectedness. The tighter ownership rules are particularly relevant for rural commercial lenders, which are transforming themselves to commercial banks from mutual institutions of credit cooperatives (see Exhibit 1).

In the banking regulator’s view, there is abundant capital to invest in bank shares, attracted by the sector’s higher profitability. As Exhibit 2 shows, rural commercial banks have had profitability and capital metrics second only to China’s big five banks.


Securing quality capital will improve banks’ creditworthiness. The draft regulation will improve the quality of capital that banks receive from significant shareholders by annually certifying a shareholder’s ability to inject capital into investee firms in times of need. The draft regulation also requires a five-year lockup period of significant shareholders’ investment to protect banks’ ability to create long-term value.

Additionally, the draft regulation tightens the enforcement of existing rules on connected-party transactions by expanding the scope of the rule. Emphasizing a “see-through” principle to improve disclosure on the ultimate beneficiaries of shareholding, the draft regulation specifies connected parties include investors’ controlling shareholder, actual controlling entity, affiliated entities, entities acting in concert and ultimate beneficiaries.

Inclusion of IFRS 9 accounting will toughen EBA’s 2018 banking stress test

Moody’s says on 17 November, the European Banking Authority (EBA) set out its draft methodology for a new round of stress tests that the European Union’s 49 biggest banks must undergo next year. The inclusion of IFRS 9 will lower Tier 1 equity, under stress by an estimated 50-60 basis point.

Similar to the 2016 stress tests, the 2018 exercise will examine banks’ resilience to both base-case and stressed-case scenarios over a three-year horizon, based on a common methodology and prescribed macro-economic scenario parameters. The EBA test will again abstain from setting a minimum capital threshold below which a bank would fail, as in 2014. However, even without set hurdles, the market will benchmark the adverse scenario results, expressed in stressed capital ratios, against banks’ minimum capital requirements, and thereby single out the weaker performers.

The first-time inclusion of International Financial Reporting Standard 9 (IFRS 9), a new accounting rule that takes effect 1 January 2018, will make next year’s stress test tougher than the last one and will likely translate into greater provisioning needs and therefore lower common equity Tier 1 ratios in the prescribed stress-case scenario. The new rules demand that banks set aside higher loan-loss provisions further in advance of default, which is credit positive for banks. While we expect that the initial effect of IFRS 9 will be limited, and therefore digestible for most EU banks, risk provisioning requirements under simulated stressed market conditions will likely be greater using the IFRS 9 rules. However, the size of provisioning will also strongly depend on the macroeconomic scenario assumptions that have yet to be published.

Our expectation of a limited initial effect of IFRS 9 is based on our projection of a 50-60 basis point decline in the ratio of common equity Tier 1 to risk-weighted assets for many European banks. However, we also expect that the initial effect will vary across regions. When additionally taking into account varying stating-point capital levels, capital ratios of banking systems starting from a weak position, including Italy and Portugal, are more at risk of stressed capital ratios falling closer to (or even below) the applicable minimum requirements (see Exhibit 1).

In the EBA’s 2018 stress test, the initial effect on capital ratios will likely be amplified when simulating stressed economic conditions. Europe’s weaker banking systems with relatively large but still performing portfolios that have deteriorated over time will experience greater capital effects under the new rules than banks that benefitted from systemwide asset quality improvements amid benign credit conditions in recent years. Such quality improvements have resulted in low nonperforming exposures in a number or European countries, including France, Germany and the UK (see Exhibit 2).

The objective of the 2018 stress test is to assess the resilience of EU banks and banking systems to shocks. The results will inform the supervisory review and evaluation process, the European Central Bank’s annual in-depth evaluation of each bank’s risk exposure. This evaluation forms the basis of the regulators’ decisions on bank-specific minimum capital requirements for the subsequent year

Australia’s decision to allow Mutuals to issue capital instruments is credit positive

According to Moody’s, last Wednesday’s  Australian government announcement that it would accept all 11 recommendations of the so-called Hammond Review on regulatory and legislative reforms to improve access to capital for co-operative and mutual enterprises, is credit positive for these entities because it provides an alternative to building capital with retained earnings. In particular in the banking sector, the allowance also shows that the government regards mutual authorized deposit-taking institutions (mutual ADIs) as integral to healthy competition in Australia’s banking system.

Mutual ADIs will be able to build capital in case of need by issuing capital instruments as opposed to relying solely on retained earnings to do so. In theory, the ability to issue capital instruments could facilitate a significant increase in mutual ADI loan growth: we estimate that mutual ADIs could raise up to AUD 1.2 billion through the mutual equity interest framework, supporting AUD 24 billion (or 21%) growth in loans.

Our estimate is based on mutual ADIs’ capital as of 30 June 2017, applying a 15% cap on the inclusion of capital instruments in common equity Tier 1 (CET1) capital, and a current CET1 ratio of around 14%. However, we do not expect such strong CET1 issuance because the mutual ADI sector is already strongly capitalized relative to the broader Australian banking sector.

Yet, some mutual ADIs with smaller capital buffers may issue capital instruments to support housing loan growth. Australia’s larger banks have moderated their residential mortgage lending as a result of macro-prudential measures to slow house price growth and steadily increasing capital requirements for banks that utilize the internal rating-based model for determining risk-weighted assets.

Since capital instruments issued by mutual ADIs would be equivalent to ordinary shares, and require dividend payments, some in the market are concerned that they will affect the traditional mutual business model.

Accordingly, the Australian Prudential Regulatory Authority (APRA) has proposed a 15% cap on the inclusion of such instruments in CET1 capital, and a cap on the distribution of profits to investors at 50% of a mutual ADI’s annual net profit after tax. These caps ensure that mutual ADIs continue to prioritize the interests of their existing members and are not incentivized to unduly increase their risk profile to boost returns to their new equity holders.

The government’s actions last week follow the July 2017 “Report on Reforms for Cooperatives, Mutuals and Member-owned Firms,” led by independent facilitator Greg Hammond. The government’s decision also follows a July 2017 proposal by APRA to allow mutual ADI to issue directly CET1-eligible capital instruments through a mutual equity interest framework.

US Banks’ Net Interest Margins Are Still Increasing

The ANZ Net Interest Margin (NIM), reported last week was 1.99%, and typically banks in Australia are achieving a NIM slightly above this. So, it was interesting to see this note from Moody’s, discussing the NIM of US banks, which has risen to 3.21%, and continues a positive trend over the past year.

Last week, US banks’ reported third-quarter earnings and higher net interest margins (NIM), a credit positive because NIM is a key driver for net interest income, which accounts for more than half of most banks’ net revenue.

Quarter over quarter, the average NIM for the largest US regional banks increased three basis points (Exhibit 1) to 3.21% from 3.18%, continuing a four-quarter positive trend. However, the rate of improvement is slowing. The Federal Funds rate increased 25 basis point (bp) in each of the past three quarters. However, as the bars show, the rate of improvement for listed regional banks’ average NIM has declined each quarter.

Accelerating deposit costs explain why the NIM is not increasing at a consistent rate with each 25 bp increase in the Federal Funds rate. Exhibit 2 shows deposit betas for total deposits (interest-bearing and noninterest-bearing) for each of the past three quarters. Deposit beta is the increase in cost of deposits relative to the increase in the Federal Funds rate. There was a significant step up in beta in the second quarter, which continued in the third quarter. In their earnings calls, most bank managements indicated that retail deposits are not repricing upward, despite the rise in market interest rates. This is not the case with deposits from the banks’ wealth management clients, and especially from their commercial clients, which are both more price sensitive.

Higher Bond Yields Could Depress Share Prices

From Moody’s

Any analysis regarding the appropriate valuation of a long-lived asset must account for the influence of interest rates. All else the same, a rise by the interest rates of lower-risk debt obligations, namely US Treasury debt, will reduce the prices of other financial and real assets. Whenever asset prices defy higher interest rates and rise, a worrisome overvaluation of asset prices may be unfolding. Today’s high price-to-earnings multiples of equities and narrow yield spreads of corporate bonds have increased the vulnerability of financial asset prices to a widely anticipated climb by short- and long-term Treasury yields.

As of 2017’s third quarter, the market value of US common stock was 15.4 times as great as the prospective moving yearlong average of US after tax profits. Third-quarter 2017’s ratio of common equity’s market value to yearlong after-tax profits was the highest since the 16.2:1 of second-quarter 2002. More importantly, the ratio last rose up to 15.4:1 in first-quarter 1998 and would ultimately peak at the 26.0:1 of third-quarter 2000. Stocks may be richly priced relative to after-tax profits, but that does not preclude a further overvaluation of equities vis-a-vis corporate earnings. (Note that the measure of after-tax profits employed in this discussion is from the National Income Product Accounts, excludes changes in the value of inventories and some extraordinary gains and losses, and uses economic depreciation instead of accounting depreciation.)

Today’s equity market differs from that of 1998-2000 for reasons extending beyond 1998-2000’s average aggregate price-to-earnings ratio (P:E) of 21.2:1, which was so much greater than the recent 15.4:1.

In addition, 1998-2000’s equity market seems even more overpriced compared to the current market because the recent 2.43% 10-year Treasury yield was so much lower than its 5.64% average of 1998-2000.

The valuation of equities very much depends on interest rates. Holding everything else constant, priceto-earnings multiples will climb higher as benchmark interest rates decline. If benchmark interest rates fall, the market will be willing to accept a lower earnings yield, or a lower ratio of earnings to the market value of common stock. At some level of corporate earnings, the attainment of a lower earnings yield will be achieved through an increase in share prices. To the contrary, a rise by interest rates will push the earnings yield higher. Barring a sufficient climb by after-tax profits, a higher earnings yield will require lower share prices.

Japanese Banks’ Voluntary Curb on Credit Card Loans

From Moody’s

Last Friday, the Nikkei reported that Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU, Sumitomo Mitsui Banking Corporation, and Mizuho Bank, Ltd. (MHBK, the main banking units of Japan’s three megabank groups, Mitsubishi UFJ Financial Group, Inc., Sumitomo Mitsui Financial Group, Inc., and Mizuho Financial Group, Inc., introduced voluntary limits on consumer credit card loans at half or one-third of a borrower’s annual income. The banks’ self-imposed limits are credit negative because they will likely hamper growth in credit card lending, one of few highly profitable domestic businesses for the banking sector.

The restriction responds to growing criticism from lawyers and politicians that excessive credit card lending could lead to a repeat of Asia’s 1997 debt crisis. In Japan, banks’ unsecured lending, including card lending, is not subject to the country’s money lending business law, which was revised in 2010 to restrict consumer finance companies’ unsecured lending to one-third of each customer’s annual income.

Some regional banks in Japan, such as the unrated Akita Bank, Ltd., the 77 Bank, Ltd., and Hyakugo Bank, Ltd., have implemented similar limits on credit card loans, and more banks will likely follow to fend off public criticism. Last Thursday, Nobuyuki Hirano, chairman of the Japanese Bankers Association and president of BTMU’s parent group, MUFG, said at a press conference that while he does not see a need to legally limit banks’ credit card lending, each bank should try to prevent consumer clients from taking on excessive debt.

Banks have benefitted from the 2010 revision to the money lending business law, which led to the rapid growth in banks’ card loans and a sharp decrease in consumer finance companies’ unsecured loans. High margins make card lending an attractive revenue source for Japanese banks and especially domestically focused regional banks as low interest rates and weak credit demand weigh on their profitability. Interest rates on banks’ card loans are 2%-15%, significantly higher than an average loan yield of 1.1% for all Japanese banks in fiscal 2016, which ended in March 2017.

Credit card lending is riskier than secured lending, but because the size of each credit card loan is small, risks from the business are easily  manageable for banks. Also, default rates for banks’ credit card loans have been low.

Canada Reinforces Mortgage Underwriting Guidelines

From Moody’s.

On Tuesday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) published the final version of “Guideline B-20 − Residential Mortgage Underwriting Practices and Procedures,” which mandates more stringent stress-testing for uninsured mortgages. The guideline, which takes effect on 1 January 2018 and applies to all federally regulated financial institutions in the country, is credit positive because it will improve asset quality for Canadian banks.

The guideline sets a new minimum qualifying rate, or stress test, for uninsured mortgages at the higher of the five-year benchmark rate published by the Bank of Canada, the central bank, or the contractual mortgage rate plus 2%. Lenders also will be required to impose and continuously update more effective loan-to-value (LTV) limits and measurements.

A key vulnerability of Canadian banks is the high and rising level of private-sector debt/GDP. Canadian mortgage debt outstanding has more than doubled in the past 10 years (see Exhibit 1) and the index of house prices to disposable income has increased 25% over this period (see Exhibit 2), raising the prospect that real estate overvaluation is driving up overall household debt and overextending borrowers.

OFSI’s action is the latest in a series of macro-prudential measures aimed at slowing house-price appreciation in Canada and moderating the availability of mortgage financing. These measures will address the increasing risk that that growing private-sector debt will weaken Canadian banks’ asset quality. Canada’s growing consumer debt and elevated housing prices threaten to make consumers and Canadian banks more vulnerable to downside risks.

In addition to requiring that all uninsured mortgages be stress-tested against a potential rise in interest rates (high-ratio insured mortgages are already required to meet such tests to qualify for mandatory mortgage insurance), the guideline requires that banks establish and adhere to risk-appropriate LTV limits that keep current with market trends. Additionally, the guideline expressly prohibits banks from arranging with another lender a mortgage, or a combination of a mortgage and other lending products (known as bundled mortgages), in any form that circumvents a bank’s maximum LTV ratio.

Housing prices are at record highs owing to price increases in the urban areas of Toronto, Ontario, and Vancouver, British Columbia. Macro-prudential initiatives dampened volumes and prices in Toronto over the summer, but the effects of similar moves in Vancouver last year appear to be lessening this year as prices regain momentum. We believe that high consumer leverage could result in future asset-quality deterioration in an economic downturn or a housing price correction. Although Canadian banks have demonstrated prudent underwriting standards in the past, this is attributable in part to thoughtful regulatory oversight.

The new guideline follows a consultation period that ended in August. Some industry participants recommended a delay in implementation, cautioning that the combined effect of multiple macro-prudential measures affecting the mortgage market risked unduly depressing the housing market, thereby triggering a severe price correction.