Martin North – Page 1015 – Digital Finance Analytics (DFA) Blog

DFA Household Finance Confidence Index Fell In February

Using data from our household surveys, we have updated our household finance confidence index to end February. We compare the confidence of households now, compared with 12 months ago. The overall index, which is still below a neutral setting, fell slightly again in the month, despite the RBA rate cut of 25 basis points in February. Households are less confident about their financial health than anytime since December 2012. To calculate the index we ask questions which cover a number of different dimensions. We start by asking households how confident they are feeling about their job security, whether their real income has risen or fallen in the past year, their view on their costs of living over the same period, whether they have increased their loans and other outstanding debts including credit cards and whether they are saving more than last year. Finally we ask about their overall change in net worth over the past 12 months – by net worth we mean net assets less outstanding debts.

Looking at the composite elements in the index, with regards to savings, those comfortable with what they have saved, fell by 1.7%, reflecting mainly lower deposit rates, especially amongst females. Those less comfortable rose a little (0.6%). Those in part-time work had similar ratings to those households unemployed, in contrast to those full time employed. In these charts, the blue is data 12 months to January, and orange is 12 months to February.

Those households who think their real incomes have grown, fell by 1.8% in the month, whilst those households whose real incomes fell, rose by 1.3%.

Looking at household debt, households who were comfortable with their level of debt fell by 1.1%, though we found males more comfortable with their debt position than females. A slightly higher proportion were as comfortable as 12 months ago.

Those whose costs of living stablised over the last 12 months rose by 0.5% to 59.3%, helped by lower interest rates, petrol and electricity bills.

More than half of the households said their net worth had increased over the past year, up by 1.1% for last month. Less households had seen a fall in net worth (down 1.85%)

Finally a slightly smaller number of households thought their jobs were as secure as a year ago, (down 1.1% to 61.6%), those who felt their jobs were more secure fell (down 0.9%), whilst those felling less secure rose a little (up 0.3%).

Our take is that household financial confidence is still in the doldrums, despite ultra low interest rates and sky high property prices. Their future spending patterns will remain conservative, and we will not see a sudden change in consumption patterns anytime soon. We will update the index again next month.

ASIC ‘s Market Supervision Activity

ASIC today published its ninth report on the supervision and surveillance of Australian financial markets and market participants. The report highlights ASIC’s direct engagement with market participants to address concerns about market conduct.

During the relevant period, there were 19,375 Trade surveillance alerts alerts compared to 17,091 alerts in the previous period.

For example, using the improved functionality of ASIC’s new market surveillance system, Market Analysis and Intelligence (MAI), a persistent pinging strategy was identified in an ASX20 security trading in ASX Centre Point and Chi-X hidden public dark venues. Following intervention by ASIC, that behaviour has now ceased. Pinging is the practice of using the placement of very small orders to test if there is liquidity.

Using MAI, surveillance analysts also identified a recurrence of hacking of retail online share trading accounts. ASIC has worked closely with the firms involved to implement strategies to disrupt this activity.

Further, between July and December 2014, discussions with market participants led to the amendment of order execution methods and the review of trading algorithms on 26 occasions.

The report also highlighted the impact of the improved functionality of ASIC’s new market surveillance system, MAI. The system has allowed ASIC to conduct very sophisticated analysis in very short periods of time.

ASIC is concerned about the high proportion of general advice compared to personal advice, particularly by full-service brokers. They intend to focus more efforts on reviewing the provision of advice by market participants, whether it is being categorised correctly as personal or general advice, and whether the relevant obligations are complied with appropriately. This may include a focus on management oversight and adviser training.

ASIC’s compliance reviews have identified deficiencies with the provision of personal advice and the requirement to provide a clear, concise and effective Statement of Advice. For example, we identified market participants that had not provided sufficient information to clients regarding the basis on which the advice was given—suggesting that inadequate consideration may have been given to clients’ circumstances, goals and objectives.

Other future areas of focus for ASIC, include the Market Entity Compliance System, which will enhance the way market participants and operators interact with ASIC. Other aspects of market conduct that ASIC will be paying close attention to in the coming six-month period include a thematic review of crossing systems which will assess how crossing system operators are meeting their regulatory obligations, targeted compliance reviews of client money obligations, and further analysis into the handling of confidential information.

They are also currently reviewing analysts’ re-ratings for the last four years and comparing them to the timing of publicly-available information. This review may identify potential leakages of confidential information that we will need to further investigate.

Unemployment Stays at 6.3% (Trend) – ABS

The ABS released the Labour Force data for February, today. Australia’s estimated seasonally adjusted unemployment rate for February 2015 was 6.3 per cent, compared with 6.4 per cent for January 2015. In trend terms, the unemployment rate was unchanged at 6.3 per cent.

The seasonally adjusted labour force participation rate decreased to 64.6 per cent in February 2015 from 64.7 per cent in January 2015.

The ABS reported the number of people employed increased by 15,600 to 11,652,400 in February 2015 (seasonally adjusted). The increase in employment was driven by increases in both full-time (up 10,300) and part-time employment (up 5,300). Seasonally adjusted employment increased for both males (up 9,300) and females (up 6,300) in February 2015.

The ABS seasonally adjusted aggregate monthly hours worked series increased in February 2015, up 13.0 million hours (0.8%) to 1,620.8 million hours.

The seasonally adjusted number of people unemployed decreased by 15,800 to 777,300 in February 2015. The decrease was driven by those looking only for part-time work, down 18,600.

The seasonally adjusted underemployment rate was 8.6 per cent in February 2015, a decrease of 0.1 percentage points from November 2014 based on unrounded estimates. Combined with the unemployment rate of 6.3 per cent, the latest seasonally adjusted estimate of total labour force underutilisation was 14.9 per cent in February 2015, a decrease of 0.1 percentage points from November 2014.

Note that The February 2015 data incorporates estimates rebenchmarked to the latest population estimates and projections. Commencing from the May 2015 issue this will be a regular quarterly process which will ensure that the Labour Force series reflect the most up to date population benchmarks. So further tweaks to the data have been made, making series comparisons difficult.

CBA Offers NFC Payments via Android Smartphones

Australia’s Commonwealth Bank has launched a new version of its CommBank app, which it says is Australia’s most popular, with 3.2 million unique users and approx 2.35 million of those logging in each week to securely manage everyday banking and payments, as reported in iTWire today.

The newly updated app introduces various new features today, alongside ‘innovations’ included in the app last year which the bank says is ‘resonating’ with its customers.

Lisa Frazier, the Commonwealth Bank’s Executive GM of Digital Channels, said: “Our evolution of CommBank app is focused on delivering a simple and convenient mobile experience with relevant and valuable features that exceed user expectations. CommBank app’s most recent features Cardless Cash, Lock & Limit, and International Money Transfers are proving popular.

“Cardless Cash has helped around 370,000 customers withdraw cash without their card at an ATM or enable a loved one to withdraw cash in an emergency. Lock & Limit has given our customers peace of mind, with over 360,000 transactional locks and limits set within the app.

Over 35,000 credit cards have been temporarily locked whilst their owners determine if they’ve lost or simply misplaced their card, while PIN changes and card activations remain the favourite self-service features in the app.”

But that’s what has already been introduced, so what’s new in the Commbank app zoo?

Tap & Pay for Android, that’s what. From today, this feature will be available on Android phones with NFC capability running Android OS Kitkat 4.4 and above. It uses Host Card Emulation (HCE) technology to enable Tap & Pay payments ‘on the most popular Android handsets’ and replaces the need to purchase a physical PayTag to make payments with a smartphone.

The CommBank App’s download page at Google Play notes that: “Payments from eligible transaction accounts only, not available for credit cards at this time)” and notes that you can “Also set up a widget for quick access to Tap & Pay”.

Angus Sullivan, who is another Executive GM at Commbank but in the Consumer Finance Payments & Strategy Division said: “Customer demand for convenient mobile payment technologies continues and we are focused on innovative payment features which deliver on this. Today, we are providing Android customers with a real mobile wallet solution which simplifies payments on-the-go.”

Andrew Cartwright, the SVP and Country Manager of MasterCard Australia said: “This collaboration between MasterCard and Commonwealth Bank places the power of mobile payment technology in the hands of more Australians. It also delivers the highest level of security for our cardholders who want a fast, easy and secure way to pay using their smartphone.

“We have seen rapid adoption of contactless payments in Australia, with more than 60 per cent of MasterCard transactions under $100 now made this way. MasterCard will continue to invest in technology that provides all Australians with a convenient and secure alternative to cash.”

The Commonwealth Bank has also banked several awards for its app, with its most recent being the Canstar Innovation Excellence 2015 award for its Cardless Cash, and Lock, Block and Limit features, getting the ‘Best’ designation, alongside the Innovative Online Banking Service in Money Magazine’s 2015 Best of the Best Innovation Awards, and finally the National iAward for Best Consumer Product.

First Time Buyer Investors On The March

The ABS published their Housing Finance to January 2015. Total lending for housing (both investment and owner occupied lending) lifted the stock 0.6% to $1.37 trillion. Investment rose 0.8% and owner occupied loans rose 0.5% in the month. Investment loans are close to 34.5% of all loans, a record.

Looking at the changes in volumes by type, we see that the purchase of existing dwellings is rising, but refinancing, construction of new dwellings and purchase of new dwellings are down.

Looking across the states, momentum is rising in just two states, NSW and TAS. All other states are slowing.

Turning to first time buyers, using the revised ABS data (method changed last month) and DFA survey data, we see that whilst first time buyers for owner occupation fell slightly (14.3% to 14.2% of all owner occupied loans), an additional 4,000 loans were written by first time buyers going direct to the investment sector. Much of this is centered on Sydney. As a result the cumulative first time buyer count is rising, with more than 21% of all loans effectively to first time buyers. You can read more analysis on this important trend here.

This is another reason why no further assistance should be offered to “help” first time buyers into the market. It would be a waste of money.

Oil Price Falls And Monetary Policy

In a speech at Durham University Business School, MPC member Ian McCafferty considers the factors contributing to the recent fall in the oil price, the impact on inflation and its likely persistence and how, given this analysis, UK monetary policy should respond.

Ian argues that as with the oil price falls seen in 1985 and 1998, ‘there is merit in examining recent oil price developments, and the implications for the outlook for the oil market, through the prism of hog-cycle theory.’ As with the livestock markets hog cycle theory is based on, short term elasticity of oil supply is low but the longer-term elasticity substantially higher. As a result the main adjustment to price falls comes from changes in investment plans which in turn impact productivity and supply in the longer term.

This analysis shows that ‘the lag in the supply response means that for a while, even after the initial price fall, supply continues to exceed demand, such that inventories continue to build.’ As the market balances and inventory levels fall back ‘the market tightens and prices begin to rise, encouraging supply to recover. But here too, there are noticeable lags – first, it will require a period of higher prices to encourage producers to commit to new investment, and geographical, geological and political issues mean that the lead time to new supply is relatively lengthy.’

Ian suggests that ‘we can expect oil production to ease in the second half of the year’ and for demand for oil to increase due to the net positive impact to global demand, estimated by Bank staff to stand at around 0.8%, which in turn will support greater demand for oil. ‘Overall, it is reasonable to assume that, by the end of 2015, supply and demand for oil will be coming back into balance, although inventories will remain high for a further period. This should translate into more stable yet still relatively low prices,’ though further out ‘prices might be expected to recover’.

The fall in oil prices, and their predicted persistence, has important implications for both the likely path of inflation and the appropriate response of monetary policy. While the immediate direct effect is clearly disinflationary, detracting ‘a bit more than half a percentage point from headline inflation for the rest of the year’ indirect effects could emerge in both directions. The fall in the oil price could generate inflationary pressure by boosting demand and with little effect on potential supply in the economy. Conversely, the risk of falling inflation expectations feeding through to lower wage settlements could create further disinflationary pressure.

‘How should monetary policy respond to such a sharp oil price shock? As always in monetary policy, the answer depends on the source of the shock.’ As it is supply rather than demand that has ‘been the dominant factor behind the recent fall in the oil price… it should be treated primarily as a simple cost or price-level shock’. This would mean looking-through the temporary impact on inflation as the MPC has done previously when rising oil prices pushed inflation well above target.

‘But how temporary is temporary? Policymakers need to consider not just the source of the shock but also its persistence.’ In doing so they should, Ian suggests, refer to the ‘optimal policy rule’ which states that ‘looking through an undershoot of inflation, even a prolonged one, is more justified if the real economy is operating at or above full capacity’.

This, combined with the likely path for spare capacity set out in the Inflation Report and Ian’s view that ‘there may be less spare capacity left in the labour market’ than the MPC’s collective judgement, would suggest that it would be right to ‘look through’ the current low level of inflation.

This, however, is complicated by the potential for the persistent, depressing effect on annual inflation to constrain a growth in pay by causing inflation expectations to become de-anchored. ‘Judging the scale of this downside risk is difficult. Some measures of inflation expectations have fallen but others suggest that inflation expectations remain well-anchored, and there are no signs at present that anything approaching deflationary psychology is likely to take hold.’ Nonetheless, it is not a risk the MPC can dismiss, ‘at least while inflation remains close to zero’. This, Ian concludes, is why he decided not to vote for an increase in Bank Rate at the January and February policy meetings.

Hot Sydney Market Distorts National Property Picture

The CoreLogic RP Data Market Summary to 8th March highlights the disparity between the Sydney market and other capital cities. For example, the monthly lift in prices was 1.3% in Sydney, compared with a combined capital city change of 0.2%. It should also sound a warning, if the London market is anything to go by.

Auction clearance rates in Sydney were at 83.3%, compared with a weighted average of 73%, and half of all properties sold were in Sydney (677 out of 1,227).

The average house price in Sydney has now broken above $800,000, compared with a combined average of $596,677. A word of warning, parallels have been drawn between Sydney and the London property markets in recent time. So, its worth reflecting on this commentary relating to the London market.

Further evidence is emerging that the central London housing market bubble has burst and price falls are spreading throughout the rest of Greater London, the latest index suggests. Prime central London prices are still falling as the supply of properties rises and confidence in property as an investment ebbs away,’ according to the data from Home.co.uk. Central London locations dominate the latest list of biggest house price falls across the UK, with Walworth in the London Borough of Southwark seeing a 15% fall in average house prices between January 2014 and January 2015.

House prices in Belgravia fell by 10.3% over the same period and Cromwell Road in Kensington saw a slump of 8.3%. Of the 20 UK areas with the biggest annual fall in sales prices, 11 are in London. Landlords’ return on investment on central London properties is also falling. Of the 15 UK locations recording negative real % yield, which occurs when the value of the property depreciates by more than the annual rent, 12 are in central London.

The index shows that in January 2015, landlords with a property in Walworth recorded a negative real % yield of 11.3%, while in Belgravia the negative real % yield stood at 7.1%.

Central London flat prices are among the hardest hit. On average, the price of a flat fell by 9% in central London between January 2014 and January 2015. Over the same time, the number of flats for sale in central London has increased by 64%.

Since November 2013, the price of a typical flat in Belgravia has fallen 20%, from £1,995,000 to £1,600,000. A similar price correction has already spread into Islington, where the typical asking price of a flat has dropped 11% since March 2014. This represents a loss of £85,000 for flat buyers in Islington over the last 10 months.

There is further evidence that price falls are rippling out to more remote areas of Greater London and look set to spread further into the South East. The spectre of negative equity is looming large for recent buyers.

Further out in Greater London, Holloway flat prices peaked in May 2014 but have since dropped by 13%, while the typical time on market for flats in the area has more than doubled. Meanwhile, Muswell Hill in North London has seen flat prices fall 4% since October last year.

‘Optimism in the UK housing market is still riding high in the rest of the country, but it comes as a shock to many to learn that prices are?crumbling in the most expensive streets in London,’ said Doug Shephard, Home.co.uk director.

‘These price movements may soon have a knock-on effect for the rest of Greater London and, later, the Home Counties,’ he added, pointing out that prices in central London went up too far, too fast during 2012 and 2013.

‘In a synthetic property boom and bust such as London has experienced, on account of ultra-low interest rates and other stimulus measures, it is hard to imagine any possible remedial action on the part of the government. Prices this time may simply have to fall back to a more natural equilibrium,’ he added.

Stress Testing Households – RBA Paper

The RBA published a Research Discussion Paper “Stress Testing the Australian Household Sector Using the HILDA Survey”. They use data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey to quantify the household sector’s financial resilience to macroeconomic shocks.

Given high household indebtedness, large mortgages and high house prices, estimating the potential impact of changes to interest rates and unemployment are important. Especially so when so much of banks lending is property related, and capital ratios are lower than pre-GFC. DFA of course models mortgage stress in our own surveys, so we have an interest in this work.

Their model suggests that through the 2000s the household sector remained resilient to scenarios involving asset price, interest rate and unemployment rate shocks, and the associated increases in household loan losses under these scenarios were limited. Indeed, the results suggest that, despite rising levels of household indebtedness in aggregate, the distribution of household debt has remained concentrated among households that are well placed to service it. In turn, this suggests that aggregate measures of household indebtedness may be misleading indicators of the household sector’s financial fragility. The results also highlight the potential for expansionary monetary policy to offset the effects of increases in unemployment and decreases in asset prices on household loan losses.

Our perspective is that the household analysis they are using is not granular enough to get at the differential stress across households, and how potential interest rate rises or unemployment will impact. In addition, interest rates are low today, so it is not possible to extrapolate from events in 2000’s. Given the larger loans, adverse interest rate movements will impact harder and faster, especially amongst households with high loan to income ratios. Therefore the results should not be used as justification for further easing of monetary policy.

Some additional points to note:

The stress-testing model uses data from the HILDA Survey, is a nationally representative household-based longitudinal study collected annually since 2001. The survey asks questions about household and individual characteristics, financial conditions, employment and wellbeing. Modules providing additional information on household wealth (‘wealth modules’) are available every four years (2002, 2006 and 2010). So some data elements are not that recent.

As they rely on information from the HILDA Survey’s wealth modules, they had to impute responses to minimise the number of missing responses and thus increase the sample size. The total sample size for each year is around 6 500 households. Individual respondent data were used to estimate probabilities of unemployment; this part of the model is based on a sample of around 9 000 individuals each year. DFA uses 26,000 households each year, our sample is larger.

How then do they estimate potential household stress? Their model uses the financial margin approach where each household is assigned a financial margin, usually the difference between each household’s income and estimated minimum expenses. This is different from a ‘threshold’ approach, where each household is assumed to default when a certain financial threshold is breached (for example, when total debt-servicing costs exceed 40 per cent of income). DFA captures data on the precursors of stress, and models the cash flow changes as unemployment and interest rates move. We also model the cumulative impact of stress which builds over time (typically households survive for 18-24 months, before having to take more drastic action).

Looking at the potential economic shocks, they examined how an increase in interest rates leads to an increase in debt-servicing costs for indebted households, by lowering their financial margins. Interest rate rises tend to increase the share of households with negative financial margins, and thus the share of households assumed to default. Interest rate shocks are assumed to pass through in equal measure to all household loans.

Falling asset prices have no effect on the share of households with negative financial margins. They assume that a given asset price shock applies equally to all households.

A rise in the unemployment rate causes the income of those individuals becoming unemployed to fall to an estimate of the unemployment benefits that they would qualify for, lowering the financial margins of the affected households. Their approach uses a logit model to estimate the probability of individuals becoming unemployed. This means that unemployment shocks in the model will tend to affect individuals with characteristics that have historically been associated with a greater likelihood of being unemployed.

In their most extreme example, households in the middle of the income distribution and renters are the most affected. Households with younger heads are also affected, while household with older heads are not especially affected in any year, suggesting that the increase in indebtedness among these households through the 2000s did not significantly expose the household sector to additional risks. Households with debt are more likely to be impacted by the scenario than those without debt. However, of those households with debt, the impact of the scenario is greatest on those with relatively little debt.

Their results from the hypothetical scenario suggest that the household sector would have remained fairly resilient to macroeconomic shocks during the 2000s, and that the households that held the bulk of debt tended to be well placed to service it, even during macroeconomic shocks. However, based on this scenario, the effect of macroeconomic shocks appears to have increased over the 2000s. This suggests that household vulnerability to shocks may have risen a little. This might be because some households were in a less sound financial position following the global financial crisis (for instance, because the labour market had weakened and the prices of some assets had declined). As a consequence, shocks of a magnitude that previously would have left these households with a positive financial margin and/or sufficient collateral so as not to generate loan losses for lenders may, following the crisis, have been large enough to push these households into having a negative financial margin and/or insufficient collateral.

The results imply that expected losses (under the scenario outlined) on banks’ household loans were equivalent to a little less than 10 per cent of total bank capital (on a licensed ADI basis), assuming that eligible collateral consists of housing assets only. This result assumes that banks have already provisioned for pre-stress losses, but this may not always be the case, as the deterioration in asset quality may surprise some institutions or may take place before objective evidence of impairment has been obtained. Assuming pre-stress losses are not provisioned for, potential losses as a share of total bank capital roughly double. It is important to reiterate that these estimates are simplistic and could differ to actual losses incurred in reality under this scenario by a large margin. For example, some of these loan losses may be absorbed by lenders mortgage insurance.

It’s The Supply Side Stupid!

Housing is, no surprise, an issue in the NSW election, with Baird promising to facilitate a small number of extra homes (20,000 over 4 years) and Labor talking about deferring stamp duty for first time buyers.

Here is the thing. DFA modelling for NSW indicates we need an additional 150,000 homes in and around Sydney, each year, for the next three years, just to bring things back to equilibrium. Many of these should be starter homes in the inner suburban area, not on the urban fringe. We also need properties designed for older less mobile households. Our modelling takes account of net migration, demographic shifts, and household preferences. In particular we know there is demand for units and small houses in the inner suburban area, from both first time buyers and investors.

We do not believe that further “assistance” to first time buyers, whether via stamp duty, or access to super, per Hockey’s comments recently have any economic merit (more likely they should be seen as dog whistle politics).

Anything which eases the purchase price will simply lift the price, as for example in the now defunct first time buyer incentives.

The right question is how will policy be changed to release more land for development, and how will planning regulations be tweaked to allow the development of starter homes. How many will be built? If the answer is not in the 100,000’s we do not have the right answer. Such an inflection in supply would have a dampening effect on house price growth.

The root cause of the current issues in property in NSW goes back to pure Economics. Simply put, supply and demand are out of kilter.

On the supply side, not enough property is being constructed to meet increasing demand from local and overseas purchasers. Either space is a problem, land releases have not kept pace, or builders cannot get funding.

Demand is being stoked by demographic shifts, like more single households, older independents and young families. Also, investment purchasers see property as a good hedge against wider uncertainty, so are very active. Many can enjoy tax breaks. Plus Chinese investors have become a major force.

Thanks to the banks, purchasers can borrow more, and this lifts prices. First, low interest rates are making larger mortgages more affordable. Second, they have been able to increase the supply of home lending credit, thanks to lower capital rules, especially for those using the most sophisticated capital management. Next, they see risks in property lending much lower than commercial lending, so are happy to skew their portfolio. Finally, they have changed their lending criteria (although some regulators are pushing back), making larger loans possible, for some.

As a result, rising property prices are artificially lifting bank and household balance sheets. History shows that prices won’t necessarily defy gravity for ever. If they do correct there could be significant consequences for households, banks and the community.

We need proper supply-side strategies.

NZ Reserve Bank Consulting On Property Investor Loans

The Reserve Bank of New Zealand is consulting on a new asset class treatment for mortgage loans to residential property investors within its capital adequacy requirements. They propose to separate investment and owner occupied loans from a capital perspective, (once loan types are defined), and apply different capital treatments, requiring more capital for investment loans, reflecting potential higher risk. This would be applied to both standards and advanced IRB banks, and they would allow a period of transition to the new arrangements, commencing 1 July 2015. The net impact would be to increase the capital costs to lenders of making investment mortgages, and potentially slowing momentum in this sector. RBA please note!

The Reserve Bank’s analysis shows that residential property investor loans are a sufficiently distinct category of loans and that by grouping them with other residential mortgage loans one is not in a position adequately to measure their risk as a separate group of loans. This can have negative consequences for a bank’s awareness of the proper risk associated with those loans and lead to insufficient levels of capital being allocated to them. The Reserve Bank therefore proposes that all locally incorporated banks hold residential property investment loans in a separate asset or sub-asset class. In addition, a primary purpose of the consultation is to seek views on how to best define a property investment loan.

Consultation closes on 7 April and once the Reserve Bank has settled upon a definition, it proposes to amend existing rules by requiring all locally incorporated banks to include residential property investment mortgage loans in a specific asset sub-class, and hold appropriate regulatory capital for those loans.

Reserve Bank Head of Prudential Supervision Toby Fiennes said: “International evidence suggests that default rates and loss rates experienced during sharp housing market downturns tend to be higher for residential property investment loans than for loans to owner occupiers.

“The proposal would bring the Reserve Bank’s framework more into line with the international Basel standards for bank capital. The proposed rule amendment is designed to ensure that banks hold adequate capital for the risks that they face from investment property lending.”

The Reserve Bank has previously consulted on a possible definition that would have seen loans to borrowers with five or more residential properties classified as loans to residential property investors. Partly as a result of submissions received, the Bank has reconsidered the definition, and is now consulting on three possible alternative ways to define loans to residential property investors:

if the mortgaged property is not owner-occupied; or
if servicing of the mortgage loan is primarily reliant on rental income; or
if servicing of the mortgage loan is at all reliant on rental income.

The proposed new rule would apply to all locally incorporated banks.

While the current proposal is not a macro-prudential policy proposal, creating consistent asset class groupings to be used by all banks would help the Reserve Bank to implement targeted macro-prudential policies in the future, should that become necessary.

Looking at the proposals in more detail:

They propose that residential property lending should be grouped in a separate asset class because the risk profile of these loans is observably different from owner-occupier mortgage loans, particularly in a severe downturn. The capital requirements that apply to IRB banks require long run PDs to be estimated on the basis of data that includes a severe downturn or, where that is not possible, to include an appropriate degree of additional conservatism.

Fortunately in New Zealand, we have not had a severe housing downturn in recent decades. But this also means that we do not have information on the difference in terms to default rates between residential property investors and owner-occupiers in such a scenario.

Based on the information available from other countries that have had a severe housing downturn, there is evidence to suggest that property investor loans are more strongly correlated with systemic risk factors than owner-occupier loans. This would point to a higher correlation factor in the Basel capital equation than the one that is currently used for all residential property loans. Moreover, although minimum downturn LGDs are prescribed within BS2B, they are effectively calibrated to owner-occupiers. It is therefore likely that the estimated risk weights that banks currently use for residential investor loans are too low and do not adequately reflect the risk that these loans represent.

The higher risk associated with residential property investment loans does not only apply to IRB banks. A residential property investment loan made by a bank operating on the standardised approach is equally a higher risk loan compared to a loan to an owner-occupier. The Basel approach seems to deal with this by recommending higher average risk weights for all residential property loans under the standardised approach.

In New Zealand, this has been implemented by allocating risk weights to residential mortgage loans that range from 35 to 100 percent, depending on a loan’s LVR and the availability of lender’s mortgage insurance.5 However, housing loans are a crucial area for maintaining financial stability in New Zealand and these risk weights do not adequately capture the higher risk associated with residential property investment loans.

The Reserve Bank believes that in this area, there are good reasons why a consistent conceptual approach across standardised and IRB banks makes sense. In addition, the Reserve Bank has a suite of macro-prudential tools available to help address financial stability concerns in certain circumstances. Having the same asset class groupings across all banks would help the Reserve Bank to implement targeted macro-prudential policies if that becomes necessary. Contrary to previous consultation papers on this subject therefore, the Reserve Bank now proposes to include a new asset class for residential property investors within the standardised approach, i.e. BS2A. This new asset class would also have separate, prescribed, risk weights from those that apply to non-residential property investment loans.

It is necessary to define what constitutes an investment loan. The first and in some ways simplest option would be to restrict the current retail residential mortgage asset class to owner-occupiers only. Any mortgage on a residential property that is not owner-occupied would be classified as a residential property investment loan and grouped in a new asset class.

Banks would have to verify the use of a property under this option. This information is already being collected at loan origination to some degree. Possible ways of identifying whether a property is owner-occupied or not include checking the borrower’s residential address and
whether the property generates any rental income. Other possible indicators could include eligibility for tax deductibility of the mortgage servicing costs on the property. The Reserve Bank appreciates that there could be cases where a borrower has more than one owner-occupied residential property and splits his or her time between those addresses. An example could be if a borrower uses one address during the week for work purposes and another on the weekends when he or she is with the family. Another case might be a bach that is not permanently occupied but also does not generate any rental income. The information the Reserve Bank collects from banks on new commitments already distinguishes between owner-occupiers and residential property investors while allowing for owner-occupiers to occupy more than one residential address. The same or a very similar definition could be used to distinguish between second and more properties that are still owner-occupied and properties that are used as residential properties, subject to considering adequate safeguards to ensure that this is not used as an avoidance mechanism.

The Reserve Bank also appreciates that there could be challenges for banks to monitor how a property is being used. A second flat that is used as a second residence by the owner-occupier when the loan is taken out could at some point be let out. While the Reserve Bank does not expect banks to regularly seek confirmation form borrowers as to the use of a property, it is expected that reasonable steps are taken to maintain up to date information. This could mean updating important information when there is a credit event.

An alternative option would be to use mortgage servicing costs as an indicator. If mortgage servicing are predominantly reliant on the rental income the property generates, then that loan should be classified as a residential property investment loan. Predominantly was defined as more than fifty percent. In other words, if a borrower’s other sources of income minus the bank’s usual allowances for living expenses, other loan servicing obligations and so on are sufficient to cover more than fifty percent of the loan servicing obligation of the residential property, that is interest as well as repayment of principal, then the loan continues to be classified as a residential mortgage loan in the retail asset class. This test would only apply to investment properties. Owner-occupied properties would be exempt from this requirement and continue to be classified as residential mortgage loans. There is, however, a question as to the point at which the reliance on the property’s rental income separates that loan from loans to owner-occupiers. The Reserve Bank has previously consulted on a threshold of 50 percent. But this still leaves plenty of scope for borrowers to acquire a small portfolio of investment properties without those mortgages being classified as residential property investment loans. A stricter definition would be to make it dependent on any rental income.

Irrespective of which definition and asset class treatment is decided on, banks are likely to require some time to implement the new requirements. For example, banks will have to assess which of their existing exposures are caught by the residential property investment loan definition, make changes to their information capture and IT systems and retrain staff. This will take some time. The Reserve Bank is therefore currently minded to phase the new requirement in over a period of nine months.

IRB banks may also have to develop new models for their residential property investment loan portfolio, although that is not necessarily the case and existing PD models would form a good basis on which to build residential property investor specific models. IRB banks, however, would have to amend their capital engines for residential investor loans to use the proposed LGDs and correlation factors.

It is proposed that IRB banks operate under the same risk weight requirements as standardised banks until their new models have been approved by the Reserve Bank. Furthermore, it is proposed that the new asset classification for residential property investors takes effect from 01 July 2015.

They are also proposing changes to capital requirements for reverse mortgages. Managing a portfolio of reverse mortgages requires long term assumptions to be made concerning a number of factors. If those assumptions turn out to be wrong, the risk to a lender could be significantly affected. For example, advances in geriatric healthcare might mean that people stay longer in their houses than currently anticipated. That could increase the risk of incurring a loss on a portfolio of reverse mortgages due to compound interest, the possibility of the borrower being granted further top ups and the difficulty of predicted house prices years and decades ahead.

While arrangements whereby the reverse mortgage has to be repaid after a certain period of time or stay below a set LVR are theoretically possible, they are not the norm and would most likely be to the disadvantage of the borrower, and thus undermine the attractiveness of a reverse mortgage.

To emphasise, one way in which the risk profile of a reverse mortgages differs from a normal mortgage is in the time dimension. Whereas a normal mortgage loan decreases over time, the opposite is the case for a reverse mortgage.

Finally, the Reserve Bank considers it more appropriate group credit card and revolving retail loans in the “other retail category and to remove QRRE as an option from its capital requirements for IRB banks. This would improve clarity within BS2B while having no direct impact on banks since no bank has been given approval to use the QRRE option.

Basel II framework for IRB banks introduced the concept of a ‘Qualifying Revolving Retail Exposure’ as one of three categories of retail loans. The other two categories are residential mortgages and other retail, a catch all for retail loans other than residential mortgages. The QRRE category is intended to be used for short-term unsecured revolving lines of credit, e.g. credit cards and certain overdraft facilities. In New Zealand credit card loans account for approximately 1 to 3 percent of banks’ total lending portfolios. Compared to the other two categories, the capital requirement for QRRE loans is generally lower (except for some very high probability of default (PD) buckets).

In line with Basel II, the Reserve Bank’s capital adequacy requirements provide for the use of the QRRE category. However, use of the QRRE classification is subject to Reserve Bank approval and no bank has been granted approval as yet. The Reserve Bank is concerned that some of the underlying assumptions of the QRRE category do not apply in the New Zealand context. The evidence supplied by banks when seeking approval for QRRE use has not able to demonstrate the validity of those assumptions in New Zealand.