Martin North – Page 1025 – Digital Finance Analytics (DFA) Blog

RBA Cuts To Record Low – 2%

The RBA cut the cash rate by 25 basis points today, in the hope that i) households who are already carrying record debt will be persuaded to spend and borrow more, and ii) the “quiet word” from the regulator will keep a cap on exploding house prices in Sydney by controlling exuberant investment lending. The journey back from this record low will be low and painful, and if a real crisis hits, there is so little left in the locker. Worth re-reading the recent Fitch commentary on the US who are facing a high debt, higher interest rate future.

At its meeting today, the Board decided to lower the cash rate by 25 basis points to 2.0 per cent, effective 6 May 2015.

The global economy is expanding at a moderate pace, but commodity prices have declined over the past year, in some cases sharply. These trends appear largely to reflect increased supply, including from Australia. Australia’s terms of trade are falling nonetheless.

The Federal Reserve is expected to start increasing its policy rate later this year, but some other major central banks are stepping up the pace of unconventional policy measures. Hence, financial conditions remain very accommodative globally, with long-term borrowing rates for sovereigns and creditworthy private borrowers remarkably low.

In Australia, the available information suggests improved trends in household demand over the past six months and stronger growth in employment. Looking ahead, the key drag on private demand is likely to be weakness in business capital expenditure in both the mining and non-mining sectors over the coming year. Public spending is also scheduled to be subdued. The economy is therefore likely to be operating with a degree of spare capacity for some time yet. Inflation is forecast to remain consistent with the target over the next one to two years, even with a lower exchange rate.

Low interest rates are acting to support borrowing and spending, and credit is recording moderate growth overall, with stronger lending to businesses of late. Growth in lending to the housing market has been steady over recent months. Dwelling prices continue to rise strongly in Sydney, though trends have been more varied in a number of other cities. The Bank is working with other regulators to assess and contain risks that may arise from the housing market. In other asset markets, prices for equities and commercial property have been supported by lower long-term interest rates.

The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.

At today’s meeting, the Board judged that the inflation outlook provided the opportunity for monetary policy to be eased further, so as to reinforce recent encouraging trends in household demand.

The Macroeconomic Effects of Public Investment

An IMF working paper was released today entitled “The Macroeconomic Effects of Public Investment:Evidence from Advanced Economies”. Six years after the global financial crisis, the recovery in many advanced economies remains tepid. This is highly relevant to the current Australian economic and budget debate.

There are now worries that demand will remain persistently weak — a possibility that has been described as “secular stagnation”. One response that is being considered (see for example the European Commission 2014) is an increase in public infrastructure investment, which could provide a much-needed fillip to demand and is one of the few remaining policy levers available to support growth. But there are open questions about the size of the public investment multipliers and the long-term returns on public capital, both of which play a role in determining how public-debt-to-GDP ratios will evolve in response to higher public investment. To assess appropriately the benefits and costs of increasing public investment in infrastructure, it is critical to determine what macroeconomic impact public investment will have. The paper attempts to shed more light on this subject.

What are the macroeconomic effects of public investment? To what extent does it raise output, both in the short and the long term? Does it increase the public-debt-to-GDP ratio? How do these effects vary with key characteristics of the economy, such as the degree of economic slack, the efficiency of public investment, and the way the investment is financed? To address these questions, the paper examined the historical evidence on the macroeconomic effects of public investment in 17 OECD economies over the 1985–2013 period.

They found that such investment raises output in both the short and long term, crowds in private investment, and reduces unemployment, with limited effect on the public debt ratio. They also found that these effects vary with a number of mediating factors. The effects of public investment are particularly strong when there is slack in the economy and monetary accommodation. In such cases, the boost to output from higher government investment may exceed the debt issued to finance the investment. Government projects are more effective in boosting output in countries with higher efficiency of public investment. Finally, the mode of financing investment matters. They find suggestive evidence that debt-financed projects have larger expansionary effects than budget-neutral investments financed by raising taxes or cutting other government spending.

The findings suggest that for economies with clearly identified infrastructure needs and efficient public investment processes and where there is economic slack and monetary accommodation, there is a strong case for increasing public infrastructure investment. Moreover, evidence suggests that increasing public infrastructure investment will be particularly effective in providing a fillip to aggregate demand and expanding productive capacity in the long run, without raising the debt-to-GDP ratio, if it is debt financed. Finally, the results show how critical increasing investment efficiency is to mitigating the possible trade-off between higher output and higher public-debt-to-GDP ratios. Thus a key priority in many economies, particularly in those with relatively low efficiency of public investment, should be to raise the quality of infrastructure investment by improving the public investment process.

ANZ 1H 2015 Results 3% Higher

ANZ released their results for 1H 2015 today. They reported a statutory profit of $3,506m up 3% from 1H14, and a cash profit of $3,676m, up 5% from 1H14. This was slightly better than expected. The result was driven by significant growth in customer deposits (up 12%) and advances (up 10%) and a provision charge of $510 million down 3%. The Group total loss rate saw a modest decline over the year, from 21bps to 19bps and ANZ’s expectation is that the loss rate will stabilise in 2H15. It expects to be operating in a lower growth operating environment going forwards.

A 4% increase in the Interim Dividend to 86 cents per share will see ANZ shareholders receive $2.4 billion, of which around 73% will be delivered to Australian based Retail and Institutional investors. ANZ expects to maintain a payout ratio for the Financial Year 2015 towards the upper end of the 65 to 70% of Cash Profit range.

ANZ’s Capital Ratio at the end of the first half was 8.7%, up 40 basis points (bps) on the same half in 20144. This half the Dividend Reinvestment Plan will operate with a 1.5% discount which is expected to result in a participation ratio of around 20% on a full year basis.

Looking across the divisions, in Australia, profit grew 8%, driven by a 6% uplift in both income and profit before provisions. Customer numbers, business volumes and market share all grew driven by investment in products, sales and service capacity and capability. Additional staff and training, new and improved digital tools including online applications, expanded customer coverage and improved service levels delivered increased Retail loan volumes, up 8% and C&CB loan volumes, up 4%. Deposits increased 3% and 6% respectively. Home lending has now grown above system for five consecutive years. Retail net interest margin fell 5 basis points from 2.01% in 2H2014 to 1.97%. The C&CB Business delivered ongoing growth despite subdued business sector confidence. ANZ’s historic strength in the Small Business Banking (SBB) segment continued with lending up 15% having grown at double digit rates for the past 3 years. Deposits in SBB have also grown strongly and at $31 billion, are more than double the level of loans.

International and Institutional Banking increased profit by 7% with strong contributions from Global Markets customer sales and the Cash Management business along with ongoing benign credit outcomes. PBP increased by 1%. Geographically, Asia Pacific Europe and America (APEA) was the standout, with profit up 18%. In Asia, customer revenues increased 13%, largely through increased focus on lower capital intensity, higher return products like Foreign Exchange, Cash Management and Debt Capital Markets. ANZ is also growing strongly in the region’s key trade and investment flow corridors including those between Australia and Hong Kong, China and Hong Kong and Australia and Singapore.

In the Trade business while volumes were broadly maintained, deteriorating commodity prices reduced the value of shipments, lowering income slightly. Lending growth across the network partially offset ongoing loan margin compression which is being felt most acutely in Australia. The quality of the loan book remains high, at 79% investment grade. Deposits increased 17%, including a 27% increase in deposits in APEA. The percentage uplift in both deposits and lending in part reflects the depreciation of the Australian Dollar during the period. A record Global Markets revenue result was in large part delivered via a record customer sales outcome, most notably in Asia. Increased activity particularly in rates, commodities and FX, assisted sales in the second quarter of the year.

In New Zealand (all figures in NZD), the business has increased momentum, with income growth of 6% and profit before provisions up 8%. Economic momentum has lifted lending volumes. Profit growth after provisions was up 1% reflected a lower level of provision write-backs than in the prior comparable period. Home lending lifted 6% with market share increasing in key regions like Auckland and Christchurch. Streamlined products and processes along with digital tools helped lift Commercial and Agri business with lending up 6%.

Focussing on the Australian mortgage performance, which made up 69% of the Australian division credit exposure, there was more growth in NSW (1x3x system) than other states. Investment lending share increased, growing at system, and more loans were originated via the broker channels at 1.3x system. ANZ has been growing is mobile lender base, with a 50% increase in NSW.

Total home lending was $218 bn, up 8% net, with 934k loan accounts. The average balance at origination was $376k, (much higher than Westpac at $235k), the average LVR was 71% at origination (same as Westpac).

43% of the portfolio was ahead on repayments (Westpac was 73%) and 35% of the portfolio is interest only. 90+ day delinquencies were 5.7 basis points with highest rates in Queensland. Note this excludes non-performing loans.

Building Approvals Up Again, Especially Units In NSW

Australian Bureau of Statistics (ABS) Building Approvals show that the number of dwellings approved rose 1.8 per cent in March 2015, in trend terms, and has risen for ten months. This continued strength was driven by increases in new flats, units or apartments in residential buildings.

The value of total building approved rose 0.9 per cent in March, in trend terms, and has risen for nine months. The value of residential building rose 2.5 per cent while non-residential building fell 2.8 per cent in trend terms.

The number of dwelling approvals increased in March in New South Wales (4.4 per cent), Tasmania (3.3 per cent), Queensland (3.0 per cent) and Victoria (1.2 per cent) but decreased in Northern Territory (14.6 per cent), Australian Capital Territory (3.8 per cent), Western Australia (1.9 per cent) and South Australia (1.7 per cent) in trend terms.

There are significant state variations with regards to the proportion of approvals relating to houses, lowest in the Sydney region.

In trend terms, approvals for private sector houses rose 0.2 per cent in March. Private sector houses rose in New South Wales (1.8 per cent) and Victoria (1.1 per cent) but fell in South Australia (1.3 per cent), Western Australia (1.3 per cent) and Queensland (0.9 per cent).

The trend value of residential building rose 2.5% and has risen for 12 months. The value of non-residential building fell 2.8% and has fallen for four months. The 6 month average value moments highlights the state variations, with NSW hot, and WA coming off.

Westpac 1H 2015 Result Flat

Westpac announced their 1H results today, with cash earnings of $3,778 million, flat compared with the prior corresponding period and 2% lower than 2H14. Statutory net profit was $3,609 million, flat on 1H14, and 8% lower than 2H14. The expense to income ratio was 42.5% from 41.2% and there was a further improvements in asset quality with impaired assets as a percentage of gross loans falling 16 basis points to 0.35%. Whilst provisions were down, and net margins maintained at 2.01% (excluding treasury), weaker treasury income eroded the overall performance. Overall result was a little below consensus forecasts. The interim fully franked dividend was 93 cents per share, up 3% from 1H14, but 1% from 2H14.

Retail banking did quite well, but the Investment bank earnings were 17% lower due to the $85 million post tax charge as a result of derivative adjustments and a lower impairment benefit, despite customer revenues rising 6% and strong lending growth.

We see indications of building headwinds ahead relating to capital requirements, significant deposit repricing to offset mortgage discounts, and a continued reliance on the mortgage book to underpin growth. We also note a tightening of lending criteria in terms of interest rate buffers, and an intent to reduce investment property lending to below the 10% growth “alert” level. We, in other words, see responses to the dead hand of the regulator.

The Group’s common equity Tier 1 (CET1) capital ratio of 8.8% is well above regulatory minimums. However, due to other items, including changes in mortgage risk factors implemented during the half, the ratio is currently at the lower end of the Group’s preferred capital range of 8.75% to 9.25%. Given the current uncertainty over future capital settings, including the introduction of the next set of reforms from the Basel Committee on Banking Supervision, and the Federal Government’s assessment of the final recommendations from the Financial System Inquiry, the Group will operate at the upper end of the preferred capital range. So the Group will issue shares to satisfy the DRP for the interim dividend (at a 1.5% discount), and partially underwrite the DRP to increase CET1 capital by approximately $2 billion.

Overall net operating income was up 1%, and within that, net interest income rose 2%, supported by growth of 3% mostly from rise in Australian mortgages, and customer deposit growth of 3%, with focus on growing efficient deposits. However, net interest margin were down 1bp due to lower Treasury revenue. Margins excluding Treasury and Markets were overall flat. Turning to non-interest income, it was down 2%, whilst fees and commissions were up 1% to $1,478m, wealth and insurance fell 1% to $1,134m, trading income was down 10% to $425m (up 16% excluding derivative adjustments) and other income was down 17% to $49m.

Net Interest Margin was down 1 bp to 2.05%. NIM up across WRBB (1bp), New Zealand (2bps), and slightly down in St.George (2bps). Most margin pressure was in WIB (down 11bps). NIM excluding Treasury and Markets flat at 2.01%. Within that, we see a 6bps decrease in asset spreads primarily from impact of competitive pricing in mortgages. Business and institutional spreads also lower, 5bps increase from improved customer deposit spreads on term deposits, online accounts and savings deposits, partially offset by 1bps impact of lower hedging benefit on low-rate deposits, 3bps benefit from term wholesale funding as pricing for new term senior issuances was lower than maturing deals, 1bp decrease from increased holdings of high quality liquid assets and cost of CLF and 1bp decline in capital and other due to lower hedging rates. Treasury and Markets down 1bp, reflecting lower Treasury earnings.

Looking at the Australian mortgage business, they have an Australian mortgage market share of 23.1% and the book grew by 0.9x system. The 3% lift in balances was partly offset by run-off of $25.2bn, up 6%. Around 20% of loans were above 80% LVR, little changed from last period, with the average LVR on new loans at 71%. 53.2% of new loans were through WBC’s proprietary channels, the share via brokers therefore continuing to rise (1H14 was 57.5% through own channels).

Portfolio losses of $38m in 1H15 represent an annualised loss rate of 2bps (net of insurance claims) and loss rates remain very low by international standards. Mortgage insurance claims for 1H15 were $1m (2H14 $6m, 1H14 $3m). Properties in possession remain <2bps of the portfolio, however have increased, mainly in Qld, where natural disasters and a decline in mining investment have seen weaker conditions and a review of treatment of hardship will likely see a rise in reported delinquencies in future periods.

Australian mortgage customers continue to display a cautious approach to debt levels, taking advantage of historically low mortgage rates to pay down debt and build buffers. Including mortgage offset account balances, 73% of customers are ahead of scheduled payments, with 23% of these being more than 2 years ahead. Mortgage offset account balances up $3.3bn or 14% (up 29% 1H15/1H14) to $27bn. Credit decisions across all brands are made by the Westpac Group, regardless of the origination channel.

Westpac has made significant changes to their serviceability assessment. Loan serviceability assessments include an interest rate buffer, adequate surplus test and discounts to certain forms of income (e.g. dividends, rental income). Westpac now has a minimum assessment rate, often referred to as a floor rate, set at 7.10% p.a. The minimum assessment rate is at least 210bps higher than the lending rate and is applied to all mortgage debt, not just the loan being applied for. We note that the minimum assessment rate and buffer has increased from 6.80% p.a. and 180bps respectively – the regulators quiet word perhaps?

Investment property loans (IPLs) are 46.3% of Westpac’s Australian mortgage portfolio and compared to owner-occupied applicants, IPL applicants are on average older (75% over 35 years), have higher incomes and higher credit scores. 87% of IPLs originated at or below 80% LVR. Majority of IPLs are interest-only, however the repayment profile closely tracks the profile of the principal and interest portfolio, and 62% of interest-only IPL customers are ahead on repayments. IPL 90+ days delinquencies is 36bps and continue to outperform the total portfolio average. IPL portfolio losses represent an annualised loss rate of 2bps (net of insurance claims) – in line with total portfolio losses of 2bps. Self-managed Superannuation Fund balances are a very small part of the portfolio, at 1% of Australian mortgage balances.

We are told that All IPLs are full recourse and loan serviceability assessments include an interest rate buffer, minimum assessment rate, adequate surplus test and discounts to certain forms of income (e.g. dividends, rental income). In adiditon, all IPLs, including interest-only loans, are assessed on a principal & interest basis and specific credit policies apply to IPLs to assist risk mitigation, including holiday apartments subject to tighter acceptance requirements, additional LVR restrictions apply to single industry towns, minimum property size and location restrictions apply, restrictions on non-resident lending include lower maximum LVR and discounts to foreign income recognition.

Westpac says it had more than 10% growth in investment loans (which may trigger interest from APRA and potentially additional capital), so it is actively managing the number down to 10%. We suspect this translates into tighter underwriting criteria. That said, bank portfolio stress testing indicates that even under extreme scenarios, losses, including those via their captive Lenders Mortgage Insurer would be manageable.

They predict that investment property lending will remain buoyant and that whilst the property market supply is not meeting demand, the market is fundamentally sound.

Turning to capital, Westpac’s preferred common equity Tier 1 (CET1) capital range is 8.75% – 9.25%. The management buffer above regulatory minimums takes into consideration the capital conservation buffer (CCB) requirement from January 2016, stress testing to maintain an appropriate buffer in a downturn, quarterly volatility of capital ratios associated with dividend payments. Given current regulatory uncertainties the Group has decided it is appropriate to move capital ratios to the upper end of the preferred range and will be issuing shares to satisfy the DRP at a 1.5% discount. They flag a number of potential capital headwinds. These include, RBNZ changes to risk weighting of investor property loans, BCBS2 initial consultation on standardised approach for determining Credit RWA and consults on RWA capital floors for advanced banks, proposals announced December 2014 with first consultation due mid-2015. BCBS work plan target date for completion end 2015. Implementation date and transition arrangements to be advised. In addition, they are awaiting Government and APRA response to provide more information on implementation of FSI recommendations, leverage ratio disclosure expected during 2015 and applicable (Pillar 1) from 2018, FSB3 undertaking a QIS4 on TLAC5 during 2015 with rules for G-SIBs expected to be finalised at G20 summit in 2015. D-SIB impacts unknown and risk model enhancements and recalibrations – IRRBB. Net net, as we have discussed we expect capital demands to be raised in the future, and this will require the bank to lift its capital buffers.

AU$ Movements Before RBA Rate Releases Were “Normal” – ASIC

ASIC today released an update on their investigations into AU$ trading movements around the time of recent RBA target rate announcements. Whilst their investigations are ongoing, ASIC says the movements are related to liquidity positions and computer based trading, and do not indicate cases of market misconduct.

ASIC today provided an update on its investigation into the movements in the Australian dollar shortly before the Reserve Bank’s monetary policy decisions for February, March and April 2015.

The enquiry is investigating trading in the dollar in the minute prior to the RBA’s interest rate decision statement at 2.30pm.

ASIC has made extensive enquiries into the management of the information flow regarding the RBA’s interest rate decision prior to the announcement of this decision.

ASIC’s current focus is on reviewing the trading behaviour of a number of foreign exchange markets and platforms including interest rate futures markets and CFD platforms providing foreign exchange markets. Notices to produce trading information have been sent to many financial institutions and platform providers to understand the basis of the trading on these markets at the point in time of interest.

ASIC’s enquiries are ongoing as to the cause of the swings in the currency markets. Preliminary findings reveal moves in the Australian Dollar ahead of the announcement to be as a result of normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement. The reduction in liquidity providers is a usual occurrence prior to announcement in all markets. Much of the trading reviewed to date was linked to position unwinds by automated trading accounts linked to risk management logic and not misconduct.

In particular, ASIC has observed liquidity being withdrawn from the market at the same moment as participants already positioned were considering their risk exposure too large ahead of the announcement and reducing their position. This lack of liquidity distorted the execution logic in the algorithms of some participant systems. This, along with a fall in trading volumes leading up to the release of key market data, means trades may have had a more pronounced impact on the price than they otherwise would.

Government Strengthens the Foreign Investment Framework

The Government today announced details of the changes which will be brought in on 1 December 2015, to clamp down on illegal foreign property purchases. Fees will be introduced for foreign investment applications. Since the measures were mooted, about 100 cases of potential illegal purchase are being investigated at the moment. For example, one case in WA involved a property of around $800,000. People have until 30th November to come forward to avoid prosecution, but will have to sell. The release follows:

The Commonwealth Government is taking action to strengthen the integrity of the foreign investment framework. Foreign investment is integral to Australia’s economy and we welcome all investment that is not contrary to our national interest. After extensive consultations on our Options Paper, we are announcing important reforms to foreign investment that will help to demonstrate that it is for our country’s benefit.

We will ensure stronger enforcement of new and existing foreign investment rules by transferring all residential real estate functions to the Australian Taxation Office. The ATO will use its data-matching systems to identify possible breaches and the Commonwealth will pursue those foreign investors who break the rules.

Australia’s foreign investment regime generally does not allow foreign investors to purchase existing residential properties. There will now be stricter penalties to make it easier to pursue foreign investors who breach the rules. Criminal penalties will be increased to $127,500 or three years imprisonment for individuals and to $637,500 for companies. Divestment orders will be supplemented by civil pecuniary penalties and infringement notices for less serious breaches.

The Government will also ensure that people who break the rules do not profit by introducing a civil penalty to capture any capital gain made on divestment of a property. Third parties who knowingly assist a foreign investor to breach the rules will also now be subject to civil and criminal penalties, including fines of $42,500 for individuals and $212,500 for companies.

Australian taxpayers will no longer foot the bill for screening foreign investment application applications. Fees will be levied on all foreign investment applications. For residential properties valued at $1 million or less, foreign investors will pay a fee of $5,000. Higher fees will apply to more expensive residential properties as well as business, agriculture and commercial real estate applications.

Australia’s foreign investment policy for residential real estate is designed to increase Australia’s housing stock, but lack of enforcement over recent years has threatened the integrity of the framework. We will enforce the rules, ensuring that all foreign investors follow the rules and don’t profit from breaking them.

The Government will introduce legislation into Parliament in the Spring Sittings to ensure that the reforms will commence on 1 December 2015.

There will also be increased scrutiny around foreign investment in agriculture and increased transparency on the levels of foreign ownership in Australia through a comprehensive land register.

Basel IV – Is More Complexity Better?

In December 2014, The Bank For International Settlements issued proposed Revisions to the Standardised Approach for credit risk for comment. It proposes an additional level of complexity to the capital calculations which are at the heart of international banking supervision. Comments on the proposals were due by 27 March 2015. These latest proposals, which have unofficially been dubbed “Basel IV”, is a continuation of the refining of the capital adequacy ratios which guide banking supervisors and relate to the standardised approach for credit risk. It forms part of broader work on reducing variability in risk-weighted asset. We want to look in detail at the proposals relating to residential real estate, because if adopted they would change the capital landscape considerably. Note this is separate from the proposal relating to the adjustment of IRB (internal model) banks. Whilst it aspires to simplify, the proposals are, to put it mildly, complex

For the main exposure classes under consideration, the key aspects of the proposals are:

Bank exposures would no longer be risk-weighted by reference to the external credit rating of the bank or of its sovereign of incorporation, but they would instead be based on a look-up table where risk weights range from 30% to 300% on the basis of two risk drivers: a capital adequacy ratio and an asset quality ratio.
Corporate exposures would no longer be risk-weighted by reference to the external credit rating of the corporate, but they would instead be based on a look-up table where risk weights range from 60% to 300% on the basis of two risk drivers: revenue and leverage. Further, risk sensitivity would be increased by introducing a specific treatment for specialised lending.
The retail category would be enhanced by tightening the criteria to qualify for the 75% preferential risk weight, and by introducing a fallback subcategory for exposures that do not meet the criteria.
Exposures secured by residential real estate would no longer receive a 35% risk weight. Instead, risk weights would be determined according to a look-up table where risk weights range from 25% to 100% on the basis of two risk drivers: loan-to-value and debt-service coverage ratios.
Exposures secured by commercial real estate are subject to further consideration where two options currently envisaged are: (a) treating them as unsecured exposures to the counterparty, with a national discretion for a preferential risk weight under certain conditions; or (b) determining the risk weight according to a look-up table where risk weights range from 75% to 120% on the basis of the loan-to-value ratio.
The credit risk mitigation framework would be amended by reducing the number of approaches, recalibrating supervisory haircuts, and updating corporate guarantor eligibility criteria.

Real Estate Capital Calculation Proposals

The recent financial crisis has demonstrated that the current treatment is not sufficiently risk-sensitive and that its calibration is not always prudent. In order to increase the risk sensitivity of real estate exposures, the Committee proposes to introduce two specialised lending categories linked to real estate (under the corporate exposure category) and specific operational requirements for real estate collateral to qualify the exposures for the real estate categories.

Currently the standardised approach contains two exposure categories in which the risk-weight treatment is based on the collateral provided to secure the relevant exposure, rather than on the counterparty of that exposure. These are exposures secured by residential real estate and exposures secured by commercial real estate. Currently, these categories receive risk weights of 35% and 100%, respectively, with a national discretion to allow a preferential risk weight under certain strict conditions in the case of commercial real estate.

Residential Owner Occupied Real Estate

In order to qualify for the risk-weight treatment of a residential real estate exposure, the property securing the mortgage must meet the following operational requirements:

Finished property: the property securing a mortgage must be fully completed. Subject to national discretion, supervisors may apply the risk-weight treatment for loans to individuals that are secured by an unfinished property, provided the loan is for a one to four family residential housing unit.
Legal enforceability: any claim (including the mortgage, charge or other security interest) on the property taken must be legally enforceable in all relevant jurisdictions. The collateral agreement and the legal process underpinning the collateral must be such that they provide for the bank to realise the value of the collateral within a reasonable time frame.
Prudent value of property: the property must be valued for determining the value in the LTV ratio. Moreover, the value of the property must not be materially dependent on the performance of the borrower. The valuation must be appraised independently using prudently conservative valuation criteria and supported by adequate appraisal documentation.

The current standardised approach applies a 35% risk weight to all exposures secured by mortgage on residential property, regardless of whether the property is owner-occupied, provided that there is a substantial margin of additional security over the amount of the loan based on strict valuation rules. Such an approach lacks risk sensitivity: a 35% risk weight may be too high for some exposures and too low for others. Additionally, there is a lack of comparability across jurisdictions as to how great a margin of additional security is required to achieve the 35% risk weight.

In order to increase risk sensitivity and harmonise global standards in this exposure category, the Committee proposes to introduce a table of risk weights ranging from 25% to 100% based on the loan-to-value (LTV) ratio. The Committee proposes that the risk weights derived from the table be applied to the full exposure amount (ie without tranching the exposure across different LTV buckets).

The Committee believes that the LTV ratio is the most appropriate risk driver in this exposure category as experience has shown that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the lower the loss incurred in the event of a default. Furthermore, data suggest that the lower the outstanding loan amount relative to the value of the residential real estate collateral, the less likely the borrower is to default. For the purposes of calculating capital requirements, the value of the property (ie the denominator of the LTV ratio) should be measured in a prudent way. Further, to dampen the effect of cyclicality in housing values, the Committee is considering requiring the value of the property to be kept constant at the value calculated at origination. Thus, the LTV ratio would be updated only as the loan balance (ie the numerator) changes.

The LTV ratio is defined as the total amount of the loan divided by the value of the property. For regulatory capital purposes, when calculating the LTV ratio, the value of the property will be kept constant at the value measured at origination, unless an extraordinary, idiosyncratic event occurs resulting in a permanent reduction of the property value. Modifications made to the property that unequivocally increase its value could also be considered in the LTV. The total amount of the loan must include the outstanding loan amount and any undrawn committed amount of the mortgage loan. The loan amount must be calculated gross of any provisions and other risk mitigants, and it must include all other loans secured with liens of equal or higher ranking than the bank’s lien securing the loan. If there is insufficient information for ascertaining the ranking of the other liens, the bank should assume that these liens rank pari passu with the lien securing the loan.

In addition, as mortgage loans on residential properties granted to individuals account for a material proportion of banks’ residential real estate portfolios, to further increase the risk sensitivity of the approach, the Committee is considering taking into account the borrower’s ability to service the mortgage, a proxy for which could be the debt service coverage (DSC) ratio. Exposures to individuals could receive preferential risk weights as long as they conform to certain requirement(s), such as a ‘low’ DSC ratio. This ratio could be defined on the basis of available income ‘net’ of taxes. The DSC ratio would be used as a binary indicator of the likelihood of loan repayment, ie loans to individuals with a DSC ratio below a certain threshold would qualify for preferential risk weights. The threshold could be set at 35%, in line with observed common practice in several jurisdictions. Given the difficulty in obtaining updated borrower income information once a loan has been funded, and also given concerns about introducing cyclicality in capital requirements, the Committee is considering whether the DSC ratio should be measured only at loan origination (and not updated) for regulatory capital purposes.

The DSC ratio is defined as the ratio of debt service payments (including principal and interest) relative to the borrower’s total income over a given period (eg on a monthly or yearly basis). The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. The DSC ratio must be prudently calculated in accordance with the following requirements:

Debt service amount: the calculation must take into account all of the borrower’s financial obligations that are known to the bank. At loan origination, all known financial obligations must be ascertained, documented and taken into account in calculating the borrower’s debt service amount. In addition to requiring borrowers to declare all such obligations, banks should perform adequate checks and enquiries, including information available from credit bureaus and credit reference agencies.
Total income: income should be ascertained and well documented at loan origination. Total income must be net of taxes and prudently calculated, including a conservative assessment of the borrower’s stable income and without providing any recognition to rental income derived from the property collateral. To ensure the debt service is prudently calculated, the bank should take into account any probable upward adjustment in the debt service payment. For instance, the loan’s interest rate should (for this purpose) be increased by a prudent margin to anticipate future interest rate rises where its current level is significantly below the loan’s long-term level. In addition, any temporary relief on repayment must not be taken into account for purposes of the debt service amount calculation.

Notwithstanding the definitions of the DSC and LTV ratios, banks must, on an ongoing basis, have a comprehensive understanding of the risk characteristics of their residential real estate portfolio.

The risk weight applicable to the full exposure amount will be assigned, as determined by the table below, according to the exposure’s loan-to-value (LTV) ratio, and in the case of exposures to individuals, also taking into account the debt service coverage (DSC) ratio. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given residential real estate exposures must apply a 100% risk weight to such an exposure.

Some points to note.

Differences in real estate markets, as well as different underwriting practices and regulations across jurisdictions make it difficult to define thresholds for the proposed risk drivers that are meaningful in all countries.
Another concern is that the proposal uses risk drivers prudently measured at origination. This is mainly to dampen the effect of cyclicality in housing values (in the case of LTV ratios) and to reduce regulatory burden (in the case of DSC ratios). The downside is that both risk drivers can become less meaningful over time, especially in the case of DSC ratios, which can change dramatically after the loan has been granted.
The DSC ratio is defined using net income (ie after taxes) in order to focus on freely disposable income. That said, the Committee recognises that differences in tax regimes and social benefits in different jurisdictions make the concept of ‘available income’ difficult to define and there are concerns that the proposed definition might not be reflective of the borrower’s ability to repay a loan. Further, the level at which the DSC threshold ratio has been set might not be appropriate for all borrowers (eg high income) or types of loans (eg those with short amortisation periods). Therefore the Committee will explore whether using either a different definition of the DSC ratio (eg using gross income, before taxes) or any other indicator, such as a debt-to-income ratio, could better reflect the borrower’s ability to service the mortgage.
There are no specific proposal to treat loans that are past-due for more than 90 days.

Investment Loans

Bearing in mind that 35% of all loans are for investment purposes in Australia, the proposals relating to loans for investment purposes are important. So how will they be treated under Basel 4?

There are a number of pointers in the proposals, though its not totally clear in our view. First, we think the proposals would apply to separate loans where repayment is predicated on income generated by the property securing the mortgage, i.e. investment loans rather than a normal loans where the mortgage is linked directly to the underlying capacity of the borrower to repay the debt from other sources. Such loans might fall into a special commercial real estate category, specialist lending category, or a fall back to the unsecured category, each with different sets of capital weights.

The Committee proposes that any exposure secured with real estate that exhibits all of the characteristics set out in the specialised lending category should be treated for regulatory capital purposes as income-producing real estate or as land acquisition, development and construction finance as the case may be, rather than as exposures secured by real estate. Any non-specialised lending exposure that is secured by real estate but does not satisfy the operational requirements should be treated for regulatory capital purposes as an unsecured exposure, either as a corporate exposure or other retail exposure, as appropriate.

Specialised lending exposure, would be defined so if all the following characteristics, either in legal form or economic substance were met:

The exposure is typically to an entity (often a special purpose entity (SPE)) that was created specifically to finance and/or operate physical assets;
The borrowing entity has few or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates; and
As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

On the other hand, in order to qualify as a commercial real estate exposure, the property securing the mortgage must meet the same operational requirements as for residential real estate. If the loan is a commercial real estate category, the risk weight applicable to the full exposure amount will be assigned according to the exposure’s loan-to-value (LTV) ratio, as determined in the table below. Banks should not tranche their exposures across different LTV buckets; the applicable risk weight will apply to the full exposure amount. A bank that does not have the necessary LTV information for a given commercial real estate exposure must apply a 120% risk weight.
LTVNote, if this LTV refers to market value, the threshold should be set at a lower level: eg 50%.

Where the requirements are not met, the exposure will be considered unsecured and treated according to the counterparty, ie as “corporate” exposure or as “other retail”. However, in exceptional circumstances for well developed and long established markets, exposures secured by mortgages on office and/or multipurpose commercial premises and/or multi-tenanted commercial premises may be risk-weighted at [50%] for the tranche of the loan that does not exceed 60% of the loan to value ratio. This exceptional treatment will be subject to very strict conditions, in particular:

the exposure does not meet the criteria to be considered specialised lending
the risk of loan repayment must not be materially dependent upon the performance of, or income generated by, the property securing the mortgage, but rather on the underlying capacity of the borrower to repay the debt from other sources
the property securing the mortgage must meet the same operational requirements as for residential real estate
two tests must be fulfilled, namely that (i) losses stemming from commercial real estate lending up to the lower of 50% of the market value or 60% of loan-to value (LTV) based on mortgage-lending-value (MLV) must not exceed 0.3% of the outstanding loans in any given year; and that (ii) overall losses stemming from commercial real estate lending must not exceed 0.5% of the outstanding loans in any given year. This is, if either of these tests is not satisfied in a given year, the eligibility to use this treatment will cease and the original eligibility criteria would need to be satisfied again before it could be applied in the future. Countries applying such a treatment must publicly disclose that these and other additional conditions (that are available from the Basel Committee Secretariat) are met. When claims benefiting from such exceptional treatment have fallen past-due, they will be risk-weighted at [100%].

Implications and Consequences

We should make the point, these are proposals, and subject to change. But it would mean that banks using the standard approach to capital could no longer just go with a 35% weighting, rather they will need to segment the book based on LTV and servicability at a loan by loan level. Investment loans may become more complex and demand higher capital weighting. The required data may be available, as part of the loan origination process, but additional processes and costs will be incurred, and it appears net-net capital buffers will be raised for most players. The capital would be determined using two risk drivers: loan-to-value and debt-service coverage ratios with risk weights ranging from 25 percent to 100 percent. Investment loans may require different treatment, (and the RBNZ discussion paper recently issued may be relevant here, where investment loans are handled on a different basis.)

Finally, a word about those banks on IRB. Currently, under their internal models, they are sitting on an average weighting of around 17% (compared with 35% for standard banks). There are proposals to lift the floor to 20% minimum, and the FSI Inquiry recommend higher. Indeed, Murray called for the big banks to lift the average mortgage risk weighting to a range of 25% to 30%. This would bring them closer to the average mortgage risk weighting used by Australia’s regional banks and credit unions, though as described above, these, in turn, may change. Incidentally, the Bank of England thinks 35% is a good target. Basel 4 will also reduce the variance between standardised banks and those using their own models by requiring the internal models not to deviate from the RWA number in the standardised model by a certain amount: the so-called “capital floor”.

Interestingly the US is focussing on an additional measure, The Tier 1 Common measure, which is unweighted assets to capital, and has set a floor of 5%, or more. The Major Banks in Australia carry real, or non-risk-weighted, equity capital of just 3.7% of assets. Some banks are leveraged over seventy times the equity capital to loans, which is scarily high, but then the RBA (aka the tax payer) would bail them out if they get into trouble, so that’s OK (or not). This means that just $1.70 in assets will now support a $100 loan.

We wonder if the ever more complex models being proposed by Basel are missing the point. Maybe we should be going for something simpler. Many banks of course have invested big in advanced models to squeeze the capital lemon as hard as they can. But stepping back we need approaches which allow greater ability to compare across banks, and more transparent disclosure so we can see where the true risks lay. Certainly capital buffers should be lifted, but we suspect Basel 4, despite the best of intentions, is going down the wrong alley.

Foreign Property Investment Up – FIRB

The Foreign Investment Review Board recently published their annual report for 2013-2014. Whilst we question whether they capture the full picture, the report shows that real estate and services related applications accounted for around 76 per cent of the value of approvals in 2013-14. China was the largest investor in 2013-14 in terms of the value of all approvals (17 per cent of the total value), followed by the United States and Canada. Three (yes three!) proposals were rejected in the year.

In 2013-14, 24,102 proposals received foreign investment approval, compared with 12,731 in 2012-13. The real estate sector had a significant increase in approvals with 23,428 approvals in 2013-14,compared with 12,025 approvals in 2012-13.

Approvals in 2013-14 were given for $167.4 billion of proposed investment. This represented a 23.4 per cent increase on the $135.7 billion in proposed investment approved in 2012-13. In real estate, approved proposed investment was $74.6 billion in 2013-14, compared with $51.9 billion in 2012-13. Proposed investment in commercial real estate increased, from $34.8 billion in 2012-13 to $39.9 billion in 2013-14. Proposed investment in residential real estate also increased, from $17.2 billion in 2012-13 to $34.7 billion in 2013-14.
In 2013-14, three proposals were rejected (compared with no rejected proposals in 2012-13). Of the three proposals rejected, two related to residential real estate and the other related to the rejection in November 2013 of Archer Daniel Midlands Company’s proposed takeover of GrainCorp Limited.

The real estate sector was the largest destination by value, with approvals in 2013-14 of $74.6 billion (an increase of $22.7 billion from 2012-13). In 2013-14, the other major sectors were: services (excluding tourism), with approved proposed investment of $53.4 billion (an increase of $27.5 billion); and mineral exploration and development, with approved proposed investment of $22.4 billion (a decrease of $23.1 billion).

Real Estate accounted for 44.6% ot the total value. Here is the more detailed breakdown.

For the first time China ($27.7 billion) was the largest source country for approved proposed investment in 2013-14, overtaking the United States ($17.5 billion). Other major source countries of approved proposed investment in 2013-14 were Canada ($15.4 billion), Malaysia ($7.2 billion) and Singapore ($7.1 billion).

On 25 February 2015, the Government released an options paper on Strengthening Australia’s Foreign Investment Framework. The paper is available on the Treasury website. The Government has announced that a $15 million cumulative threshold will apply to acquisitions of interests in agricultural land from 1 March 2015. More announcements are expected very soon on how the regime will be reinforced, with fines for potential investors who flout the rules, professionals who assist them, and rules to stop investors from profiting from any potential capital appreciation if they are found out, and forced to sell.

Can Indebtedness and Interest Rates Both Increase?

In FitchRating’s latest Global Perspective, James McCormack, Fitch’s Global Head of Sovereign Ratings highlights the dilemma facing the US where rates are low and debt is high. What happens when interest rates rise? Given that both household and corporate debt levels are much higher now, the potential exists for a much more negative impact in terms of debt sustainability and economic performance.

Private sector deleveraging has been a critical feature of the post-crisis US economic recovery, and will remain an important consideration for growth and stability as interest rates move higher. Borrowers have benefited from a more-than 30-year trend of falling rates, but the eventual reversal will test the degree to which private sector balance sheets have been strengthened in the post crisis period. With debt levels still high by historical standards, higher interest rates may have a pronounced impact on growth in the period ahead.

A Cycle Ends: Meaningful Deleveraging

The increase in household debt by 30 percentage points of GDP between 2000 and 2008 was unprecedented, as has been the subsequent deleveraging (see chart 1).

The previous 30 percentage point increase took more than 40 years, and there had never been a meaningful deleveraging prior to 2009. At end-2014, household debt was back to its 2002 level as a share of GDP, and below its 2008 peak in nominal terms. A similar, though less marked, pattern is evident in the corporate sector, unlike in previous credit cycles when corporate debt levels were more volatile than those of households. Corporate debt is now lower than in 2009 as a share of GDP, but 12% higher than the pre-crisis peak in nominal terms.

The Long View: Lower Rates Allowed for Higher Debt

Taking a much longer view, even accounting for post-crisis reductions, household and corporate debt levels have trended higher since the early 1950s (when data became available). Moreover, it is widely accepted – if not explicitly acknowledged – that a continuation of this trend is a sign the US economy is getting back to “normal”. The resumption of private sector credit growth on the back of improved balance sheets is a big part of the narrative of the US recovery, and a meaningful difference with conditions in the Eurozone. Historical interest rate developments provide insight to the steady run-up in US debt, and are a basis of concern looking forward. Both nominal and real medium-term interest rates (approximated by 10-year US Treasury yields) have been falling since the early 1980s. Over the same period, there have been matching declines in effective interest rates faced by the household and corporate sectors (see chart 2).

Effective rates are calculated using BEA data on Interest Paid and Received by Sector, and Flow of Funds data on outstanding debt stocks. Critically, for the last 30 years, falling interest rates have offset the effects of higher debt levels to keep interest service ratios manageable (see chart 3).

There is a strong historical relationship between US economic growth and interest rates in both real and nominal terms. Over the last 50 years real GDP growth and 10-year US Treasury yields (using the GDP deflator) averaged 3.1% and 3.0%, respectively. In nominal terms they averaged 6.7% and 6.6%. On this basis, with 10-year Treasuries yielding less than 2%, they appear low by historical standards. Current conditions are certainly not unique. There have been periods when 10-year Treasury yields were consistently lower than economic growth. The last episode was the mid-2000s, when a global savings glut led to what Alan Greenspan described as a “conundrum”, whereby increases in the Fed Fund rate from 2004 were not matched by 10-year yields. With reasonably strong US growth at the time, households and corporates responded as might be expected – they borrowed more. Private credit growth subsequently outpaced nominal GDP growth and was one of the contributing factors of the global financial crisis.

The critical question is what will happen to 10-year Treasury yields and the effective interest rates faced by the corporate and household sectors as monetary policy is tightened in the current cycle? With smaller current account surpluses in Asia and among Middle East oil exporters, it seems less probable that a global savings glut will continue to hold US rates down. Despite the deleveraging that began in 2009, neither the household nor corporate sector is particularly well placed for a higher interest rate environment. Household interest payments as a share of GDP are now at the same level as the mid-1970s, when debt was lower by 35 percentage points of GDP. Corporate sector debt has increased by less, but interest payments are also at mid-1970s levels. It appears that for the first time since the early 1980s, the outlook for the US economy may be characterised by simultaneous increases in debt levels and effective interest rates. The difference now, however, is household and corporate debt levels are much higher, suggesting the potential for a much more negative impact in terms of debt sustainability and economic performance.