Author: Martin North

Martin North is the Principal of Digital Finance Analytics

House Prices Match Income Growth – RBA

Luci Ellis, Head of Financial Stability Department spoke to the Australian Housing and Urban Research Institute (AHURI) Panel Roundtable. You can hear her remarks, and a transcript is promised later. My notes follow.

  • Cross country comparisons on housing markets are important, but sometimes comparisons need to be used with care, e.g. specific issues like overbuilding in USA and Ireland had significant impacts. There are differences which need to be understood. Canada is a better comparator for Australia, with a similar geographic footprint but they do have some differences such as fixed rate mortgages, and the government takes tail risk as mortgage insurer.
  • There is much more data post GFC on housing related issues, BIS, IMF, etc. proved richer data. The latest data has changed the perspectives, but many conversations have not caught up yet. For example, housing prices corrected for inflation, shows Australia is not one of the “boomier” countries and prices have not materially grown faster than household incomes. There is evidence of risk in the system as shown by the house prices fall (in Sydney and nationally) if you look back over the past 15 years. Overall housing prices have tracked income.
  • Financial liberation has been one of the drivers to lift house prices relative to income, alongside credit constraints and high inflation. Inflation is lower now, though credit constraints still exist, for example, ratio of serviceability, is an important indicator. As inflation falls, loan to income ratios can be higher.
  • This change in the loan size does has important macroeconomic implications. But mortgage repayments are lower now, thanks to low interest rates. Household savings ratio turned up 2005, before the crisis.
  • Housing crashes do not improve affordability. Need to focus on where real unaffordability lives, e.g. renters who cannot afford to buy.
  • There are risks attached to overbuilding as seen overseas. Supply in Australia is increasing and it is needed, and intended as part of handover from mining investment boom. Building approvals are around 200,000 a year – bit higher than in the past thanks to more high density properties and strong population growth. But we need to understand the composition of the population growth. For example look at migration by visa type – student numbers picked up in the last two years. Students want to live in apartments in inner areas near universities. That’s where lots of the new building is in for example Sydney. There is a premium to be closer in, and it has increased in recent times.
  • There are implications for policy makers from local planning issues. Dublin example, building needs to be in the right areas. We do not build new towns in Australia, maybe we should have a long term plan for new Cities.
  • There is little speculative building in Australia (compared with other countries). Instead demand is from small investors, and future demand is more linked to expected house price growth.
  • Getting the right balance between supply of property and finance is important.

Some observations. First, average income and house prices mask the differences, many household segments in our analysis are worst today. Second, household savings ratios are being buttressed by inflated housing, and appear to be falling and they so vary by segment. Third, we see incomes in real terms falling, so what does that say for future house prices growth? We feel that RBA’s story is therefore over optimistic, despite some interesting points. What if interest rates do rise?

Moodys Warns About The Rise In Interest Only Loans

Moodys today published commentary on the risks attached to the rising number of interest only loans.

An increase in the number of Australian “owner-occupier” home buyers who are taking out interest-only (IO) mortgages is credit negative for future Australian Residential Mortgage Backed Securities (RMBS) because such loans have a higher risk of delinquency and default, particularly if interest rates rise from their current record low levels.

Over the past year, a notable rise has occurred in the amount of IO loans in Australia and owner-occupiers – people who buy a home to live in, as opposed to investors who buy to rent out — are accounting for a growing share of these loans.

IO loans are common among real estate investors in Australia because interest costs on investment loans can be claimed as a tax deduction. However, owner-occupiers cannot claim such deductions. There are concerns that many of the owner-occupiers taking out these loans — which are generally larger than the traditional Principal and Interest (PI) loans — would consequently find it difficult to service them if interest rates start to rise.

Greater Delinquency Risk as Owner-Occupier Interest Only Loans Grow

IO loans accounted for 43.2% of all new mortgages in June 2014, up from 38.6% in June 2013, according to the latest Australian Prudential Regulation Authority figures. Over the same period, the proportion of loans for investment properties also rose — to 37.9%, from 35.2% — but not by as much as the rise in IO loans.

The growing gap between the percentage of IO loans and investment loans shows that more owner-occupier borrowers are taking out IO loans.

IO loans, whether they are for owner-occupiers or real estate investors, generally carry a greater risk of delinquencies and default than traditional PI loans.

In particular, IO loans are more sensitive to interest rate rises than PI loans because of their larger amounts and slower amortization rates. IO loans are most sensitive to higher interest rates when they revert to PI loans — which typically occurs after 5-10 years — and monthly repayment amounts rise significantly.

If the proportion of owner-occupier IO loans continues to rise, we would expect that they would also make up a greater proportion of the loans in future RMBS transactions, which would be credit negative, given their higher propensity for delinquency and default.

Owner-occupier IO loans account for 16.5% of the current RMBS portfolio, but these do not present the same risk as new owner-occupier IO loans because they were underwritten when interest rates were higher and would be more resilient when rates rise again.

In the current record low interest rate environment in Australia, delinquency rates for IO loans have in fact been lower than for PI loans. This situation reflects the fact that monthly repayments for IO loans are lower than PI loans. However, our expectation is that interest rates in Australia will rise in 2015, putting more pressure on IO borrowers and resulting in greater levels of delinquencies and defaults.

Real estate investors in Australia can claim a tax deduction for the interest costs of their loans, which will help offset the impact of higher rates. However, owner-occupiers are not eligible for such deductions. For this reason, all else being equal, an increase in interest rates will be more severe for owner-occupier IO borrowers than investment borrowers.

Owner-Occupiers Turn to IO Loans as Property Prices Increase

At a time when property prices and therefore the size of mortgages in Australia is rising rapidly, the increase in the number of owner occupiers taking out IO loans may reflect their decision to take out larger loans amounts, given the rise in property prices.

In Australia, national house prices have increased by 9.3% over the year ended September 2014, while in Sydney, the city with the highest growth, prices have risen by 14.3%.

Against this backdrop, home buyers may view IO loans as an option if they seek to borrow larger amounts without having to service as large a monthly repayment amount as they would have to with a similarly sized PI loan.

In our existing RMBS portfolio, the average loan size of owner-occupier IO loans is AUD289,800, compared with AUD187,500 for PI loans.

In addition, the current loan-to-value ratio of owner-occupier IO loans is 2.1% higher than PI loans. IO loans are also paid off at a slower rate, as reflected by the fact that they are 5.1% in advance of their scheduled payment balance, compared with 6.5% for PI loans. Hence, owner occupier IO loans are larger, more leveraged and slower to amortize than PI loans.

Accordingly, once interest rates rise from their current record low levels, any issues owner-occupier IO loan borrowers have with servicing their mortgages will be exacerbated, leading to higher delinquencies and defaults.

However, it is also important to note that some owner-occupier borrowers may be choosing IO loans simply to maintain a level of flexibility in managing their repayment obligations, rather than because of serviceability reasons. Given that interest rates are at record lows, these borrowers may feel comfortable in paying only the interest on their mortgages and using any remaining available funds for other purposes.

But, because these borrowers are making few, if any, principal repayments, their loan amounts will remain high relative to PI loans, leaving them more susceptible to payment shocks when interest rates rise.

Early Access To Super Is On The Rise

The Department of Human Services released their 2013-14 Annual Report. One topic of note is the rise in the early release of superannuation savings.

According to the DHS, Superannuation cannot generally be accessed before a person reaches their preservation age. In some limited circumstances the law allows for early access to superannuation. Most of the grounds under which early access is permitted are administered directly by the superannuation funds. These include:

  • severe financial hardship
  • terminal illness
  • permanent incapacity
  • balances of $200 or less
  • permanent departure from Australia

The DHS is responsible for assessing applications for the early release of superannuation on compassionate grounds. These include payments for:

  • medical or dental treatment for you or your dependent
  • transport for medical or dental treatment for you or your dependent
  • arrears on your mortgage to prevent your home being sold by your lender
  • modification to your home or vehicle to accommodate a severe disability for you or your dependent
  • palliative care for a terminal illness for you or your dependent
  • expenses associated with your dependent’s death, funeral or burial

The regulations of compassionate grounds are set out in Australian law. While early access to superannuation is possible it is always subject to strict legal criteria. Applications must be supported by evidence. You must not be able to meet the costs by other means, such as savings

There was 7% uplift in withdraws, from last year, but the increase in applications was not matched by a rise in approvals by the department. Two-thirds of all applications were approved in full or part, with the total value of early payouts rising only 3.8%, or $5.4 million, to $151 million. The average payment approved by the department rose only two per cent to $12,874 from $12,643 in 2012/13. This is small beer relative to the $1.85 billion in super held by Australians and will reduce the chatter about the rising hardship levels amongst households. The main motivation is to pay down the mortgage, and this is confirmed by our household surveys.

DHS Chart

The Payment Wars

Apple pushed mobile payments forward when it launched Apple Pay. In fact the launch in the US has been popular, Bloomberg reported that on Apple Pay’s first day, at Chase banking services seven times more people added Chase credit cards to Apple Pay than signed up for new credit card. But it is already creating a counter revolution. Over the weekend, Rite Aid and CVS disabled the near field sensors that allowed customers to use Apple Pay and Google Wallet.

This is the tip of an iceberg as more than 50 other major retailers in the US have voted against NFC payments. The rival is based on CurrentC technologies and is being developed by a consortium of merchants known as Merchant Customer Exchange, or MCX. A number of major retailers are involved, which in total account for about one fifth of all sales turnover. They include Gap, Best Buy and Walmart.

CurrentCThere are some important differences between the two systems, because whilst both facilitate payments, they do so in a different way. Apple Pay uses near field communication, and payment transaction details are anonymous, whereas CurrentC, which actually won’t be launched in the US until next year relies on an ap, which users will need to launch to pay and the merchant must scan a QR code, and it does not use NFC. They also link to debit accounts, so bypass the credit card processors, which are fundamental to the Apple Pay model. The key benefit for retailers is that CurrentC works will work with existing loyalty schemes, and allow retailers to accumulate transaction data about their customers (the holy grail of retailing). Apple Pay effectively destroys that link.

The problem is that with completing systems, all backed by large names, customers will be confused, and this confusion will potentially slow the payment revolution. At the heart of the battle is the future of retailing, and who has access to that precious customer data.

It may seen an academic debate seeing as none of the solutions are in Australia (as yet), Apply Pay requires Apple’s latest technologies and CurrentC won’t launch until 2015 in the US; but how this plays out will have a profound impact on the local payment wars down the track. We also expect to see a further proliferation of competing payment solutions which are likely to changing the landscape into the future.

Where The European Banks’ Bodies Are Buried

Over the weekend there was a lot of coverage on the results from the European Central Bank’s stress testing – looking at how banks would respond if for example, house prices were to fall, or exchange rates move significantly. Actually, of the 130 banks tested, 25 failed, but many were smaller players in southern Europe, and are already in the process of plugging the gaps. Stress tests by their nature are imprecise, and market reaction was as expected.

The much more interesting aspect though was the parallel testing under the Asset Quality Review. According to the Economist, this was only applied to 123 big banks in the euro zone’s 18 countries, which from next month will be regulated by the ECB instead of national watchdogs.

The ECB found €136 billion in troubled loans banks had not fessed up to, bringing the European total to €879 billion ($1.1 trillion). Italy will have to implement the biggest reclassification of loans (€12 billion), with Greek (€8 billion) and German banks (€7 billion) also challenged.

Many banks that thought they might fail the tests have raised over €45 billion in equity, strengthening them considerably. That explains why only 12 banks will have to unveil plans to raise capital when 25 have apparently failed, including Eurobank in Greece, Monte dei Paschi di Siena in Italy and Portugal’s BCP, the only three with more than €1 billion to raise. They now have to come up with plans to strengthen their balance sheets.

These tests are as much a stress test of the European Central bank which is taking on an ever more important role, as the individual banks themselves.

 

SME Working Capital Courtesy Of PayPal

In the recent DFA SME survey we highlighted the pressure many SME’s are under with regards to funding working capital. We also highlighted that in Australia, SME’s have few places to go to get financial assistance, hence the fact that the big banks have lifted their lending criteria and interest rates into the captive market.

SMEFundingSept14So the recent announcement by PayPal that they intend to launch their working capital solution for business in Australia is significant. PayPal Working Capital will be introduced to a limited number of PayPal merchant partners between now and the end of the year, followed by a broader roll out in 2015. This service has been launched already in the US and more recently in the UK.  You can watch a video about the service on their site. Since the US launch in September 2013, via lender WebBank the PayPal Working Capital programme has provided more than $140 million in loans to SMEs and according to The PayPal Working Capital Customer Satisfaction Survey conducted in June, 2014.

The PayPal solution is not your average overdraft.

PayPal Working Capital gives businesses access to the capital they need, but it’s faster and easier than traditional loans. It’s available to select businesses that already process payments through PayPal. If your business qualifies, the lender reviews your PayPal cash flow history to customize a special offer.

PayPal Working Capital is a business loan of a fixed amount, with a single fixed fee. There are no due dates, minimum monthly payments, periodic interest charges, late fees, pre-payment fees, penalty fees, or any other fees.

The process is easy:

  • Select your loan amount. In most cases, your max loan amount is up to 8% of your PayPal sales over the past 12 months.
  • Choose the percentage of your future PayPal sales that you want to go toward repayment of the loan amount and the loan fee.
  • Get the loan amount deposited to your PayPal account within minutes to use for your business.
  • Start making repayments as a percentage of your daily sales until your balance is paid in full. You can also make additional payments or even pay the loan in full early without penalty.

The lender reviews your PayPal sales history to determine your loan amount. In most cases, your maximum loan amount is up to 8% of the sales your business processed through PayPal in the past 12 months. The maximum amount may be less for new or larger businesses, or for businesses with volatile or seasonally variable sales.

Unlike traditional loans, PayPal Working Capital charges a single, fixed fee that you’ll know before you sign up. No periodic interest, no hidden fees, no set payment plan, no payment due dates, and no late fees. You’re charged a single, fixed fee on your loan, not a traditional periodic interest rate. The lender determines your eligibility based on your business’s PayPal sales history, not your business or personal credit score. Applying for or using this loan won’t impact either credit score.

PayPal4 PayPal3 PayPal2 PayPal1SME’s who decide to consider this option will need to flow transactions via PayPal, so redirecting traffic through the PayPay system. It may prove attractive to SME’s who struggle to get unsecured loans in the current (despite low rate) environment.

Australian player Moula, already offers online loans to business, and have plans to expand offline, but a player with the credentials of PayPal (soon to be split from eBay, its current owner) could start a welcome shake-up of SME lending. The winners could be the small business owners in Australia, and the banks perhaps the loosers. According to DFA bank modelling, SME lending is more profitable, on average than retail mortgages, so the banks will be watching development carefully. It also highlights again the digital disruption coming to the industry, alongside peer-to-peer lending, retail payments and online channels as featured in our recent Quiet Revolution report.

 

ABC Covers Macroprudential

The ABC The Business last night covered the property market, “The RBA’s Property Problem” – including comments from the RBA and APRA. Industry analysts also make the point that the tax incentives for investment property will work again the intention of macroprudential – we discussed negative gearing yesterday.

A Perspective On Negative Gearing

There is no doubt that negative gearing is a hot issue. As the ASIC Money Smart web site says:

Negative gearing is when your income from an investment is less than your expenses. In the case of property this means the rental income you receive is less than the interest and other expenses you pay. Your investment is making a loss which most investors hope they will make up with a capital gain when the value of the property increases. A loss can be used to reduce your taxable income which will reduce the amount of tax you pay. See the Australian Taxation Office’s section on residential rental properties for details of income you must declare and expenses you can claim. Remember, you are only reducing your tax payable because the income from your investment isn’t covering your expenses.

In the year to 2012, the ATO reported that whilst income from rental properties reached $33bn, the total tax offsets including interest costs were $49.6bn, leaving a net loss to the tax payer of $8bn. So, negative gearing costs. The chart below shows the trend for recent years. Well over 1.2 million households gear into property, and two in three reported a loss (to offset income elsewhere). The RBA’s Financial Stability Report, illustrated that the top fifth of income earners hold around 60 per cent of investment housing debt.

RentalTaxIncomeTo2012Now, many argue that negative gearing is essential to support house building and the rental sector, and should not be touched. However, the data tells a different story. We went back to our household surveys, to examine the penetration of gearing. First, we looked at those borrowing for owner occupation, versus for investment purposes. No surprise that more were property investors. However some owner occupied households also geared their property into, for example stock market investments. Recently, the growth in investment gearing has been much stronger. We already know this is being driven by expectations of future capital growth, as reported in our earlier posts.

NegativeGearing2Then we looked at the type of property geared. We found that whilst a proportion were geared into new property, most were gearing into existing property, for rent.

NegativeGearing1No surprise, given the growth in loans for investment purposes, and only a small proportion go towards new builds.

PCInvestmentLendingAug2014So, we conclude that gearing has more to do with stoking prices in the established market than directly stimulating new building. Rents are set as a combination of the costs of a property, and income levels. If prices were more realistic, rents would be lower, because loans would be lower. More rentals loose money than make money today, and the only saving grace in the minds of investors is hoped for future capital growth.

A more logical approach would be to focus, from this point forward negative gearing on new builds only, thus helping to boost supply and stabilise prices. Appropriate transition arrangements for existing gearing would be needed, but the current arrangements are not fair, and will become an even greater drain on government coffers if interest rates (and net rental losses) rise.

ASIC Crackdown on Payday Lenders

ASIC just announced they have forced a number of payday lenders to stop offering “leaseback” arrangements to consumers who want a payday loan.

ASIC was concerned that the Cash Loan Money Centres and Sunshine Loans were using business models which deliberately attempt to avoid the protections for consumers contained in the small amount lending provisions in the National Consumer Credit Protection Act 2009 (National Credit Act).

Consumers who approached a Cash Loan Money Centre for a payday loan were signed up to an arrangement where the consumer ‘sold’ a household item such as a washing machine or fridge to the business, in return for a sum of money, and simultaneously ‘leased’ the goods back from the business. In practice, the goods never changed hands, and the business never actually saw the household goods, or confirmed the current market value before ‘purchasing’ them from the consumer.

Similarly, under the model used by Sunshine Loans, a consumer would approach the business for a payday loan, and enter into an agreement to assign the rights to use their mobile phone or car to the lender for a fee, and then simultaneously lease the rights back.

ASIC was primarily concerned that, in both cases, consumers were charged considerably more than the amount allowed under the legislative cap on costs for payday loans. In one example, a consumer received $1,000 and repaid a total of $1,682.10, when the statutory maximum the consumer would have repaid for a small amount loan of the same amount was $1,280.

Deputy Chairman Peter Kell said, ‘Where we see business models or arrangements being used which are designed to avoid obligations imposed by the consumer credit legislation, we will take action’.

‘Payday lenders and their advisers need to ensure any change to their lending models are legitimate and do not seek to avoid the small amount lending provisions’, Mr Kell said.

After ASIC intervention, Cash Loan Money Centres and Sunshine Loans have ceased using these models and are now offering consumers a small amount credit contract.

Before July 2013, some states and territories had laws capping the cost of credit for small amount loans. These laws were replaced by the national cap which was introduced in July last year and is regulated by ASIC.

A small amount loan, in general terms, is a loan where the amount borrowed is $2,000 or less and the term is between 16 days and one year. From 1 July 2013, only the following fees can be charged on small amount loans:

  • a monthly fee of 4% of the amount lent
  • an establishment fee of 20% of the amount lent
  • Government fees or charges
  • enforcement expenses, and
  • default fees (the lender cannot recover more than 200% of the amount lent).

Providers of small amount loans are also subject to enhanced responsible lending obligations, including providing a warning statement to the consumer which contains information about the alternatives to a payday loan.

Payday lending attracts households who are less able to access other forms of credit, and are likely to end up paying very high effective rates on small values lent.