Economics and Banking – Page 222 – Digital Finance Analytics (DFA) Blog

Let The Games Begin – The Property Imperative Weekly 11 August 2018

Welcome to the Property Imperative weekly to 11^th August 2018, our digest of the latest finance and property news with a distinctively Australian flavour. Another week, more data, so let’s dive straight in.

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

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

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We start with the trauma from Turkey which showed how fragile the financial markets are at the moment. Turkey’s finance minister (the President’s Son in Law) unveiled a new plan for their economy. The new economic stance will be one with “determination” — that’s a key part of it, he said. It will “transform” Turkey’s economy. It will also have a “strategic” and “powerful infrastructure.”

U.S. President Trump has repeatedly lashed out at Turkey over the continued detention of pastor Andrew Brunson, whom Turkish officials accuse of terrorism for his part of the failed 2016 coup, and no progress was made as delegates from both NATO countries met in Washington this week. Then Donald Trump, tweeted that he would double tariffs on Turkish steel and aluminum products.

As a result, the Turkish Lira plummeted further. In the course of an hour, it reached a new low of 6.80 to the dollar, marking its worst daily performance in over a decade. This from Bloomberg:

It recovered a little afterwards, but it has lost about 40% of its value against the dollar since the start of the year.

Many fear the fallout could spread beyond Turkey’s border, prompting traders to abandon riskier assets like stocks in search of safe-havens like gold, yen and Treasuries. Volatility, as measured by the VIX “fear index”, rose nearly 17%, highlighting investor concerns about the broader impact of a possible crash in Turkey’s economy.

One analyst said the exposure to a slump in Turkey’s economy is “pretty international,” though limited to the banking sector, but data from the Bank for International Settlements showed that Japanese banks are owed $14 billion, U.K. lenders $19.2 billion and the United States about $18 billion. Enough to make a dent.

The Turkish Lira also moved the same way against the Euro, up 14.33%. “We’re not going to lose the economic warfare” being waged against Turkey said President Erdogan.

In the US, core consumer prices rose by their quickest pace in a decade in July and topped market forecasts, keeping the Federal Reserve on track to raise interest rates twice more this year. The data add to a robust picture of the US economy, which grew by a speedy annual rate of 4.1 per cent in the June quarter. The unemployment rate is close to its lowest level in 18 years. Core inflation, which strips out volatile energy and food prices and is closely followed by the Fed, rose 2.4 per cent year on year in July and up from 2.3 per cent in June. That was the fastest annual pace of core inflation since September 2008.

While headline inflation is rising more quickly than average hourly earnings, wages may pick up given the strength of the labour market. The Fed seems well positioned to carry on tightening policy at its current pace, with no reason to either speed up or slow down. That said, the Turkish situation took the probability of two more cuts down a little according to Bloomberg.

The US dollar was relatively steady following the inflation data. The DXY index, tracking the US currency against a weighted basket of global peers, was up 0.8 per cent following the inflation figures, having been up 0.6 per cent before the data release. The index rose above 96 on Friday for the first time in 11 months.

Looking at the US indices, the NASDAQ slipped 0.67% to 7,838 on Friday, while the DOW Jones Industrial slipped 0.77% to 25,313. Gold futures slide a little to 1,219 and Copper was down 0.74% to 2.75. Oil futures rose 1.45% to 67.78, as the International Energy Agency warned that the recent cooling in the market may not last. Bitcoin was weaker, down 6.03% to 6,153, not helped by the news that creditors of the defunct coin exchange Mt. Gox are trying to recoup money.

European shares also fell on Friday as worries over a dramatic fall in the Turkish lira jolted financial markets amid concerns of the region’s banks’ exposure to upheaval in Turkey. The Germans DAX fell 1.99% to 12,424.

Asian stocks closed mostly lower on Friday as global investors opted to sell risk assets while they also continued to assess the impact of the latest tit-for-tat in the trade war between the U.S. and China.

China’s Shanghai Composite index managed to eke out meagre gains on high volatility. The index had recorded seven straight swings of 1% or more, the longest stretch since Chinese markets crashed in 2015.

In other emerging markets currency, the Russian rouble continued its decline, hitting fresh two year lows, after the US imposed fresh sanctions against the Kremlin for its alleged part in poisoning a former British spy and his daughter in the UK. It closed at 67.71, up 1.52%.

The Aussie continued to slide, as expected, down 1.04% on Friday to 72.96. And we also slipped against the British pound, down 0.63%.

Trade Tariffs continue to worry the market, with Fitch suggesting there is every reason to believe the United States’ trade dispute with China will get worse before it gets better, and that the US trade deficit will widen further rather than shrinking.

Now that they are on the receiving end of US tariffs, Chinese policymakers have three options. First, they could capitulate, by scaling back many of the “discriminatory practices” identified in the US Trade Representative’s March 2018 report on technology transfers and intellectual property. So far, there is no indication that China is considering this option. Second, China could escalate the dispute. It could set its own tariffs higher than those of the US, apply them to a larger range (and greater dollar value) of US exports, or offset the impact of US tariffs on Chinese exporters by allowing the renminbi to depreciate against the dollar. Alternatively, policymakers could look beyond trade in goods to consider capital flows and related businesses associated with US firms, effectively allowing the authorities to impede US financial and nonfinancial firms’ Chinese operations. As with the first option, this one seems unlikely, at least at this stage of the dispute. So far, China has chosen the third option, which lies between capitulation and escalation. China has retaliated, but only on a like-for-like basis, matching US tariff rates and the dollar value of trade affected. At the same time, it has tried to claim the moral high ground, by eliciting international condemnations of protectionism and unilateralism. This hasn’t been difficult, given that several other major economies are currently facing US tariffs. Securing such third-party buy-in is critical for the Chinese leadership’s domestic position. If the government were perceived at home as being bullied by the US, it would have to take a much tougher line in the trade dispute.

Fitch thinks that the US actually has rather limited options, despite having initiated the dispute. Even for a notoriously unpredictable administration, a full and unconditional reversal on tariffs seems out of the question. But so is the status quo, now that China has already levelled the playing field by retaliating in kind. That leaves only escalation – a possibility that the Trump administration has already raised by threatening additional tariffs on all imports from China

With the US locked in a trade war with China and other nations, Gregory Daco at Oxford Economics suggested that higher tariffs could gradually filter through to producer and consumer prices, supporting expectations of a gradual pick-up of inflationary pressures.

Locally, the RBA released its quarterly Statement on Monetary Policy with updated forecasts for inflation, unemployment and economic growth. The central bank has downgraded its inflation forecast for 2018. The RBA now expects both core and underlying inflation to rise by 1.75% to December 2018, down from the May forecasts of 2.25% and 2% respectively. Beyond that time frame, the central bank kept its inflation forecasts relatively unchanged. Previously, it expected both core and underlying inflation to reach 2.25% by the middle of 2020. In Tuesday’s rate announcement, Lowe also said that “a further gradual decline in the unemployment rate is expected over the next couple of years to around 5%”. The bank has maintained its forecasts that the unemployment rate will stay at around 5.25% through to June 2020, before dropping to 5% in December.

It’s also worth looking at Lowe’s speech on Wednesday, when he said that “Electricity prices in some cities have declined recently after earlier large increases, and changes in government policy are likely to result in a decline in child care prices as recorded in the CPI,” Lowe said. “There have also been changes to some state government programs that are expected to lead to lower measured prices for some services.” In Tuesday’s rates decision, Lowe said “the central forecast is for inflation to be higher in 2019 and 2020 than it is currently”.

The central bank slightly bumped up its forecasts for GDP growth in Q2 2018, to 3% from 2.75%. Longer-term, the bank’s growth projections were little-changed. It still expects GDP growth to average 3.25% over the next two financial years, before falling to 3% in June 2020 and remaining at that level through to December.

Given the projections were the first to include a time frame out to December 2020, the forecasts confirmed that underlying inflation pressures are expected to remain low for at least the next two and a half years. The latest set of projections confirmed that the RBA still looks set to keep interest rates on hold for the foreseeable future.

The Royal Commission hearings were back with avengence this week, with NAB’s MLC Wealth management business in the spotlight first, and later in the week IOOF. We saw more of the poor cultural norms on display, with investors being charged for no service, and attempts to block the release of documents and the late delivery of evidence to the commission. In fact, the CEO of NAB went as far as releasing an apology in Twitter. NAB shares ended up slightly to $28.09.

Shares in IOOF, Australia’s second largest wealth manager fell as senior executives from the fund manager appeared before the commission. At the close, the shares were down 2.7% to $8.73. Questioning in the royal commission centred around payments to related parties and the flow of cash back to the super fund from external fund managers when IOOF invests in those funds. Michael Hodge, senior counsel assisting the royal commission, said: “One of the things we are trying to understand is how trustees go about dealing with these volumes based fees where a percentage of the investment of the trust’s money is being paid to another part of the retail group.” Tendered to the commission today was a letter from prudential regulator APRA to IOOF about the conflicts of interest between members of the IOOF super fund and shareholders of IOOF.

The bottom line, is that poor corporate behaviour and the inability of regulators to get to the key facts was again in evidence, and again, consumers lose out as a result. It is shameful.

The CBA’s full-year results to 30 June 2018 (FY18) highlighted the pressure on Australian banks with an increase in wholesale funding costs squeezing CBA’s net interest margin in 2H18, slower loan growth and continued investment into the business and compliance contributed to higher expenses. Mortgage arrears also trended upwards due to some pockets of stress, and while they have not translated into higher provision charges as yet due to strong security values, continued moderation in Australian house prices may result in higher provisioning charges in future financial periods. CBA shares were up 0.03% on Friday to 75.39, and several commentators are claiming the worst is over for them, unlike for AMP, who also reported, and whose shares remain in the doldrums, reflecting the major changes to turn that ship around. Suncorp also reported and they did pretty well in the tight market, their shares rose after their results, and now stands at 15.63.

However, expect more bad news ahead, placing pressure on profit growth for all Australian banks. Increased regulatory and public scrutiny of the sector may make it difficult for the larger banks to reprice loans to incorporate the increase in wholesale funding costs, meaning net interest margins are likely to face some downward pressure. Loan growth is likely to further slow as the housing market continues to moderate, while compliance costs continue to rise due to the scrutiny on the sector. And of course the most prominent scrutiny is the royal commission into misconduct in the banking, superannuation and financial services industry, which has already identified a number of shortcomings within the industry.

That said, CBA’s FY18 results show a level of resiliency despite these issues. The bank reported cash net profit after tax from continuing operations declined 5% to AUD9.2 billion in FY18, but this was driven by a number of one-off charges, including a AUD700 million fine to settle a civil case in relation to breaches of anti-money laundering and counter-terrorism financing requirements. Cash net profit after tax from continuing operations rose by 4% to AUD10.0 billion when the one-off items were excluded.

CBA has much more to do to fix its reputation, and strong capital ratios are not sufficient to allay the concerns in the business. It is more about culture and putting customers first.

So, perhaps no surprise this week, the Greens called for the big banks to be broken up. They said “It’s time that banks became banks again. Australians are sick and tired of these massive financial institutions getting away with murder because they can throw stacks of money at the two old political parties. Our banks should be working for us, not against us and this policy will make sure that happens.

Under the Greens proposal: Banks will no longer be able to own wealth management businesses that both create financial products and spruik them to unsuspecting customers. Consumers will be able to easily distinguish between the simple and essential products and services that the vast majority of Australians use—deposits and loans, superannuation and insurance—and the more complex and selective activity that is the domain of big business, the wealthy, and the adventurous. By removing hidden conflicts of interest, Australians will be able to trust that the advice they’re getting from their banker is designed to line their own pocket, not the other way round. The watchdogs have failed. They would strip ASIC of its responsibility for overseeing consumer protection and competition within the essential services of basic banking, insurance and superannuation and return them to the ACCC.

But we believe there is much more to do than just breakup the banks. We will be discussing this in a future post. The major banks have too much market power, as we discussed on our recent video How Much Market Power Do “The Big Four” Hold? and they continue to milk customers using poor business practice, for example in the home loan market, the mortgage rate you get is hard to compare, and obtuse. We discussed this in our show “Price Information In the Home Loan Market”.

You might also like to watch our show on the latest lending statistics and mortgage stress data, “Lending, Stress and All Things DFA”, as we are not going to have time to cover these today.

So quickly to the property market. Once again prices continue to fall in the main centres of Sydney and Melbourne.

In terms of auctions, CoreLogic says that last week the number across the combined capital cities fell with 1,324 held with a final clearance rate of 54 per cent, down from the previous week. Combined clearance rates have levelled out somewhat remaining within the low to mid 50 per cent range for 13 consecutive weeks. They note that despite the continued slowing in the market, clearance rates are still tracking higher each week relative to the same period in 2012; during the last significant downturn in home values.

Melbourne’s final clearance rate came in at 57 per cent across 629 auctions last week compared with 911 last year returning a substantially higher clearance rate of 73.9 per cent. Sydney’s final auction clearance rate fell to 51.9 per cent across 462 auctions last week, down on the previous weeks. In same week last year, 620 homes went to auction and a clearance rate of 66.4 per cent was recorded.

This week, 1,320 capital city auctions are currently being tracked by CoreLogic; remaining relatively steady on last week’s final result which saw 1,324 auctions held. Over the same period one year ago, there was a considerably higher 2,040 homes taken to auction.

In June, according to the latest ABS housing finance data, first-home buyers accounted for 18.1% of the growth in owner-occupier loans, continuing a trend seen throughout this year. The chart from the RBA helps illustrate the effect that first home-buyers are having on the market. Clearly, there’s a trend underway in Sydney and Melbourne: The value of cheaper homes is holding up, while more expensive home prices have gone into reverse.

This is explained by increasing incentives in NSW and Victoria for first time buyers, and also more lower priced small apartments are coming on stream. The figures tie in with recent trends evident in the Sydney market, with more evidence of recent price falls among higher-end properties valued above $2 million.

Of course the question is, with prices falling, and likely to continue to fall further, could first time buyers get a better deal later by waiting for further falls. That, in my view is a tricky call but our modelling of future credit growth suggests first time buyers will continue to prop up the lower end of the market for some time to come yet.

And finally today, mark your diary, the next DFA live stream event will be on Tuesday 21^st August at eight PM Sydney. I will be providing more information shortly about the event, but is already scheduled on the channel if you want to set a reminder. And feel free to send questions in beforehand.

CBA Results Highlight Pressure Points for Australian Banks

From Fitch Ratings.

Fitch Ratings says the Commonwealth Bank of Australia’s full-year results to 30 June 2018 (FY18) broadly support the agency’s expectation that earnings pressure would emerge for Australian banks during 2018. An increase in wholesale funding costs led to a reduction in CBA’s net interest margin in 2H18, loan growth continued to slow and continued investment into the business and compliance contributed to higher expenses. Mortgage arrears also trended upwards due to some pockets of stress, and while they have not translated into higher provision charges as yet due to strong security values, continued moderation in Australian house prices may result in higher provisioning charges in future financial periods.

Most of the earnings issues appear applicable across the sector and are likely to remain into 2019, placing pressure on profit growth for all Australian banks. Increased regulatory and public scrutiny of the sector may make it difficult for the larger banks to reprice loans to incorporate the increase in wholesale funding costs, meaning net interest margins are likely to face some downward pressure. Loan growth is likely to further slow as the housing market continues to moderate, while compliance costs continue to rise due to the scrutiny on the sector.

The most prominent scrutiny is the royal commission into misconduct in the banking, superannuation and financial services industry, which has already identified a number of shortcomings within the industry. We expect the release of the interim royal commission report, due to be published by the end of September 2018, to give a better view of how widespread these shortcomings are and what impact they may have on the credit profile of Australian banks.

CBA’s FY18 results show a level of resiliency despite these issues. The bank reported cash net profit after tax from continuing operations declined 5% to AUD9.2 billion in FY18, but this was driven by a number of one-off charges, including a AUD700 million fine to settle a civil case in relation to breaches of anti-money laundering and counter-terrorism financing requirements. Cash net profit after tax from continuing operations rose by 4% to AUD10.0 billion when the one-off items were excluded.

Balance-sheet metrics remain consistent with Fitch’s expectations. The bank reported a stable common equity Tier 1 ratio of 10.1%, which incorporates the AUD1 billion additional operational risk charge (essentially an increase of AUD12.5 billion in operational risk-weighted assets) put in place following the publication of the independent prudential inquiry report in May 2018. The divestiture of a number of assets planned for FY19 as well as CBA’s ability to generate capital through retained earnings mean the bank is well-positioned to meet the regulator’s “unquestionably strong” capital requirements ahead of schedule. CBA’s liquidity coverage ratio (131%) and net stable funding ratio (112%) both increased due to an improvement in the bank’s deposit mix towards more stable deposit types and a lengthening in the average term to maturity of its wholesale funding.

Fitch continues to monitor CBA’s progress in remediating shortcomings in its operational risk controls and governance identified in the May 2018 independent prudential inquiry report as risks around this process were a key driver of Fitch’s revision of CBA’s Outlook to Negative. CBA noted in the FY18 results announcement that the remediation program has received approval from the Australian Prudential Regulation Authority and that it aims to make significant progress in implementing the program over FY19. However, CBA also noted that full remediation would be a multiyear process for the bank.

Turkish Lira Under the Bus

More evidence of the global fragility of the financial markets on Friday.

Turkey’s finance minister, Berat Albayrak, unveiled a new plan for their economy on August 10th.

The new economic stance will be one with “determination” — that’s a key part of it, Albayrak says. It will “transform” Turkey’s economy. It will also have a “strategic” and “powerful infrastructure.”

But Donald Trump, tweeted that he would double tariffs on Turkish steel and aluminium products.

As a result, the lira plummeted further. In the course of an hour, it reached a new low of 6.80 to the dollar, marking its worst daily performance in over a decade. It recovered a little afterwards, but has lost about 40% of its value against the dollar since the start of the year.

Many fear the fallout could spread beyond Turkey’s border, prompting traders to abandon riskier assets like stocks in search of safe-havens like gold, yen and Treasuries.

Volatility, as measured by the “fear index”, rose nearly 17%, underlying investor concerns about the broader impact of a possible crash in Turkey’s economy.

The exposure to a slump in Turkey’s economy is “pretty international,” though limited to the banking sector, said Tim Ash, a senior EM strategist at Bluebay Asset Management.

Data from the Bank for International Settlements showed that Japanese banks are owed $14 billion, U.K. lenders $19.2 billion and the United States about $18 billion.

The Turkish Lira also moved the same way against the Euro.

“We’re not going to lose the economic warfare” being waged against Turkey said President Recep Tayyip Erdogan.

Erdogan is boasting of Turkey’s 7.4 percent growth rate in the first quarter. Forget about the exchange rate, he says. “It’s going to be better.”

How Much Market Power Do The “Big Four” Hold?

The Productivity Commission Report into Competition in The Australian Financial System looked specifically at the role and function of the big four banks. Today we look at some of the evidence which they presented, in the light of the Green’s recently released policy on “Breaking Up the Banks”.

Whilst the market dominance of the big four, Westpac, CBA NAB and ANZ does not necessarily in itself mean the market is not competitive, the Productivity Commission suggests that such dominance may allow them to stifle competition by maintaining prices at artificially high levels or limiting innovation without losing any market share.

In many banking systems globally, larger institutions have more market power, and Australia is no exception. Their sheer size allows the major banks to spread their fixed costs (such as investment in new IT systems) across a broader asset base. They are also able to grow more quickly, as they have greater capacity to respond to an increase in demand. At the same time, size can create challenges — for example, changes are more difficult to implement in very large systems. There is a tipping point beyond which large organisations are no longer efficient and they operate at declining returns to scale.

The clearest and most powerful advantage that larger banks have over smaller ADIs, and one that gives them substantial market power, is their ability to raise funds at lower costs. Larger banks have better credit ratings, and as a result, investors and depositors are willing to lend them funds at lower rates. In part, these credit ratings can reflect the ability of larger banks to hold more diversified lending portfolios. However, these ratings also benefit from explicit and implicit government guarantees, such as being considered ‘too big to fail’. Their lower costs of funding enable the bigger banks to maintain their profits and offset some of the increases in their costs resulting from regulatory change, which may prove more difficult for smaller institutions.

Larger operators also benefit, to an extent, from integration, which gives them the ability to exert additional control over some markets. Vertical integration allows larger institutions to have more control over the costs of their inputs, while smaller entities rely on third parties to access funding markets and other types of services. In effect, small ADIs compete against the major banks, but also depend on them to access the funds that allow them to continue competing. Cross-product (conglomerate) integration gives the larger institutions the opportunity to cross subsidise some of their products, and also offer consumers an integrated bundle of services, which may help to lock customers into the provider and raise customer switching costs.

Despite the consolidation of some smaller players, the major banks still maintain substantial market power — because the difference in size between them and the other providers in the market is exceptional. Based on the value of their assets in April 2018, ANZ (the smallest of the majors) was seven times bigger than Macquarie, the next bank by size of assets. Twenty banks (ranking 5th to 24th by size of assets) would need to merge in order to match ANZ. Only if all banks in Australia, other than the big four, merged would they be able to rival the biggest two — Westpac and the CBA.

An important aspect of banks’ size is their geographical reach, either through branches or other distribution networks. In 2017, there were about 5300 bank branches, over 390 credit union branches and 74 building society branches. The major banks accounted for 60% of all branches, and only two other ADIs (Bendigo and Adelaide Bank and Bank of Queensland) had branches in every state and territory. Major banks are also strongly represented in other distribution networks, such as mortgage brokers.

At the same time, customer satisfaction levels reported by individual banks, including the major banks, remains high. While consumers may be disillusioned with the banking system, it seems they are satisfied with their chosen institution. Of course, consumers may not always be aware of the alternative services and prices available from other institutions — or even their own institution — that may be more suitable for their circumstances.

Australia’s major banks have some of the strongest business brands in our economy. Industry estimates put the value of their brands between $6 and $8 billion, with CBA having the highest brand value. Their public image has been affected by a series of scandals and the continued community perception that they do not operate in their customers’ best interests

The major banks benefit from the perception that they are safe, stable institutions, and that the government will step in to help them if needed. This supports their existing market power, and in some cases increases it further — during the global financial crisis (GFC), consumers transferred some of their savings to the major banks, as they were perceived as safer. Even when no financial crisis looms, small institutions may find it difficult to attract consumers from rivals that are perceived as safer. This is despite the fact that retail deposits benefit from the same government guarantee, regardless of ADI size.

Consumer behaviour may also contribute to market power; the low levels of consumer switching and a general disengagement from financial services help ADIs maintain their position in the market, and make it harder for new competitors to gain any significant market share.

The major banks benefit from a substantial asset base and stable market shares, which give them the ability to cope more easily with regulatory change, while also investing and innovating — which in turn can contribute further to their market power. Small institutions argue that their regulatory burden is disproportionately large. For some, the pace and extent of regulatory change has left them limited resources to increase market share.

Measures introduced by the Australian Government and APRA are intended, in part, to offset the cost advantages of large banks — examples include the major bank levy and potentially the specific prudential regulation imposed on domestically significant banks, which applies to the big four banks. It has been argued by Government that when such regulations raise the costs of the major banks, they may help smaller competitors.

But the PC says the objective of competition policy is not to assist some competitors by adding burdens to others, but rather to have the least necessary intervention that is consistent with allowing choice and innovation to meet consumer interests in an efficient manner. Viewed simply, to raise the cost of businesses that have market power — while doing nothing to address adverse use of that market power — risks seeing those costs imposed on customers.

They conclude that the major banks benefit from advantages of scale, scope and branding which give them substantial market power and the ability to remain broadly insulated from competitive threats posed by smaller incumbents or new entrants. They concluded that this balance of power gives the major banks the ability to pass on cost increases and set prices that maintain high levels of profitability — without losing market share.

While high concentration on its own is not necessarily indicative of market power resulting in inefficient pricing or (tacitly collusive) oligopolistic behaviour and the major banks have all argued that vigorous competition in the banking system is evident in a number of market outcomes, their analysis shows that major banks are the dominant force in the market. As a result, they are able to charge higher premiums above their marginal costs, compared with other institutions. Approximately half of the loan price that major banks charge is a premium over the marginal cost — double the margin that other Australian-owned banks have.

In fact, they say, over the past five years, changes to prudential regulations have increased the cost of funding for the major banks. However, and as has been anticipated by regulators, they have been able to recoup these higher costs by increasing interest rates for borrowers. According to the ACCC, the big four banks tend to disregard the pricing decisions of smaller lenders — rather, they focus on the expected reactions of the other majors and any changes they may make to interest rates. As a result, each of the banks examined by the ACCC ‘generally aim to set their headline variable rates to broadly align with the big four banks’ . The major banks view this behaviour as an attempt to compete and maximise their profits — but the end result from a consumer point of view is non-competitive pricing. The lack of price competition is reinforced by obfuscation. The prices that ADIs advertise are often not indicative of what consumers actually pay, as we discussed the other day.

The PC concludes that oligopoly behaviour and the ability to use market power adversely are evident Indeed, the major banks themselves are unable to identify competitive threats in the domestic markets, and they focus on large technology companies overseas as their future potential competitors. Such threats have yet to eventuate, and will in any event need to exist in the regulated environment that consciously limits rivalrous behaviour. Whilst the ‘tail’ of smaller providers aims primarily to match the major banks in their pricing, they are subject to similar or, at times, more costly regulation and do not benefit from the funding or efficiency advantages of the major banks, so they are often unable to offer prices that are substantially lower. Some of the smaller banks, in particular foreign institutions, operate in niche markets (such as agribusiness) where they can potentially benefit from specialisation and set prices that reflect their capacity to price discriminate. Others, such as credit unions and other mutually owned institutions, are consolidating in order to benefit from economies of scale. But in the market for retail banking services, it is the major banks that dominate, and other players follow their lead.

So, standing back, the Big Four are dominant, exert structural market power to the detriment of their customers and the broader society. We are paying through the nose to bolster their profitability. Something needs to change. I will share my own thoughts in a subsequent post.

Estimating Future Home Lending Growth

One of my clients asked me to share my thoughts on the trajectory of future home loan growth, in the light of the current market dynamics. We run a series on this in our Core Market Model, and it is updated each time we get data from our surveys, APRA, ABS or RBA.

So I included the data from the ABS in terms of lending flows, factored in deep discounting and rate cuts from some lenders (like ANZ) and the ability of some lenders, like Macquarie, HSBC and some Credit Unions, to fly higher than the APRA imposed cap on investor loan growth.

In fact we run three scenarios, a base case, which we will discuss in a moment, an aggressive growth case, and a lower bounds case. We have assumed no move in the RBA cash rate over the next 18 months, a continued fall in the pressure on the BBSW rate, and some continued momentum from first time buyers. We also factored in the ongoing shift from interest only loans to principal and interest loans, and appetite for finance from some household sectors, especially those seeking to refinance, including those seeking to assist their offspring to buy via the banks of Mum and Dad. Our model has been tracking close to the RBA data in recent months, so we are pretty confident about the trends. But it is only a projection, and it will be wrong!

The first chart shows the overall value of housing loan portfolios, split between owner occupied and investor loans. The astonishing momentum in investor lending up until mid 2017, when APRA’s new regulations kicked in, eases back, and the current growth in investor loans portfolios is pretty flat. In fact we expect a small rise in the months ahead, as some non-bank lenders have to compete harder with the APRA “approved” lenders who can go above the cap. Remember though lenders still have tighter underwriting standards than before, so there is not going to be a massive resurgence in my view, at least until the Royal Commission reports. Owner occupied loans will continue to lift, as first time buyers are still active, and attracted by the lower property prices.

Refinancing of existing loans does continue, though some are having difficulty finding a loan, as we discussed yesterday.

Turning to the percentage change, our base case is for a slow rise in investor lending and a slow fall in owner occupied loans, with an overall growth still well above inflation at between 5-6%.

This suggests that the lenders will need to compete hard for business which is available, continue with more rigorous loan assessments and manage tighter margins as a result.

As a result, we think property prices will continue to go lower through 2019, but does not as yet signal a crash.

This could all change if funding costs go higher, or the banks get slugged with more costs relating to poor practice, or even face criminal cases relating to charging fees for no service, or making unsuitable loans to borrowers.

As a result there is significantly more downside risk than upside gain at the moment. Our worst case scenario actually sees the overall lending portfolio shrink. If this were to happen, then all bets are off, and we must expect significantly more property price falls through 2019. Actually we do not think, as some are saying, that the worst is over. Rather its just the end of the beginning!

CBA is Less Focused On Brokers

In the CBA’s full-year 2018 (FY19) financial results, released yesterday, the share of new home loans originated by brokers dropped from 43 per cent in FY17 to 41 per cent in FY18, as they focus on “their core market”.

CBA’s net profit after tax (NPAT) also took a hit over FY18, falling by 4.8 per cent to $9.23 billion, the first profit decline in 9 years. NIM was lower in the second half.

They warned of higher home loan defaults “as some households experienced difficulties with rising essential costs and limited income, leading to some pockets of stress”.

CEO Matt Comyn attributed the decline in profit growth to “one-off” payments, which included CBA’s $700 million AUSTRAC penalty, the $20 million settlement paid to ASIC for alleged bank bill swap rate (BBSW) rigging, and $155 million in regulatory costs incurred from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

“There has been a number of one-off items that have impacted the result, including a couple of large penalties that we have resolved. If you strip some of those out, actually the result looks more from an underlying perspective up 3.7 per cent,” Mr Comyn said.

We discussed the results in our latest video.

June Home Lending Flows Take A Dive

The ABS released their Housing Finance data to June 2018 today.

They reported that the trend estimate for the total value of dwelling finance commitments excluding alterations and additions fell 0.7%. Owner occupied housing commitments fell 0.2% and investment housing commitments fell 1.8%. In seasonally adjusted terms, the total value of dwelling finance commitments excluding alterations and additions fell 1.6%.

The proportion of loans for investment purposes, excluding refinance, was 41.4%, down from 53% in 2015. The proportion of refinanced owner occupied loans was 19.7%, similar to the past couple of months.

Looking at the changes month on month, owner occupied purchase of new dwellings fell 0.3%, while owner occupied purchase of established dwellings rose 0.1%, or $14,2 million. Investment construction lending rose 1.3%, or $14 million, borrowing for investment purposes by individuals fell 1.8%, down $154 million and investment by other entities fell 5.1% of $45.7 million. Refinance of owner occupied loans fell 0.9% or $53 million.

Overall around $31 billion of loan flows were written, down 0.7% in trend terms.

In original terms, the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments rose to 18.1% in June 2018 from 17.6% in May 2018.

The number of loans fell 762 compared to last month, to 9,541. Within that we still some rises in NSW and VIC compared with a year ago, thanks to the recent FTB grants. The proportion of loans written at fixed rates fell again.

Out First Time Buyer Tracker, which includes an estimate of first time buyers going direct to the investment sector continued at a low level, compared with a year ago.

Two final slides, first the original data showing the portfolio of loans outstanding at the banks registered an overall rise of $8 billion, and a fall in the proportion of loans for investment purposes to 33.7%, the lowest level for several years.

And the mix across states of owner occupied loans shows the strongest growth in Tasmania and Queensland, and falls in loan volumes most announced in ACT and Western Australia.

So the tighter lending conditions continue to bit, with investors less likely to get a loan. Some of this relates to demand (or lack of it) but also is being driven by the tighter lending requirements.

This is clearly seen in our surveys, where the number of rejected applications have risen significantly. This is especially true for those seeking to refinance an existing loan, including interest only loans.

The net portfolio growth, of around $9 billion, or 0.5% in the month in original terms, so overall lending remains quite strong, despite the weaker flows.

Household Financial Pressure Tightens Some More

Digital Finance Analytics (DFA) has released the July 2018 mortgage stress and default analysis update. The latest RBA data on household debt to income to March reached a new high of 190.1[1], and CBA today said in their results announcement ”there has been an uptick in home loan arrears as some households experienced difficulties with rising essential costs and limited income growth, leading to some pockets of stress”.

So no surprise to see mortgage stress continuing to rise. Across Australia, more than 990,000 households are estimated to be now in mortgage stress (last month 970,000). This equates to 30.4% of owner occupied borrowing households. In addition, more than 23,000 of these are in severe stress. We estimate that more than 57,900 households risk 30-day default in the next 12 months. We expect bank portfolio losses to be around 2.7 basis points, though losses in WA are higher at 5.1 basis points. We continue to see the impact of flat wages growth, rising living costs and higher real mortgage rates.

Martin North, Principal of Digital Finance Analytics says “households remain under pressure, with many coping with very large mortgages against stretched incomes, reflecting the over generous lending standards which existed until recently. Some who are less stretched are able to refinance to cut their monthly repayments, but we find that the more stretched households are locked in to existing higher rate loans”.

“Given that lending for housing continues to rise at more than 6% on an annualised basis, household pressure is still set to get more intense. In addition, prices are falling in some post codes, and the threat of negative equity is now rearing its ugly head”.

“The caustic formula of coping with rising living costs – notably child care, school fees and fuel – whilst real incomes continue to fall and underemployment is causing significant pain. Many households have larger mortgages, thanks to the strong rise in home prices, especially in the main eastern state centres, and now prices are slipping. While mortgage interest rates remain quite low for owner occupied borrowers, those with interest only loans or investment loans have seen significant rises. Many are dipping into savings to support their finances.”

Recent easing interest rate pressures on the banks has decreased the need for them to lift rates higher by reference to the Bank Bill Swap Rates (BBSW), despite the fact that a number of smaller players have done so already.

Our analysis uses the DFA core market model which combines information from our 52,000 household surveys, public data from the RBA, ABS and APRA; and private data from lenders and aggregators. The data is current to end June 2018. We analyse household cash flow based on real incomes, outgoings and mortgage repayments, rather than using an arbitrary 30% of income.

Households are defined as “stressed” when net income (or cash flow) does not cover ongoing costs. They may or may not have access to other available assets, and some have paid ahead, but households in mild stress have little leeway in their cash flows, whereas those in severe stress are unable to meet repayments from current income. In both cases, households manage this deficit by cutting back on spending, putting more on credit cards and seeking to refinance, restructure or sell their home. Those in severe stress are more likely to be seeking hardship assistance and are often forced to sell.

Probability of default extends our mortgage stress analysis by overlaying economic indicators such as employment, future wage growth and cpi changes. Our Core Market Model also examines the potential of portfolio risk of loss in basis point and value terms. Losses are likely to be higher among more affluent households, contrary to the popular belief that affluent households are well protected.

The outlined data and analysis on mortgage stress does not occur in a vacuum. The revelations from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (the Commission) have highlighted deep issues in the regulatory environment that have contributed to the household debt “stress bomb”. However, most of the media commentary on the regulatory framework has been superficial or poorly informed. For example, several commentators have strongly criticised the Australian Securities and Investments Commission (ASIC) for not doing enough but have failed to explain what ASIC has in fact done, and what it ought to have done.

The Commission has highlighted major concerns regarding the law and practice of responsible lending. North has published widely on responsible lending law, standards and practices over the last 3-4 years, and continues to do so. Her latest work (which is co-authored with Therese Wilson from Griffith University) outlines and critiques the responsible lending actions taken ASIC from the beginning of 2014 until the end of June 2017. This paper was published by the Federal Law Review, a top ranked law journal, this month. A draft version of the paper can be downloaded at https://ssrn.com/author=905894.

The responsible lending study by North and Wilson found that ASIC proactively engaged with lenders, encouraged tighter lending standards, and sought or imposed severe penalties for egregious conduct. Further, ASIC strategically targeted credit products commonly acknowledged as the riskiest or most material from a borrower’s perspective, such as small amount credit contracts (commonly referred to as payday loans), interest only home loans, and car loans. North suggests “ASIC deserves commendation for these efforts but could (and should) have done more given the very high levels of household debt. The area of lending of most concern, and that ASIC should have targeted more robustly and systematically, is home mortgages (including investment and owner occupier loans).”

Reported concerns regarding actions taken by the other major regulator of the finance sector, the Australian Prudential Regulation Authority (APRA), have been muted so far. However, an upcoming paper by North and Wilson suggests APRA (rather than ASIC) should be the primary focus of regulatory criticism. This paper concludes that “APRA failed to reasonably prevent or constrain the accumulation of major systemic risks across the financial system and its regulatory approach was light touch at best.”

Stress by The Numbers.

Regional analysis shows that NSW has 267,298 households in stress (264,737 last month), VIC 279,207 (266,958 last month), QLD 174,137 (172,088 last month) and WA has 132,035 (129,741 last month). The probability of default over the next 12 months rose, with around 11,000 in WA, around 10,500 in QLD, 14,500 in VIC and 15,300 in NSW.

The largest financial losses relating to bank write-offs reside in NSW ($1.3 billion) from Owner Occupied borrowers) and VIC ($943 million) from Owner Occupied Borrowers, which equates to 2.10 and 2.7 basis points respectively. Losses are likely to be highest in WA at 5.1 basis points, which equates to $744 million from Owner Occupied borrowers.

Top Post Codes By Stressed Households

[1] RBA E2 Household Finances – Selected Ratios March 2018

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Poor price information in the home loan market

The Productivity Commission report into Competition in The Financial Services Sector has shone a light on home loan pricing, and especially the fact that it is almost impossible for consumers to effectively compare products and prices. We think this is deliberate obfuscation by the industry. So today we look at home loan pricing section of the report in more detail.

The so called standard variable rate (SVR) is the starting point. This is an artificial price, an interest rate that each lender sets by taking into account their cost of funds, operating costs and target profit margins. Lenders make reference to their own SVR when pricing home loans and advertising home loan interest rates. They use it as their benchmark rate to which a margin may be added or (more usually) subtracted when making offers to consumers. Linking actual home loan interest rates to an SVR in this way allows lenders to easily increase or decrease prices on all variable rate loans on their books in response to changes in business or regulatory conditions.

The SVR provides a useful mechanism for each bank to control its entire book of variable rate mortgages while price discriminating between customers. While SVRs are individually set by each bank, they are public information and the SVRs set by different ADIs are closely related.

But the SVR is a source of misinformation for consumers The SVR is the advertised price of a home loan. But it is not the true market price, for almost anyone. Moreover, this ‘rate’ provides consumers with little useful information. It does not provide a meaningful price benchmark for the consumer regarding the actual price of home loans being offered in the market, as most home loans are priced below the SVR.

Almost no-one has to pay the SVR. In addition, customers might not have full information about the products and prices offered by other providers, preventing them from making an informed choice. For instance, transparency in the small business and home loan markets can be poor given the prevalence of unadvertised discounts to the standard variable rate, in many cases negotiated directly. Under these circumstances a customer will have difficulty determining the competitive price without incurring large search costs.

Looking at unpublished data on actual home loan interest rates, the PC found that, the overall discounting relative to the SVR is more prevalent among major lenders, discounting is slightly more widespread for loans issued to investors compared to owner-occupiers; this is more pronounced for non-major lenders. The shares of investor and owner-occupier loans at or below the SVR issued by non-major lenders have been similar in more recent years.

This strongly suggest there is no ‘discount’, just a hidden price that varies between consumers at the discretion of the lender. ASIC noted “that pricing and comparative pricing of mortgages is somewhat opaque at the moment, partly because the standard variable rate is not what a lot of people get, and it’s hard to know whether the discount you’re getting is the same as the discount other people are getting.”

These unpublished discretionary discounts can apply to a substantial portion of loans — for example, NAB submitted that, as at June 2017, discretionary pricing was being applied to up to 70% of new NAB-branded home loans. With the majority of successful home loan applicants offered a lower rate than the SVR, this suggests that the discretionary ‘discounts’ being offered by lenders, including those offered as part of a home loan package, are potentially being used to lull consumers into feeling good about accepting the offer without further negotiation on price or other aspects of the home loan.

In 2017 Deloitte noted that the long-term average discount on lenders’ back books was about 70 basis points. The ACCC reported that discounts on the headline interest rate on home loans by the four largest banks range from 78 to 139 basis points, over the period of 30 June 2015 to 30 June 2017. For major banks, the gap between SVRs and actual interest rates has increased over time. While only some of this gap is likely due to discounts on SVR, the gap nevertheless is in line with ASIC’s finding that, for most banks, the discount margin for home loans was larger in 2015 than in 2012. Similarly, RBA research found that interest rate discounts increased between 2014 and 2017, with home loan discounts higher for newer and larger loans.

In addition to most consumers paying below the SVR, it is difficult for consumers to reliably discover the actual price for the loan they anticipate seeking, as few of the discounts offered to consumers are public. While anecdotes, apps and websites abound, there is no benchmark against which to genuinely judge the market price. Information about individually-negotiated or discretionary discounts are usually not published. The ACCC noted that ‘lenders know the size of discounts they are prepared to offer and the type of borrowers they are prepared to offer them to but this information is not publicly available’.

Furthermore, since the decision criteria for discretionary discounts vary across lenders, borrowers may find it difficult to identify and assess the discounts for which they are eligible. But the potential savings from the total discounts are significant with borrowers potentially saving almost $4000 in the first year of the loan — highlighting the need for price transparency.

Despite the empirical evidence to the contrary, CBA sought to claim that the information available is indicative of the rate received. The PC says the “CBA’s linkage of advertised rates, comparison websites and the actual end rates paid by customers implies an ease of access to information that cannot be observed in practice”.

To the contrary, brokers in discussion with the Commission confirmed that consumers are generally only able to be certain of the actual size of their ‘discount’ once they have formally had their home loan application assessed. For a complex product, the idea of starting again, if the offer is unattractive, is a substantial barrier to pro-competitive customer behaviour (despite potentially being the best course of action). A consumer’s main focus is buying the property; the home loan facilitates this goal.

Next, bundling increases complexity of pricing. Many financial institutions offer package home loans: a bundle of products that usually includes a home loan, a transaction, offset or savings account, a credit card, and some types of insurance.

Consumers are attracted to home loan packages as lenders offer ‘discounts’ on the interest rate, including the SVR, or waive fees on some or all of the components of the package. However, bundling of a number of products into a home loan package can obscure the price of individual products making it difficult for consumers to assess the value of each individual component. It can also lock consumers into ongoing use of products that become less competitive over time as financial circumstances change).

The RBA said that “product bundling and a lack of transparency in the pricing of mortgages (with the prevalence of large unadvertised discounts in interest rates from advertised standard variable rates), are impediments to competitive outcomes”.

But this means that comparison rates are meaningless. The National Consumer Credit Protection Act requires that when advertising home loan products, lenders provide a comparison rate that includes the interest rate as well as most fees and charges. The purpose of comparison rates is to allow consumers to compare products with different fees and charges.

However, comparison rates are calculated using SVRs as the base interest rate. While comparison rates could potentially improve the competitiveness of the home loan market, they are only as useful as the interest rates on which they are based. As discussed above, for more than 90% of customers, SVRs (or the advertised rate) are not the market rate.

ASIC highlighted that the comparison rate is based on the advertised rate, not on the rate that people get when they either talk to a broker or a lender. So again, it’s not a very good guide as to whether the rate you are being offered is a good rate. It also doesn’t include other things that, you know, affect the cost of the loan like LMI, because the requirement is that a comparison rate include mandatory fees, but not contingent fees, and LMI, being a contingent fee is not included within the comparison rate.

The P&N Bank also noted the lack of relevance of the comparison rate: “While the home loan comparison rate methodology was a way of demonstrating comparability across product rates and fees, we acknowledge that it may not reflect real life scenarios based on borrower type, LVR, actual loan terms/amounts — or how pricing strategies are applied over the duration of that loan. And a submission from Home Loan Experts, a specialist mortgage broker, further noted the lack of understanding of comparison rates among consumers “We have not seen a customer use comparison rates or one that understands them. They are largely ignored by the industry and customers alike. For this reason, we recommend scrapping them altogether. And finally Canstar noted additional problems with the comparison rate — the assumptions used in formulating the rate are no longer representative of the lending market (including the loan.

SO when you are buying a home loan, the rate you get is frankly rigged, and you will never know whether you really ever got a good deal. That might help support bank profits, but once again consumers are being taken to the cleaners, and the regulators appear happy to support the poor customer outcomes. Frankly this is a disgrace,

RBA Holds As Expected.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

The global economic expansion is continuing. A number of advanced economies are growing at an above-trend rate and unemployment rates are low. Growth in China has slowed a little, with the authorities easing policy while continuing to pay close attention to the risks in the financial sector. Globally, inflation remains low, although it has increased in some economies and further increases are expected given the tight labour markets. One uncertainty regarding the global outlook stems from the direction of international trade policy in the United States.

Financial conditions remain expansionary, although they are gradually becoming less so in some countries. There has been a broad-based appreciation of the US dollar over recent months. In Australia, money-market interest rates are higher than they were at the start of the year, although they have declined somewhat since the end of June. These higher money-market rates have not fed through into higher interest rates on retail deposits. Some lenders have increased mortgage rates by small amounts, although the average mortgage rate paid is lower than a year ago.

The Bank’s central forecast for the Australian economy remains unchanged. GDP growth is expected to average a bit above 3 per cent in 2018 and 2019. This should see some further reduction in spare capacity. Business conditions are positive and non-mining business investment is continuing to increase. Higher levels of public infrastructure investment are also supporting the economy, as is growth in resource exports. One continuing source of uncertainty is the outlook for household consumption. Household income has been growing slowly and debt levels are high. The drought has led to difficult conditions in parts of the farm sector.

Australia’s terms of trade have increased over the past couple of years due to rises in some commodity prices. While the terms of trade are expected to decline over time, they are likely to stay at a relatively high level. The Australian dollar remains within the range that it has been in over the past two years.

The outlook for the labour market remains positive. The vacancy rate is high and other forward-looking indicators continue to point to solid growth in employment. Employment growth continues to be faster than growth in the working-age population. A further gradual decline in the unemployment rate is expected over the next couple of years to around 5 per cent. Wages growth remains low. This is likely to continue for a while yet, although the improvement in the economy should see some lift in wages growth over time. Consistent with this, the rate of wages growth appears to have troughed and there are increased reports of skills shortages in some areas.

The latest inflation data were in line with the Bank’s expectations. Over the past year, the CPI increased by 2.1 per cent, and in underlying terms, inflation was close to 2 per cent. The central forecast is for inflation to be higher in 2019 and 2020 than it is currently. In the interim, once-off declines in some administered prices in the September quarter are expected to result in headline inflation in 2018 being a little lower than earlier expected, at 1¾ per cent.

Conditions in the Sydney and Melbourne housing markets have continued to ease and nationwide measures of rent inflation remain low. Housing credit growth has declined to an annual rate of 5½ per cent. This is largely due to reduced demand by investors as the dynamics of the housing market have changed. Lending standards are also tighter than they were a few years ago, partly reflecting APRA’s earlier supervisory measures to help contain the build-up of risk in household balance sheets. There is competition for borrowers of high credit quality.

The low level of interest rates is continuing to support the Australian economy. Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.