Economics and Banking – Page 451 – Digital Finance Analytics (DFA) Blog

Lazard Warns On Australian Property

According to the Australian today, Lazard Asset Management fund managers are concerned about the banks’ skyhigh valuations and the risks of a housing market correction.

“…it’s record high household debt in a hot property market — a more worrying scenario for it tends to cause deeper economic pain.

“Property prices, bank valuations — we’re still in the pre-2007 paradigm: as soon as we get a rate cut, we go out and buy another property,” Mr Hofflin said, citing higher median prices in Wagga Wagga than Chicago.

“What happened in the US in terms of the wealth effect when property fell could be worse here because property dominates Australians’ balance sheet … and because prices are so high in the first place.

“If you have an asset that is expensive but there’s no debt against it, we think it’s much less dangerous to the economy … in this case there is a lot of debt against it.”

While there is a view that Australia’s circumstances such as tight land supply and tax incentives protected the nation from a property collapse, regulators are growing increasingly concerned, particularly in Sydney.

As chief banking regulator Wayne Byres noted last week, the nation’s good housing fortune over the years “doesn’t mean that will always be the case”.

Mr Hofflin, fresh from speaking at the national “Big Day Out” events for financial advisers, shares regulators’ concerns about the state of lending, where almost half of new loans are to investors and 45 per cent on interest-only terms. He added that if you use gross rental yields, costs and taxes to generate, residential property is trading on a massive 60 times earnings — four times the value investors ascribe to the stockmarket.

The housing credit boom and insatiable appetite for yield stocks has pushed bank market capitalisations to about 35 per cent of the stockmarket, a level Mr Hofflin said he’d never seen before”.

RBA Data On Bank Funding

In the latest RBA Bulletin for the March quarter, there is an interesting article on bank funding “Developments in Banks’ Funding Costs and Lending Rates”. It demonstrates mix of forces in play, including competitive dynamics, relative product pricing, and the impact of the global financial system on the banks. The main finding is that the spread between the major banks’ outstanding funding costs and the cash rate narrowed a little over 2014. This was due to slightly lower costs of deposits combined with a more favourable mix of deposit funding. The contribution of wholesale funding to the narrowing was marginal as more favourable conditions in long-term debt markets were mostly offset by a rise in the cost of short-term debt. Lending rates declined a little more than funding costs, reflecting competitive pressures.

The spread of banks’ funding costs to the cash rate is estimated to have narrowed by about 9 basis points in 2014. With the cash rate unchanged over the past year, the slight narrowing in the spread was entirely due to changes in the absolute cost and mix of funding liabilities. In particular, the narrowing was driven by a lower cost of deposit funding and changes in the composition of deposits. Changes in the costs and composition of wholesale funding (i.e. bonds and bills) contributed only marginally to the fall in funding costs. Nonetheless, funding costs relative to the cash rate remain significantly higher than they were before the global financial crisis in 2008.

Interest rates offered on some types of deposits declined over the year. The cost of outstanding term deposits is estimated to have fallen by about 40 basis points as deposits issued at higher rates matured and were replaced by new deposits at lower rates. Similarly, the major banks’ advertised ‘specials’ on new term deposits fell by about 40 basis points over the past year.

During 2014, the estimated average interest rate on outstanding variable-rate housing loans continued to drift lower relative to the cash rate. The overall outstanding rate declined as new or refinanced loans were written at lower rates than existing and maturing loans. This reflected a sizeable reduction in fixed rates over the year and an increase in the level and availability of discounting below advertised rates. The interest rates on around two-thirds of business
loans are typically set at a margin over the bank bill swap rate rather than the cash rate. While these spreads remain wider, reflecting the reassessment
of risk since the global financial crisis, they have generally trended down over the past two years. Much of the narrowing of spreads over 2014 was due to average business lending rates declining by over 20 basis points, with outstanding rates for small business decreasing by more than rates for large businesses.

Deep Mortgage Discounts To Be Had

We have updated our survey models, and we note that since January banks have been discounting their mortgage dealss in an attempt to gain relative share. The average discount is more than 100 basis points off the standard advertised rate. So households should be negotiating hard to get the best deal.

We also see that the range of discounts available are still wide, depending on elements such as customer segment, LVR, loan type, loans size and location. Different players appear to to targeting different business. The best discounts are around 130 basis points.

Our analysis shows that mortgage competition and SME lending is being supported by banks further reducing their returns to depositors. Something which we foreshadowed last year.

APRA Waiting For Global Capital Developments Before Acting

In Wayne Byres speech today to the House of Representatives Standing Committee on Economics, there was a clear indication that they would wait for the results of the international work of changes to capital rules before doing much locally. Meantime they will continue to talk to the local banks about sound lending practice. Too little, to late in my view. We need to move beyond a fixation on financial stability.

Sound Lending Practices for Housing

When we made our last appearance, we were still contemplating potential actions with respect to emerging risks in the housing market. We have since written to all authorised deposit-taking institutions (or ADIs) encouraging them to maintain sound lending standards, and identified some benchmarks that APRA supervisors will be using in deciding whether additional supervisory action – such as higher capital requirements – might be warranted.

I would like to emphasise that, in alerting ADIs to our concerns in this area, we are seeking to ensure emerging risks and imbalances do not get out of hand. We are not targeting house price levels – as I have said elsewhere, that is beyond our mandate – and we are not at this point asking banks to materially reduce their lending. We have identified some areas where we have set benchmarks that we think will be useful indicators of where risk could be building, and in doing so, will help reinforce sound lending practices amongst all ADIs. We are currently assessing the plans and practices of individual ADIs and, over the next month or so, will be considering whether any supervisory action is needed. So far, our discussions with the major lenders have suggested they recognise it is in everyone’s interests for sound lending standards to be maintained. But we shall see – we are ready to take further action if needed.

Financial System Inquiry

Beyond this immediate issue, we are also giving thought to the more fundamental issues in relation to ADI capital contained in the recommendations of the Financial System Inquiry. There are two key influences on how we will proceed on these issues: first, the submissions made through the Government’s consultation process, and second, the work still underway on a number of related issues in the international standard-setting bodies, particularly the Basel Committee on Banking Supervision.

Helpfully, the FSI and the international work are pointing us in the same direction. There are, however, complexities in the detail that we need to work through carefully. In terms of timing, we do not need to wait for every i to be dotted and t to be crossed in the international work before we turn our minds to an appropriate response to the FSI’s recommendations. But it will be in everyone’s interests if, over the next few months, we are able to glean a better sense of some of the likely outcomes of the international work before we make too many decisions on proposed changes to the Australian capital adequacy framework.

Conflicts Management in Superannuation

When we last appeared before this Committee, we spent some of our time discussing the management of conflicts of interest in the superannuation industry. Since the introduction of prudential standards for superannuation in 2013, APRA has been assessing how well trustees have adjusted to the heightened expectations placed upon them, with a particular focus on conflicts management. The main message from our recent review in this area is that, while there have been improvements across the industry and some trustees have established quite good practices, others still have more work to do to meet the objectives of the prudential standard. Unfortunately, we still see instances where actual and potential conflicts are viewed very narrowly: a minimalist, compliance-based approach is taken to the design of conflicts management frameworks, rather than an approach that seeks to meet the spirit and intent of the requirements. Some trustees also take a reactive approach to dealing with conflicts, rather than ensuring regular and appropriate prior consideration of conflicts and a proactive approach to their effective management.

APRA’s supervisors are engaging with the entities that were covered by the review to ensure that appropriate and timely action is taken on any specific issues that were identified. We are also issuing a general letter to the industry, providing the key findings from the review and identifying a range of specific questions for trustees to consider in reviewing and enhancing their conflicts management frameworks. APRA will continue to focus on conflicts management as part of its future supervision activities, and will continue to push the industry to meet the enhanced governance and risk management expectations set out in our standards.

Private Health Insurance

Finally, let me make a quick comment on private health insurance. As you would be aware, APRA is not currently the prudential regulator of private health insurance – the Private Health Insurance Administration Council (PHIAC) performs that function – but we are preparing to take on that task from 1 July 2015, assuming the passage of the relevant legislation. For our part, we are working closely with PHIAC and other stakeholders, and will be ready to take on these new responsibilities. We are proposing only the minimum change necessary to the prudential standards and rules to align them with the proposed new legislation – in practice, health insurers should notice very little difference in their prudential arrangements from 1 July. But, even though the impact of the change may not be particularly noticeable, we would stress that a lot of work has gone into the preparations and it is in everyone’s interest that the momentum is not lost. APRA, PHIAC staff and industry will all benefit from the certainty provided by that.

NZ Loan To Income Ratios Higher

The Reserve Bank of NZ released a report today “Vulnerability of new mortgage borrowers prior to the introduction of the LVR speed limit: Insights from the Household Economic Survey.” The paper uses household level data for New Zealand to assess the vulnerability of new mortgage loans to owner-occupiers between 2005 and 2013.

They modelled financial vulnerability, considering:

Does the household have adequate cash flow to support mortgage borrowing?
How large is the equity buffer of the household?

Their analysis suggests a move towards more stretched debt-to-income ratios between the 2008-10 and 2011-13 cohorts.

They highlighted that most banks will lend at much higher DTIs to high income borrowers than low income borrowers. Owner occupiers with an income of greater than $80,000 do account for almost half of high DTI lending in the 2011-13 cohort. However, this is significantly lower than their share of total lending of around 70 percent. By number, such households account for only 30 percent of owner occupiers with a high DTI.19 Subject to the caveat that our sample of high DTI borrowers is relatively small, this suggests that owner-occupiers with a high DTI are more likely to have an income below $80,000 than those with a low DTI (despite banks’ preference to supply high DTI loans to high income households).

They found an increase in typical DTI multiples compared to earlier years, in addition to the well-known rise in the share of high-LVR lending. The proportion of borrowers with both a high-DTI and a high-LVR also increased sharply and was higher than prior to the GFC. These results are consistent with an increase in the vulnerability within the 2011-13 cohort, although the quantum of lending undertaken and the tail of very high DTI borrowers both remained smaller than prior to the GFC.

Note that an assessment of the vulnerability of other borrower types – including investors and owner occupiers that have not recently bought – is left for future work.

Mortgage Delinquencies Up In Q4

Fitch says that competitive lending, high house prices and low interest rates did not benefit residential mortgage performance in 4Q14, with the delinquencies in the Dinkum RMBS index increasing by 7bp to 1.15%. However, overall performance was better than a year earlier when the 30+ days delinquency ratio was 1.21%.

Fitch believes that in the current low-interest rate environment, rising unemployment will be a key driver of mortgage performance in 2015, as indicated by the 90+ days arrears increase by 3bp to 0.50% despite the strong housing market.

Self-employed and non-conforming borrowers continue to benefit from the strong Australian economy, appreciating housing market and competitive lending environment. Low-documentation (low-doc) loans are usually provided to self-employed borrowers and tend to experience four to five times the level of full-documentation (full-doc) loan delinquencies. The low-doc Dinkum Index worsened by 14bp down to 4.91%, which is better in relative terms compared to the 7bp decrease among full-doc loans.

Non-conforming loans, which are usually provided to borrowers that have an adverse credit history or do not conform to Lenders Mortgage Insurer’s (LMI) standards, continue to show strong resilience with 30+ days arrears improving to 6.70% in December 2014, down from 6.85% in September 2014. Repayment rates in the non-conforming segment have increased to pre-2008 levels, driven by refinancing in the currently competitive lending environment.

Australian house prices gained 7.9% year-on-year at December 2014. This was predominantly driven by increases in Sydney and Melbourne’s property prices. High property prices have benefited LMI claims as it reduced the likelihood of a principal shortfall on defaulted loans. In 4Q14, the Dinkum LMI payment ratio was 95.2%, compared to 93.6% in 3Q14, with an average 4Q14 LMI claim of AUD71,498, below the average cumulative LMI claim of AUD73,097.

A stable Australian economy, low interest rates, and appreciating housing market have assisted mortgage performance. Fitch expects the current rate of property price growth to be unsustainable in the long term, unless household income increases. The agency believes unemployment rate and house prices are key drivers of 90+ days arrears in the current low interest rate environment. The agency expects that the seasonal Christmas spending will be offset by the February 2015 interest-rate cut and the temporary reduction in petrol prices, in turn resulting in stable 1Q15 arrears.

RBA Leaves Door Open For More Rate Cuts

The RBA released their Minutes of the Monetary Policy Meeting of the Reserve Bank Board from 3 March 2015. Clearly housing is the potential brake on further cuts, but that said further falls are possible.

In assessing the appropriate stance for monetary policy in Australia, members noted that the outlook for global economic growth had not changed, with Australia’s major trading partners forecast to grow by around the average of recent years in 2015. Lower oil prices were expected to boost growth in major trading partners and reduce inflation temporarily. More generally, although the decline in many commodity prices over the past year had largely been in response to expansions in global supply, members observed that demand-side factors, including the weakness in Chinese property markets, had also played a role. Although the Australian dollar had depreciated, particularly against the US dollar, it remained above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. Conditions in global financial markets remained very accommodative. Changes to the stance of monetary policy by the major central banks were likely to be important influences on financial markets over the coming year.

Data available at the time of the meeting suggested that the Australian economy had continued to grow at a below-trend pace in the December quarter and that domestic demand growth had remained weak overall. There had been some evidence suggesting that growth of dwelling investment and consumption had picked up in the December quarter, but there had also been indications that business investment could remain subdued for longer than had been previously expected. On balance, the evidence suggested that labour market conditions were likely to remain subdued and the economy would continue to operate with a degree of spare capacity for some time. As a result, wage pressures were expected to remain contained and inflation was forecast to remain consistent with the target over the next year or so, even with a lower exchange rate.

At the same time, activity in the housing market had remained strong. Housing prices had continued to increase strongly in Sydney and at a solid pace in Melbourne. In other capital cities, trends had been more mixed and annual increases in capital city housing prices (excluding Sydney and Melbourne) had averaged about 3 per cent. Growth of dwelling investment was estimated to have picked up in the December quarter and was expected to remain at a high level in the near term. While credit had continued to grow a little faster than incomes, household leverage had not increased significantly and the Bank would continue to work with other regulators to assess and contain risks that might arise from the housing market.

Members noted that the current setting of monetary policy had been accommodative for some time and that the recent reduction in the cash rate would provide some further support to the economy. They also acknowledged that a lower exchange rate would help achieve balanced growth in the economy. Nonetheless, on the basis of the current forecasts for growth and inflation, members were of the view that a case to ease monetary policy further might emerge.

In considering whether or not to reduce the cash rate further at this meeting, members saw benefit in allowing some time for the structure of interest rates and the economy to adjust to the earlier change. They also saw advantages in receiving more data to indicate whether or not the economy was on the previously forecast path. Further, they noted the greater degree of uncertainty about the behaviour of borrowers and savers in a world of very low interest rates. Taking account of all these factors, members judged it appropriate to hold the cash rate steady for the time being, while recognising that further easing over the period ahead may be appropriate to foster sustainable growth in demand while maintaining inflation consistent with the target.

Latest DFA Survey – Drilling Down On Overseas Investors

Over the next few days we will be posting the results of our latest household surveys. We are going to start with the hot investment segment, and look specifically at the vexed question of the proportion of overseas investors buying investment property for the first time. This is a tough data set to capture, because by definition such households are hard to contact, or prefer not to talk and they do not use an Australian mortgage. However, we devised a proxy set of questions focussing on funding sources, and as a result we now have a view of the proportion of first time investors in the market, and the overseas mix.

Taking the January data as a starting point, ABS tells us that there were 5,961 loans to owner occupied purchasers. In addition, we identified a further 3,661 first time buyers getting a mortgage for investment purposes. These amount to 35% of loans who are not identified as first time buyers in the ABS data, but are in the overall loan volume data. 8%, or 850, require no mortgage at all, and do not show in the mortgage statistics. We would need reliable purchase transfer records to get at the true picture, something not readily available.

From our surveys we teased out the funding options that first time buyers went with. 36% of deals used an interest only mortgage, 41% used a standard repayment mortgage, but the rest, 850 transactions (8%) did not require mortgage funding from an Australian bank but rather used other sources including parents, or were an overseas purchase.

We can dissect these purchases based on funding. About 125 were local purchasers without finance, over 200 were financed by parents and under 100 financed from other sources. However the most significant number was the 415 by overseas investors, using funding from offshore.

Looking at these 850 transactions through the lens of our surveys, we found that more than 550 were in NSW, more than 200 in VIC and a few sprinkled across the other states. This equates to about 4% of all first time buyers and 9.2% of investor first time buyers. Enough to more than move the dial, especially given the concentration in Sydney.

Next time we will look at investor motivations, and future plans. We think the investment housing boom is likely to continue to run, as more investors get the bug.

ASIC puts payday lending industry on notice to lift standards

ASIC today released a report Payday lenders and the new small amount lending provisions that found that payday lenders need to improve compliance with some of the key consumer protection laws operating in the industry. As at December 2014 there were approximately 1,136 Australian credit licensees that identified that they operate in the payday lending industry (out of a total of 5,842 Australian credit licensees). This figure has declined slightly (by about 6%) over the last 12 months.

Nine of the 13 payday lenders in the review have also diversified their business since the new cap-on-costs provisions commenced. Other business interests and products offered identified in the review include:

medium amount loans;
other credit contracts;
cheque cashing;
gold buying;
purchasing delinquent debts;
secured loans; and
pawnbroking.

ASIC’s review of 288 consumer files for 13 payday lenders – who are responsible for more than 75 per cent of payday loans made to consumers in Australia – found some lenders engaging in conduct that risks breaching responsible lending obligations. 187 recorded the consumer’s purpose for the loan.

While ASIC’s review found compliance with some rules was working, it also found that payday lenders are falling short in meeting important new obligations introduced as part of the small amount lending reforms in 2013.

ASIC’s review found particular compliance risks around the tests for loan suitability, which must be considered when the consumer has multiple other payday loans or is in default under a payday loan.

The review also identified concerns where payday lenders set their loan terms at 12 months or more, thereby charging the consumer more fees, in circumstances where a consumer had requested a shorter term and paid the loan back in that shorter time.

The report also found systemic weaknesses in documentation and record keeping, including around the issue of the consumer’s objectives and needs.

ASIC’s review found better levels of compliance with some regulations, including the requirement to provide a warning about alternative credit options and the income protection rules for Centrelink recipients.

ASIC’s review follows a series of enforcement actions against payday lenders, including the recent Cash Store decision which saw penalties of almost $19 million handed down by the Federal Court for irresponsible lending and unconscionable conduct.

Following the work and the conduct that has been uncovered ASIC has commenced investigations and further follow-up work in certain cases, and will consider enforcement action or other regulatory action.

ASIC became the national credit regulator in 2010. Tighter consumer credit rules for small amount lending were introduced in 2013.

ASIC has focused on three areas of misconduct in the payday lending sector:

irresponsible lending
avoidance through business models that attempt to circumvent the law, and
unfair fees and misleading advertising.

Since 2010, ASIC enforcement action has resulted in close to $2 million in refunds to more than 10,000 consumers who have been overcharged when taking out a payday loan. Payday lenders have also been issued with 13 infringement notices totalling approximately $120,000 in response to ASIC concerns about their compliance with the credit laws.

ASIC notes the 2013 small amount credit reforms will be independently reviewed after 1 July 2015. ASIC will continue its focus on enforcing the current provisions and raising industry standards.

Policy Responses In A Falling Market

The IMF just published a discussion paper looking at what happened in Spain, Ireland, US and Iceland after the 2007 crash. In some countries, as house prices fell (some as much a 50%) creating an negative equity situation, the main response was a default sale, whereas elsewhere other strategies were tried, sometimes with government assistance or intervention. With the benefit of hindsight, it appears that loan modification or restructuring offered the best path to economic recovery and provided better outcomes for individual households. Worth noting when the Aussie housing market finally turns!

A number of interesting variations to loan modification were found in the research:

Trial modification – A trial period allows borrowers to showcase their debt service commitment and provides time to further calibrate the efficiency of the loan modification terms, in particular when the recovery is ongoing. In the US, HAMP requires borrowers to enter into a 90-day Trial Period Plan, during which a Net Present Value test is carried out to determine whether the borrower can be offered a permanent loan modification.

Split mortgage – A split mortgage divides the original principal into a part that continues to be serviced in full and a warehoused part that falls due at a later time. The warehoused part may be charged interest. At maturity, this portion may be refinanced, repaid if borrower circumstances allow, paid off from the sale of the home, or written off.

Shared appreciation – A shared appreciation modification reduces the outstanding balance on a mortgage until the borrower is no longer underwater, while entitling the lender to a portion of any home price gain once the home is sold.

Earned principal forgiveness – Arrears or principal forgiveness necessary to ensure long term sustainability may be granted to borrowers that remain in good standing on their mortgage payments. In Ireland and the US, earned principal forgiveness schemes forebear interest on a portion of the loan which may subsequently be forgiven if the borrowers remain current on all debt service obligations.

Negative equity transfer – Products allowing the transfer of negative equity to a new mortgage give mortgagees in negative equity the opportunity to benefit from refinancing at lower rates or move to smaller homes, which may improve their overall debt servicing capacity.

Debt overhang in the aftermath of a systemic housing crisis can cause a weak and protracted recovery. The effects of debt overhang from excessive debt payment burdens or declines in household wealth can create negative feedback effects that hamper the recovery and increase the cost of a crisis. As in other downturns, monetary policy and social safety nets provide a first line of defense. In addition, policies that temporarily allow forbearance of lenders vis-à-vis borrowers and facilitate the modification of distressed mortgages can help to contain the undershooting of house prices by reducing the extent of foreclosure and associated deadweight losses and social costs. Systemic crises can affect the trade-offs involved in these policy choices and warrant policies that deviate from “normal” times. However, different country circumstances suggest there cannot be a “one-size-fits-all” approach, and policy formulation should take into account important country specific factors as well as the stage of the recovery.

Temporary forbearance offers breathing space during a crisis, but should be selective and time-bound. Forbearance can reduce household financial distress in the short run, helping households to adjust their consumption more smoothly. However, temporary forbearance can induce free riding and should only be considered in cases of sufficiently strong prospects for a recovery of the borrower’s debt service capacity. While forbearance can help to act as a circuit breaker at the peak of the crisis, it is important that lenders remain selective in granting forbearance and reach formal forbearance agreements in order to avoid an erosion of the debt service culture and to ensure that borrowers remain engaged. Temporary forbearance can also tie in with loan modification by serving as a “trial modification” and bridging a period of elevated uncertainty about future incomes and house prices.

Systemic housing crises can tilt workout choices from foreclosure towards loan modification. Foreclosures are costly and can have negative externalities on house prices. Negative equity and prospects for the recovery of borrowers’ income suggest that loan modification becomes a net present value efficient solution for a larger share of delinquent borrowers. However, renegotiation cost and other obstacles often obstruct loan modification.

Policies can help to facilitate loan modification. Frameworks for orderly debt renegotiation in form of a code of conduct for lenders dealing with distressed borrowers, together with an efficient statutory framework for personal insolvency, can shape expectations and improve coordination, thereby facilitating timely loan modification. Prudential policies can set appropriate incentives to encourage loan modifications and facilitate the use of innovative modification techniques. A temporary tax exemption could help to enable loan principal relief. Depending on the availability of fiscal resources, support could be provided for mortgage counseling and targeted incentive payments could promote loan modifications. However, experience from Ireland and the US shows that even with such policies, a significant number of mortgages can remain unsustainable and require foreclosure.

Efficient foreclosure procedures provide a resolution of last resort and an important incentive for constructive borrower behavior. In cases where constructive cooperation between borrowers and lenders breaks down, or where no sustainable loan modification would be net present value optimal, foreclosure must remain as last resort. Delays in foreclosure procedures have been found to increase defaults and overall workout costs. Instead, a temporary increase in foreclosure costs through fees or taxes could reduce lenders’ reliance on foreclosure as workout tool. To avoid a deterioration of credit service culture, protections from foreclosure should only be extended to cases where other solutions are likely sustainable (with exceptions for hardship cases), and a foreclosure threat needs to remain present to deter strategic borrower behavior.

Across-the-board debt relief is costly and may require intrusive government intervention. Across-the-board debt relief is sometimes considered as crisis measure as it can be implemented quickly and provides immediate relief to many mortgagees. However, the macroeconomic benefit of a broad-based debt reduction tends to be small relative to its cost, and blanket debt reductions are not well targeted to address debt servicing difficulties. Implementing across-the-board debt relief can also have negative ramifications for the supply of mortgage credit in the long run.