Tag: HEM

Westpac admits to breaching responsible lending obligations

ASIC says Westpac has admitted breaching its responsible lending obligations when providing home loans and agreed to submit to a $35 million civil penalty to resolve Federal Court proceedings under the National Consumer Credit Protection Act 2009 (Cth) (the National Credit Act). A three-week trial for this matter was due to commence in the Federal Court yesterday.

The parties have jointly approached the Federal Court seeking orders that Westpac contravened the responsible lending provisions of the National Credit Act because its automated decision system:

  • did not have regard to consumers’ declared living expenses when assessing their capacity to repay home loans, and instead used a benchmark (the Household Expenditure Measure); and
  • for home loans to owner occupiers with an interest-only period, failed to use the higher repayments at the end of the interest-only period when assessing a consumer’s capacity to repay the loan. For example, for a loan of $500,000 at 5.24% with a term of 30 years and a 10-year interest-only period, the assumed repayment using the incorrect method is $2,758 per month, whereas the actual repayment after the expiry of the interest-only period using the correct method is $3,366 per month.

The litigation related to Westpac’s home loan assessment process during the period December 2011 and March 2015, during which approximately 260,000 home loans were approved by Westpac’s automated decision system. For approximately 50,000 home loans, Westpac received, and did not use, consumers’ actual expense information that was higher than the Household Expenditure Measure. For approximately 50,000 home loans, Westpac used the incorrect method when assessing a consumer’s capacity to repay a home loan at the end of the interest-only period. Of these approximately 100,000 loans, Westpac should not have automatically approved approximately 10,500 loans.

If approved by the Federal Court, this will represent the largest civil penalty awarded under the National Credit Act.

Westpac admitted contraventions of the National Credit Act and the parties filed a Statement of Agreed Facts and joint submissions as to the appropriate penalty. Westpac will also pay ASIC’s litigation and investigation costs.

The National Credit Act provides consumer protections to ensure that credit providers make reasonable inquiries about a borrower’s financial situation, verify the information that they obtain and assess whether a loan contract will be unsuitable for the borrowers.

The responsible lending laws are designed to ensure that lenders have regard to all relevant information about the consumer before approving a loan to minimise the risk of adverse outcomes for the consumer over the course of the loan. Lenders must have in place the right processes to ensure that they comply with these important obligations.

ASIC Chair James Shipton said, ’This is a very positive outcome and sends a strong regulatory message to industry that non-compliance with the responsible lending obligations will not be tolerated. Responsible lending in the home lending market is absolutely vital to consumers, banks and our economy.

‘This outcome, and ASIC’s actions in relation to responsible lending, reinforce that all lenders must obtain information from individual borrowers about their financial situation to ensure that they can properly assess the ability of the customer to repay the loan. Lenders must then verify the information to ensure that it is true, and then assess whether the loan is unsuitable for the borrower. Taken together, these responsible lending obligations are a cornerstone protection for both borrowers and lenders,’ he said.

‘This outcome is a warning to all lenders that they must comply with the responsible lending obligations. If they do not, ASIC will take action to enforce the law.’

Background

ASIC published its review of interest-only loans in August 2015 (refer: 15-220MR), as part of a broader review by the Council of Financial Regulators into home-lending standards. The review included 11 lenders, including the big four banks, and found that lenders were often failing to consider whether an interest-only loan would meet a consumer’s needs, particularly in the medium to long-term (refer: 15-220MR). ASIC was particularly concerned with Westpac’s home loan assessment process, and with Westpac providing very lengthy interest-only periods (up to 15 years) for owner occupiers.

As part of the outcomes of ASIC’s work, ASIC required lenders and brokers to raise standards to ensure they were complying with responsible lending obligations. The 11 firms in our review, including Westpac, all committed to implementing stronger standards.

ASIC has provided guidance on responsible lending in Regulatory Guide 209 Credit licensing: Responsible lending conduct (RG 209). ASIC is updating its guidance this year and will be engaging in a full public consultation as part of this process.

ASIC has also been engaging with the Government in relation to comprehensive credit reporting and a proposed open banking regime. These initiatives will assist in improving responsible lending standards by making high-quality information about consumers’ financial situation available to lenders when assessing the suitability of a loan.

Home Prices and Lending To Fall? Perhaps Hard!

The good people at UBS has published further analysis of the mortgage market, arguing that the Royal Commission outcomes are likely to drive a further material tightening in mortgage underwriting. As a result they think households “borrowing power” could drop by ~35%, mainly thanks to changes to analysis of expenses, as the HEM benchmark, so much critised in the Inquiry, is revised.

Their starting point assumes a family of four has living expenses equal to the HEM ‘Basic’ benchmark of $32,400 p.a. (ie less than the Old Age Pension). This is broadly consistent with the Major banks’ lending practices through 2017.

As a result, the borrowing limits provided by the banks’ home loan calculators fell by ~35% (Loan-to-Income ratio fell from ~5-6x to ~3-4x).

This leads to a reduction in housing credit and a further potential fall in home prices.

This plays out similarly to our own scenarios, which we discussed a couple of weeks back, exploring the outcomes from a mild correction, to a crash. A 20% reduction in borrowing power has already hit, by the way, and this before the Royal Commission revelations.

This will have a significant impact on the banks, but a broader hit to the economy also.

 

The Affordability Conundrum

We have highlighted the rise in mortgage stress. We identified rising mortgage rates, underemployment, higher costs of living and flat incomes as causes of stress. But we need to stop and ask how come more households are under mortgage pressure than ever?

After all, lenders should have been operating with at least a 2.5% buffer between the mortgage rate offered and the rate they use for affordability assessment, and they should be looking at the household spending to ensure they can afford the loan. Failure to do this would make the loan “unsuitable” and under the lending provisions if loans were not made in compliance with the responsible lending provisions, the borrower can dispute the loan.

Mortgage stress should just not be as high as it is these guidelines were followed. Whilst interest rates have moved from their lows, thanks to out of cycle rises, (which in sum for owner occupied borrowers amount to around 30-40 basis points, whereas interest only loans, and investor loans are now 75-100 basis points) are still well within the 2.5% mortgage affordability rate buffer.

To try and unpick this, we have been looking at real household expenditure budgets from our core market model (using our surveys and other data), and comparing this with the standard Household Expenditure Measure (HEM) used by the banks.

HEM is based on more than 600 items in the ABS Household Expenditure Survey (HES). The HEM is calculated as the median spend on absolute basics (food, utilities, transport, communications, kids’ clothing) and the 25th percentile spend on discretionary basics, which includes expenses like alcohol, eating out and childcare. Non-basic expenses, for example overseas holidays, are excluded from calculations.

The National Consumer Credit Protection Act regulations say that whilst banks may use a HEM to guide the analysis, they must still do more complete analysis and validate the expenditure profile by looking at statements and other evidence. Relying on HEM is not sufficient.

Whats interesting about this is that APRA said last year:

On the expense side, the major differences across ADIs seen in the original exercise related to whether the ADI used a benchmark living expenses measures, such as the Household Expenditure Measure (HEM), the customer’s own reported expenses, or a more targeted calculation of the benchmark.   Most people have a hard time actually estimating their own living expenses, so the customer-declared figure may not be particularly accurate. However, the basic benchmark measures are also simplistic; scaling expense assumptions to the borrower’s income level (and potentially other factors including geography) is a more realistic and prudent approach.

About half of the ADIs in our exercise were still using the basic HEM, but others have moved to implement more sophisticated approaches or are in the process of doing so. At a minimum, all ADIs now reflect the customer’s declared living expenses where these are higher than the benchmark.

A strong alignment between the HEM calculation and the final expenses assessment might be a warning of expenses being understated.

Regulators said recently that there was often a “coincidental” alignment between HEM and actual costs, especially for more affluent purchasers.

So we obtained some HEM data for a typical household in our survey, and compared the HEM output with the data on real expenditure, using the same basis of calculation as HEM.

We found that in all states except SA, the standard HEM understated household expenditure significantly, net of mortgage payments, many were more than 10% higher. ACT, WA and NSW had the highest divergence. So did lenders make sufficient allowance to actual spending in the current low growth, higher cost of living environment?

If not, or if HEM had been used, households might have obtained a larger mortgage than could comfortably be serviced.

So, we need to ask – why the variation between HEM and reality? We suggest it may be a combination of:

  1. Households incomes being squeezed as costs rise and underemployment rises (households are not generally reassessed in flight by the banks)
  2. Banks were too generous in their initial affordability assessments and did not take actual spending sufficiently into account.
  3. Households did not fully disclose costs and banks did not fully check them out. HEM became the default.

Finally, we also looked across our household segments, and found that (no surprise) expenses of more affluent households were significant higher.

This helps to explain why we are seeing more affluent households getting into mortgage stress territory.

Should banks be obliged to review household spending patterns on a recurring basis, rather than at mortgage underwriting time? Is there  merit in the regulators looking in more detail at the extent to which all lenders (including non-banks) are compliant. We suspect some lenders have been too willing to operate on lower spending buffers to enable a deal to be done.

Borrowers of course should not borrow just because the bank says they are willing to lend to a certain level. Households should prepare their own budgets and include allowance for higher mortgage rates and rising living costs. They may get a smaller loan as a result, but they will be more secure in a rising market.

Our industry contacts suggest that many lenders are reviewing their spending assessment, and that more details and granular information is now been used. However, this may nor help those who got bigger loans in easier conditions as affordability bites.