RBA – Page 65 – Digital Finance Analytics (DFA) Blog

Navigating the inflection in global inflation

Global inflation appears to be at a point of inflection, which can create challenges for investors and necessitate a re-evaluation of strategies.

Inflation has only been a problem because there hasn’t been enough of it. Lack of inflation fuels fears of deflation, despite lengthy and innovative attempts by central banks to stimulate growth and push prices higher.

However, inflation is seemingly at an inflection point. The word ‘deflation’ may exit the financial lexicon over the coming months as commodity prices stabilise and global excess capacity is slowly reduced, and investors position for modestly higher rates of inflation.

In the past week, inflation in both the UK and the US has reached the highest rates in almost two years at 1.0 per cent and 1.5 per cent year-over-year respectively.

In the US economy the rise in the price of oil over the last year is filtering through into higher energy costs, meanwhile the UK inflation rate got an additional boost from the tumbling value of the pound.

Sterling has declined by 16 per cent on a trade weighted basis since the EU referendum back in July and 22 per cent since last November. It’s worthwhile to note that an increase in inflation in these two economies can result in very different policy responses.

In the US, rising prices is a signal of a healthier economy and removes another obstacle to the Federal Reserve hiking rates later this year.

The story is very different in the UK as rising inflation is a symptom of the stress that the threat of a ‘hard brexit’ is placing on the economy.

This could result in further easing of monetary policy as the Bank of England is prepared to look past the near term rise in prices, preferring to focus on the potential drag on growth of the UK extracting itself from the European Union.

In Australia, we may not yet be at the point were we start to see inflation rise, and there are structural reasons for why inflation is low and why it can remain relatively benign – international competition in retail and low wage growth are just two examples.

We do not expect it to plunge further however, and the rate of inflation here has not skirted with deflation as it has in the UK and the US.

This week’s inflation release will be critical for the outlook on monetary policy, given that the rate of inflation has missed the bottom of the RBA’s target band for six consecutive quarters already.

The RBA’s current projection is for inflation to be 1.5 per cent year-on-year in December and then remaining between 1.5-2.5 per cent in 2017.

Only if inflation threatens to undershoot these already low projections will the RBA be spurred to cut rates again and, as a reluctant cutter, they will likely keep rates where they are into next year.

The outlook for global inflation is on the turn. A modest rise in inflation – and inflation expectations – from their very low levels in the US and UK will be echoed through the rising yields in the global government bond market.

This is especially the case when combined with exhaustion from monetary policy and the focus on increased levels of fiscal spending.

Yields on the US and Australian ten-year government bonds have increased by over 20 basis points since the end of September and while these moves may seem sharp, they are not nearly as dramatic as the back-up in yields experienced during the 2013 taper tantrum.

Yields on core government bonds are likely to rise but are unlikely to surge thanks to demand from insurance companies and pension funds that have been starved of safe yield bearing assets for many years.

Government bonds hold a fundamental position in any portfolio as a diversifier, but play a diminished role in providing income.

The perceived riskier areas of the fixed income market provide some income relief. Spreads in investment grade and high yield credit have narrowed to their historical averages but can tighten further.

The performance of emerging market debt this year has been staggering. US dollar denominated debt returned nearly 15 per cent in the first nine months of the year and investors may be wondering if they have missed the rally, however the improvement in growth prospects and upward revision to corporate earnings suggests that there are still opportunities for investors.

Author: Kerry Craig global market strategist at J.P. Morgan Asset Management.

RBA Minutes On Housing

The RBA minutes, released today, have several paragraphs on the housing sector, yet seem to be quite selective in their narrative. So we have laid out our own perspectives alongside the words from the RBA.

We think the housing risks are higher for one simple reason. Debt enables households to bring forward purchases, to be paid for from later income. But with income rising so slowly, and debts still growing fast, how will the debts be repaid?

RBA Minutes Says	DFA Says
Household consumption growth had moderated in the June quarter. This was driven by a decline in the consumption of goods, consistent with low growth in retail sales volumes, while growth in the consumption of services had remained around average. More timely indicators of household consumption had been mixed: although growth in retail sales had been low over the few months to July, households’ perceptions of their personal finances had remained above average. Members noted that future consumption growth would largely depend on growth in household income. Members observed that the household saving ratio had been little changed in the June quarter but remained on a gradual downward trend, in line with earlier forecasts.	Why no mention of the rising household debt ratio? It is now higher than ever it has been. With income growth so low, whilst serviceability of large loans at current interest rates is manageable by many, how will the capital value of the loan be paid off? The proportion of households who are property inactive continues to rise, as more are excluded on affordability grounds.
Dwelling investment had been increasing more rapidly than housing credit, suggesting that households were increasing their housing equity at a relatively strong rate. Indeed, private dwelling investment had continued to grow at an above-average rate in the June quarter. The large amount of work in the pipeline and the high level of building approvals in July and August were expected to support a high level of dwelling investment for some time, although the rate of growth in dwelling investment was expected to decline over the forecast period.	Investment loans were the only growth area in the August ABS data- up 1%. Lenders are very willing to lend to this sector. We think stronger macro-prudential policies are needed. Demand for investment property remains strong, on the expectation of continued future home price growth. The growth of home prices is not matched to growth in rental incomes, in fact they are slower than they have been for years. This creates a further risk in the investment sector. We know many households are not covering the costs of their rental property from rent received, relying on tax breaks and offsets, especially in VIC and NSW, whilst hoping for capital growth.
In the established housing market, conditions had eased relative to a year earlier, although there had been some signs that conditions had strengthened a little more recently. Housing price growth in Sydney and Melbourne had increased in recent months and auction clearance rates in these two cities had risen. In contrast, turnover and housing credit growth had been noticeably lower than a year earlier and the value of housing loan approvals had been little changed in recent months. Conditions in the rental market had continued to soften, particularly in Perth, where population growth had been easing and the rental vacancy rate had risen.	There is debate as to the rate of real growth in home prices, but they are still rising, especially in VIC and NSW. High auction clearance rates show demand remains strong. Home prices could well continue to rise, enabling more lending. We need DSR and LTI macro-prudential measures. LVR measures do not help much in a rising market.
Conditions in the housing market had been mixed over prior months. The effects of tighter lending standards had been apparent in indicators such as the shares of interest-only loans and loans with high loan-to-valuation ratios in new lending, both of which had declined over the past year. Turnover had declined and housing credit growth had been steady at a noticeably lower rate than a year earlier. Although the rate of increase in housing prices had been lower than a year earlier, growth in housing prices and auction clearance rates had strengthened in Sydney and Melbourne in the months leading up to the meeting. Members noted that considerable supply of apartments was scheduled to come on stream over the next couple of years, particularly in the eastern capital cities. Overall, members assessed that while the risks associated with rapid growth in housing prices and lending had receded over the past year, developments would need to be monitored closely.	Interest only loans are actually rising again according the APRA’s latest data, as investment loan growth continues. Several lenders are offering attractive discounts now. Household have high levels of debt. The risks are quite high now, and would become severe if interest rates were to rise

RBA on Inflation and Monetary Policy

Philip Lowe’s first speech as RBA Governor was on the topic of inflation and monetary policy. He showed just how powerful the impact of low income growth as been, with the wage price index (WPI) growing by just over 2 per cent over the past year, which is the slowest rate of increase since the series began in the late 1990s. Over recent years, there has been a decline in the frequency of wage increases and, when wage increases do occur, the average size is lower. This has profound impact on households loaded with high debt – yet this was NOT discussed.

The two measures shown are headline CPI inflation and the trimmed mean measure. We too have now joined the club of countries with headline inflation noticeably below the medium-term average, although we are a more recent member than many others. Headline inflation here is 1 per cent and measures of underlying inflation are running at around 1½ per cent.

These low inflation outcomes globally and in Australia are coexisting with low wage outcomes. In many industrialised countries, wage growth has been close to multi-decade lows and below what historical relationships with the unemployment rate would suggest.

The low inflation outcomes in the advanced economies reflect a combination of three factors – excess capacity, lower commodity prices and perceptions of reduced pricing power.

I would like to offer some reflections on these three factors from an Australian perspective.

First, excess capacity. While the Australian economy has performed better than many others over the past decade, we still have some spare capacity. Determining exactly how much is difficult, but Bank staff estimate that the current unemployment rate of 5.6 per cent is around ½ percentage point or a bit more above full employment. While this gap has narrowed over the past year, we do still have some spare capacity. Looking at broader measures of labour market utilisation reinforces this point. Over the past year, the Australian Bureau of Statistics’ (ABS) measure of underemployment has risen, not fallen, so that overall labour market underutilisation has been little changed. This largely reflects the fact that many of the people finding work recently have been employed in part-time jobs and report that they would like to work more hours.

The second factor is the decline in commodity prices. The most direct effect is the fall in petrol prices. Over the past two years, the price of petrol in Australia has declined by around 20 per cent. This has lowered the year-ended rate of headline inflation by almost 0.4 percentage points over each of these years. More broadly though, the decline in commodity prices has perhaps had a bigger effect in Australia than elsewhere, given that it has weighed on our aggregate income and thus demand. Over the past five years, the prices of Australia’s commodity exports have fallen by more than 50 per cent and Australia’s terms of trade have fallen by 35 per cent as a result, which is the main reason that growth in national income has been weak over recent years.

The third factor is the feeling of reduced pricing power, partly from greater competition.

One good example of this is in the retail sector, where the entry of foreign retailers has made a real difference in groceries and clothing. Over recent times, food price inflation has been unusually low and the prices of many goods have not risen as quickly as suggested by the conventional relationship with import prices.^[1] Increased competition has forced existing retailers to find efficiencies to lower their cost bases and, in turn, their prices. Reflecting this, there has been a pick-up in the rate of productivity growth in the retail sector, which is good news for consumers. More broadly, though, many Australian workers are facing some of the insecurities that workers in other advanced economies are facing.

The effects of these three factors – excess capacity, lower commodity prices and reduced pricing power – are evident in the wage outcomes in Australia. In particular, the wage price index (WPI) has increased by just over 2 per cent over the past year, which is the slowest rate of increase since the series began in the late 1990s.

The Reserve Bank and the ABS have been working together to obtain some additional insight into what is happening here. Together we have looked at the wage increases for all the 18,000 individual jobs that the ABS uses to construct the WPI. The results are interesting. Over recent years, there has been a decline in the frequency of wage increases and, when wage increases do occur, the average size is lower. The decline in the average size of increases is largely due to a very sharp drop in the share of jobs where wages are increasing at what, by today’s standards, would be considered a rapid rate.

For example, six years ago, almost 40 per cent of the 18,000 individual jobs being tracked by the ABS received a wage increase in excess of 4 per cent. In contrast, over the past year, less than 10 per cent of jobs got this type of wage increase. And almost half of the individual jobs tracked by the ABS had a wage increase of between 2 and 3 per cent.

The low CPI and wage outcomes in Australia have seen some decline in inflation expectations, although not to the levels seen in many other countries. Consumer inflation expectations are lower than they were some years back, but are not at unprecedented levels. Market-based measures of long-term inflation expectations have also declined, but they remain consistent with the inflation target.

Looking to the future, we expect that the various factors holding inflation down will continue for a while yet. But this does not mean that we have drifted into a world of permanently lower inflation in Australia.

Domestic demand is expected to strengthen gradually as the drag on our economy from the decline in mining investment comes to an end. As this happens, the excess capacity, including in the labour market, is likely to be wound back. Some pick-up in wages and prices could then be expected. In addition, commodity prices, after having declined over the preceding four years, have increased this year. If sustained, this will boost national income and falls in petrol prices will no longer be having a significant effect on headline inflation. In terms of the downward pressure on prices and wages from increased competition, this is likely to continue for a while yet, but it is probable that this pressure will lessen at some point as domestic demand strengthens.

Putting all this together, our central forecast remains that inflation in Australia will gradually pick up over the next couple of years, although it is still likely to be closer to 2 per cent than 3 per cent by the end of this period.

The risks in Australia’s housing market shouldn’t be downplayed

From The Conversation.

The Reserve Bank of Australia (RBA) sees housing finance as a smaller danger than in the past, judging by its latest Financial Stability Review, but we aren’t back to happy days just yet. A number of economic indicators still show there’s cause for concern in the property market.

The review does acknowledge some problems in the apartment markets in Brisbane and Melbourne, but it sees major threats to the resilience of the Australian financial system overseas: examples are the rising debt levels in China, the low performance of European banks, the Brexit, and the impact of low milk prices on New Zealand farmers (with a possible feedback effect to Australian banks).

The review highlights Australian banks’ stronger capital buffers and compliance with toughened prudential standards from the Australian Prudential Regulation Authority (APRA). Because house price growth has moderated and mortgage borrowers are substantially ahead of their scheduled payments, the risk from mortgage lending is somewhat lower.

However, it’s surprising that the review doesn’t stress some aspects that are obvious.

What the RBA didn’t say

Although Australia hasn’t experienced the type of shock to the economy the United States did, due to the sub-prime mortgage crisis, there is substantial risk due to a large portion of mortgage loans being subject to interest-only periods of typically five years. Research for US home equity lines of credit finds the risk that people won’t be able to pay mortgage expenses increases substantially towards the end of flexible repayment terms, in particular during times of increasing lending standards.

Mortgage borrowers often have the expectation that they are able to refinance at the end of the interest-only term into a similar loan with a new interest-only period. However, this rollover is not possible in economic downturns when banks suddenly tighten their lending standards and and are likely to cut refinancing.

The RBA’s review shows that Australian banks have tightened their lending standards and have room for further tightening, but currently we do not see larger impacts on delinquencies. Current rates of people not being able to make their mortgage payments are low but may quickly change in an economic downturn. It’s also difficult to forecast whether this will change judging by medium- to long-term trends.

There might be other reasons why people might struggle to make their mortgage repayments. We have seen central banks following the European and US central banks in lowering interest rates and markets are expecting a reversal in the future. As most mortgage loans in Australia are at a floating rate this would imply that the largest relative payment increase will be to interest-only loans, should the RBA follow these leads.

In addition to this, Australia continues to enjoy low unemployment rates. This may change and lower the average income levels, putting more stress on people’s ability to pay mortgage loans.

Other risk factors at play in the property market

House prices continue to grow at annualised rates of approximately 10.2% and 9% in the largest cities Sydney and Melbourne. Housing price growth has slowed down, but prices are still increasing and new mortgages are underwritten based on house prices that are disengaged with national income levels. The growth rate continues to be above the historic averages and other developed economies that have experienced similar rate cuts.

Banks have relatively reduced interest only loans and high loan to valuation ratio (LVR) style loans. However, it is also clear that origins of high risk mortgages continue at relative high levels.
Australian Prudential Regulation, new mortgage loans for ADIs with greater than $1 bn of term loans
The fraction of interest-only loans has come down from 44% in December 2014 to 36% in March 2016. While this is a noticable decrease, more than a third of loans continue to be interest-only.

The RBA’s review argues that Australian mortgage borrowers are on average approximately two and a half years ahead of the scheduled payments. This argument does not take interest-only loans into account.

Prepayments are generally made into offset accounts which include a redraw facility and are generally used when new properties are used. In other words, these prepayments may be quickly depleted to increase leverage but also in situations when borrowers have difficulties making payments.

Dominance of housing loans on bank books

The largest problem of Australian banks remains the dominance of housing loans on bank books. Approximately 60% of total loans are for residential properties, and 36% of loans are business loans dominated by commercial real estate loans and loans to small and medium sized companies, which are often backed by the real estate of the business owner.

This over-concentration is the Achilles’ heel of the Australian banking system and hard to protect against. It’s a reflection of demand for bank loans in Australia and alternatives to bank lending available to large firms.

International financial markets may provide a solution, allowing banks to diversify and risk transfer via asset risk swaps. Unfortunately, these solutions have not been explored much in the past . The reluctance to do this is mostly based on the poor performance of overseas assets during the global financial crisis.

The RBA’s review further discusses the achievements under the Basel Committee on Banking Supervision to limit the systemic risk of financial institutions via increased regulation and higher capital buffers. The review further notes that no Australian bank is of global systemic importance.

However this is not a reason for complacency as the failure of one of the largest Australian banks would lead to a great shock to the Australian economy. A further concentration in the banking industry would make bank products more expensive than they would be in a competitive system.

Melbourne and Brisbane face apartment supply shocks – RBA

From The New Daily.

The Reserve Bank has warned that a sharp fall in the value of inner-city apartments in Melbourne and Brisbane is “closer to materialising”, as developers continue to flood both markets with new high-rise dwellings.

The central bank made the observation in its latest financial stability review, which noted that supply pressures are likely to weigh most on apartment prices in Brisbane and Melbourne.

Over the next two years, around 16,000 new apartments will be completed in Melbourne, raising the prospect of a glut in high-rise units.

About 12,000 new apartments are expected to be built in Brisbane.

The RBA is concerned that a fall in demand for new apartments could test the ability of developers and property buyers to meet repayments on loans that collectively run into the tens of billions.

How borrowers, brokers fudge numbers to get a home loan

“In residential property development, the risks in some apartment markets are closer to materialising, as the large and geographically concentrated increase in supply approaches,” the central bank said.

“If apartment market conditions were to deteriorate in these inner-city areas, it is more likely that banks would experience material losses on their development lending rather than on their mortgages.

“Banks would experience losses on these exposures in default events where the value of the properties is insufficient to cover the debt outstanding.”

Home borrowers in WA and Queensland under ‘stress’

In its wide-ranging survey of the domestic housing market, the RBA also observed that the number of home borrowers unable to meet mortgage repayments was rising “substantially” throughout the mining regions of Queensland and Western Australia.

House prices in some have more than halved in the last three years, leaving many borrowers without means to repay loans.

This has triggered a significant rise in the number of homes being repossessed by banks, particularly in WA’s Pilbara mining region where the median house price has slumped to less than $400,000 from $830,000 in 2013.
Many borrowers have been left without means to repay loans. Photo: Getty
Borrowers are also under pressure in Queensland’s Central Highlands where house values have been crunched by more than 55 per cent.

“Although the household sector’s aggregate financial position has remained broadly steady, households in some parts of the country are experiencing increased financial stress,” the RBA observed.

“Housing loan performance in Western Australia and Queensland in particular deteriorated further over the first half of 2016.

“The (commercial) banks attributed this deterioration largely to declining incomes in the mining states rather than to unemployment.”

The big problem for many borrowers in mining towns is that it has become extremely difficult to repay lenders because there are simply no buyers for their properties, even when they are offered at big discounts.

The national picture: risks have ‘lessened a little’

While thousands of borrowers living in mining areas are doing it tough, the RBA believes that the overall risk profile of Australian home borrowers actually improved in the first half of the year.

The Reserve attributed the modest improvement to the slowdown in house price growth and the effect of tighter lending measures imposed by the Australian Prudential Regulation Authority on the banks.

Although the average mortgage debt of Australian home borrowers rose to a record $256,000 at the end of June, the RBA observed that a larger proportion of recent home buyers had stumped up bigger deposits compared to people who applied for loans last year.

The RBA also observed that fewer borrowers took out interest-only loans in the June quarter.
The Reserve Bank acknowledged that fewer borrowers took out interest-only loans in the June quarter. Photo: AAP
One of Australia’s leading banking industry researchers – Martin North of Digital Finance Analytics – is less sanguine about the risk profile of home loans and general lending by the banks.

He pointed to the latest loan data published by the Australian Bureau of Statistics, which showed that investment property lending was the only credit category to grow in August.

“The lack of business investment growth is hobbling overall economic outcomes, whilst our housing stock value, and bank balance sheets are artificially being inflated,” he said.

“This mix of lending and the implications, is what the RBA should be discussing.

“Ultra-low interest rates are not helping to restore productive growth.”

Who Says Home Lending Is Easing?

The RBA Financial Stability Review, released today, says

Risks to financial stability from lending to households have lessened a little over the past six months, as serviceability metrics and other lending standards have continued to strengthen and the pace of credit growth has slowed. Housing price growth is also slower than it was a year or so ago, although it has picked up a little in Sydney and Melbourne in recent months. The risk profile of new borrowing has improved further. The share of new high loan-to-valuation (LVR) lending and interest-only loans has fallen; high-LVR lending is now at its lowest share in almost a decade.

Nonetheless, the household debt-to-income ratio is still drifting higher, even after adjusting for the rapid growth of balances in offset accounts. Non-performing mortgage loans have also picked up nationally but remain low. This pick-up has been most pronounced in mining areas where housing market conditions have deteriorated sharply, though only a small share of banks’ mortgage lending is to these areas.

But, the latest release from the ABS seems to tell a rather different, and more disturbing story. I will focus in the trend series, which irons out month on month distortions.

In trend terms owner occupation loans fell 0.9% compared with the previous month, to $19.8 bn, personal finance fell 0.8% to $6.9bn and commercial finance fell 0.7% to $38.3bn. But this does not tell the full story.

Here are the month on month movements by a more granular set of categories. The only segment which rose was lending for housing investment purposes (which is reported within the commercial sector numbers). This rose 1%, t0 $11.9 bn. Other lending for commercial purposes, excluding for housing investment fell, commercial fixed loans fell 0.5% to $18.6 bn and revolving commercial credit fell 3.6% to $7.7 bn.

Therefore the total fixed commercial credit (sum of housing investment loans and other commercial fixed loans) netted off with a rise of 0.04%.

All other lending categories saw a fall in month on month movements, owner occupied housing indeed fell 0.9% $19.8 bn.

Turning to the trend analysis, the chart below shows a fall in overall lending, but the mix of lending is the main concern. The only thing holding up bank lending is growth in the investment property sector, whilst the rest of the commercial sector continues to borrow less. The ratio of fixed commercial lending for investment housing has moved up from 31% in 2012 to 39% now, whilst the proportion of lending for productive commercial investment has fallen from 69% in 2012 to 61% now. Another way to look at it is commercial lending, excluding for housing has fallen to 40% of all lending, from 46% in 2012.

So, it is momentum in investment lending which is supporting overall lending, which would have otherwise fallen significantly, but this is not a productive activity. The lack of business investment growth is hobling overall economic outcomes, whilst our housing stock value, and bank balance sheets are artificially being inflated.

This mix of lending and the implications, is what the RBA should be discussing. Ultra-low interest rates are not helping to restore productive growth.

Also, it is worth bearing in mind, interest only loans tend to be used by property investors to maximise their tax refunds, one reason why more are being written than earlier in the year.

RBA On Inner City Apartment Exposures

The latest RBA Financial Stability Review includes coverage on the Banks’ Exposures to Inner-city Apartment Markets. They say banks are most exposed to inner-city housing markets through their mortgage lending rather than via their development lending. Sydney and Melbourne have the largest exposures. That said, they downplay the risks, thanks to the run-up in prices providing a buffer (though this is not true for new transactions) whilst admitting that there is no data on the geographic footprint of mortgage lending in the returns the banks provide, and not all banks would necessarily have the same level of exposures. Another area where we think better data is needed. Also, what happens if off-the-plan purchasers walk away before completion?

The large number of new apartments recently completed and currently under construction in many capital cities raises the risk of a marked oversupply in some geographic areas. The banking system’s exposure to these apartment markets arises from its financing of apartment construction as well as lending to the purchasers of the apartments once construction is complete. This box examines the banking system’s development and mortgage exposures in the inner-city areas of Brisbane, Melbourne and Sydney, where apartment construction has recently been most concentrated.

As indicated here, if apartment market conditions were to deteriorate in these inner-city areas it is more likely that banks would experience material losses on their development lending rather than on their mortgages. This is because of both a higher probability of default and higher loss-given-default on their development lending than on their mortgage lending for apartment purchases. However, while this box examines the situation for the Australian banking system as a whole, individual banks may have more concentrated exposures in certain geographic areas, including exposures to riskier or lower-quality developments, and hence it is unlikely that losses would be evenly distributed across the banking system if a downturn were to happen.

Current Market Conditions

Following the marked pick-up in apartment construction in recent years, inner-city Melbourne is forecast to have the largest number of completions (around 16 000) over the next two years, followed by Brisbane (12 000) and Sydney (10 000) (Figure B1a, Figure B1b, Figure B1c).

In Brisbane and Melbourne these new apartments will represent a far larger increase in the dwelling stock than in Sydney. Furthermore, apartment price and rental growth in Brisbane and Melbourne are relatively subdued – notwithstanding some strengthening in rents in Melbourne of late – and rental vacancy rates are higher than in Sydney (Graph B1). It is therefore foreseeable that these additions to the stock will have a greater effect on housing market conditions in these areas.

Exposures

The routine regulatory data disclosures do not require banks to report their exposures by geographic region. Nonetheless, data on banks’ total Australian mortgage and development lending – along with data on construction activity, housing prices and buyer profile in these areas – can provide some rough estimates of the magnitude of these exposures and hence a broad indication of how exposed banks are to a downturn in these markets.

Overall, these estimates suggest that, by value, banks are most exposed to inner-city housing markets through their mortgage lending rather than via their development lending (Graph B2). The data suggest that around 2–5 per cent of banks’ total outstanding mortgage lending is to inner-city Brisbane, Melbourne and Sydney, and this share is likely to grow as the apartments currently under construction are completed. At around $20– 30 billion, mortgage exposures are estimated to be larger in Sydney, reflecting Sydney’s higher apartment prices and greater number of mortgaged dwellings, than in Brisbane and Melbourne where mortgage exposures are estimated at around $10–20 billion in each inner-city area. By contrast, the available data suggest that around one-fifth of banks’ total residential development lending is to these areas. Development exposures are a little larger in Melbourne and Brisbane than in Sydney, due to the greater volume of apartment construction currently underway, though they are each less than $5 billion.

Potential Losses

Banks would experience losses on these exposures in default events where the value of the properties is insufficient to cover the debt outstanding. Australian mortgage lending has historically had very low default rates – around ½ per cent – and had high levels of collateralisation. In Sydney in particular, a very large price fall would be required before the banks would experience sizeable losses, since the rapid price growth over recent years has increased borrowers’ equity in their apartments and thereby lowered banks’ losses-given-default.

In contrast, inner-city Melbourne and Brisbane have experienced far less price growth, limiting borrowers’ accumulation of equity. To gain a broad indication of the size of potential losses to banks, one can consider a hypothetical scenario where default rates rose to between 5 and 15 per cent on inner-city mortgages, and then combine this with a range of housing price falls. Under this scenario, bank losses remain very low until price falls reach over 25 per cent or so (Graph B3).

Repeating this scenario for developer exposures is challenging, because the exposures are more idiosyncratic and the largest losses can be on incomplete developments. In addition, the average level of developer equity in their apartment projects is not readily available and anecdotal evidence suggests that it varies significantly by building. A simple way to model potential losses on developer lending is to use loss rates in line with those seen on all Australian residential development lending during the financial crisis.

In this scenario, losses still remain fairly small (Graph B4). Alternative comparisons are the Spanish and Irish financial crisis experiences, which were associated with housing price falls of more than 30 and 50 per cent, respectively, and impairment rates on commercial property of over 30 per cent.

In these situations, the losses to banks would be several times larger than the recent Australian experience. However, Australia is not facing the same economic and financial headwinds as Spain or Ireland did during the financial crisis, where the extent of overbuilding was much greater and prevalent across their entire countries, contributing to very sharp deteriorations in economic conditions. More likely, any oversupply in Australia would be more localised to certain geographic areas, and potential price falls tempered as the population moved to absorb the new (and cheaper) supply of housing in these areas over time.

Banks make millions in delaying interest rate cuts

From The Conversation.

When Australia’s central bank moves interest rates as part of its monetary policy, it’s not just politicians who stand to lose if banks don’t follow suit.

Retail lending markets form an integral part of the monetary policy transmission mechanism. If interest rate rises are passed on at a different rate to cuts it can adversely affect the efficacy of expansionary versus contractionary monetary policy.

In August 2016, APRA data showed the big four Australian banks held 83% of the home loan market (including both the owner occupier and investment categories).

At an individual level, the ability and willingness of lenders to pass on the official interest rate cuts to borrowers depends on many factors. These include exposure to overseas funding sources, market power, the funding mix, reserves and the extent of securitisation. But it’s also clear delaying interest rate cuts can significantly impact their bottom line.

According to my analysis, the big four banks can make approximately $A8.6 million per day as a group if they do not fully pass onto borrowers a hypothetical 0.25% cut in the RBA’s cash rate.

More specifically, if ANZ, CBA, NAB and Westpac manage to postpone lowering their mortgage interest rates say by 10 days, they can potentially make an extra A$16, A$28, A$16 and $A26 million dollars in profits, respectively.

Previous studies on mortgages, small business loans and credit card interest rates have found significant evidence for the “rockets and feathers” hypothesis. That is, when the cash rate increases, various lending rates shoot up like rockets but when the opposite occurs they go down like feathers.

In my research I used monthly data (2000-2012) for 39 bank and non-bank financial institutions including 7 building societies, 15 Australian-owned banks, 3 foreign subsidiary banks, 13 credit unions, and 1 major mortgage broker. The research found the mortgage interest rate spread of all lenders rose after the 2008 global financial crisis, albeit to varying degrees.

In general, the research shows most building societies and some credit unions can offer more competitive home loans than banks.

There is no significant relationship between lenders’ markups and the level of over the counter customer service since the 2008 financial crisis. This is an important observation as the mortgage spreads of larger lenders are typically higher than those of their smaller non-bank counterparts. This puts lie to the view that the relatively higher mortgage interest rates of the larger banks in Australia are justified by higher overhead costs associated with the running of their large branch networks.

Author: Abbas Valadkhani, Professor of Economics, Swinburne University of Technology

RBA Holds Cash Rate

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

The global economy is continuing to grow, at a lower than average pace. Labour market conditions in the advanced economies have improved over the past year, but growth in global industrial production and trade remains subdued. Actions by Chinese policymakers have been supporting growth, but the underlying pace of growth in China has been moderating. Inflation remains below most central banks’ targets.

Commodity prices have risen over recent months, following the very substantial declines over the past few years. The higher commodity prices have supported a rise in Australia’s terms of trade, although they remain much lower than they have been in recent years.

Financial markets have continued to function effectively. Funding costs for high-quality borrowers remain low and, globally, monetary policy remains remarkably accommodative. Government bond yields are near their historical lows.

In Australia, the economy is continuing to grow at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently. Measures of household and business sentiment remain above average.

Labour market indicators have been somewhat mixed. The unemployment rate has fallen further, although there is considerable variation in employment growth across the country. Part-time employment has been growing strongly, while growth in full-time employment has been subdued. The forward-looking indicators point to continued expansion in employment in the near term.

Inflation remains quite low. Given very subdued growth in labour costs and very low cost pressures elsewhere in the world, this is expected to remain the case for some time.

Low interest rates have been supporting domestic demand and the lower exchange rate since 2013 has been helping the traded sector. Financial institutions are in a position to lend for worthwhile purposes. These factors are all assisting the economy to make the necessary economic adjustments, though an appreciating exchange rate could complicate this.

Supervisory measures have strengthened lending standards in the housing market. Separately, a number of lenders are also taking a more cautious attitude to lending in certain segments. Growth in lending for housing has slowed over the past year. Turnover in the housing market has declined. The rate of increase in housing prices is lower than it was a year ago, although some markets have strengthened recently. Considerable supply of apartments is scheduled to come on stream over the next couple of years, particularly in the eastern capital cities. Growth in rents is the slowest for some decades.

Taking account of the available information, and having eased monetary policy at its May and August meetings, the Board judged that holding the stance of policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Securitisation Still In The Doldrums

The RBA statistics gives a view of the state of play of in particular mortgage backed securitisation. Prior to the GFC this form of financing was accelerating, but since then has been less popular – due to higher regulatory requirements, lower overseas demand, and the emergence of other funding structures. The costs of issuance, which before the GFC were significantly lower than more traditional funding alternatives, has largely been negated.

As a result, total mortgage backed assets fell 0.37% month on month to $114 billion. Compare this with a peak of $215 billion in June 2007.

Remembering that bank credit has been growing significantly, the fall is, in real terms, even more stark. The chart above depreciates the total securitisation pool of ~$138 billion by credit growth, from its peak in 2007. It shows that in 2007 terms, the fall is even greater, to ~$78 billion, a significant drop from its peak of $274 billion.

The other significant fact is that now 94% of securitisation deals are being sold in Australia, of which 75% are short term, and 19% long term. Overseas issuance, which peaked in 2007, remains close to their lows, at around 1.6%.