A risky property lending sea change

The unprecedented power of the big four in home lending will make it hard for policymakers to effect any change in that market. But it wasn't always this way.

Property Observer

Change seems to be the meme of the day. I guess by next week we could have a Gillard government, a new Rudd government, or, more improbably, an Abbott-led Liberal government.

I think change is one of the hardest things for humans to internalise. We tend to be wired to taking all that we see around us as given, we assume that this slice of time will remain static. History teaches us that one of the few constants is, however, change.

With this inspiration, I will try and address three questions about ‘change’ today.

First, has the change in interest rate expectations, and the banks’ controversial decision to raise rates, altered the outlook for Australian housing?

Second, would it be hard to permanently change the competitive complexion of Australia’s banking system, which is subject to so much heated debate?

And, lastly, should changes in market lending rates be tied to the RBA’s monthly meetings?

To the detail.

By the end of last year we had grounds for optimism about the direction of Australia’s housing market. Over November and December, home values in Australia’s capital cities actually edged higher, on average, in seasonally-adjusted terms.

This was a noteworthy break from the 2011 trend of modest house price depreciation in concert with robustly rising household incomes. That is, striking improvements in affordability.

The apparent turn in Australian housing conditions coincided with two very important interest rate reductions by Australia’s central bank, which, at the time, were fully passed on to borrowers by private sector lenders. This helped push average variable mortgage rates to levels that were clearly below their long-term averages. Fixed-rate loans are even more accommodative again.

The final dynamic of consequence was the dramatic improvement in consumer expectations about their future finances, which I have discussed many times here before.

Households went from budgeting for several rate hikes to banking on rate cuts. Indeed, the financial markets were forecasting a total of six RBA rate cuts by the middle of this year. I was of the view that while this was incredibly unlikely, it would almost certainly spark very sprightly house price growth if it did come to pass.

Sitting in February 2012, things have changed. As we know, the banks have boosted mortgage rates back up by about 10 basis points. The RBA shocked most observers by not cutting rates in February. And consumers and the financial markets now no longer expect a huge amount of additional interest rate relief.

These are the new facts we have to work with. While a central case cannot be quite as bullish as it was following the fully-passed-through December cuts, it remains arguably characterised by one of stability.

I am confident Aussie house prices will find a base at some point in the next one to two quarters. And, once they do, it is reasonable to think that the cost of housing will continue, as it has typically done in the past, to accrete broadly in line with purchasing power, and hence household incomes.

Was there a time when the competitive contours of Australia’s housing financing market were very different to that which we are so accustomed to seeing today?

It transpires that there was. I was recently wading through the ABS’s housing finance data when I decided to have a look at how the market share of different lenders varied through time. The chart below illustrates the results.


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In 1975, building societies and non-bank lenders accounted for about half of all the new home loans written. This situation, facilitated by tighter regulations on banks, including interest rate caps, persisted until the early-to-mid 1980s.

A combination of financial market deregulation, the removal of barriers to foreign bank competition, industry consolidation, and the transformation of some building societies into banks, resulted in a structural change in the bank versus non-bank market shares from 50:50 to circa 80:20 by the late 1980s.

After an additional rise in the banks’ share of the competitive pie to around 90 per cent of all new flows in the early 1990s, something began to change.

In short, the advent of a cost-effective, and arguably safer form of "matched” funding, which involved the packaging up and sale of entire parcels of home loans to third-party portfolio investors that were prepared to buy them, spurred a decade and a half of new competition with the return of non-banks, like Aussie, Wizard and RAMS, and also, importantly, empowered smaller banks and building societies, such as Adelaide Bank and CUA.

Once again we were greeted by ‘change’, with a new industry equilibrium. Building societies and non-banks consistently attracted about one-fifth of all customers, with the banks keeping the remainder.

One problem with the new funding medium was that it had no government support since the regulatory infrastructure was not divined with securitisation in mind. Bankers like to claim that those lenders that relied on securitisation had "flawed business models”.

In truth, funding yourself via an arms-length sale of your assets is intrinsically safer than funding with an asset-liability mismatch: that is, borrowing in the short-term from retail depositors and wholesale creditors, and committing that money to long-term loans. The latter approach constantly exposes banks to the risk of insolvency, which is why they inherently need so much taxpayer support (and a liquidity provider of last resort known as the central bank).

During the GFC, the government’s reflexive response was to protect the core of the financial system and worry about smaller competitors later. That is, it focused on so-called "system stability”. And so taxpayers guaranteed bank deposits, bank liabilities, and the central bank lent to the banks like it never had before.

With the effluxion of time minds turned to how the increasingly uneven playing field could be levelled. This compelled the government to support the liquidity of securitisers by having a subsidiary of the Treasury invest in AAA-rated portfolios of bundled home loans. Definitionally, this was safer than guaranteeing more lowly rated banks.

Nevertheless, we have today an unprecedented concentration in major bank power, with building societies and non-banks now accounting for just 7.5 per cent of the flows. There is naturally an almost unfathomable amount of capital that has a vested interest in preserving this state of affairs. It will not, therefore, be easy for policymakers to effect any change to it. I think somebody once called this 'money-power'.

The final question I posed was whether the banks are correct in arguing that they should be able to set their lending rates independently of the RBA’s monthly meetings.

The RBA’s former head of domestic markets, John Broadbent, notes that, "Funding costs are not entirely determined by the [RBA’s] cash rate, but the major determinant is either the present level of the cash rate or expected changes in the cash rate.”

The other main driver of costs is the margin banks pay above the government bond rate for their funding. This spread reflects, amongst other things, the risk of a bank defaulting on its debts. Much of the time these credit spreads are relatively stable. Every couple of decades, however, a credit crisis comes along and the markets reprice bank risk.

Yet the highest-frequency influence on funding costs is the RBA’s monthly board meeting, which sets the overnight cash rate. The RBA’s goal is to work out whether the banks’ lending rates are at the ‘right’ levels to keep inflation within its target band. If they are not, the RBA adjusts its cash rate.

Millions of Australians with variable rate loans have been conditioned to this convention. While banks are right to highlight other influences on the price of money, they are wrong to create an artificial disconnect with monetary policy.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.

This article first appeared Property Observer on February 23. Republished with permission.

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