Shadow banking and the Amazon effect

A friend of mine with a Commonwealth Bank investment property interest-only loan was crossing his fingers with vigour, hoping it wouldn't happen. But it was all in vain.

This week the bank raised its interest-only loan to property investors from 5.94 to 6.24 per cent, and that is a whopping 0.44 per cent above the standard investor principal and interest loan rate.

It is true that some of the other banks have a 0.5 per cent differential, but on all the sums my friend is now going to shift from an interest-only loan to a principal and interest loan. And by the way, he looks longingly at the 5.22 per cent principal and interest home owner-occupied rate which is now more than 1 per cent lower than his investor interest-only rate.

My friend can muster the extra money that is involved in repaying both interest and principal, but he will take that money out of discretionary spending. Given the boom we have seen in interest-only loans, as more and more investors follow my friend and switch it will take money out of the community and certainly lessen the attraction of buying houses.

Those that can't afford the repayments of principal and interest will usually be the higher-risk lending propositions for banks. Overall, this is not good news for the housing market given the importance of investors in recent times. But it is also not good news for the banks.

By far the most aggressive promoter of interest-only loans was Westpac. So, my guess is that a greater proportion of its loans will be converted, and that is going to mean that its home lending growth rate will be greatly subdued. Right now, Westpac is earning big dollars from the high rates on its interest-only loans to investors. All the other banks will be affected in a similar way, but not to the same extent as Westpac. When you combine this with the fact that the increased capital requirements and the regulations are cutting back on the amount banks can loan on houses, we are looking at a considerable squeeze on bank profits. And we haven't even talked about the banking tax.

The only way banks can restore some form of profit growth is to really cut back their costs, and I am sure over time that is exactly what they will do. But, in the meantime, the growth of their business is set to be much more subdued and that will affect profitability.

A rising threat to banks

And there is another threat—the rise in the shadow banking system, which will take up a lot of the interest-only loans.

For the last 20 years I have had a small portion of my portfolio in solicitor arranged individual mortgages. The amount has not changed for a long time because the solicitor runs a good business and there has always been a strong demand from clients wanting to invest in the mortgages. But this week he sought extra funds for an interest-only land purchase investment – the borrower was paying 6.9 per cent. I did not take it up, but I think there are going to be a lot more opportunities as the banks reduce their stake in the market.

And with all these forces reducing growth, there will come greater debates over bank dividend rates which many, including me, think are too high.

Now, as we have discussed before, the market has fears of a big fall in house prices, which will really savage bank profits. I might be wrong but I just don't feel that is about to happen. There is still a lot of money out there for dwelling purchases. My warning about the banks is about profit growth and dividend reduction on the margin, not about a collapse.

But we should all be aware that if dwelling prices fall, say 10 per cent, that is going to create a substantial flow-on effect not just to bank profits but to the whole economy. So, we do have to keep an eye on real estate values each weekend.

The best and worst deals of 2016-17

At the end of every financial year for the last decade or two, I have undertaken a task that will surprise many. I appear on the Saturday Midnight Show on 3RRR, which is hosted by Hedley Ritter (not his real name). I am not a fan of the political views of 3RRR but midnight to 2am to celebrate the end of the financial year is fun. In the early days Barbara and I used to come into the radio studio, but now it is all done over the phone. Each year he asks me the same question: What was the best decision made by corporate Australia in the proceeding financial year and what was the worst? This year I chose as the second-best decision the acquisition of the Vegemite and Kraft peanut butter brands by Bega. It gave the stock a whole new vision and, at a time of great turmoil, it sent the shares up 40 per cent.

But I had no hesitation in nominating the best deal for 2016-17 as Andrew Muir's sale of his Good Guys appliance chain to JB Hi-Fi for just under $900 million. Cash! In the months that followed the market increasingly began discussing the imminent invasion by Amazon, which in the US and other countries had as great a success in consumer and household goods. Muir picked the very top of the market. JB Hi-Fi shares have fallen from $30 to around $23, and my guess is that if Muir tried to sell the Good Guys in today's market he would receive substantially less. Of course, JB Hi-Fi may still make the acquisition work and it is possible the Amazon fear is overdone.

JB Hi-Fi and Harvey Norman along with department stores are regarded as the most vulnerable to Amazon.

Where Australian retailers are missing the boat

As we have discussed, the key to Amazon is not only its supply chain mechanisms but its ability to market to customers and know what customers want. Part of that knowledge comes through intense analysis of what individual customers are buying and communicating with them. So let's conduct a poll based on one person — me.

I have purchased goods from the Good Guys, JB Hi-Fi and Harvey Norman over the last year or so, and it is interesting to see what sort of communications they have compared to that of Amazon.

The Good Guys has my name on its customer register and knows the address and such matters, but it has never sent me an email looking for a follow-up transaction. So JB Hi-Fi is buying a business that has not developed electronic communication with its customers. In fairness, Good Guys are in the same boat as Harvey Norman. I have bought goods from Harvey Norman and it has never attempted to follow up with email promotions of related purchases.

JB Hi-Fi does communicate with emails following purchases in its stores but it hasn't “done an Amazon” and linked the fact that people who buy certain goods are more likely to buy a related set of goods. The JB Hi-Fi emails are normally price related and don't appear to have any particular relevance to the goods I purchased.

By contrast, I have purchased three CDs from Amazon UK in the last few weeks and they are already chasing me with purchases that people who bought the products I purchased often find attractive. And they are not bad. But frankly, I am staggered that companies that know they are in the front line of any Amazon invasion have not copied the communication systems of the American-based giant.

I might add that Bunnings also doesn't communicate, but to be fair to Bunnings Amazon has not done well in home improvement product penetration in the US. So I guess that Bunnings believes that the purchasers of its products are going to continue to visit their stores.

It might be right, but I certainly would be very attracted to online offerings of home improvement goods. Bunnings is taking a risk.