Christopher Joye| Australian Financial Review| 4 May 2018
Before I dive into where housing is heading, the banking regulator’s analysis of CBA’s vulnerabilities was spot on. This column has long argued that the essential conundrum is one of excessive complexity and the difficulty supervising these byzantine banking beasts.
In 2010 I posited that while the four oligarchs’ much-lauded diversification into non-core businesses might smooth their return distributions during the good times, it lifted the probability of adverse fat-tail events of the kind NAB experienced in the UK, ANZ discovered in Asia, and CBA suffered with the Storm, CommInsure and Austrac sagas. (To say nothing of overpaid prop traders manipulating markets!)
On Thursday we heard a major bank boss acknowledge this for the first time, with NAB’s Andrew Thorburn conceding that “complexity in the bank is just killing us”. One of APRA’s recurring theses is that CBA was, paradoxically, a victim of its own success and, more specifically, its outstanding financial risk management.
Over the last three decades there has not been a better performing retail bank in the world. APRA contends that CBA’s focus on minimising credit losses, and its demonstrated multi-cycle ability to do so, engendered hubris that resulted in it taking its eye off the ball on new compliance laws and non-operating risk requirements.
So while CBA has consistently produced remarkable returns accompanied by tiny arrears, and avoided the bank-killing losses of peers in the 1991 recession and the global financial crisis, it has latterly been plagued by problems in non-core areas like financial advice, insurance and anti-money laundering compliance.
In response to APRA’s findings, CBA’s share price jumped 1.9 per cent while Standard & Poor’s concluded that there was no adverse credit rating impact. Under conservative new CEO Matt Comyn, CBA will galvanise its position as one of the strongest banks in the world, trading off a modest compression in returns on equity against even lower probabilities of loss.
Many moving parts
On the subject of losses, there are many moving parts influencing the $6.9 trillion housing market.
This column forecast strong house price growth between 2013 and 2017, and called an end to the boom in April 2018. Sydney prices started falling in September and have since corrected 4.4 per cent according to CoreLogic. Home values in Melbourne began melting in December, and are off 1.1 per cent. Across the five largest cities, the turning point was October: the value of bricks and mortar has since shrunk 2 per cent.
It is instructive to compare this correction with the two preceding episodes between March 2008 and January 2009 and June 2010 and April 2012. During the GFC, Australian capital city prices fell 8.3 per cent on a peak-to-trough basis. Yet the contemporary house price trajectory is more closely tracking the path of the 2010 to 2012 downturn in which prices dropped 6.3 per cent, with both notably being triggered by a tightening of lending conditions.
My base case had been a minimum drawdown of around 5 per cent in the absence of aggressive Reserve Bank of Australia interest rate hikes. If we were ultimately hit with, say, two to four hikes (noting that the RBA’s “neutral” cash rate is eight hikes away), my view has been that national prices will correct 10 per cent to 20 per cent, which would be manageable payback for the 50 per cent explosion in values since the last cyclical trough in April 2012.
In 2018 there have been several new developments. First, we have had a 25 basis point jump in short-term interest rates, as measured by the bank bill rate which, all other things being equal, should be passed on by lenders via out-of-cycle rate hikes. Some like ME Bank have already started this process. If this occurs, it would be tantamount to an early RBA rate increase, which was not expected until later, and is clearly negative.
A counterargument is that the royal commission atmospherics will make it hard for banks to pass on rising funding costs to borrowers. They could, alternatively, shift the burden to depositors through lower savings rates and/or continue to crush their operating costs which remain bloated.
Another negative is undoubtedly the more stringent lending standards APRA is imposing on banks, which are being reinforced by the royal commission’s findings. It is not widely understood that most of the tightening in credit assessment processes has already happened. APRA has been hammering the banks on serviceability since December 2014 when it introduced the 10 per cent annual speed limit on investment loan growth and its minimum 7 per cent interest rate repayment test, which is more than 3 percentage points above current discounted rates.
More recently APRA has ramped up its focus on lenders verifying the income and expense data that borrowers attest is accurate in their loan application forms. This may result in longer approval times and, at the margin, crimp borrowing capacity to the extent any borrowers have, heaven forbid, been lying. (APRA is also introducing new limits on maximum debt-to-income ratios.)
Last week this column explained that one of the points overlooked by UBS banking analyst Jon Mott is that if borrowers have been telling fibs by inflating incomes and/or understating expenses on their application forms, they have defrauded their bank. This puts lenders in a tremendous position of legal power should they choose to exercise it, and arguably neutralises the economic consequences of falling foul of responsible lending laws, which our research suggests is extremely unlikely to have occurred on any systematic basis.
There is frankly scant empirical evidence that the major banks’ home loan books are anything other than extremely high quality in arrears and equity coverage terms. That includes, ironically, the billions of dollars worth of real “liar loans”, which in May 2016 we revealed had been fraudulently obtained by Chinese borrowers using fake pay slips. They have outperformed ANZ and Westpac’s average customer on a pure servicing basis.
A final negative is Labor’s move to remove negative gearing and increase capital gains tax on investment properties, if it gets elected next year.
These headwinds have to be balanced against several tailwinds. The first is that APRA is removing its 10 per cent cap on investment loan growth, which is a big plus for credit creation and prices more generally. The quid pro quo is that banks will have to meet a range of new regulatory tests regarding the integrity of their credit processes.
Moody’s analyst Daniel Yu comments that “although removal of this cap will likely spur growth in investor lending…APRA’s increased oversight to ensure that bank underwriting continues to strengthen contains the risk [and is] a credit positive”.
Moody’s believes that APRA’s relaxation of the restriction “reflects its recognition that since…December 2014, banks’ loan underwriting and lending practices have improved, as reflected by the decline in investor interest-only and high loan-to-value lending”.
Here the hard data undermines the hyperbole. The share of new borrowers approved with loan-to-value ratios (LVRs) over 90 per cent has slumped from a peak of 22 per cent in 2009 to 13 per cent in 2014 and 7 per cent today. The share with LVRs between 80 per cent and 90 per cent has likewise shrunk from 21 per cent in 2011 to just 14 per cent today.
A second positive for housing is the revitalisation of the securitisation market, which has massively boosted the quantum of cheap funding available to non-banks.
In early 2016 we predicted the return of the non-banks that proliferated before the GFC. Issuance of residential mortgage-backed securities (RMBS) has leapt from around $10 billion annually since 2008 to over $40 billion in 2017. Notwithstanding falling house prices, rising arrears and a decade-low in prepayment speeds, the former sub-prime lender and now near-prime non-bank Liberty Financial managed to sell $1.5 billion of its loans this week via a huge RMBS deal. This money represents a tremendous injection of liquidity for non-banks that can offer loans to borrowers completely outside APRA’s tough serviceability rules.
A final plus is, of course, employment growth and the economy more generally, which is powering along on the back of a synchronised upturn in global growth.
It’s difficult to discern what transpires from these cross-currents. My expectation remains that we are on track for a soft landing similar to between 2010 and 2012, although it will be a lot worse if the RBA musters the gumption to normalise its cash rate back to its “neutral” 3.5 per cent level.