Submission to the Inquiry into Competition in the Banking and Non-Banking Sectors 2. Housing Finance

House of Representatives Standing Committee on Economics

The Australian mortgage market has been characterised by strong competitive pressures over the past decade or so. The result is that housing finance has been much more readily available, and at lower cost, than was the case in the past. Many new lenders have entered the market, the range and flexibility of products has expanded, and margins have narrowed. Competition has also led to an easing in lending standards, although not nearly to the same extent as occurred over recent years in the United States, where overly aggressive competition is one of the factors that contributed to the sub-prime problems.

Reflecting these developments, together with the significant reduction in nominal interest rates that was made possible by the decline in inflation in the early 1990s, household debt in Australia has grown at an average annual rate of around 13 per cent since 1990. As a result, the ratio of debt to disposable income has roughly tripled to 160 per cent, and the debt-to-assets ratio has risen from 8 per cent to 18 per cent (Graph 1). These trends have seen Australian households move from a situation in which they were relatively lowly geared 20 years ago to one in which their gearing is now similar to that of households in many other countries.

As discussed below, the recent capital market turbulence has changed the competitive dynamics in the mortgage market. In particular, it has improved the competitive position of lenders that rely relatively heavily on deposits for their funding, with lenders that rely on the securitisation markets facing a sharper increase in costs than other lenders. It is not, however, unusual for the competitive position of different lenders to vary over the course of the credit cycle. For much of the past five years, the availability of cheap credit in global markets – which saw spreads fall to unusually low levels – has underpinned the competitive position of lenders relying on securitisation.

The recent developments in financial markets have reduced the availability of finance to some higher-risk borrowers, although the bulk of borrowers have not experienced significantly tighter lending conditions. Lenders have also increased their variable lending rates relative to the cash rate, although for most lenders the increase has been broadly in line with the increase in their cost of funds.

2.1 Market shares and funding mixes of different types of lenders

The structure of the mortgage market has changed significantly over the past decade or so. In particular, since the mid 1990s, the share of outstanding loans accounted for by ‘mortgage originators’ has increased from less than 2 per cent to around 10 per cent in mid 2007 (Graph 2). Conversely, the share of outstanding housing loans accounted for by the five largest banks has declined, despite their acquisition of a number of other lenders over this period. The share of outstanding loans accounted for by the smaller banks has risen since 2000, while the share accounted for by credit unions and building societies has declined.

These longer-term trends have been influenced by changes in the funding costs of the different types of lenders. In particular, the strong growth of the mortgage originators from the mid 1990s until quite recently was underpinned by their ability to securitise mortgages at ever narrower spreads to the bank bill rate. As an illustration, prior to the recent turmoil, the spread on the AAA-rated tranche of residential mortgage-backed securities (RMBS) had fallen to around 15 basis points, compared to 34 basis points in 2000 (Table 1).

In aggregate, over recent years about 20 per cent of Australian mortgages have been funded via the issuance of RMBS. This is similar to the share in Canada, but much lower than that in the United States, where around 60 per cent of mortgages are funded by RMBS, around two-thirds of which are guaranteed by government-sponsored enterprises. In Europe, RMBS provide only about 5 per cent of funding, with covered bonds – where the investor has a claim over a specific pool of loans and the lenders' broader balance sheet – accounting for a further 15–20 per cent.[1]

The recent strains in financial markets have seen a turnaround in these longer-term trends, with the five largest banks significantly increasing their share of new loans since late 2007 (Graph 3). Over recent months these banks have accounted for 67 per cent of owner-occupier loan approvals, while the share accounted for by mortgage originators has fallen from around 12 per cent in 2006 to 5 per cent.

Since August 2007, spreads on RMBS have increased markedly and issuance has been limited. Where issues have taken place, they have recently been at spreads of around 120 basis points over the bank bill rate. At this pricing, new mortgage business financed through the RMBS market is unlikely to be profitable. This change in funding costs has had a significant impact on the competitive position of different lenders, given the differences across lenders in how housing loans are funded. The five largest banks have diversified funding bases, with a little under half of total funding coming from deposits, around half from domestic and foreign capital markets, and only about 5 per cent from securitisation (Table 2). The foreign-owned banks have traditionally relied less on deposits, and more heavily on domestic capital markets and offshore funding. As a group, the regional banks rely more heavily on securitisation than the other banks, although deposits still account for the largest share of their funding. Mortgage originators source essentially all of their funding from securitisation, as typically they have neither the balance-sheet size nor the capital base from which loans could be provided.

While there has been very limited issuance of RMBS over the past six months, there are some tentative signs of recovery in the market. The relatively low credit risk historically associated with Australian prime mortgages, together with strong longer-term demand for highly rated bonds from institutional investors, provide some basis for expecting that this recovery will continue. In time, spreads could be expected to decline from current levels, although probably not to the very low levels seen in 2007. This would help to restore the competitive position of institutions that rely heavily on securitisation to fund their lending.

The changed competitive dynamics have led to a number of proposals for government support of the RMBS market, including the adoption of arrangements similar to those that exist in Canada; these arrangements and the recent experience in the Canadian mortgage market are discussed in Appendix A. The changed environment, however, does not warrant government intervention in the structure of the housing finance market. As evidenced by overseas experience, such intervention can have long-term unforeseen consequences. The recent increase in the cost of funds for securitisers comes at the end of a prolonged period of easy global credit and, as noted above, is likely to be at least partly reversed over time.

2.2 Product types

By international standards, Australian borrowers are offered a wide range of mortgage products and are able to choose from a large number of different loan types, with many of these offering more flexibility than is available in other countries.

The standard housing loan in Australia is a prime, fully documented loan with a 25–30 year maturity, and a maximum loan-to-valuation ratio (LVR) of about 95 per cent. These loans – which account for just under 70 per cent of all housing loans – are offered with various features including (Table 3):

  • flexible repayments (including scope for excess repayments, refinancing and repayment holidays);
  • redraw and offset facilities;
  • the ability to make interest-only payments for up to 10–15 years, after which the loan typically converts to a principal-and-interest loan[2]; and
  • the capacity to split the loan into investor and owner-occupier components.

The majority of Australian housing loans are at variable interest rates, with fixed-rate loans typically accounting for between 10 and 20 per cent of new housing loans.

In addition to standard loans, a number of other types of loans are offered, including:

  • high LVR loans, which allow borrowers that do not have a deposit to cover the transaction costs associated with buying a home. These loans have maximum LVRs of up to 105 per cent, and are only offered by a few specialist lenders;
  • home equity loans, which provide a line-of-credit secured against the property that can be used for home improvements or non-housing purposes, such as to purchase a car, holiday or financial assets. These loans have been available since the mid 1990s and typically have a maximum LVR of 80–90 per cent, and a maximum loan term of 30 years. Home-equity loans are offered by all of the major lenders, and currently account for 17 per cent of all outstanding owner-occupier housing loans;
  • low-doc loans, which tend to be used by households with undocumented or irregular incomes. Initially, these loans were offered by a few specialist lenders, but over recent years the five largest banks have expanded their presence in this market. Low-doc loans currently account for about 7 per cent of all outstanding housing loans;
  • non-conforming loans, which are offered to borrowers who do not meet the standard lending criteria of mainstream lenders, usually because of poor credit or repayment histories. Almost all non-conforming loans are provided by non-bank lenders, and they currently account for only about 1 per cent of outstanding loans;
  • shared appreciation loans, where, rather than paying interest, the borrower surrenders a proportion of any capital gain/loss that has accrued between the time that the loan was taken out and the time that the dwelling was sold or the loan repaid. These loans are usually structured as a second mortgage, with the borrower also taking out a standard mortgage to fund the bulk of the cost of the dwelling. This market is currently very small, with several state government agencies having offered these loans to low-to-medium income households on reasonably attractive terms, and a small number of private lenders marketing shared appreciation loans to all borrowers at commercial rates; and
  • reverse mortgages, which tend to be used by older homeowners to access equity in their property while they continue to live there, in order to fund other expenditures. Provided the loan is not repaid early, the principal and accumulated interest is repaid from the proceeds of the sale of the property when the borrower dies or moves home. While reverse mortgages are widely available in Australia, including from several of the largest banks, they accounted for less than ½ per cent of outstanding housing loans in 2007.

One aspect of the Australian market that is unusual by international standards is the limited use of long-term fixed-rate loans, with only around 5 per cent of new fixed-rate loans (and less than 1 per cent of all new loans) having an initial maturity of greater than five years. While such products are offered by some lenders, Australian borrowers have chosen not to make much use of them. This stands in contrast to some other countries, including the United States, Denmark, Belgium and Germany, where long-term fixed-rate mortgages predominate. Another feature of the Australian market is that virtually all variable home loan interest rates can be changed at the discretion of the lender. While similar variable-rate products are available in a number of other countries, banks also offer variable-rate loans that are linked to an independent benchmark rate (e.g. in the United Kingdom and the United States), or are only variable up to a maximum interest rate ‘cap’ (eg. Canada, New Zealand, and the United Kingdom).

2.3 Cost of housing finance

The competitive pressures in the Australian mortgage market over the past decade or so have seen interest margins on mortgages fall considerably.

In 1993, the margin between the four largest banks' indicator rate on prime, full-doc, variable-rate housing loans and the cash rate was around 450 basis points (Graph 4). By the mid 1990s, this margin had fallen to 180 basis points. Subsequently, strong competition has meant that it has become commonplace for lenders to offer almost all borrowers a discount of up to 70 basis points on the indicator rate.

Since the mid 1990s it has become common practice for banks to move their indicator rates in line with the Reserve Bank's cash rate. Similarly, money-market interest rates have tended to move broadly in line with the cash rate. The recent tightening in credit conditions has, however, seen a change in these long-standing relationships, with short-term money-market rates increasing by considerably more than the increase in the cash rate, and there has also been a significant increase in long-term funding costs. Reflecting these higher costs, lenders have increased their mortgage rates relative to the cash rate by an average of 40 basis points, although the spread between the mortgage rate and the 90-day bank bill rate is similar to its average level over the past few years of around 100 basis points. While it is difficult to precisely estimate the impact of the tighter financial conditions on the banks' overall cost of funding – including from deposits and short-term and long-term capital market sources – it appears that, at the time of writing, the higher margins to the cash rate are broadly in line with the higher cost of funding for most lenders.

Interest spreads on prime low-doc housing loans have also declined noticeably over an extended period, with the spread over the cash rate falling from 280 basis points in 2000 to 150 basis points in mid 2007. As is the case for full-doc loans, spreads on low-doc loans have risen recently, although they remain low by historical standards. The same general pattern is evident in spreads on non-conforming loans, although the recent increase has been more pronounced due to the problems in securitisation markets and a reassessment of the risks of lending to credit impaired borrowers.

International comparisons of interest margins on housing loans are always difficult, as the nature of the standard mortgage product differs across countries and there is often discounting of posted rates. In some countries, including Australia and the United Kingdom, variable-rate loans predominate, whereas in Sweden, New Zealand and Canada, 2–5 year fixed-rate loans are the most common, and in the United States and some European countries long-term fixed-rate mortgages predominate. The features offered on housing loans also differ significantly across countries; for example, loans with redraw facilities and flexible repayment structures are relatively uncommon in many continental European countries.[3] Notwithstanding the difficulties in making comparisons, the available evidence suggests that interest margins on variable- and fixed-rate full-doc housing loans in Australia are broadly in line with those in most other developed countries, although margins in the United Kingdom had been lower than elsewhere over recent years.

Further, the evidence suggests that the impact of the capital market turbulence on mortgage rates in Australia has been similar to that seen on the predominant mortgage products in many other countries. As noted above, since mid 2007, the largest Australian lenders have raised their rates on prime full-doc variable-rate mortgages by about 40 basis points more than the cumulative increase in the cash rate. In comparison, in the United States, the spread between the interest rate on conforming 30-year fixed rate mortgages and government bond yields of the same maturity has risen by 30–40 basis points, with spreads on adjustable-rate mortgages increasing by considerably more than this. Similarly, in New Zealand spreads (to government bond yields) on 2-year fixed-rate mortgages have increased by around 40 basis points. In contrast, in Canada spreads on 5-year fixed-rate mortgages, relative to government bond yields, have increased by around 100 basis points, while the spread between the rate on variable-rate mortgages and the Bank of Canada's target for the overnight rate has increased by 35–40 basis points.

As interest margins in Australia have fallen over the past decade or so, lenders have introduced, or increased, a number of fees. Despite this, the ratio of total fees paid on housing loans to the value of housing loans has fallen over this period. This can be seen in the Reserve Bank's annual Bank Fees Survey which shows that banks' annual fee income from housing loans (which includes establishment fees, ongoing loan-servicing fees and early-repayment fees) has fallen from 0.20 per cent of the value of outstanding housing credit in 2000 to 0.15 per cent in 2007 (Graph 5).[4]

Recent research by ASIC/Fujitsu Consulting suggests that Australia has lower loan establishment and discharge fees than the United States or the United Kingdom, but higher early-repayment fees. ASIC suggests that the compulsory use of comparison rates in Australia (which do not include early-repayment fees as they are deemed to be optional for the borrower) has contributed to the relative composition of fees in the three countries. Overall, ASIC/Fujitsu Consulting suggest that the level of total housing loan fees in Australia is similar to that in the United States and lower than in the United Kingdom.[5]

Footnotes

Data for the US are from the Board of Governors of the Federal Reserve System. Data for Europe are from the European Mortgage Federation. [1]

In 2006, interest-only loans accounted for about 20 per cent of all outstanding loans and about 60 per cent of outstanding investor loans. See Reserve Bank of Australia (2006), ‘Box B: Interest-only Housing Loans’, Financial Stability Review, September. [2]

Bank For International Settlements, Housing Finance in the Global Financial Market, 2006; European Mortgage Federation & Mercer Oliver Wyman, Study on the Financial Integration of European Mortgage Markets, 2003; and European Mortgage Federation Factsheets. [3]

Reserve Bank of Australia (2008), Banking Fees in Australia, RBA Bulletin, May. [4]

Australian Securities & Investments Commission, Review of Mortgage Entry and Exit Fees, 1 April 2008. [5]