Australia | Sep 01 2008
By Greg Peel
Most Australians would suggest the banks have no heart; from experiences in the credit crunch the question could also be asked as to whether they have a brain; and we are about to find out whether they have the courage to drop their mortgage rates by the full 25 basis point cut expected from the RBA tomorrow. Non-bank lender Wizard has led the charge, recognising that in this game there’s no place like home lending.
This is a bold move for Wizard and clearly a PR exercise. As a non-bank lender once reliant on the securitisation market for funds, Wizard’s business model is under threat as the dust attempts to settle over the global credit crunch. There has been a flight to safety among borrowers since the credit crunch began, meaning a return to strong market share for Australia’s big deposit-centre banks. If Wizard hasn’t enough of a problem with funds on the one side, it has another problem in enticing the Emerald City back to the fold of the “discount” lenders.
But what does a 25 basis point drop in a bank’s variable mortgage rate actually mean? For the mortgage holder, it’s definitely good news. But if the RBA cuts the cash rate by 25 basis points, an equivalent rate drop from the banks means simply that existing margins are retained, not reduced. A bank would have to drop its rate by more than the RBA to actually be making a bold step into competitive lending. For a while now the money markets have been anticipating this 25 basis point drop in the cash rate, and indeed potentially more rate cuts ahead, given a significant shift in RBA rhetoric. This means the banks have been enjoying a brief window of margin strength as they are borrowing at a lower, anticipatory rate while as yet still receiving interest payments at higher established lending rates.
As soon as the banks drop their lending rates by 25 basis points, assuming that’s what the RBA will do, then it’s just a return to where they were before. Current mortgage rates include 50 basis points of additional margin added by banks over the past year due to the tightness of global credit markets. If they drop by 25, they have not yet chipped off any of this additional margin.
The RBA’s target cash rate is effectively the rate at which banks, corporations and other institutions borrow/lend at to square up their overnight imbalances. If a borrower pays off a loan to a bank that day, then the bank has an excess of cash it can lend overnight. On the flipside, a bank can borrow overnight to make up a shortfall. This is the “overnight money market”, and the RBA cash rate effectively sets this price. Bank funding for its asset portfolios (mortgages etc) is sought, however, at the 90-day bank bill rate. Banks issue bills of 90-day maturity to raise funds, and in the course of any one day’s proceedings “swap” funding with other banks between fixed and variable rates. The daily price is called the Bank Bill Swap rate or BBSW. As 90 days is further out the maturity curve from overnight cash, BBSW is most often at a premium to cash, although occasionally brief vagaries occur.
When Australia entered recession in the early nineties it did so from RBA cash rate levels of up to 17.5%. As recession struck, the RBA quickly began slashing the rate and by May 1992 it had reached 6.50%. From then until August 2007 the cash rate was set within a range of 4.25% to 6.50% before the inflation scare of late ’07/early ’08 sent the rate up to its current 7.25% – it’s highest level since January 1992.
When Australia began to come out of recession in 1994, the typical bank margin between cash and the mortgage rate was 4%, which largely mirrored the spread between interest paid on deposits and interest charged on loans – a bank’s raison d’etre. However, it was at this point that Australia discovered the mortgage securitisation market – something that had been going on the US for a while. “Aussie” John Symonds was the most celebrated pioneer of packaged-up mortgage security funding, which started out as a means of offering cheaper home loans than the big banks (“We’ll save ya”) and eventually morphed into – in the US at least – the dreaded subprime CDO market.
Competition from Aussie Home Loans and its competitors such as RAMS and Wizard meant that banks had to either cut their own lending margins or fade away. Hence by 1997, the average spread from funding cost to home loan rate was only 1.8%, down from 4% three years earlier. While it was easy for little mortgage-only non-bank lenders to offer cheap loans, given their very low cost base operations, the big behemoth banks had to find a way to compete despite running huge cost bases covering a wealth of different financial services. There were only so many efficiencies banks could introduce in order to be able to operate profitably on such a tight margin. In order to compete, the banks had to match the non-bank lenders and significantly loosen their lending standards.
As Dr Steve Keen, Associate Professor of Finance & Economics at the University of Western Sydney puts it, “It should now be painfully obvious to everyone that this was not necessarily a good thing”.
Since the banks began raising their mortgage rates above and beyond the RBA’s cash rate adjustments over recent months, the margin has extended from the 1.8% low to around 2.35%. Nevertheless, the old 4% average is still a long way away. Dr Keen suggests that a margin of only 2.35% is still “too low to support responsible lending”.
That means over time the margin will need to return to a more comfortable 3-4% for the big banks to continue operating securely. “Aussie” John may have tapped into the Australian psyche back in 1995, spreading the belief that banks were evil rip-off merchants, but at the end of the day what we got were cheaper mortgages and much higher bank fees. Those fees have also come under pressure in recent years, so now the big Aussie banks are left with tight margins that can only lead to an ongoing compromise in lending practices – practices that got us into this mess in the first place – unless they can gradually move to the realistic margin averages of history and ensure ongoing profitability.
While it might please some, it is really in no one’s interest were a bank to fail.
What does this then mean for home loans? Well Dr Keen thinks it’s simple. He believes the RBA is about to embark on another aggressive cutting phase, just as it did in the early nineties, as the Australian economy begins to tip into recession. The first cut, expected tomorrow, will bring about a matching cut from the banks (provided it is only 25 basis points and not 50). This will be a big PR exercise, but it will also mean margins are maintained rather than reduced.
Thereafter, as the RBA continues to cut over time, the banks will not cut their mortgage and other lending rates by the full amount. Just as they incrementally added to the margin on the way up, they will incrementally add on the way down. Mortgage holders looking for significant relief ahead from RBA rate cuts are set to be disappointed, Dr Keen believes.
One might take as an example the US experience over the same period, bearing in mind that the US has had to deal with a massive slump in house prices and Australia has not (yet).
When then Fed chairman Alan Greenspan cut the US cash rate from 6.5% to 1% following the tech-wreck and 9/11, the US mortgage rate fell from 8.5% to 5.5%, meaning a bit over half the cash rate cut was passed on to borrowers. From 2007, the now Fed chairman Ben Bernanke has cut the cash rate from 5.25% to 2% to deal with the financial crisis, but the US mortgage rate has only fallen from 6.7% to 6.4%. The same sorts of minimal rate falls have been experienced by corporate borrowers. The Fed has tried to restart the economy and financial activity by making funds cheaper, but uncertainty, fear and suspicion amongst financial institutions has meant this policy has failed. It doesn’t mean Bernanke shouldn’t have cut the cash rate, but it does mean the US is not out of the woods and the global credit crunch is not yet over, by a long chalk. Says Dr Keen:
“It does appear that one other casualty of the credit crunch [among the many] has been the capacity of Central Banks to manipulate the market interest rate. The days of interest rate targeting by Central Banks may well be over”.
Thus, one might also say you can lead a horse to water but you can’t make it drink. Central banks have a brief to manage an economy’s growth and inflation through interest rate manipulation, but they can’t force a bank to lose money in the process. If a bank can’t borrow money more cheaply, then it can’t lend more cheaply – end of story. The only outlet for a government is to have a state-run lending facility which runs at a loss for a while to stabilise the market. Such a bank does not exist in the US (unless the government nationalises Fannie Mae and Freddie Mac) nor in Australia since the Commonwealth Bank and various state government banks were privatised.
Dr Keen anticipates that as the RBA moves into its rate cutting phase, Australian banks will use the opportunity to quietly increase margins back to more secure levels as we go. The government and the opposition can rant and rave all they like, but banks are simply not answerable to politicians. (And nor are oil refiners or supermarkets, as we have recently discovered. And nor would be the local corner sandwich shop which is a business just like a bank is a business.)
If overstretched Australian borrowers – which includes everyone from Babcock & Brown to the average mortgage and credit card holder – are looking for an economic slowdown to bring relief from borrowing costs anytime soon then they are not going to get it, or at least not the extent of relief they really need, Dr Keen implies. What this means is that debt will have to be reduced. We are clearly witnessing such a reduction at present among the various overleveraged listed companies such as your Babcocks, Centros, ABC Learnings et al.
These forced sales are having the obvious effect of forcing down asset prices. Those with the capacity to buy office blocks, shopping malls, wind farms, power stations and so forth are not about to “pay up” in a hurry when they know the sellers are “stressed”. And when they know there are an awful lot of stressed sellers right across the globe. Asset prices are beginning to suffer significant falls.
Dr Keen notes that Australia’s debt-to-GDP ratio “appears to be approaching a peak”, at about 166% of GDP. If the ratio does peak, then this means debt is being reduced, which can only come about through widespread asset sales. It is not as if Australian households and corporations are also sitting on mountains of cash they could use to pay down debt with, and nor is a devalued stock market offering much potential to sell for cash as well. The prices of malls and power stations etc have already begun to fall. House prices must be next.
Dr Keen notes that a debt-to-GDP ratio of 166% is twice that of the level in Australia prior to the Great Depression.