Australian Mortgage is a neo lender which is about to launch a mortgage origination and funding platform that relies on providing mortgages at market rates and funding in the banking and securitisation markets at market rates. Whilst there is a correlation between market mortgage rates and margins that a neo lender may be able to obtain for its securities from banks or securitisation investors, nothing guarantees that any lender will be able to earn enough interest spread between market mortgage rates and funding rates and remain competitive.
Therefore, an understanding of future interest rates and the spread risk is needed to appropriately plan to mitigate this risk. Understanding will come from looking at how the system works and the reactions of regulators to the current state of the economy and financial system.
Australia and most of the western world are in an interest rate environment unique in modern history, with official interest rates at low levels for long periods and debt levels at highs relative to measures like GDP and national income that have never been seen before. These debt and interest levels have been the oxygen for asset inflation in Australia and the world.
Primarily due to the Banking RC but also the actions of APRA and ASIC, credit for housing is not as loose, returning to more responsible levels (although some overreaction) and that has contributed to a significant decline in housing values over the last year with no let-up in sight.
Does declining credit availability and house prices mean disaster, or what will the RBA and the Government do about ensuring it does not turn into a disaster? As central banks in Europe and the US have shown they are willing to pump economies using interest rates and Quantitative Easing (QE). In Australia the RBA is sure to be of the same ilk.
At the beginning of 2017 I wrote an article for Australasian Banking and Finance where I stated, “If you want to know the direction of Australian house prices watch what the Fed does with US interest rates (up for them and its down for us)”. This correlation is driven by Australia’s large external debt account. Since then US rates have increased and Australian house prices have decreased as forecast.
Whilst credit availability is a strong factor in house price declines, so are the interest rates of the world’s reserve currency relative to our own. Australian banks and lenders have funded upwards of $800Bn of their wholesale debt from offshore so a significant part of the determination of the cost of debt is offshore lenders. The US Fed increasing rates to the 2.25-2.5% range whilst the RBA maintained a cash rate of 1.5% lessened the attractiveness of Australian bank and lender debt; contributing to the widening of bank bill rates relative to the cash rate. Amongst other macroprudential factors, this ensured that there were out of cycle rate rises by the lenders to current mortgage holders. Consequently, the RBA has not been controlling the interest rates at which banks fund as effectively as they would like.
With the Australian economy showing weakness in GDP with a per capita recession, plus little growth in average household incomes and housing price declines, both the market and the RBA have turned and are signalling rate cuts. The signals are so strong its almost as if cuts of 0.5 to 1.0% are baked in.
So what effect will RBA cash rate cutting have on Australian mortgage rates? Again, we must first look at what the US Fed is doing. On March 20 the Fed indicated that its rates would be on hold during 2019 and that reversing its QE program would end at the end of 2019. So at least Australia is not being battered by the headwinds of further rising US rates that were previously indicated. Nevertheless, when Australia drops rates it further exacerbates the interest rate differential and this is likely to again push bank funding costs higher through the bank bill rate and therefore ensure that the full extent of the RBA’s cuts will not be passed onto mortgage borrowers.
So, at this stage of our analysis, the forecast is that the RBA will cut the cash rate hard but not all of those cuts will be passed onto borrowers. Maybe very little- but let’s see how the market plays out and what the Fed does with US interest rates that are now looking weak for 2020. The US yield curve has turned negative for the first time in over 10 years as has the Australian yield curve.
Slashing rates relative to US rates would normally dramatically reduce the $A relative to the $US, however, if bill rates hold up so foreigners still receive a commensurate yield and there is little capital flight to higher rates for risk, then the effect on the $A will be much less than otherwise.
What about other tools the RBA can use? The RBA could use the Australian form of QE by buying mortgage backed securities and other forms of securities that are repo-ed to inject funds into the banking system. Whilst the Committed Liquidity Facility (CLF) was not set up for this purpose, the infrastructure could be used for QE. Funds raised by banks in this manner are additional to the banking system and therefore can be used to lend more or pay down foreign debt.
QE done at cheap rates could help alleviate interest rates that offshore borrowing has imposed on the system and this could allow the RBA’s actions in reducing rates to be passed onto borrowers. Unfortunately, this may only be a temporary measure.
The issue for the RBA is that banks repaying offshore debt will put significant pressure on reducing the $A. Australia has a current account deficit, and this must be continually funded. If this is now funded by the RBA printing money (QE) because the banks are using RBA funds to repay debt, the system is stoking the fires of inflation through a lower $A and higher prices.
The RBA could not stay still in a world of high inflation and foreign capital flight and would need to reverse its rate reducing regime and start to increase rates. How much will depend on relative international rates, again particularly the US. Nevertheless, at this point there will be much higher rates for Australian mortgage borrowers imposed by externalities that the RBA will not be able to control.
At the point in the cycle when borrowers are suffering with no RBA relief, the government could step in with a QE for the people. This could take the form of printing money and paying directly into people’s bank accounts or forms of debt forgiveness and direct support for the banks. QE for the people may alleviate a system collapse but it’s unlikely to support house prices nor stop a slowing of credit to the system.
Once this point is reached, the whole financial system will be suffering under the weight of higher loss provisions and higher capital requirements for much of the mortgage book.
So, as we approach the end of the long Australian credit cycle, rates are likely to fall but mortgage spreads widen due to externalities. Rates are then forced to increase to support the $A and as the banks try to repair their balance sheets, mortgage spreads will widen even further. Whilst there are some extreme outcomes that may involve a high level of government interference, the outlook is for mortgage spreads to widen regardless of how the RBA moves the official cash rate over the next few years.
For Australian Mortgage to take advantage of wide spreads, it must have a demonstrably clean mortgage book with second to none reporting to its debt investors, so they price our debt securities accordingly. The Company’s Smart Securitisation platform called, Carbon that provides real time trusted data to investors when viewed from an interest rate and financial system risk perspective is critical funding infrastructure for capital markets that will be necessary as the end of the credit cycle nears and stresses appear.