Too close to home: coming to grips with the credit squeeze

Many Australian mortgage borrowers are finding their loan repayments are increasing despite no movement (at the time of writing) in the official cash rate since November 2007.

It is not often we see lenders changing their mortgage interest rates outside the Reserve Bank of Australia (RBA) rate cycle, which now sees cash rate decisions announced on the first Tuesday of every month excluding January.

So why is this happening, and what is in store for Australian borrowers and the housing finance market in 2008?

Essentially, the current credit crunch boils down to the sub-prime lending situation, which has reached crisis point in the US and has had a flow-on effect here.

Two key issues have caused concerns about mortgage lending.

Firstly, widespread exposure of international financial institutions to lending losses in the US sub-prime (credit impaired) mortgage market.

Secondly, a subsequent reluctance on the part of investors to place their money into facilities that fund mortgage lending, in case their investments are subsequently exposed to such losses.

Sub-prime: a definition

Firstly, let’s clear up the difference between a ‘sub-prime’ mortgage (or ‘non-conforming’ loan) and a ‘prime’ mortgage.

A sub-prime mortgage is a mortgage granted to a borrower whose credit history is impaired — that is, they have a less-than-perfect credit record.

Sub-prime borrowers have generally missed repayments, been consistently late with payments or defaulted on a previous loan for some reason.

In this instance, a traditional lender generally would not assist that borrower, so they seek another source for that loan.

Typically, if the loan application is acceptable to an alternative lender, they will generally approve it under certain terms and conditions, including an interest rate premium of around 1 to 2 per cent higher (in some cases, much higher).

Conversely, a prime mortgage is a ‘traditional’ mortgage usually granted to a borrower with a good to pristine credit record. Prime lending is for an owner-occupier, investor or first homebuyer.

Sub-prime: the situation

Several of the world’s largest banks have in recent months announced some very impressive losses in connection with actual or impending mortgage defaults by borrowers in the US sub-prime market.

There is still confusion within the world’s banking system about who is going to lose how much money on sub-prime — and, conceivably, some prime — mortgages. Banks may suspect the worst of other banks, but are not entirely confident about their own positions.

As a result, everyone is holding as much cash as possible and consciously not putting it into places from which it could be difficult to retrieve quickly — like mortgage-backed securities.

This is affecting Australian lenders, as they receive wholesale funding from international markets as well as our own.

As mentioned, those markets are becoming hesitant about the risk involved in lending for mortgages and so are increasing their cost for funding mortgage lenders.

While most mortgages are offered over terms of 25 or 30 years, some lenders raise the money they lend via short-term funding from international wholesale markets that they roll over at maturity into new facilities.

The problem is that as these short-term arrangements mature, many lenders are finding it more costly to renew them under current market conditions. Some are even finding that they cannot renew them at all.

While Australian mortgages remain of exceptionally high quality by international standards, the Australian money markets have not been immune to these overseas problems.

Consequently, an increasing number of Australian lenders have been finding that the cost of raising funds to lend, in turn, to Australian borrowers has increased significantly in recent days and weeks.

Australian lenders have complied with the Uniform Consumer Credit Code (UCCC) and have lent to a nation with some of the best-behaved borrowers in the world.

However, with investors giving mortgages a wide berth, Australian lenders have to look to their ‘traditional’ sources of funding, that is, depositors, more traditional term funding from more expert lenders/investors and shareholders.

Although Australian sub-prime losses are growing off a very low base, our banks have an approximate $1 billion of sub-prime exposure and so have started to act on recouping some of the losses they are incurring.

At the time of writing, Australia’s five leading banks had raised their variable mortgage interest rates independently of the RBA cash rate cycle.

ANZ has raised its standard variable mortgage rate by 0.2 per cent, National Australia Bank by 0.12 per cent, St George by 0.2 per cent, Westpac by 0.15 per cent and the Commonwealth Bank (the biggest writer of Australian home loans) has raised its rate by a relatively modest 0.1 per cent.

As the situation in Australian and international credit markets isn’t likely to improve quickly, it’s worth taking stock of what this might mean for borrowers and the banking and finance industry as a whole.

We don’t have a crystal ball, but it is possible to answer some questions about what is likely to occur in 2008.

What do the rate rises mean for customers?

> Obviously, these borrowers will see their repayments increase.

> They may also see some service disruption as lenders adjust.

> They have to weigh up the increase against their needs, wants and financial situation.

> There are many aspects to a home loan for each borrower — depending on their circumstances — apart from the interest rate.

> It is always a good idea for borrowers to reassess their home loan situation when they find it changes or they are being stretched, while remembering that today’s best rate may not be tomorrow’s.

> With new home loans regularly entering Australia’s competitive market, it is always sensible for borrowers to annually research their options to ensure their home loan is still the best choice for them.

> As always, it is important for borrowers to consider break costs, application fees and the like when estimating the dollar benefit provided by switching loans or lenders.

Will other lenders follow suit?

> Since the credit crisis began in mid-2007, financing costs have increased for lenders (there are different wholesale funding rates for different lenders).

> It is widely known that lenders are reassessing their pricing strategies because almost all lenders draw their supply from the same drought-stricken markets, and what money there is — by historical standards — is much more expensive.

> Whether more lenders increase their home loan rates is yet to be seen.

> How and whether they recover the margin is up to them.

What does it mean for mortgage brokers?

> Little change for reputable brokers that concentrate on sourcing the most suitable home loan for each individual’s circumstances.

> Ultimately, each customer chooses the loan that is right for them. Again, the interest rate is only one aspect of a loan, albeit a very important one.

In some cases, notably Citigroup in the US, the losses are so severe that the institution’s capital position has been impaired. It has revived itself by raising money at an incredible 11 per cent per annum, a rate higher than some junk bonds.

Even with relatively under-control businesses, there’s a big gap between supply of money and the demand for it.

As one market professional put it: “It’s down to a mixture of investors being reluctant to buy new deals and issuers reluctant to lock in at prices that are some of the worst for years.”

So, the most obvious effect of all this has been that the supply of money from investors for the world’s banks to lend to the world’s residential borrowers has all but dried up.

The future

Where is housing finance headed for the near future?

Despite the current credit crunch, housing finance is still moving fairly steadily and property prices continue to rise.

The Real Estate Institute of Australia’s (REIA) Outlook report for 2008 states that the sub-prime crisis has had no impact on housing prices (both houses and other dwellings), though buying numbers are slightly down.

However, REIA president Noel Dyett warned any significant jump in interest rates of 1 per cent or more would have a lasting effect on property prices.

Housing finance remains at healthy levels.

The latest Australian Bureau of Statistics housing finance reports states that, compared to September 2007, October 2007 saw the total value of dwelling finance commitments excluding alterations and additions increase by 1.7 per cent.

Owner-occupied housing commitments increased 1.1 per cent and investment-housing commitments increased 2.9 per cent.

In accordance with the REIA data, the number of commitments for owner-occupied housing finance decreased by 0.7 per cent, while the number excluding refinancing increased by 0.5 per cent, and the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments increased from 17.7 per cent in September 2007 to 18.7 per cent in October 2007.

Market predictions and key indicators:

> Gross domestic product (GDP) growth for 2007-08 of 3.75 per cent and GDP growth for 2008-09 of 3.5 per cent.

> Retail sales are up, job vacancies have risen, consumer spending overall has increased and inflation has risen in the December 2007 quarter — with inflation for 2008 likely to slightly exceed 3 per cent but then revert to high 2’s.

> Odds are on for an increase in the cash rate in the first few months of 2008 to 7.0 per cent (the highest level since July 1996) then stability in the rate before a possible decrease.

In summary, the sub-prime situation is having a small effect on some Australian borrowers thanks to some lenders increasing interest rates and it is obviously affecting a number of our lenders, though to what extent we cannot be sure yet.

Despite this ‘credit crunch’, housing finance growth remains at a healthy pace and the property market continues to show much promise for homebuyers and investors.

Warren O’Rourke is the national manager of corporate affairs at Mortgage Choice.