Is this the end of mortgage super-profits?
You might be forgiven for thinking the banks are starting to soften up their customer base for a post-election rate hike regardless of whether or not the Reserve Bank resumes its cycle of raising official rates.
From the recent renewed murmurings about funding and margin pressures, you might be forgiven for thinking the banks are starting to soften up their customer base for a post-election rate hike regardless of whether or not the Reserve Bank resumes its cycle of raising official rates.
Whether it is the Bank of Queensland talking this week of the increased pressure created by deteriorating funding conditions, or Westpac denying last week’s reports that it had told analysts it would re-price its mortgage book next year, or ANZ last month reminding its investors that its average funding costs are continuing to rise, the issue remains front-of-mind for the banks.
While the issue is a real one -- the cost of wholesale and deposit funding remains high and average costs will continue to push up as post-crisis borrowings displace cheaper pre-crisis funding -- underlying it is a larger question, one raised by National Australia Bank chief financial officer Mark Joiner in an interview last month.
Joiner told The Australian that an era of super profitability for mortgage lending would eventually end. According to Joiner, the introduction of the Basel II prudential regime in 2008, with its risk-weightings for loans, had doubled the industry’s average return on the equity-devoted to mortgage lending from about 22% to 45%.
With a risk-weighting of less than half that of a commercial loan, it's hard to argue with the view that in ROE terms mortgage lending became instantly super-profitable as a result of Basel II (a view that has been expressed forcefully, and frequently, by Business Spectator columnist Christopher Joye). While some of that excess profitability was competed away as the mortgage originators bit increasingly into bank margins (although offset to some degree by volume growth and cost cutting) non-banks disappeared as a source of competitive tension at the onset of the financial crisis.
Westpac and Commonwealth, in particular, took advantage of the competitive vacuum and the crisis to make major acquisitions and launch aggressive drives for mortgage market share. Now, with some political constraints to passing on their steadily increasing funding costs, their margins are being squeezed and their ROEs would be sliding.
Preserving the phenomenal returns isn’t just a question of their ability to restore their margins by passing on the higher funding costs. In the post-crisis environment banks will have to hold -- and already are holding -- a lot more capital and higher-cost liquidity. By itself, the extra capital would have a material impact on ROEs.
They can’t churn that capital by securitising their mortgages, given the weak and shallow state of the residential mortgage-backed securities market, or tweak their returns by leveraging them through capital management. Nor is there likely to be the same levels of volume growth in the near to medium term that there has been in the past decade or so.
With their retail banking fees already being wound back after coming under attack from initially NAB’s decision to remove the most unpopular fees and then by legislators and, via a class action, their customers, the banks are facing a potentially even more ‘damaging’ assault on exit fees.
The Australian Securities and Investment Commission has been directed to crack down on ‘unconscionable’ charges for repaying a mortgage early and a Senate committee has recommended they be abolished, by legislative decree if necessary.
The fees, because customers are reluctant to move and trigger them, have little consequence for bank earnings, but are a major impediment to competition. If they were abolished, even if only for new home loans, churn rates would be likely to rise.
A home loan basically covers its costs, through establishment fees and margin, within 12 to 18 months. After that it is a very profitable annuity and one that also provides cross-selling opportunities.
If there were an enhanced ability to wrest customers from their existing lenders, price-based competition would be far more potent and the latent profitability of mortgage books would be significantly diminished.
The unbalanced structure of the home loan market -- with Westpac and CBA dominating and ANZ and NAB relegated to a distant second tier -- gives the Sydney banks major and unchallengeable scale advantages.
It also, however, makes them vulnerable because the Melbourne banks have far less to lose and far more to gain -- in both absolute and relative terms -- from price-led competition. The smaller banks, having stayed out of the first home-buyers’ grant-fuelled lending spree, also don’t have the same funding requirements of their larger peers.
With Basel III taking a somewhat less benign view of the relative security of home lending than the Basel II regime -- it doesn’t recognise securitised mortgages in its liquidity requirements and the proposed leverage ratio awarding mortgages the same weighting as a commercial loan -- the allure of home lending will be somewhat duller than it has been.
Lower margins, increased capital requirements, the proposed liquidity regime, higher churn rates and lower-volume growth would, one would expect, lower the profitability of home lending and pare back the remarkable ROEs the banks have been able to generate in the past.
With the structure of the banking post-crisis quite different to the pre-crisis period, where the four majors looked broadly similar, the incentives for the smaller banks (with some assistance from legislators and regulators) to chase still highly attractive returns by igniting real price-driven competition could transform those super-returns of the past into an aberration rather than the norm.