What’s the outlook for mortgage rates?

What’s the outlook for mortgage rates?

As we have discussed a number of times in the past, the major banks face significant headwinds from increasing capital adequacy requirements over the next few years. This is due to a partial reversal of the significantly lower risk weightings that were applied to major bank mortgages, combined with the need to generally hold more equity capital to reduce the potential risks given their ‘too big to fail’ status in the Australian economy.

So far we have seen NAB raise A$5.5 billion of incremental equity, CBA A$5 billion, ANZ A$3 billion and WBC A$2.6 to 2.7 billion (including the sale of part of its stake in BTIM), with more equity raisings or capital retention likely to come in future. The need to hold more equity capital against their loan books means that the future return on capital is likely to be lower, impacting not just earnings per share, but also the value of those earnings and the sustainable dividend payout ratio. This is because a lower future return on equity means the bank needs to retain a greater proportion of its earnings to fund a given rate of earnings growth, leaving less surplus profit to be distributed as dividends.

The oligopolistic nature of the Australian banking industry is expected to cause the major banks to reprice products to boost margins. Resulting in at least a partial offset to the return dilution from the increase in equity capital requirements. This is likely to take the form of higher lending rates relative to funding costs (ie. deposit rates and wholesale funding costs), fee increases, and a greater focus on reducing operating expenses.

In July we saw the first moves by the banks with CBA, ANZ and WBC raising their standard variable rate by 27bpts on investment loans, while NAB raised its standard variable rate on interest only loans by 29bpts. The regional banks followed suit over the next month or so.

The repricing of investment and interest only loans will only offset around 25 per cent of the return on equity dilution. Clearly the banks will be looking to do a lot more. With most of the increase in capital requirements falling on mortgage products, the banks will be most adamant to reprice occupied mortgages.

We expect that the major banks are hoping for another rate cut by the RBA to effectively reprice owner occupied loans by only passing through a limited amount of the rate cut to mortgagees, while passing on as much as possible to depositors.

However there is a potential problem. The increase in capital adequacy requirements largely impacts the major banks, while the regional banks and non-bank financial institutions (NBFIs) are far less unaffected.

As was highlighted in a recent article in the Australian Financial Review, over the last 12 months, mortgage rates have fallen more than the 50bpt fall in official interest rates with some NBFI rates falling by more than 100bpts. The gap between the headline variable mortgage rates offered by the major banks and some of the NBFIs has widened to well over 100bpts. Of course this does not take into account the discounts the major banks offer customers, but the gap even including these discounts has widened.

As we saw in the late 1990s and early part of the last decade with the rise of mortgage originators like Aussie Home Loans and RAMS, major bank mortgage shares can be negatively impacted by competition if pricing increases too aggressively.

The negative shift in the capital advantage of the major banks relative to regionals and NBFIs could result in limited ability for the major banks to recover the reduction in ROE (return on equity) through repricing.

The NBFIs ability to take meaningful share from the major banks will be limited by their ability to access wholesale funds through the residential mortgage backed security (RMBS) market. While the domestic RMBS market has recovered, it is not a large pool of funds. The offshore RMBS market remains tight, however if the market improves, the NBFI segment could once again become a threat to the majors, limiting their ability to reprice mortgages.

This means that the banks would need to utilise other means to improve earnings.

Fee increases would form part of the solution given the control they have over the payments system. However, the current regulatory oversight of excessive charges is likely to limit meaningful increases in fees.

Cost reductions are likely to take longer to realise. We note at WBC’s recent strategy day it set of an expense ratio target below 40 per cent by the 2018 financial year with expenses expected to average 2 to 3 per cent growth a year.

The net result would be a more elongated period of ROE dilution for the major banks and a slow recovery over time through greater focus on cost reductions if the banks are unable to simply reprice mortgages and lower the amount of recovery of the return on equity dilution from the increase capital adequacy requirements.

The end result in terms of the proportion of the lost ROE recovered is likely to depend on whether the offshore RMBS market opens up for NBFI lenders. If not, the major are likely to claw back most of the dilution through higher mortgage rates relative to the official cash rate.

Stuart Jackson is a Senior Analyst with Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.