Non-banks capitalise on the big banks’ flight to quality
When it comes to home lending, most of the attention is put on the big four banks. But what about the non-bank lenders like Liberty Financial, Resimac, Pepper Money and AFG? It seems they are faring pretty well, and picking up new customers as the majors re-set their focus on the highest quality borrowers.
In my last blog I discussed the recent bank results and the drivers of the lower than expected net interest margins generated in the last 3 to 6 months. With most of the weakness coming from reducing spreads in the mortgage books, the share prices of the non-bank lenders have also taken a hit recently.
As I noted last week, the primary driver of the reduction in mortgage margins in the bank results was the cessation of the term funding facility (TFF) at the end of June, combined with the increase in 3 to 5 year swap rates in September. This materially impacted the margins generated in new fixed rate originations for the major banks, and when combined with a surge in demand for these products, overall bank net interest margins came under intense pressure toward the end of the period.
The non-bank financial institutions write little or no fixed rate mortgages. While there was competitive pressure in variable rate products as well, it was a lot less intense. This is because the reference rate for wholesale funding is the 1 or 3 months bank bill swap rate. Because this is very short duration, it more closely mirrors the official RBA rate. While the market is betting that the RBA is likely to bring forward its current 2024 interest rate increase expectation given current inflationary signals, the official overnight rate remains at 0.1 per cent. Therefore, variable rate mortgage margins have not experienced the same degree of margin squeeze from rising funding costs as the banks saw in 3 to 5 year fixed rate mortgages.
Looking at the comments from the trading updates provided by the four major listed non-bank mortgage providers, Liberty Financial, Pepper Money, Resimac and AFG, all of the companies pointed to intensive competition in mortgages, but margins had remained relatively stable for all but one of the companies.
- Funding costs remain supportive of the net interest margin.
- Liberty is seeing ongoing growth in loan originations and the asset portfolio with A$1.4 billion in the September quarter.
- Mortgage discharges and principal repayments are elevated at present, offsetting the strong growth in originations, and reducing the rate of growth in the loan book.
- The loan book is expected to continue growing and diversifying in FY22.
- There is likely to be some net interest margin (NIM) compression coming given the acceleration in refinancing activity across the industry. The effect on net interest revenue is being offset by strong growth in the loan book.
- Asset finance offers a good mix offset as does an increase in the proportion of new mortgages that are near prime rather than prime.
- The major banks are increasingly focused on the highest quality mortgages. This is where the greatest competition is at present. Resimac is competing more with other non-banks rather than the majors.
- Resimac reported record mortgage settlements in the 4 months to October 2021 of A$2.5 billion. This was up 72 per cent on the same period in FY21.
- In the 6 months to December 2021, Resimac expects to settle A$3.3 billion of new mortgages.
- The overall mortgage book has grown 5.1 per cent to A$14.5 billion over the 4 months to October. This implies an annualised rate of growth of around 15 per cent.
- Pepper has generated A$5.1 billion of mortgage originations in the ten months to October 2021.This implies A$1.7 billion of originations in the four months to October 2021.
- Applications are currently up 43 per cent over last year.
- Pepper expects to deliver on its mortgage NIM forecast from the prospectus. The forecast was 2.30 per cent for CY21. Given the mortgage NIM in the first half of CY21 was 2.40 per cent, this implies a NIM in the 6 months to December of at least 2.20 per cent.
- The fall in mortgage NIM that was factored into the prospectus forecasts was due to an assumption that BBSW would increase relative to the official RBA overnight rate. This has not occurred, allowing Pepper to be more aggressive on pricing to accelerate the growth in the loan book.
- Pepper has not been immune to the intense competition and elevated level of prepayments in mortgages.
- Most of the intense competition coming from the banks is in the super prime space where margins are ultra thin. Pepper is not playing in this market.
- As the banks have moved increasingly toward lower and lower risk loans, there are areas of the prime market that have opened up for Pepper. Pepper has grown its prime business by 55 per cent in the first half of CY21 relative to 38 per cent growth in near prime. Mix is therefore having a negative impact on NIM for Pepper but the quality of the loan book is improving.
- A shift in mix toward higher margin products in near prime, SMSF and low doc will assist in supporting long term NIM in the securitised mortgage book.
- These higher margin products generate approximately 40 basis points higher NIM than the core prime mortgage book.
- Growth in the AFG loan book is well above market growth despite the higher amortisation and refinancing rate across the market.
- Applications in the first 4 months of FY22 totalled A$1,373 million. Higher margin products made up 22.5 per cent of these applications, well above the average of the back book in these products at around 6 per cent as at 30 June.
- Recent increases in fixed rates by major banks is leveling the playing field for competition from non-major lenders. The addressable market for AFG is now expected to increase as fixed rate products ultimately become less attractive to borrowers.
- AFG has rolled out one of its two warehouse facilities by 12 months to Dec 2022 as well as adding a new warehouse facility with another major bank. Both facilities will have a lower funding margin that the existing warehouse facilities. Additionally, while residential mortgage backed securities (RMBS) spreads have increased by around 10-15 basis points from their lows in the middle of the year, they remain well below AFG’s average funding cost. This will see the average funding margin over 1 month BBSW fall over the coming year, supporting NIM.
Overall, it appears there is some margin pressure in the mortgage books of the non-bank lenders but not to the extent shown in the recent Westpac, the Commonwealth Bank of Australia and National Australia Bank results. This is because the primary source of margin pressure in the September quarter came from funding cost pressure in 3 to 5 year fixed rate products, combined with increasing focus by the banks on the highest quality borrowers.
The non-banks focus exclusively on variable rate products and the underserviced borrowers that are too difficult for the major banks.
However, Pepper and Resimac are likely to report weaker NIM trends on a sequential basis and Liberty and AFG due to the decision to boost loan book growth through more aggressive pricing and in the case of Pepper, a mix shift toward lower risk and margin prime loans.
With fixed rates having been forced to rise materially in recent weeks, combined with an increased focus from the majors on the highest quality borrowers, the opportunity set for the non-banks has grown rapidly, leading to record application and settlement volumes, partially offset by the acceleration in refinancing activity driven by historically low interest rates.
The increase in refinancing activity has seen greater rotation of the back book to front book pricing causing some dilution of mortgage margins for the non-banks. However, funding costs continue to fall as warehouse facilities are rolled and new RMBS issuance filters into the funding mix.
You can read my previous blog here: WILL AUSSIE BANKS REBOUND FROM HERE?
The Montgomery Funds owns shares in Westpac, Commonwealth Bank and National Australia Bank. This article was prepared 02 December 2021 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade these companies you should seek financial advice.