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Mortgage lending and bank stability

30 November 2004

Mortgage lending and bank stability

Recently, the head of the Reserve Bank of Australia issued a direct warning about Australian mortgage lending. He specifically noted that banks "may be tempted to further lower lending standards, and that would carry with it serious medium-term risks". Interestingly, he emphasised how he used the word 'further', and he is clearly worried that bank credit standards are already on the way down.

If the Australian banks are on this slippery slope, that could impact their New Zealand operations. Further, it raises the question as to whether these same banks are pursuing similar credit-standard slippage here.

The issue is important for New Zealand right now, because the housing market is softening markedly, and to keep their growth and profit growing, the Banks will need to replace volume-growth with other strategies. Changing credit standards is one of the few options they have.

The other is to fight aggressively for market share, and this battle is been waged in the 2-year fixed mortgage segment, although it recently spilled over into the 1-year fixed segment as well. The jury is out as to how effectively these campaigns have worked, but in any event, it is a zero-sum game. The winners will be happy, but the losers will look to other strategies to make up their losses.

Credit standard slippage has been occurring in the non-bank mortgage sector for some time, with the rise of the 'low-doc' segment. These are loans where the proof of income and supporting security of the borrower is not rigorous, and the lender relies on the security of the house being financed. This works in a rising market, but may be trouble in a static or declining market.

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Until recently, the loan aggregators providing this service have been fringe players. However, the recent announcement by ASB Bank family member Sovereign of its 'Go Low Doc' and 'Go First Home' products is a clear indication that the main lenders are widening their appetite for this corner of the market and the risks that go with it.

ASB Bank is the New Zealand operations of the Commonwealth Bank, Australia's largest. It also has the distinction of being the New Zealand bank with the fastest growing residential mortgage book. It has grown more than $1.1 billion per quarter for the past four quarters, although it has fallen back in the September quarter recording growth of 'only' $756 million. Recent growth at these levels beats all it's competitors by a wide margin.

But at that level, it also has the most to lose. Entering the low doc market is another way to keep the growth and profits flowing.

Residential mortgages are overwhelmingly important to banks. More than half of their total loans and advances are in residential mortgages. And that share is growing. In the eighteen months from December 2002 until June 2004 and September 2004, the bank's balance sheets have shown that lending on residential mortgages has grown by about +5% of total loans and advances. This dominant share has grown even more so.

ASB Bank is of particular concern. Most of their eggs are in the residential mortgage basket. If that sector slows, they will be vulnerable to poorer earnings and substantial credit risks in that mortgage portfolio. This is a bank that has broad and deep distribution channels, relying on brokers to collect and present borrower's financial and security information for a substantial portion of their business. While there is nothing inherently wrong with such channels, it must be recognised that when economic circumstances turn, the drive to maintain transaction levels will bump up against credit standards, and the level of control and discipline the bank can impose on its channels will require very strict management.

A downward spiral on credit quality has been likened to an 'airline price war'. As the Governor of the RBA, Ian Macfarlane pointed out, "in attempting to resist the slowing credit demand, [banks] may be tempted to further lower lending standards". "It is not hard to see how a situation like this develops," says Macfarlane. "Once a few lenders adopt an aggressive approach, others must match them or lose market share."

Macfarlane also makes the point that it is during the good times that the biggest mistakes can be made. "When everyone feels that risks are at their minimum, over-confidence can take over and elementary precautions start to get watered down. In addition, competitive pressures from those who under-estimate risk can push the more prudent institutions into actions they will later regret."

New Zealand banks are in good shape at present. Growth and profits are healthy, reflecting a healthy economic environment. But we are in the middle of a mortgage price 'war', and the largest mortgage lender is expanding into 'low-doc' products. All this as housing sales volumes are declining, and house prices have peaked.

It is time to expect our dominating banks, all Australian owned, to do their part to help a soft landing. Aggressive fights that compromise credit standards are the last thing the New Zealand housing market needs right now. If profits are lower in the short term, that will be a cost of responsible stewardship of New Zealand's financial system.

Let's hope our regulator is singing the same tune as Dr Macfarlane.


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