The monolith, CBA is also a bellwether for the broader housing market, so worth analysing for investors with exposure to residential property, either direct or indirect such as Residential Mortgage Backed Securities (RMBS)
On 9 August 2018, Commonwealth Bank of Australia (CBA) released their results for fiscal 2018. CBA is the largest home lender in Australia, accounting for close to a quarter of all home loans. As such, and beyond the headline results - which have been covered considerably in the mainstream media - the results provide another indicator into the health of the residential mortgage market in Australia, including relevant securities such as residential mortgage backed securities (RMBS).
It should be noted that each RMBS is different, based on the composition of loans and the level of credit enhancement. As such, the themes stemming from the CBA results do not necessarily correlate to the future performance of any particularly RMBS.
CBA home loan arrears are edging higher, although the increase is gradual, and coming off a low base. They also remain considerably lower than levels witnessed with other lending classes, including credit cards and personal loans (see graph further below), highlighting the relatively low risk nature of home loan lending. The current rise in arrears has also yet to translate into higher losses. Credit conditions are tighter and households are facing a confluence of rising living costs, low income growth, and increasing mortgage repayments. Nevertheless, a backdrop of very low interest rates and low unemployment, for now, should see credit losses remain very low in the foreseeable future. We believe the low level of credit losses observed with CBA (see graph further below) will be largely mirrored in the performance of Australian RMBS.
Home loan arrears edged higher but losses remain very low
Consistent with the recent trend across the industry, home loan arrears edged higher in the year ended 30 June 2018 (FY18), with loans 90-days past due up to 70 basis points (bps) from 60bps in the prior corresponding period (pcp, year end June 30, 2017). We note the graph below displaying home loan arrears includes the New Zealand business; we estimate the arrears on the Australian business at between 75bps and 80bps in FY18, up from between 65bps and 70ps in the pcp. Housing arrears continue to track considerably lower than other lending classes including credit cards and personal loans (see graph below), highlighting the lower risk nature of home loan lending. Crucially, the loss rate within the home loan portfolio remained very low at 3bps, unchanged in recent years, and appears set to remain that way in the near term.
Source: Commonwealth Bank of Australia
CBA attributed the increase in arrears to pockets of stress. In particular, it highlighted rising essential costs and limited income growth, as well as some households switching to principal and interest repayments, from interest only (see further below). Western Australia and the Northern Territory remain the worst performers, although the general trend across all states is a gradual deterioration (see graph below). Note that CBA is likely to have a relatively higher exposure to Western Australia as the owner of Bankwest.
Source: Commonwealth Bank of Australia
The fall in arrears to around 50bps in recent years was unlikely to prove sustainable and some revision to the mean should be expected. The financial pressures on household budgets (re: rising costs and low income growth) as well as recent loan repricing has undermined two key factors underpinning the strong performance in housing since 2013 -low unemployment and historically low interest rates. We see these and other pressures (see below) prevailing in the foreseeable future, suggesting housing arrears will drift higher. However, they are yet to meaningfully transition to higher loss rates, and we see this remaining the case in the near term.
More home loans are switching to principal and interest terms, from interest only
Demand for credit (and as such, house prices) has drifted lower over the last 18 months. We attribute much of the slowdown to the imposition of limits on the level of interest only loans Australian banks can underwrite. Interest-only loans have been popular with Australian investors for their tax benefits, but increasingly for owner occupiers. The general practice in Australia is for banks to assess the creditworthiness of an interest only borrower on principal and interest terms. This suggests that if a borrower transitions to principal and interest terms, they should be able to adjust to a higher level of repayments, all else being equal. In any event, the popularity of interest only loans, which reached close to 50% of housing credit demand in 2015, has underpinned a significant rise in household leverage and house prices between 2013 and 2017.
For CBA, the level of interest only lending on its balance sheet decreased to 30%, from 39% in FY17. This is a significant adjustment in a short period of time. Around 8% of CBA’s loan book shifted to principal and interest repayments, from interest only, in FY18, with a further 15% set to assess their position over the next two years (see graph below). Although not all 15% will necessarily revert to principal and interest--particularly investors who are incentivised to remain on interest only terms, pricing and policy measures are likely to encourage a large proportion to do so.
Interest only loans and conversion to P&I
Source: Commonwealth Bank of Australia
CBA highlighted the adjustment to principal and interest terms as one factor contributing to a higher level of home loan arrears. In the longer run, the transition should be a positive for the health of the Australian housing market, although the adjustment in the interim is likely to be difficult for some households.
It is likely a similar transition has and will take place with other Australian banks over the next few years. With a further 50% of interest only loans resetting over the next two years, again likely to be consistent with other banks given interest only terms are generally less than five years. It is highly probable in our view that this adjustment will contribute to an increase in housing arrears over the next few years.
Margins face a number of headwinds, placing further pressure on banks…and households
CBA’s margins were up by 5bps in FY18 (a solid outcome), although much of it stemmed from loan repricing in the first half; margins were off by 2bps in the second half.
Loan discounting and switching cost 2bps, while the cost of funding from wholesale markets cost a further 4bps (and CBA has a stronger funding mix compared with other peers, suggesting other banks with a higher reliance on wholesale market funding will be feeling the pressure more acutely).
Analysis of net interest margin
Source: Commonwealth Bank of Australia
In light of slowing credit demand, pressure on front book (new loan) margins will likely persist for the foreseeable future. We also note that the forementioned switching underway to principal and interest comes at a cost to banks in the form of lower margins and a quicker amortisation of loans, placing further pressure on margins as volumes slow.
These headwinds are not unique to CBA and will equally apply to banks and non banks--although the magnitude will vary greatly depending on the institutions’ lending and funding mix.
So called ‘out of cycle’ loan repricing has become commonplace in Australia more recently. With an unchanged official cash rate since August 2016, the role of tightening monetary policy has been effectively replaced in some respects in the form of loan repricing (relatedly, CBA noted a tightening in its serviceability and underwriting standards has been underway since 2016). The increased cost of credit for households reduces the demand for new credit, but also has the effect of increasing repayments on existing loans. Our base case is for further loan repricing, even though it appears banks and non banks are more discerning in who they apply higher rates to (particularly as the Royal Commission into financial services casts a long shadow over the banking sector).
Against the backdrop of low income growth and an increased cost of living, we expect tighter credit conditions to contribute to higher home loan arrears in the near term.
Please call you Relationship Manager of you’d like more information on any RMBS you might own or are interested in the asset class.