26 June 2008

Mortgage mayhem - holding up the sky

The effects of the USA's current economic crisis are now rippling through to Australia. While the official cash rate determined by the Reserve Bank of Australia (RBA) is the highest in 12 years, lenders are raising rates over and above the RBA rate. This is necessary, say the banks, in order to recoup some of the losses incurred as a result of the increased cost of money on the wholesale market, the most obvious effect of the USA-driven monetary turbulence. Apart from causing widespread pain and anxiety to many consumers with mortgages or those saving for one, the ever-changing situation in the money market is behind the current repositioning of products by some lenders. CANNEX are now seeing many lenders withdrawing some or all lending products from the market. Others, the big banks in particular, are making more and more noises about restricting lending and not taking on new customers. Mortgage brokers are also feeling the pinch of shrinking profit margins, as banks put the squeeze on the sector and smaller lenders withdraw from this distribution avenue. Is credit rationing on the cards a little further down the track? We are yet to feel the full impact of this changed lending landscape.

The sky is still not falling

If you are cashed up, you are probably rubbing your hands in glee right now as banks court you with offers of good interest rates in return for minding your money. The reason for such a focus on boosting deposit accounts is simply that ordinary mum-and-dad deposits make up the retail deposit base. This source of funding helps the banks reduce their dependence on purchasing money from the more expensive wholesale market. Hence the gap between the official cash rate and what the banks are offering deposit account holders is narrowing all the time. In such a competitive environment, it's not hard to find a good deal, especially if you look at saving online.

Debunking the myth

Banks are an easy and frequent target of general consumer dissatisfaction over the discrepancy between the interest rates they offer on lending and deposit products. Banks have long been criticised over their promptness to take with the one hand and not give back quite so quickly with the other. However, banks' decisions are based on market place supply and demand pressures, just as any other business experiences. CANNEX has tracked the margins between mortgages and 90-day term deposits offered by banks over the past five years and discovered the 90-day term deposit rate has actually increased faster than the mortgage rate. As you can see, the gap between lending and deposit products has never been slimmer. The reason for this is that mortgages are priced off the Reserve Bank cash rate, and lenders feel constrained in exceeding RBA increases. However, they fund mortgages from both wholesale and retail deposits, and wholesale rates (as indicated by the 90-day bill rate) have increased more than the cash rate.

Term deposits have been bid up as the alternative to wholesale funding so that the margin between lending and term deposits has narrowed. Recent turmoil in capital markets has made retail deposits still more attractive, hence the recent move away over and above the 90-day bill rate. The ultimate outcome is leaner lending margins and a narrow gap to deposits.

Lending - Deposit Margin Analysis

Average Mortgage Rates 90-day bank bill 90-day term deposit RBA cash rate. Source: CANNEX 18/3/08. Based on bank lending & deposits of $50,000.

To fix or not to fix

With so much uncertainty surrounding the mortgage market, it's not surprising growing proportions of Australian's are choosing to fix their loans. The big issue to weigh up is the timing of entering into a fixed loan. If rates are at the top of the cycle when you fix your loan, it's likely that they will come down during your fixed period - leaving you paying more. The other issue to consider is the break cost of the loan. This can be significant and unexpected to most borrowers.

As its name implies, a break cost can be charged when a fixed loan is exited before the full term. If, by breaking the loan early, the lender incurs a loss, this will be passed on to the borrower.

The lender will incur a loss if the wholesale money rates fall after the loan is fixed. The lender will be locked into the higher priced funding for the loan. The wholesale money market is volatile and unpredictable at the moment and changes almost hourly. It is not related to official RBA cash rate.

Calculating or measuring a break cost on a loan is not easy for borrowers, predominantly because of the fluctuating wholesale money market. Apart from looking at what the wholesale rate is at settlement, lenders also take into account the loan amount, average loan balance and the loan term remaining. To make it even more confusing, figures vary between lenders. Nobody has a crystal ball, and it is impossible to say categorically which way rates will move. Fixing rates today gives certainty of repayments for the next two, three or five years. The trade-off is that if rates fall you will not enjoy that benefit and if your circumstances change and you have to sell, you could be up for break costs.

Fixed Rate Market Share - Owner Occupied

CANNEX has noted the preference by Australian home owners for fixed rate loans is steadily increasing. The latest figures available as at January this year show just on 30% of all owner occupied home loans are fixed. This is not surprising, considering the current global money market situation and it is a trend we expect will continue until at least the end of the year.

Source: Cannex.

Best regards
Iain Pepper


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Iain Pepper
Head of Lending

Iain Pepper is a Vice-President and the Head of Lending for the La Trobe Group.Read full profile here.

La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 145 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.

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