The Australian Financial Review’s (AFR) Due Diligence section today ran a superb article on the challenges facing the Australian banking sector. Below is an extract of the best parts (“Banks feel chill wind of housing slump”, 30 May 2011):
For all their mind-boggling complexity, banks are largely a play on house prices. During tha past two decades, house prices have risen and so has the size of mortgages. As people get more equity in their homes they feel richer and spend more on their credit cards…
[But] house prices are now either falling or going nowhere. The effect on Australia’s banks will be profound.
As one senior banker explains, when mortgage credit growth was running at 15%, a bank could get 10% revenue growth “even if you weren’t any good. You just had to be in the market”.
Suddenly we hit a wall about two years ago. You’re not getting the earnings growth any more…Housing credit is growing at its slowest pace in 30 years…
More than any other factor, a series of housing booms is what has fuelled the growth in banks’ profits. Mortgages are banks’ single biggest asset class… they make up 65% of total assets at the CBA and Westpac, 55% at ANZ and 50% at NAB. They are also more profitable than any other type of loan…
Some simple numbers illustrate the pickle the banks are in. According to the Australian Prudential Regulatory Authority, there was just over $1 trillion of mortgages sitting in the banking sector in March. Growth at 6.6% [the rate of mortgage growth in the 12 month’s to March] means $66 billion of mortgages in 12 months.
Applying a 1% net interest margin – the difference between the rate at which a bank borrows money and lends it – means the entire banking sector can expect $660 million in additional revenue in the next 12 months from mortgages.
If housing credit growth was running at 15%, as it did for most of the last two decades, the additional revenue would be $1.5 billion. That’s just under $900 million that is no longer trickling into the banks, and most of it would have gone straight to the bottom line.
There is no way an increase in business lending will plug the gap…
The key challenge facing the Australian banking sector is that it has become too heavily exposed to the Australian housing market.
Following the implementation of the Basel Capital Adequacy Accord in 1988 (“Basel I”) and the updated Basel II Capital Adequacy Framework in 2008, Australian banks have been permitted to hold far lower levels of capital against mortgages relative to business loans, which has encouraged the banks to lend large sums to housing in order to earn significantly higher profits.
According to the above AFR article, despite lower margins on mortgage lending (1% against 2.15% on business loans), the Australian banks have typically delivered a return on equity on mortgages of around 25% versus 18% for business lending.
Little wonder then that Australia’s banks have, over the past two decades, so heavily shifted their focus from business lending to housing. As shown below, business lending comprised nearly two-thirds of total lending in 1990, with housing lending and personal lending making up the difference. However, in 2011, business’ share of total lending has fallen to around one-third, swallowed up by housing lending.
The growth in mortgage lending has been staggering, rising almost exponentially since 1990.
To illustrate, first consider the growth of mortgage lending expressed as an index:
Second, the growth of mortgage lending expressed in nominal dollar terms:
And finally, the growth of Australia’s mortgage debt relative to other advanced economies (chart from the IMF):
The problem for the banks is that mortgage growth has dropped to its lowest level in two decades – from between 10% and 20% per annum in the decade and a half prior to the global financial crisis to only 6.6% in the 12 months to March 2011 (see below chart).
And with mortgage credit growth constrained, the prospect of continued house price growth is diminished as is the banks’ ability to continue growing their profits.
In many ways, the banks are caught in a pincer in that they must continue lending liberally to housing or risk a house price correction and a significant increase in non-performing loans.
This reality has recently been articulated by Robert Gottliebsen in Business Spectator. In April, Gotti described the banks’ predicament as follows:
As long as banks keep restricting the supply of dwellings and fostering the demand by generous consumer loans, dwelling prices will not slump.
But if Australian banks restrict consumer housing credit in the same way as the US banks and the banks involved in the Gold and Sunshine coasts market did we will see a big fall in property asset prices, which, in turn, will lead to a rise in bank bad debts.
In many ways the Australian banks are trapped. They must keep up consumer housing funding to avoid a fall.
And today, Gotti followed-up with another article demonstrating the catch-22 position that the banks are in:
Australian banks were the major cause of the housing boom and if they make a false move they risk bringing on a crisis in which they will be the major losers.
The most publicised reasons for the fall in the dwelling market have been the rise in interest rates, fewer overseas buyers, the increase in power, petrol and other costs. But ranking with those forces has been a rapid and severe tightening of bank credit. Whereas before banks would lend up 105 per cent on an investment dwelling, now those loans are not available and banks are being much more careful who they lend to and how they apply lending criteria. Accordingly, it can take borrowers weeks to get a decision that would once be made in hours.
If the banks were to continue the current tightening then it is highly likely that the market would fall between another 5 per cent and 10 per cent, given that is bank credit plays such a big role in determining the level of dwelling prices…
The banks, having pushed the market up, cannot afford to let it fall too far or they will suffer very large losses, particularly if the current decline in non-mining economic activity in the major capitals causes unemployment to rise.
Nevertheless, although they are trapped, it takes great courage for the banks to lower lending standards and cut prices on a falling market because if there is a further economic downturn then your losses may compound. In addition there is a prospect of an overseas crisis that leads to much higher costs of overseas wholesale funding of our banks.
Clearly, Australia’s banks have painted themselves into a corner. If they attempt to belatedly limit their exposure to housing by reducing the availability of mortgage credit, then they risk causing a slump in housing demand and falling prices.
However, if the banks relax lending standards, they may succeed in keeping Australia’s housing bubble inflated for a while longer. But in doing so, they would increase their exposure to future shocks and potentially larger loan losses down the track.
They say the best way to cure a hang over is to keep drinking…