Australian 3Q17 Mortgage Arrears See Seasonal Falls

Australia’s RBMS mortgage arrears fell to 1.02% in 3Q17, a 15bp decrease from the previous quarter; consistent with the nine-year long seasonal trend where 30+ days arrears have eased in the third quarter. Fitch Ratings believes the curing of third-quarter arrears was helped by borrowers using tax return receipts to make repayments.

The 30+ days arrears were 4bp lower than in 3Q16, reflecting Australia’s improved economic environment and lower standard variable interest rates for owner-occupied lending. Unemployment improved by 10bp and real wage growth, although low, was positive. Underemployment has continued to improve, reflecting an increase in available work for underemployed workers.

Prepayment rates remained low during 2017, with the conditional prepayment rate (CPR) staying below 20% for three consecutive quarters; the longest period this rate has remained below 20% since 2011. The CPR increased slightly qoq to 19.6%, from 19.1%, while the Dinkum RMBS Index borrower payment rate increased to 21.6% qoq, from 21.2%.

The gap between investor lending and owner-occupied rates has widened, as authorised deposit-taking institutions respond to regulatory investment and interest-only limits on new loan origination. Historically, investors paid a 25bp-30bp premium over owner-occupied loans, but this widened to 60bp in September 2017.

Losses experienced after the sale of collateral property remained extremely low, with lenders’ mortgage insurance payments and excess spread sufficient to cover principal shortfalls in all transactions during the quarter.

Fitch’s Dinkum RMBS Index tracks arrears and the performance of mortgages underlying Australian residential mortgage-backed securities.

Australia’s Major Banks Face Earnings Pressure in FY18

Fitch Ratings expects Australia’s four major banks to face earnings pressure from higher impairment charges and lower revenue growth in their 2018 financial year, with cost control to remain an important focus. This follows the banks’ solid results for the 2017 financial year, supported by robust net interest margins and strong asset quality.

Australia and New Zealand Banking Group Limited (AA-/Stable), Commonwealth Bank of Australia (AA-/Stable), National Australia Bank Limited (AA-/Stable) and Westpac Banking Corporation (AA-/Stable) reported total statutory net profit after tax of AUD29.6 billion in FYE17 (up 30.3% compared with FYE16, which included National Australia Bank’s one-off losses on the sale and demerger of subsidiaries, or 6.4% higher based on cash net profit after tax).

Net interest margins held up well during the year despite strong competition for both retail deposits and loans. The major banks benefitted from asset repricing in the second half of the year largely in response to the Australian Prudential Regulation Authority’s (APRA) announced additional macro-prudential limits on mortgages in March 2017 (for more details, see Fitch: Further Regulatory Tightening Possible in Australia, dated 31 March 2017). Volume growth held up reasonably well during the year, which supported revenue growth, although this is likely to slow through the next financial year.

All four major banks reported lower impairment charges and a reduction in impaired assets (apart from a small uptick for Commonwealth Bank of Australia) relative to recent years, which also supported operating profits. Fitch expects the current impairment levels to be close to the peak of the asset quality cycle, with impairments likely to increase in FY18. Mortgage arrears have increased modestly from low bases in most markets – Western Australia has had more noticeable deterioration – and we expect this trend to continue in FY18 due in part to continued low wage growth and an increase in interest rates for some types of mortgages. However, interest rates in general are likely to remain low and we do not think unemployment will increase so any increase in mortgage arrears is likely to be modest and manageable.

The banks highlighted an ongoing focus on cost management, efficiency improvements, and investment, including in their IT systems and digital distribution, and regulatory changes in their FY17 results announcements. National Australia Bank especially flagged a significant increase in digital investment of AUD1.5 billion over three years to enhance its technology and customer experience. Rising investments and a focus on cost reduction to improve profitability will be a challenge for the major banks in the coming years. The banks are likely to face pressure on their profitability in the short term, although in the longer term these measures should improve efficiency. Conduct related charges may also have a negative impact on future costs.

Common equity Tier 1 (CET1) ratios are broadly at the regulator’s definition of “unquestionably strong” levels well ahead of the 2020 deadline. The CET1 ratios of National Australia Bank and Commonwealth Bank of Australia lag the other two major banks, but Fitch expects both to get to the minimum levels through internal capital generation, and, in the case of Commonwealth Bank of Australia, the sale of its life insurance business. Fitch is awaiting further clarification from APRA on how the “unquestionably strong” capital levels will be implemented, with the regulator likely to provide details by the end of this calendar year.

US Tax Plan Will Be Revenue Negative, Result in Higher Deficits

United States: Outlook for Public Finances Worsens says Fitch Ratings who expects a version of the tax cuts presented in the Tax Cuts and Jobs Act to pass the US Congress.

Such reform would deliver a modest and temporary spur to growth, already reflected in growth forecasts of 2.5% for 2018. However, it will lead to wider fiscal deficits and add significantly to US government debt. As such, Fitch has revised up its medium-term debt forecast.

US federal debt was 77% of GDP for this fiscal year. Fitch believes the tax package will be revenue negative, even under generous assumptions about its growth impact. Under a realistic scenario of tax cuts and macro conditions, the federal deficit will reach 4% of GDP by next year, and the US debt/GDP ratio would rise to 120% of GDP by 2027.

The Republican tax plan delivers a tax cut on corporations, seeking to lower the corporate tax rate to 20% from 35%, and removing many exemptions, while eliminating some tax breaks affecting corporate and personal filers. It would leave the overall personal tax burden somewhat lower, although the effects would differ depending on circumstances.

Tax cuts may lead to a short-lived boost to output, but Fitch believes that they will not pay for themselves or lead to a permanently higher growth rate. The cost of capital is already low and corporate profits are elevated. In addition, the effective tax rate paid by large corporations is well below the existing statutory rate. From a macroeconomic perspective, adding to demand at this point in the economic cycle could add to inflationary pressures and lead to additional monetary policy tightening.

Fitch expects US economic growth to peak at 2.5% in 2018 before falling back to 2.2% in 2019. The US will enter the next downturn with a general government “structural deficit” (subtracting the impact of the economic cycle) larger than any other ‘AAA’ sovereign, leaving the US more exposed to a downturn than other similarly rated sovereigns.

The US is the most indebted ‘AAA’ country and it is running the loosest fiscal stance. Long-term debt dynamics are also more negative than those of peers, with health and social security spending commitments set to rise over the next decade. In Fitch’s view, these weaknesses are outweighed by financing flexibility and the US dollar’s reserve currency status, underpinning its ‘AAA’/Stable rating. The main short-term risk to the rating would be a failure to raise the debt ceiling by 1Q18, when the Treasury’s scope for extraordinary measures is expected to be exhausted. The debt ceiling is currently suspended until early December.

China, QE and Housing Key Australian Investor Concerns

A China downturn has moved back into the top spot of Australian credit markets risks over the next 12 months, according to Fitch Ratings‘ 4Q17 fixed-income investor survey, with 42% of respondents ranking a hard landing as a high risk, up from 25% in 2Q17. China replaces a domestic housing market downturn as the top risk, which has dropped to third, while the prospect of quantitative easing (QE) withdrawal has moved into second place.

More investors (43%) expect fundamental credit conditions to deteriorate for financials, rather than improve (16%). Property market exposure is still considered the main threat to bank asset quality, although risks were broadly considered to be rising. Most investors also expect bank lending conditions to tighten over the next year.

However, investors are decidedly more upbeat about the economic outlook. More than 80% believe unemployment will not rise above 6% over the next two years and 37% expect house prices to rise over the next three years, up from 23% in our 2Q17 survey. Consistent with this improving outlook, not one investor anticipates interest rates being cut over the next 12 months.

Our 4Q17 survey shows a continued rise in investors expecting cash to be used for capex by Australian corporates; 67% see this as a significant or moderate use of cash, up from 45% in 2Q17 and 33% in 4Q16. However, shareholder oriented activities remain as the most likely use of cash, consistent with the finding of all eight surveys undertaken over the previous four years.

Australian fixed-income investors believe debt issuance is likely to increase over the next 12 months, and structured finance remains the favoured asset class, with 67% expecting issuance to increase, up from 58% in our 2Q17 survey.

A new question introduced in our 4Q17 survey asked investors about the effect of environmental, social and governance risks on their investments. A 60% majority expect an increased financial impact.

The 4Q17 survey was undertaken in partnership with KangaNews – a specialist publishing house that provides commentary on fixed-income markets in Australia and New Zealand. Findings represent the views of managers of more than AUD500 billion of fixed-income assets, accounting for over three-quarters of Australia’s domestic real-money market.

Fitch’s 4Q17 fixed-income investor survey was conducted between 28 August and 11 September 2017. This survey is unique in the Australian context, reflecting the partners’ strong ties with the local investor community.

Australian 2Q17 Mortgage Arrears Remain Stable

Australia’s mortgage arrears remained stable in 2Q17, with a 4bp decrease to 1.17% from the previous quarter, reflecting Fitch Ratings‘ expected seasonal recovery from Christmas and holiday spending.

The 30+ days arrears were 3bp higher from 2Q16, despite Australia’s improved economic environment and lower standard variable interest rates for owner occupied lending.

Unemployment improved by 20bp and real wage growth was low, but positive. Underemployment also improved by 20bp, reflecting a proportional increase of full-time employment during the quarter.

Repayment rates have decreased as borrowers recover from Christmas and holiday spending. The Dinkum RMBS Index borrower payment rate fell to 21.2% at end-2Q17, from 21.9% in the previous quarter. The conditional prepayment rate also dropped qoq to 19.1%, from 19.8%.

Losses experienced after the sale of collateral property remained extremely low, with lenders’ mortgage insurance payments and/or excess spread sufficient to cover principal shortfalls in all transactions during the quarter.

Fitch’s Dinkum RMBS Index tracks arrears and performance of mortgages underlying Australian residential mortgage-backed securities.

U.S. Home Prices Climb to Pre-Crisis Levels

Home prices in the United States have now climbed to levels last seen a decade ago, though unlike 10 years prior, much of the country’s growth is now sustainable, according to Fitch Ratings in its latest quarterly U.S. RMBS sustainable home price report.

Home prices grew at nearly a 5% annualized rate last quarter and are 36% higher nationally since reaching their low in 2012. As a result they are now slightly above peak levels reached in 2006 – 2007. The difference this time around compared to a decade ago rests with several other notable factors aside from the much talked about low mortgage rates and falling unemployment.

“The U.S. population has increased by more than 30 million people and personal income per capita has increased by more than 30% since 2006,” said Managing Director Grant Bailey. “Both the significantly higher population and income levels provide much greater support for the price levels today.”

That said, growth remains somewhat disjointed in some regions of the US. “Prices in major metro areas of Texas are now more than 50% higher than they were in 2006, while prices in New York, Philadelphia and Washington DC are still 4% – 10% below 2006 levels,” said Bailey. “Elsewhere, home prices in major cities throughout Florida remain more than 15% below 2006 levels.”

The overheated home price pockets remain largely in the Western United States (Texas, Portland, Phoenix and Las Vegas), which Fitch lists at more than 10% overvalued.

Genworth Under Ratings Agency Scrutiny

Genworth, the listed Lenders Mortgage Insurer updated the ASX yesterday of the results of the outcomes of recent rating agency reviews. The ratings agencies appear somewhat split on how to assess the risks in the sector.

Fitch ratings affirmed the A+ IFSR and maintained the outlook at stable – saying Genworth had a robust standalone credit profile, solid operating performance, strong capital ratios and conservative investment approach. They noted a generally stable operating environment which continues to support the performance of the insurance portfolio.

Standard & Poor’s rating affirmed the A+ IFSR and maintained the outlook at negative noting standalone credit profile, business risk profile and strong capital and earnings position. “Claims paying resources, which include conservatively invested capital, claims reserves and external reinsurance are supportive of the company’s ability to absorb a significant level of claims if Australia were to experience a severe extended economic downturn”.

Moody’s has however revised its unsolicited IFSR on GFM1 from A3 with a negative outlook to Baa1 with stable outlook. This follows Moody’s wider rating action on financial institutions in June 2017 to reflect its view that “risks in the Australian housing market have risen, heightening the financial sector’s sensitivity to adverse shocks”.

So, you “pays your money and takes your choice!”

Mortgage Arrears Rise – Fitch

Fitch Ratings says Australia’s mortgage arrears increased by 12bp qoq to 1.21% at end-1Q17, due to seasonal Christmas/holiday spending and possible difficulties faced by consumers because of low real-wage growth. The qoq increase in arrears from 4Q16 to 1Q17 was less than 1Q16 (16bp qoq to 1.10%).

The 30+ days arrears in 1Q17 were 11bp higher yoy, despite an improved economic environment and lower standard variable interest rates. Unemployment increased slightly by 2bp and real wage growth was low, but positive. Underemployment has been growing despite relatively stable unemployment.

Fitch Ratings expects arrears to fall in 2Q17 and 3Q17 after the holiday season due to the current low interest rate environment and decreasing unemployment.

Fitch-rated residential mortgage-backed securities transactions have continued to experience extremely low levels of realised losses since closing and an increasing lenders’ mortgage insurance (LMI) payment ratio since 4Q12. Excess spread was sufficient to cover principal shortfalls during 1Q17

New Capital Requirements Will Strengthen Australian Banks – Fitch

The new higher target set for Australian banks’ common equity Tier 1 (CET1) ratios will support their credit profiles and bolster the banking system’s resilience to downturns, says Fitch Ratings. The four major banks should all be able to meet the requirements comfortably through internal capital generation and existing dividend re-investment programmes.

The Australian Prudential Regulation Authority (APRA) has increased the minimum CET1 ratio from 8% to 9.5% for the major banks – ANZ, CBA, NAB and Westpac – and has given them until January 2020 at the latest to meet the new targets. The capital requirements have been raised in response to the recommendation by a 2014 financial system inquiry (FSI) that Australian banks’ capital ratios should be “unquestionably strong”. The decision to focus on CET1 and take a long-term, through-the-cycle approach, rather than tying capital ratios to the top quartile of international banks, was in line with our expectations.

The major banks already have CET1 ratios that are 150bp-200bp above the current minimum in anticipation of the changes. This capital surplus is likely to fall to a more normal 100bp as the new standards are implemented, which implies CET1 ratios will rise to at least 10.5%, from an average of around 9.5% at end-2016.

It is possible that the major banks will issue fresh equity if they see a benefit in raising the extra capital ahead of schedule. There is also a chance that lending rates could be increased to offset the cost of holding more capital. However, the new capital requirements are unlikely to create significant pressures for any of the four major banks, with APRA estimating that the additional capital could be raised by the deadline without any changes in business growth plans or dividend policies.

The minimum CET1 ratio for smaller banks using standardised models is set to rise by about 50bp, but most already run surpluses above the current requirement and are unlikely to need additional capital.

APRA had hoped that the FSI recommendation could be addressed together with revisions to the risk-weighting framework that are currently being debated by the Basel committee. The new international framework is likely to raise internal-ratings based risk weights for investor mortgages and mortgages with high loan-to-value ratios. This change would further add to Australian banks’ capital needs, but strengthened capital requirements for mortgage lending are already part of APRA’s future regulatory plans to ensure banks are unquestionably strong – and it expects any further capital requirements to be met “in an orderly fashion”.

The paper that APRA released to announce the new minimum capital ratios also noted that capital is just one aspect of creating an unquestionably strong banking system, with liquidity, funding, governance, culture, risk management and asset quality also important. APRA reiterated that its supervisory philosophy will continue to assess all of these factors – as well as the operating environment – when assessing bank risk profiles. It also highlighted improvements since the 2008 global financial crisis in some of these areas, such as liquidity and funding.

Risk Mounts for Canada Housing, but Don’t Expect U.S. Crisis Redux

Unsustainable home prices and record high household leverage render the Toronto and Vancouver housing markets increasingly vulnerable to a steep price correction, though key structural features will safeguard Canada from repeating the U.S. housing crisis, according to Fitch Ratings in a new report.

Home prices in Toronto and Vancouver are up 45% and 36%, respectively, since January 2015 through May of this year. Additionally, household debt to disposable income remains elevated at 167% in 1Q17, the highest amongst G7 sovereigns.

Mortgage-market reforms are also increasing the focus on a private label RMBS market in Canada. This will inevitably draw comparisons by some in the market to the U.S. RMBS market and the influential role it played in the U.S. housing crisis a decade ago. “However, Canada is unlikely to mirror the declines and fallout experienced during the U.S. housing crisis due to major differences in the housing and mortgage finance systems,” said Fitch Director Kate Lin.

“Canadian banks are subject to rigorous oversight and regulations requiring prudent mortgage lending and underwriting standards,” added Lin. “What’s more, credit quality for Canadian mortgage loans remains strong unlike the drift towards weak borrower and loan quality that we saw a decade ago in the U.S.” Further, nonprime credit quality originations in Canada are low, making up approximately 10% of volume compared to 50% in the U.S. during the peak. The Canadian government has also been proactive in managing the risk of the nation’s housing market by taking unprecedented steps to tighten credit and limit speculation.