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Mortgage Originators: New Financial Stars
Phil Hanratty
Economics, Commerce and Industrial Relations Group
At last, the traditional lenders in the housing loan market are facing
strong competition from low-priced rivals. Such lending has been dominated
by banks (with smaller contributions from building societies and credit
unions) and has been very profitable for them. Funds have been largely
raised from vast, low-cost household deposits. Strong demand for housing
(based upon widespread aspirations to "own your own castle"
and expectations of capital gains through house price appreciation) and
a quite concentrated, uncompetitive market structure have both put upward
pressure on home loan rates charged. Home lending has also been a safe,
secure activity for these lenders. Loan default rates have been quite
low and house price appreciation minimises the lender's risk of capital
loss after repossession.
High profits attract new competitors if barriers to entry are not insuperably
high. Until recently, it seems that barriers to new residential lenders
have indeed been prohibitively high. New lenders need both a source
of funds at reasonable cost and a way of contacting and engaging house
mortgage borrowers. Traditional lenders rely on both their vast base of
cheap deposits and their extensive branch systems to engage and service
such borrowers. Aspiring rivals have been deterred by the problems and
costs of acquiring such commercial prerequisites.
But new suppliers of home lending have largely overcome these barriers.
The dramatic expansion of mortgage originators in residential lending
(such as Aussie Home Loans, its ally PUMA and RAMS) has attracted much
attention. Their funds have been raised very largely from professional
investors at reasonable cost. The use of extensive advertising and mobile
loan assessment staff, who go to the clients' residence at times to suit
the client, have allowed these new lenders to overcome the marketing advantages
of the branch system. Indeed, the branch system seems to have become something
of a disadvantage for traditional lenders since it entails higher administrative/
overhead costs. Many banks have reduced their branch numbers in recent
years for this very reason. Operating costs for the new mortgage lenders
seem to be much lower, thus allowing them to set their loan interest rates
a notch lower.
The data on interest rates for residential loans highlights these changes.
In April 1996 the average standard indicator interest rate charged by
banks on variable housing loans (where the rate varies as financial conditions
change) was 10.50 % while for the mortgage originators/ managers it was
9.0%. Indeed, this differential of 1.5 percentage points was higher than
the differential in June 1994 of 1.05 percentage points (1). Consequently,
there has been a large flow of borrowers away from the banks. For example,
it is estimated that between June 1994 and December 1995 the banks' share
of new secured housing finance commitments dropped by about 6 percentage
points (from about 91% to about 85%), albeit from a high base (2).
The mortgage originators have enjoyed spectacular growth in their loan
volumes. For example, in the year to June 1995 the number of mortgages
under the management of Aussie Home Loans increased from 356,000 to 1,352,000
(3). After incurring some losses in its initial years of operation, Aussie
Home Loans is now extremely profitable, earning a rate of return on shareholders'
equity of 214% in 1994-95 (4). Similar results are expected for 1995-96.
However, the banks are fighting back with "no frills" cut-price
loan packages and some seem set to launch their own mortgage originator
subsidiaries. Many banks have recently cut their standard variable housing
loan interest rates below 10%.
The mortgage originators/ managers operate using a financial process
called "securitisation". Once loans are made, they are bundled
together into trusts and units (i.e. securities) in those trusts are sold
off, largely to professional investors. Interest payments on the housing
loans are thus converted, after subtraction of operating costs and fees,
into interest payments for the investors. Unlike a bank, the home loans
do not generally stay on the balance sheet of these mortgage providers,
who often continue to manage the mortgages (for a fee). This allows these
providers (in contrast to banks) to specialise in their strength in credit
risk assessment without the direct legal burden of continuing responsibility
for the loans (and the borrowings which finance them). The efficiencies
of this process seem sufficiently large that the majority of home loans
could, at some time in the future, be funded and managed in this way.
This prospect poses a formidable challenge to traditional banking.
Demand for such securities has grown substantially in recent years.
This higher demand has allowed the mortgage originators/ managers to raise
substantial volumes of funds from professional capital markets at a cost
low enough to challenge the traditional housing lenders. A large portion
of such funds has been raised within Australia. This seems to be bound
up with the recent growth in superannuation. The rapid increase in superannuation
fund contributions has, in turn, increased the appetite of superannuation
funds managers for securitised residential loans, especially since the
latter are relatively safe (i.e. low default rates and low risk of capital
loss). This is an unexpected benefit of the development of compulsory
superannuation. As well, some funds have been raised through better access
to overseas capital markets.
The appropriate regulation of the mortgage originators/ managers is
now beginning to be discussed. There are some striking differences in
regulatory burdens between the traditional and new housing loan providers.
For example, Australian banks are required to have shareholder capital
of at least 8% of their (risk weighted) assets; similar requirements are
made of building societies and credit unions. Such regulations tend to
push up loan interest rates; the mortgage originators/ managers are not
subject to them.
This might seem a blatant case of regulatory divergence creating an
"unlevel playing field" between competitors. However, the Reserve
Bank of Australia (RBA) argues that these minimum capital requirements
for banks exist to protect the bank deposits of ordinary Australians who
may know very little about financial risk or what their own bank has been
doing (if very risky loans are made and the borrowers default, then bank
shareholders can bear the costs rather than depositors). Since the mortgage
originators/ managers rely on professional capital markets, where risk
is routinely accepted and risk assessment is sophisticated, the RBA concludes
that it would not be sensible to impose the same regulatory burdens on
these new housing lenders. However, the banks argue for some lightening
of their other regulatory burdens (especially the controls on mergers
and takeovers) in order to achieve "fairer competition". The
recently announced Wallis Financial System Inquiry will be examining such
issues.
Endnotes
- Reserve Bank of Australia Bulletin, May 1996: Table F.4.
- KPMG, Financial Institutions Survey 1996: 7.
- Ibid, 1996: 77.
- Ibid, 1996: 77.
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