Importantly, he directly addresses the central criticism I recently raised of the commentariat seeking to justify the banks’ lending rate changes exclusively with reference to funding costs. My argument was that if we want to debate the integrity of lending rates, we need to do so in the context of bank profitability, or return on equity. I have no problem with the major banks not passing on RBA cash rate cuts, or boosting rates beyond cash rate increases. Yet in order to credibly justify these decisions one has to do so taking account of all the positive and negative changes to their cost base and revenue opportunities (see my original article here for more detail).
The Deputy Governor arrives at several important conclusions:
* If the major banks had not passed on any of their funding cost increases, profitability would have declined to effectively nothing during the GFC (refer to red line in the chart below). So they were clearly warranted in passing on some of these costs;
* If, on the other hand, they had just passed on all of their costs 1:1, the major banks would have remained very profitable throughout the GFC, albeit at slightly lower levels than the boom-time pre-GFC conditions (see grey line). Since the banks are promising shareholders double-digit long-term returns, investors expect considerable variability in profits over time. As to whether these taxpayer subsidised utilities should have borne much more pain during the GFC in line with most other businesses is a complex question that is hard to objectively address here. All we know is that profitability hardly shifted notwithstanding the dire circumstances;
Source: RBA (click to enlarge)* Margins on home loans are unchanged from pre-crisis days. Margins on business lending have increased significantly. Overall major bank margins are actually 0.20 per cent higher than they were before the crisis. But this is where the margin analysis gets deceptive. The profitability of business lending has been in free-fall during the GFC due to the huge expected losses. The key profit driver for the major banks has been their home loan books, as I explained previously;
* Finally, Battelino delivers the big banks a blunt warning: don’t attempt to hide behind the RBA, as they have repeatedly done in the past, to justify future mortgage rate hikes (cf. Gail Kelly’s application of RBA analysis as a fig-leaf to rationalise Westpac’s much maligned mortgage rate decision). Or, in the Deputy Governor’s surprisingly frank words:
“With the economy and business climate now improving, the economic justification for wider margins on loans is becoming less compelling, so it would be reasonable to assume that, in a competitive banking sector, we should see margins level out soon. Over the past couple of months, there have been some signs that this is starting to occur.”
One of the RBA’s closest confidants, Ross Gittins, also delivers in spades today. Now I am not always a fan of what Gittins' writes. It is normally pretty good, but can sometimes also be a bit dry. Today he offers a very sensible characterisation of our housing market situation. This will not be news to regular readers here, as he recycles many of the things both we and the RBA have belaboured in the past. Yet Gittins’ contribution is significant insofar as it seeks to put a different perspective on the housing cost guff that we often hear from senior media commentators.
Ross could have done better, however. He was loose on the taxation of housing, which is another trap his peers frequently fall into. As I’ve noted before, owner-occupiers pay a massive cost for the CGT exemption: non-deductible mortgage debt, which is different to the tax treatment of debt in every other asset-class. And he could have leveraged off more sophisticated analysis to bolster his arguments.
For example, we recently provided some new data on dwelling price to income ratios that demonstrated that Australian housing costs are materially lower than some would have us believe (see first chart below with stars denoting other estimates that have been bandied around).
Source: RP Data-Rismark (click to enlarge)Another way of thinking about affordability is via default rates. If households are truly stressed, they will start missing mortgage repayments. The next chart below is the RBA’s estimate of our system-wide 90 day mortgage default rate, which they put at around 0.66 per cent. This is nearly one-tenth of the US default rate (5.7 per cent) and one-quarter of UK default rates (2.4 per cent). Notice that Australia has always had a much lower default rate than the US and UK. There are good reasons why, which I have explained before. The bottom line, though, is that only around 33,000 of the circa 5 million borrowers out there are in serious mortgage stress.
Source: RBA (click to enlarge)The final chart below shows some fascinating RBA analysis (prepared by Dr Anthony Richards back in March 2008) of the representative younger household’s disposable income after their mortgage repayments since 1982 assuming a 90 per cent loan-to-value ratio loan and a home in the 30th price percentile. The data ends in June 2007 when the standard variable mortgage rate was 8.05 per cent.
The conclusion here is that households in June 2007 had more cash left-over after servicing all their mortgage costs than at any other point in recorded history. The obvious explanations relate to the rise in multi-income households, the downward shift in nominal mortgage rates from the 17 per cent highs reached at the start of the 1990s, the structural decline in the unemployment rate well below the previous 6-7 per cent estimate of the non-accelerating inflation rate of unemployment (NAIRU), and so on.
But the hard empirical fact remains that younger home owners in 2007 actually had more cash in their hip pockets than ever before notwithstanding the strong growth in real house prices.
Source: RBA (click to enlarge)
