When it comes to home loans, Australians have a reputation for being risk takers. This is not because we borrow for irresponsible purposes (everyone does that). Our reputation comes from our strong preference for variable loans.
The Australian Bureau of Statistics housing finance report, shows that in July 2014, fixed loans represented 13.7% of the total market. Our willingness to ride the interest rate roller coaster, has made us stand out when compared to European or American borrowers.
Australians have learned to accept the risk. Borrowers know that if the Reserve Bank makes a change to the official cash rate, then they will see a similar change in their mortgage interest in the not too distant future.
Fixed rate loans have less financial risk. They offer certainty for both the lender and the borrower, who can manage their cash flows with out the risk of interest rates moving against them. Why is it that less than 1 in 8 loans in Australia is fixed.
Here at TFG, we believe the Australian loan market is designed to favour variable loans. It's not a case of taking the risky option, it's a case of taking the cheaper option which offers better flexibility. The banks want us to take variable loans, so they design their offerings in a way to make variable more attractive.
We had a quick look at the loans offered by Bank of America. The most popular loan (according to their website), is a 30 year fixed loan adjustable rates are available on request. A similar look at the Commonwealth Bank of Australia, shows an emphasis on variable loans, with the longest fixed term being 5 years.
While our sample of two banks is hardly extensive, it does show that in Australia it is difficult to fix a loan for more than 5 years, while in America, it is encouraged to fix for the life of the loan. The low volume of fixed loans in Australia is due to the supply side, not the demand side. That is, Australians might go for 30 year fixed loans, but they are simply not available. Does this make our lending market more risky?
We do not believe that banks are gamblers. The banks understand that if rates go up, there is a risk of borrower default, and if rates go down, their cash flows are reduced. The banks have risk management processes in place to deal with these risks.
To reduce the risk of borrowers defaulting during rising interest rates, the banks assess applications with an interest rate buffer. This means if you apply for a loan at 5%, the bank will test your ability to repay the loan at 7% (or whatever margin they use). This is a way of testing the applicants ability to cope with rising interest rates.
When rates fall, the banks receive less interest from existing loans. However they also pay less interest to their funding sources. Banks get their funds from the wholesale market as well as from savings held on deposit with them. They pay interest on savings, and are charged interest by the wholesale market. This is known as the cost of funds.
The gap between this cost of funds, and what they charge for loans, is known as the 'lending margin' to the bank, it's profit. In a variable market, their cash flows will be safe as long as they maintain this lending margin. For example, if the cost of funds goes up 0.2%, they would need to increase their variable rate by 0.2% to maintain lending margin.
Using shorter term funds to finance a book of variable loans, seems to have been a good strategy during the GFC. Australian banks managed to side step the crisis, and have performed very well since that day in August 2007 when the world of credit changed so drastically. If the banks are risk takers, then perhaps the risks have paid off.
Interest rates all over the world fell sharply during the GFC, and in most cases are still at very low levels. The Finance Guy wanted to know how well Australian banks have managed their lending margins since the GFC hit.
For simplicity, we used the RBA cash rate as our cost of funds. We compared this to the standard variable rate charged by banks for loans. Rather than pick on a single bank, we looked at the average standard variable rate of the Big 4 Australian banks.
Our findings are shown in the graph below:
As we can see the gap between the cash rate, and the average variable rate has risen from 1.82% to 3.42% since the GFC. Is this due to increases in other funding costs (not reflected in changes to the cash rate)?
The flexibility of the variable system has enabled Australian banks to grow their margins since the GFC. The real lending margin is not 3.42%. Most borrowers have a discount variable rate, and as we noted, the actual cost of funds, may differ from the RBA cash rate.
The Finance Guy still wanted to know if Australian Banks have performed better or worse than other banks with 'less risky' lending structures. We could have spent hours analyzing 7 years of financials, but this has been done for us, but the stock market. We are happy using historic stock prices as the foot prints for prior financial performance.
In the spirit of keeping it simple, we only looked at two stocks. Bank of America, and Commonwealth Bank of Australia. It seemed fair to use the same two companies we looked at earlier. A quick visit to Yahoo Finance, gave us the chart below:
The price of CBA shares has risen more than 40% since the GFC, while the price of BAC is still at less than half of what it was in 2007. Over the same period, the Dow Jones has risen almost 30%, while the Australian ASX 200 index has fallen approximately 5%
The Finance Guy agrees that fixing loans will reduce interest rate risk. Australia has a lending market which is based on variable rates. The Australians are exposed to changes in interest rates, but it's a system which seems to work for them.
It would be interesting to see what would happen if a 30 year fixed loan were available in Australia. I wonder how many people would want this.