The last post looked at the increasing margins on Australian mortgages and small business loans. On the way is another post that tries to estimate how much the banks’ own margins have been increasing. Interesting though that may be, the real problem with Australian mortgages has nothing to do with whether bank margins are or are not going up. The problem is the product itself. This post explains why.
There was an article in the the Sydney Morning Herald today which explored exactly this issue, pointing out that Australia’s “standard variable rate” mortgage, which is the most common type of mortgage in Australia, is quite an unusual type of mortgage by international standards.
Banks tend to talk about “standard variable rate” mortgages, but a better term used in the industry is “discretionary variable rate”. The problem with Australian mortgages is encapsulated in that word “discretionary”. I can clearly remember almost 15 years ago trying to explain to European and US investors who were considering buying Australian mortgage-backed securities how a discretionary variable rate mortgage worked. The conversations went something like this:
INVESTOR: So, the bank can change the interest rate whenever they like to whatever they like?
INVESTOR: Why would anyone ever accept a mortgage under those terms?
ME: Well, it’s the standard product, so people are used to it and in practice the banks tend to just change the interest rates in line with the Reserve Bank cash rate.
INVESTOR: But they don’t have to do that?
Why were these investors so surprised by these sorts of mortgages? It’s certainly true that in many other countries, such as the US and France, the most common type of mortgages have fixed rates, but variable rate mortgages are found all over the world too. The difference is that most of these variable rate mortgages are pegged to some kind of indicator rate that the lender cannot control. Sometimes referred to as “tracker rates”, these mortgages would specify a fixed margin (say 2%) over a benchmark rate. This benchmark may be a central bank cash rate or some other kind of short-term market rate, but the important point is from then on that margin can never change. In contrast, with Australian mortgages, variable rates move up and down with market interest rates, but banks can also tweak the margin over market rates whenever they see fit.
Last year Westpac was pilloried when it tried to use the analogy of a banana smoothie to explain why mortgage rates were rising. It may not have worked for Westpac, but the analogy can help to highlight how strange discretionary variable rate mortgages are. Imagine that the cost of bananas goes up due to a cyclone-induced banana shortage. It may well be that the price of banana smoothies goes up (although it may also be that café owners take a portfolio view of their business, value their customers and absorb a bit of margin compression on their smoothies, but that’s another story). What certainly does not happen is that café owners go around to everyone who has bought a smoothie in the last year, explain to them that bananas are now more expensive and demand that their customer pays a bit more now for last year’s smoothie.
That is essentially what happens with discretionary rate mortgages. You might have taken out a mortgage a few months ago after doing extensive research comparing interest rates and deciding that the best value mortgage you could find was from the Commonwealth Bank as it was 0.1% cheaper than the next best offer (this may or may not have actually been the case). So far Commonwealth Bank is the only bank to have hiked their mortgage rate by 0.2% more than the Reserve Bank and now your “cheap” mortgage is 0.1% more expensive than the bank you turned down. So much for shopping around! Banks may argue that you are free to change to another bank if you are unhappy (although you can expect exit fees, particularly if you received any kind of rate or fee reduction when you first took on the loan). This does not change the fact that it is a rather unusual product that allows the seller to increase their margins after they have done the deal.
This hypothetical example highlights one of the real problems with the discretionary variable rate mortgage. It is inherently anti-competitive. There is little point shopping around for the cheapest mortgage when after next week it may not be the cheapest any more and you are locked in for 25 years. Is it any wonder that most people shrug their shoulders, say that the banks are all as bad as each other, hold their noses and just pick one almost at random?
There is another problem with discretionary variable rate mortgages, as one Mule reader pointed out in an email. It has the surprising effect of creating some credit risk for the borrower. Normally, depositors are exposed to the risk that the bank will fail, while banks are exposed to the risk that the borrower will fail. But, if you take out a discretionary variable rate mortgages, you may end up paying more if the credit quality of the lender deteriorates. The Herald article gave this hypothetical scenario:
Suppose one of our banks got downgraded from a AA to B. What would happen at the moment is they would just increase the margin on their mortgage rates to cover the extra costs they would face, whereas that risk should fall on the management and the shareholders.
But this sort of thing actually has happened! Many of the non-bank lenders like RAMS got into trouble during the global financial crisis and found funding through securitisation difficult, if not downright impossible. Some collapsed or turned to banks for support, but all of them suffered fast rising costs. Many borrowers who took out mortgages with these lenders saw their interest rates go up as a result. Some were able to refinance their mortgages with another lender, but those struggling the most to pay the higher interest rates would also be the ones least able to get refinancing approved.
In my view, abolishing discretionary variable rate mortgages, though unlikely to happen, would be a good thing for the Australian market. There’s certainly no guarantee that margins would drop. But it would change the stakes for banks considering raising rates to preserve their margins. Rather than being able simply to recoup that margin from their existing mortgage book, they would have to seriously consider the impact the move would have on new business, because it would only be new loans that would be paying the higher margins.