Heightened competition among home lenders has prompted the banking regulator to issue a reminder of what constitutes prudent lending, but its suggestion that loans being generated by mortgage brokers should come in for scrutiny has not gone down well in some quarters.
The Australian Prudential Regulation Authority (APRA) released a draft prudential practice guide on residential mortgage lending in May, with retiring chairman John Laker saying that “in this environment, APRA is seeing increasing evidence of lending with higher risk characteristics and it does not want this trend to continue”.
Residential mortgages constitute the largest credit exposure in the Australian banking system and APRA has made it clear it wants to ensure prudential lending standards are maintained.
Lending standards apply to the loan origination process, the risk appraisal of the borrower and to the style of mortgage product – including standard mortgage loans, reverse mortgages, home equity lines of credit and interest-only loans. APRA’s draft – which is still the subject of consultation – also provides guidance on hardship loans, “stress-testing” of loan exposures and on mortgage insurance.
The draft has triggered controversy among mortgage brokers, however, because the guidelines encourage banks to scrutinise loans that are originated by brokers. The Mortgage and Finance Association of Australia has questioned whether broker-originated loans are more risky than bank-originated ones.
Mortgage brokers generally assess the financial situation of borrowers, recommend mortgage loan products and lenders, and then manage the application process. It is common in Australia for banks to pay mortgage brokers upfront or ongoing fees for this “origination” of a loan.
Their remuneration is generally tied to the loan amount and is payable by the bank to the broker either upfront or over time. As a result, there could be an incentive for brokers to advise consumers to borrow a higher amount than they might need. Another common practice is for borrowers to be directed to interest-only loans, to be used in combination with a mortgage offset account.
As well as new loans, brokers also help consumers refinance existing mortgages often to purchase additional property. In this process, houses are revalued and consumers can take the opportunity to reduce their equity in a property – in effect, withdrawing cash.
Lenders are happy to originate loans at loan-to-value ratios of 80%, which implies equity funding of 20%. The risk of a mortgage loan decreases over time as the borrower builds up equity. Interest-only loans and loans made with the intention to cash out equity maintain the risk to the lending bank at a high level.
The recent global financial crisis has shown that real estate values and home loan defaults are closely related. Economic downturns can trigger house price devaluations and cause mortgage defaults.
Australian house prices have grown by double-digit percentages in recent years, and some people argue the property market is ripe for a correction. Some home owners would face negative equity if double-digit decreases were to occur and could have incentives to default on their loans. Such a scenario was realised in the US during the GFC, when there was a dramatic increase in default rates.
But the interests of brokers and banks are not necessarily aligned when it comes to the consideration of borrower risk. A broker may have a low incentive to consider risk if they are paid regardless of what happens to the loan in the future.
APRA says that “experience has shown that commissions paid upfront tend to encourage less rigorous attention to loan application quality”. Trailing commissions, which are paid over time, are on the other hand more likely to provide incentives for brokers to retain and monitor customers, it says.
APRA wants to encourage banks to link broker remuneration to mortgage delinquency risk.
There is limited academic research on the issue of whether broker-originated loans are more risky, partly because of the difficulty of accessing this information.
The research that is available does confirm that broker-originated loans are more risky, but it also shows that about three-quarters of this additional risk can be explained by observable information such as higher loan to valuation ratios or lower credit scores.
In response, banks could charge higher risk borrowers an increased mortgage rate, or alternatively, reduce the remuneration it is prepared to pay the broker originating the higher risk loan.
This research is important because it highlights the need for a bank to include this sort of information on risk into its pricing, provisioning, capital and stress-testing calculations – something APRA aims to encourage with its guidance note. It is reasonable to include this cost differential in mortgage pricing and/or broker remuneration.
The current APRA initiative supports the resilience of the Australian financial system and are in line with actions by regulators in other countries, including the US. But more needs to be done.
Australian banks are exposed to mortgages to a larger degree than their international counterparts, with a high allocation to these loans versus other banking products. This means an economic shock affecting property prices or borrowers’ ability to repay could cause tremors in Australia’s financial system. We need to think of creative ways to limit the exposure of Australian lenders to mortgages.
This could occur, for example, by encouraging the internationalisation or diversification of bank assets, something that could be supported by further development of financial market instruments such as covered bonds, derivatives, insurance policies and asset securitisation.