Australian nonbanks take glass half full outlook
Attention in 2022 has turned to the undeniable challenges the credit market is facing – perhaps most notably higher rates and cost of living, and pressure on the funding side. But Australia’s leading nonbank lenders – speaking at a roundtable discussion hosted by KangaNews and Natixis – say the new environment carries opportunities for growth.
Davison Funding and lending conditions have undoubtedly been challenging in 2022 – but this is not entirely unexpected. There were widespread predictions that the cash rate would start to rise this year, for instance. At the same time, a lot of Australian nonbank lenders have dealt with difficult markets on many previous occasions. How did lenders prepare for a more challenging environment and how did past experience help?
ZILELI On the funding side, we did our private warehouse work early and this enabled us to lock in favourable pricing. We run three-year warehouses, which means our maturities are carefully managed. We are able to sit out of the capital market and be selective in choosing funding windows.
We have also established and expanded our hedging strategies to protect against the risk of materially higher rates. In general on rates direction, we are in ongoing dialogue with our product teams about the developing outlook and the impact higher rates could have on profitability. This means the business is prepared for coming change and ready to adjust product offerings to reflect the new environment.
AUSTIN Our balance sheet funding is well positioned as we fund long and adhere to limits around short-tenor funding. At the same time, we are not seeing any early signs of stress in the loan book and we don’t expect to until the cash rate exceeds roughly 2.5-3 per cent – this being the level of service buffer stress testing for loans settled during 2020 and 2021. Since 2021, we have been originating and testing loans with a 3 per cent payment buffer – and another 3 per cent of rate hikes from here seems unlikely.
Mortgages originated in 2020 and 2021 are our focus as they will be the first vintage of loans to reach the level of buffer where they were stress tested. So far, arrears conditions have remained benign.
BARRY First-home borrowers may be under pressure, specifically those with generally higher loan-to-value ratio (LVR) loans originated in the second half of 2020 and 2021. We may see some emerging pressure, but I agree that we haven’t seen any yet.
SCANLON None of us were writing loans in 2020 or 2021 in the expectation that the conditions of the time would be with us forever. What is surprising, though, is the pace at which rate increases have come through. Exceptional circumstances in the last few years have led to exceptional market conditions, and we have all had the opportunity to write very good business for a decent period of time.
We lend to small business clients on the mortgage side and we are at the pointier end of the risk profile, so we have been paying particularly close attention to interest rates and rate increases for some time now. We did not experience much change in arrears from the first few interest-rate hikes, but the most recent [in August] has increased arrears slightly – to around 1.3 per cent from 1 per cent.
AUSTIN There is a very big difference in the level of advanced redraw positions in the loan book between loans with LVRs above and below 80 per cent. We have to acknowledge that the higher the LVR, the higher the risk.
RIEDEL We are very discerning risk managers who originate new credit based on specific criteria, which are fundamentally a function of the medium-term outlook for the economy. This drives our credit appetite and borrower performance.
Rates are increasing. But it is important to remember that we are also in an environment in which rates are still at a historically low long-term average, employment is strong, and wages and rental income are increasing.
It is easy to get swept up in the negative conversation about how bad things are, especially in the increasing expense side of the consumer’s profit and loss account. Of course, being mindful of the higher expense burden is important. But, on the other side of the ledger, incomes are rising.
Our position is like Firstmac’s in that a small number of customer cohorts will need support – but only if they stop earning income. Even this is not our base case, though. Our view is that, notwithstanding some potential short-term borrower hardship, the environment is largely positive – economically and for credit growth.
From the asset side of our portfolios, I am hopeful we are all making very sensible risk decisions to ensure we maintain balanced portfolios for the benefit of our businesses, our shareholders and our debt investors.
Davison Is the suggestion here that even if we do start to see these specific areas of stress it should not be assumed that the dominoes are about to fall – in other words, that issues will be contained rather than systemic?
RIEDEL It is easy to get swept up with all the negativity. Property prices may fall by, say, 15 per cent but this in the context of having increased by 30 per cent in the last two years.
It is true that borrowers will need to adapt to higher repayment requirements over the period ahead. But they are paying down their loans at a faster rate than required and holding cash balances in offset accounts at greater levels than ever before. The resilience of the Australian consumer is stronger now than it has ever been.
BARRY It is important to note that the Reserve Bank of Australia (RBA) echoes these comments. It has stated that the savings buffers that have been built up over the last two years and the A$260 billion (US$176.4 billion) of term deposits mean most borrowers will be fine, especially with unemployment at record lows.
O’BRIEN It is also important to highlight the changes in credit processes Australian nonbanks have put in place since 2016. From wherever the pockets of pain might come, the market is in good shape to meet them.
GUESDE I very much agree with the framing of a positive environment for Australia. I keep reading about how concerned Australians are but if we compare Australia with the rest of the world, arrears are super low – and falling – while vacancy rates are at levels much lower than we see elsewhere. Yes, there is inflation – but even this is not as high as in Europe or the US. Australia is definitely one of the winners.
It is not as if rates will go up forever – this is a temporary measure. It has been shown that the fall in real estate prices cannot be sustained, which is another important message to convey.
My perspective is that Australians tend to err on the side of pessimism perhaps because they are some distance from the rest of the world. This is understandable: one always assumes the worst from the inside. But my feeling is that there is no cause to be overly worried.
MOIR There are strengths evident in the Australian economy that we tend to forget about. These include the high savings ratio, the record low level of unemployment and the fact that job vacancies outweigh the number of people unemployed, and the low percentage of disposable income going to mortgage interest payments.
A key message I have been giving is that we are transitioning to a more normal market environment from what has been an exceptional period since 2020.
O’BRIEN It is worth noting that lenders have historically been very patient and willing to consider case-by-case arrangements with borrowers. A good example came during the height of the pandemic, when banks and nonbanks, with the support of the government, came together to develop an industry solution. It is in everyone’s benefit to work together with borrowers to find the most appropriate outcome.
MARSDEN It is heartening to hear the realistic positivity of the discussion so far. I agree that the operating environment – for our sector and for the banks, and more broadly for consumer credit portfolios – is relatively conducive.
There are elements of scaremongering by the mainstream media, which plays into a unique aspect of Australian culture. When it comes to personal finances and the economic outlook, we like to follow a pessimistic route – and there is a recessionary sentiment out there at the moment. But the core macro drivers of portfolio performance remain very strong.
As far as the Resimac portfolio is concerned, we have a fair degree of resilience across the book. Our prime and nonconforming payment buffers are at all-time highs.
Looking back at the historic performance of mortgage books and at consumer credit, what drives adverse performance is more correlated to the labour market and unemployment, and the point of the business cycle itself.
At this point there are headwinds in certain segments of the market and we still have some legacy concerns from lockdowns, in the tourism and hospitality sectors. But we only have a small exposure to the construction industry. The bulk of our onshore book is in good shape.
ZILELI We have to acknowledge that it is still early in the cycle and the impact of higher rates is only just starting to feed through. But what we have seen so far is consistent with credit quality remaining strong. The key risk to the quality of the book, and the potential source of significant stress for loan performance, continues to be unemployment.
No rush to sector consolidation
Difficult business conditions often produce consolidation as the more robust players gobble up struggling competitors. While the KangaNews-Natixis roundtable brought together most of Australia’s largest nonbanks, the focus is more on growing the funding base than outright acquisition.
ZILELI This is our expectation. We have been active in acquiring Symple Loans last year and with our proposed acquisition of the humm consumer book. We anticipate further consolidation and rationalisation as capital demands greater return in a rising interest rate market.
BARRY The issue with consolidation for some in the sector is the funding model. By combining businesses there is a risk of losing aggregate funding capacity – because there is a finite single-name limit to any nonbank’s capacity to fund. This is a barrier to some potential consolidation. Also, fundamentally if a nonbank lender retains access to funding markets it is certainly possible that it will not need to consolidate to grow.
The whole-loan market has been talked about for many years. There have been a few portfolio sales but this has never been a very active space in Australia compared with other jurisdictions.
MORTGAGE BORROWER TYPES
O’Brien It has been suggested that the most likely component of lending books to come under pressure is borrowers who came into the market in 2020-21 when rates were low but who have not yet built up much equity. Does this suggest investor lending should be in a stronger state?
SPENCER We engage in a lot of investor lending owing to the yield pickup it offers. All our loans come directly from our website – in other words, we don’t use brokers. We find that most of our lending is to people who are simply seeking a better investment than the volatility of shares or a fixed deposit rate.
If Australia’s history is any guide, a piece of prime real estate is likely to increase in value over time. I don’t see a recession coming. It might be close, but the reality is it is unlikely given there is so much cash sloshing around the globe.
MARSDEN I think it would be accurate to say that most or even all the lenders around this table that have investor loan portfolios will have seen them outperform versus owneroccupier. This is certainly Resimac’s experience.
When we discuss the characteristics of the residential property investor market with offshore investors, we explain that it is a cultural feature of wealth management and creation. Direct investment in property is one of the only avenues for tax structuring that a salaried person can undertake, which makes it a unique feature of the Australian market.
We generally find that the majority of residential investors, at least in our case, are not in the habit of flipping properties for short-term speculative objectives. There is some turnover in this segment but most investors are looking for longer-term performance.
AUSTIN Over the past three decades there has not been a single period in which owner-occupiers have outperformed investors when it comes to delinquencies. This raises the obvious question of why the rating agencies penalise investor loans. I can only assume this is based on US experience.
Davison As rates and cost of living increase, it makes sense that discretionary spending is the first to disappear. Is Latitude Financial Services starting to see this coming through?
ZILELI We still have not seen this in volume, although I agree that one might expect discretionary spend to be falling. Equally, one of our value propositions is interest-free credit and this type of environment is where one might expect these products to come into their own – but we are not seeing this yet, either.
Spending is in a business-as-usual setting at present, in the sense that it is similar to last year but with a repayment dynamic that is very different now from the pre-pandemic era. The repayment rate shot up in 2020 as borrowers started paying back their loans at a faster rate than ever before.
This goes back to the amount of liquidity households have after 2020 and the higher buffers consumers have built up in their deposits and savings. This is often discussed in the context of mortgages, but from a consumer-spend standpoint it also means borrowers typically have more cash available to pay down credit card bills or personal loans more quickly.
On the funding side, coming into each year we can never be sure how accommodative markets will be so we pursue a risk-based funding approach. This led us to refinance all our warehouse maturities due in 2022 earlier this year. It means we have warehouse capacity if market conditions sour – and we expect greater competition on the funding side, because of market conditions.
Davison Are other lenders seeing signs that households are starting to rein in spending? In other words, is there less demand for nonmortgage credit?
BARRY High-frequency credit card data from CBA [Commonwealth Bank of Australia] show consumer spending is already adjusting. Discretionary spending is down and is expected to continue to decline in the months ahead.
AUSTIN We have not seen any early indications of stress, while at the same time we are seeing rising consumer auto volume. We cannot rule out the possibility that this is because smaller lenders are encountering funding constraints and pulling back. Even so, right now, one would not know we are in a period of rate rises – and this is why I mention the neutral rate. I don’t think we are near this level yet.
RIEDEL We support customers with auto and personal loans, and the theme is consistent whatever the nature of the loan or product. Customers are prepaying their loans at a faster rate than ever before, including shortening loan life because they are using deposits to pay down debt.
We expect credit growth to slow in response to the current uncertain economic environment and short-term outlook. Across our portfolios, though, borrowers are feeling positive about the medium-term outlook and progressing with their life ambitions undeterred.
MOIR Electric vehicle lending is a big focus for us, and this has been very quiet for a specific reason: supply issues.
BARRY We are experiencing a good volume of origination even though system growth is decreasing. Everyone has tightened credit around the edges, in the buffers and the smaller points within credit policy – which is a prudent move at this point of the cycle.
ZILELI Despite acknowledging the challenges that exist, we have not wound back our growth aspirations. We are still seeking to advance our market share across all our products.
We continue to enhance the customer experience with a focus on technology to streamline originations to compete with the banks. Take our personal loans business as an example: we have integrated the Symple platform we acquired last year, and this has enabled us to offer variable rate personal loans – which are new to Latitude. We are very much still focused on progression and growth.
O’Brien The observation that borrowers are prepaying their loans more quickly – and that this has continued even as we emerge from the pandemic – seems significant. Does it suggest that borrowers are using nonbanks differently nowadays, and that this is coming through in conditional prepayment rates (CPRs)?
GUESDE I find it surprising that there are very high CPRs for the nonbanks – probably higher than we have ever seen – and at the same time CPRs are down for banks. It is an interesting dynamic, which we believe demonstrates significant market evolution. It suggests borrowers are using and valuing nonbanks for what they can provide in quality of service and speed to market.
There is strong competition through very high levels of sales promotions, particularly through brokers. This means borrowers can choose the right lender for their situation and then, eventually, refinance.
RIEDEL I have a perspective on CPRs and how the refinancing market may evolve into the next period. First, the banks were handed free money and they heavily incentivised borrowers to refinance via unprecedented short-term fixed-rate loan offers of 1.6-1.9 per cent. Many borrowers moved from nonbank portfolios as they sought cheaper rates.
Consequently, over the next 24 months approximately A$630 billion of short-term fixed-rate loans will expire and will need to be refinanced. This equates to about one-third of the mortgage market. It will be a fascinating period and should be an opportunity for us all as fixed rates are now higher than variable.
The headwind, of course, is price-led competition from the banks. This will likely be the case more than ever because the banks are exiting nonmortgage books and as such will seek to protect their position in the mortgage space.
The tailwind is that about a third of borrowers will have to consider the future of their fixed-rate loans in the next 12 months. Such a significant proportion of Australians having to refinance in such a short period has not happened before.
Our competitive advantage as a group is speed to market with delivery of a customer service proposition that far outperforms the banks. In this context, the nonbanks ought to be beneficiaries in the next 24 months – whereas in the past 24 months it was the banks that benefited because nonbanks could not compete with fixed-rate offers.
SPENCER The mainstream media is putting a massive amount of pressure on borrowers in the home loan market, with the result that borrowers believe they need to act now. The dominoes fall from there. The driver nowadays is always where rates are now and for how long they can be locked in.
I completely agree that the scale of refinancing opportunities in the next two years is incredible, if one is able to be competitive and if technology can be applied quickly. Not all lenders have these capabilities, but the principle is that they must be swift if they are to get borrowers in their clutches.
“We have not seen any early indications of stress, while at the same time we are seeing rising consumer auto volume. We cannot rule out the possibility that this is because smaller lenders are encountering funding constraints and pulling back. Even so, right now, one would not know we are in a period of rate rises.”
Davison Is the suggestion here that the old norm, where many borrowers would take out a mortgage and more or less forget about it until they move house, is going to dissipate significantly?
SPENCER Yes – although what most articles do not say is that changing lender is not that simple and can be costly. It is certainly true that refinancing is quite clearly becoming an industry in itself.
Davison Would it be fair to say that the overall willingness to change lender has been increased by the number of borrowers that fixed their rate for the first time in the last 2-3 years, as doing so often brought them into contact with a broker – possibly for the first time?
SPENCER Many of these people would have taken out loans in their twenties and are now in their forties, with a more mature outlook and approach. This maturity is affecting what they are looking for and I think this is what will bring about the biggest change. But we should also not forget what is clearly the biggest driver: that rates were less than 2 per cent, are now 3-4 per cent and could get to 5 per cent and beyond.
O’Brien How will the banks respond to the massive volume of fixed-rate mortgages rolling off their books?
RIEDEL My sense is that the banks will fight very hard to protect their market share. Considering the relationship between the refinancing of significant volume of customers and changing regulatory capital standards that apply from 1 January 2023, we are anticipating strong competition for owner-occupier customers with LVRs of less than 70 per cent.
We believe competition may be less for LVRs around 80 per cent and for investors, because risk weights will be higher than they are today.
The extent to which the banks are able to allocate capital to different customer cohorts and price differentiate is the big question. If the banks can do this, I believe we will see greater differentiated risk-based pricing in the overall market than we have ever seen.
AUSTIN This is exactly what CBA has done with UnLoan, its online lender, which it has set up ahead of the “great refinance” that we know is coming. This product is targeting exactly the customer base that has just been outlined and it will presumably help CBA retain its own customers in this situation.
Nonbanks' ESG aspirations
Integrating environmental, social and governance (ESG) considerations with securitisation funding structures has been something of a holy grail for the Australian market. There have been notable steps forward in 2022 but plenty of work is still to be done.
MOIR We executed our first social bond during challenging conditions this year. Overall, our objective is to break through the perception that we are trying to do something different with social RMBS. The lending that qualifies for this type of issuance is structurally and philosophically an important part of Pepper’s business model, and financial inclusion has always been part of how we operate – it was a foundational pillar set more than 20 years ago.
Over time, we will expand the product suite and add depth to the social programme. We view our current product offering to home buyers who would not qualify for a loan with a traditional bank in Australia as the core of this programme.
Our objective is to break through the perception that we are trying to do something different with social RMBS. The lending that qualifies for this type of issuance is structurally and philosophically an important part of Pepper’s business model, and financial inclusion has always been part of how we operate.
O’Brien Funding has been challenging in 2022, including market pricing that has reverted to pre-2019 levels and beyond. Liquidity and market depth have also been squeezed, and it is particularly notable that bank balance sheets have not been as active in the RMBS [residential mortgage-backed securities] market. How would issuers describe the state of liquidity in the securitisation market at present?
MOIR I agree that market conditions have been more difficult but, on a positive note, transactions are still getting done. Fundamentally, we have found investors’ view of the Australian market to be very positive – credit has not been a concern.
Relative value has been the issue for US and UK investors, as Australian triple-A paper has been trading well inside global counterparts. This has now corrected materially and we are very much hoping to put relative value discussions to bed.
O’BRIEN We had similar discussions with our Japanese desk around the pricing of CLOs [collateralised loan obligations] relative to Australian RMBS.
BARRY Our experience is very similar to Pepper’s. Investor feedback on Australia is positive from the perspective of consumers being in good shape heading into challenging times. Australia is still seen as a great investment destination with lots of goodwill to nonbanks and the mortgage sector.
Markets have been choppy but we found robust interest in our most recent RMBS deal through a private placement-style bookbuild. What is challenging in the process of building a transaction is how investors are managing their cash positions and dealing with redemption requests.
It is hard to predict investor interest on any given day in an environment in which the secondary market is challenged to the extent that investors cannot offload positions to create cash while simultaneously being faced with withdrawal requests.
Having said this, as we moved through the bookbuild process in our latest transaction, we garnered more than A$1 billion of orders. This demonstrates that there is liquidity available – issuers just have to meet the market at the right price.
RIEDEL We have not been in the market since April. We have built a business on diversification, as best we can as a nonbank, through different opportunities to access liquidity. With access to different forms of funding, we haven’t needed to access the market.
We have been fortunate in the sense that we have been able to stay out of the funding market in an environment of economic uncertainty in which liquidity was being taken out of the system – particularly in the northern hemisphere, where banks are also returning to the securitisation market and thus providing product competition for investors.
There is also a technical aspect whereby there has been a material widening of short-end rates, in particular between one-month and three-month BBSW. Asset-backed securities (ABS) will not be as disadvantaged when the differential tightens and this should support increased investor demand for the ABS offering. The market has been challenged in the last six months, but of course this will resolve in time.
AUSTIN I agree that the biggest problems with markets in recent months have been the gap between one-month BBSW and three-month BBSW, and the rapid widening of spreads. This has caused material mark-to-market issues for investment books.
I don’t believe asset quality is the cause of this at all. It is purely to do with factors affecting investors, and these will dissipate. This time of year, when the northern hemisphere is on holiday, liquidity tends to be lower anyway. I think it is a case of waiting for a little time to pass.
MARSDEN I agree that nothing in the market is fundamentally broken. On the other hand, it is incumbent on our sector to meet new pricing levels. We knew the RBA’s term funding facility would come to an end and the banks would once again be active in wholesale funding markets.
We have also seen a fundamental change to the makeup of the triple-A bid during the last 12-18 months. This will play into the overall capacity of the nonbank triple-A market.
We brought forward some of our 2022 funding task late last year and also shored up warehouse limits, which means we were in a good position in the sense of not having to access trickier markets. Having said all this, I also believe the market will take on a more constructive tone as northern hemisphere participants return from their summer holidays.
O’Brien We have two lenders at the table that might have been considering debuting in the public market this year. How have market conditions affected plans?
SCANLON We have been adequately funded by warehouses to date. We have started to have conversations about a public transaction but it may make sense to wait until the new year. Fortunately, we are in a position to wait until conditions normalise.
SPENCER Stargate/Flexstar Group is a little different as we are not an institution. We sold our Interstar Securities business in 2003 and used the proceeds to build the Flexstar Well Money business. We see challenges and the market certainly is not straightforward, but we can make it easier by having talented people who understand the industry. At Stargate/Flexstar, the ability to mitigate risk and to explain it to investors is the most important requirement.
O’Brien What about nonmortgage issuance?
ZILELI Market conditions have caused a pause to our public market plans. We can stay out of the market all year, but we want to continue to be programmatic with our issuance so we continue to watch for signs of stability and increasing liquidity – recognising that wider spreads are here to stay for a while.
GUESDE What we are seeing from global debt capital market books is that investors are in wait-and-see mode. There is liquidity, but it is at the very short end of the spectrum and investors have very little appetite for anything that goes beyond three years, even for bank paper.
I suspect many investors are waiting for pricing to widen while others have liquidity shortfalls. There are opportunities: CLOs, for instance, are often offering discounts of a level that makes this market appealing. When the RMBS market reprices, investors will return. In the meantime, issuers are exploring private placements.
O’Brien How have liquidity, pricing and relationships held up in the warehouse sector during 2022?
AUSTIN It is how a lender positions ahead of periods like this that dictates how it is likely to fare. In general, having to rely on short-term funding is never a great thing and, typically, a warehouse is a 12-month facility. The more short-term funding we take on, the greater the repricing risk in our business.
I can’t share a view about the extent to which banks are inclined to provide additional liquidity through warehouses as we have been well-positioned and have not needed to engage in this way. We are also not particularly keen to take on short-term, public term money.
O’Brien How can Australian issuers go about finding new investors and attracting those that have been less active back in – especially accounts from offshore?
SPENCER The Australian RMBS story is excellent. The credit story is also excellent – in fact unparalleled. At the end of the day the critical piece is relative value. It is this, and the swap cost where relevant, that will drive international investment – or not.
BARRY The nonbank sector is well supported by domestic banks and investors. International investors have come back during the last 10 years, after they left during the global financial crisis. We have made great headway in developing these relationships, which has put us in good stead.
Developing new investors is an ongoing task and not without challenges. It was interesting to see the withdrawal of Japanese investors through COVID-19, for example. This wasn’t related to credit per se, which is a positive.
There could be opportunities – particularly with things like environmental, social and governance overlays – to re-engage with some investors, show them the credit story and showcase our strong macro backdrop.
I agree that it comes back to relative value. We are in a good position and there is a good level of international interest. It needs to be nurtured, though – via things like conferences and this publication.
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