Posts Tagged ‘mortgage’

Fixed vs variable mortgage rates?

Friday, April 24th, 2009

One of our readers have this question to ask in the forum:

Hi, I am looking at buying a property in the next 6-12 months and was wondering what everyone’s thoughts were regarding fixed vs variable rate mortgages. With interest rates quite low at the moment do you think I would be better off locking in a fixed rate for the first year (or five), particularly with the chance of inflation rising in the near future?

I understand that any comments posted here are not to be considered financial advice but hope that this can generate a little bit of discussion.


Everyone is welcome to discuss this question at the forum.

How are governments driving up fixed mortgage rates?

Thursday, April 23rd, 2009

Newton’s Third Law of Motion says that for every action, there is an equal and opposite reaction. Likewise, in the field of economics and finance, for every government intervention in the financial market, there is always a side-effect (some of them will be unintended).

As Marc Faber reckoned, the bull market for long-term government bonds, which started in the 1980s, has come to an end in late 2008, with a tentative rising trend of long-term government bond yields. With the private sectors all over the world de-leveraging (unwinding of debt) in an unprecedented scale from an unprecedented credit bubble, governments will be forced to fill the slack via bailouts and stimulus. As our of our concerned readers pointed out the government’s “spend, spend, spend” slogan in Can government create jobs?, government budget deficit will be a rising trend all over the world.

Consequently, government borrowings will have to increase (or taxes raised and/or money being printed). In a world where credit is scarce, government demand for credit will make it even scarcer. If the government resort to ‘printing’ money (issuing government bonds from thin air to be sold to central banks who created money from thin air to buy them), concerns about rising long-term government inflation will force long-term government bond yields to go up. As a result, this will result in a trend of rising long-term interest rates.

As fixed rate mortgages tend to follow long-term interest rates, banks will be raising their fixed mortgage rates too.

De-leveraging in the real economy- mortgages

Sunday, May 18th, 2008

In our previous article, Is the credit crisis the end of the beginning?, we said that the de-leveraging of the financial sector will usher in a new phase whereby the real economy de-leverage. Today, we will show you how it will unfold by looking at mortgage de-leveraging.

First, we will explain the concept of de-leveraging. As Satyajit Das said in Nuclear De-Leveraging,

Assume a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage 5 times, then the hedge fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Assume the asset falls $10 (10%) in value. The hedge fund leverage increases to 9 times ($10 of equity (the original amount less the loss) and $80 of debt supporting $90 of assets). If the permitted leverage stays constant at 5 times then the hedge fund must sell $50 of assets – 50% of its holdings ($10 of equity and $40 of debt funding $50 of the asset). If lenders (more realistically) reduce permissible leverage, say, to 3 times, then the hedge fund must then sell $70 of assets – 70% of its holdings ($10 of equity and $20 of debt funding $30 of the asset).

That is why, as we said before in Why are fantastic stocks sold off in a bear market?, with so much leverage, even a tiny fall in value of assets will result in savage selling, which results in even more fall in value.

Now, look at Australia’s household sector. For a typical first-home buyer, it is possible to leverage 9 times (i.e. 10% deposit and 90% debt for a house). With house price at record un-affordability, debt-servicing burden for such buyers are stretched to the limit. With a leverage of 9 times, highest debt-servicing burden and a loan term of 30 years, first-home buyers are most vulnerable to any fall in value of their property. 30 years is a very long-term commitment. A lot can happen in 30 years. With a leverage of 9 times, there is very little margin for error for first home buyers.

For those who are thinking of buying their first home in such a time, note this: as you start of with your loan repayments, the vast majority of the payment comprise of interests. In other words, most of your initial years of loan repayments goes to making the bank rich and not to reduce the principal of your loan. For example, suppose you have a $300,000 loan for 30 years at 10% p.a. Your loan repayment will cost $2632.71 per month. The first month of payment will only reduce the principal of your loan by a miserly $132.71! At the end of 3 years, the principal reduction per month is only another miserly $177.44! In other words, after of 3 years of slaving after your mortgage, you still owe the bank $294,454.94! That is just only a 1.8% reduction of your total debt in exchange for 3 years of slavery!

Of course, if house prices go up forever and ever till infinity, this is not a problem for the banks. At worst, the banks can just foreclose the house and get back their money. The home ‘owners’ have to bear the consequences of losing their homes and go back to renting. A consolation is that they will at least get back their 10% deposit, plus whatever is above the original purchase of the house, minus fees, taxes and charges. But if house price goes down by more than 10%, then the home ‘owners’ will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

For property investors this is a tip: in any property downturn, newly built estates are most vulnerable because the first home buyers are the majority there.

Now, a first home buyer who can faithfully pay $2632.71 per month is doing okay (assuming they can still remain employed). But as Satyajit Das wrote,

Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of ?easy? credit will force de-leveraging.

In the US (and to a lesser degree in other countries), banks allow the consumers to ‘extract’ the equity of their house as cash, especially in the days of rising house prices. Here, we have to emphasise that the rising of house price is an illusion (see Spectre of deflation for the concept of imputed valuation) because debt is real but the ‘value’ of houses is not real. In the case of the first home buyer, consistent and faithful repayments hardly put a dent in the amount of his or her total debt initially. If equity were to be ‘extracted’ from the loan (on the assumption that house price will rise forever and ever till infinity), wouldn’t the total amount of debt increase further due to the compounding effect?

Now that the days of Chinese deflation are over, borrowers have another worry to fret (in addition to falling house price): rising price inflation. As Satyajit Das continues,

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt. Higher food and energy cost, especially over a sustained period, may affect the degree of de-leveraging if income levels do not adjust.

Imagine the situation of a household that is already highly leveraged with crippling mortgage debt. ‘Extracting’ equity from the house will result in an increase in the amount of total debt owed. Now, with price inflation added into the powder keg mix, wouldn’t this lead to the situation whereby the chances of debt default increases (because the margin for error is reduced to razor thin level)? As debt default increases, this means banks’ bad debts will increase. This will lead to the increase of bad bank assets, which means more write-downs, capital raising and de-leveraging in the financial sector.

The only short-term fix for the household is to resort to the plastic (credit card debt) to pay for the mounting cash-flow problem. That will further exacerbate the debt problem in the longer term. With the financial sector in the process of further de-leveraging, how realistic can we expect the tap of credit to flow further? That is why Ben Bernanke and company is doing everything to keep the credit tap flowing from the banks.

Given such a situation, de-leveraging of the household sector means that consumer spending has to cut back significantly. Given that more than 70% of the US economy is made up of consumer spending, there is no avoiding of a serious recession (in fact, the US is already in a recession).

Make no mistake- the real economy will be affected acutely.

Reserve Bank of Australia entering the landlord business

Monday, April 21st, 2008

Last Friday and today, The Reserve Bank of Australia (RBA) got move involved in the landlord business by buying up a total of AU$1.1 billion of mortgages. Effectively, the RBA produced AU$1.1 billion from thin air and lent it at around 7.8% to banks, who in turn lent it to mortgage borrowers at above 9%. Most of that money had to be repaid to the RBA in around a year’s time. Since October last year, the RBA had been buying up around AU$2.64 billion worth of mortgages (source of RBA’s market operations data can be found here).

Let us give you a sense of scale of how big those landlord business transactions were. As at February 2008, there were around AU$218 billion of securitised housing loan (see Rising price of money through the demise of ?shadow? banking system for the meaning of securitisation). Therefore, the AU$2.64 billion of mortgage purchase constitutes 1.2% of the February 2008 securitised housing loan figures.

For now, we are not trying to read too much into this. The RBA is not the only central banking getting involved in the landlord business in the name of providing liquidity. What might be the possible repercussions if the RBA had not done that? Keep in tune!

Support mortgage lenders to keep borrowers in indentured servitude?

Thursday, April 3rd, 2008

Last week, there was an article in the mainstream news media, Call to support mortgage lenders,

THE global credit crunch is destroying competition in the home-lending market, leading to the threat of permanently higher mortgage rates.

The warning comes from two leading economists, who are calling on the Rudd Government to establish a scheme similar to those operating in the US and Canada, under which it would use its AAA credit rating to bolster the funds available for home lending, helping to keep small operators in business.

So, these ‘leading’ economists are asking the government to get into the landlord business? By reviving the shadow banking system that way (see Rising price of money through the demise of ?shadow? banking system), they hope to re-introduce ‘competition’ into the mortgage industry to lower mortgage rates.

These economists do not understand the concept of competition. In the real economy, competition means utilising scarce resources in a more efficient way to produce more, create new products or make better products. But for the mortgage industry where the product is credit, how can the idea of ‘competition’ be applied when the product (money and credit) can be created limitlessly out of thin air by the government (central bank) and financial system?

Mortgage rates have to rise for a good reason. Money had been too cheap for too long, and this is the primary reason why there are so many bad debts in the global financial system as far too many gorged on debt that they cannot really repay. Rising mortgage rates is just a reversion to what should have been long time ago. Supporting mortgage lenders will not solve the problems of scarcity in the real world- it will merely lead more people into indentured servitude.

Australia has no sub-prime debt? Think again!

Monday, March 31st, 2008

There is a widespread belief that the sub-prime debt problems in the US is something that can never happen to Australia. The idea that Australian lending is more ‘prudent’ and ‘responsible’ than their US brethren is quite popular. That, along with record low unemployment and the strong resource boom powered by the eternally booming Chinese economy gives the impression that the Australian economy is very strong and that no harm shall befall it forever and ever. Add the mob-pleasing cheerleading ‘research’ by institutions such as BIS Shrapnel (see Another faulty analysis: BIS Shrapnel on house prices) into the mix and we get further incitement into debt overindulgence. Indeed, Australia’s love affair with debt is no different from drug addiction. Eventually, when the drug wears off, painful cold turkey treatment will follow. As we have warned before in Aussie household debt not as bad as it seems?, we will sound our warning again.

Today, we will refer you to a sobering documentary from the ABC- Debtland. This documentary is highly recommended, especially for those who are (1) thinking of ‘investing’ in residential property (see our guide, Are Australian residential properties good investments?), (2) owning huge amounts of debt and (3) thinking of getting deeper into debt. Here, we will quote some important points and add some of our own comments from the transcript of this documentary:

Brian Johnson, a Banking Analyst from JP Morgan said,

The Banks are just handing out money on credit cards like there is no tomorrow. For me it’s quite terrifying to think that the average household in Australia, so the average, now has three months of their monthly disposable income on a credit card balance.

In addition to their burdensome mortgage debts, Australians are taking up even more debts from multiple credit cards, store cards, personal loans, car loans, etc. As Brain Johnson said,

It strikes me that it’s nonsensical, the amount of total debt out there. And no-one seems to know how much debt because a borrower can borrow money across multiple providers of credit.

Thus, each provider of credit does not know the true picture of a borrower’s financial position. While each credit may be sound on its own, how sound will all these combined credit be when concentrated on a borrower? If we do not really know how much debt a person has, how can we really know what the effect of rising interest rates be on that person?

Now, what about those families who are under severe mortgage stress? ABC reporter, asked,

So do you think we’re seeing a situation where people are really under stress on their mortgages and are getting credit cards and basically living off credit on the plastic?

Brian Johnson answered,

There’s no other way that you, there’s no other conclusion you can really draw from the data. And in fact when you speak to the banks about that quantum level of credit card debt there’s a noticeable silence.

Does Australia’s lender practice prudent lending practices? Here are some of the shocking cases…

Kim White, former National Australia Bank (NAB) said,

We would see people come through and we’d estimate how much it cost to lend them all their payments, everything else like that. At the end of the month they’d have $100 left over, but sometimes the system would still say, lend them the money and that person is living on a razor edge.

And you know that they’re not going to be able to afford it. They’re going to live on their credit card for their basic living expenses and get themselves into worse debt. But the system would say do it, the bank would say do it or else you’re going to be under the gun, you’re going to be performance managed out. So we’re in the situation where we lent to whoever we could and as much money as they wanted.

ABC’s Four Corners said

If Kim White wouldn’t rev up the credit limits, someone else would.

In another case, Commonwealth Bank of Australia (CBA) provided credit to a refugee family:

Deng Gatluak and his family fled to Melbourne from war torn Sudan. A refugee with no English, no job, and no concept of finance – yet the Commonwealth Bank gave him a $20,000 car loan. The repayments left this large family with next to nothing to live on.

His wife Nyatut still speaks virtually no English and has no assets, yet she was made the guarantor on the car loan.

Is this just some isolated cases? Good question. As Gary Rothman from Uniting Care said,

If we’re seeing people on low incomes and on Centrelink benefits being lent money that they have no way of repaying, then what are they doing to people who are on even higher incomes and how are they burdening them with debt that they can’t repay?

Good question.

What if an economic recession hits Australia? As we said before in Aussie household debt not as bad as it seems?

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

Professor Terry Burke from Swinburne University would agree with us,

What we found was that almost 50 per cent of all households were relying on either overtime or a second job of the main income earner to sustain the mortgage. Now that’s fine so long as the economy is still steaming along at full speed but any slow down in the economy, that’s what will go, the part-time job, the casual payments, overtime, and then you’re in trouble.

In a Sydney suburb of Kellyville,

Out here houses bought for $900,000 a few years ago have sold for not much more than half that. The staggering decline raises questions about the valuations the banks and the buyers relied on.

Brendon Hulcombe, CEO of Herron Todd White said,

The valuer should be able to act without fear or favour but unfortunately we’re getting a lot of pressure from lenders who want to get high valuations to get their deals through.

I don’t know how many are being over-valued but I can tell you that every hour of every day, pressure is put on valuers to write higher figures.

Furthermore, ABC reported that,

Just as banks have become freer with their lending they’ve become looser when it comes to assessing what a property is worth.

Often they don’t even bother to send a valuer through the front door and they’re not always aware of the backdoor deals being done to get the sales though.

As it turns out, valuations are subjected to corruption too as Matt Ganter, a valuer from Herron Todd White said,

There’s a bit of an issue out here where developers rebate to the tune of up to around about 15,000 on a block for 160,000, which brings the true value of what people are paying down to the 145,000 mark.

[Banks are getting false valuation] if they’re relying on the automated valuation models and there’s rebates involved, absolutely.

Now, in addition to mortgage loans and credit card, there are other kinds of loans including margin lending for shares, store cards, and so on. One of them, GE Money was singled out for irresponsible lending with exorbitant with high interest rates.

We wonder how much sub-prime debt does Australia have.

How to dump risk to consumers: securitisation

Thursday, February 1st, 2007

Nowadays, in the world of business, we often hear the idea of ?risk management,? which imbue a sense of control over the unpredictability of life under the sun. While it is true to some extent, this idea had often been corrupted to the point where risks are ?managed? by simply dumping them to unsuspecting consumers. As we alluded before in Are you being ripped off by fund managers?, it is often consumers who get the worse end of the deal because of their lack of financial literacy.

Today, we will look at one of the ways of how this is done?securitisation of debt. For this, we will use the mortgage lending industry as an example. Traditionally, banks make their money through mortgage lending by borrowing money at a lower rate of interest and lending to mortgage borrowers at a higher rate. The differential between the two rates make up the profit. The only risk lenders take is the threat of default by the borrowers. When that happens, in the case of mortgage debt, the home is foreclosed and the lender sells it to the market to recoup its losses.

With the recent financial ?innovation? of debt securitisation, lenders can now aggregate their loans, and through dicing, slicing, splicing and divesting, repackage it into an ?investment? product. An example of such ?investment? product is the mortgage fund. These ?investment? products are then sold to retail investors (i.e. consumers) directly and indirectly (through their retirement funds). As with all financial products, these ?investment? products come with ?management? fees. In Australia, there is another twist?mortgage ‘insurance.’ For borrowers who cannot afford 20% of the home equity, they have to pay mortgage ‘insurance? on top of their regular mortgage payments. These mortgage ?insurance? protects the lenders (NOT the borrowers) against mortgage defaults.

Thus, such lending businesses are highly lucrative. There are hardly any risks by playing the role of the middle-person since they are mainly being offloaded to consumers on both sides of the deal. Since this is the case, we can expect lenders to be more tempted to offer their loans to less credit-worthy borrowers (that is, the sub-prime borrowers) were it not for the securitisation of debt.

In Australia, securitised debts are mainly confined to mortgage loans. But in the US, the level of financial ?innovation? even allow credit card debt to be securitised. Thus, retail investors beware!