Our next Prime Minster should prepare for mortgage rate rises: Bartholomeusz

It is becoming increasingly probable that, regardless of the outcome of the federal election there is going to be an out-of-cycle rise in mortgage interest rates.

Last week’s Commonwealth Bank profit, at face value recording a phenomenally profitable year, also revealed rapidly building stresses within the bank’s mortgage book, which constitutes about 60% of its balance sheet. When the other majors report for their years to September, it is inevitable they will reveal similar trends within their retail banks.

The impact of the inexorable rise in average funding costs on CBA’s earnings was disguised in the first half by the re-pricing of the bank’s business loans, very strong volume growth in the mortgage book and, most notably, the continuing sharp reduction in impairment charges.

For the year CBA grew its mortgage loan portfolio by 11% (half the rate of growth experienced in 2009 during the first home buyers’ grant-fuelled boom) but that fell away to a modest 4.3 per cent in the second half as the bank’s net interest margin fell from 218 basis points in the December half to 208 basis points in the June half. In the retail bank, CBA lost 14 basis points of net interest margin in the second half.

The abolition of some of the more contentious fees ($47 million) and margin erosion ($280 million) cost the bank $327 million of income in that second half, with volume growth only providing $135 million of offset. Given that the bank’s third-quarter update didn’t point to the severity of the growing margin pressure, it appears that the pressure really ratcheted up in the final months of the year.

The abrupt slowdown in the growth in mortgage lending towards the end of the year signals the bank’s concern about the intensifying margin squeeze and also points to the unsustainability of the current rate settings.

The banks says its average funding costs are rising at about two basis points a month, which bears no resemblance to the Reserve Bank’s estimates of a five basis point rise over the next 18 months, but which does appear to be borne out by CBA’s disclosures.

CBA and its peers would almost certainly be already losing money on their new mortgage originations on the basis of their marginal rather than average funding costs.

There is a certain amount of lending banks have to do to stay in business and satisfy their customer bases, and mortgages that are unprofitable when written can become profitable with time and cross-selling.

The situation confronting the banks will, however, worsen over time unless they either virtually stop lending or are able to pass through at least some of the higher cost of raising wholesale funding or attracting retail deposits.

A problem for the RBA and whoever wins government at the weekend is that neither the central bank nor the government nor the government can do much to influence the major banks’ funding costs, with the cost of wholesale funds set in global markets and affected by supply, demand and risk equations in the markets and economies that bear little resemblance to our own.

In the meantime the banks – and particularly CBA and Westpac, which are most exposed to a margin crunch because of their dominant shares of home lending – are shifting their emphasis from mortgage lending to the less politically sensitive lending to business, with its better margins but lower returns on capital.

That helps, but with weak demand for credit from the conservatively recapitalised large corporates, small business staying very cautious and a majority of the NSW-headquartered banks’ asset bases exposed to their mortgage books (ANZ and NAB are closer to 40 per cent), it doesn’t address the building pressure to re-price those loans once the election is out of the way.

This article first appeared on Business Spectator.