Unpacking UBS criticism of Westpac

Christopher Joye

In my AFR column I explain why UBS's banking analyst Jon Mott has jumped to incorrect conclusions in regard to the quality of Westpac's mortgage book (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"Westpac demolished Mott's allegations on loan quality, revealing that of the 420 loans in the sample file just one borrower (0.2 per cent of the total) was three months or more in arrears, which is "well below [Westpac's] portfolio average for delinquencies". The bank further reported that the 90-day default rate on its $400 billion mortgage book was a low 0.67 per cent and a fraction of what comparable US, UK and European banks report even though Aussie home loan rates have historically been higher.

PwC found that 38 of the 420 loans failed APRA's loan assessment standards and should not, on this test, have been originated. On Thursday Westpac disclosed that PwC used a limited data file on each borrower, and once Westpac applied its full data file 37 of the 38 loans were, in fact, appropriately approved. And the one loan that should not have passed its credit scoring system is "currently ahead on its repayments".

Finally, Westpac highlighted that 90 of the 420 loans have already been fully repaid, which combined with its other evidence suggests that the bank's loan portfolio remains of a high quality. Westpac's chief financial officer Peter King hammered this point home, noting that "our mortgage delinquencies and losses remain low both relative to historical and industry standards". That's important because Westpac has aggressively raised its interest-only loan rates, which should have propagated higher defaults.

While I am sympathetic to Mott's negative view on bank valuations, I would contend he is right for the wrong reasons.

Mott claims that to comply with APRA's unusually tough loan assessment requirements, which the regulator has progressively tightened since 2014, banks will have to savagely constrain credit creation. There is truth to this insofar as the banks' more exacting standards do mean it is harder to get a loan approved. Sadly, it will be lower-income families who find it most difficult to buy a new property. And this will certainly undermine credit growth at the margin.

Balanced against this, however, is APRA's announcement on Tuesday that it is lifting its 10 per cent speed limit on investment lending growth for any bank that can demonstrate it is fully compliant with APRA's upgraded standards. This will liberate a significant increase in previously constrained lending that should go some way to offsetting credit rationing to higher risk borrowers. A surge in non-bank lending, underwritten by a huge $50 billion increase in residential mortgage securitisation since the start of 2017, will provide another new tailwind for credit creation.

Interest rates are at all-time lows (a colleague was just approved for a 3.4 per cent mortgage) and there is no evidence the RBA will hike any time soon. So it's more likely that credit growth will remain positive, albeit at a more modest pace, and that house prices will move sideways, than the gloom Mott projects.

Another concern Mott had was the possibility Westpac breached responsible lending laws based on the PwC analysis. Here he has erroneously conflated APRA's lending standards with the responsible lending laws introduced by Labor in 2009, which are completely different things.

As PwC explained, "lenders are held to a higher standard of reasonableness than relevant laws and regulations" and failures to meet APRA's standards "should not be directly interpreted as a breach of regulations".

Since late 2014, APRA has dictated that all banks assess a borrower's ability to repay a loan not using the current interest rate, but one that is at least the greater of 2 percentage points above the current rate or 7 per cent. Since many new loans today are approved with rates below 4 per cent, banks have been very conservatively testing repayment capacity using rate assumptions that are 75 per cent above what they actually charge.

The 2009 responsible lending laws require lenders to: make "reasonable inquiries" about a consumer's financial situation, requirements and objectives; then take "reasonable steps to verify the consumer's financial situation"; and finally make an assessment about whether the credit contract is "not unsuitable" for the consumer.

ASIC's regulatory guidance on this law stresses that what represents a "reasonable" inquiry and verification varies markedly on a case-by-case basis, with no systematic rules that can be generalised across borrowers or used to judge a lender's performance.

Depending on the circumstances, reasonable inquiries may involve asking the borrower to complete a detailed application form and warrant that all the information they have submitted on their income, expenses, and assets and liabilities is correct.

This may or may not be supplemented by the bank requesting a third-party credit score on the borrower and/or further evidence of their income and expenses. Note that expenses in particular are notoriously difficult to standardise, which is why banks commonly rely on an average index of costs proxied by the Melbourne Institute's household expenditure measure (HEM). (In 2012 the HEM was adopted in preference to the previous benchmark, which was the Henderson Poverty Index.)

A long-time customer of a bank, or a very low loan-to-value ratio (LVR) borrower, may not necessitate additional income or expense diligence given the access the bank has to their earnings and spending records, or the fact that repayments are such a small percentage of their income with massive equity coverage via the secured property collateral. In contrast, a low-income borrower with a high LVR might be asked for payslips, bank accounts and credit card statements.

According to legal experts, this makes it awfully hard to initiate a class-action law suit – because what represents reasonable inquiries and verification, and therefore responsible lending, varies dramatically borrower by borrower. Early test cases have, for example, forced the Australian Securities and Investments Commission (ASIC) to rewrite its own interpretation of the law and ruled in favour of the lender, especially where a borrower fudged their income and expense data.

Corrs Chambers Westgarth partner Michael Chaaya says "class actions against banks for breaching responsible lending laws are generally problematic as loans are assessed on an individual basis and no two borrowers are identical". "What is suitable for one borrower may be unsuitable for another," Chaaya says. "A natural grouping is not likely to occur in consumer lending other than for bank errors (eg, an incorrect interest calculation) or 'penalty' cases for high fees where the loss is common, which are not a breach of responsible lending laws."

The financial upside is also limited. The financial ombudsmen says that if there has been a case of irresponsible lending, the most a borrower can normally expect is to have interest waived. They still have to pay back the full principal sum. Penalty interest is actually very rare on home loans, and usually only kicks in if you have been in default for more than 6 months.

Finally, most recorded disputes involve a situation where a borrower has deliberately understated expenses, and/or overstated income, on a loan application that he or she represented is truthful to gain a benefit in the form of a bigger loan. By doing, he or she has defrauded the bank which (even if it is found to have possibly breached responsible lending laws) could, Chaaya says, have the case neutralised if the borrower made a false or misleading representation to obtain the credit." Read the rest of the article here.


Christopher Joye

Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.

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