The lending universe can at times appear complex, when you move beyond the familiar major banks. Semper Capital’s Andrew Way demystifies the lending spectrum
There can be no doubt that the operating environment for today’s mortgage broker is far more challenging than it has ever been. Regulatory changes have brought increasing responsibilities and the threat of criminal as well as civil charges for offenders.
Against this backdrop lenders and products have changed too, but this is nothing new. Brokers with experience know that the continuous evolution of lenders and products is as inevitable as the shifting of sand.
The one constant in Australia has always been a wide array of market participants; something every government should be keen to promote. There are APRA-regulated banks and ADIs, building societies, mortgage managers, managed investment schemes, unit funds, finance companies and private lenders. Each offers something different and together they offer the spectrum of products that fulfill the varied demands of borrowers.
An important strategy for successful deal flow is maintaining a broad knowledge of lenders’ attitudes to risk across this spectrum, although brokers in broker or aggregator groups might be restricted to dealing with on-panel lenders.
So what influences lenders in regard to risk? And how can understanding this help with successful deal placement? The factors that affect credit decisions with every lender are:
1) Capacity of capital;
2) Price of funds raised;
3) Margins for profit; and
4) Appetite for risk.
In simple terms the graph (pictured opposite) represents lenders across the spectrum of the market. It provides a simplified representation of their funding capacities, risk motivations and credit flexibility.
Banks have the greatest number of funding options but they are by nature high volume / low margin operators. Under APRA regulations and international banking protocols they may borrow funds at a multiple of the value of assets on balance sheet. They can also do the things non-bank lenders can, including but not limited to the securitization of assets (packaging a pool of mortgage receivables for sale), the issuing of bonds and soon perhaps, covered bonds (debt instruments issued to investors where the mortgage assets and receivables are quarantined from the balance sheet and other liabilities, and held for the benefit of bond holders).
A bank’s capacity to borrow and the rates they pay for funds is determined by the prevailing Reserve Bank capital adequacy and other prudential requirements, interest rates on wholesale markets as well as balance sheet strength and credit rating.
Australian banks came through the GFC fairly unscathed. Their exposure to other international banks (counter-party risk) and governments (sovereign risk) was low. Their profitability is high and their rates of defaulting loans are currently low. But their options for funding have diminished somewhat; the securitization market is currently static and the international banking accord (now Basel III) has made changes to the way banks calculate asset-values for prudential purposes and to liquidity requirements, which has sent many Australian banks scrambling to increase deposits. Luckily for the banks competition has also diminished.
The cost of international wholesale funds has risen and, since Australian banks rely on this as part of their funding requirements, their margins - as represented according to the bank bill swap rate (BBSY) and RBA cash rate - have increased. Where three years ago the average bank margin above the BBSY might have been between 70-90 basis points, today it is nearer 300.
High volume / low margin businesses typically de-centralise decisions. The credit process begins with the relationship manager who packages information and enters the deal into credit. From credit the file passes to legal. Once documents are signed it goes back to credit for checking, then legal for the same, then lodgment and legal again, before drawdown. Decisions are by nature objective rather than subjective. In short, lower margins mean less flexibility and less tolerance for credit deviation.
Banks appear to have become cherry-pickers, choosing the best deals from the market. They seem to be reducing exposure to commercial property, and lowering acceptable LVRs to tighten credit exposure and further protect their balance sheets. They are showing less appetite for so called non-conforming loans from, for example, self-employed persons and small businesses. Also, the time they are taking to administer applications has significantly lengthened.
Brokers with anything less than a vanilla residential, municipal, high-doc, low-LVR deal scenario can expect high levels of credit scrutiny.
Non-Bank ADIs include credit unions and building societies, many of which are not rated and, as such, do not enjoy the same benefits in terms of access to international wholesale funds. Along with the banks they benefit from the Government’s Deposit Guarantee, which protects deposits of up to $1m without charge, and sums above $1m and wholesale facilities with a fee. While this has brought stability to ADIs and a flood of deposits from non-guaranteed entities, it has not translated into a truly competitive, so-called ‘Fifth Pillar’ alternative to the banks. They are lower volume and enjoy a slightly higher degree of autonomy but they are largely process-driven and traditionally prefer residential assets of a certain class and location.
Non-bank, non-ADI lenders
Lenders in this group include originators, mortgage managers, managed investment schemes, unit funds and finance companies who raise funds by issuing debt and / or equity instruments. Each of these is regulated by ASIC and provides a unique alternative to the banks, particularly in relation to commercial and rural risk. They vary in size from companies that manage tens of millions of dollars to those that manage billions. Some are rated and listed whereas many remain unlisted and unrated.
Most lenders in this category raise funds from wholesale or retail investors by way of a prospectus and pay a fixed rate of return, or coupon. These companies were excluded from the Government Guarantee. Their costs of capital vary from lender to lender but fluctuate less in relation to the BBSY rate because their coupon rates bare no relation to it. They may also securitize, when the market is receptive.
These lenders are lower volume / higher margin operators with generally fewer participants in the credit chain. They are often specialists who departmentalize according to asset classes, which provides for a higher degree of credit autonomy.
There are some surprising benefits of dealing with lenders in this sector at present. While the cash rate has risen only slightly, the margin banks charge in comparison to the cash rate has risen more. But rates paid by banks on deposits have remained closer to the cash rate. Conversely, the coupon rates offered by non-ADI lenders have traditionally been higher than the deposit rates offered by banks, but the margins they charge borrowers is currently less than (or comparable to) the banks, making them increasingly competitive. Furthermore, they are extremely flexible and enjoy a high degree of credit autonomy.
Non-ADI lenders are currently perhaps at their peak of competitiveness with the banks. However, their capacity to rapidly grow is limited by their capacity to match deposits in with loans out. If they raise too many deposits they suffer cost of capital overhangs that add to their Weighted Average Cost of Capital, unless they have wholesale facilities to take up this elasticity of demand pending repayment by deposits. Furthermore, smaller companies with less than $200m under management may not enjoy the economies of scale that their larger counterparts enjoy.
Brokers should get to know some of these lenders. They are receptive and surprisingly approachable. A relationship with a strong non-ADI lender will often prove an asset in settling a deal that makes perfect credit sense, but falls outside the matrix of ADI lenders.
There is a surprising number of private lenders in Australia. They range from single, wealthy investors, to private company funds and larger mortgage managers such as my company, which manages risk on behalf of a number of funds and non-ADI finance companies.
Most private lenders suffer from limited access to capital and their credit decisions and rates of interest are dictated by this. They tend to occupy the risk areas where the highest return for a manageable risk can be attained, such as in short-term and bridging finance. Lenders with less than $5m under management will be largely equity funded, and expensive. Lenders with greater than $20m under management have increased funding options such as wholesale and warehouse facilities from the banks.
The benefits of obtaining funding from a private lender are; a high degree of autonomy in credit decisions, a bespoke approach to risk, and speedy drawdown. But brokers should exercise a high degree of caution dealing with private lenders particularly in the non-consumer space which remains largely unregulated. Despite the current lack of regulation, brokers can find themselves at risk of breaching ‘responsible lending’ obligations. Rather than be tempted by expensive private lenders’ offers of iPads and other trinkets or the promise of high commissions, it pays to compare and compare, then choose wisely. Furthermore don’t let clients pay fees unless a loan is provided.
The lending market
In summary, if effort is spent extending lender options beyond mainstream banks and bank-funded or bank-owned ADIs, the chance of placing deals will improve greatly. But be proactive. Call lenders and discuss their credit processes and target market then meet with them and get acquainted. Treat lenders as your treat prospective borrowers; maintain a CRM system for them because, as a broker you rely on upstream and downstream relationships; lenders upstream and borrowers downstream. If you manage relationships well with both you will greatly improve your chances of successful deal placement.