Guy Debelle: The state of the mortgage market
Address by Mr Guy Debelle, Assistant Governor of the Reserve Bank of Australia, at the
Mortgage Innovation Conference, Sydney, 30 March 2010.
* * *
I thank Michael Davies, Dan Fabbro, Megan Garner and Jennifer Pitman for their help in preparing this talk.
Thank you for the opportunity to address this forum. Today, I intend to talk about the past,
present and future of the mortgage market in Australia. It is useful to recount some of the
history of the mortgage market to put the current state of the market in to better context and
provide a basis for thinking about how the market might evolve in the period ahead.
History
In the 1960s and early 1970s, the Australian financial system was heavily regulated.1 There
was a number of wide-ranging controls including:

The interest rates that banks could charge on their loans and pay on their deposits
were controlled.

Banks were subject to reserve ratios and liquidity ratios.
 There were directives on the overall quantity of loans banks should make, as well as
moral suasion on who they should lend to.
 Institutions were specialised - trading banks lent to businesses, savings banks held
large quantities of Government debt and lent to households (almost entirely for
housing), and finance companies lent for more risky property loans and consumer
credit.
These regulatory controls on the banks reduced their capacity to adjust to changing
conditions and imposed a cost disadvantage on them. As a result they lost market share to
the unregulated financial sector, primarily building societies. The banks' share of total
financial intermediary assets declined from nearly 90 per cent in the early 1950s to
70 per cent in 1970. The banks' share of housing credit was just below 60 per cent in 1976
with much of the rest of the mortgage market being provided by credit unions and building
societies. Finance companies, which were generally associated with the banks, often
provided top-up funding to bank mortgages but were not a particularly large share of the
overall market.
Graph 1
Financial deregulation in Australia began slowly in the 1970s, before accelerating sharply in
the early 1980s. It affected the quantity of credit provided, the pricing and the structure of the
mortgage market (Graph 1).
The main developments were the reduction of the prescribed assets ratio which was the
minimum share of total assets that savings banks were required to invest in Government
debt. As this was gradually reduced from 70 per cent to 40 per cent between 1963 and 1978,
savings banks could correspondingly increase the share of housing lending in their assets.
On the pricing front, the interest rate ceiling on large housing loans was removed in the early
1970s and then in April 1986, the interest rate ceiling on all new housing loans, 131⁄2 per cent
at the time, was removed. (Existing loans remained subject to the 131⁄2 per cent cap until they
were discharged.)
In terms of the structure of the market, the distinction between savings banks and trading
banks was removed in 1989. Prior to that, in the mid 1980s, 15 foreign banks were given
licences to operate in the Australian market. However, the foreign banks, in the main,
focussed on lending to businesses rather than lending to households, in large part because
they did not have a branch network which would enable them to compete effectively against
the local banks. Further financial innovation which would have facilitated their ability to
compete without a branch network was still nearly a decade away.
The major change in market structure was that a number of building societies and credit
unions converted to banks through the 1980s and early 1990s. Becoming a bank allowed
these institutions a greater capacity to expand their capital base.
More generally, in the first few years after deregulation, business lending grew much more
quickly than housing lending. Between January 1985 and December 1988 business lending
grew at an average annual pace of 30 per cent, while housing lending grew by 22 per cent.2
As a result, the share of business loans in banks' total lending rose from 54 per cent to
62 per cent over this period.
However, in the early 1990s, a number of factors contributed to the banking system shifting
its focus from lending to business towards housing:
 First, the banks suffered large losses on their business loan portfolios during the
early 1990s recession. In contrast, the losses on their housing loans were relatively
mild, notwithstanding the fact that the unemployment rate rose to about 11 per cent
and mortgage rates reached as high as 17 per cent.

Second, demand for credit from the corporate sector declined as the sector
underwent a period of deleveraging.

Third, the introduction of the (first) Basel Capital Accord saw a change in the risk
weighting in favour of housing assets. In August 1988, the Reserve Bank of
Australia (which was then the banking sector regulator) issued guidelines for a
riskbased measurement of banks' capital adequacy, broadly consistent with the Basel
proposals. Prior to this, Australia used a capital-to-total assets ratio for measuring
the capital adequacy of banks, which gave banks an incentive to invest in riskier, but
higher yielding assets.3 Under the new risk-based approach, housing loans were
given a risk weight of 50 per cent, whereas business and personal loans had a risk
weight of 100 per cent. Banks were required to satisfy the new capital adequacy
requirements by 1992, but as early as 1990 they had taken steps to increase their
capital bases to the required levels.
As a result of these factors, between 1991 and 1995 the share of business loans in banks'
total lending fell by 15 percentage points to 48 per cent, while the share of housing lending
rose by 16 percentage points to 46 per cent. Since then, this trend has continued, reinforced
by the continuing strong performance of housing loans and, in terms of demand for credit,
the shift downwards in the nominal interest rate structure as the low inflation environment
was achieved and maintained. Currently, the share of housing loans in banks' total lending
stands at 58 per cent, while the share of business lending is about 35 per cent.
Rise of the wholesale lenders
The next development which had a material effect on the structure and pricing of the
mortgage market was the rise of the wholesale lenders.
As nominal interest rates came down in the early 1990s, mortgage rates declined more
slowly such that the spreads on banks' housing loans increased. In 1993, the spread
between the variable mortgage rate and the cash rate was about 430 basis points (Graph 2).
The reduction in inflation and nominal interest rates eroded the banks' funding advantage
obtained from interest-free deposits. These factors, together with the lower level of money
market rates (and their increased stability), provided the opportunity for wholesale lenders to
enter the market. These new institutions competed aggressively for market share by
undercutting banks' mortgage rates and by introducing new mortgage products such as
home equity loans, interest only loans and low documentation loans (see below). The
wholesale lenders' share of housing loan approvals rose quickly from 2 per cent in 1993 to
8 per cent in 1996 (Graph 3). The banks responded to this increased competition by reducing
their spreads, such that by 1997, the spread over the cash rate on their indicator housing
rates had decreased to about 175 basis points.
The ability of the wholesale lenders to compete effectively was considerably enhanced by the
growth of the residential mortgage backed securities (RMBS) market. This provided a source
of funds to these lenders which did not have the deposit base of the financial institutions.
These lenders had no balance sheet, little capital and no branch structure and hence were
low cost operations with a large degree of flexibility.
In subsequent years, the regional banks, along with credit unions and building societies, also
made significant use of securitisation as a relatively cheap source of funding. The major
banks also issued RMBS to diversify their funding base but it was never a large part of their
funding.
Graph 2
Graph 3
In a further response to the competition from the wholesale lenders, in the early 2000s,
banks began increasing the discount offered on the standard mortgage rate to new
borrowers. This enabled banks to slow the repricing of their loan books because only new or
refinancing borrowers benefited from the discounts, whereas changes to their standard
variable rate immediately flowed through to all borrowers. Initially banks did not publicise
these discounts, but since the mid 2000s, they have been quite open about them, and now
the vast majority of new borrowers pay an interest rate that is below the standard variable
rate. The discount has grown over time and has spread to most borrowers. Currently the
average borrower is receiving a discount of around 60 basis points on the standard variable
rate. This discounting saw the spread between the cash rate and the actual mortgage rate
paid narrow further over the decade to 2007.
As I mentioned earlier, the foreign banks focussed primarily on the corporate market when
they first began business in the mid 1980s, but from the beginning of this decade, they have
increased their focus on retail banking, including housing lending. Their share of housing
loan approvals increased from about 1 per cent in 2000 to a peak of about 15 per cent in
2008 (Graph 4). Two related factors have contributed to the foreign banks' increased market
share. First, starting off with a small portfolio of mortgages meant that the foreign-owned
banks were able to advertise lower interest rates without adversely affecting the profitability
of a large stock of loans to existing customers. Second, the wider acceptance on the part of
customers of applying for loans over the internet and the use of the broker network has
increased the ability of these banks to reach new borrowers without establishing a costly
branch network.4 During late 2008 and 2009 however, the foreign banks' market share fell
significantly, in large part because of the reduction in lending by Bank-West.
Graph 4
More generally, the emergence of mortgage brokers, who act as intermediaries between
lenders and borrowers and make it easier for borrowers to compare the costs and features of
different loans, has contributed to the increase in competition between lenders in the
Australian mortgage market. Mortgage brokers' share of total mortgage settlements is about
one-third of all loans.
Product innovation
Through the late 1990s and first half of the 2000s, there was considerable product innovation
in the Australian mortgage market. Lenders sought to cater for a wider range of potential
borrowers and found new ways to assess their borrowing capacity. Some of this innovation
has resulted in an easing in lending standards and an increase in risk for both borrowers and
lenders, but its overwhelming effect has been to widen the range of households who can
access finance.5 Moreover, when the lending was more risky, lenders charged a larger
spread on these loans to take account of the greater risk and required lower loan to valuation
ratios (LVRs) for these loans.
Lenders introduced home-equity loans, redraw facilities and reverse mortgages, all of which
allowed households to borrow against the equity they have built up in their homes. Lenders
also introduced interest-only loans and shared-equity loans, which made it easier for
households, particularly first home buyers, to purchase their home.
Loan products that better meet the needs of certain types of borrowers, such as those with
irregular income streams or those who do not meet the standard lending criteria, were also
introduced. Low-doc loans, for which borrowers self-certify their income in the application
process, accounted for about 10 per cent of newly approved housing loans in 2006,
compared with less than 1⁄2 per cent in 2000 (Table 1).
There was also an increase in non-conforming loans for borrowers who do not meet the
standard lending criteria of mainstream lenders. These borrowers typically have poor credit
or payment histories. In 2006, non-conforming loans comprised 2 per cent of new loan
approvals, compared with less than 1⁄2 per cent in 2000.
Table 1
Housing loans
Lending standards and arrears
Fortunately, lending standards in Australia did not loosen as much as in some offshore
markets. There was very little sub-prime lending of the form more common in the United
States for example, where loans were provided to those with poor credit histories. The
non-conforming loan market, which was the closest equivalent in Australia, never reached
more than 2 per cent of new loans, and is currently less than 1 per cent of loans outstanding.
Only a few fringe institutions were involved in the market. There are almost no
nonconforming loans being issued at the moment, with the providers of such loans having exited
or gone into extended hibernation.
Consistent with this, and the stronger underlying economic conditions in Australia, the share
of non-performing housing loans in Australia has remained very low (Graph 5). In December
2009, the share was 0.6 per cent in Australia, much the same as it was 15 years ago.
Compared with other countries, this is only a little above the 0.4 per cent in Canada and well
below the 21⁄2-3 per cent in the UK and Spain and 8 per cent in the US.
Graph 5
Looking at the Australian data in more detail, the proportion of banks' on-balance sheet
housing loans that were in arrears or impaired in December 2009 was 0.6 per cent. This is
up from the very low levels in 2002-2003, but still low in absolute terms. The arrears rate has
tended to be relatively stable in recent months.
Australian residential mortgage backed securities have continued to perform very well. This
is reflected in data from a lenders' mortgage insurance provider and the RMBS market,
which show that annual losses on insured prime housing loans averaged 4 basis points
between 1980 and 2010, with the highest loss in any one year being 10 basis points.6 As a
result, even the holders of lower rated tranches of RMBS have not suffered any losses, as
the insurance, together with the subordination embodied in the RMBS, has provided a more
than adequate buffer.
The effect of the financial crisis
The financial crisis has had a material affect on pricing and structure in the Australian
mortgage market but has not had a particularly marked impact on the quantity of housing
credit provided.
Beginning around the middle of 2007, there was a widespread reappraisal of the risks
associated with investing in structured credit products. Securitisation started to suffer severe
brand damage as primarily US RMBS incurred significant credit problems as delinquency
rates began to rise.7 Initially, the problems were most evident in the sub-prime mortgage
market, but they later spread to prime mortgages in the US as well. Combined with the
decline in house prices, these delinquency rates have led to large losses for investors in US
RMBS.
The Australian RMBS market was significantly affected, even though (as already discussed)
lending standards were much better in Australia, and the RMBS continued to perform well.
Issuance dried up markedly (Graph 6). Most of the issuance during late 2008 and the first
half of 2009 was purchased by the Australian Government through the Australian Office of
Financial Management. Offshore SIVs, which had been large buyers of Australian RMBS
prior to the financial crisis, were forced to liquidate their portfolios as they were no longer
able to fund themselves. These sales into the secondary market drove spreads from about
15 basis points (over the bank bill swap rate) pre-crisis to a peak of over 400 basis points in
early 2009. This very wide secondary market spreads also deterred new issuance.
Graph 6
The crisis also had a material effect on the funding costs of all providers in the mortgage
market. In addition to the effect on RMBS funding described above, wholesale (and
particularly recently) retail funding costs have risen relative to the cash rate.8
In response to the rise in funding costs, all institutions have raised their mortgage rates
relative to the cash rate. Interestingly, while the standard variable rate has been increased,
there is little sign of any reduction in the discounts offered on new loans. The average rate on
variable rate housing loans has increased by around 110 basis points relative to the cash
rate since mid 2007 (Graph 7).9 This increase, relative to the cash rate, is below the
estimated 130 to 140 basis point rise in banks' overall funding costs over this period. In
contrast, banks' business and personal loans have increased by even more relative to the
cash rate and by more than the rise in funding costs.
Because the funding costs of the smaller participants have tended to rise by more, their profit
margins have been squeezed more and in some cases, their capacity to provide new loans
has also been curtailed. Some participants have been able to remain competitive and
profitable only by cross-subsidising their new issuance using the large spread they are
earning on their back book of mortgages. These mortgages were funded pre-crisis, so that
the subsequent upward repricing of the whole mortgage book has resulted in the older loans
now earning a wide margin.
Graph 7
The pressure on funding during the crisis, together with the near closure of the RMBS
market, changed the competitive dynamics in the mortgage market. The market share of
wholesale lenders (who relied almost exclusively on securitisation) fell from about
13 per cent in mid 2007 to about 2 per cent by early 2009. Several of the larger wholesale
lenders were acquired by the major banks (CBA bought into Aussie and Aussie bought
Wizard; Westpac bought RAMS distribution business; NAB bought Challenger's mortgage
business). The share of housing loan approvals by smaller banks, credit unions and building
societies also declined, though not as sharply. The major banks' combined market share
rose from 60 per cent to over 80 per cent over this period.
Nevertheless, housing finance has been readily available throughout the crisis period, with
housing credit growing at about 8 per cent a year. The larger banks have filled the gap left by
the decline of the wholesale lenders, so that there has not been a material constraint on the
quantity of housing credit available in Australia throughout the crisis.
There has, however, been some tightening in lending standards, with several banks reducing
their maximum LVRs on prime, full-doc loans for new borrowers from 95-97 per cent to
about 90 per cent during 2009. Banks have also raised their interest rate buffers and
increased their "genuine savings" requirements. Low-doc and non-conforming loans have
become much harder to obtain. This has seen a decline in the share of new owner-occupier
housing loans with a LVR above 90 per cent, from a peak of 27 per cent in the March quarter
2009 to 17 per cent by the end of the year. The share of low-doc loans has declined to about
7 per cent.
There has been a decrease in the shares of new investor loans that are being written with
higher loan-to-valuation ratios (LVRs) or lower documentation standards. There has also
been a decline in the share of interest-only loans, though it is still the case that close to half
of all new investor housing borrowers are opting to not make any principal repayments,
reflecting the tax advantages of this funding strategy.
The future
Looking forward, the competitive state of the current market is reflected in the fact that home
lending rates have not risen by as much as funding costs. Moreover, the outlook for the
smaller lenders has improved since mid 2009. The securitisation market is starting to
recover, with the volume of issuance to non-AOFM investors picking up and secondary
market spreads decreasing.
Securitisation is once again becoming a more viable funding source for lenders, with spreads
on newly issued RMBS - around 130 to 135 basis points over one-month bank bills for
nonAOFM supported deals - a little below our estimated break-even spread of around 160 basis
points. However, our estimate of the break-even spread, and hence the profitability of the
issue, does not take into account different degrees of subordination across issues. To the
extent that that the degree of subordination required by investors is greater than it was
previously, the overall profitability of the issue will be lower. This is because a greater share
of the security is retained on the book of the issuer, or sold at a higher cost to another
investor, reducing the return from the deal. (However, this effect on overall profitability is
much smaller than the increase in spreads since the crisis.)
The cost of long-term and short-term wholesale funding has also decreased since mid 2009,
though the cost of deposits remains high. Consistent with this, the smaller lenders' market
shares have risen slightly over recent months, though they are unlikely to return to pre-crisis
levels any time soon. The pre-crisis level of RMBS activity, which these institutions relied
more heavily on, was supported by demand from offshore SIVs which is no longer there. But
as the major banks have increased their lending rates to recoup increased funding costs, and
as funding costs for securitisation have fallen, the smaller participants have become
increasingly more competitive.
While interest rates on mortgages have increased relative to the cash rate, the Reserve Bank
is able to take account of those changes in its policy deliberations. The cash rate determined
by the Reserve Bank is still the major determinant of the interest rate structure in Australia,
including that of mortgage rates.
With the securitisation market showing greater vitality in recent months, the housing loan
market remains contestable. Any widening in margins is likely to attract new competitors into
the market. Already, the improvement in securitisation has encouraged some of the smaller
lenders back into the market and encouraged some brokers to again look to increase their
own mortgage lending.
With these developments, the provision of mortgage credit in Australia is likely to continue to
be adequate in a competitive marketplace.