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Re-shaping retail mortgage lending

By Anthony Crook - posted Wednesday, 14 May 2008

In the wake of the sub-prime crisis, community expectations of banks have come under great scrutiny. Bank shareholders as well as customers and governments have all weighed in with expectations. Three core expectations of lenders have emerged:

  • more transparency of their loan book and the assets which underwrite it;
  • greater responsibility and due diligence of lending practices to individual borrowers; and
  • competition and appropriate compensation of costs and risks.

Collateralised Debt Obligations (CDOs) may not have been responsible for the collapse of the US housing market but they were partly responsible for the failure of banks to lend to one another afterwards. The primary reason is because there was a fundamental lack of transparency. Banks still do not have a complete understanding of the exposure of one another to the sub-prime market. This creates mistrust in an industry that relies on trust to function.


From the negatives of the collapse in sub-prime lending in the US there are lessons to be learned. Much closer attention needs to be paid to the borrower of debt when making the initial loan. The banks need to have a clear understanding of what their risks are. To do that they need to first understand what loans are on their balance sheets and what the risks are of each of them.

A positive lesson to emerge from the rapid expansion of CDOs is that debt priced in stages of risk is a very popular product. Through CDOs, banks were able to off-load a large amount of new lending onto secondary and tertiary markets. These debt instruments were traded as having a reduced risk because of the large and diverse range of mortgage securities underwriting them. The CDOs were often then used as security for loans from banks themselves.

Now we consider the customer. If we consider the impact of the current credit-crunch on an individual borrower, the largest burden falls on two borrowing types.

The first is obvious, young and first time low-deposit borrowers. These borrowers are now struggling to secure finance at all as no-deposit products dry up across the world. Greater clarity in the financial markets and lower wholesale funding costs will need to occur before any improvement accrues to this type.

The other more silent sufferers are older, long-term mortgage holders. A mid-term loan customer on a variable interest rate that has been making repayments for ten years or more is now faced with an increased interest rate (increased credit spreads above RBA moves) due to increased risk of the bank's entire loan portfolio. There is no obvious reason to believe that such an individual borrower poses any additional risk, any more than they did before the on-set of the sub-prime crisis. They are therefore being penalised despite having a relative lower risk. This raises the risk and also the opportunity to a bank, for the “best customers” have an incentive to leave and go to another lender offering a cheaper product that recognises their low risk. They can often do so without an exit penalty.

By Australian law, lenders are required to obtain lenders mortgage insurance for loans over 80 per cent of the security value of a property (Loan to Valuation Ratio  -LVR). One potential solution for investors looking for clean balance sheets, governments looking to regulate and customers looking for a fair deal, is to introduce tiered interest rates.


Lenders could offer interest rate products where the first 50 per cent of a loan is charged at a base rate. The rate could then increase in 5 per cent security (LVR) increments. A slightly higher rate for loans of 55 per cent, 60 per cent, and so on, up to100 per cent. The rate charged for the final 5-10 per cent may resemble unsecured loans. The bank could then reward both long term customers as well as new customers with a sizeable deposit. Once introduced, the market could accurately price each band of debt.

This would look good in the eyes of governments as it encourages customers to save a large deposit before embarking on a large loan commitment. It would also cause customers to re-think mortgage re-financing for consumption at higher LVRs as it would be more expensive.

Most importantly it would offer clarity to investors about the portfolio of loans that the bank has. The key to success of the strategy is the rate being charged for each portion of the debt is separate and can be raised or lowered independently of the other portions. More accurate pricing of each portion of the loan can then occur. When a credit problem occurs and a lender has too much exposure to a risky portion of the debt, the lender can raise that rate. This reflects the change in risk as well as giving customers the option of moving this portion of the debt to another lender.

For example, this would allow banks to lend the first 70-80 per cent and then a second lender the remaining portion of the loan. This would also assist competition. The market would also be informed of both the number of loans and size of loans across the “LVR distribution”. Performance of riskier portions of debt could be analysed with greater accuracy leading to a better understanding of the risk-reward balance.

Were a loan to default, the primary lender would have first rights to the equity and therefore the last burden of the loan-default transaction cost. The first 50 per cent of loan would incur a low risk of default and a high chance of recovery in the event of a default. You would expect the first 50 per cent of a home to have a small premium to government debt.

The overall benefit to society is in pricing risk more accurately at a retail level and achieving lower risks for the banking sector as a whole as a result of greater transparency.

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About the Author

Anthony Crook has been an economist at Access Economics since 2001. Anthony is at the forefront of shaping public policy, taking part in keystone reviews such as the 2003 Hogan review on the state of the aged care industry. He has a wide ranging body of work from inter-generational issues in health, employment and education to applied market modelling of the housing and office/retail sectors. His goal is to provide quality independent advice to both the public and private sectors.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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