Lower Costs, But Not For Long As Pressure Hits

Sydney Morning Herald

Monday August 25, 2008

Danny John

THE fall in home-loan costs expected for as early next month could be short-lived as the longer term funding pressures on banks are set to increase rather than ease over the coming year.

With the National Australia Bank and the ANZ having committed themselves to passing on in full a Reserve Bank-prompted 0.25 per cent reduction, the rest of the industry will almost certainly follow, despite the pressures in money markets that has pushed up the cost of borrowing.

Nonetheless, the National's pre-emptive decision last week to cut the rate of its standard variable mortgage by the same amount of the Reserve if it moves, as hinted, in two weeks' time, caught its rivals on the hop.

All of the banks had, until then, argued it was too early to commit to a 25 basis points cut, as their decision would have to consider the state of short-term borrowing markets and the separate cost of longer-term financing.

The widespread view is that not all of that amount would have been passed on by the banks, given they have been absorbing nearly half of the extra borrowing costs. They had held to that line, despite pressure from the Prime Minister, the Treasurer and even the Reserve, all of whom claimed the banks' short-term financing costs had fallen in recent weeks.

The slowdown in the economy has also become a factor in the debate, with the Reserve indicating it is time to reverse the trend of rising interest rates as inflation is being brought under control.

Part of the Reserve's job has been done by the leading banks, which broke the cycle of raising home loan and borrowing costs in line with the Reserve in January, as the global credit crisis sent their own financing bills soaring.

Mortgage rates are at least 50 to 60 basis points (0.5 to 0.6 per cent) higher than normal because of soaring interest rates on new debt charged by hard-hit international credit markets.

The banks use what is called wholesale funding to make up the lending shortfall that cannot be met by personal and business deposits they take in. In recent weeks, one of those key funding sources - the 90-day bank bill market - has seen its charges drop dramatically, largely in anticipation the Reserve will cut its cost of borrowing.

Before the credit crisis that swept the world last August, the difference between the Reserve's cash rate and that charged by the 90 BBSW market was about 15 basis points.

But that difference jumped in the following months to the point that the gap blew out in March this year to more than 100 basis points - or one full percentage point. That led the big banks to increase their own interest rates to try to recover part of their extra financing costs from consumers.

At the same time, it was also costing the banks a great deal more to borrow from long-term credit markets - typically in chunks of three to five years.

Those rates have been much higher, with charges of between 100 basis points to 200 basis points over "cash" becoming the norm since January. It is the cost of borrowing tens of billions of dollars from these markets to meet the country's lending demands that is most worrying the banks, since this funding has been "locked in" to as far out as 2013.

Also, previously cheap long-term debt they took out between 2003 and 2005 is coming up for replacement. Refinancing will be at higher rates than last time.

About a quarter of the funding needs of the Big Four banks - Commonwealth, NAB, Westpac and ANZ - is sourced from long-term markets with another fifth to a quarter provided by the short-term ones. The rest is from customer deposits.

The trend in long-term markets is for bank borrowing costs to rise - from about 42 basis points above "cash" rates at present to 82 basis points by the end of next June. The relief provided by the short-term money markets where the difference is just 10 basis points (0.1 per cent) is likely to be reversed once the Reserve cuts its own rates - by as much as 50 basis points (0.5 per cent) by Christmas.

Bank economists are forecasting the spread in rates will rise to 58 basis points which, with the additional long-term price pressures, could lead to an overall cost rise to 140 basis points - 1.4 per cent - within the next 10 months.

Under that scenario, the banks will face the same dilemma they have faced since late last year: raise their rates no matter what the Reserve does, or take an even bigger hit to the bottom lines of their home-loan divisions. Given money markets trends, betting in the industry is that home loans won't come down as quickly as they went up, and may stay as high for months.