European debt crisis could hurt Australians' hip pockets

The sovereign debt crisis being experienced in Europe could soon be hitting the hip pockets of Australian mortgage holders. 

As eurozone finance ministers prepare to meet in Brussels tomorrow and Wednesday to try and find a path out of the current crisis, Australian economists and banking analysts are warning that the major banks may decide not to pass on the full extent of future interest rate cuts in order to maintain net profit margins on their lending and other financial products. 

Margins on home loans are expected to come under pressure due to an increase in the cost of re-financing wholesale funding lines as more jittery offshore institutional investors demand a greater return for their money (despite Australian mortgage-backed securities and other debt products rated among the safest in the world). 

The risk was made clear last week by Katie Dean, head of Australian economics at ANZ, who said a key transmission risk to Australia from European sovereign debt troubles was “a systemic shock to the supply and/or cost of global credit”. 

“This week, we saw a range of worrying developments that signal these transmission risks have risen,” she said.

“If global credit costs fail to resettle, the cost of Australian wholesale bank funding will likely rise. 

“This increases the risk that these higher wholesale costs will be passed on to the end-users of credit: businesses and households.” 

Over the past financial year the Big Four banks raised about $100 billion annually from wholesale debt markets to fund mortgage lending – primarily from institutional investors in Europe and the United States. 

While the major banks have all said they can hold off tapping into off-shore markets until 2012, Goldman Sachs estimates they will collectively require around $72 billion in wholesale funding for the 2012 financial year. 

According to figures prepared by Deutsche Bank for Business Day, the Big Four banks will need to refinance a total of $48 billion in bonds by June next year,  with $16 billion needed to be refinanced by the end of January. 

This refinancing will have to be done at higher rate of borrowing, meaning either borrowers or the bank’s shareholders will have to bear the cost. 

Australians don’t need very long memories to recall that a similar situation evolved in the wake of the sub-prime mortgage crisis of 2007 and 2008 when banks either raised interest rates above official rate rises or did not pass on rate cuts in full, blaming this on the high cost of offshore funding. 

This culminated in Westpac’s infamous “banana smoothie” animated video, where it tried unsuccessfully to explain how the increase cost of wholesale funding (bananas) was pushing up the price of mortgages (banana smoothies) after the bank raised mortgage rates by 45 basis points in December 2009 following an RBA increase of just 25 basis points. 

An escalation of the crisis in Europe would only add to the cost of borrowing money offshore with the increase likely to be passed on to borrowers rather than shareholders.

This appears to be happening already. with ANZ chief executive and new chairman of the Australian Bankers Association Mike Smith telling the Weekend Australian Europe was already in a “nasty” credit crunch, which was likely to spread to Asia and Australia. 

Offshore jitters has already caused the Commonwealth Bank to pull an issue of covered bonds – considered an exceptionally safe investment because they are backed the  bank’s assets  - due to “heightened market volatility”. 

Aside from increased wholesale funding costs, banks will also be looking to maintain home loan profit margins following a home loan pricing war, with the most recent JP Morgan Banking Sector report warning that “current [home loan] pricing is about as competitive as it can get prior to diluting group returns”.