Joshua Peach: Thousands of Australians are facing higher mortgage repayments following further rate rises from the RBA earlier this year. I'm here with Morningstar's Nathan Zaia to discuss what it means for the nation's banking sector.

Thanks for being here with us, Nathan.

Nathan Zaia: Pleasure to be here. 

Peach: There was a lot of talk earlier this year about a mortgage cliff. Can you explain a little what that is and why it had people concerned?

Zaia: Yeah. So, basically, the RBA [Reserve Bank of Australia] provided the banks with really cheap funding, and during late '20, early '21, there was also really high savings among households. So, there was a lot of liquidity. And so, banks went and used that to offer home borrowers really low fixed home loan rates, so probably the lowest we'll ever see.

So, this cliff that we hear a lot about, it's those low rates maturing now and they're going to be refinanced at a higher rate. So, there's going to be a big cohort that see their 2% rate go to, say, a 6%, so that's a material increase. So, that's the fear that within that group a lot of them won't be able to meet those loan repayments and so we're going to see higher defaults and mortgage stress and people having been forced to sell their properties.

Peach: With the increase in potential mortgage stress, people are concerned about knock-on effects to the major banking institutions in Australia. Do you think investors in the big four should be concerned? 

Zaia: Well, I mean, it is a risk. The higher rates go, the bigger the risk that it's going to impact more households, I guess. But we're starting to see some signs of consumers pulling back in their spending. So, that's what we think we'll see first. A lot of those households that they are doing a tough, it is a fine margin between being able to meet their repayments, cutting back on a lot of discretionary spend. So, we expect we'll see that first. The other thing is a lot of these loans are principal and interest repayment. So, we would probably see a lot of switching from that to interest-only.

So that lowers your repayments by quite a significant amount. You might do that for a year or two and then reassess, can we continue to live like this, or should we sell? Can we generate more income? Can we make lifestyle changes? Do we have other assets that we can sell? So, it gives people time. So, I think, we've got a few things we need to see at play out first before I'd be worried about, okay, this is a material group that are in a position where the default is the only option. And banks are going to work with borrowers. It's in the bank's best interest too to keep the market going, I guess.

Peach: Looking forward, earning season is just around the corner. What are you expecting to see from the major banks and what's your outlook for the sector in the back half of this year? 

Zaia: Yeah. So, in the first half, we saw them really benefit from the higher cash rates. They benefit from having those transaction account deposits, so they've repriced the loans quicker. Some of that was eroded just by competition, but they still did get a bit of a kick. So, we started to see that come down, and we expect it would have continued to – and when I talk, come down, the margins come down over the second half and probably continue to ease.

But we are also seeing some signs that rational pricing will prevail over time eventually as well. So, we've seen a few of the banks lift their new loan lending rates by more than the cash rate increases. Most of the banks have pulled their cashback offers as well. So, I think we've got to a point where the pricing on both the loans and the deposits got to a point where the returns just weren't there for the majors, let alone the smaller lenders. So, we expect there will be pressure in the short term still. There's a lot of fixed rate customers rolling off.

So, there is potentially a lot of switching, and credit growth is slow as well. So, competition is going to be pretty tough still, but we think we've probably reached the height of how aggressive you are willing to price to get those customers as well.

Peach: It has been in a lot of ways a difficult first six months for the sector. From an investment perspective, where are you seeing value for investors right now? 

Zaia: We think Westpac (WBC) and ANZ (ANZ) are the most undervalued out of the major banks. And I think they're the ones that have had operational issues and not being able to grow their loan books and keep up with the market. Westpac also had a more heavily skewed investor loan book. So, they've been reweighting towards owner occupier and investor demand was slower, so that also hurt them. But we are seeing signs that they can grow in line with the market again.

So, we don't think that was a permanent issue. And at the same time that was happening, they had a few regulatory and compliance issues. So, you've got loans not growing as quickly as everyone else, but you've got your cost base growing by a lot more than everyone else.

So, that's really impacted their profitability. But we think over time, they can grow their loans in line with market again, not necessarily take back all that lost share, and there's potential for some of those costs to come out. So, once you've addressed some of those compliance issues, maybe not all of them fall out, but some of them probably do fall out. So, we think if Westpac can demonstrate that, an ability to keep up with the market and take costs out, then it is materially undervalued. 

Peach: Looking outside the big four, are there also any opportunities amongst the smaller banks in Australia?

Zaia: Yeah, I think Bank of Queensland (BOQ) and MyState (MYS), which is a very small bank, are both very undervalued. They're going to have more of the margin pressure because more of their funding is the term deposits, which has been a lot more price-sensitive and also wholesale funding. So, they don't get as much of that benefit of the major banks that people just have their money in a transaction account.

So, they're seeing a lot of margin pressure. But over the sector, we expect to see a bit of repricing and they will benefit from that as that flows through. So, yeah, I think the pessimistic view around margins in the short term is probably overlooking what happens over the medium term as well.

Peach: Thanks for talking with us today.

Zaia: Thanks for having me.