mortgage

Finance Broking

in Practice (FBP)

By

Matthew Bagra

Published by International Institute of Technology

Note:

Disclaimer: The International Institute of Technology (IIT) and all contributing authors have used reasonable care and skill in compiling the content

of this material. However, IIT or contributing authors make no warranty as to the accuracy or completeness of any information in these materials.

These materials are not intended to be advice, whether legal or professional. All names, figures, solutions and scenarios are fictitious and have been

established for training purposes only. You should not act solely on the basis of the information contained in these materials as parts may be generalised

and the application of exercises, examples and case studies may vary from organisation to organisation and may apply differently to different people

and circumstances. Further, as laws change frequently, all students, readers, viewers and users are advised to undertake their own research or to

seek professional advice to keep abreast of any reforms and developments in the law.

International Institute of Technology © 2 VR261018

Table of Contents Chapter 2 Understanding the Industry and the Economic Environment 3

1. Introduction to the Financial Services Industry ................................... 4 2. Financial Intermediaries ...................................................................... 4 3. Government agencies ........................................................................... 7 4. Economic Environment ....................................................................... 11 5. Economic Activities and Economic Growth ......................................... 12 6. Inflation ............................................................................................. 14 7. Business Cycles .................................................................................. 15 8. Fiscal and Monetary Policies ............................................................... 16 9. Interest Rates .................................................................................... 19 10. External Influences on the Australian Economy ............................... 19 11. How to Access Economic Indicators ................................................. 20

Bibliography 23

**The copyright to this book is held by the International Institute of Technology Pty Ltd. Apart from any fair dealing for the purposes of study, research, criticism or review, as permitted under the Copyright Act, no part may be reproduced by any process without written permission from the company.

Please note due to the ever changing operating environment for Financial advisers, rates and figures provided in the course work are subject to change some every quarter, therefore it is imperative that you complete your own research so that you are familiar with the current rates or figures which may not necessarily be reflected in the coursework at the time of you undertaking your studies.

International Institute of Technology © 3 VR261018

Chapter 2 Understanding the Industry and the Economic Environment

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1. Introduction to the Financial Services Industry

The financial services industry encompasses a broad range of organizations that deal with

the management of financial assets and provide various financial services. This industry is

an important and major part of the Australian economy. The Australian Bureau of Statistics

reports that financial services industry is among the three largest sectors in the economy

along with manufacturing and the property/business services. It is estimated that the

industry currently employs about 500,000 people. Similarly, the 'Finance and Insurance'

category is said to make up around 40% of market capitalisation on the Australian

Securities Exchange.

Market participants, such as individuals, companies, markets and government agencies,

are all involved in the process of exchanging financial assets, transforming and assuming

risks. The institutions providing financial services are cogs in the financial system and are

necessary to help the flow of financial assets between the various sectors of the economy.

These institutions act as financial intermediaries and help to match the supply and demand

for financial assets. They are:

 Retail and commercial banks

 Investment banks

 Finance companies

 Life insurance companies

 General insurance companies

 Building societies

 Credit unions

 The stock exchange

 Brokers

 Superannuation funds

With such a large environment it is vital a broker keeps up with changes and there are a

variety of consumer reports available to do this including:

 Australian Broker - m.brokernews.com.au

 MPA Editor – m.mpamagazine.com.au

 The Adviser – www.theadviser.com.au

 The Australian Bureau of Statistics (ABS) GDP data released quarterly

 ABS Building Approvals

 Central Bank of Australia (RBA) Quarterly Minutes & commentary on interest

rates

 Weekly clearance rates form real estate institute

2. Financial Intermediaries

Financial intermediaries can be broken down into two major sectors; retail and

wholesale.

The retail sector includes the following services:

 Cash management and deposit services

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 Withdrawal and safe-keeping of cash

 Issuance of chequebooks so that payments can be made securely

 Personal loans, commercial loans and mortgage loans

 Credit cards and processing of credit card transactions and billing

 Debit cards for use as a substitute for cheques

 Financial transactions at branches or by using Automatic Teller Machines (ATMs)

 Wire transfers of funds and electronic fund transfers between banks

 Standing orders and direct debits so that bills can be paid automatically

 Overdraft facilities, which are temporary advancements of the bank's own money

to meet monthly spending commitments of a customer in their current account

 Charge card advances of the bank's own money for customers wishing to settle

credit advances monthly

 Bank cheques guaranteed by the bank itself and prepaid by the customer.

 Private banking services extended exclusively to high net worth individuals

 Financial planning services

 Credit card machine services and networks

 Foreign exchange services including currency exchange, international wire

transfer and foreign currency banking

 Insurance brokerage where insurance brokers shop for insurance (generally

corporate property and casualty insurance) on behalf of customers

The wholesale sector includes the following services:

 Capital market bank – a bank that underwrites debt and equity, assists company

deals (advisory services, underwriting and advisory fees), and restructures debt

into structured finance products

 Asset management – the term usually given to describe companies which run

collective investment funds

 Hedge fund management – these funds often employ the services of ‘prime

brokerage’ divisions at major investment banks to execute their trades

 Custody services – the safe-keeping and processing of the world's securities

trades and servicing the associated portfolios

 Reinsurance – insurance sold to insurers themselves to protect them from

catastrophic losses

 Intermediation or advisory services

 Venture capital investing

A financial services institution that is active in more than one sector of the financial

services market e.g. life insurance, general insurance, health insurance, asset

management, retail banking, wholesale banking, investment banking, is called a

conglomerate. A key rationale for the existence of such businesses is the existence of

diversification benefits and cross-selling potential that are present when different types of

businesses are aggregated.

Retail banks are the largest deposit-taking and financial institutions in Australia. The

Australia and New Zealand Banking Group (ANZ), Commonwealth Bank of Australia,

National Australia Bank (NAB) and the Westpac Banking Corporation are the largest four

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banks in Australia. They account for over half the total assets of all banking industry.

These four banks provide extensive banking services and retail branch network throughout

Australia. The remaining banks provide similar banking services through limited branch

networks, often located in particular regions throughout Australia.

In addition to banks, financial institutions such as building societies, credit unions and

merchant banks all play an important role in the Australian financial system. Investment

banks (also known as money market corporations) operate at the 'wholesale end' of the

financial markets; the 'middleman' between companies issuing securities to raise funds

and the investors who buy the paper. They perform an important intermediary role,

channelling sizeable parcels of funds to large private corporations and government

agencies and are an important conduit by which overseas capital is brought into Australia.

Investment banks deal in private and government securities, accept bills, underwrite

issues of debt and equity capital, and devise innovative finance packages (in return for a

fee) for corporate clients. They are not subject to the same regulation as ordinary banks

nor do they accept deposits from the public like retail banks.

The Australian financial system also includes a range of non-bank financial institutions

(NBFIs). These are:

 Building societies

 Credit unions

 Finance companies

 Managed funds

 Securitisers

 Private lenders

Building societies are involved mainly in the provision of mortgage finance for owner-

occupied housing. They collect funds mainly by tapping into household savings. Since the

mid-1980s, building societies have sought to increase the range of services on offer in

order to maintain market share.

Credit unions are co-operative organizations, owned by their members and run on a non-

profit basis. They concentrate upon meeting the financial requirements of members,

providing avenues for investment and borrowing. They differ from building societies in two

main respects. Firstly, membership is limited to those with some common bond, e.g.

people working in the same industry. However, with amalgamations between different

credit unions these bonds are less prevalent and most people would now qualify to join a

credit union. Secondly, lending to members is for more general purposes than housing,

e.g. cars, holidays and boats.

Finance companies provide various types of loans, including credit for retail sales,

personal loans, finance for housing, wholesale financing, lease financing and other

commercial loans. Most loans to consumers are for the purchase of consumer durables

over relatively short terms. Lending to the business sector includes lease financing as well

as other commercial loans, including loans for non-residential property investment. These

are generally for short to medium-term periods. Finance companies represent an

alternative destination for individuals and business savings because funds required for

lending are borrowed from the public, mainly by way of debentures, notes and deposits.

Managed fund is a pool of invested funds of individual investors. These funds invest the

pool on various financial instruments on their behalf. By using a managed fund, investors

gain access to markets, instruments and expertise that would otherwise be unavailable to

them. Each has a share, proportional to the number of units they own, in all the

distributions of income earned by the fund. Changes in the value of the fund's underlying

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assets are reflected for each unit holder by changes to the unit price of the fund.

Securitisers deals with the securitisation process. This is a financing technique involving

the conversion of non-liquid assets with predictable cash flows into marketable securities.

Loans or mortgages fall into this category. Normally a lender may hold all loans as non-

liquid assets on its balance sheet. Since these assets provide cash flows consisting of both

principal and interest payments, they can be packaged and turned into securities which

are then sold to investors through trusts or companies. As the transaction is generally

structured as an asset sale, they will be removed from the seller's balance sheet.

Private lenders are another source of funding. Private lending involves borrowers using

the underlying value of their properties, more so than their capacity to service the loan,

to borrow a relatively conservative amount of money compared to the value of the property

(generally no more than 70% of the property value). The borrowed money comes from

private investors marshalled by a lending lawyer. Loan terms are generally short (one to

three years) and interest rates are generally set at a premium above bank rates.

3. Government agencies

Government agencies including the Australian Securities and Investment Commission

(ASIC), Australian Competition and Consumer Commission (ACCC) and Australian

Prudential Regulation Authority (APRA) have roles in overseeing financial services industry.

The respective roles of these regulatory agencies are discussed below.

Australian Securities and Investment Commission

ASIC is responsible for the administration of the corporation legislation and the regulation

of the financial services industry in Australia. ASIC grants licences to financial services

providers where they prove that they have the organizational competency to comply with

a range of obligations under the Corporations Act. Licensees are also required to put in

place compliance arrangements, make certain disclosures and join an ASIC approved

dispute resolution scheme.

ASIC regulates the activities of all organizations that provide financial services. It is

responsible for protecting consumers who have savings or deposit accounts and credit

cards. ASIC is also responsible for overseeing the market conduct and consumer protection

issues on credit.

ASIC has recently started to assume full responsibility for being the sole and national

regulator of consumer credit lending and finance broking in Australia. The consumer

protection laws apply to a wide range of credit products including:

 credit cards

 small business overdraft facilities

 investment loans

 hire purchase agreements

 personal and home loans

 mortgages and guarantees which secure borrowings

 negotiable instruments including bills of exchange and promissory notes used to

provide credit

Lending to small businesses and lending for investment purposes are under the regulation

of ASIC. It does not regulate loans between friends or family members, or other non-

commercial arrangements. In other words, its influence is limited to activities that take

place in the context of "trade or commerce".

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Australian Competition and Consumer Commission

The ACCC, which ensures that there is vigorous competition in the marketplace, enforces

the consumer protection and fair trading law. The ACCC is an independent statutory

authority. It was formed in 1995 to administer the Competition and Consumer Act (2010)

which replaced the Trade Practices Act (1974) and other Acts. It has the power to enforce

the Competition and Consumer Act. The ACCC’s role is to promote competition and fair

trade in the market place to benefit consumers, business and the community. It also

regulates national infrastructure industries.

Its primary responsibility is to ensure that individuals and businesses comply with the

Commonwealth's competition, fair trading and consumer protection laws. The ACCC is the

only national agency dealing with competition matters and the only agency with

responsibility for enforcing the Competition and Consumer Act and the state/territory

application legislation. In fair trading and consumer protection its role complements the

Competition and Consumer Policy Division of Federal Treasury as well as the state and

territory consumer affairs agencies that oversee the mirror legislation of their jurisdictions.

The charging of interest, bank fees and credit card surcharges are regarded as 'financial

services' and are therefore not within the jurisdiction of the ACCC. The ACCC does not

handle complaints about misleading or deceptive conduct in relation to financial services

as this falls under ASIC’s jurisdiction.

Australian Prudential Regulation Authority

APRA is another government agency that has the prudential (meaning cautious or sensible)

regulation authority over a range of financial institutions including banks, credit unions,

insurance companies and superannuation funds. The fundamental aim of prudential

regulation is to ensure sound practices and financial stability.

APRA oversees banks, credit unions, building societies, general insurance and reinsurance

companies, life insurance, friendly societies, and most members of the superannuation

industry.

APRA was established on 1 July 1998 to administer the APRA Act. The key requirements

of the Prudential Standard as at January 2008 are that an authorised deposit-taking

institution must:

 have an Internal Capital Adequacy Assessment Process

 maintain minimum levels of capital, at both Level 1 and Level 2 as appropriate

 inform APRA of any significant adverse changes in capital

APRA is funded largely by the industries that it supervises. In June 2008 it reported that

it supervises institutions holding approximately $3 trillion in assets for 21 million Australian

depositors, policyholders and superannuation fund members. APRA suggested that it is

not possible to come up with an exhaustive and prescriptive definition of the expression

'financial services' as it has not been defined in the legislation. The definition it provides

includes investment business, insurance business and banking business.

A banking business cannot operate in Australia without authorisation from APRA.

Applicants need not offer a full range of banking services on authorisation. They may

choose to provide specialised services, provided they can demonstrate expertise in their

selected area of operation. An institution granted an authority to carry on banking business

in Australia is referred to as an authorised deposit-taking institution or ADI.

APRA is responsible for promoting the safety and soundness of deposit-taking institutions

and supervising the organizations operating in the financial services industry. It was given

the responsibility of ensuring that authorised deposit-taking institutions operate with

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integrity and act in a sensible manner with careful thought and wisdom in their everyday

practice. APRA will only authorise suitable applicants with the capacity and commitment

to conduct banking business with integrity, prudence and competence on a continuing

basis.

Australia's regulatory approach sets out certain prudential standards before an entity can

become a bank. Prudential standards aim to ensure that authorised deposit-taking

institutions maintain adequate capital, on both an individual and group basis, to act as a

buffer against the risks associated with their activities. A key principle in bank supervision

is that capital is the cornerstone of a bank's strength.

The Bank for International Settlements devised a risk-weighted framework for bank capital

adequacy which has been adopted in all Organisation for Economic Cooperation and

Development (OECD) countries, including Australia. Prudential standards outline the

overall framework adopted by APRA for the purpose of assessing the capital adequacy of

an authorised deposit-taking institution. Applicants are required to satisfy APRA that they

are able to comply with the stated capital adequacy requirements from the commencement

of their banking operations.

APRA will assess the adequacy of start-up capital for an applicant on a case-by-case basis

based on the scale, nature and complexity of the operations proposed in the business plan.

An applicant proposing to operate as a bank in Australia is required to have a minimum of

$50 million in Tier 1 capital. Otherwise, no set amount of capital is required for an authority

to carry on banking business. Foreign authorised deposit-taking institutions are not

required to maintain endowed capital in Australia. Newly established authorised deposit-

taking institutions may be subject to a higher minimum capital ratio in their formative

years, depending on the risk profile of the proposed operations.

Under prudential standards, banks are required to have a minimum of 4% of credit risk-

weighted assets as 'core' or Tier 1 capital and a ratio of total capital. Tiers 1 and 2 are

required to be of not less than 8% of credit risk-weighted assets.

Tier 1 capital consists of paid-up ordinary shares, non-repayable share premium account,

general reserves, retained earnings, non-cumulative irredeemable preference shares and

minority interests in subsidiaries. Tier 2 or supplementary capital includes general

provisions to a limit for doubtful debts, asset revaluation reserves, cumulative

irredeemable preference shares, mandatory convertible notes and similar capital

instruments, perpetual subordinated debt and redeemable preference shares, and term

subordinated debt (up to a limit). Tier 1 capital is required to always exceed Tier 2.

Capital is the cornerstone of an authorised deposit-taking institution’s financial strength.

Capital supports authorised deposit-taking institutions’ operations by providing a buffer to

absorb unanticipated losses from its activities and, in the event of problems, enables the

authorised deposit-taking institution to continue to operate in a sound and viable manner

while the problems are addressed or resolved. The board of directors of any authorised

deposit-taking institution has a duty to ensure that the institution maintains an appropriate

level and quality of capital commensurate with the level and extent of risks to which the

authorised deposit-taking institution is exposed from its activities.

Authorised deposit-taking institutions (ADIs) are also required to have in place an Internal

Capital Adequacy Assessment Process (ICAAP) that includes adequate systems and

procedures to identify, measure, monitor and manage the risks that arise from the ADI’s

activities on a continuous basis. This ensures that capital is held at a level consistent with

the ADI’s risk profile. An ADI has to provide a minimum ratio of total capital to risk-

weighted assets of 8%.

For capital adequacy purposes (meaning financially sound), most loans approved by an

ADI are given a risk-weight of 100%. However a concessional risk-weight of varying

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percentage is applied to loans given to an individual borrower for housing or other

purposes in which the security provided is a registered mortgage over a residential

property.

Australian banks have a limit on ownership; individual or groups of related shareholders

are limited to a maximum holding of 15% of voting shares. However a higher percentage

limit may be approved by the Treasurer on national interest grounds.

Capital is the financial heart on which the strength of a banking institution and the whole

banking system is built. Capital offers flexibility. It is a base for future growth and is a

symbol of muscle power to markets and customers. Capital is a critical shock absorber

which enables an institution to continue operating soundly through unanticipated losses

and it keeps the organization operating while resolving any problems if or when they arise.

The capital held suggests strength and represents a permanent and unrestricted promise

of funds.

APRA requires the capital to:

 provide a permanent and unrestricted pledge of funds so that the capital is

available when it is most needed

 be freely available to absorb losses – it needs to shield creditors from losses

 be efficient in service charges against earnings – it need not act as a drain on

cash flows when funds are needed to meet obligations to creditors (it ranks behind

the claims of depositors and other creditors in the event of insolvency or wind-

up)

An ADI is required to at all times have definite enforcement rights over a mortgaged

residential property (including a power of sale and a right to possession) in the event of

default by the borrower. Loans covered by security provided by third parties, where the

relevant mortgage is unenforceable under the National Credit Code, are risk-weighted at

100% in the absence of any eligible collateral and guarantees.

Subject to satisfying other criteria, loans for purposes other than housing are required to

be secured against mortgages over existing residential property to receive a risk-weight

of less than 100%. Loans, for whatever purpose, secured against speculative residential

construction or property development do not qualify for a risk-weight of less than 100%.

In order to determine the appropriate risk-weight for a residential mortgage, an ADI is

required to classify the loan as either a standard or non-standard eligible mortgage and

determine the ratio of the outstanding amount of the loan to the value of the residential

property or properties that secure the exposure. For this purpose, the valuation may be

based on the valuation at origination or, where relevant, on a subsequent formal

revaluation by an independent accredited valuer.

The determination of the appropriate risk-weight is also dependent upon mortgage

insurance provided by an acceptable lenders mortgage insurer (LMI). For this purpose,

lenders mortgage insurance must provide cover for all losses up to at least 40% of the

original loan amount and outstanding loan amount, if currently higher than the original

loan amount.

A standard eligible mortgage is defined as a residential mortgage where the ADI has:

 prior to loan approval and, as part of the loan origination and approval process,

has documented, assessed and verified the ability of the borrowers to meet their

repayment obligation

 valued any residential property offered as security, and

 established that any property offered as security for the loan is readily marketable

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An ADI is required to revalue any property offered as security for such loans when it

becomes aware of a material change in the market value of property in an area or region.

However, loans that are secured by residential properties fail to meet the criteria detailed

above because they are required to be classified as non-standard eligible mortgages. Such

loans may be reclassified as standard loans where the borrowers have substantially met

their contractual loan repayments to the ADI continuously over the previous 36 months.

Criteria defining when contractual loan repayments are substantially met must be set out

in the ADI's lending/credit policy and procedures manual.

The outstanding amount of a loan must be calculated as the balance of all claims on the

borrower that are secured against the mortgaged residential property. This includes

accrued interest arid fees, as well as the gross value of any undrawn limits on

commitments that cannot be cancelled at any time without notice.

The outstanding amount under an 'all moneys mortgage' is required to include all loans

and other exposures to the borrower that are effectively secured against the mortgage. If

a loan is also secured against a second mortgage, the outstanding amount of the loan is

required to be the sum of all claims on the borrower secured by both the first and second

mortgages over the same residential property for the purpose of assessing the loan-to-

value ratio (LVR).

If a loan is secured by more than one property, the loan-to-value ratio (LVR) is required

to be determined on the basis of the outstanding amount of all claims on the borrower

that are secured against the mortgaged residential properties to the aggregate value of

the mortgaged residential properties.

An approved deposit-taking institution may, in risk-weighting a loan secured by a

residential mortgage, make allowance for eligible collateral and guarantees. A mortgage

offset or other similar account may only be netted off against the outstanding amount of

the loan where the arrangement meets the requirements for eligible cash collateral.

4. Economic Environment

Mortgage brokers operate within the financial services industry. There are various reasons

why a broker needs to understand the overall economy and be able to interpret economic

indicators. First of all, there is a close relationship between the loan market and overall

economic conditions. Each economic variable has an interaction with the conditions in the

loan market and the prevailing interest rates. To evaluate these, one has to have a good

understanding of how an economy performs and how the economic activity is measured.

A key participant in the economy is the government. The government’s economic policies

have great impact on the loan market therefore a broker needs to understand how the

government policies are shaped.

Presenting loan products involves making appropriate forecasts about the future and

comprehending the economic situations around the globe. This chapter introduces general

economic concepts and discusses the major economic indicators to highlight linkages and

aid interpretation. These are the economy and economic growth, prices and wages,

government fiscal policies, interest rates, external flows and exchange rates. Some other

external forces that might be monitored for their impact on the financial climate include

the value of the dollar, the political climate and the effect of media, press and public

relations reports upon the market. Some news reports (or even unfounded rumours) can

affect share prices and the stock market and start a run on a bank within minutes of their

release.

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5. Economic Activities and Economic Growth

Economic activities are mainly measured by gross domestic product (GDP). GDP is the key

figure indicating the level of economic activities in an economy. Technically, the GDP figure

represents the market value of all final goods and services produced in an economy during

a specific period. The growth rate of GDP is used as a broad gauge of the overall economic

health. Robust GDP growth signals a heightened level of activity that is generally

associated with a healthy economy. However, economic expansion also raises concerns

about inflationary pressures and strong GDP growth may induce the Reserve Bank to raise

interest rates in order to combat inflation. It is fair to say that positive GDP readings are

typically bullish for the Australian dollar, while slumping GDP growth is usually bearish.

Technically, GDP is calculated according to the following formula:

GDP = C + I + G + (EX - IM) where:

C: Private consumption

I: Private investment

G: Government expenditure

EX: Exports of goods and services

IM: Imports of goods and services

A rise in the first four of the above variables – that is, a rise in government expenditure,

private sector expenditure, personal consumption spending or revenue from exports – will

lead to a rise in the GDP. Alternatively, a fall in imports would have the same effect on

GDP. The headline figure for GDP is an annualised percentage growth rate.

Australia has one of the world’s most open and innovative economies. Strong growth since

the 1990s has been accompanied by strong productivity performance. Australia’s stable

economic, political and social environment has led to increased foreign investment in

recent years. Australia’s GDP growth averaged “0.88 percent from 1959 until 2013,

reaching an all-time high of 4.50 precent in the first quarter of 1976 and a record low of

-2 percent in the second quarter of 1974”

http://www.tradingeconomics.com/australia/gdp-growth.

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The Australia Gross Domestic Product is worth 1,638.92 billion dollars in 2014

(http://www.statista.com/statistics/263573/gross-domestic-product-gdp-of-australia/)

which ranks as 18th highest http://www.statista.com/statistics/264575/countries-with-

the-largest-gross-domestic-product-gdp-at-purchasing-power-parity/ around 1.64% of

the world economy, according to the World Bank. Australia's economy is dominated by its

services sector, yet its economic success is based on an abundance of agricultural and

mineral resources. Australia's comparative advantage in the export of primary products is

a reflection of the natural wealth of the Australian continent and its small domestic market.

The country is a major regional financial centre and a vital component of the global

financial system. Australia is expected to out-perform most advanced economies over the

next two years.

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Australia: Gross domestic product (GDP) in current prices from 2004 to 2014 (in billion U.S. dollars) (Source: Statista 2014)

It is fair to say that there is a positive relationship between strong economic growth and

demand for real estate property. Economic growth facilitates favourable conditions in the

loan market. On the other hand, extreme economic growth (higher than 4%) is definitely

accompanied by the inflationary pressures and rising interest rates which limit the appetite

for real estate.

6. Inflation

Inflation is defined as a rise in the general level of prices. The opposite is called deflation,

which is a fall in the general price level. To be able to calculate the rise or fall in prices we

require a statistic that will give us information about the level of prices. Such a statistic is

the Consumer Price Index (CPI). The CPI is used as the main measure of inflation and

movements in the cost of living in Australia. The CPI is an index number which is used to

summarise the price of goods and services. There are five steps in calculating the CPI:

1) A selection of goods and services are selected to be included in the index.

2) Accurate prices must be obtained for the relevant goods and services that are

included in the index.

3) The aggregate price must be calculated, in other words the total cost of all the

goods and services included in the index.

4) A base year must be chosen and the aggregate price found for that base year.

5) The aggregate price for the current period must be obtained.

The price index can be calculated for the current period as follows:

100 x period base for the prices of Aggregate

periodcurrent for the prices of Aggregate

The CPI is expressed as a percentage to two decimal places. It is calculated on a quarterly

basis. The following table shows the value of the CPI over recent years. Historically, one

purpose of the CPI was to determine the taxation relief granted by the Australian Taxation

Office for taxable capital gains.

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The CPI when the asset was sold was compared with the CPI value when it was purchased

to determine a reduced capital gain on which tax was paid.

As the table shows, inflation can be classified according to its value:

Level Type

Up to 3% Moderate

4 – 10% Gnawing

11 – 20% Acute

20 – 49% Galloping

Over 50% Hyperinflation

There are five main types of inflation:

1) Demand pull inflation occurs when there is full employment and the demand

for goods and services exceeds the supply of goods and services.

2) Cost push inflation occurs when the cost of production is rising and

manufacturers decide to pass on the increased costs to consumers in the form

of higher prices.

3) Imported inflation occurs when the prices of goods and services rise in world

markets and the rising price of imports increases the costs of goods and

services in Australia.

4) Psychological inflation occurs when expectations of inflation lead to decisions

being taken which add to inflation.

5) Excess money supply inflation occurs when there is an increase in the money

supply. Many economists feel that this is the sole cause of inflation since

academic studies have shown that there is a strong correlation between the

rate of expansion of the money supply and the rate of inflation.

7. Business Cycles

A mortgage broker is expected to be able to comment on the current stage of economy.

They need to be familiar with all major economic developments in the economy and their

impact on loan and real estate markets. In macroeconomics theory, it has been stated

that there is a strong interaction between real estate activities and business cycles.

The term business cycle (or economic cycle) refers to economy-wide fluctuations in

production and economic activities. These cycles may take several months or years. Long-

term economic growth trends (called expansion or boom) are followed by economic slow-

downs (referred to as contraction or recession). These fluctuations are often measured

using the growth rate of real gross domestic product.

Despite being termed cycles, most of these fluctuations in economic activities do not follow

a mechanical or predictable periodic pattern. There is no exact length to a business cycle,

nor is there an exact repetitive pattern to economic change. No two business cycles will

be alike in their length or the strength of their rises and falls. It is fair to say that we have

been witnessing more frequent and severe cycles than we did in the past.

The business cycles are usually described under two distinct periods in the economy;

expansion and contraction. Economists usually argue that there are four phases in an

economic cycle; recession, recovery, boom and contraction. A recession is identified with

low levels of profit expectation, low levels of private and government investment, high

level of unemployment and reduced output. A recovery is identified with increasing profit,

increasing investment, increasing consumer spending, decreasing unemployment and

increasing national income. A boom is identified with high profits, higher interest rates,

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faltering business optimism, a slackening of investment, higher costs, high levels of

employment and the commencement of unfavourable trends in international trade. A

contraction is identified with declining profits, decreasing investment, decreases in

spending, decreasing wages and price levels and decreasing national income.

Boom years are normally accompanied by periods of rising inflation. Inflation occurs when

supply cannot satisfy demand and those individuals or companies with excess purchasing

power can have their demand satisfied by offering higher prices than others for the goods

and services they require. A mortgage broker needs to be aware of business cycles since

such cycles affect the property and credit markets as well as the level of interest rates.

The business cycle may also affect the creditors, their needs, borrowing and repayment

capabilities. Interest rates tend to vary during the business cycles, being low during

periods of recession and high during periods of boom. An understanding of this

phenomenon assists a mortgage broker in directing their clients into appropriate credit

products.

Real estate is particularly susceptible to the ups and downs of the economy simply because

it is a substantial industry. The purchase of a single-family dwelling, the sale of a condo,

the lease of industrial or office space requires transactions of large amounts. One of the

key insights of business cycles is that many economic indicators move together. During a

boom, or expansion, not only does output rise, employment also rises and unemployment

falls. New construction and prices typically rise during a boom as well. Conversely, during

a downturn or depression, not only does the output of goods and services decline, but

employment falls and unemployment rises. New construction also declines. Real estate

prices may very well continue to rise in real estate even during downturns, though usually

more slowly than during booms.

Clearly government policies affect the real estate and loan markets, as do external

influences such as developments in the global economy. Two things which have an

enormous effect on the real estate industry and loan markets are movements in interest

rates and the economic outlook. One of the greatest influences on interest rates is the rate

of inflation, as measured by the consumer price index (CPI). A rise in interest rates can

cause property and share investments to become less attractive and in certain

circumstances to fall in value.

8. Fiscal and Monetary Policies

In an ideal economy those governing the country would wish for continued steady

economic growth. However there are many variables influencing the economy that such a

state of affairs is not possible. The government will try to boost the economy when it is in

recession and try and depress the economy when it is in boom times in order to prevent

inflation.

Essentially the government will be trying to even out the economic or business cycles in

some way so that a sustainable growth can be achieved. There are a number of ways in

which the government can interfere with the economy to ensure that its wishes are carried

out. The two most common ways are by:

1) Fiscal policies

2) Monetary policies

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Fiscal policies

Fiscal policy is concerned with the government's use of its budget which can result in a

surplus over time i.e. it has more money than it has spent or a deficit where it has less

money than has been spent. A particular budget is in surplus when the expenditure of the

government is less than the revenue of the government. Alternatively the budget is in

deficit when the expenditure is greater than the revenue. When the government has a

budget deficit, it needs to borrow to cover the shortfall. If the government borrows then

money is withdrawn from bank deposits and placed in government securities. This means

that banks have less money to lend to clients. This results in less bank lending and

therefore less credit available in the economy.

This fact is known as the crowding-out effect which may lead to rising interest rates. If

demand for credit is greater than the amount available then clearly the cost of credit will

rise, this will discourage borrowing and will lead to a contraction in the economy. When

the government runs a budget surplus, it can pay back some of its previous borrowings.

In other words, the government can reduce its debt. This ensures that there will be a

surplus of credit and abundance of funds available for borrowers.

The government's budget needs to go through Parliament and gain the majority support

of the House of Representatives which typically occurs in May. It is a plan of the

government's expenditures and revenues for the coming year. The expenditures are made

to provide services for the community and fund the interest payments on the outstanding

government debt. The revenue mainly comes from income tax, company tax and other

indirect taxes such as GST.

Government policies can have social effects as well as economic effects. They can cause

changes in people’s behaviour. An example of this is the Federal Government's retirement

policy. As it became apparent in the late 1980s that there was an ageing population and

that there may come a time when the state would no longer be able to support its aged,

the government had to seek ways of solving this problem. It is attempting to solve the

problem by a mixture of social and economic policy; by trying to change the behaviour of

the Australian population and trying to make them net savers. To achieve this it is using

a mixture of inducements (such as a concessional tax environment for savings) and

penalties (such as discouraging the withdrawal of lump sum amounts). There are three

main effects that the government's fiscal policy can have on the demand in the economy.

Firstly, there is a psychological effect. The expectations of business will be affected by the

announcements in the budget, particularly if there is uncertainty involved. For instance,

the introduction of GST had a psychological effect on the business community.

Secondly, there is a liquidity effect. If new taxes are introduced or the rate of tax is

increased then this can affect the amount of money available for investment. When the

government introduced the GST, it gave the impression that because of changes in

personal tax rates, everybody would be better off.

Thirdly, there is an income effect. Changes in taxation levels or in government spending

will affect an individual’s level of income and this may reduce the individual’s level of

consumption in the economy. The effect of the latter two will be less than the effect of the

Reserve Bank of Australia’s monetary policy.

Monetary policy

The government's monetary policy is taken care of by the Reserve Bank of Australia (RBA).

The main responsibility of the RBA is controlling the inflation rate through monetary policy.

The RBA gives banking and registry services to agencies of the government, to other

central banks, and other official institutions as well. The RBA is fully owned by the

Australian government and the profits are transferred back to the government. Having an

independent status, the bank is isolated from the political influences of the government.

Chapter 2– Understanding the Industry and the Economic Environment

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The RBA carries out the following five essential roles in the economy:

1) Controlling the issue of national currency

By this it regulates the amount of money in the community.

2) Being the banker to the federal government and all the state governments

In this role, it acts as the financial agent for the state and federal governments

and as the financial adviser to those governments.

3) Acting as the banker to the banking system

Any bank which is subject to the Banking Act – such as a trading bank like the

Commonwealth, ANZ, National Australian, Westpac and St. George – has to

keep a settlement account with the Reserve Bank. These accounts must have

designated amounts in them. They are essentially current accounts in that the

trading bank can deposit funds in or withdraw funds from the account. The

accounts are used to settle debts between banks, pay for the purchase of

banknotes, pay for foreign currency and for government securities.

4) Controlling the interest rates by changing the base lending rate

This affects the lending policy of banks. When the Reserve Bank raises its base

rate, the trading banks will follow suit. This affects the flow of money in the

economy.

5) Being the lender of last resort

It has the power to lend money to trading banks in order to maintain their

liquidity.

A mortgage broker should observe the RBA’s monetary policy and possible effects on

various loan products. The current objective of the RBA is a policy of inflation targeting

aimed at maintaining the annual inflation rate between 2–3%, on average, over the cycle.

Monetary policy decisions are expressed in terms of a target for the cash rate, which is

the overnight money market interest rate. This rate is very important for lending

institutions as this is the main determinant of the price of a loan product. Financial

institutions add their operational costs and risk premiums to this base rate and then

determine the final interest rate of a loan.

The cash rate is the interest rate on overnight loans made between institutions in the

money market. The RBA targets the cash rate in order to alter the interest rate, i.e. the

RBA intervenes in the overnight cash market to influence the cash rate. These

interventions are known as open market operations (OMO). Each bank holds an Exchange

Settlement Account (ESA) with the RBA. To settle transactions amongst themselves the

banks use funds in these accounts. This is known as the payments system and it creates

a demand for exchange settlement funds. The RBA influences the supply of funds in the

banks’ ESAs through its OMO (buying and selling of securities). By influencing the supply

of funds in ESAs, the RBA is able to bring about changes to interest rates.

In general, the RBA raises the cash rate by selling securities on the open market. This

takes cash out of the banks’ ESAs (as purchasers of securities write cheques to the

government drawn on private banks). The banks now have deficits on their ESAs. So the

banks borrow on the overnight market. The increased supply of short-term securities leads

to a higher interest rate. By the same reasoning, the RBA lowers the cash rate by buying

securities on the open market.

The cash rate has a close relationship with all prevailing interest rates in the economy.

Suppose an investor could gain a larger return on an investment by lending money on 90

consecutive overnight loans as opposed to lending for a 90-day period. The demand for

short-term securities would increase and their interest rate would fall, whereas the

Chapter 2– Understanding the Industry and the Economic Environment

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demand for 90-day securities would decrease and their interest rate would rise. This would

go on until both investment options yielded the same return.

Interest rates affect an economy’s GDP through their impact on the level of personal

consumption spending and fixed capital expenditure. A low interest rate causes increased

consumption because people are able to borrow without the fear of high interest rates. For

sure, this is only in the short terms since those people will eventually have to repay their

loans. Low interest rates also cause an increase in capital expenditures for the same

reason. Thus, in the short term, a decrease in interest rates leads to an increase in

economic activities and GDP.

9. Interest Rates

One of the key decisions faced by a consumer in the economy is whether to consume more

than their income allows (borrow and pay back their borrowings with future income) or

save now so that they may spend more in the future (lend). Financial assets enable this

trade between those who wish to spend today and pay back tomorrow and those who wish

to lend today and spend in the future. The interest rate is the price that adjusts so as to

equilibrate lending and borrowing decisions.

On an economic level, two important concepts – the demand for money and the supply of

money – determine the market interest rate. Put differently, the market interest rate is

the interaction between supply and demand of money in the economy. In order to examine

the demand for money, let us suppose that we have a choice of holding our wealth either

in cash or in bonds, where bonds are affected by the interest rate and cash is not. If the

interest rate increases, you would want to be holding as little cash as possible (money

demand decreases) in order to increase your wealth through the interest gained on the

bonds. Alternatively, if the interest rate decreases, you would want to hold more cash

(demand for money increases) and fewer bonds since there is less to be gained on the

bonds. So there is an inverse relationship between the interest rate and the demand for

money.

On the other hand, money supply is determined by the amount of currency and deposits

in the financial system. Assuming that neither of these is affected by the interest rate, the

supply of money remains constant regardless of the interest rate. The interest rate at any

particular point in time is determined by the equilibrium between the demand for and the

supply of money. If there is an excess demand for money, people would sell their bonds

in order to increase their money holdings. The increased supply of bonds would lead to a

fall in the price of bonds and an increase in the interest rate. This process would continue

until the demand and supply of money was back at equilibrium. Alternatively, if there were

an excess supply of money, people would purchase bonds to decrease their money

holdings. This would lead to a decreased supply of bonds and an increase in price. So the

interest rate would decrease, and again this process would continue until demand and

supply of money are at equilibrium.

10. External Influences on the Australian Economy

The external influences on the Australian economy may occur in many ways. The exchange

rate, foreign direct investments and even the expectations in the global economy affect

Australia. Exchange rates impact on the GDP through imports and exports. Suppose the

Australian dollar depreciates compared to the US dollar – it now takes more Australian

dollars to buy US$1 worth of USA produced goods and services. This means that USA

goods and services are now relatively more expensive, from the viewpoint of someone

holding Australian dollars. So imports of USA goods into Australia fall. By the same

reasoning, Australian goods and services now become cheaper to people holding US

dollars, so exports of Australian goods to the USA rise. Since imports fall and exports rise,

the Australian GDP increases.

Chapter 2– Understanding the Industry and the Economic Environment

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Interest rates are closely related to the currencies. According to the interest rate parity,

the interest rate differential between two countries is equal to the differential between the

forward exchange rate and the spot exchange rate. Interest rate parity plays an essential

role in foreign exchange markets, connecting interest rates, spot exchange rates and

foreign exchange rates.

A country’s exchange rate is determined by a number of things, but the most important

determinant is the supply and the demand of foreign exchange in the country. For

example, if there was plenty of demand in Australia for US dollars and a limited supply of

them, the AUD would be very low because the people with more money who wanted US

dollars would pay more, so their price would increase, devaluing the AUD. On the other

hand, if demand for foreign exchange was low, and the supply high, the AUD would be

highly valued since there would be an excess of foreign exchange dollars and people

wouldn’t need to pay much for them.

Countries have the decision to adopt one of three different exchange rates. A flexible

(floating) exchange rate is when market forces solely determine the price at which one

currency exchanges for another. A managed float is where market forces set the exchange

rate, but the central bank intervenes from time to time to smooth out potentially large

changes in the exchange rate. A situation in which the central bank of a country continually

intervenes to keep the exchange rate at some fixed, pre-determined level is known as a

fixed exchange rate. The type of exchange rate a country wishes to adopt depends greatly

on the type of government policy they wish to run. Currently Australia adopts the flexible

(floating) exchange rate model, so the currency parity is determined in the foreign

exchange markets.

Illustrated Example 1

GLOBAL FINANCIAL CRISIS

The global financial crisis started to show its effects in the middle of 2007 and into 2008,

with the failure and merging of a number of American financial companies. The crisis

mainly affected the developed economies in which the economy is built on credit (i.e. firms

borrowing money from other firms and the general consumer borrowing money for homes

and cars).

Around the world, stock markets fell, large financial institutions collapsed or were bought

out, and governments in even the wealthiest nations were forced to come up with rescue

packages to bail out their financial systems.

Between 2000 and 2007, the mortgage business was characterised by a surge in

originations of subprime mortgage refinance loans. Since 2007, many of those mortgages

have defaulted and property values have declined, making home sales and rate and term

refinances difficult to impossible. Many people were taking advantage of the housing boom

in the USA when it ended, leaving both investors and mortgage companies in trouble.

Consumer spending has fallen and banks are much less likely to approve loans. The global

financial crisis also affected the Australian economy and resulted in a tightening loan

market, dropping interest rates and falling real estate prices.

11. How to Access Economic Indicators

Statistics on economic indicators regularly dominate the daily news reports. A mortgage

broker should know how to obtain these statistics as these economic indicators influence

investment decisions, the exchange rate and interest rates. Using these statistics, a

mortgage broker can predict likely economic trends, understand the economy and evaluate

government’s economic policies and the effects these policies will have on the economy,

particularly interest rates.

Chapter 2– Understanding the Industry and the Economic Environment

International Institute of Technology © 21 VR261018

The Australian Bureau of Statistics (ABS) is the main source of economic statistics. It

publishes data on a regular basis about prices, wages, economic growth, trade, labour

market and investment. Its website provides access to its publications and data, free of

charge, on the day of publication. Information about expected release dates for the current

and following six months can be found on the ABS’s website on the ‘Release Calendar’

page. Publications on the ABS website are usually listed in accordance with the advertised

release dates.

The Reserve Bank of Australia (RBA) also provides a range of statistics including exchange

rates, official interest rates and other financial statistics. Apart from the ABS and RBA

there are many institutions in the public and private sector that provide statistical research

into the state of the economy. The main economic indicators prepared and published by

the Australian Bureau of Statistics are provided below:

Australian National Accounts

 Provides the detailed breakdown of national accounts including Gross Domestic

Product (GDP)

 Released every March, June, September and December on the last Wednesday of

the second month following the reference period or the first Wednesday of the

third month

Balance of Payments and International Investment Position

 Provides the data on the Current Account, Capital Account, foreign investment

and foreign debt

 Released every March, June, September and December, 42 working days after

the end of the reference period

International Trade in Goods and Services

 Provides monthly balance of trade figures

 Released every month, 21 working days after the end of the reference period

International Merchandise Trade

 Provides detailed trade figures by commodity and country

 Released every March, June, September and December, 35 working days after

the end of the reference period

Housing Finance for Owner Occupation

 Figures by type of borrower, dwelling, lending institution and State

 Released every month, 27 to 28 working days after the end of the reference period

but not on the same day as other indicators

Private New Capital Expenditure and Expected Expenditure

 Expenditure on buildings, construction, plant and equipment by industry

 Released every March, June, September and December, on the last week of the

second month after the end of the reference period

Labour Force, Australia, Preliminary

 Labour force status of persons 15 and over

 Released every month, generally the second Thursday of the month

Chapter 2– Understanding the Industry and the Economic Environment

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Average Weekly Earnings, Australia

 Average weekly ordinary time earnings and average weekly total earnings

 Released every February, March, August and November, 13 weeks after the end

of the reference period

Consumer Price Index

 Movement in the retail price of goods and services for capital cities

 Released every March, June, September and December, on the Wednesday of the

4th week after the end of the reference period

Retail Trade

 Retail turnover by industry sector and State

 Released every month, 22 working days after the reference period except for

June, September, December and March, which are after 30 days

Building Approvals

 Approvals by number and value for residential and commercial properties

 Released every month, 22 working days after the end of the reference period

Sales of New Motor Vehicles

 Sales of new motor vehicles by State and class of vehicle

 Released every month, in the third week of the month after the end of the

reference period

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International Institute of Technology © 23 VR261018

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