Recently we’ve noticed a shift in the banks’ lending patterns with dramatic increases in interest rates offered to clients, even to those in very good standing. This shift was caused by the ratings agency downgrades of South Africa and its financial institutions.
But how can an agency and it rating impact South African home owners so dramatically?
What is a ratings agency?
Governments and companies often seek funding by issuing debt obligations. These debt-obligations are an offer or contract which states that the institution or government will, in exchange for an immediate cash injection, repay the debt at a set amount or interest rate over a pre-determined period. These debt-obligations are mostly issued not as single amounts to a single investor, like what you and I might experience if we approach a bank for a loan, but as individual tradeable notes or fixed income securities.
There are thousands of these debt obligations available for purchase and trade on the open market. Funds (like pension funds), other nations, companies and even individuals all make purchases on this market. Ratings agencies provide information and analyses necessary for investors to determine how likely it is that the promised repayments will occur. Ratings act as shorthand for determining which fixed-income securities and debts to purchase.
There are three major global agencies: Fitch Ratings, Moody’s Investors Services and Standard & Poor’s. These agencies infamously gave positive ratings to what later turned out to be bad debt and this was a significant contributing factor to the 2008 financial crisis! Still they remain trusted institutions and markets will react to their ratings.
What do the ratings do?
The likelihood of repayment impacts the rating of the issuer and the debt. If a ratings agency determines that a debt issuer (the nation/institution offering the repayment) is likely to repay the debt as stated, they will receive a good rating. The highest likelihood of repayment will receive an AAA or equivalent rating (different agencies use different, yet similar, symbols).
A country receiving AAA ratings is seen by investors to be a very safe investment with a near-certain likelihood of repayment. This low risk also means that the debt issuer can sell their debt obligations with cheaper repayment offers. Conversely those receiving lower ratings must price their debt up accordingly to entice investors.
Many investors shy away from riskier investments and forego higher returns for the relative security of the repayment. Those with an appetite for risk might purchase poorly-rated debt to receive higher returns.
What is a downgrade?
Ratings agencies continuously review their ratings and will “upgrade” or “downgrade” these ratings based on their assessment of underlying fundamentals of a country or institution. For a nation state these fundamentals include ratios of debt to GDP, the growth of the economy and political stability.
If a nation is experiencing poor growth, increasing debt and political instability, the Ratings agency will reduce the rating down toward junk status. This is a “downgrade”.
The further from AAA and the closer to Junk Status, the greater perceived risk and this will see a reduction in demand for this debt from investors. Many institutional investors (like Pension funds) have mandates that preclude their investment in debt or securities holding a junk status. The risk to pensions is considered too high and when an investment is rated as “junk” they are forced to divest (sell their holdings). This can lead to massive capital outflows and further weakening of economies that are normally already struggling.
In a well-managed national economy, downgrades can serve as a wake-up call to governments and can lead to a re-assessment of policy. But a ratings downgrade can act as a cruel self-fulfilling prophecy, as the downgrading of a nation’s debt because of say, an increased debt to GDP ratio, can cause a debt spiral. It goes something like this:
- Increasing debt leads to a downgrade
- A downgrade leads to increased cost of issuing debt
- The increased cost of debt forces the country to spend more on debt repayments
- The greater spend on debt forces the country to issue more debt to pay for services or development
- This increases debt and leads to a downgrade
The road out of such a spiral, like the road out of junk status, is painful one and often involves austerity measures and massive public sector job losses. Invariably it is the poor that suffer the most in these circumstances and in South Africa, where so many rely on government assistance, should it occur it would prove to be a catastrophe.
What has happened in SA to cause a downgrade?
The South African economy has been near-stagnant for over two years and there has been no indication that the current government has any solutions to this. Last year the nation received several warnings from the ratings agencies that if significant changes were not implemented, junk status would be inevitable.
Changes have certainly been made but not of the kind investors and agencies were expecting or looking for: the recent shuffling of President Zuma’s cabinet saw the removal of performing ministers and the retention of under and non-performing ministers. To the rating agencies this shows that the current regime is unwilling or unable to tackle the problems that beset the nation and that going forward there are unlikely to be positive changes in the economy.
As a result of this assessment and the other massive challenges facing the nation (massive unemployment, poverty & crime), Standard & Poor’s was the first agency to downgrade South Africa to junk status. The other two agencies are likely to follow suit in the next two months. Along with this downgrade of South African sovereign debt, many South African companies also received a downgrade to junk status, including the banks of South Africa.
What does this mean for home loans?
The cost of lending for the State as well as many corporations based in the country has now increased significantly. These increased costs will result in price increases for goods and services. This includes bank fees and the increase to interest rates we are already seeing.
It is important to remember that this pricing isn’t only about safeguarding profits: a loan is an inherently risky business proposition. Interest rates offered by the banks are a barometer for risk.
It works something like this: if you have received an offer of a home loan with an interest below prime the bank has decided that the risk of lending to you is low. If you received an interest rate above prime the bank deems your application to be at a higher risk of default.
But don’t take this personally! The risk posed by the individual because of age, credit history or source of income is not the only source of risk. The wider economy is also under scrutiny: if there is increased risk of an economic downturn this could result in job losses among home owners which in turn could result in an increased number of defaults in home loan repayments. It could also directly threaten the operation of the bank.
The banks have already made deals with previous home loan applicants and cannot, for most part, increase interest rates to those clients. As a result they must seek to cover themselves going forward. This means that prospective homeowners and home loan applicants in the current economic climate will likely not see the generous interest rates they might have received even a month earlier.
Our main piece of advice is the same as it has been for the last 3 years: REDUCE YOUR DEBT. South Africa is in for a rough ride for at least the rest of 2017. South Africans are swimming in debt but with the current economic headwinds, many face the possibility of retrenchment. Suddenly they will find themselves not swimming but drowning.
Our company relies on people buying homes and applying for home loans so it is difficult to give advice dissuading people from making property purchases, but we pride ourselves on our honesty and integrity so here goes:
You will in all likelihood not receive an interest rate below prime for the next few months. If you were banking on this, or needed it to qualify for a certain amount, we suggest that you scale down your requirements/expectations and opt for cheaper properties and smaller loans wherever possible. Property is still a very good investment, but if you are on the borderline of affordability now, you could find yourself suffering in the months to come!
Good luck out there!