2/10/2017 GenworthsresultpointstoincreasinglevelsofstressinourhighlygearedeconomyROGERMONTGOMERY

GENWORTHS RESULT POINTS TO INCREASING LEVELS OF STRESS IN

OUR HIGHLY GEARED ECONOMY
COMPANIES
February 10, 2017

If you want to find more signs of stress in the Australian economy, then look no further than the recent
result of Genworth (GMA:ASX), our largest mortgage insurer. In its announcement, GMA noted rising
delinquencies, moderating economic conditions, and increasing underemployment. The result also
signals that bad debt provisions may be a headwind for banks in FY18.
Genworth reported its full year result to the end of December 2016 on 8 February. The result showed a few
notable items:
1. Gross written premium fell 25% yoy in CY16 and 14% in 2H16.

Gross written premium is the revenue flowing from new mortgage insurance policies written in the period.
As such, it provides a better snapshot of the current demand for mortgage insurance in the Australian
market.
The weakness in gross written premium is being driven by 2 factors. The first is a loss of customers. This is
notably Westpac, which has decided to move more toward self-insurance. This would add to Westpacs
exposure to any mortgage bad debt cycle. The second factor is the reduction in new high LVR mortgages
that are being written. This is due to a combination of APRAs focus as well as increased risk aversion from
the banks. This is oset by premium increases implemented by GMA last year.
2. Delinquencies remain on the rise

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Mortgage delinquencies are defined as mortgages that are more than 90 days in arrears. Delinquency rates
increased in the half with the larger jump occurring in the September quarter. The chart below shows the
increase over the last 3 years, as well as delinquencies by months in arrears. This suggests that the average
number of months in arrears has been increasing slightly over the last 2 years, with the percentage of
delinquencies 3-5 months in arrears falling from 46% as at June 2015 to 42% now, and 10+ months
increasing from 16% to 19%.

(http://rogermontgomery.com/content/uploads/2017/02/17.png)

But the absolute level of delinquencies, while higher than in CY14 and CY15, is only just getting back
toward the levels of early 2012, and remains well below the recent peak from mid CY11.

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(http://rogermontgomery.com/content/uploads/2017/02/24.png)

The rise in delinquencies as a percentage of the overall book is primarily being driven by increases in WA,
SA and QLD. However, VIC appears to have bottomed in 2H14 and has been rising slowly since then.

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(http://rogermontgomery.com/content/uploads/2017/02/31.png)

(http://rogermontgomery.com/content/uploads/2017/02/4.png)

Delinquencies are being driven by an acceleration in new delinquencies rather than a fall in Cures or
claims paid.

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(http://rogermontgomery.com/content/uploads/2017/02/5.png)

We also note that the number of calls to the National Debt Hotline has been increasing at an accelerating
rate, with calls in the December quarter increasing 12% on the prior year. This indicates that stress is still
increasing. As such, delinquencies are more likely to keep increasing, eventually feeding into higher loan
losses.

1. Claims expenses have increased, resulting in rising loss ratios

GMAs claims cost ratio has continued to rise. Of greater concern for the market has been the guidance
management provided for CY17, which expects the claims cost ratio to increase to between 40% and 50%.

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(http://rogermontgomery.com/content/uploads/2017/02/8.png)

While this is well up on the lows of CY14, it remains well below the peaks from mid 2012.
The drivers of the increased claims cost ratio are a combination of:
A 10-15% reduction in net premium earned. Growth in net premium earned is following gross written
premium down on a lagged basis.
Rising claims expenses.
The guidance implies an increase in claims expenses of between 3% and 21% relative to CY16.
Interestingly, claims paid remain well below the levels of CY12. The bigger driver of net claims incurred has
been increased reserves. The movement in reserves is driven by increases in delinquencies, eectively
preparing the balance sheet for what is expected to be an increased level of claims to be paid in future
periods.

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(http://rogermontgomery.com/content/uploads/2017/02/9.png)

In the most recent spike in bad debts, the peak of claims paid occurred one year aer the peak in
delinquencies. So the impact on impairments of mortgage books is likely to be somewhat lagged.

1. Guidance highlights an expectation that conditions will continue to deteriorate

GMA points to:
Recent moderations in economic conditions.
Underemployment, implying that there is more slack in the economy than is indicated by the current 5.8%
unemployment rate. This reduces household wages while excess labour supply is also resulting in slowing
wages growth. Both of these factors are increasing mortgage stress in certain regional economies. This is
expected to result in continued increases in delinquencies from these regions.
House price growth is expected to moderate in 2017, with Sydney and Melbourne expected to outperform
the other major cities.
Any rolling over of the construction cycle in Sydney, Melbourne and Brisbane will act as an incremental
drag on economic growth and labour demand. This presents an added risk to the outlook beyond CY17 as
the current pipeline of residential construction projects is completed.
As reported by Bloomberg, a Roy Morgan report from last week suggests that 10.2% of mortgages have no
equity buer, while 8% of mortgages in SA and 7.2% in QLD have negative equity. Weak wage growth
combined with falling property prices would have negative implications for more than just the banks, with
debt-laden households having to significantly cut back discretionary consumption spending.

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