Sept. 29 (Bloomberg) -- Australia's purchase of A$4 billion ($3.3 billion) of mortgage-backed securities to revive frozen markets for the debt may increase competition in the banking industry and encourage lenders to pass on any interest rate cuts.

``Increased bank competition always adds pressure to pass on rate reductions,'' Hans Kunnen, head of investment market research in Sydney at Colonial First State Global Management, which manages about $128 billion, said in a telephone interview on Sept. 27. ``Competition impacts price decisions.''

The purchases in two separate operations of A$2 billion each through the Australian Office of Financial Management are intended to reinvigorate the home-lending market by providing funding for small lenders. Such funding has all but dried up because of the global credit squeeze, Treasurer Wayne Swan, 54, said in Canberra on Sept 26 when announcing the program.

The pricing and settlement of the first tender is expected to be completed in December, with the second tender conducted in early 2009, the AOFM said today. The purchases will provide a A$4 billion source of capital for small and non-bank lenders who've been unable to offer competitive mortgage-loan rates for a year.

Australia's banking industry is dominated by its largest lenders -- National Australia Bank, Commonwealth Bank of Australia, Westpac Banking Corp. and Australia & New Zealand Banking Group -- who are barred from merging with each other under the government's so-called Four Pillars policy. The four are benefiting as smaller mortgage providers struggle amid rising wholesale funding costs.

Banking Industry

``This move will certainly assist competition and may help with a decision to pass on cuts'' by the banks, said Su-Lin Ong, a senior economist at RBC Capital Markets Ltd. in Sydney. ``It will put pressure on them, but the bottom line is their cost of funding. Capital is still hard to get and expensive.''

Australia's four biggest lenders this year each increased their main home-loan rates by at least 1 percentage point as the central bank raised the cash rate by 0.5 percentage point.

The Reserve Bank of Australia will cut its benchmark borrowing rate by at least 0.25 percentage point on Oct. 7, according to a Credit Suisse Group index based on interest-rate swaps. Bank Governor Glenn Stevens reduced the cash-rate target by 0.25 percentage point to 7 percent this month, the first cut in seven years.

Mortgage Bond Sales

Mortgage bond sales slumped 85 percent to A$2.5 billion a quarter since the middle of last year as international investors retreated from property lending after losses and writedowns from the U.S. subprime collapse swelled to $522 billion.

That's crippled the ability of smaller banks including Bank of Queensland and Aussie Home Loans to make loans because such lenders don't have large deposits to fund their mortgages.

Australian short-term funding costs surged this year to the highest since at least 1999, based on the spread between interbank lending rates and government bonds.

A year ago, smaller lenders accounted for 15 percent of the market, according to Mortgage and Finance Association of Australia. Their share of the market has dropped to 5 percent. Meanwhile, Aussie founder John Symond says he hasn't been able to offer a mortgage with competitive rates for 12 months.

``This will give non-bank lenders a chance to come back into the market and apply competitive pressure on interest rates,'' MFAA Chief Executive Officer Phil Naylor said in a telephone interview from Sydney on Sept. 27. ``This will put downward pressure on interest rates.''

Bundling

Australian mortgage lenders such as Aussie bundle their loans into securities that are then sold to pension funds like AMP Ltd. and international investors like Pacific Investment Management Co. Demand for these securities dried up as credit markets froze in the wake of some $556 billion in losses and writedowns prompted by the collapse of the U.S. subprime market.

The number of Western Sydney mortgage holders in arrears is more than double the national rate, the Reserve Bank said last week.

Mike Smith, head of ANZ Banking , signaled last week the nation's fourth-largest bank may not pass on to mortgage customers all of any potential central bank rate cuts when policy makers meet next month.

``Wholesale funding costs will determine whether cuts are going to be passed through,'' Joshua Williamson, a senior strategist at TD Securities Ltd. in Sydney, said in a telephone interview on Sept. 27.

The nation's one-month bank bill swap rate, which Australian banks typically use to determine yields on variable-rate loans, reached a 13-year high of 7.80 percent on June 11. It has since dropped to 7.4 percent.

The spread between one-year interbank rates and the one-year Australian government bond touched 1.45 percentage point on March 10, based on Bloomberg data. The spread was little changed today a 1.16 percentage points, compared with 0.97 on Sept. 1.

U.S. Plan

The Australian plan coincides with a push by U.S. lawmakers to revive credit markets by authorizing a $700 billion plan to buy troubled assets from financial institutions.

In the case of Australia, the Reserve Bank's recent stability review showed Western Sydney homebuyers, who took out prime loans as prices peaked in 2004, have since had the worst rate of arrears in the nation. As a result, western Sydney has seen a sharp rise in property repossessions, the bank said.

``A competitive lending market is vital to make sure consumers get the best variety of products, the best service and the lowest interest rates,'' MFAA's Naylor said. ``That's critical at the moment when there are mortgagees in trouble.''

To contact the reporter on this story: Gemma Daley in Canberra at gdaley@bloomberg.net

Last Updated: September 29, 2008 03:37 EDT