More On The RBA Tweaks – Messy Or What!

I did a mapping between the old and new basis for investor and interest only loans in the RBA credit aggregates. I posted the data earlier.

Since mid-2015 the bank has been writing back perceived loan reclassifications which pushed the investor loans higher and the owner occupied loans lower.

They have now reversed this policy, so the flow of investment loans is lower (and more in line with the data from APRA on bank portfolios). Investor loans are suddenly 2% lower. Magically!

This is the monthly switching:

But two points.

First I am amazed the  banks feels its OK to suddenly change the basis of their calculations, when its such a critical issue. The provided reasoning is perverse – loan switching is “normal”. Suddenly back tracking over the past two years is plain weird.  The section in the Stability Report said it was going to happen. That is all.

Second, it once again highlights the rubbery nature of the data on lending in Australia. What with data problems in the banks, and at the RBA, we really do not have a good chart and compass.  It just happens to be the biggest threat to financial stability but never mind.

Standing back though, despite the static growth in investment lending, do not forget that overall debt is still rising faster than incomes, by a factor of two to three times.

Owner occupied lending must be tamed too if we are to ever get back to a more even keel – the case for more macro-prudential intervention just got stronger!

Why More Lending Curbs Are Still Likely

There is a rising chorus demanding that APRA loosen their rules for mortgage lending in the face of slipping home prices. This despite the RBA’s recent comments about the risks in the system, especially relating to investor and interest only loans.  But this is unlikely, and in fact more tightening, either by a rate rise, or macroprudential will be needed to contain the risks in the system. The latter is more likely.

Some of this will come from the lenders directly. For example, last week ANZ said it will be regarding all interest-only loan renewals as credit critical event requiring full income verification from 5 March. If loans failed this assessment these loans would revert to P&I loans (with of course higher repayment terms).  We are already seeing a number of forced switches, or forced sales thanks to the tighter IO rules more generally. This is just the start. More than $60 billion of IO loans are outside current underwriting standards on our estimates.

But, as ANZ has pointed out in a separate note from David Plank, Head of Australian Economics at ANZ; household leverage is still increasing, this despite a moderation in housing credit growth over the past year. Household debt continues to grow faster than disposable income.

With household debt being close to double disposable income it will actually require the growth in household debt to slow well below that of income in order for the ratio of household debt to income to stabilise, let alone fall.

In fact, he questions whether financial stability has really being improved so far, when interest rates are so very low.

A key concern we have with the RBA’s comfort with recent household debt trends is whether the slowdown in household debt growth is likely to be sustained with interest rates so low.

Our analysis on the debt/income gap suggests that the RBA’s comfort with how things are evolving on the debt front may be misplaced.

The first sign of this will be clear evidence of recovery in house prices, possibly already underway, which will likely be followed by a reacceleration in debt growth.

If things develop in this fashion it will be interesting to see whether the RBA maintains its focus on clear progress toward the mid-point of the inflation target range as the key to the setting of interest rates.

We suspect that the first port of call to any signs of a reacceleration in household debt will be additional macro-prudential policy…

In other words expect more tightening before the cash rate goes up.


Housing Weakness Could Drive Rates Lower, and Ease Macroprudential

So now we come to it. Australia’s future is totally locked into the housing market. If prices continue to fall (to begin to correct the massive over swing) , the macroprudential settings may be eased, and the RBA may cut the cash rate to stimulate the already over high household debt (200%).

Or in other words, once again the property sector becomes a political football.  The question is does the “independent” RBA have the intestinal fortitude to resist the chorus. We simply have to get housing under control, as the longer term harm in not so doing will cripple us down the track .

In an AFR interview, the Treasurer signals that the macro-prudential lending controls could be eased.

Financial regulators may dial back home lending restrictions which have helped clamp down on rampant property price growth, if the recent slowdown in property values descends into sharper-than-anticipated falls, the federal Treasurer has signalled.

The government was “closely watching” the cooling residential real estate market Scott Morrison said.

Tighter home lending measures imposed on banks over the past year were “completely malleable”, he told The Australian Financial Review in an exclusive and wide-ranging interview in the United States.

Mr Morrison said he was meeting regularly with the Australian Prudential Regulation Authority – led by chairman Wayne Byres – and Reserve Bank of Australia – headed by governor Philip Lowe – to discuss the Council of Financial Regulators’ process.

The council, comprising the heads of APRA, RBA, the Australian Securities and Investments Commission and Mr Morrison’s Treasury Secretary, John Fraser, meets at least quarterly and is the guiding body informing APRA’s home lending rules for banks.

Mr Morrison said APRA’s restrictions over the past year to control lending to investors and to cap interest only loans had been “very effective” in achieving a “soft landing”.

But he signalled the rules were open to revision according to market conditions.

And elsewhere, Credit Suisse analysts are forecasting a large miss in Australian economic growth for the December quarter and residential investment could fall a lot sooner-than-expected if house prices weaken further, requiring a CUT in official interest rates. From Business Insider.

Credit Suisse analysts are forecasting a large miss in Australian economic growth for the December quarter.

And the recent housing downturn forms a central part of their analysis, as consumers reduce spending amid cooling house prices and other areas of the economy fail to pick up the slack.

The consensus forecast is for Q4 economic growth to come in around 0.9%, leaving annual growth in a range between 2.75% and 3.25%. The data is scheduled for release on March 7.

“We believe that the actual number is likely to come in south of 0.5%, taking year-ended growth below 2.4%,” Credit Suisse said.

The chart below shows the bank’s GDP tracker, which is pointing to softer growth in the near-term:

This chart shows each of the components Credit Suisse uses in the tracker to calculate its GDP forecasts:

“We remain of the view that without timely rate cuts, house prices are on an L-shaped trajectory, meaning that consumption and employment growth could slow sharply, while residential and infrastructure investment flatten out,” Credit Suisse said.

So when it comes to Australia’s near-term growth prospects and the outlook for interest rates, “much turns on the housing outlook”.

The analysts said the recent decline in foreign investment — along with tighter bank lending standards in the wake of the latest APRA restrictions — were two key factors in the recent house price-action.

“If the RBA is satisfied that eventually, foreign buying will return and banks will relax their lending standards, perhaps a short-term downturn is tolerable without cutting rates.”

“But if officials cannot see a recovery in house prices over the next few years, there is more urgency to cut rates, because the direct and indirect effects of housing weakness are too big to ignore.”

The analysts cited the December decline in building approvals as further evidence that Australia’s housing market is at risk of a sustained downturn.

They noted the result was partly due to monthly volatility after a sharp rise in November, but said recent numbers are indicative of a broader downtrend.

“It appears that fundamentals are now re-asseting themselves. Consistent with past experience, building approvals are now coming off their highs with house prices, albeit with a slight delay.”

“The bad news is that residential investment could fall a lot sooner-than-expected if house prices weaken further.”

“This is over and above the negative wealth and credit effects on consumer spending from falling house prices.”

In view of that, it’s “hard to see a silver lining without rate cuts”.

The Property Market is Repeating US Mortgage Mistakes

In an opinion piece on the UNSW site, Professor Richard Holden writes that troubling borrowing and lending markers in the Australian housing market suggest that the lessons from the US mortgage meltdown have not been learned. We agree!

For all the endless discussion of housing prices in Australia, it is very hard to tell if there is a bubble. Sydney price-to-income ratios are the second highest in the world – above London and New York – but hey, Sydney is a great place to live. Supply is constrained by zoning laws, two national parks, a mountain range and an ocean. Yet demand continues to grow, so prices tend to rise.

I don’t know if there’s a bubble in the Australian housing market, but there are some very troubling markers that suggest imprudent borrowing and lending. Just the sort of things that preceded the US housing implosion nearly a decade ago. And I worry that bankers, borrowers, and regulators seem not to have learned the lessons of that very painful piece of economic history.

First, the markers.

Australia lenders will let you borrow a lot compared to your income. If one adjusts for tax and exchange rates and uses an online mortgage calculator, it is easy to see than a major Australian bank will lend about 25% more for the same income level compared with what a major US bank will now lend.

Not only can one borrow a lot, the structure of the loans is often very risk. A staggering 35.4% of home loans in Australia are interest only, according to recent APRA figures. That has dropped from above 40% thanks to APRA’s recent 30% cap on the amount of new loans that can be interest only.

Don’t forget that a key trigger of the US housing meltdown was when five-year adjustable rate mortgages could not be refinanced, and borrowers faced steep upticks every quarter in their interest rates.

Interest-only loans in Australia typically have a five-year horizon and to date have often been refinanced. If this stops then repayments will soar, adding to mortgage stress, delinquencies, and eventually foreclosures.

So-called “liar loans”, where borrowers provide inaccurate information about their income, assets, or expenses to lenders seem both prevalent and on the rise. A UBS survey in late 2017 found that approximately 30 per cent of home loans, or $500 billion worth could be affected. This is exactly what occurred in the US – as anyone who has read Michael Lewis’s book The Big Short, seen the movie, can tell you.

We can’t even be sure that people have true equity in their new properties. With deposit insurance one can get away with a 5% deposit, although it is typically 20% without. But how careful are banks about where the deposit comes from? There are now troubling suggestions that the leading use of unsecured personal loans is for a mortgage deposit.

All of this is aided and abetted by mortgage brokers – or at least some of them. A remarkable 55% of all new mortgages come through a broker. And those brokers get paid based on how many dollars of home loans they write.

Their incentives are thoroughly misaligned with both borrowers and lenders – just as was the case in the US a decade ago. There are also high-powered incentives for those originating loans with banks, creating more moral hazard.

But perhaps the biggest marker of all is the response from lenders. On liar loans, an ANZ spokesperson said UBS’s survey of 907 people was “extremely limited” compared to the total number of home loans.

Opinion polls the day before an election are also small compared to the number of total voters, but they have been pretty accurate in Australian elections overall. A representative sample of around 1000 respondents tells us a lot.

In October last year Westpac CEO Brian Hartzer told the House of Representatives Standing Committee on Economics: “We don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

ANZ’s Shayne Elliott holds the same view, telling the same committee the same thing: “It’s not in our interest to lend money to people who can’t afford to repay.” And if it was them lending their own money then I might believe it. But people act differently when they are playing with other people’s money. That is the essence of the moral hazard problem.

Mr Elliott, also told ABC’s Four Corners that mortgages are all individual risks, saying: “The reality is that housing loans are pretty good because they’re quite diverse in terms of lots of relatively small loans across ah across the country.” “Ah”, indeed. One of the key lessons from the US experience was how highly correlated the risks on mortgages are. Do Australia’s lenders really not get that?

Bubble or no bubble, we seem to be blithely repeating the US housing-market experience in almost every respect. People borrow too much and banks let them; there is moral hazard and fraud in mortgage issuances; regulators finally do something – very little and very late.

The happy scenario is that macro-prudential regulation is finally biting, and that underwriting standards are starting to improve. Even if that is true, we are still left with highly indebted households who have nearly $2 of debt for every $1 of GDP, a raft of interest-only loans that will soon involve principal repayments, and stagnant wage growth.

Having lived in the US during the mortgage meltdown I’m sorry to say that I’ve seen this movie before. The question is: why haven’t our bankers?

Richard Holden is Professor of Economics at UNSW Business School.

This article was originally published in the Australian Financial Review.

Its All About Momentum – The Property Imperative Weekly 16 Dec 2017

This week, it’s all about momentum – home prices are sliding, auctions clearance rates are slipping, mortgage standards are tightening and brokers are proposing to lift their business practices – welcome to the Property Imperative Weekly, to 16 December 2017.

Watch the video, or read the transcript. In this week’s edition we start with home prices.

The REIA Real Estate Market Facts report said median house price for Australia’s combined capital cities fell 0.8 per cent during the September quarter. Only Melbourne, Brisbane and Hobart recorded higher property prices and Darwin prices fell the most sharply, dropping 13.8 per cent.

The ABS Residential Property Price Index (RPPI) for Sydney fell 1.4 per cent in the September quarter following positive growth over the last five quarters. Hobart now leads the annual growth rates (13.8%), from a lower base, followed by Melbourne (13.2%) and Sydney (9.4%). Darwin dropped 6.3% and Perth 2.4%. For the weighted average of the eight capital cities, the RPPI fell 0.2 per cent and this was the first fall since the March quarter 2016. The total value of Australia’s 10.0 million residential dwellings increased $14.8 billion to $6.8 trillion. The mean price of dwellings in Australia fell by $1,200 over the quarter to $681,100.

So, further evidence of a fall in home prices in Sydney, as lending restrictions begin to bite, and property investors lose confidence in never-ending growth. So now the question becomes – is this a temporary fall, or does it mark the start of something more sustained? Frankly, I can give you reasons for further falls, but it is hard to argue for improvement anytime soon.  Melbourne momentum is also weakening, but is about 6 months behind Sydney. Yet, so far prices in the eastern states are still up on last year!

CoreLogic said continual softening conditions are evident across the two largest markets of Melbourne and Sydney. This week across the combined capital cities, auction volumes remained high with 3,353 homes taken to auction  and achieving a preliminary clearance rate of 63.1 per cent The final clearance rate last week recorded the lowest not only this year, but the lowest reading since late 2015/ early 2016 (59.5 per cent).

The employment data from the ABS showed a 5.4% result again in November. But there are considerable differences across the states, and age groups. Female part-time work grew, while younger persons continued to struggle to find work. Full-time employment grew by a further 15,000 in November, while part-time employment increased by 7,000, underpinning a total increase in employment of 22,000 persons. Over the past year, trend employment increased by 3.1 per cent, which is above the average year-on-year growth over the past 20 years (1.9 per cent). Trend underemployment rate decreased by 0.2 pts to 8.4% over the quarter and the underutilisation rate decreased by 0.3 pts to 13.8%; both still quite high.

The HIA said there have been a fall in the number of new homes sold in 2017. New home sales were 6 per cent lower in the year to November 2017 than in the same period last year. Building approvals are also down over this time frame by 2.1 per cent for the year. The HIA expects that the market will continue to cool as subdued wage pressures, lower economic growth and constraints on investors result in the new building activity transitioning back to more sustainable levels by the end of 2018.

The HIA also reported that home renovation spending is down, again thanks to low wage growth and fewer home sales by 3.1 per cent. A further decline of a similar magnitude is projected for 2018.

Moody’s gave an interesting summary of the Australian economy. They recognise the problem with household finances, and low income growth. They expect the housing market to ease and mortgage arrears to rise in 2018. They also suggest, mirroring the Reserve Bank NZ, that macroprudential policy might be loosened a little next year.

I have to say, given credit for housing is still running at three times income growth, and at very high debt levels, we are not convinced! I find it weird that there is a fixation among many on home price movements, yet the concentration and level of household debt (and the implications for the economy should rates rise), plays second fiddle. Also, the NZ measures were significantly tighter, and the recent loosening only slight (and in the face of significant political measures introduced to tame the housing market). So we think lending controls should be tighter still in 2018.

The latest ABS lending finance data  for October, showed business investment was still sluggish, with too much lending for property investment, and too much additional debt pressure on households. If we look at the fixed business lending, and split it into lending for property investment and other business lending, the horrible truth is that even with all the investment lending tightening, relatively the proportion for this purpose grew, while fixed business lending as a proportion of all lending fell. I will repeat. Lending growth for housing which is running at three times income and cpi is simply not sustainable. Households will continue to drift deeper into debt, at these ultra-low interest rates. This all makes the RBA’s job of normalising rates even harder.

HSBC, among others, is suggesting a further fall in home price momentum next year, writing that slowdowns in the Sydney and Melbourne housing markets will continue to weigh on national house price growth for the next few quarters. They expect only a slow pace of cash rate tightening and some relaxation of current tight prudential settings as the housing market cools.

Despite this, most analysts appear to believe the next RBA cash rate move will be higher and ANZ pointed out with employment so strong, there is little expectation of rate cuts in response to easing home prices. In addition, the FED’s move to raise the US cash rate this week to a heady 1.5% despite inflation still running below target, will tend to propagate through to other markets later. More rate rises are expected in 2018.  The Bank of England held theirs steady, after last month’s hike.

The UK Property Investment Market could be a leading indicator of what is ahead for our market. But in the UK just 15% of all mortgages are for investment purposes (Buy-to-let), compared with ~35% in Australia.  Yet, in a down turn, the Bank of England says investment property owners are four times more likely to default than owner occupied owners when prices slide and they are more likely to hold interest only loans. Sounds familiar? According to a report in The Economist,  “one in every 30 adults—and one in four MPs—is a landlord; rent from buy-to-let properties is estimated at up to £65bn a year. But yields on rental properties are falling and government policy has made life tougher for landlords. The age of the amateur landlord may be over”.

In company news, Genworth, the Lender Mortgage Insurer announced that it had changed the way it accounts for premium revenue. ASIC had raised concerns about how this maps to the pattern of historical claims. Genworth said that losses from the mining sector where many of the losses occur, do so at a late duration, and improvements in underwriting quality in response to regulatory actions, along with continued lower interest rates, extended the average time to first delinquency. As a result, Net Earned Premium (NEP) is negatively impact by approximately $40 million, and so 2017 NEP is expected to be approximately 17 – 19 per cent lower than 2016, instead of the previous guidance of a 10 to 15 per cent reduction.

CBA was in the news this week, with AUSTRAC alleging further contraventions of Australia’s anti-money laundering and counter-terrorism financing legislation. The new allegations, among other things, increase the total number of alleged contraventions by 100 to approximately 53,800. CBA contests a number of allegations but admit others.  eChoice, in voluntary administration, has been bought by CBA via its subsidiary Finconnect Australia, saying the sale will allow eChoice’s employees, suppliers, brokers, lenders and leadership team to continue to operate and deliver for customers. Finally, CBA announced that, from next year, it will no longer accept accreditations from new mortgage brokers with less than two years of experience or from those that only hold a Cert IV in Finance & Mortgage Broking, in a move intended to “lift standards and ensure the bank is working with high-quality brokers who are meeting customers’ home lending needs.”

The Combined Industry Forum, in response to ASIC’s Review of Mortgage Broker Remuneration has come out with a set of proposals. The CIF defines a good customer outcome as when “the customer has obtained a loan which is appropriate (in terms of size and structure), is affordable, applied for in a compliant manner and meets the customer’s set of objectives at the time of seeking the loan.” Additionally, lenders will report back to aggregators on ‘key risk indicators’ of individual brokers. These include the percentage of the portfolio in interest only, 60+ day arrears, switching in the first 12 months of settlements, an elevated level of customer complaints or poor post-settlement survey results. Now this mirrors the legal requirement not to make “unsuitable” loans, but falls short of consumer advocates, such as CHOICE, who wanted brokers to be legally required to act in the best interests of consumers, in common with financial planners. But both the CBA and CIF moves indicate a need to tighten current mortgage broking practices, as ASIC highlighted, which can only be good for borrowers.  By the end of 2020, brokers will also be given a “unique identifier number”.

ASIC says Westpac will provide 13,000 owner-occupiers who have interest-only home loans with an interest refund, an interest rate discount, or both. The refunds amount to $11 million for 9,400 of those customers. The remediation follows an error in Westpac’s systems which meant that these interest-only home loans were not automatically switched to principal and interest repayments at the end of the contracted interest-only period.

We featured a piece we asked to write on What To Do When The Interest-only Period On Your Home Loan Ends. There is a sleeping problem in the Australian Mortgage Industry, stemming from households who have interest-only mortgages, who will have a reset coming (typically after a 5-year or 10-year set period). This is important because now the banks have tightened their lending criteria, and some may find they cannot roll the loan on, on the same terms. Interest only loans do not repay capital during their life, so what happens next?

The House of Representatives Standing Committee on Economics released their third report on their Review of the Four Major Banks.  They highlight issues relating to IO Mortgage Pricing, Tap and Go Debt Payments, Comprehensive Credit and AUSTRAC Thresholds. The report recommended that the ACCC, as a part of its inquiry into residential mortgage products, should assess the repricing of interest‐only mortgages that occurred in June 2017, and whether customers had been misled. While the banks’ media releases at the time indicated that the rate increases were primarily, or exclusively, due to APRA’s regulatory requirements, the banks stated under scrutiny that other factors contributed to the decision. In particular, banks acknowledged that the increased interest rates would improve their profitability.

So, in summary plenty of evidence home prices are slipping, and lending standards are under the microscope. We think home prices will slide further, and wages growth will remain sluggish for some time to come, so more pressure on households ahead.  You can hear more about our predictions for 2018 in our upcoming end of year review, to be published soon, following the mid-year Treasury forecast.

Meantime, do check back next week for our latest update, subscribe to receive research alerts, and many thanks for watching.


BIS Special Feature On Household Debt

The Bank for International Settlements has featured the issues arising from high household debt in its December 2017 Quarterly Review. They call out the risks from high mortgage lending, high debt servicing ratios, and the risks to financial stability and economic growth.  All themes we have already explored on the DFA Blog, but it is a well argued summary. Also note Australia figures as a higher risk case study.  Here is a summary of their analysis.

Central banks are increasingly concerned that high household debt may pose a threat to macroeconomic and financial stability.  This special feature seeks to highlight some of the mechanisms through which household debt may threaten both macroeconomic and financial stability.

Australia is put in the “High and rising” category.  The debt ratio now exceeds 120% in both Australia and Switzerland.  Mortgages make up the lion’s share of debt (between 62 and 97%).  In Australia mortgage debt has risen from 86% of household debt in 2007 to 92% in 2017.

High household debt can make the economy more vulnerable to disruptions, potentially harming growth. As aggregate consumption and output shrink, the likelihood of systemic banking distress could increase, since banks hold both direct and indirect credit risk exposures to the household sector.

They say  the size of household debt burdens matters too. This is best measured by the ratio of interest payments and amortisation to income – the debt service ratio (DSR).   They say that rising household debt can reflect either stronger credit demand or an increased supply of credit from lenders, or some combination of the two. In Australia, for instance, heightened
competition among lenders seems to have resulted in a relaxation of lending standards.  In addition, the interest rate sensitivity of a household’s debt service burden is likely to matter. High debt (relative to assets) can make a household less mobile, and hence less able to adjust by finding a new or better job in another town or region. Homeowners may be tied down by mortgages on properties that have depreciated in value, especially those that are underwater (ie worth less than the loan balance).

These household-level observations have implications for aggregate demand and aggregate supply. From an aggregate demand perspective, the distribution of debt across households can amplify any drop in  consumption. Notable examples include high debt concentration among households with limited access to credit (ie close to borrowing constraints) or less scope for self-insurance (ie low liquid balances).

Since poorer households are more likely to face these credit and liquidity
constraints, an economy’s vulnerability to amplification can be assessed by looking at the distribution of debt by income and wealth.  In Australia, households in the top income brackets tend to have substantially higher debt ratios than those at the bottom of the distribution (eg in 2014, the top two quintiles had debt ratios of about 200%, while the bottom two had ratios of about 50%. [Note this is based on OLD 2014 HILDA data, and debt to higher income households has risen further since then!]

In countries where household debt has risen rapidly since the crisis, and where the majority of mortgages are adjustable rate, DSRs are already above their historical average, and would be pushed yet further away by higher interest rates.

From an aggregate supply perspective, an economy’s ability to adjust via labour reallocation across different regions can weaken if household leverage grows over time. In such an economy, a fall in house prices – as may be associated with interest rate hikes – would saddle a number of households with mortgages worth less than the underlying property. A share of these “underwater” homeowners might also lose their jobs in the ensuing contraction. In turn, their unwillingness to realise losses by selling their property at depressed prices may prolong their spell of unemployment by preventing them from taking jobs in locations that would require a house move.

Elevated levels of household debt could pose a threat to financial stability, defined here as distress among financial institutions. These exposures relate not only to direct and indirect credit risks, but also to funding risks. There is some evidence that this may be occurring in Australia, where high-DSR households are more likely to miss mortgage payments.

The indirect exposure to household debt arises from any increase in credit risk linked to households’ expenditure cuts. These are bound to have a broader impact on output and hence on credit risk more generally. Deleveraging by highly indebted households could induce a recession so that banks’ non-household loan assets are likely to suffer. Financial stability may also be threatened by funding risks . The network of counterparty relationships could become a channel for the transmission of stress, as any decline in the value of one bank’s cover pool could rapidly affect that of all the others.

They conclude:

Central banks and other authorities need to monitor developments in household debt. Several features of household indebtedness help to shape the behaviour of aggregate expenditure, especially after economic shocks. The level of debt and its duration – as well as whether debt has financed the acquisition of illiquid assets such as housing – all play a role in determining how far an individual household will cut back its consumption. Aggregating up, the distribution of debt across households can amplify these  adjustments. In turn, such amplification is more likely if debt is concentrated among households with limited access to credit or less scope for selfinsurance. Since these households are also likely to be poorer households, keeping track of the distribution of debt by income and wealth can help indicate an economy’s vulnerability to amplification.

OECD Signals RBA Rate Hike

According to the OECD,  Australia – Economic forecast summary (November 2017),  things are looking better. As a result, they expect rate hikes next year to help cool the housing market. But they call out a number of risks to economic growth and says macro-prudential measures should be maintained. Also their growth rates are lower than than latest from the RBA!

The economy will continue growing at a robust pace. Business investment outside the housing and mining sectors will pick up, with exports boosted as new resource-sector capacity comes on stream. The strengthening labour market and household incomes will sustain private consumption, and inflation and wages will pick up gradually.

The central bank is projected to start raising the policy rate in the second half of 2018 and expectations of this move, together with macro-prudential measures, are helping cool the housing market. The fiscal position is sound and the government is committed to gradually close the budget deficit. In the event of an unexpected downturn, fiscal policy should be used to support activity and protect the incomes of the most vulnerable.

The prolonged period of low interest rates has fuelled high house prices in large metropolitan areas. Substantial mortgage borrowing has resulted in households being highly indebted. To contain risks associated with potential large house-price corrections and financial stress, macro-prudential measures should be maintained. Australia is also vulnerable to “too big to fail” risks, due to its highly concentrated banking sector.

RBNZ Backs Supply Not DTI To Address Housing Risks

The Reserve Bank New Zeland has today published the Response to submissions on the Consultation Paper: Serviceability Restrictions as a Potential Macroprudential Tool in New Zealand.

Given the current slowdown in the housing market, the Reserve Bank considers a serviceability restriction would not be appropriate at present, but could still have a role to play in the future. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

In the meantime, they will continue to work with banks to improve the data being received on DTIs. The Reserve Bank is aware that system issues mean data from some banks includes overstated DTI ratios for some customers, and would like this to be gradually improved. The Reserve Bank may also provide further guidance around technical areas such as treatment of guarantees.

This is significant because many of the responses were from lenders who also operate in Australia, so we get a read on their arguments, ahead of the expected APRA paper on mortgage risk.  Good DTI data is a problem, but one which could and should be sorted.

This is interesting also, given the broader use of DTI in other jurisdictions (such as the UK) and the view expressed by IMF that DTI should be the macroprudential tool of choice.

Falling back to supply side issues squibs the core demand issues, in our view.

The NZ Reserve Bank received 25 submissions. A majority of submissions that expressed a clear view were against serviceability restrictions being added to the Reserve Bank’s toolkit. On the other hand, there were supportive submissions, and some submissions which went further and suggested serviceability instruments such as a debt-to-income ratio (DTI) restriction should be immediately deployed (not just added to the macroprudential toolkit set out in the MoU as the Reserve Bank had proposed).

Many submissions stated that loan-to-value ratio (LVR) restrictions are currently having a significant effect on the housing market and mortgage lending. Others said with mortgage rates rising recently and the housing market softening, DTI restrictions are not needed now.

Submitters expressed a range of views on whether house prices are currently overvalued. Some submissions stated that supply is the best way to correct imbalances and that LVR or serviceability restrictions cannot permanently solve housing market imbalances.

A number of submissions noted that banks’ own serviceability policies have tightened recently. Some noted that New Zealand consumer law (Credit Contracts and Consumer Finance Act 2003 (CCFA) and the related Responsible Lending Code (RLC)) requires lenders to undertake serviceability assessments. Some banks with Australian parents submitted that they are subject to the Australian Prudential Regulation Authority’s (APRA) prudential practice guide on residential mortgage lending, APG 223.2 Both the RLC and APG 223 require lenders to take the risk of rising interest rates into account when deciding if lending will be affordable.

Most of these points were consistent with the Reserve Bank’s views in the consultation paper. In particular, the Reserve Bank does not believe DTI restrictions should be deployed in the current housing market environment, and considers that the key longer term solution to housing market imbalances is to facilitate growth in housing supply in areas that need it.

We also acknowledged in the consultation paper that banks already undertake serviceability assessments and allow for the risk of rising interest rates. However, the Reserve Bank remains of the view that individual bank lending decisions may fail to take account of their impact on systemic risk during periods of intense competition for mortgage loans, and that there can be a role for limits on banks’ serviceability practices during these periods.

Canada Reinforces Mortgage Underwriting Guidelines

From Moody’s.

On Tuesday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) published the final version of “Guideline B-20 − Residential Mortgage Underwriting Practices and Procedures,” which mandates more stringent stress-testing for uninsured mortgages. The guideline, which takes effect on 1 January 2018 and applies to all federally regulated financial institutions in the country, is credit positive because it will improve asset quality for Canadian banks.

The guideline sets a new minimum qualifying rate, or stress test, for uninsured mortgages at the higher of the five-year benchmark rate published by the Bank of Canada, the central bank, or the contractual mortgage rate plus 2%. Lenders also will be required to impose and continuously update more effective loan-to-value (LTV) limits and measurements.

A key vulnerability of Canadian banks is the high and rising level of private-sector debt/GDP. Canadian mortgage debt outstanding has more than doubled in the past 10 years (see Exhibit 1) and the index of house prices to disposable income has increased 25% over this period (see Exhibit 2), raising the prospect that real estate overvaluation is driving up overall household debt and overextending borrowers.

OFSI’s action is the latest in a series of macro-prudential measures aimed at slowing house-price appreciation in Canada and moderating the availability of mortgage financing. These measures will address the increasing risk that that growing private-sector debt will weaken Canadian banks’ asset quality. Canada’s growing consumer debt and elevated housing prices threaten to make consumers and Canadian banks more vulnerable to downside risks.

In addition to requiring that all uninsured mortgages be stress-tested against a potential rise in interest rates (high-ratio insured mortgages are already required to meet such tests to qualify for mandatory mortgage insurance), the guideline requires that banks establish and adhere to risk-appropriate LTV limits that keep current with market trends. Additionally, the guideline expressly prohibits banks from arranging with another lender a mortgage, or a combination of a mortgage and other lending products (known as bundled mortgages), in any form that circumvents a bank’s maximum LTV ratio.

Housing prices are at record highs owing to price increases in the urban areas of Toronto, Ontario, and Vancouver, British Columbia. Macro-prudential initiatives dampened volumes and prices in Toronto over the summer, but the effects of similar moves in Vancouver last year appear to be lessening this year as prices regain momentum. We believe that high consumer leverage could result in future asset-quality deterioration in an economic downturn or a housing price correction. Although Canadian banks have demonstrated prudent underwriting standards in the past, this is attributable in part to thoughtful regulatory oversight.

The new guideline follows a consultation period that ended in August. Some industry participants recommended a delay in implementation, cautioning that the combined effect of multiple macro-prudential measures affecting the mortgage market risked unduly depressing the housing market, thereby triggering a severe price correction.

Housing and Financial Stability

An excellent speech by Fed Vice Chairman Stanley Fischer at the DNB-Riksbank Macroprudential Conference Series, Amsterdam, Netherlands

It is often said that real estate is at the center of almost every financial crisis. That is not quite accurate, for financial crises can, and do, occur without a real estate crisis. But it is true that there is a strong link between financial crises and difficulties in the real estate sector. In their research about financial crises, Carmen Reinhart and Ken Rogoff document that the six major historical episodes of banking crises in advanced economies since the 1970s were all associated with a housing bust. Plus, the drop in house prices in a bust is often bigger following credit-fueled housing booms, and recessions associated with housing busts are two to three times more severe than other recessions. And, perhaps most significantly, real estate was at the center of the most recent crisis.

In addition to its role in financial stability, or instability, housing is also a sector that draws on and faces heavy government intervention, even in economies that generally rely on market mechanisms. Coming out of the financial crisis, many jurisdictions are undergoing housing finance reforms, and enacting policies to prevent the next crisis. Today I would like to focus on where we now stand on the role of housing and real estate in financial crises, and what we should be doing about that situation. We shall discuss primarily the situation in the United States, and to a much lesser extent, that in other countries.

Housing and Government
Why are governments involved in housing markets? Housing is a basic human need, and politically important‑‑and rightly so. Using a once-popular term, housing is a merit good‑‑it can be produced by the private sector, but its benefit to society is deemed by many great enough that governments strive to make it widely available. As such, over the course of time, governments have supported homebuilding and in most countries have also encouraged homeownership.

Governments are involved in housing in a myriad of ways. One way is through incentives for homeownership. In many countries, including the United States, taxpayers can deduct interest paid on home mortgages, and various initiatives by state and local authorities support lower-income homebuyers. France and Germany created government-subsidized home-purchase savings accounts. And Canada allows early withdrawal from government-provided retirement pension funds for home purchases.

And‑‑as we all know‑‑governments are also involved in housing finance. They guarantee credit to consumers through housing agencies such as the U.S. Federal Housing Administration or the Canada Mortgage and Housing Corporation. The Canadian government also guarantees mortgages on banks’ books. And at various points in time, jurisdictions have explicitly or implicitly backstopped various intermediaries critical to the mortgage market.

Government intervention in the United States has also addressed the problem of the fundamental illiquidity of mortgages. Going back 100 years, before the Great Depression, the U.S. mortgage system relied on small institutions with local deposit bases and lending markets. In the face of widespread runs at the start of the Great Depression, banks holding large portfolios of illiquid home loans had to close, exacerbating the contraction. In response, the Congress established housing agencies as part of the New Deal to facilitate housing market liquidity by providing a way for banks to mutually insure and sell mortgages.

In time, the housing agencies, augmented by post-World War II efforts to increase homeownership, grew and became the familiar government-sponsored enterprises, or GSEs: Fannie, Freddie, and the Federal Home Loan Banks (FHLBs). The GSEs bought mortgages from both bank and nonbank mortgage originators, and in turn, the GSEs bundled these loans and securitized them; these mortgage-backed securities were then sold to investors. The resulting deep securitized market supported mortgage liquidity and led to broader homeownership.

Costs of Mortgage Credit
While the benefits to society from homeownership could suggest a case for government involvement in securitization and other measures to expand mortgage credit availability, these benefits are not without costs. A rapid increase in mortgage credit, especially when it is accompanied by a rise in house prices, can threaten the resilience of the financial system.

One particularly problematic policy is government guarantees of mortgage-related assets. Pre-crisis, U.S. agency mortgage-backed securities (MBS) were viewed by investors as having an implicit government guarantee, despite the GSEs’ representations to the contrary. Because of the perceived guarantee, investors did not fully internalize the consequence of defaults, and so risk was mispriced in the agency MBS market. This mispricing can be notable, and is attributable not only to the improved liquidity, but also to implicit government guarantees. Taken together, the government guarantee and resulting lower mortgage rates likely boosted both mortgage credit extended and the rise in house prices in the run-up to the crisis.

Another factor boosting credit availability and house price appreciation before the crisis was extensive securitization. In the United States, securitization through both public and private entities weakened the housing finance system by contributing to lax lending standards, rendering the mid-2000 house price bust more severe. Although the causes are somewhat obscure, it does seem that securitization weakened the link between the mortgage loan and the lender, resulting in risks that were not sufficiently calculated or internalized by institutions along the intermediation chain. For example, even without government involvement, in Spain, securitization grew rapidly in the early 2000s and accounted for about 45 percent of mortgage loans in 2007. Observers suggest that Spain’s broad securitization practices led to lax lending standards and financial instability.

Yet, as the Irish experience suggests, housing finance systems are vulnerable even if they do not rely on securitization. Although securitization in Ireland amounted to only about 10 percent of outstanding mortgages in 2007, lax lending standards and light regulatory oversight contributed to the housing boom and bust in Ireland.

Macroprudential Policies
To summarize, murky government guarantees, lax lending terms, and securitization were some of the key factors that made the housing crisis so severe. Since then, to damp the house price-credit cycle that can lead to a housing crisis, countries worldwide have worked to create or expand existing macroprudential policies that would, in principle, limit credit growth and the rate of house price appreciation.

Most macroprudential policies focus on borrowers. Loan-to-value (LTV) and debt-to-income (DTI) ratio limits aim to prevent borrowers from taking on excessive debt. The limits can also be adjusted in response to conditions in housing markets; for example, the Financial Policy Committee of the Bank of England has the authority to tighten LTV or DTI limits when threats to financial stability emerge from the U.K. housing market. Stricter LTV or DTI limits find some measure of success. One study conducted across 119 countries from 2000 to 2013 suggests that lower LTV limits lead to slower credit growth. In addition, evidence from a range of studies suggests that decreases in the LTV ratio lead to a slowing of the rate of house price appreciation. However, some other research suggests that the effectiveness of LTV limits is not significant or somewhat temporary.

Other macroprudential policies focus on lenders. First and foremost, tightening bank capital regulation enhances loss-absorbing capacity, strengthening financial system resilience. In addition, bank capital requirements for mortgages that increase when house prices rise may be used to lean against mortgage credit growth and house price appreciation. These policies are intended to make bank mortgage lending more expensive, leading borrowers to reduce their demand for credit, which tends to push house prices down. Estimates of the effects of such changes vary widely: After consideration of a range of estimates from the literature, an increase of 50 percentage points in the risk weights on mortgages would result in a house price decrease from as low as 0.6 percent to as high as 4.0 percent. These policies are more effective if borrowers are fairly sensitive to a rise in interest rates and if migration of intermediation outside the banking sector to nonbanks is limited.

Of course, regulatory reforms and in some countries, macroprudential policies‑‑are still being implemented, and analysis is currently under way to monitor the effects. So far, research suggests that macroprudential tightening is associated with slower bank credit growth, slower housing credit growth, and less house price appreciation. Borrower, lender, and securitization-focused macroprudential policies are likely all useful in strengthening financial stability.

Loan Modification in a Crisis
Even though macroprudential policies reduce the incidence and severity of housing related crises, they may still occur. When house prices drop, households with mortgages may find themselves underwater, with the amount of their loan in excess of their home’s current price. As Atif Mian and Amir Sufi have pointed out, this deterioration in household balance sheets can lead to a substantial drop in consumption and employment. Extensive mortgage foreclosures–that is, undertaking the legal process to evict borrowers and repossess the house and then selling the house–as a response to household distress can exacerbate the downturn by imposing substantial dead-weight costs and, as properties are sold, causing house prices to fall further.

Modifying loans rather than foreclosing on them, including measures such as reducing the principal balance of a loan or changing the loan terms, can allow borrowers to stay in their homes. In addition, it can substantially reduce the dead-weight costs of foreclosure.

Yet in some countries, institutional or legal frictions impeded desired mortgage modifications during the recent crisis. And in many cases, governments stepped in to solve the problem. For example, U.S. mortgage loans that had been securitized into private-label MBS relied on the servicers of the loans to perform the modification. However, operational and legal procedures for servicers to do so were limited, and, as a result, foreclosure, rather than modification, was commonly used in the early stages of the crisis. In 2008, new U.S. government policies were introduced to address the lack of modifications. These policies helped in three ways. First, they standardized protocols for modification, which provided servicers of private-label securities some sense of common practice. Second, they provided financial incentives to servicers for modifying loans. Third, they established key criteria for judging whether modifications were sustainable or not, particularly limits on mortgage payments as a percentage of household income. This last policy was to ensure that borrowers could actually repay the modified loans, which prompted lenders to agree more readily to the modification policies in the first place.

Ireland and Spain also aimed to restructure nonperforming loans. Again, government involvement was necessary to push these initiatives forward. In Ireland, mortgage arrears continued to accumulate until the introduction of the Mortgage Arrears Resolution Targets scheme in 2013, and in Spain, about 10 percent of mortgages were restructured by 2014, following government initiatives to protect vulnerable households. Public initiatives promoting socially desirable mortgage modifications in times of crises tend to be accompanied by explicit public fund support even though government guarantees may be absent in normal times.

What Has Been Done? What Needs to Be Done?
With the recent crisis fresh in mind, a number of countries have taken steps to strengthen the resilience of their housing finance systems. Many of the most egregious practices that emerged during the lending boom in the United States‑‑such as no- or low-documentation loans or negatively amortizing mortgages‑‑have been severely limited. Other jurisdictions are taking actions as well. Canadian authorities withdrew government insurance backing on non-amortizing lines of credit secured by homes. The United States and the European Union required issuers of securities to retain some of the credit risk in them to better align incentives among participants (although in the United States, MBS issued by Fannie and Freddie are currently exempt from this requirement). And post-crisis, many countries are more actively pursuing macroprudential policies, particularly those targeted at the housing sector. New Zealand, Norway, and Denmark instituted tighter LTV limits or guidelines for areas that had overheating housing markets. Globally, the introduction of new capital and liquidity regulations has increased the resilience of the banking system.

But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.

What should be done as we move ahead?

First, macroprudential policies can help reduce the incidence and severity of housing crises. While some policies focus on the cost of mortgage credit, others attempt directly to restrict households’ ability to borrow. Each policy has its own merits and working out their respective advantages is important.

Second, government involvement can promote the social benefits of homeownership, but those benefits come at a cost, both directly, for example through the beneficial tax treatment of homeownership, and indirectly through government assumption of risk. To that extent, government support, where present, should be explicit rather than implicit, and the costs should be balanced against the benefits, including greater liquidity in housing finance engendered through a uniform, guaranteed instrument.

Third, a capital regime that takes the possibility of severe stress seriously is important to calm markets and restart the normal process of intermediation should a crisis materialize. A well-capitalized banking system is a necessary condition for stability in bank-based financial systems as well as those with large nonbank sectors. This necessity points to the importance of having resilient banking systems and also stress testing the system against scenarios with sharp declines in house prices.

Fourth, rules and expectations for mortgage modifications and foreclosure should be clear and workable. Past experience suggests that both lenders and borrowers benefit substantially from avoiding costly foreclosures. Housing-sector reforms should consider polices that promote efficient modifications in systemic crises.

In the United States, as around the world, much has been done. The core of the financial system is much stronger, the worst lending practices have been curtailed, much progress has been made in processes to reduce unnecessary foreclosures, and the actions associated with the Housing and Economic Recovery Act of 2008 created some improvement over the previous ambiguity surrounding the status of government support for Fannie and Freddie.

But there is more to be done, and much improvement to be preserved and built on, for the world as we know it cannot afford another pair of crises of the magnitude of the Great Recession and the Global Financial Crisis.