Social Trends – Page 172 – Digital Finance Analytics (DFA) Blog

The Problems with Relying on the Bank of Mum and Dad

DFA recently highlighted the rise of the bank of Mum and Dad. In The conversation, there is an article highlighting some of the potential risks, especially with formal bank guarantees.

Ask a parent how far they would go to support the financial aspirations of their children, and chances are they will say: “Yes, if I had the money I would be happy to act as a guarantor for my children to purchase a property.”

Australian capital city house prices rose by 7.9% in 2014, while the number of first home buyer commitments as a percentage of total owner occupied housing finance commitments is near record lows – 14.2% in January 2015, compared to 20.4% in December 2012.

Many family-assisted first-home purchases are not being counted in the first home buyer data collected by the Australian Bureau of Statistics, but it’s likely the growing cost of owning a home is encouraging an increasing number of parents to help out via a guarantee, interest-free loan, initial deposit or simply making a monetary gift to their children. This financial support can change an individual’s decision to buy or rent a house or unit. Parental support can also help first home buyers avoid mortgage insurance charges that can easily exceed A$15,000 for a family home in a desirable suburb.

The risk to parents

Consumer advocates cite “lots of cases” where guarantors have been faced with the prospect of losing their home.

Since 2004 Australian banks have offered specific “family pledge” or “family guarantee” loans, allowing parents to provide both equity support and income support. These products are driving growth in the sector, adding to the risk for parents.

In the current economic climate with rising unemployment and costs of living, parents need to understand the risks of acting as guarantor, and all the legal responsibilities that come with it. The guarantor has a legal responsibility to repay the loan (along with any fees, charges and interest) if the borrower defaults. If the guarantee is tied against assets such as the family home, guarantors may end up losing their home, particularly if the parents’ financial position or health conditions have changed over the years. Often the lenders can sue the guarantor if the loan obligations are not met by the debtor. If parents have concerns, it may be a good idea to contribute towards the deposit so that a guarantee is not required.

It is equally important for parents to be educated with regard to the purpose of the loan, amount of the guarantee, to know in detail if their children have stable incomes, and the kind of loan they are guaranteeing (such as lines of credit or overdraft which have no specific time to maturity).

The risk to the banking sector

Family-pledged loans can be categorised as non-conforming loans, an area where lenders seek to minimise the level of risk as much as possible. The Australian Prudential Regulatory Authority has outlined some guidelines for ADIs with regard to loans including a guarantor relationship (e.g. from a parent of the borrower) to cover shortfalls in minimum deposit requirements. APRA acknowledges these loans carry a high risk and ADIs should carefully assess the guarantor’s income, credit worthiness, enforceability of potential claims and the value of any collateral pledged by the guarantor. APRA also emphasises that as a risk management strategy a prudent ADI should establish portfolio limits within its risk appetite for such lending. Such limits can be stress tested.

Since the 1997 Wallis Inquiry, household leverage has almost doubled. This has been accompanied by a significant increase in house prices relative to income over the past decade. Australian home prices are 50% higher than usual relative to rents, and around 40% higher than usual when compared to incomes. The Bank of International Settlements has already warned that a price correction may be coming.

The Financial System Inquiry is seeking measures to ease the effects of the housing market on the economy along with ways that these measures can be implemented.

Inadequate bank supervision and poorly underwritten home mortgages led to the financial crisis. Easing credit constraints, delivering innovative products (along with fee generating activities) without considering the associated risks, and a lack of internal and external monitoring and supervision, can increase non-performing loans and threaten the financial system and its stability.

Sydney Dwelling Values Surged 3% Higher in March – CoreLogic RP Data

Home values across the combined capital cities increased by 1.4 per cent in March 2015 according to the CoreLogic RP Data Home Value Index, driven by an exceptionally strong Sydney result where dwelling values were 3.0 per cent higher over the month. The latest indices reading shows capital city dwelling values moved 3.0 per cent higher over the first quarter of the year. CoreLogic RP Data head of research Tim Lawless said, “although value growth has started 2015 on a strong note, the annual rate of growth has moderated back to 7.4 per cent, which is
the slowest annual growth rate since September 2013.”

Sydney remains the standout capital growth performer, with values rising by 3.0 per cent over the month, 5.8 per cent over the quarter and 13.9 per cent over the year. With stronger housing market conditions over the first three months of the year, annual home value growth across the Sydney market has rebounded after slowing to 12.4 per cent in December 2014. Sydney is the only housing market where dwelling value growth remains in double digits, with the next strongest performer, Melbourne, showing a much lower rate of annual capital gain at just 5.6 per cent.

Each of the remaining capital cities have recorded an annual rate of growth which is less than three per cent, with values having declined across Perth, Darwin and Hobart over the year. Since home values began their current growth phase in June 2012, dwelling values across the combined capital cities have increased by 24.3 per cent. “Most of this growth is emanating from Sydney,” Mr Lawless said. “Over the current growth phase, Sydney dwelling values have increased by 38.8 per cent with Melbourne second strongest at 23.6 per cent. On the other hand, total dwelling value growth over the current cycle has been less than 10 per cent in Adelaide, Hobart and Canberra. “Combined capital city home values have increased by 3.0 per cent over the first quarter of 2015. While that rate of growth is strong it is important to note that it is lower than the 3.5 per cent increase in home values over the first quarter of 2014,” he said.

Based on the March results, Sydney’s growth trend appears to have disengaged from the rest of the capital city housing markets in terms of demand and subsequently in terms of value growth. The 5.8 per cent growth in Sydney dwelling values over the first quarter is the strongest quarterly growth rate since home values increased by 6.2 per cent over the three months to April 2009. The strength of the Sydney housing market currently is further highlighted by the fact that since the Reserve Bank cut official interest rates to 2.25 per cent at the beginning of February, auction clearance rates have been above 80 per cent each week.

Economic Implications of High and Rising Household Indebtedness

The Reserve Bank of New Zealand just published an interesting report on this important topic. High and rapidly rising levels of household debt can be risky. A high level of debt increases the sensitivity of households to any shock to their income or balance sheet. And during periods of financial stress, highly indebted households tend to cut their spending more than their less-indebted peers. This can amplify a downturn and helps to explain why many advanced economies since the 2008-09 crisis have had subdued recoveries. Financial institutions can suffer direct losses from lending to households, although these losses are rarely enough on their own to cause a systemic banking crisis. The sustainability of household debt can be assessed best by looking at data detailed enough to build a picture of how debt and debt servicing capacity is distributed across different types of borrowers.

Households, either individually, or in aggregate, can ‘over-borrow’, and financial institutions can ‘over-lend’ to them. A high level of household debt can affect both the financial system and the economy in several ways that are explained in this article.

Two sets of comparative data makes interesting reading. First, household debt-to-disposable income ratio – by country. Cross-country comparisons of debt levels need to be treated with caution, given a variety of measurement issues and different institutional features. That said, the rise in household debt in New Zealand over the last cycle was not exceptional compared to other countries, and Australia is higher.Second, Household debt-to-income ratios – selected countries. The Reserve Bank comments that “in quite a few countries there was no domestic financial crisis and little sustained fall in house prices. Policymakers in several of these economies, including New Zealand, have subsequently become concerned by household sector developments over the past several years – developments underpinned by low interest rates and an easing in lending standards. Household debt levels have started to increase from already high levels, while house prices are growing from a starting point of ‘over-valuation’.

The implementation of an LVR speed limit in New Zealand reflected emerging developments in the housing market that if left unchecked, could have threatened future macroeconomic stability. Some other jurisdictions have also used new macro-prudential tools, in combination with improving the existing underlying prudential framework. In addition to LVR restrictions, other measures include: maximum debt servicing-to-income limits, maximum debt to-income limits, higher risk weights on banks’ housing loans and prudent (or responsible) lending guidelines.

They conclude that:

“This article has focused on the various channels through which household debt can affect the financial system and broader economy. In this sense, households can ‘over-borrow’, although this is often not apparent in ‘real time’ and excess debt levels can lead to, or aggravate, economic downturns or periods of financial distress. The relationship between household indebtedness and consumption volatility is important for the macroeconomy, because it means that the behaviour of highly indebted households during periods of financial duress can amplify downturns. While historical evidence suggests losses on household lending are rarely the sole factor in systemic banking crises, housing-related credit booms and busts often occur alongside booms and busts in other sectors such as the (much riskier) construction and commercial property sector. It is also worth noting that, over time, housing loan portfolios have become a larger share of bank lending in many countries, including New Zealand, increasing their potential to play a larger part in future financial crises. Thus household debt is an important area of focus from a financial stability perspective.

Good micro-level household data provide an important window into how debt and debt servicing capacity is distributed across the household sector, and are also helpful for carrying out simple stress-tests of the sector using a range of large, but plausible shocks. New Zealand’s data in this area are improving. Data from the Household Economic Survey show a rise in the proportion of borrowers with a high LVR and high debt-to-income ratio, thereby supporting the view that LVR speed limits have been appropriate to curtail risks to financial stability. The Reserve Bank will continue to develop its framework for analysing household sector risk and vulnerabilities.”

Latest DFA Survey – Drilling Down On Overseas Investors

Over the next few days we will be posting the results of our latest household surveys. We are going to start with the hot investment segment, and look specifically at the vexed question of the proportion of overseas investors buying investment property for the first time. This is a tough data set to capture, because by definition such households are hard to contact, or prefer not to talk and they do not use an Australian mortgage. However, we devised a proxy set of questions focussing on funding sources, and as a result we now have a view of the proportion of first time investors in the market, and the overseas mix.

Taking the January data as a starting point, ABS tells us that there were 5,961 loans to owner occupied purchasers. In addition, we identified a further 3,661 first time buyers getting a mortgage for investment purposes. These amount to 35% of loans who are not identified as first time buyers in the ABS data, but are in the overall loan volume data. 8%, or 850, require no mortgage at all, and do not show in the mortgage statistics. We would need reliable purchase transfer records to get at the true picture, something not readily available.

From our surveys we teased out the funding options that first time buyers went with. 36% of deals used an interest only mortgage, 41% used a standard repayment mortgage, but the rest, 850 transactions (8%) did not require mortgage funding from an Australian bank but rather used other sources including parents, or were an overseas purchase.

We can dissect these purchases based on funding. About 125 were local purchasers without finance, over 200 were financed by parents and under 100 financed from other sources. However the most significant number was the 415 by overseas investors, using funding from offshore.

Looking at these 850 transactions through the lens of our surveys, we found that more than 550 were in NSW, more than 200 in VIC and a few sprinkled across the other states. This equates to about 4% of all first time buyers and 9.2% of investor first time buyers. Enough to more than move the dial, especially given the concentration in Sydney.

Next time we will look at investor motivations, and future plans. We think the investment housing boom is likely to continue to run, as more investors get the bug.