One of the most powerful tools to assess risk in a mortgage portfolio is dynamic loan to income ratios (LTI). Whilst Loan to Value (LVR) has traditionally been seen as a simple lead indicator of risk, in a rising priced market, risks are hidden, while in a falling market risks suddenly reappear. In any case LVR is about the equity buffer which protects the bank, not necessarily the household, and then only once default occurs.
Among advanced economies, loan to income ratios have started to take their place as the more accurate indicator of potential risk because they look at the household cash flow, and ongoing ability to service the loan. There has been reluctance in Australia to want to get to grips with LTI, but APRA’s recent comment suggests this may, and rightly change.
The point though is LTI at loan origination, just as LVR at origination, does not tell the full story. To be effective LTI should be dynamically adjusted, so as income changes, risk does too. This should then be back-ended into the banks’ risk and capital models.
The Digital Finance Analytics Core Market Model includes dynamic LTI. Currently we estimate that more than 20% of owner occupied mortgage loans on book have a dynamic LTI of more than 4 times income.
Some LTI’s are above 10 times income, though a relatively small number, they are at significantly higher risk.
Looking at the data by state, we see that by far the highest count of high LTI loans resides in NSW (mainly in Greater Sydney), then VIC and WA.
Younger households have a relatively larger distribution of higher LTI loans.
Reading across our core segmentation, we see that Young Affluent, Exclusive Professionals and Multi Cultural Establishment are the three groups more likely to have a high dynamic LTI. We also see a number of Young Growing Families in the upper bands too.
Many lenders also hold the transaction account for their mortgage borrowers, so it is perfectly feasible to build an algorithm which calculates estimated income dynamically from their transaction history, and use this to estimate a dynamic LTI. This would give greater insight into the real portfolio risks, compared with the blunt instrument of LVR. It is less misleading that LTI or LVR at origination.
Indeed, perhaps lenders should be running annual health checks on their mortgage portfolios, using LTI as the key discriminator. This is a leading indicator of down stream risks.
It also assists in assessing the true portfolio risks, because currently if households are in difficulty, it is in the banks’ interests to close out the loan quickly, to release equity to repay the loan and reduce the number of “bad loans” on book. One simple reason why losses are so low on a portfolio basis around 2 basis points, is that in a rising market, equity gains more than cover the loans. But that could change if home prices stall or reverse.
Dynamic LTI is a tool to assess risks earlier in the cycle.
