Tag: Interest Only Loans

SMH Does Interest Only Loans

The SMH published an article today “‘It’s our version of the GFC’: warning on looming interest-only crisis” which dissects the Interest Only Loan repayment issue, and includes a number of quotes from DFA.

Martin North, the principal at consultancy Digital Finance Analytics, said interest-only loans account for about $700 billion of the $1.7 trillion in Australian mortgage lending and it was “our version of the GFC”.

“My view is we’re in somewhat similar territory to where the US was in 2006 before the GFC,” Mr North said.

“This is absolutely not ‘sub-prime’ in the US definition but there were people [in Australia] who were being encouraged to get very big loans on the fact that principal & interest was impossible to service but they could service interest-only,” Mr North said.

“We also know that some interest-only loans were not investors but they are actually first-home buyers encouraged to go in at the top of the market.”

Those who follow our posts will know this has been an area of concern for several years as the volume of IO loans accelerated to a peak of more than 40%, before the regulator finally acted.

Now lending standards have been tightened, but there is a large overhang of loans which now will fail to be refinanced again.

So many households will need to step-up to an interest and principal repayment loan, which could be 40% or more higher to service, or be forced to sell.

In addition, some borrowers appear to not understand that they hold an IO loan, so this could all come as a nasty shock, at a time when property values are sliding, incomes are flat and costs of living are rising.

In addition, we know that many investment properties are already underwater from a net cash flow (before tax) position.

Despite the RBA’s recent assurances that many will cope just fine (and some households will) this has the potential indeed to be our version of the GFC.

Here is analysis by state and region looking the the gross and net yield on investment properties (excluding capital appreciation).  Many of the loans coming up for reset will require cash from sources other than the rentals.  Most pressures appear to be in NSW and VIC, where on average loans are larger, and households more leveraged.

 

 

The Economic Outlook (According to the RBA)

We got some more data on the state of the Australian Economy today from RBA Deputy Governor, Guy Debelle, which built on the recently released Statement on Monetary Policy (SMP).

There were four items which caught my attention.

First, the recent rise in money market interest rates in the US, particularly LIBOR. He said there are a number of explanations for the rise, including a large increase in bill issuance by the US Treasury and the effect of various tax changes on investment decisions by CFOs at some US companies with large cash pools.  This rise in LIBOR in the US has been reflected in rises in money market rates in a number of other countries, including here in Australia. This is because the Australian banks raise some of their short-term funding in the US market to fund their $A lending, so the rise in price there has led to a similar rise in the cost of short-term funding for the banks here; that is, a rise in BBSW. This increases the wholesale funding costs for the Australian banks, as well as increasing the costs for borrowers whose lending rates are priced off BBSW, which includes many corporates.

However, he says the effect to date has not been that large in terms of the overall impact on bank funding costs. It is not clear how much of the rise in LIBOR (and hence BBSW) is due to structural changes in money markets and how much is temporary. In the last couple of weeks, these money market rates have declined noticeably from their peaks.  But to my mind it shows one of the potential risks ahead.

Second the gradual decline in spare capacity is expected to lead to a gradual pick-up in wages growth. But when? The experience of other countries with labour markets closer to full capacity than Australia’s is that wages growth may remain lower than historical experience would suggest. In Australia, 2 per cent seems to have become the focal point for wage outcomes, compared with 3–4 per cent in the past. Work done at the Bank shows the shift of the distribution of wages growth to the left and a bunching of wage outcomes around 2 per cent over the past five years or so.

The RBA says that recent data on wages provides some assurance that wages growth has troughed. The majority of firms surveyed in the Bank’s liaison program expect wages growth to remain broadly stable over the period ahead. Over the past year, there has been a pick-up in firms expecting higher wage growth outcomes. Some part of that is the effect of the Fair Work Commission’s decision to raise award and minimum wages by 3.3 per cent.  They suggest there are pockets where wage pressures are more acute. But, while those pockets are increasing gradually, they remain fairly contained at this point

But he concluded that there is a risk that it may take a lower unemployment rate than we currently expect to generate a sustained move higher than the 2 per cent focal point evident in many wage outcomes today.

Third, he takes some comfort from the fact that arrears rates on mortgages remain low. This despite Wayne Byres comment a couple of months back, that at these low interest rates, defaults should be even lower! Debelle said that even in Western Australia, where there has been a marked rise in unemployment and where house prices have fallen by around 10 per cent, arrears rates have risen to around 1½ per cent, which is not all that high compared with what we have seen in other countries in similar circumstances and earlier episodes in Australia’s history. To which I would add, yes but interest rates are ultra-low. What happens if rates rise as we discussed above or unemployment rises further?

Finally, the interest rate resets on interest-only loans will potentially require mortgage payments to rise by nearly 30–40 per cent for some borrowers. There are a number of these loans whose interest-only periods expire this year. It is worth noting that there were about the same number of loans resetting last year too. The RBA says there are quite a few mitigants which will allow these borrowers to cope with this increase in required payments, including the prevalence of offset accounts and the ability to refinance to a principal and interest loan with a lower interest rate. While some borrowers will clearly struggle with this, our expectation is that most will be able to handle the adjustment so that the overall effect on the economy should be small.

This switch away from interest-only loans should see a shift towards a higher share of scheduled principal repayments relative to unscheduled repayments for a time. We are seeing that in the data. It also implies faster debt amortisation, which may have implications for credit growth.

And there is a risk of a further tightening in lending standards in the period ahead. This may have its largest effect on the amount of funds an individual household can borrow, more than the effect on the number of households that are eligible for a loan. This, in turn, means that credit growth may be slower than otherwise for a time. That he says has more of an implication for house prices, than it does for the outlook for consumption. To which I would add, yes, but consumption is being funded by raiding deposits and higher debt. Hardly sustainable.

So in summary, there are still significant risks in the system and the net effect could well drive prices lower, as credit tightens. And I see the RBA slowly turning towards the views we have held for some time. I guess if there is more of a down turn ahead, they can claim they warned us (despite their settings setting up the problem in the first place).

Interest only loans are an economic debacle that could bust the property market

From The Conversation.

This week’s Australian consumer price inflation figures revealed a 0.4% increase for the March quarter, and 1.9% for the last 12 months. The March quarter figure was below market expectations of 0.5%, and also the previous (December quarter) figure of 0.6%. Education prices were up 2.6% on the quarter, and health prices up 2.2% (or 4.2% for the year to March 2018).

This puts inflation still below the Reserve Bank of Australia’s (RBA) target band of 2-3%. That band, of course, has been in place since the early 1990s – beginning with this speech by then governor Bernie Fraser.

Numerous central banks around the world have a similar approach. The basic idea is that a central bank can build a reputation over time to commit to monetary policy such that inflation lies in the band.

Now there are pros and cons to this approach to monetary policy, and it has its critics. But that is another tale for another day.

Just assuming that inflation targeting is the correct objective, how is the RBA doing? Well, one small hitch in the plan is that inflation has been outside the band for a long time now (basically since 2014), as the RBA’s own figures show.

Given the level of unemployment in Australia, low wages growth, and stubbornly low inflation, the RBA probably should have cut rates further a fair while back. But they seem, probably rightly, terrified of further fuelling a potential housing bubble.

Meanwhile, the credibility of their commitment to the inflation target withers. If only the regulation of our banking and finance sector had been better for the last, say, decade or two.

Speaking of such regulation, RBA assistant governor Chris Kent gave a speech Tuesday about the important issue of interest-only loans. Kent’s speech was significant because it followed up on remarks in the RBA minutes about the same issue that I discussed in this column last week.

It seems that the RBA “house view” on interest only loans is as follows. There could be a problem but the Australian Prudential Regulation Authority (APRA) stepped in and the banks have voluntarily tightened lending standards recently. Also because the average household with an interest only loan has a buffer of savings, everything will be fine. Nothing to see here.

I hope the RBA’s conclusion is right, but I know for sure that the reasoning is not. It’s actually the marginal household’s financial position and behaviour that matters, not the average household.

The average United States borrower with an adjustable-rate mortgage did not default in 2007, 2008 or 2009. But these mortgages were a huge contributor to the financial crisis, along with subprime mortgages.

Kent dutifully laid out the risks from interest only loans, saying:

Because there’s no need to pay down principal initially, the required payments are lower during the interest-only period. But when that ends, there is a significant step-up in required payments (unless the interest-only loans are rolled over).

Indeed, unless they can be rolled over. Which they can’t now because of APRA and the banks finally doing something.

Now, prices (interest rates) on interest only loans have gone up as part of the bank response. This has led a bunch of folks to shift to amortising loans, where the principal of the loan is paid down over the life of the loan. So those borrowers who haven’t shifted to these loans already, really don’t want to.

Maybe they can’t afford to because of the increased repayments, that can jump 30% or more per month.

So what does happen? First Kent says many borrowers save ahead of time, expecting a rise in repayments. Yes, the prudent ones.

But how many non-prudent borrowers have their been in the Australian property market in recent years? Hint: a lot.

Kent also points to borrowers who seek to refinance their interest only loan. But banks don’t really want to, and APRA doesn’t want to let them. And who is going to be able to? The safer borrowers who did save and so don’t really need to avoid amortisation. The risky borrowers can’t refinance.

Kent says some borrowers will have to cut their spending. Chuckle, chuckle. And the final option is to sell their house.

Sure, no problem, unless lots of folks want to do that all at once. Then it’s a fire sale that detonates the housing market.

I really do hope we escape the interest only debacle unscathed. But if we do it will be pure, dumb luck, not a consequence of good design or sound regulation.

It definitely doesn’t justify the RBA’s house view in Kent’s concluding remarks that:

The substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so. Nevertheless, it is something that we will continue to monitor closely.

Perhaps a there should have been a little more monitoring before interest only loans got to be 40% of all loans and more than half of the loan book of one of our biggest banks.

Author: Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

The Limits of Interest-Only Lending – RBA

Christopher Kent, Assistant Governor (Financial Markets) spoke at the Housing Industry Association Breakfast.

Mortgages on interest-only terms have become an increasingly prominent part of Australian housing finance over the past decade. At their recent peak, they accounted for almost 40 per cent of all mortgages. While interest-only loans have a role to play in Australian mortgage finance, their value has limits.

Other things equal, interest-only loans can carry greater risks compared with principal-and-interest (P&I) loans. Because there’s no need to pay down principal initially, the required payments are lower during the interest-only period. But when that ends, there is a significant step-up in required payments (unless the interest-only loans are rolled over). This owes to the need to repay the principal over a shorter period; that is, over the remaining term of the loan. Also, because the debt level is higher over the term of the loan, the interest costs are also larger.

For housing investors, the key motivation for using an interest-only loan is clear. By enabling borrowers to sustain debt at a higher level over the term of the loan, interest-only loans maximise interest expenses, which are tax deductible for investors. They also free up funds for other investments.

For those purchasing a home to live in, there are other motivations for an interest-only loan. They provide a degree of flexibility when it comes to repayment. They can assist households to manage a temporary period of reduced income or heightened expenditure. That might occur, for example, when a household wants to work less in order to raise children, cover the cost of significant renovations or obtain bridging finance to buy and sell properties. They can also appeal to households without a steady flow of regular income, such as the self-employed. So there are understandable reasons why borrowers have taken out interest-only loans.

During interest-only periods, disciplined borrowers will be able to provision for future repayment of principal. They can accumulate funds in an offset or redraw account, or build up other assets. With sufficient saving over the interest-only period, the health of their balance sheet need be no different than it would have been with a P&I loan.

If, however, a borrower spends the extra cash flow available to them during the interest-only period (compared with the alternative of a P&I loan), they will need to make sizeable adjustments when that ends. They will have to either secure additional income by that time or reduce their consumption (or some combination of both). That will be more difficult and possibly come as a shock to the borrower if they haven’t planned for it in advance.

If the borrower has made no provisions and is unable to make the necessary adjustment, they may need to sell the property to repay the loan. Therein lies an additional risk inherent in interest-only lending. Moreover, the borrower’s ability to service the loan is not fully tested until the end of the interest-only period. If the borrower defaults, the potential loss for the lender will be larger than in the case of a P&I loan given that interest-only loans by design allow borrowers to maintain the debt at a higher level over the term of the loan.

That’s why, when providing interest-only loans, prudent lenders will carefully assess the borrower’s ability to make both interest and principal payments. Among other things, banks have to make their loan ‘serviceability assessments’ based on the status of the borrower’s income and expenditure at the time of origination. To help manage risks, lenders also typically limit the maximum interest-only period to five years.

The role of interest-only lending and its potential implications for financial stability have been of interest to the Reserve Bank for some time. The possible effects of the transition at the end of interest-only periods were discussed in the recent Financial Stability Review. I will come to that issue shortly, but first I want to review the regulatory responses to the strong growth of interest-only lending in recent years.

Tightening of Lending Standards

Interest-only loans had grown very strongly for a number of years in an environment of low mortgage rates and heightened competitive pressures among lenders. The share of housing credit on interest-only terms had increased steadily to almost 40 per cent by 2015 (Graph 1). The share of credit on interest-only terms has always been much higher for investors than owner-occupiers (consistent with the associated tax benefits for investors). But interest-only loans for owner-occupiers had also grown strongly.

Graph 1
Graph 1: Interest-only Housing Loans

 

In 2014, the Australian Prudential Regulation Authority (APRA) acted to tighten standards for interest-only loans, and mortgages more generally. APRA required serviceability assessments for new loans to be more conservative by basing them on the required principal and interest payments over the term of the loan remaining after the interest-only period. (Previously, some banks were assuming that the principal was being re-payed over the entire life of the loan, which was clearly a lower bar for the borrower to meet.) At about the same time, APRA acted to ensure that the interest rate ‘buffer’ used in the serviceability assessments for all loans was at least 2 percentage points above the relevant benchmark rate (with an interest rate floor of at least 7 per cent). Also, that test was required to include other, existing debt (which is often substantial for investors). The application of such a buffer in serviceability assessments implies that borrowers should be able to accommodate a notable rise in required repayments.

When APRA tightened loan serviceability requirements, it also limited the growth of investor lending (to 10 per cent annually). The share of interest-only loans in total housing credit then stabilised for a time at around 40 per cent, having increased steadily up to that point.

In early 2017, in recognition that continued strong growth of interest-only loans was contributing to rising risks, APRA further tightened standards on interest-only lending. Among other things, banks were required to limit new interest-only lending to be no more than 30 per cent of new mortgage lending. Banks were also required to tightly manage new interest-only loans extended at high loan-to valuation ratios (LVRs).

The Past Year or So

In response to those recent regulatory measures, the banks raised interest rates on investor and interest-only loans. From around the middle of 2017, the average interest rates on the stock of outstanding variable interest-only loans increased to be about 40 basis points above interest rates on equivalent P&I loans (Graph 2). Prior to that, there was little difference in interest rates on these loans.

Graph 2
Graph 2: Average Variable Interest Rates

 

The higher interest rates contributed to a reduction in the demand for new interest-only loans. In addition, because banks had raised interest rates on all of their (variable rate) interest-only loans, existing customers had an incentive to switch their loans from interest-only to P&I terms before their scheduled interest-only periods ended. Many took up that option.

The combination of higher interest rates and tighter lending standards contributed to the share of new loans that are interest-only falling comfortably below the 30 per cent limit. The stock of interest-only loans in total housing credit has also declined noticeably, from close to 40 per cent to almost 30 per cent.

This reduction in the stock of interest-only loans over the past year was substantial. It represented about $75 billion of loans (out of a total stock of interest-only loans of almost $600 billion in late 2016).

While many of the customers switching chose to do so in response to the higher rates on interest-only loans, there are likely to have been some borrowers who had less choice in the matter. Some borrowers may have preferred to extend their interest-only periods but may not have qualified in light of the tighter lending standards. We don’t have a good sense of the split between those borrowers that switched voluntarily and those that switched reluctantly. However, our liaison with the banks suggests that most borrowers have managed the transition reasonably well. Also, the share of non-performing housing loans over the past year remains little changed at relatively low levels. Moreover, the growth of household consumption has been sustained; indeed it picked up a touch in year ended-terms over 2017.

Given the large number of borrowers switching to P&I loans, it’s not surprising that scheduled housing loan repayments have increased over the past year (Graph 3). Meanwhile, unscheduled payments have declined. With total payments little changed, the rise in scheduled payments has had no obvious implications for household consumption.

Graph 3
Graph 3: Components of Household Mortgage Payments

The Next Few Years

So, many interest-only borrowers appear to have responded voluntarily to the pricing incentives and switched to P&I loans. This means that it is possible that the current pool of interest-only borrowers is a little more likely than usual to want to continue with their interest-only loans. For some of these borrowers, the decision not to switch to a lower interest rate P&I loan may reflect the higher required payments for such a loan.

Some commentators have gone so far as to suggest that when scheduled interest-only periods end, many borrowers will be forced onto P&I loans and will find it challenging to make the higher required payments. Commentators go on to suggest that such borrowers will either have to sell their property or reduce other expenditure significantly in order to service their loans.

In what follows, I’ll explore these concerns by providing some estimates of the effect of borrowers switching to P&I loans in the years ahead. I’ll focus my attention on the potential size of the change in households’ cash flows as well as the effect on the household sector’s consumption.

Around two-thirds of interest-only loans in the Reserve Bank’s Securitisation Dataset are due to have their interest-only periods expire by 2020 (Graph 4). That is consistent with interest-only periods typically being around five years. Only a small share of loans have interest-only periods of 10 years (or longer), with very few loans on these terms having been written (and securitised) since 2015. This is in line with the earlier measures to tighten lending standards.

Graph 4
Graph 4: Interest-only Period Expiry - share

 

Applying this profile of expiries to the total value of all interest-only loans suggests that about $120 billion of interest-only loans is scheduled to roll over to P&I loans each year over the next three years (Graph 5). This annual figure is equivalent to around 7 per cent of the stock of housing credit outstanding.

While the value of loans scheduled to reach the end of the interest-only periods appears large, it is worth emphasising that expirations of this size are not unprecedented. At the end of 2016, a similar value of loans was due to have their interest-only periods expire in 2017. What is different now, however, is that many households have already switched willingly in 2017 in response to pricing differentials, and lending standards were tightened further in recent years. This could affect the ability of some borrowers to extend their interest-only periods or to refinance to a P&I loan with a longer amortising period so as to reduce required payments on the loan.

Graph 5
Graph 5: Estimated Interest-only Period Expiry

 

To estimate the effect the expiry of interest-only periods, I’ll consider the case where all of the interest-only periods expire as scheduled. While extreme, this provides a useful upper-bound estimate of the effect of the transition ahead.

Consider a ‘representative’ interest-only borrower with a $400,000 30-year mortgage with a 5-year interest-only period. The left-hand side bar in Graph 6 shows the approximate interest payments (of 5 per cent) that such a borrower makes during the interest-only period. At the expiry of the interest-only period, required payments will increase by around 30–40 per cent (with an example shown in the bar on the right). (As shown in the graph, the interest rate applied to the loan is expected to be lower when it switches to P&I (by around 40 basis points) but this effect is more than offset by the principal repayments.)

Graph 6
Graph 6: Loan Payments at Interest-Only Period Expiry

 

The rise in scheduled payments amounts to about $7,000 per year for the representative interest-only borrower. This is a non-trivial sum for the household concerned.

But how big is this cash flow effect when summed up across all households currently holding interest-only loans? Again, I adopt the extreme assumption that all interest-only periods expire as scheduled over the coming few years. As a share of total household sector disposable income, the cash flow effect in this scenario is estimated be less than 0.2 per cent on average per annum over each of the next three years (Graph 7).

For the household sector as a whole, this upper-bound estimate of the effect is relatively modest. Even so, there are a number of reasons why the actual cash flow effect is likely to be even less than this. More importantly, the actual effect on household consumption is likely to be lower still. So let me step through the various reasons.

Graph 7
Graph 7: Additional Mortgage Payments

Savings

Many borrowers make provisions ahead of time for the rise in required repayments. It is common for borrowers to build up savings in the form of offset accounts, redraw balances or other assets. They can draw upon these to cover the increase in scheduled payments or reduce their debt. Others may not even need to draw down on existing savings. Instead, they can simply redirect their current flow of savings to cover the additional payments. In either case, such households are well placed to accommodate the extra required payments without needing to adjust their consumption very much, if at all.

As shown in the chart above, about half of owner-occupier loans have prepayment balances of more than 6 months of scheduled payments. While that leaves half with only modest balances, some of those borrowers have relatively new loans. They wouldn’t have had time to accumulate large prepayment balances nor are they likely to be close to the scheduled end of their interest-only period.

There are borrowers who have had an interest-only loan for some time but haven’t accumulated offset or redraw balances of substance. Offset and redraw balances are typically lower for investor loans compared with owner-occupier loans. That is consistent with investors’ incentives to maximise tax deductible interest. However, in comparison to households that only hold owner-occupier debt, there is evidence that investors tend to accumulate higher savings in the form of other assets (such as paying ahead of schedule on a loan for their own home, as well as accumulating equities, bank accounts and other financial instruments).

Refinancing

Another option for borrowers is to negotiate an extension to their interest-only period with their current lender or refinance their interest-only loan with a different lender. Similarly, they may be able to refinance into a new P&I loan with a longer loan term, thereby reducing required payments. Based on loans in the Securitisation Dataset, a large majority of borrowers would be eligible to alter their loans in at least one of these ways.

Any such refinancing will reduce the demands on a borrower’s cash flows for a time. However, it is worth noting that by further delaying regular principal repayments, eventually those repayments will be larger than otherwise.

Extra income or lower expenditures

What about borrowers who have not built up savings ahead of time or are unable to refinance their loans? The Securitisation Dataset suggests that such borrowers are in the minority. More importantly, most of them appear to be in a position to service the additional required payments. Indeed, the tightening of loan serviceability standards a few years ago was no doubt helpful in that regard.

Some fraction of interest-only borrowers may have used the reduced demands on their cash flows during the interest-only period to spend more than otherwise. However, the available data, and our liaison with the banks, suggest that there are only a small minority of borrowers who will need to reduce their expenditure to service their loans when their interest-only periods expire.

Sale of the property

Finally, some interest-only borrowers may have to consider selling their properties to repay their loans. Difficult as that may be – most notably for owner-occupiers – doing so could free up cash flow for other purposes. It would also allow them to extract any equity they have in the property. The extent of that can be gauged by estimating LVRs from the Securitisation Dataset. The LVRs of almost all of those interest-only loans (both owner-occupier and investor) are below 80 per cent (based on current valuations and including offset balances) (Graph 8). This reflects the combined effects of loan serviceability tests and the increase in housing prices over recent years.

Graph 8
Graph 8: Indexed Loan-to-Valuation Ratio

Some risks remain

While the various estimates I’ve provided suggest that the aggregate effect of the transition ahead on household cash flows and consumption is likely to be small, some borrowers may experience genuine difficulties when their interest-only periods expire. The most vulnerable are likely to be owner-occupiers, with high LVRs, who might find it more difficult to refinance or resolve their situation by selling the property.

Currently, it appears that the share of borrowers who cannot afford the step-up in scheduled payments and are not eligible to alleviate their situation by refinancing is small. Our liaison with the banks suggests that there are a few borrowers needing assistance to manage the transition. Over the past year, some banks have reported that there has been a small deterioration in asset quality. For some borrowers this has tended to be only temporary as they take time to adjust their financial affairs to cope with the rise in scheduled payments. For a small share of borrowers, though, it reflects difficulty making these higher payments. That share could increase in the event that an adverse shock led to a deterioration in overall economic conditions.

Conclusion

Today, I have discussed some of the risks associated with interest-only loans, which imply that their value as a form of mortgage finance has limits. I have also presented rough estimates of the likely effect of the upcoming expiry of interest-only loan periods. The step-up in required payments at that time for some individual borrowers is non-trivial. For the household sector as a whole, however, the cash flow effect of the transition is likely to be moderate. The effect on household consumption is likely to be even less. This is because some interest-only borrowers will be willing and able to refinance their loans. Also, many others have built up a sufficient pool of savings, or will be able to redirect their current flow of savings to meet the payments, or have planned for, and will manage, this change in other ways.

Indeed, the substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so. Nevertheless, it is something that we will continue to monitor closely.

Finally, the observation that the transition is proceeding smoothly is not an argument that the tightening in lending standards on interest-only loans was unwarranted; far from it. The tightening in standards starting in 2014 has helped to ensure that borrowers are generally well placed to service their loans. And the limit on new interest-only lending more recently has prompted a reduction in the use of those loans during a time of relatively robust growth of employment and still very low interest rates. In this way, it has helped to lessen the risk of a larger adjustment later on in what could be less favourable circumstances.

Preparing for the Switch

From Australian Broker.

Interest only loans are rarely out of the news. Following ASIC’s interim review the September quarter posted a knee-jerk 44.8% decline in new IO loans and lending practices are now firmly in the regulator’s crosshairs. APRA and RBA have already clamped down and further scrutiny is expected during the royal commission.

The regulators aren’t the only ones concerned. In February, assistant governor Michele Bullock delivered a speech on mortgage stress in which she highlighted a “large proportion of interest-only loans are due to expire between 2018 and 2022”.

That large proportion is, in fact, almost every IO loan written between 2013 and 2016, and subsequent analysis of IO property fixed-term lending by Digital Finance Analytics has calculated the total number at 220,000, with values upwards of $100bn.

These loans originate from before the reviews of 2015 and 2017, and in the coming year the fixed terms on 14% of them will face a reset outside of current lending criteria. By 2020, the value of loans due for renegotiation is expected to reach $27bn.

While there are many options open to these borrowers, Bullock calls it an “area to watch”, saying many could find themselves in financial stress.

“Some homeowners may not realise they are fast approaching the end of their five-year term and, if they do nothing, their lender will automatically roll them onto a P&I loan that could be challenging for them to support,” says Zippy Loans’ principal broker Louisa Sanghera.

“Combine this scenario with a slowing of the property market and clients may not have the buffer of equity to soften the blow.”

To the customer, interest-only is an attractive proposition for a number of reasons, from freeing up cash to tax incentives. Additionally, investors have widely financed rental property investments on an IO basis while paying down their owner-occupied P&I loan. Executive director of The Local Loan Company, Ray Hair, observes that it’s a decades-long trend, one that has taken place right under the radar of regulators and banks.

To date, availability has largely driven demand for IO, but with many borrowers now preparing to face the consequences of their honeymoon financial planning, a mounting collection of horror stories could change that.

“Whenever regulators initiate corrective action in a market there is an initial period of over correction, however the pendulum generally swings back to a position of equilibrium. Sadly, this is of little comfort to those caught out by the overnight changes in policy, increased interest rates and institutional disregard for the personal cost,” says Hair.

“Expect to see some very angry investors looking for a lender, broker or adviser to blame, and pay compensation” Ray Hair, The Local Loan Company

Major lenders are preparing their broker networks for further changes to lending criteria, and are actively assessing the terms of loans due to expire to 2022. But with many below the cap and borrowers looking for IO products, the call to return to business as (almost) usual has been too strong to resist.

“We have seen several major lenders loosen the reigns and cut the rates for interest-only loans again, likely because they are sitting below the cap and are looking to add more interest-only loans to their books. It will be interesting to observe whether other lenders follow and how this plays out in terms of consumer behaviour,” says Uno Home Loans CEO Vincent Turner.

The mortgage crunch

In January, UNSW professor of economics Richard Holden published a sobering observation of Australia’s relationship with high-LVR and IO loans. In it he reported Australian banks lend an average 25% more than their US counterparts and that these loans are poorly structured and sometimes based on falsified or inaccurate household finances.

 

A decade ago, US banks learned this lesson the hard way, when five-year adjustable rate mortgages could not be refinanced and the fallout triggered a chain reaction that dragged most of the globe into recession.

In Australia, IO lending has comprised as much as 40% of the loan book at the major banks, and a particularly large share of property investors choose IO. The number of new IO loans is in overall decline, $156bn borrowed in 2015 to $135.5bn in 2017, but their share is still significant. In the owner-occupier market they count for one in four loans, and in the investor market it’s two in three.

“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,” Holden told Australian Broker at the time.

“It’s our professional and ethical obligation to look after the best interests of our clients and help them plan strategies” Louisa Sanghera, Zippy Loans

A teacher at the University of Chicago when the US housing market crashed, he added, “The high proportion is similar to the high proportion of adjustable rate mortgages in the US circa 2007.”

So how scared should people be? According to Hair, a lot of people “should be very afraid”, although he says dynamic lending policies, a banking sector unwilling to lose market share and strength in non-bank lenders will dampen some impact.

Quoting the DFA data, he adds, “Unfortunately, there will be pain for highly leveraged borrowers with negative equity, as there has been in the past with an oversupply of apartments, restrictions on non-resident lending and the fall
in property values in mining-dependent regional towns.”

For Turner, the concerns are overstated on a macro level, and reasonable lead times for a switch are all most borrowers will need. However, he warns, “The bigger concern should always be unemployment that triggers substantial hardship, very quickly across a broad group of people, which has the effect of contagion.”

Hero or villain?

While there are many unknowns in how borrowers and lenders will cope with the switch to P&I, what is known is that brokers could find themselves very busy between now and 2022.

“It’s our professional and ethical obligation to look after the best interests of our clients and help them plan strategies that are sustainable and supportive of their personal financial goals,” says Sanghera, who predicts a “positive impact overall” for brokers.

At Zippy Loans active management of IO customers means the lender has very few of the loans on its books. Responding to the rises in interest rate charges over recent months, Zippy has contacted its IO clients to move them onto a workable P&I solution.

“Clients will need to consider a broader range of lending options to find a product that works for them and brokers are ideally placed to research these options on their behalf. I believe this will result in more people turning to brokers to navigate the ever-more complex market place and secure the right solution,” she adds.

Throughout this process, transparency will be key, as Turner notes, “Brokers who continue to push expensive interest-only loans will probably lose business to those who show their customers when P&I works and when IO is the better option. In most cases it isn’t.”

However, brokers will also be the bearers of bad news as some are forced to sell and, according to Hair, it’s likely a lot of disgruntled borrowers will pursue their brokers in the courts, as many have done before when things have not gone their way.

Advising brokers to keep “well documented notes” of original transactions and borrower objectives, as well as subsequent attempts to refinance, he says: “Brokers will be both the heroes and the villains in this pantomime.”

“Expect to see some very angry investors looking for a lender, broker or adviser to blame, and pay compensation, for the position they find themselves in,” he adds.

Is this Australia’s sub-prime crisis? From those in the industry it’s a unanimous no. However that doesn’t mean to say a significant number of borrowers won’t receive a harsh wake-up call.

“The bigger concern should always be unemployment that triggers substantial hardship … which has the effect of contagion” Richard Holden, UNSW

For Holden, the damage has already happened and recent measures are too little too late. Although he refers to tighter lending standards as “comforting”, he says the 30% cap is “about all that can be done” at this point.

Australia’s smaller lenders lack the resources to manage more of the IO debt burden, meaning a mass exodus of customers away from the majors is unlikely. That doesn’t mean to say the majors won’t step up to the potential competition. As Hair predicts,
this could bring some attractive offers for borrowers looking to switch or refinance.

For now, it’s all eyes on the interest rate. On the one hand, no change in the cash rate for 19 months has manufactured a level of stability, on the other it’s delayed the hangover. The IMF has already advised implementation of US-style signalling for potential hikes, although after the last month there is some way to go before reaching the 4% rate it expects to see by late 2019.

Regardless of what happens, some pockets of stress are expected.

Within the industry, brokers have a chance to step up and guide customers through the uncertainties, but the watchful eyes of the regulators will be on them.

A $100bn question remains: how wealthy is the average Australian borrower? Those writing the rulebook say wealthy enough to cover higher mortgage payments. Those who have seen the cycle play out elsewhere, say otherwise.

Our Own Version Of Sub-Prime?

The RBA has released their Financial Stability Review today. It is worth reading the 70 odd pages as it give a comprehensive picture of the current state of play, though through the Central Bank’s rose-tinted spectacles!

They home in on the say $480 billion interest only mortgage loans due for reset over the over the next four years, which is around 30 per cent of outstanding loans. Resets to principal and interest will lift repayments by at least 30%. Some borrowers will be forced to sell.

This scenario mirrors the roll over of adjustable rate home loans in the United States which triggered the 2008 sub-prime mortgage crisis. Perhaps this is our own version!

We have previously estimated more than $100 billion in these loans would now fail current tighter underwriting standards.

One area of potential concern is for borrowers at the end of their current IO period. Much of the large stock of IO loans are due to convert to P&I loans between 2018 and 2021, with loans with expiring IO periods estimated to average around $120 billion per year or, in total, around 30 per cent of the current stock of outstanding mortgage credit. The step-up in mortgage
payments when the IO period ends can be in the range of 30 to 40 per cent, even after factoring in the typically lower interest rates charged on P&I loans.

However, a number of factors suggest that any resulting increase in financial stress should not be widespread. Most borrowers should be able to afford the step-up in mortgage repayments because many have  accumulated substantial prepayments, and the serviceability assessments used to write IO loans incorporate a range of buffers, including those that factor in potential future interest rate increases and those that directly account for the step-up in payments at the end of the IO period.

Moreover, these buffers have increased in recent years. In addition to raising the interest rate buffer, APRA tightened its loan serviceability standards for IO loans in late 2014, requiring banks to conduct serviceability assessments for new loans based on the required repayments over the residual P&I period of the loan that follows the IO period.

Prior to this, some banks were conducting these assessments assuming P&I repayments were made over the entire life of the loan (including the IO period), which in the Australian Securities and Investments Commission’s (ASIC’s) view was not consistent with responsible lending requirements. As a result, eight lenders have agreed to provide remediation to borrowers that face financial stress as a direct result of past poor IO lending practices.

However, to date, only a small number of borrowers have been identified as being eligible for such remediation action. Some borrowers have voluntarily switched to P&I repayments early to avoid the new higher interest rates on IO loans, and these borrowers appear well placed to handle the higher repayments.

Some IO borrowers may be able to delay or reduce the step-up in repayments. Depending on personal circumstances some may be eligible to extend the IO period on their existing loan or refinance into a new IO loan or a new P&I loan with a longer residual loan term. The share of borrowers who cannot afford higher P&I repayments and are not eligible to alleviate their situation by refinancing is thought to be small.

In addition, borrowers who are in this situation as a result of past poor lending practices may be eligible for remediation from lenders. Most would be expected to have positive equity given substantial housing price growth in many parts of the country over recent years and hence would at least have the option to sell the property if they experienced financial stress from the increase in repayments. The most vulnerable borrowers would likely be owner-occupiers that still have a high LVR and who might find it more difficult to refinance or resolve their situation by selling the property.

Looking more broadly  at household finances, they say that the ratio of total household debt to income has increased by almost 30 percentage points over the past five years to almost 190 per cent, after having been broadly unchanged for close to a decade.

Australia’s household debt-to-income ratio is high relative to many other advanced economies, including some that have also continued to see strong growth in household lending in the post-crisis period, such as Canada, New Zealand and Sweden.

Household debt in these economies is notably higher than in those that were more affected by the financial crisis and experienced deleveraging, including Spain, the United Kingdom and the United States. While Australia’s high level of household indebtedness increases the risk that some households might experience financial stress in the event of a negative shock, most indicators of aggregate household financial stress currently remain fairly low (notwithstanding some areas of concern, particularly in mining regions). In addition, total household mortgage debt repayments as a share of income have been broadly steady for several years.

Note of course this is because interest rates have been cut to ultra-low levels, and should rates rise, payments would rise significantly.

The RBA says that default rates on mortgages (More than $1.7 trillion) is low, but concedes higher in the mining heavy states.

Then they defend the situation by saying that household wealth is rising (though thanks mainly to inflated property values, currently beginning to correct), and continue to cite out of date HILDA survey data from 3 years ago to demonstrate that the share of households experiencing financial stress has been the lowest since at least the early 2000s. But this is so old as to be laughable, remembering the interest rates and living costs have risen, and incomes are flat in real terms.

And they argue again that households are prepaying on their mortgages. We agree some are, but not those in the stressed category. Averaging data is a wonderful thing!

Finally, a word on the profitability outlook of the banks.

Despite the recent lift, analysts are cautious about the outlook for profit growth. The recent benefits to profit growth from a widening of the NIM and falling bad debt charges are expected to fade, especially if short-term wholesale spreads remain elevated. The financial impact of the multiple inquiries into the financial services sector remains a key uncertainty, including the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the Productivity Commission’s Inquiry into Competition in Australia‘s Financial System, and the Australian Competition and Consumer Commission’s Residential Mortgage Products Price Inquiry. There is the potential that these will result in banks having to set aside provisions and/or face penalties for past misconduct or perhaps (more notably) being constrained in the operation of parts of their businesses.

This uncertainty around banks’ future earnings has weighed on their share prices, which have underperformed global peers (although Australian banks still have higher price-to-book ratios). The decline in share prices has also seen banks’ forward earnings yields (a proxy for their cost of equity capital) further diverge from that of the rest of the Australian market since mid 2017 (Graph 3.8). Banks’ current forward earnings yields remain a little above their pre-crisis average, despite a large decline in risk-free rates since then.

New Wave Of Cheap Interest Only Loans Hits

The story so far. Banks were lending up to 40%+ of mortgages with interest only loans, some even more.

The regulator eventually put a 30% cap on these loans and the volume has fallen well below the limit. Some banks almost stopped writing IO loans.

Source: APRA

They also repriced their IO book by up to 100 basis points, so creating a windfall profit. This is subject to an ACCC investigation to report soon.

The RBA and APRA both warn of the higher risks on IO loans, especially on investment properties, in a down turn.

APRA has confirmed the “temporary” 30% cap will stay for now, although the 10% growth cap in investment loans is now redundant, thanks to better underwriting standards.

Banks have now started to ramp up their selling of new IO loans, to customers who fit within current underwriting standards and are offering significant discounts.  Borrowers will be encouraged to churn to this lower rate.

This from Your Mortgage.

CBA will cut fixed interest rates for property investors across one-, two-, three-, and four-year terms. The cuts, which range from 0.05 percentage points to 0.5 percentage points, apply to both interest-only investor loans and principal-and-interest investor loans.

CBA is also cutting some of its fixed rates for owner-occupiers, including a reduction on owner-occupied principal-and-interest fixed-rate loans by 0.1% over terms of one to two years, landing at 3.89% for borrowers on package deals.

Key rival Westpac also unveiled a suite of fixed-rate changes on Friday, including some cuts to fixed-rate interest-only mortgages, another area where banks have been forced to apply the brakes. The Sydney-based bank also hiked rates across various fixed terms for owner-occupiers.

Westpac will increase fixed-rate owner-occupied home-loan interest rates by 0.1 percentage points for loans of one-, two-, four-, and five-year terms. Across three-year terms, the bank will leave rates unchanged at 4.19%.

Both banks’ rate changes will only impact customers who are taking out new fixed-rate loans, leaving existing mortgages untouched.

CBA’s aggressive pursuit of property investors comes after it said in its most recent half-year results that its loan book was growing more slowly than allowed by the regulators. Credit growth has slowed across the board and house prices in Sydney and Melbourne have begun to soften.

And this from the AFR:

Major lenders are expected to follow the Commonwealth Bank of Australia’s latest round of interest-only mortgage cuts after losing market share because of massively over-estimating the impact of lending caps on their loan books, despite regulatory fears about rising debt and prices, according to analysts.

“Expect others to follow,” said Steve Mickenbecker, group executive for financial services at Canstar, which monitors rates and charges for financial service products, about the CBA’s recent cuts.

Big four lenders started losing market share to smaller lenders and regulation-lite non-bank financial institutions when they slammed on the brakes to meet Australian Prudential Regulation Authority’s 30 per cent cap on interest-only loans.

CBA’s CEO-elect, Matt Comyn, recently flagged plans to rebuild interest-only market share after over-shooting the regulatory 30 per cent target and ending in the low 20s.

Well under lending caps

The bank’s mortgage growth in the 12 months to December 31 was about 5 per cent, compared with about 6 per cent system growth and more than 11 per cent for non-bank financial institutions (NBFI).

From Mortgage Professional Australia.

Meanwhile, Westpac-owned St George cut its two-year fixed-rate investment property loan marginally by -0.04% to 4.60%, and Aussie Home Loans cut its one-year fixed IQ Basic Investment Loan by -0.25% to 4.24%.

Other smaller lenders, such as ING, Mortgage House, and Virgin Money have also dropped some interest-only rates over the previous month.

… the story continues….

Problem IO Loans Close To Home – The $100 Billion Problem

Today we discuss which post codes will be most impacted by the interest only mortgage loan reset issue, and update our estimates of the number and value of loans likely to be impacted. This received media coverage in the AFR and the Australian over the weekend.

We discussed recently the size of the interest only loan mortgage portfolio, in the light of tighter lending standards now in place.  We also discussed the issue in a recent edition of the Property Imperative Weekly video blog.

Here are some facts.

The value of IO loans in Sept 2017 was $549 billion, down from a peak of $587 billion in March 2017. The number of loans outstanding was 1.56 million loans, down from a peak of 1.69 million loans in December 2016.

Lenders are now required to make a more detailed assessment of a borrower when the loan comes up for periodic review, typically after 5, or in some cases 10 years. Some of the changes we are seeing are:

  • rental income cut to 80% of flows, to allow for vacancy periods
  • borrowers must have a stated concrete plan to repay the capital element of the loan (vague “from property sale”, probably wont be sufficient, especially given current home price movements).
  • overall borrower income and serviceability to be assessed
  • loans to be assessed as if they were a principal and interest loan

In addition, loans must be “suitable” taking into account the overall financial footprint and objectives of the borrowers (and this must be documented in case of later action). Otherwise the loan could be voided.

If an interest only loan comes up for review, and it fails to be renewed because it falls outside current assessments, borrowers have limited choices.

  • They may shop around for an alternative lender. Most banks are following the same regulatory guidelines (though there are some differences as to how the rules are being applied). Non-banks are less restricted at the moment (but watch this space..).
  • They may move to a principal and interest loan, which could double the monthly repayments. Bearing in mind half of investment properties are under water on a net rental basis, this means finding funds from other sources. If multiple properties and loans are involved, this could be a cascading problem
  • Arrange to sell the property. We are already seeing some forced sales, especially in Sydney and Melbourne. More will follow.

Recent UBS research suggested that some borrowers are not aware they have an IO loan, so might get a very nasty surprise when then bank contacts them!

Using data from our household surveys to end February we re-ran our analysis of IO loans which will fall outside serviceability currently. We had previously estimated $60 billion were exposed, but this has now risen, first because we extended the analysis by a year, and second because we updated the lending standards which have become tighter in recent weeks. It is now a $100 billion problem on a $550 billion loan book.  More than 220,000 households will be caught over the next few years.

Here is the state breakout.

We can then identify the post code where the borrowers are residing. This may of course be different from where the investment properties are located.  Here is the list of top post codes impacted. Click to view the larger version. Note the household segments which are impacted are predominately more affluent ones!

Finally, to get the juices flowing here is the geo-mapping for Greater Sydney. We will share other locations in subsequent posts. Again you can click on the map to view a larger version.

This is a significant issue, and mirrors the US in 2005 onwards as loans were reset to higher rates, lifting repayments. But the difference in Australia is that the households most impacted appear to be more affluent. In theory, therefore they may be able to rearrange their finances, but investors of course have the freedom to exit the market. Expect more forced sales in the months ahead, with consequential downward pressure on home prices as a result.

 

 

APRA’s Latest On IO and Investment Loans

Wayne Byres, APRA chairman appeared before the Senate Economics Legislation Committee today.

During the session he said that the 10% cap on banks lending to housing investors imposed in December 2014 was “probably reaching the end of its useful life” as lending standards have improved. Essentially it had become redundant.

But the other policy which is a limit of more than 30% of lending interest only will stay in place. This more recent additional intervention, dating from March 2017, will stay for now, despite it being a temporary measure. The 30% cap is based on the flow of new lending in a particular quarter, relative to the total flow of new lending in that quarter.

This all points to tighter mortgage lending standards ahead, but still does not address the risks in the back book.

But the tougher lending standards which are now in place will be part of the furniture, plus the new capital risk weightings recently announced. Its all now focussing on loan serviceability, something which should have been on the agenda 5 years ago!

The evidence before the Senate on mortgage fraud is worth watching.

He also included some interesting and relevant charts.

Around 10% of new loans are still Loan to income is still tracking above 6 times loan to income.

This despite a fall in high LVR new loans.

The volume of new interest only loans is down, 20% of loans from the major banks are interest only, higher than other ADI’s

Overall investor loan growth is lower, in fact small ADI’s have slightly higher growth rates than the majors.

As a result of the changes the share of new interest only loans has dropped below the target 30%, to about 20%.

And investor loans are growing at less than 5% overall, significantly lower than previously.

So you could say the APRA caps have worked, but more permanent and calibrated measures are the future.

More broadly, here are his remarks:

I’d like to start this morning by highlighting the importance of the Financial Sector Legislation Amendment (Crisis Resolution Powers and Other Measures) Bill 2017 which – with the welcome endorsement of this Committee – was recently passed into law by the Parliament.

The Bill delivers a long-awaited and much needed strengthening of APRA’s crisis management powers, better equipping us to deal with a financial crisis and thereby to protect the financial well-being of the Australian community. Put simply, these powers give us enhanced tools to fulfil our key purpose in relation to banking and insurance: to protect bank depositors and insurance policyholders. That purpose is at the heart of all that we do, and the legislation is designed with that protection very much in mind.

With the Bill now passed, the task ahead for APRA is to invest in the necessary preparation and planning to make sure the tools within the new legislation can be effectively used when needed. We hope that is neither an imminent nor common occurrence, but we have much work to do in the period ahead to make sure we, along with the other agencies within the Council of Financial Regulators that will be part of any crisis response, have done the necessary homework to use these new powers effectively when the time comes.

So that is one key piece of work for us in the foreseeable future. But it is far from the only issue on our plate. With the goal of giving industry participants and other stakeholders more visibility and a better understanding of our work program, we released a new publication in January this year outlining our policy priorities for the year ahead across each of the industries we supervise.1 Initial feedback has welcomed this improved transparency of the future pipeline of regulatory initiatives, and the broad timeline for them.

That publication is one example of our ongoing effort to improve our processes of engagement and consultation with the financial sector and other stakeholders. Another prominent example is that we’ve just embarked on our most substantial program of industry engagement to date as we seek input into the design and implementation of our next generation data collection tool.2 Through this process, which we launched on Monday this week, all of our stakeholders will have an opportunity to tell us – at an early stage of its design – what they would like to see the new system deliver, as well as influence how we roll it out.

More generally, and recognising the increased expectations of all public institutions, I thought it would also be timely to briefly recap the ways APRA is accountable for the work we do supervising financial institutions for the benefit of the Australian community. At a time when Parliament has moved to strengthen APRA’s regulatory powers, we fully accept that these accountability measures take on added importance. They play a crucial role in reassuring all of our stakeholders that APRA is acting at all times according to our statutory mandate.

APRA’s accountability measures are many and varied. They start with the obvious measures such as our Annual Report, our Corporate Plan and Annual Performance Statement, and our assessment against the Government’s Regulator Performance Framework. We obviously also make regular appearances before Parliamentary committees such as this to answer questions about our activities, and now meet with the Financial Sector Advisory Council in their role reporting on the performance of regulators. Our annual budget, and the industry levies that fund us, are set by the Government, which also issues us a Statement of Expectations as to how we should approach our role. We comply with the requirements of the Office of Best Practice Regulation in our making of regulation, and our prudential standards for banking and insurance may be disallowed by Parliament, should it so wish.

To give greater visibility to these mechanisms, we have recently set out an overview of our accountability requirements – including some that we impose on ourselves – on our website so that they can be better understood by our stakeholders.3

I’d like to also note that we will be subject to additional scrutiny this year through two other means:

  • We expect that aspects of APRA’s activities will be of interest to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. We have already provided, at their request, documents and information to the Commission, and will continue to cooperate fully as it undertakes its important work.
  • We will be subject to extensive international scrutiny from the IMF over the year ahead as part of its 2018 Financial Sector Assessment Program (FSAP).4 The FSAP will look at financial sector vulnerabilities and regulatory oversight arrangements in Australia, providing a report card on Australia (and APRA in particular) against internationally-accepted principles of sound prudential regulation. As was the case previously, we expect the IMF to find things we could do better. APRA is ready, along with other members of the regulatory community, to give the IMF our full cooperation and look forward to their feedback.

Finally, time does not permit me to discuss our on-going work in relation to housing lending but, anticipating some questions on this issue, I have circulated some charts which might be helpful for any discussion (see attached).

With those opening remarks, we would now be happy to answer the Committee’s questions.

The Interest Only Loan Problem – The Property Imperative Weekly 24 Feb 2018

What’s the story with Interest only? Welcome to the Property Imperative Weekly to 24th February 2018.

Welcome to the latest weekly digest of property and finance news. Watch the video or read the transcript.

Michelle Bullock from the RBA spoke about Mortgage Stress and Investor Loans this week. She argued that, based on HILDA data from 2016, mortgage stress was not a major issue, (we beg to differ) but also warned there were elevated risks to Property Investors, and especially those holding interest only loans.  This mirrors APRA’s warnings the previous week. She said that investors have less incentive than owner-occupiers to pay down their debt. Many take out interest-only loans so that their debt does not decline over time. If housing prices were to fall substantially, therefore, such borrowers might find themselves in a position of negative equity more quickly than borrowers with an equivalent starting LVR that had paid down some principal. The macro-financial risks are potentially heightened with investor lending. For example, since it is not their home, investors might be more inclined to sell investment properties in an environment of falling house prices in order to minimise capital losses. This might exacerbate the fall in prices, impacting the housing wealth of all home owners. As investors purchase more new dwellings than owner-occupiers, they might also exacerbate the housing construction cycle, making it prone to periods of oversupply and having a knock on effect to developers.

So we did some further analysis on Interest Only Loans, we already identified that conservatively $60 billion of loans will fail current underwriting standards on reset, which is more than 10% of the portfolio.  We discussed this with Ross Greenwood on 2GB’s Money Show.

But how many loans are interest only, and what is the value of these loans? A good question, and one which is not straightforward to answer, as the monthly stats from the RBA and ABS do not split out IO loans. They should.

The only public source is from APRA’s Quarterly Property Exposures, the next edition to December 2017 comes out in mid March, hardly timely. So we have to revert to the September 2017 data which came out in December. This data is all ADI’s with greater than $1 billion of term loans, and does not include the non-bank sector which is not reported anywhere!

They reported that 26.9% of all loans, by number of loans were IO loans, down from a peak of 29.8% in September 2015. They also reported the value of these loans were 35.4% of all loans outstanding, down from a peak of 39.5% in September 2015.

So, what does this trend look like. Well the first chart shows the value of loans in Sept 2017 was $549 billion, down from a peak of $587 billion in March 2017. The number of loans outstanding was 1.56 million loans, down from a peak of 1.69 million loans in December 2016.

If we plot the trends by number of loans and value of loans, we see that the value exposed is still very high. Finally, the average loan size for IO loans is significantly higher at $347,000 compared with $264,300 for all loans. Despite the fall in volume the average loan size is not falling (so far). The point is the regulatory intervention is having a SMALL effect, and there is a large back book of loans written, so the problem is risky lending has not gone away.

US Mortgage rates continue to climb, following the recent FED minutes which were more upbeat, and continues to signal more rate hikes this year. As a result, average rates moved to their highest levels in more than 4 years.  Moody’s made the point that US Government debt will likely rise by 5.9% in the next year, significantly faster than private sector debt, yet argued that this might not be sufficient to drive rates higher. On the other hand, Westpac argues that the Fed may have to lift rates faster and higher than many expect thanks to strong wage growth and higher government spending, and are forecasting rises of 1.25% ahead. This would have a significant knock-on effect.  In fact, the recent IMF country report on Australia forecast that the average mortgage rate in Australia would rise by 2% to 7.1% in 2021.  That would cause some pain (and lift mortgage stress from ~920k to 1.25m households on our models. We heard this week that the ACCC is due to release its interim report into residential mortgage pricing shortly. As directed by the Treasurer, a key focus will be on transparency, particularly how the major banks balance the interests of consumers and shareholders in making their interest rate decisions.  And the RBA minutes seemed to suggest a wait and see approach to changing the cash rate.

The Royal Commission continues its deep dive into lending misconduct, and announced the dates for the next set of hearings in early March. They also released a background document spotlighting Mortgage Brokers. The data highlights broker share is up to 55% of mortgages, and some of the largest players are owned by the big banks, for example Aussie, is owned by CBA.

Separately ASIC discussed structural conflicts from the relationship between Financial Planners and Mortgage Brokers and the companies who own them and the commission structures which are in place. To reduce the impact of ownership structure, ASIC proposed that participants in the industry “more clearly disclose their ownership structures”.

When asked whether mortgage brokers should come under “conflicted remuneration laws”, ASIC’s Peter Kell said: “There’s been a lot of work done on this, so it’s difficult to get a yes or no answer, but we’ve obviously highlighted in our report that we think there are some aspects of the way that remuneration works in the mortgage-broking sector that would be better to take out of the sector because they raise unreasonable conflicts.”

However, the Productivity Commission has gone a step further by calling for a legal provision to be imposed by ASIC to require lender-owned aggregators to work in the “best interest” of customers.

Draft recommendation 8.1 reads: “The Australian Securities and Investments Commission should impose a clear legal duty on mortgage aggregators owned by lenders to act in the consumer’s best interests.

“Such a duty should be imposed even if these aggregators operate as independent subsidiaries of their parent lender institution, and should also apply to the mortgage brokers operating under them.”

We caught up with several investment management teams this week who are in the country visiting the major banks as part of their regular reviews. One observation which came from these is that the major banks generally believe there will be very little change coming from the plethora of reviews currently in train, so it will be business as usual. We are less sure, as some of the issues being explored appear to be structurally significant.

Economic news this week included the latest wage price data from the ABS. You can clearly see the gap between trend public and private sector rates, with the private sector sitting at 1.9% and public sector 2.4%. The CPI was 1.9% in December, so no real growth for more than half of all households! Victoria was the highest through the year wage growth of 2.4 per cent and The Northern Territory recorded the lowest of 1.1 per cent. So if you want a wage rise, go to the Public Sector in Victoria!

There were more warnings, this time from comparison site Mozo on the risks of borrowers grabbing the “cheap” special mortgage offers which are flooding the market at the moment. Crunching the numbers in the Mozo database, they found that homeowners could pay as much as 174 basis points more when the ‘honeymoon period’ on their home loan ends. In fact, the research revealed that the average homeowner with a $300,000 home loan could end up paying as much as $3,423 in additional interest charges each year if they’re caught taking the introductory rate bait. But this can become an even more costly error when you consider how much extra interest you could end up paying over the life of the loan.

And mortgage underwriting standards continue to tighten as NAB has made a change to its home lending policy amid concerns over the rising household debt to income ratio and as APRA zeroes in on loan serviceability. From Friday, 16 February, the loan to income ratio used in its home lending credit assessment has been changed from 8 to 7.  With the new change, loan applications with an LTI ratio of 7 or less will proceed as normal and will be subject to standard lending criteria, according to the note. But stop and think about this, because a loan to income of 7 is hardly conservative in the current environment. In fact, when I used to underwrite mortgages we used a basic calculation of no more than 3.5 times one income plus one time any second income. We still think underwriting is too loose.

Finally home prices continued to drift lower, especially in Sydney according to CoreLogic, who also said the final auction clearance rate across the combined capital cities rose to 66.1 per cent across a higher volume of auctions last week, with 1,992 auctions held, increasing from the 1,470 auctions the week prior when 63.7 per cent cleared.  But last week’s clearance rate was lower than the 74.9 per cent recorded one year ago when volumes were higher (2,291). So momentum is still sluggish.

We think lending standards, and misconduct will be coming to the fore in the coming couple of weeks leading up to the next Banking Commission Hearing sessions. Remember this, if a loan is judged as “suitable”, it opens the door for recourse to the lender, which may include cancellation or alternation of the loan. Now, if volumes of interest only loans were judged “not suitable” this could open the flood gates on potential claims. Things might just get interesting!