Tag: Mortgage Risk

Market headwinds to increase risk for LMI sector

From Australian Broker.

Structural headwinds in the property market could result in heightened risks to the Australian mortgage insurance industry, according to a major international ratings agency.

In a new report from S&P Global Ratings, Insurance Industry and Country Risk Assessment: Australia Mortgage, analysts looked at the health of the industry and posited that the risk for the overall sector was intermediate.

Encroaching macroeconomic risks such as rising house prices and a growing ratio of household debt to disposable income have the potential to cause volatility in the mortgage insurance industry, analysts said.

If these factors cause a sharp correction in house prices – as mentioned in S&P’s recent downgrade of 23 Australian financial institutions – this could create a significant rise in credit losses.

“This increases the risk of material adverse claims experience for lenders’ mortgage insurers in Australia,” S&P said.

However, the agency’s base case scenario assumed that current and future actions by the government and regulators could lessen the impact of this scenario.

For the short term, analysts predicted that an “orderly correction” of house prices in Western Australia and Queensland would continue throughout the rest of the year.

“While the latter could increase insurance claims originating from these states, it is unlikely to pose a significant challenge to the credit profiles of insurers that offer lenders’ mortgage insurance (LMI).”

Furthermore, S&P predicts that employment levels – which can drive claims frequency for the sector – are likely to improve from 5.8% in fiscal year 2017 to approximately 5.2% in fiscal year 2019.

One pressure point highlighted by S&P was continued restrictions on lending practices put in place by the Australian Prudential Regulation Authority (APRA).

“We expect these regulatory actions to weaken LMI premium demand, absent a structural change to the product or market,” analysts said.

As well as reduced lender risk appetite in the high-LVR segment, S&P warned that outside factors could further drive market contractions as they have affected the market in the past.

“Other contributing factors include a major Australian bank shifting part of its mortgage insurance requirements offshore and, more recently, a material home lender choosing to retain the risk instead of purchasing insurance.”

As a result of these factors, S&P predicts a moderation in return on equity within the mortgage insurance sector over the next two to three years.

 

Mortgage Book Risks – LTI The Key

An excellent research piece from institutional investment fund JCP Investment Partners, picked up in the AFR today.  Their granular analysis of the mortgage sector (including leveraging our data), underscores the risks in the mortgage books, and explains the RBA’s recent change of tune on household finances.

As a young bank analyst learning the trade in the early 1990’s, understanding credit and capital was the primary focus. Discussions with seasoned bank credit officers provided much insight and learnings.

In credit, I learnt that security/collateral is ‘makeweight’ and one should only lend on ability to service and repay from cash flow. Hence the old mortgage lending rule of thumb; lend no more than 3x gross income unless it’s a doctor, then maybe stretch it to 4x. On this basis, a loan is generally repaid within 10 years, ceteris paribus – a suitable outcome for both lender and borrower.

In the UK, this is embedded in regulation. The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) ensure that mortgage lenders do not extend more than 15% of their total number of new residential mortgages at loan to income (LTI) ratios at to or greater than 4.5x.

Understanding the borrower’s capacity to service as time moves on is paramount. Many bank bad debts are caused by future changes in borrower circumstances. Accordingly, a bank’s corporate loan book is generally reviewed annually.

However, mortgages don’t have the same level of scrutiny, yet the amount borrowed could be higher and the lender more exposed. Take the eventual transition from “interest only” to “principal & interest”; where does the borrower find the additional 40% repayment obligation?

The Australian credit system now looks over exposed to one asset class – the residential home. A function of both very low mortgage credit risk weights and the disintermediation of corporate debt.

Given the dynamics of the Australian housing market over the last three to five years; low interest rates, proliferation of interest only products coupled with low income and employment growth, the embedded risks in the mortgage system have increased materially.

When one scrutinises the typical bank earnings release (some 250 pages of information), the loan to income ratio is not mentioned or disclosed, yet it is one of the most important credit metrics for an analyst/investor to
understand.

We suspect the old 3x gross income rule has been fundamentally breached. Data from the RBA, HILDA, APRA and the major banks, plus our own proprietary sources confirm this. Indeed, we believe gross incomes could have been capitalised to well over 6x, which would partly explain the rapid increase in Melbourne and Sydney house prices.

What is the difference between 3x and 6x? At least 15 years in repayment terms, assuming no material change in income and the level of interest rates. However, the Australian cash rate has never been lower than its current 1.50%, and the rest of the developed world is beginning to move rates up.

A recent conversation with a high-end Sydney mortgage broker was a revealing insight to practices “if we included private school fees and child care costs, there would be no borrow”. Expenses are quite simply fudged. Gone is, the historical rational reliance on gross income and 3x that as the maximum mortgage lend. The banks appear to have weakened underwriting standards to pursue the asset backed lend – sustaining credit fuelled house prices.

Then consider the mortgage broker revenue model. An upfront payment of ~65bps and a trail of ~16bps – this makes large interest only mortgages very lucrative.

As exuberance towards the Australian home grew to now irrational levels, the old credit rules of thumb appears to have been left by the wayside. Banks talk about mortgage account numbers, but not values. Banks talk about LVRs, but not LTIs. Banks talk about averages, but not distributions. And Banks talk about loss rates of a mere 2bps, but fail to capture a full credit cycle.

We draw from the paper “Stabilising and Healing the Irish Banking System: Policy Lessons” Dirk Schoenmaker, Duisenberg School of Finance 12 January 2015. The Minsky ‘financial instability’ hypothesis captures the typical credit cycle quite well; five stages from the emerging boom to the eventual bust … human behaviour the primary driver:

1. Credit expansion: characterised by rising asset prices;
2. Euphoria: characterised by overtrading;
3. Distress: characterised by unexpected failures;
4. Discredit: characterised by liquidation; and
5. Panic: characterised by the desire for cash

Minsky’s financial instability hypothesis highlights the procyclicality of the financial system; risk is under-estimated in good times, and overestimated in bad times. Moreover, the more debt is built up in the upswing, the more severe is the deleveraging in the downswing. Thus, the importance of equity capital for banks. Financial fragility builds over time as information about counterparties decays; the loan to income ratio underwriting discipline is lost. A crisis may arise when a (possibly immaterial) shock causes lenders to suddenly have incentives to produce information, what is the loan to income ratio?

Could the current action in the Federal Court of Australia, Australian Securities and Investment Commission vs. Westpac Banking Corporation, be that seemingly small shock that causes lenders and investors to request more information and adjust future mortgage sizes? The marginal buyer is then less financially equipped to pay more. ASIC simply has to establish that Westpac breached provisions of the National Consumer Credit Protection Act 2009 that require a lender to assess whether a loan would be ‘unsuitable’ for the consumer (sections 128, 131 and 133). While the Act does not define, what constitutes an ‘unsuitable’ loan, section 131(2) expressly provides that a loan must be assessed as ‘unsuitable’ if the consumer will be, or is likely to be unable to meet their payment obligations either at all, or only with substantial hardship (section 131(2)(a)).

Or, could it be the Regulators and Central Bankers eventual understanding of the embedded risk in the Australian mortgage system that will cause them to respond with further control and restriction? Credit fuels a bubble, and its ultimate rationing and eventual withdrawal deflates it. In Ireland, it is postulated by Schoenmaker that “‘Groupthink’ among bankers, supervisors and central bankers may explain that the dangers of the strong build-up of house prices were not appreciated” – The euphoria stage, where capital misallocation exacerbates the fervour.

This is where we are today

Post the global financial crisis of 2007/08, most economies de-levered. However, in Australia we kept on going on, 6% cagr owner occupied mortgage growth and 8% cagr investor mortgage growth. Interest only loans were ~30% of mortgage credit in 2012, today they’re ~42% and well above investor credit: Westpac is especially concerning at 50%.

Proprietary data

Collecting quality information is central to our research process. We have assembled a range of data from APRA, the RBA, the ABS, HILDA, the major banks and Digital Finance Analytics.

We then ran a query which broke down the mortgage system, by value, on two metrics – Loan to Income (“LTI”) and Loan to Value (“LVR”). Both metrics are dynamic, in that they pick up current income and current collateral values. By value is an important distinction as most of the Banks’ publish data averages, and distributions by number.

There are enough very low mortgage accounts which distort the averages. It is not uncommon for a borrower to essentially fully pay the mortgage but keep the account open with a nominal outstanding amount as a “rainy day” facility.
The findings

  • 49% of credit outstanding is held by households
    with: Current LTI ratio > 4.0x; the average LTI is 6.4x
  • Current LVR > 50%; the average LVR is 78%
  • These households represent 70% of owner occupied credit.

At first glance this was somewhat of a surprising outcome. But when put into the context of very low interest rates, the proliferation of interest only mortgages and the rapid appreciation of house prices in Sydney and Melbourne, it makes more sense.

Older loans (7+ years) started much smaller, are more likely paired with houses that have risen substantially, and more likely to be amortising (not interest only).

These results are corroborated with the RBA’s recent Financial Stability Review analysis of the 2014 HILDA data (shown below). More than 50% of debt was held by household, with a 4.0x or larger LTI, regardless of LVR. Our analysis suggests the level has increased a further 5-10% since 2014.

We identified three specific cohorts that appear to pose the most risk:

  • Professional Households
  • Young Pretenders with stretched budgets
  • Young Families

Almost one third of the High LTI / High LVR exposure is held by high income households with an average of $250k in gross income. Despite being less than 2% of all households they represent 17% of the mortgage book, with an average mortgage outstanding of $1.6m. In addition, almost half have an investment property loan also.

Younger households last into the property market always suffer; amongst these we identify two groups with high LTI’s and high LVR’s; the “Young Pretenders” and “Young Families”. Bank lending behaviour has put these groups at risk also.

The “Young Pretenders” with an average income of $110k and a mortgage outstanding of $810k are burdened with an eye-watering average LTI of 7.4x. Despite being less than 0.5% of households, they represent 2.5% of the mortgage book.

The “Young Families” with high LTI and high LVR appear slightly better placed, with $80k in gross income vs. $420k mortgage outstanding. Clearly less leverage, and only 4.1% of the book, but with question marks surrounding treatment of expenses in home loan applications, and generally high costs of living faced by this cohort, actual stress may be very high.

Interest only could be Australia’s sub-prime. Interest only loans proliferate throughout the mortgage book, across cohorts and circumstances. Only one trend emerges; interest only households tend to have lower incomes and higher amounts of credit outstanding and tend to use interest only to borrow more. With caps on interest only loans, only time will tell if such households can afford the mortgages they have.

Buffers are sometimes touted as the offset to systematic stress in the mortgage book. However, our analysis shows the buffers primarily reside with the low risk cohort. That is 60% of the buffers (five months) are with the low risk households with low LTI’s and/or low LVR’s, this cohort represent only 30% of the debt. The borrowers who need the buffers don’t have them.

Needless to say, the system looks vulnerable. The old LTI ratio has left the banking lexicon, exposing a risk that we may have over capitalised incomes and hence over extended credit into certain cohorts.

The long virtuous housing wealth cycle could easily transition to a vicious cycle. Smaller mortgages to deleveraging, flat to decreasing house prices and exuberant to melancholic animal spirits will likely expose much bad lending behaviour.

If we breakdown the system by our cohorts and apply a sensible Probability of Default (PD) and Loss Given Default (LGD) to each, 20% of bank equity capital is at risk (refer tables below). If we apply the Irish scenario to the high-risk cohort; 20% impairment rate with 50% provision cover, then 50% of bank equity capital is destroyed.

Ten years on, the Irish mortgage system remains weighed down with 25% non-performing loan ratios, as banks balance antiquated personal insolvency laws, politics and hope for economic recovery and write backs. Caught in the middle of the Anglo-Saxon system of easy credit provision and the Roman system of strong creditor’s rights.

Probability of default (PD) – the likelihood of a default over a time horizon. It provides an estimate of the likelihood their a borrower will be unable to meet its debt obligations.

Loss given default (LGD) – is the share of an asset that is lost if a borrower defaults.

20% of Equity Capital at Risk

The Australian mortgage system, February 2017.

Latest reported major bank core equity positions and forecast losses given likely PDs and LGDs.

PDs and LGDs formulated based on APRA tables and JCP judgement.

In summary, we see significant risk in Australian commercial bank lending books. The risk in a banks book is a function of recent lending behaviour, especially in a market with low rates, high interest-only shares, and quickly growing prices.

Reproduced with permission.

Note their disclosures:

The information contained in these papers is general advice only. This advice has been prepared without taking into account client objectives, financial situation or needs. Because of that, clients should, before acting on the advice, consider the appropriateness of the advice, having regard to the client’s objectives, financial situation and needs. If the advice relates to the acquisition or possible acquisition of a financial product, clients should obtain a PDS relating to the product, consider the PDS and seek professional advice before making any decision about whether to acquire the product. JCP cannot guarantee the success of the return of capital of any investment in the product. Any forecasts or opinions are JCP’s own at the date of the paper and may be subject to change without notice.

Budget ignores housing market risks: Moody’s

From Investor Daily.

Tax initiatives introduced in the 2017 federal budget to address housing affordability concerns will do little to alleviate the build-up of “latent risks” in the housing market, according to Moody’s Investors Service.

The federal budget, released on Tuesday, 9 May, outlined a number of changes designed to improve housing affordability, offering tax incentives for first home buyers and tougher rules on foreign investors.

These include allowing retirees to exceed the non-concessional super contribution cap when they downsize their home, creating a new savings account within the super system for first home buyers, limiting foreign ownership in new developments and charging foreign investors who leave properties unoccupied for six or more months a year.

Moody’s noted that these initiatives may prove successful in improving housing affordability over the long-term, but cautioned that an immediate impact on halting the build-up of risk in the housing market was “unlikely”.

“Latent risks in the housing market have been rising in recent years as significant house price appreciation in the core housing markets of Sydney and Melbourne have led to very high and rising household indebtedness,” the ratings agency said.

This increase in household debt coincides with a period of low wage growth and a structural shift in labour markets, Moody’s said, subsequently leading to a rise in underemployment

“Whilst mortgage affordability for most borrowers remains good at current interest rates, the reduction in the savings rate, the rise in household leverage and the rising prevalence of interest-only and investment loans are all indicators of rising risks,” Moody’s said.

The ratings agency cautioned that loan borrowers “are more vulnerable to change in financial conditions” and this put banks at higher risk of losses in their residential mortgage portfolios and “triggering negative second-order consequences for the broader economy”.

How our addiction to safety could lead to another financial crisis

From The Conversation.

Research shows that the human brain is biased in favour of making safe choices. This is part of the drive behind “securitisation”, where the financial sector turns risky debt into “safe” debt by pooling assets together or carving out the safe bits.

But this debt may not be as safe as we think. And as individual traders load up on “safe” debt, they are putting us collectively at risk of another financial crisis.

This exact scenario has led to previous financial crises. It contributed to the panic of 1857. It also led to the 2008 global financial crisis.

Safe debt

Imagine a bank lends someone A$1 million to buy a house, but should the person default the bank can only recover A$500,000 by foreclosing and selling the home. The bank does not want this loan on its books so it sells the loan to a financial institution that specialises in creating “safe debt”.

The loan is then split into two pieces of A$500,000, one labelled a “senior tranche” that gets paid first, the other is called the “junior tranche”. Because A$500,000 can be recovered by foreclosing and selling the home, the senior tranche is sure to get all its money back.

Voila, A$500,000 of safe debt has just been carved-out of a risky A$1 million loan.

But the junior tranche can also be made safer by pooling several different loans together. This process can and does take place with many different kinds of debt – mortgages, corporate bonds, credit cards, car loans, and student loans among them.

This is how trillions of dollars of risky assets were transformed into supposedly “safe” assets before the global financial crisis.

An obsession with safety

Studies have found that different regions of the brain are involved in evaluating safe and risky choices. Because of this, humans are hardwired to treat safe and risky choices differently.

A collection of experimental studies have more directly tested the notion that certain and uncertain choices are evaluated differently. They found that people display a disproportionate preference for safety.

This means that financial institutions have an incentive to carve-out as much safe debt as they possibly can, because we are willing-to-pay disproportionately more for safe debt.

This is fine as long as the assets really are safe. But if they aren’t, it’s potentially a big problem.

Going back to the example from earlier, how sure can we be that in a real crisis the house wouldn’t actually be sold for less than A$500,000? Perhaps A$400,000 or even A$300,000?

If A$500,000 of the debt was carved-out and considered safe, but only A$300,000 is recovered, then the “safe” debt is really not that safe. It is, in fact, a risky asset.

And if our brains lead us to pay disproportionately more for safe debt, then the same preference, in reverse, could cause a sudden and sharp decline in the value of its risky incarnation.

How it could go wrong

The fact that we have a disproportionate preference for safety means financial institutions have an incentive to create as much safe debt as possible. In the past this has led to excess creation of safe debt, where even risky debt is traded as safe debt.

In this context, a financial crisis is a sudden realisation that what was previously thought to be safe, is actually risky.

The onset of the global financial crisis has been linked to exactly this phenomena. Before the crisis, the hunger for safe debt had led to the creation of huge numbers of supposedly safe debt. By July 2007, mortgage defaults revealed how risky this debt actually was, and a crisis ensued.

To prevent another financial crisis we need to be proactive. There needs to be regulations in place with the aim of preventing the excess creation of safe debt.

It’s not an easy problem to solve, as the human desire for safety will continue, and no one will ever know exactly what is safe, especially in a crisis. However, more regulatory caution should be built into the system.

Author: Hammad Siddiqi, Research Fellow in Financial Economics, The University of Queensland

Reserve Bank governor Philip Lowe zeroes in on bank lending

From The Australian Financial Review.

The Reserve Bank of Australia under governor Philip Lowe has backed the concerns of regulators about bank lending standards, seizing on the rising number of households who are a month away from missing a mortgage payment in his first major review of the financial system.

Dr Lowe has zeroed in on a rise in the percentage of households who have a buffer of less than one month’s mortgage payments, in contrast with the last review conducted under his predecessor which saw risks abating.

The RBA has put the spotlight firmly bank on the banks in its twice yearly report by noting “one-third of borrowers have either no accrued buffer or a buffer of less than one month’s payments”.

This latest study of the financial architecture adds more detail to the worrying picture emerging about the unbalanced housing market. It follows concerns from the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority about a build up of risks and warnings from credit ratings agencies that the property market could face an orderly unwinding of prices.

The RBA also noted that these risks would have consequences for the banks themselves, pointing to the prospect of additional losses on mortgage portfolios for banks with exposures to the mining sector.

Significant pivot

The focus on households and the state of their balance sheets marks a significant pivot from the previous Financial Stability Review released one month before Dr Lowe was made governor and found that risks to households had lessened.

Founder of boutique research house Digital Finance Analytics Martin North said it was about time the Reserve Bank woke up to the risks posed by higher levels of household debt and stagnant incomes.

“This situation hasn’t fundamentally worsened in six months so it stands to reason what has changed is the RBA’s perception of the world,” Mr North said.

Statistics from Digital Finance Analytics show the percentage of Australian households that are cutting back expenditure, dipping into savings or using credit facilities to meet mortgage payments has risen to 22 per cent following a series of out-of-cycle rate rises from the banks.

Mr North said the number of households experiencing some level of financial stress would rise to 26 per cent in the case of a 50 basis-point rise. If they were to rise by another 100 basis points the percentage would rise to 31.1 per cent.

Big four data supports warning

Data published by the big four banks supports the warning from the RBA with anywhere between 20 and 40 per cent of big four bank mortgage holders just a misstep away from missing a mortgage payment.

ANZ and NAB, which measure the percentage of mortgage holders who do not have buffers of one month or more, count 61 per cent and 27.7 per cent of their customers respectively in the non-buffer bracket.

Commonwealth Bank and Westpac, which use a less stringent buffer measure to include any additional repayment and factor in offset accounts, put 23 per cent and 28 per cent of customers in the RBA’s danger zone.

Annual result data from the banks shows that the percentage of customers who do not have sufficient buffers have worsened by between 2 per cent and 3 per cent over the last 12 months alone.

The worsening position of households has been attributed to rising healthcare and energy costs combined with out-of-cycle rate rises and flat incomes.

Mr North noted that much of the data on households was predicated on the HILDA data which had a lag of several years.

“We have always had households that struggle to make mortgage payments,” Mr North said. “So the intriguing question for me is why have they woken up now? It could be that the governor has taken a different view on household debt.”

One In Three Households Have No Mortgage Buffer – RBA

The latest Financial Stability Review from the RBA has a different tone to it, compared with previous edition, because whereas they have previously played up the “cushion” some households have by paying their mortgages ahead, now they say one third of households have no buffer and are exposed to potential interest rate rises. What has changed is not the underlying data, but how it is being presented. Here are some key extracts.

In Australia, vulnerabilities related to household debt and the housing market more generally have increased, though the nature of the risks differs across the country. Household indebtedness has continued to rise and some riskier types of borrowing, such as interest-only lending, remain prevalent. Investor activity and housing price growth have picked up strongly in Sydney and Melbourne. A large pipeline of new supply is weighing on apartment prices and rents in Brisbane, while housing market conditions remain weak in Perth.

Nonetheless, indicators of household financial stress currently remain contained and low interest rates are supporting households’ ability to service their debt and build repayment buffers.

The Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets, focusing in particular on interest-only and high loan-to‑valuation lending, investor credit growth and lending standards. In an environment of heightened risks, the Australian Prudential Regulation Authority (APRA) has recently taken additional supervisory measures to reinforce sound residential mortgage lending practices. The Australian Securities and Investments Commission has also announced further steps to ensure that interest-only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of past poor lending practices. The CFR will continue to monitor developments carefully and consider further measures if necessary.

Investor credit has also risen noticeably over the past six months, with investor demand particularly strong in Sydney and Melbourne (Graph 2.3).

Overall household indebtedness has increased while income growth has remained weak. Some types of higher-risk mortgage lending, such as IO loans, also remain prevalent and have increased of late.

The risks associated with strong investor credit growth and increased household indebtedness are primarily macroeconomic in nature rather than direct risks to the stability of financial institutions. Indeed, some evidence suggests that investor housing debt has historically performed better than owner-occupier housing debt in Australia, though this has not been tested in a severe downturn. Rather, the concern is that investors are likely to contribute to the amplification of the cycles in borrowing and housing prices, generating additional risks to the future health of the economy. Periods of rapidly rising prices can create the expectation of further price rises, drawing more households into the market, increasing the willingness to pay more for a given property, and leading to an overall increase in household indebtedness. While it is not possible to know what level of overall household indebtedness is sustainable, a highly indebted household sector is likely to be more sensitive to declines in income and wealth and may respond by reducing consumption sharply.

A further risk during periods of strong price growth is that it may be accompanied by an increase in construction that could result in a future overhang of supply for some types of properties or in some locations. In this environment, as well as amplifying the upswing for such properties, any subsequent downswing is likely to be larger and more likely to see prices and rents fall if the vacancy rate rises. This poses risks to the whole housing market and household sector, not just to the recent investors.

While the financial position of households has been fairly resilient, vulnerabilities persist for some highly indebted households, especially those located in the resource-rich states. Household indebtedness (as measured by the ratio of debt to disposable income) has increased further, primarily due to rising levels of housing debt, although weak income growth is also contributing. Rising indebtedness can make households more vulnerable to potential income declines and higher interest rates. This is of most concern for households that have very high levels of debt.

Low interest rates are helping to offset the cost of servicing larger amounts of debt and hence total mortgage servicing costs remain around their recent lows (Graph 2.5). In this regard, lenders have tightened mortgage serviceability assessments in recent years to include larger interest rate buffers, which should provide some protection against the potential effects of higher interest rates.

Prepayments on mortgages increase the resilience of household balance sheets. Aggregate mortgage buffers – balances in offset accounts and redraw facilities – are high, at around 17 per cent of outstanding loan balances or around 2½ years of scheduled repayments at current interest rates. However, these aggregate figures mask significant variation across borrowers, with available data suggesting that around one-third of borrowers have either no accrued buffer or a buffer of less than one month’s repayments. Those with minimal buffers tend to have newer mortgages, or to be lower-income or lower-wealth households.

Interest-only (IO) loans account for a sizeable and growing share of total housing credit in Australia, now representing around 23 per cent of owner‑occupier lending and 64 per cent of investor lending (Graph B1). IO lending has the potential to increase households’ vulnerability in part due to the higher average level of indebtedness over the life of an IO loan compared with a regular principal-and-interest (P&I) loan.

For some time regulators have highlighted the potential risks associated with IO compared with P&I loans. Because IO loans allow borrowers to remain more indebted for longer, there may be greater credit risks associated with such loans. When loan balances stay high, there is an increased risk of borrowers falling into negative equity should housing prices decline.

Another risk is that borrowers may find it difficult to service higher required payments at the end of the IO period, which increases the chance of default. For example, repayments on a $400 000 loan with a 4 per cent interest rate and a five-year IO period would typically increase by around 60 per cent at the end of the IO period. While some borrowers may have planned to refinance into another IO loan at the end of the IO period, this may be difficult if circumstances have changed.

Borrowers who anticipate future price rises can use IO loans to maintain a higher level of leverage for a given servicing payment, thereby magnifying their returns from rising housing prices but also magnifying any losses. More generally, at an aggregate level this behaviour could induce a more pronounced cycle in housing prices than would otherwise occur, amplifying the size of any subsequent downswing in housing prices.

One in three Sydney landlords risk income shortfall

From The Australian Financial Review.

Falling rents or loss of tenants could seriously jeopardise the financial viability of nearly 36,000 property investment portfolios around the country.

Analysis by advisory group Digital Finance Analytics (DFA) highlights the danger of investors’ reliance on tenants to pay borrowing costs.

More than one in three portfolios with Sydney property would be at risk, says DFA, compared with Melbourne where one in four properties could be impacted.

“These are investors who would not have income or savings to pay for their investment property mortgages if rent were to stop,” says Martin North, principal of DFA.

His consultancy puts the number of property portfolios that may be affected at 36,000 based on analysis of household surveys, public and private data to model the nation’s property market.

Increasing supply of houses and apartments and falling rents are already creating pressures for many investors, North warns.

About 20 per cent of investors in Brisbane property could be at risk, compared with under 10 per cent in Adelaide, Perth and Canberra, according to the analysis.

Weak cash flows from investment properties, low equity, high gearing and large loan commitments are loud warning bells for investors to review, restructure and roll back debt, say investment advisers, mortgage brokers and analysts.

Reserve Bank of Australia governor Philip Lowe cautions that too many banks are giving owner occupier and investor loans to struggling investors, increasing the risk of defaults if even small shocks hit the economy.

Mario Borg, principal of Mario Borg Strategic Finance, says: “Not having the cash flow to maintain your repayment commitments is where you can run into trouble.”

Borg, who owns a mix of houses and apartments in a personal portfolio worth more than $10 million, adds: “There is no one-size-fits-all when it comes to an optimal portfolio size, as everyone’s financial situation and personal circumstances are different.”

He creates a buffer against potential financial stress caused by falling markets or rising rates via borrowing only 30-40 per cent on investment properties.

“Ask yourself whether you can still maintain your investment loan portfolio if interest rates were 2 per higher,” he recommends for stress testing a portfolio.

For example, a rate rise from 5 per cent to 7 per cent on a $1 million loan for a borrower with an 80 per cent loan to valuation (paying principal and interest) would mean a monthly repayment increase of $1222 to $7,068, according to research house Canstar.

“You should also ask whether there are adequate financial buffers in place should the unforeseen happen and you lose your job, or the business takes a turn and cash flow is reduced all of a sudden,” suggests Borg.

Christopher Foster-Ramsay, principal of Foster Ramsay Finance, says borrowers will need to face up to higher interest, bigger deposits and much closer scrutiny of their finances and ability to repay.

“There is going to be an upheaval for property investors,” he warns. “Obtaining interest-only loans is going to get very hard.”

Daren McDonald, head of property for property consultancy ShineWing Australia, urges investors to review their holdings to ensure they are maximising each property’s potential and investment returns.

“Property is generally an illiquid investment, so good planning is required, forecasting and risk assessment is required,” he says.

McDonald, who has advised on property for more than 20 years, recommends investors look at ways of improving their portfolio’s income and valuations, reconsider financing options to satisfy changing conditions and consider asset protection and taxation implications.

He offers detailed commentary on how to review a property portfolio in the accompanying checklist.

The nation’s trillion-dollar love affair with property has been cemented by historically low interest rates, generous negative gearing allowances and heady property price rises in Melbourne and Sydney.

The average Aussie property investor has two properties, says DFA’s North, with the bulk of the remainder having between three and five.

North says the “striking observation” about households with large numbers of investment properties is the size of their debt, preference for interest-only loans and smaller number of quality portfolios.

“That means they are the most vulnerable to a rapid interest rate increase or a downturn in property values, which is likely to impact lower-quality properties first,” says North.

Investors dumping property into the market will trigger bigger falls, analysts warn.

The property market’s outlook, values and returns vary widely between cities and sometimes postcodes.

For example, house prices in Perth and Darwin dropped by up to 7 per cent during the past 12 months. Falls were even bigger for apartments.

Melbourne is the nation’s top performer with houses up by more than 7 per cent and units 5 per cent. Melbourne and Sydney are regularly posting weekend auction clearance rates of 80 per cent or higher.

Since March more than 20 banks have increased the cost of nearly 300 mortgage products by between 5 basis points and 60 basis points, says Canstar,

APRA Looking At Capital Ratios For Mortgages

Wayne Byres speech “Fortis Fortuna Adiuvat: Fortune Favours the strong”, as Chairman of APRA, at the AFR Banking & Wealth Summit, makes two significant points.

First, there are elevated risks in the residential lending sector (even after the recent tactical announcements on interest only loans). Banks remain  highly leveraged businesses.

Second, despite the delays from Basel, APRA will consult this year on potential changes to the capital ratios, reflecting the Australian Banks’ focus on mortgage lending and the need to be “unquestionably strong”.

A further indication that mortgage costs will continue to rise!

In the past few days, there has been a great deal of attention given to our recent announcement on additional measures to strengthen one particular part of the financial system: the residential mortgage lending market. These measures build on the steps we have taken over the past two years to bolster loan underwriting practices and moderate investor lending, in an environment that we considered to be one of heightened risk.

Those measures had a positive impact (Chart 1), but at the same time the risk environment certainly hasn’t moderated:

  • house prices remain high;
  • household income growth remains subdued;
  • the already high ratio of household debt to income has got higher;
  • the already low official cash rate has got lower (although not all of this reduction has flowed to borrowers, particularly investors; and
  • competitive pressures haven’t diminished.

It’s important to be clear that our goal in implementing the additional measures we announced on Friday is not to determine house prices. Housing prices are not within the control, nor the mandate, of the prudential regulator. Nor, as the Reserve Bank Governor said last night, can prudential measures address underlying supply-demand issues within the housing market. Rather, our role in the current environment is to promote a higher-than-normal degree of prudence – definitely by lenders and, ideally, also borrowers – in both credit decisions and balance sheet strength. On this occasion, we have focussed on interest-only lending to complement our earlier measures. Although there are perfectly legitimate reasons why individual borrowers might prefer an interest-only loan, in aggregate the level of interest-only lending creates additional vulnerabilities and we came to the view some additional moderation in this area was warranted.

We chose not to lower the investor lending growth benchmark at this point in time, given the need to accommodate the increasing supply of housing in the construction pipeline. However, limitations on the volume of new interest-only lending will impact investors more acutely than owner-occupiers, given that around two-thirds of lending to investors is on an interest-only basis. Furthermore, although the 12-month annual growth rate for investor lending is currently below the 10 per cent benchmark, the run rate in more recent months has been closer to (if not a little above) 10 per cent on an annualised basis. Therefore, even with the benchmark unchanged, lenders are still likely to have to tighten their lending practices and slow lending from that in recent months to ensure they remain comfortably below the desired level.

This latest step is a tactical response to current market conditions – we can and will do more (or less) as conditions evolve. We also developing a more strategic response that recognises that, in the Australian banking system, housing lending risks and capital adequacy are far from independent issues.

The banking system certainly has higher capital adequacy ratios than it used to. But overall leverage has not materially declined. The proportion of equity that is funding banking system assets has improved only modestly, from a touch under 6 per cent a decade ago to just on 6½ per cent at the end of 2016. Notwithstanding the extra capital that new regulation has required, banking remains a highly leveraged business.

Unquestionably strong

One way to think about our objective in establishing ‘unquestionably strong’ capital requirements is that we should be able to assert, with credibility, that the banking system can withstand reasonably foreseeable adversity and continue to provide its core function of financial intermediation for the Australian community.

Unfortunately, there is no universal measure of financial strength that provides a clear cut answer to that test. So we need to be able to look at this question through multiple lenses. In thinking about the concept of ‘unquestionably strong’, there are three basic ways to do that:

  • relative measures: the FSI adopted a relative approach in suggesting that unquestionably strong regulatory capital ratios would be positioned in the top quartile of international peers. We have said on a number of occasions that we do not intend to tie ourselves mechanically to some particular percentile, but top quartile positioning is a useful sense check which we can certainly use to guide our policy-making.
  • alternative measures: regulators do not have exclusive domain over measures of financial strength. There are a range of alternative measures, such as those used by rating agencies, which can be used to benchmark Australian banks. Again, we do not intend to tie ourselves too closely to these measures, but it would be difficult to argue the banking system is unquestionably strong if alternative measures of capital strength, particularly those that are influential in investment decision-making, were to suggest something to the contrary.
  • absolute measures: relative and alternative measures are useful guides, but the real test for a bank to claim it is unquestionably strong is whether it can comfortably survive extreme but plausible adversity. So stress testing, which doesn’t rely on relativities with other banks, or competing measures of strength, provides another useful guide for us.
    Using multiple measures will provide useful insights on the banking system’s strength, but unfortunately will be unlikely to give us a single ‘right’ answer. At best it will provide a range for possible calibration which would reasonably meet our objective that, whichever lens you look through, we can credibly claim to have capital standards that produce an unquestionably strong banking system. We will still need to exercise judgement, taking account of other dimensions of risk within the system – both quantitative (such as liquidity and funding) and qualitative (such as risk management and risk culture within banks, and the strengths of the statutory framework and crisis management powers on which the stability of the system is built). Inevitably, some will argue the calibration should be higher, and others think it too high, but at the very least our logic and rationale should be transparent, and we can readily explain how our decisions are consistent with the FSI’s intent.

As things stand today, our plan is to issue an information paper around the middle of the year, which will set out how we view the banking system through the various lenses that I have just mentioned, the extent of further strengthening required, and the timeframe over which that can be achieved in an orderly manner.

Beyond establishing the aggregate level of capital, we will need to follow that up with consultation on how the regulatory framework should allocate that capital across the different types of risk exposure. Some of those changes will flow from the inevitable direction of the work in Basel that I referred to earlier: this will include, for example, greater limitations on the use of internal credit risk models, and the inevitable removal of operational risk models. These changes will primarily impact the larger banks.

But, coming back to my starting point, probably the biggest issue we will need to resolve in ensuring capital is appropriately allocated is whether and how we adjust the risk weights for housing-related exposures. Our announcement last week reflected a tactical response to current conditions in the housing market. We will continue to refine these sorts of measures as long as they are needed. But a longer term and more strategic response will involve a review, during the course of our work on ‘unquestionably strong’, of the relative and absolute capital requirements for housing exposures. That should not be taken to imply that there will be a dramatic increase in capital requirements for housing lending: APRA has always imposed capital requirements for housing exposures that are well above international minimum standards, so we do not start with glaring deficiencies. By anyone’s standard, however, we have a banking system that has a notable concentration in housing. It is therefore important we give that issue particular attention as we think about how to put the concept of ‘unquestionably strong’ into practice.

 

House price growth could create ‘systemic risk’

Australian bank hybrids, equities, term deposits and residential investment properties are all essentially one big bet on Australian housing.

From InvestorDaily.

The housing sector has supported the Australian economy for several years, but further increases to house prices without increases in wage growth will increase the possibility of systemic risks, says Pimco.

Housing has been the “main domestic growth engine” in Australia since the economy shifted away from mining in 2012, said Pimco co-head of Asia portfolio management Robert Mead, which improved headline economic growth but increased household debt at lower interest rates.

Mr Mead noted that average lending rates for standard housing loans as measured by the Reserve Bank of Australia (RBA) fell from 7.3 per cent in 2012 to 5.25 currently, while the RBA policy rate fell from 4.25 per cent to 1.5 per cent in the same period of time.

“This demonstrates a highly effective transmission mechanism of monetary policy: more than 76 per cent of RBA policy rate reductions have flowed directly through to the main consumer borrowing rate,” Mr Mead said.

“However, during this same period wage growth fell from over 3.5 per cent per annum to less than 2 per cent, and the unemployment rate increased from 5.1 per cent to 5.9 per cent. This suggests that the capacity of the average Australian borrower to take on additional debt was actually weakening, not improving.”

While the RBA’s monetary policy regime was “highly effective” as the economy weakened, Mr Mead cautioned the bank’s implementation of policy is likely to be made more difficult by the “significant” increase in household debt at a lower borrowing rate.

“Looking forward, we believe the current economic backdrop accompanied by some recent increases in mortgage rates by the Australian banks will keep the RBA on the sidelines for all of 2017,” he said.

“We also expect increasing reliance on macro–prudential policies to limit the upside in property prices. While housing has definitely helped support the economy over the past four to five years, any further increases in house prices that are in excess of wage growth will represent potential systemic risks for the economy.”

Mr Mead said diversification was critical to investors, and should be a key theme for portfolios.

“Australian bank hybrids, equities, term deposits and residential investment properties are all essentially one big bet on Australian housing,” he said.

RBA and Macroprudential

In a speech “Has the Way We Look at Financial Stability Changed Since the Global Financial Crisis?“, Michele Bullock, RBA Assistant Governor (Financial System) discussed the RBA’s perspective on macroprudential.

Referring to APRA’s 2014 “tightening” of mortgage lending, she says that whilst borrowers risks may have lowered, “the initial effects on credit and some other indicators we use to assess risk may fade over time”.

Agreed. It is clear that the regulators have not done enough to tame housing credit growth, conflicted as they are between seeing housing momentum as a replacement for the fading mining boom on one side, and the risks to households, their high levels of debt, and broader financial stability on the other. Actually, we think the Council of Financial Regulators (that shadowy body, chaired by the RBA, and including APRA, ASIC and Treasury) has failed to manage the fundamentals in the past few years. Did they not see the risks, or did they choose to ignore them? In that light, Bullock’s comments have a hollow ring!

Post-GFC, there is now more acceptance of the need to take action when system-wide risks are rising. This is reflected in the increasing use of what are commonly known as macroprudential policies.

As my colleagues David Orsmond and Fiona Price note in a Bulletin article in December 2016, there is no universally accepted definition of macroprudential policy. They define it as ‘the use of prudential actions to contain risks that, if realised, could have widespread implications for the financial system as a whole as well as the real economy.’ They also note that the use of such tools has increased in a number of countries post-GFC.

In Australia, we see macroprudential policy as part and parcel of the financial stability framework. As we have set out on other occasions, the essence of macroprudential policy is that prudential supervisors recognise potential system-wide risks in their supervision of individual institutions and react accordingly.[3] APRA can and does take an active supervisory stance, modifying the intensity of its prudential supervision as it sees fit to address institution-specific risks, sectoral risks or overall systemic risk. A recent example might help to illustrate this.

In 2014, the Australian regulators took the view that risks were building in the residential housing market that warranted attention. There was very strong demand for residential housing loans, particularly by investors. Price competition in the mortgage market had intensified and discounts on advertised variable rates were common. There also seemed to be a relaxation in non-price lending terms. The share of new loans that were interest only was drifting up and the growth of lending for investment properties was accelerating. Unsurprisingly in this environment, the growth in housing prices was strong, particularly in Melbourne and Sydney.

The regulators judged that more targeted action was needed to address the risks – to put a bit of sand in the gears. So APRA tightened a number of aspects of its supervision. It indicated that it would be alert to annual growth in a bank’s investor housing lending above a benchmark of 10 per cent. It also set some more prescriptive guidelines for serviceability assessments and intensified its scrutiny of lending practices. ASIC also undertook a review of lending with a focus on whether lenders were complying with responsible lending obligations.

There is no doubt that the actions did address some of the risks. Nevertheless, the early experience suggests that, while the resilience of both borrowers and lenders has no doubt improved, the initial effects on credit and some other indicators we use to assess risk may fade over time. We are continuing to monitor their ongoing effects and are prepared to do more if needed.

Where to from here? With the GFC close to 10 years ago now and a substantial amount of regulatory reform having been undertaken, the focus is turning to implementation and taking stock of the effectiveness of the reforms. This is reflected in the FSB’s current agenda. But there is also some thinking to be done about how monetary policy considerations should factor in financial stability issues, and the role that macroprudential policies might play in addressing system-wide risks in a low interest rate environment.

In conclusion, I would like to return to the question I posed at the beginning of this talk, and in fact the question I posed myself when I first came into this area a few months ago – has the way we look at financial stability changed since the GFC? While the basic way we look at financial stability has not changed, experience with the GFC reinforced the need to focus on system-wide issues. We need to spend time analysing them and thinking about whether policy responses might be required. We are still learning how best to do this.