The ABC cited a Western Australian borrower who managed to get mortgages – often interest only loans – for more than a dozen properties without the financial status to service them.
I provided some grabs for the segment, referring to the size of the impending IO loan problem across the country.
Norway, one of the countries mirroring the Australian mortgage debt bubble (223%) has taken steps to tighten mortgage lending further. This includes a limit of 5x gross annual income and a 5% interest rate buffer.
According to Moody’s, last Wednesday, the Norwegian Financial Services Authority (FSA) proposed to the Ministry of Finance a new regulation on requirements for residential loans. The proposed national regulation is based on existing and Oslo-specific policy measures introduced in January 2017 and scheduled to expire 30 June 2018 that cap the portion of a mortgage that does not comply with the national applicable loan-to-value (LTV) ratio limit at 8% from 10% previously. Extending these measures past their scheduled expiration will contain borrower leverage, a structural risk for Norway’s banking sector, and dampen house price inflation, both credit positive.
The proposal maintains the maximum LTV for home equity credit lines at 60%, continues to cap the LTV on mortgages at 85%, and leaves unchanged the limit on borrowers’ aggregate debt at 5x gross annual income. However, the FSA suggests eliminating the existing LTV limit of 60% for secondary homes located in Oslo (see exhibit).
Household debt reached a record 223% of disposable income in June 2017, far above that of other Nordic countries, and we expect it to remain close to current levels over the next 12-18 months. This trend remains a structural risk for Norway’s banking sector.
Although the Ministry of Finance will make the final decision on whether to accept the recommendation and in what form, the proposal is a step to improve mortgage underwriting standards by containing borrower leverage. Norwegian banks are retail focused, with mortgages accounting for almost 50% of their total lending. The proposed expansion of the previously Oslo-specific measures will improve banks’ asset quality and increase mortgage competition in Oslo. Smaller regional banks will be able to compete for mortgages in Oslo with DNB Bank ASA (Aa2/Aa2 negative, a34), which has the largest share of Oslo’s retail market, because they will be able to account for deviations from the suggested LTV limits against their entire loan book rather than the small share of Oslo-originated loans in accordance with current regulation.
House prices in Norway have declined 4.2% since peaking in March 2017. The decline followed the Ministry of Finance’s 2017 implementation of tighter mortgage lending criteria in response to accelerating property price inflation and rising household indebtedness. The restrictions have cut demand for investment properties in large city centres, particularly the Oslo metropolitan area, where house prices have grown fastest in recent years.
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!
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.
Aussie lenders are luring prospective home loan customers with competitive introductory rates, but these could cost you thousands in unnecessary interest over the long run, according to recent Mozo research.
Crunching the numbers in the Mozo database, we 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, said Mozo Director, Kirsty Lamont.
“If borrowers fail to check the fine print they can end up stuck with a loan that has an uncompetitive ongoing rate after the introductory period ends,” she said.
“That mistake can end up costing you tens of thousands of dollars in extra interest over the term of the loan.”
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.
“Regulatory bodies have raised concerns about Australia’s household debt-to-income ratio, which has risen significantly over the past decade,” said NAB in a note to brokers.
It said it is committed to ensuring its customers can meet their home loan repayments now and into the future.
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.
For an application with an LTI ratio of more than 7, the bank will automatically decline or refer it depending on the income structure, i.e. pay as you go or self-employed.
NAB said its serviceability calculator will be updated to reflect these changes.
The bank introduced an LTI ratio calculation for all home loan applications last year. It was also last year when it started declining interest-only loans for customers with high LTI ratios.
As Australian Broker reported in July 2017, the bank extended the use of LTI calculation to determine the credit decision outcome for all interest-only home loan applications.
NAB said then that tougher serviceability assessments for interest-only loans would help strengthen its lending policies.
The bank’s latest change to its credit policy comes after after ANZ and Westpac made changes to their assessment and approval of borrowers.
Westpac recently introduced strict tests of residential property borrowers’ current and future capacities to repay their loans, to identify scenarios that might affect their ability to service their debts.
From 26 February, brokers who make changes to a loan application that has been submitted to Westpac will have to resubmit it.
Similarly, ANZ added “a higher level of approval for some discretions” used in its home loan policy for assessing serviceability. It was also reported to be clipping the discretion of its frontline mortgage assessors.
Stricter assessment of borrowers’ ability to repay their loans will likely become the norm now that APRA is focusing on serviceability in its proposal that targets higher-risk residential mortgage lending.
The prudential regulator released a discussion paper on 14 February proposing changes to authorised deposit-taking institutions’ capital framework and addressing what it calls systemic concentration of ADI portfolios in residential mortgages.
ANZ and Westpac Group are said to have introduced confidential changes to their assessment and approval of borrowers.
The Australian Financial Review reported yesterday (15 February) that ANZ was clipping the discretion of its frontline mortgage assessors.
A spokesman for ANZ said the bank recently added “a higher level of approval for some discretions” used in its home loan policy for assessing serviceability.
The spokesman said the move was not a change to the bank’s credit policy or underwriting standards and that it applies to all housing loans, not just those originated through brokers.
Mortgage brokers claim banks seem to be showing less flexibility in interpreting guidelines on such matters as irregular income when assessing loan applications, said the AFR.
The report also said that Westpac recently introduced strict tests of residential property borrowers’ current and future capacities to repay their loans.
The change is said to be intended to identify scenarios that might affect borrowers’ capacity to pay back their loans. These scenarios include having dependents with special needs that might require borrowers to spend on long-term care and treatment.
Brokers who make any changes to a loan application that has been submitted have to alert the bank from 26 February, said the report.
Earlier this month, Westpac amended its borrowing terms, including allowing the use of desktop valuations only for a maximum LVR of 90%.
A Westpac spokesperson told Australian Broker that the bank has also updated its household expenditure measure in line with the benchmark published by the Melbourne Institute for Social and Economic Research.
This followed Westpac’s announcement in December that it would require home loan borrowers to disclose what they owe on short-term buy-now, pay-later loans on digital credit platforms like AfterPay and ZipPay. The move was part of the bank’s effort to bolster its assessment of borrowers’ loan serviceability.
Stricter assessment of borrowers’ ability to repay their loans will likely become the norm among lenders now that APRA is focusing on serviceability in its proposal that targets higher-risk residential mortgage lending.
The prudential regulator released a discussion paper on 14 February proposing changes to authorised deposit-taking institutions’ capital framework and addressing what it calls systemic concentration of ADI portfolios in residential mortgages.
Significantly, he says the temporary measures taken to address too-free mortgage lending will morph into the more permanent focus on amongst other things, further strengthening of borrower serviceability assessments by lenders, strengthened capital requirements for mortgage lending imposed by us, and comprehensive credit reporting being mandated by the Government.
Bank capital
One area that was of interest to this audience last year was the strengthening of banking system capital. On that front, I’m pleased to say we are getting close to the end of the journey.
As some of you would know, the Australian Government conducted a broad-ranging inquiry into the Australian Financial System in 2014. Amongst other things, that inquiry tasked us with ensuring that Australian banks had ‘unquestionably strong’ capital ratios. In July last year, we published a paper setting out the benchmarks that we considered to be consistent with that goal. At a headline level, this required the four major Australian banks to strengthen their capital ratios, relative to end 2016 levels, by around 100 basis points on average to target CET1 ratio of 10.5 per cent (or about 16 per cent on an internationally comparable basis). We also said we expected that strengthening should be achieved by 2020 at the latest.
As things stand, the major banks haven’t quite hit this target yet, but are well on the way to doing so in an orderly fashion. We set a smaller task for the smaller institutions, and they by and large have it covered already.
That capital build-up is important because, as you’re all no doubt aware, we received a Christmas present from the Basel Committee in the form of the long-awaited package of reforms to finalise Basel III. The changes, in total, represent a significant overhaul of many components of the capital framework1.
We have, however, committed to ensure that changes in capital requirements emanating from Basel will be accommodated within the unquestionably strong target we have set. In other words, given the banking system has largely built the necessary capital, the recent Basel announcement does not have any real impact on the aggregate capital needs of the Australian banks. They will change the relative allocation of capital within the system, but not add to the aggregate requirement beyond what has already been announced.
We’ll begin consultation on the proposed approach to implementing Basel III changes in the next week or two. Our initial public release will include indicative risk weights, but these will be subject to further analysis and an impact study to calibrate the final proposed risk weights and ensure we end up with a capital requirement that is consistent with our assessment of unquestionably strong capital levels. We also have some recent input from the Productivity Commission to feed into our deliberations, which we’ll give consideration to as we work through the consultation process.
In terms of timelines, the Basel Committee has agreed to an implementation timetable commencing in 2022, with further phase-ins after that. As I said earlier, we expect banks to be planning to increase their capital strength to exceed the ‘unquestionably strong’ benchmarks by the beginning of 2020. Whether we implement our risk weight changes in line with Basel timeframes or modify that timeline somewhat, it’s unlikely there will be any need for additional phase-in and transitional arrangements given the industry will be well placed to meet the new requirements.
And just quickly on the other key components of the Basel reforms, we instituted the Basel liquidity and funding requirements in line with the internationally agreed timetable – the Liquidity Coverage Ratio (LCR) from 2015, and the Net Stable Funding Ratio (NSFR) from the beginning of this year – in full and without any transition. So the adjustment process to the post-crisis international reforms in Australia has the finish line well in sight.
Housing
The other topic that generated some questions last year concerned housing, and so I thought I should say a few words about our actions in that area.
The broad environment – high house prices, high household debt, low interest rates, and subdued household income growth – hasn’t changed greatly over the past 12 months (although in more recent times house price appreciation has certainly slowed in the largest cities – Sydney and Melbourne). Those conditions are not unique to Australia – a number of other jurisdictions continue to battle with somewhat similar conditions and imbalances. What’s notable for Australia, however, is the relatively high proportion of mortgage lending on the banking system’s balance sheet.
Against that backdrop, and amidst strong competitive pressures among lenders, the quality of new mortgage lending and the re-establishment of sound lending standards have been a major focus of APRA for the past few years now. We introduced industry-wide benchmarks on (in 2014) lending to investors and (in 2017) lending on interest-only terms. As I have spoken about many times previously, these are temporary measures we have put in place to deliberately temper competitive pressures, which were having a negative impact on lending practices throughout the industry, and help to moderate the volume of new lending with higher risk characteristics. Left unchecked, the drive for growth and market share was producing an adverse outcome as lenders sought ways to accommodate higher risk propositions to grow new lending volumes. Instead of prudently trimming their sails to reflect an environment of heightened risk, lenders were pressured to sail closer to the wind.
Over time, our interventions have served their purpose and we have seen lending standards improve. Our most recent intervention was in relation to interest-only lending. Imposing quantitative limits is not our preferred modus operandi, but over many years we’d seen interest-only loans become easily available, and options for extending or refinancing on interest-only terms allowed borrowers to avoid paying down debt for prolonged periods. Those loans do, however, provide less protection to borrower and lender when house prices soften, and expose borrowers to ‘repayment shock’ when the loan begins amortising (made worse if it occurs at a time when interest rates are rising from a low base).
Our benchmark of no more than 30 per cent of new lending being on interest-only terms is not overly restrictive for borrowers who genuinely need this form of finance – roughly 1-in-3 loans granted can still be on an interest-only basis – but it has required the major interest-only lenders to establish strategies that incentivise more borrowers to repay their principal. The industry has been quite successful in doing so: recent data for the last quarter of 2017 shows that only about 1-in-5 loans were interest-only, and the number of interest-only loans with high LVRs continued to fall to quite low levels. All of that is positive for the quality of loan portfolios.
While the direction in asset quality is positive, we’re not declaring victory just yet. We still want to see that the improvements the industry has made are truly embedded into industry practice. And we can modify our interventions as more permanent measures come into play. That will include, amongst other things, further strengthening of borrower serviceability assessments by lenders, strengthened capital requirements for mortgage lending imposed by us, and comprehensive credit reporting being mandated by the Government. Through these initiatives, we are laying the platform to make sure prudent lending is maintained on an ongoing basis.
Governance and culture
In addition to improvements in financial strength and asset quality, it’s also critical to the long run health of the financial system that the Australian community has a high degree of confidence that individual financial institutions are well governed and prudently managed. What has become more apparent and pronounced over the past year is that – despite their financial health and profitability – community faith in financial institutions in Australia, as has been the case elsewhere, has been eroded due to too many incidences of poor behaviour and poor customer outcomes. None of these have thus far threatened the viability of any institution, but they have certainly not been without commercial and reputational damage.
While most matters of conduct are primarily the responsibility of our colleagues at ASIC, these issues are nevertheless of great interest to a prudential regulator for what they say about an organisation’s attitudes towards risk. So as with the balance sheet strengthening of the financial system over the past few years, we have also taken a greater interest in efforts to strengthen behaviours and cultures. We can’t regulate these into existence, but we have been working to ensure Australian financial institutions have been giving greater attention to these matters than may have traditionally been the case. On these issues, it’s fair to say the journey continues.
Adelaide Bank is introducing an alert system that will monitor property borrowers that are struggling with their repayments.
The bank and its subsidiaries and affiliates will compare monthly mortgage repayments with borrowers’ income ratios.
“As part of our ongoing commitment to responsible lending, we are introducing the visibility of metrics relating to loan to income and monthly mortgage repayment to income ratios into our serviceability calculator for new loan applications – at the application stage only,” said Darren Kasehagen, Adelaide Bank’s head of business development and strategy.
Kasehagen told Australian Broker that additional commentary from the broker will be required when these internal guides are exceeded.
He stressed that this only applies to new loans.
“There is currently no change to our monitoring of existing loans,” he said.
The Australian Financial Review reported yesterday (8 February) that loans that exceed the bank’s guidelines will prompt a “diary note commentary” to alert the bank of possible mortgage stress.
The report said that this will automatically happen where the loan-to-income ratio exceeds five times or monthly mortgage repayments exceed 35% of a borrower’s income.
“The bank is telling third parties the data ‘is only required for internal purposes’,” said the AFR.
It attributed the bank’s move to an effort by lenders to prevent problem loans amid concern over rising household debt.
As reported in the AFR, UBS has continued their analysis of the Australian mortgage market, with a focus on disclosed incomes of applicants.
UBS said its work suggested 42 per cent of all households with income of more than $500,000, and 27 per cent of all households with income between $200,000 and $500,000, had taken out a mortgage in 2017, which Mr Mott said “did not appear logical and [is] highly improbable”. Borrowers could be “materially overstating their household income to secure a mortgage”, or the population could be consistently understating income across the census, ATO tax returns and ABS surveys, he suggested.
The extension of the terms of reference for the financial services royal commission to include mortgage brokers and intermediaries provides “a clear indication” it will focus on mortgage mis-selling, Mr Mott added.
“We believe that it is imperative that the Australian banks continue to focus on improving underwriting standards,” he said.
We have to agree with their analysis, as our surveys lead us to the same conclusion. Here is a plot of income bands and number of mortgaged households. On this data, around 15% of households would reside in the $200-500k zone, compared with the 27% from bank data.
We have been calling for tighter underwriting standards for some time. As UBS concludes:
We believe that responsible lending and mortgage mis-selling are material risks for the banks.
APRA released their Policy Agenda 2018 today which sets their priorities and agenda.
Looking at banking, they outlined the following:
Capital adequacy tweaking will likely continue for the next 2-3 years, plus revisions to the prudential standards for operational risk, interest rate risk in the banking book and market risk, and associated changes to reporting and public disclosure requirements. APRA is considering changes to its overall approach to capital requirements in a number of areas where APRA’s methodology is more conservative than minimum international requirements.
APRA does not anticipate the need to incorporate BEAR expectations into the prudential standards or prudential practice guides in 2018 but will provide guidance where appropriate, potentially in the form of published Frequently Asked Questions.
They will finalise arrangements to licensing some new ADIs through a phased approach.
Expect more changes to APG 223 Residential Mortgage Lending, revising underwriting standards and the development of a prudential practice guide for commercial property lending.
