Australia's property risk is rising Aug 28 Tony Boyd and Lisa Murray
Australians now have vastly increased opportunities to get into debt, and they have embraced them with gusto. There is now a smorgasbord of credit options permitting an average salary earner to borrow amounts unheard of just a few years ago. Banks are even pushing loans for the elderly to cover day-to-day expenses that permit borrowing until the day they die.
There are more hustlers than ever before and even the traditional financial institutions have loosened their purses. The rapid growth in household debt tells the story. It was 50 per cent of disposable income just 15 years ago; now it's 140 per cent. Property borrowings account for the vast bulk of that debt at 120 per cent.
Naturally, we can expect this surge in debt to have been matched by an increase in vigilance by lenders, careful to ensure borrowers are able to meet repayments, can't we?
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Well, actually no. On the contrary, an analysis of 21 major home lenders by the Weekend AFR shows a lowering of credit standards. This complacency among banks and the many new lenders comes at a time when there are increasing concerns about Australia's overexposure to the property market.
Consequently the Australian economy, courtesy of property debt in particular, is carrying a large risk not well understood by the wave of investors embracing housing as a savings plan. The Australian Prudential Regulation Authority has pointed out that a study of property bubbles in 14 countries (including Australia) by the International Monetary Fund found the fallout from a property crash is four times worse than a sharemarket crash.
As Reserve Bank warnings go relatively unheeded and overall debt continues to rise, just as alarming is the complacency of borrowers who seem to have no grasp of the fact that even a 1per cent rise in interest rates would have a quite dramatic effect on their repayments.
Just pause and reflect on these statistics: a 2 per cent rate rise at this low point in the interest-rate cycle would mean a 30 per cent rise in interest repayments. Property investors were badly scalded in 1986 when interests rates moved from 15.5 per cent to 17 per cent. Yet this was just a 13 per cent rise in repayments.
"When you take out a home loan you're taking a view on interest rates," says Tim See, senior analyst with credit rating agency Moody's Investors Service. "Australians don't understand interest-rate risk. They don't understand the sensitivity of their housing loan payments to a 1 per cent rise in interest rates."
After a decade of rising property prices, strong economic growth, low inflation and relatively low interest rates there is now a generation of investors with no experience of a sharply falling market and many others who have probably forgotten that what goes up, can also come down.
"What we're worried about is that the last seven or eight years have been an abnormal period in the economic cycle, in terms of inflation and in terms of interest rates," says Matthew Hassan, senior economist at Bis Shrapnel. "We've not had a proper interest rate tightening cycle for a long time and what we're worried about is that it's become embedded in expectations. People no longer believe that interest rates will go above 7 or 8 per cent."
The embedded thinking that interest rates are low and will remain low probably helps explain the explosion in Australia's household debt.
In the year to June 30, while mortgage lending rose 19 per cent to $200 billion, margin lending was up 23 per cent to $14 billion and credit card debt rose 14 per cent to $28 billion.
There have never been so many choices when it comes to borrowing money and there are a huge number of people with big incentives to making borrowing look good. Despite the fall from grace of Henry Kaye, property spruikers continue to promote get-rich-quick schemes involving buying units off the plan.
Negative gearing into shares and property also remains popular.
One of the biggest spurs to the surge in lending has been the emergence of mortgage brokers. Not only did mortgage brokers such as Aussie Home Loans help bring down the interest rates and fees charged by banks, they opened up a whole new source of funding - mortgage originators who get their money from the global capital markets.
Mortgages sold by brokers are packaged and sold to investors as mortgage-backed securities. This is called securitisation and it is the hottest lending market in Australia.
Notwithstanding the many warnings from the Reserve Bank of Australia about property lending and house prices, finance provided through mortgage-backed securities has been growing at twice the rate as mortgages sold through financial intermediaries. About $50 billion of mortgage backed securities are expected to be issued this year, up 56 per cent on last year.
Australia is now the world's third largest issuer of mortgage-backed securities after the United States and United Kingdom.
A key element in the success of mortgage-backed securities is the use of mortgage insurance which protects the buyers of those securities from loan default and helps give the mortgage paper AAA credit status.
Mortgage brokers, who now write about 30 per cent of all mortgages sold in Australia, have big incentives to keep the mortgage originators busy, thanks to a commission tied to the amount they lend. And the higher the incentives for lending, the more pressure is placed on you to borrow.
"Do you want to buy a car as well?" is the most common question put to those applying for a loan, while equity in the home is seen as a big bank account that can be used for anything from holidays to school fees.
Nobody knows how much consumption is being paid for by drawing down on mortgages but based on the rate of credit growth it must be large.
While mortgage brokers have an incentive to make sure borrowers can sustain higher interest rates, because they receive a trailing commission for the life of the loan, evidence shows that credit checking is not what it used to be.
The traditional conservative approach to lending observed a limit of 35 per cent of gross income for the interest repayments on a loan, together with any other financial commitments.
As an added protection for the borrower, repayments were calculated on the basis of an interest rate 2 per cent higher than the standard variable rate loan, or about 9 per cent in today's terms.
So, if you earned $80,000 a year and had a loan to valuation ratio of 80 per cent, you could borrow about $330,000.
That prudent approach is now hardly used at all. It has been replaced with a "cash flow" analysis of the borrower. The lender asks you to calculate your living expenses and if you have a surplus of income over outgoings you'll get the loan.
A survey of 21 lenders by the Weekend AFR found that a person earning $80,000 a year with an LVR of 80 per cent can now borrow from $290,000 up to $500,000.
In other words, Australians can now borrow up to 50 per cent more than they could when credit checking was tight and the only person willing to lend money was a bank manager who wanted to know your parents before he would let you into his office.
A borrower is now likely to make a home loan application sitting next to a mortgage broker with a laptop computer. The broker will choose from a panel of lenders including banks, building societies and mortgage originators.
That in itself has changed the dynamics of credit assessment, according to John Symond from Aussie Home Loans.
"It puts more risk on lenders to be prudent with their checking because they're not sitting face-to-face with the customer," he says. "They have to validate the information and make sure it's not fraudulent. But there's no evidence that there's a significant risk."
In the AFR survey, the big four banks were near the top of the list of those willing to lend amounts in excess of $440,000 to a person earning $80,000.
"Some people are more aggressive in chasing business than others," says Mike Barrett, head of mortgages at Macquarie Bank, which maintains the traditional approach to assessing the ability to repay.
Macquarie, the largest packager of mortgage loans in Australia under the PUMA securitisation brand, will bend its general rule on credit assessment for people earning $1 million but it has rejected the "cash surplus" approach because it is too subjective.
The most dramatic change in credit assessment has been in the mortgage securitisation market where investors are willing to buy loans that are self-verified. For these, instead of providing two years of tax returns, the borrower gives the mortgage broker a written statement of income only.
These loans, which are typically taken out by the self-employed, have added a whole new layer of risk to the Australian debt picture.
Credit ratings agency Moody's warned this month that such low document loans were more risky because self-employed borrowers tended to have greater income volatility and self-verification was "biased towards an optimistic view of earnings".
Moody's however, says it does not think the loss severity of such loans is greater because property valuation standards are as stringent as for other loans. Sherman Ma, managing director of non-conforming lender Liberty Financial, which writes low doc loans, says his company's credit checking is better than the banks.
"We don't just use a set figure for singles and couples in terms of what they are likely to live on," he says. "If people are earning more money, they're probably spending more money. Traditional lenders are driven by scale. They're processing shops rather than lending shops."
There is growing unease at the Reserve Bank over the rapid growth in private non-financial debt which is now equal to about 150 per cent of GDP.
In a speech last month, RBA assistant governor Ric Battellino said there was a risk too much finance was being made available "leading to inflation and asset bubbles". He said the sustained expansion of private non-financial debt relative to GDP had made the economy more vulnerable to shocks.
No one knows where those shocks will come from or what form they will take but history shows they happen regularly.
Bis Shrapnel says interest rates will start rising sharply in 2005-06 and housing mortgage rates will peak in 2006-07.
"Debt will become a major issue, with some households likely to be hit by two problems as high interest rates are followed by a sharp rise in unemployment as a recession comes through," the company said in its latest forecast released in July.
Leading bankers in the private sector reject the idea that Australia is sitting on a debt bubble that is about to burst.
"The panic merchants are saying the end of the world is nigh but it doesn't have to be that way," says Michael Katz, head of premium business services at Commonwealth Bank. "In the context of Australia while there are high levels of debt, it's not the case that we're at a point that it has to result in tears all round."
But the financial regulator is worried about the impact of a crash as well as complacency among bankers. One of the purposes behind its stress testing of the housing portfolios of deposit-taking institutions last year was to try to change the psychology of both lenders and borrowers.
Apra assumed a 30 per cent fall in property prices and a rise in home loan default rates to 3.5 per cent. It found that depositors' money would be safe but, based on its assumptions, borrowers would stop paying interest on about 140,000 mortgages.
Apra did not examine the second or third level effects of a housing price crash but it referred to a study by the International Monetary Fund in 2003 which examined the impact of bursting housing price bubbles in 14 countries between 1970 and 2002. The study identified 20 housing price crashes, and found on average that a housing price crash occurred once every 20 years, lasted about four years, involved a decline in real prices of 30 per cent and was associated with an output loss equivalent to 8per cent of GDP.
Apra officials have done their own work on asset price bubbles. A paper by Jeffrey Carmichael and Neil Esho published in 2001, found that Australia's major banks had tended to underprovision relative to a respected international standard developed in Spain for prudential supervision.
The message from that paper was that the longer an economic boom lasts, the more provision should be set aside by banks which can be run down during a downturn.
The Bank for International Settlements has warned of the dangers of asset bubbles building up during the good times.
"Widespread financial distress typically arises from the unwinding of financial imbalances that build up disguised by benign economic conditions," according to a paper by Claudio Borio and Philip Lowe published in July 2002.
Apra reckons that borrowers with loans that are two to four years old tend to have the highest default rates and during a downturn properties that have experienced the greatest price rises are also likely to have the greatest price falls.
