Big four face $270b of growing ‘zombie mortgage’ risk
Almost $270 billion of Australian home loans are at risk of defaulting or being classified as severely stressed in the next year, as the borrowers behind “zombie mortgages” struggle to keep up with their repayments.
The COVID-19 mortgage boom may come to haunt the major banks, warned Barrenjoey banking analyst Jon Mott, as loans written when interest rates were at record lows become increasingly expensive to service as the employment outlook deteriorates and the cost-of-living bites.
This follows 12 cash rate increases fromRBA deputy governor Michele Bullock warned unemployment had to reach 4.5 per cent the Reserve Bank over the past 13 months that have added about $20,000 to annual repayments on a $750,000 loan.
“With mortgage rates now well through the serviceability buffers used during the pandemic boom, we believe many borrowers are entering a period of severe stress,” Mr Mott said.
As in the next 18 months to tame persistently high inflation, Mr Mott said Australia was likely to hit a technical recession – two straight quarters of economic contraction – and the jobless rate could stretch as high as 5 per cent and create a wave of “zombie mortgages”.
New Zealand’s economy slipped into recession this month.
“This will have a significant impact on many mortgagors who borrowed their maximum,” the bank analyst said. “Many of these customers are likely to fall into delinquency as serviceability buffers have been exceeded, real wages have fallen, and additional work is likely to become harder to come by.”
The big four banks wrote $267 billion in home loans over the 2020 to 2022 financial years to borrowers who took on debt of more than six times their income, analysis by Barrenjoey found. A debt-to-income ratio of six times or more is considered “risky” by the prudential regulator.
Bank shareholders say lenders may be able to withstand the fallout as borrowers are forced to tighten their belts on discretionary spending in restaurants or on travel in favour of repaying their loan to stay in their home.
“As a bank investor, what I am concerned about is loan losses,” said Hugh Dive, chief investment officer at Atlas Funds Management.
“This will be very unpleasant for the people involved with high DTI loans – but will this result in foreclosure sales [by banks], that will impact on bad debts and bank profits? Given where house prices are – most borrowers are in positive equity – are bank shareholders going to take massive hits? Probably not.”
Still, other bank analysts point to rising levels of mortgage stress and suggest that credit losses are likely to move higher after an extraordinary period of ultra-low bad debts while the RBA nailed the cash rate to the floor during the pandemic.
UBS released a survey of mortgage borrowers earlier this month which found more were turning to interest-only loans to reduce repayments, and that fewer borrowers were still ahead on their payments, as the rising cost of living ate into savings buffers created by COVID-19 stimulus payments.
“Further stress is likely to emerge over the next six months, with [some] mortgage borrowers already through the assessed interest rate serviceability buffers from the beginning of the cycle,” said UBS analyst John Storey.
“We think the potential last few rate hikes could be a catalyst to drive retail credit loss ratios back to longer term – if not higher – averages.”
Bank bosses are becoming more concerned that additional rate rises will start to crunch a growing number of their customers, especially those who borrowed to the hilt to get into the housing market near its peak.
“Rate rises from here have an exponential impact,” Westpac CEO Peter King told a lunch with sell-side analysts earlier this month.
“Unemployment, over-commitment and deleveraging will drive house prices lower.
Most of the risk is with high DTI mortgages, especially where borrower circumstances have changed,” Mr King added.
Challenge for Lowe
The comments highlight the challenge for embattled RBA governor Philip Lowe, who is desperate to reduce inflation and may decide to lift rates further even though household indebtedness in Australia remains high by both historical and international standards.
ANZ chief Shayne Elliott told investors last week that challenges in the housing market “have recently been exacerbated by higher interest rates, particularly those with higher levels of debt, first-home buyers, those more exposed to cost-of-living challenges, or who have less stable employment”.
AMP chief economist Shane Oliver said the risk of an Australian recession was now about 50 per cent. He also flagged high debt servicing costs as a key risk for discretionary spending across the economy.
“Consumer spending is almost certain to start going backwards later this year and into next year, as the 4 per cent-plus cash rate will push debt servicing costs into record territory as a share of household income,” Dr Oliver said.
“On the RBA’s analysis, 15 per cent of households with a variable rate mortgage – which means about 1 million people – will be cash-flow negative by year-end at a 3.75 per cent cash rate – and we are now well beyond this.”
In the first half of 2022, about 28 per cent of all mortgages were written in a range above six times debt-to-income, before APRA forced banks to reduce this last year to pull back on excessive risk.
“The banks will have to deal with elevated levels of ‘zombie mortgages’ which are likely to be restructured to interest-only or extend-and-pretend” loans, Mr Mott said, referring to a bank response where the length of a loan can be extended in the hope a struggling borrower can get a better paying job.
He expects bank profits will come under pressure, with credit impairment charges rising to $7.7 billion next financial year if the economy enters a recession, $3.6 billion higher than under the “soft landing” outcome the RBA is trying to engineer by lifting interest rates at the fastest rate in a generation.
Under a more pessimistic scenario, the economy could suffer a hard landing with unemployment surging to 5.5 per cent to 6 per cent, and, if rates stay higher for longer, credit impairments could then surge to $12.8 billion, triggering “house prices to double-dip as forced sellers come to the market”. This would put pressure on bank share prices as investors fear cuts to dividends.
Mr Mott also lashed the banks for running internal models of expected losses that are “overly optimistic”, suggesting they “don’t pass the sniff test”. “All models are only as good as their assumptions, and banks have an incentive to provide a more optimistic view.”
He reckons there is now a 25 per cent change of a hard landing for the economy, a 60 per cent chance there will be a technical recession, and he ascribes just a 15 per cent chance the RBA will pull off its soft landing scenario.
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