Head of Credit Research & Strategy
Reporting by journalists and financial analysts alike has been dominated by housing bubble talk this month and its gone hand-in-hand with debate about the strength of the big Australian banks.
Fears of a market correction were easy to stoke with memories of the 2008 debt crisis still raw.
The recent release of the film The Big Short offered some easy headlines, but in reality the Australian housing market differs significantly from the pre-GFC housing market in the US. Any allusions are more editorial flourishes, than based in fact.
Our view on Australian housing remains cautiously optimistic. While the strong price growth of recent years is set to slow, prices aren’t likely to recede significantly.
We see a period of flat-lining prices, with pockets of weakness such as inner city apartments in some capital cities and some mining regions. In the unlikely event of a material fall in house prices, Australia’s big four banks are well placed to weather the storm.
QIC’s Senior Economist Jimmy Louca explored this issue in a recent Economic Brief, and in this note we continue to analyse risks around Australian housing.
The first point to highlight is that the Australian mortgage market is a very different beast to that of the US.
Australia isn’t haunted by the supremely risky “sub-prime” loans that were issued with reckless abandon in the lead-up to the GFC—and then bundled up to obtain sanitised credit ratings. The low-documentation loans (which make up the bulk of Australia’s sub-prime contingent) comprise just 2 per cent of this country’s home loan market, a level that is well down on the near 7 per cent that existed pre-GFC.
Australia’s full-recourse foreclosure laws differ greatly to the non-recourse loans that exist in some US states. Non-recourse loans make it easier for a borrower to walk away from a property if the value drops below that of the loan. It’s a recipe for defaults that simply doesn’t exist here.
Australia has a conservative regulator and tight bank lending standards, but most importantly it is the banks that control the loan approval process for mortgage originations. Unlike in the US, Australian mortgage brokers don't do the final verifications, the banks do, and they’re far more judicious in ensuring their loans are not at risk of default.
This prudence is also seen in the scarcity of loan approvals that have a high Loan-to-Value-Ratio (LVR). The total number issued by Australian banks has been trailing off for the past three years. (Figure 01)
The strength in the housing market has been driven by low interest rates, tax incentives and limits on supply. The consequent view is that such a boom must lead to a bust. While this is understandable the data doesn’t support such pessimism.
Geographically, the sharp price growth has not been a national phenomenon. Sydney and Melbourne have dominated the run-up in house prices with price increases over the last 12 months of 9.5 per cent and 11.1 per cent respectively, according to CoreLogic RP Data. Growth outside these centres has been far more muted, with Brisbane increasing 5.5 per cent, Adelaide 2.8 per cent and Perth falling 3.1 per cent.
The two key factors that could potentially put pressure on the housing market are a sizeable jump in unemployment or a large rise in interest rates, but we don’t see a high level of risk of either.
The housing market does have a high correlation to the employment market and currently the unemployment rate is under control. Although we expect unemployment to rise this year, it should only increase moderately and not to an extent that would fuel a sharp house price correction.
We’re confident borrowing rates will remain low for the near to medium term. Real wage growth is weak and accommodative monetary policy will be vital to support growth.
At the same time the currency wars are driving rates lower all over the globe. We’ve seen the Bank of Japan and the European Central Bank push rates negative. We’re also likely to see the local cash rate being cut further before the cycle turns.
When considering interest rates we must of course look beyond the RBA’s monthly cash rate call as the banks have shown a willingness to act independently.
This fundamental shift re-surfaced in 2014 when the Australian Prudential Regulation Authority (APRA) imposed macro-prudential requirements on the country’s major lenders.
With a focus on mortgage lending standards, the tightening of rules aimed to reduce risk levels and take the heat out of investor activity in the housing market.
APRA indicated it would be paying particular attention to high risk mortgage lending, investor loan growth and loan affordability tests for new borrowers. The banks complied by imposing stringent new lending standards, which is clearly apparent in the fall in investor lending growth. (See figure 02)
APRA didn’t stop there; the next round came in July 2015 when it announced increased mortgage risk weights for the big-four banks plus Macquarie (to take effect from 1 July 2016).
The rules further boosted the resilience of these systemically important banks and it was the primary driver of the four majors raising around $19 billion of common equity during 2015. This then flowed onto the banks increasing interest rates on a range of home loan products in order to offset the dilutive effect on their return on equity.
In an environment of high private debt and vigorous investor activity, this out-of-cycle rate hike signalled a shift in housing market dynamics.
And we don’t think they’re done yet—we expect further independent rate rises from the banks in 2016.
They’re faced with continued pressure to defend their return on equity and wholesale funding costs are rising, but it should be stressed that this won’t necessarily trigger a sharp fall in house prices.
The Reserve Bank’s cash rate may be at historic lows, but among developed economies it is also one of the highest. This affords the RBA considerable capacity to implement an offsetting rate cut should the banks move independently.
Similar defence comes from an interest rate buffer of at least 2 per cent, which domestic banks incorporate into their loan affordability assessments. The intention is to ensure borrowers have greater capacity to absorb an increase in lending rates.
On top of this, borrowers aren’t stretched. Mortgage servicing obligations, as a share of income, are well managed in this low rate environment (see figure 03) and households have consistently increased their offset balances while also paying more than their minimum loan repayments (see figure 04).
The aggregate of these mortgage buffers currently equates to almost 2.5 years of scheduled mortgage payments or 16 per cent of total home loans.
If market forces were to turn sour and the housing market did see losses, the banks are in reassuringly good shape to deal with it. Earnings on the whole are strong with pre-provision profits of the four majors in excess of $45 billion. The aforementioned capital requirements imposed by APRA have strengthened the banks’ capital levels and their common equity tier 1 ratios are now at all time high levels.
Conservative Loan to Valuation Ratios (LVR) offer protection with current-balance/current-indexed-valuation sitting just under 50 per cent on average for the 4 major banks. The sound level of equity that borrowers have in their properties helps to limit the losses felt by banks on any defaulted loans.
Also, problem loans are very low. The Australian housing market generally has a very low level of outstanding payments and the rare loans with high LVR’s also have sizeable mortgage insurance protection. While we do expect the normalisation of delinquencies to lead to higher credit costs, this is off a very low base. We think the banks have ample ability to manage this scenario within their current strong credit ratings. (See Figure 05)
Adding to the housing-market debate are calls from the opposition to abolish negative gearing for existing properties and to increase capital gains tax. The suggestion has certainly fuelled debate with wildly disparate modelling suggesting a variety of property price impacts from any reductions in negative gearing. But at this stage it seems clear a coalition government won’t make any major changes.
The Australian propensity to take interest-only loans has also been cited as a risk factor, but this bias has more to do with negative gearing tax deductions than they do with repayment capacity. Negative gearing allows a property investor to claim rental losses against their income tax, so paying down principal is not in the interest of many borrowers who are more focussed on dropping into a lower tax bracket.
A combination of tight supply in the capital cities, asset price inflation as investors search for yield, record low interest rates and accommodative federal government policies have all conspired to send property prices higher in Sydney and Melbourne.
While this has been accompanied by ongoing debate about a potential housing bubble, we think it’s important to recognise the contribution played by this market strength in supporting Australia’s slow transition beyond the resource boom.
We may be seeing the tail-end of this run-up in prices, but we don’t think a sharp correction is imminent. We believe a sustained period of broadly flat house prices is more likely.
If unemployment remains under control, if stimulatory monetary policy is maintained—and as long as the banks funding flows continuing uninterrupted—we don’t see any major calls for alarm.
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