The APRA Draft Prudential Practice Guide 223 Residential Mortgage Lending released last month is long on motherhood statements but short on specifics. This is somewhat understandable in an environment where the banks are lobbying aggressively for as few risk restrictions as possible on their businesses when overall credit growth has been sluggish. However, the lessons learnt by other countries during the financial crisis are being ignored by many in Australia, with the predominant view being that since Australia escaped largely unscathed in the last decade it is immune from credit problems in the years to come.
A number of key measures indicate that Australian house prices are at elevated levels, with Australian cities routinely coming near the bottom of global affordability rankings. The combination of low unemployment and very low interest rates means that the pool of potential buyers has increased over the last two years. At the same time as economic factors have favoured borrowers, banks have eased their lending criteria with APRA publicly noting its concerns. Together these changes have allowed potential borrowers to qualify with smaller deposits and/or lower income levels, or to borrow more than they previously would have been able to. Should unemployment or interest rates increase materially, or if tax changes reduce the availability of negative gearing or increase land taxes, a reversion of house prices is eminently possible. There is clearly an increased heat level in the Australian home lending market.
As a guide to what action APRA and banks should be taking now, specific limits are proposed below on key loan characteristics. Potential borrowers should also note these recommendations, as banks may seek to maximise the amount they lend rather than suggesting a lower amount that may be in the customer’s best interests.
Loan to value ratios (LVRs)
LVRs measure how much debt and equity a borrower has in a property. Australian and international default studies have found a very high correlation between high LVR loans (those with low equity) and high default rates. Low levels of equity leave little or no room for periods of greatly reduced income levels such as unemployment or maternity leave. LVRs for bank loans should therefore be capped at 90%, with borrowers required to raise at least 10% of the purchase price as well as covering the cost of stamp duty and lenders mortgage insurance.
Second lien (or second mortgage) loans
Default studies in the United States have shown that loans with second liens default at a much higher rate than loans without. Whilst having multiple layers of debt secured against residential property is rare in Australia, if the maximum LVR is reduced the demand for second lien debt may increase. Australian banks should be limited to offering first lien loans, with no allowance for second liens on properties securing bank loans.
Affordability tests
For many years, common industry practice has been to test the ability of borrowers to meet their repayments assuming interest rates rise by 2% from current levels. With home loan rates now at record lows, banks should increase this test to 3%. This increased stress test implies a movement in the RBA cash rate from the current level of 2.50% to 5.50%, which would be approximately in line with the average of the cash rate over the last 20 years. Banks that use a standardised measure such as the Henderson Poverty Index for living expenses should also be required to have a buffer of at least 10% in their servicing calculations. Many potential borrowers are unlikely to live on such a meagre existence, particularly higher income earners who are disproportionately represented in new lending. Affordability tests should also be based on amortisation of the loan over no more than 25 years.
Interest only loans
Interest only loans are most common with investors, with owner occupiers typically making principal and interest repayments. The lack of amortisation increases the risk of these loans, particularly if interest rates should rise materially without a similar increase in rental yields. To counter this risk, interest only loans should be limited to 80% LVR and for a maximum of five years.
Loan tenor
Long dated loans mean that borrowers make very little headway in reducing their principal in their first few years. They can also be an indicator that borrowers are stretching to make the minimum repayments. Banks should be allowed to offer loan tenors to a maximum of 25 years, with interest only loans limited to five years followed by a 20 year amortisation period.
Lenders mortgage insurance (LMI)
The international experience with LMI is chequered, with poor outcomes in the United States during the global financial crisis and in the United Kingdom in the 1990’s. However, many banks in Australia see the risk of loss on insured loans as minimal. The international experience indicates that during a time when claims are most likely to be made and the insurance is most vital, (when a substantial and sustained increase in unemployment is accompanied by falling house prices) LMI providers may not be able to meet all claims in a timely fashion. To take into account this risk, banks should not be able to treat high LVR insured loans the same as low LVR uninsured loans.
Capital weights
The introduction of Basel III capital weights has seen the major Australian banks holding lower levels of capital against home loans at a time when house prices are arguably most elevated. A tiered system should be introduced that recognises the lower risk attached to low LVR loans and that also provides some credit to insurance from well capitalised LMI providers. Uninsured loans at or below 70% LVR and insured loans at or below 80% LVR could continue to receive the highly discounted risk weighting allowed by Basel III. Uninsured loans of 70-80% and insured loans of 80-85% should be subject to a 50% risk weighting. All other loans should be subject to a full risk weighting. It is acknowledged that such a change would likely result in tiered interest rates to borrowers. This would be a positive development with lower risk borrowers rewarded with a lower interest rate.
Conclusion
In the provision of credit, bad outcomes are not evenly spread with marginal borrowers being a disproportionately large source of impairments and losses. The combination of the current economic environment and easing of lending criteria has brought substantial heat to the Australian home lending market with a greater number of marginal borrowers obtaining finance from banks. The elevated risk posed by these borrowers is added to the systemic risks of Australian banks with their highly leveraged business models and strong dependence on overseas funding. By introducing specific measures aimed at limiting high risk home lending now, APRA would be able to substantially lower the risk profile of Australian banks in advance of a potential reversion in house prices.
Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities including those issued by banks.