Loan Denied: Tightening Loan Serviceability

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We have written a few blogs on our view of residential investor mortgages and want to reinforce a few further points:

  1. Many banks view investor loans as lower risk than owner-occupier. This is wrong.
  2. Serviceability criteria will slow lending dramatically. ASIC is as much in-play as APRA.
  3. Serviceability is a yes/no result, meaning many investors will soon be blocked out from the market.

Investors loans have higher risk:

Most secured loan products for IRB banks follow the Basel PD, LGD formula to determine an unexpected loss value that is then a direct input into regulatory capital. The PD in this case is seen to be a through-the-cycle probability of default (TTC PD), which is then scaled up to a 1-in-1000 year stressed probability of default.

Australia has had benign lending environments in the last 2 decades, in effect no true credit cycle. So the first point to make is the TTC PD estimation is potentially a little low. In this data set, investor loans are showing a lower TTC PD than owner-occupiers*. One rationale banks believe is that rental properties have a replaceable occupant, so if one tenant loses his job, you can find another with a job.

However, the PD/LGD model is probably the wrong assessment for this asset class. Investment properties are revenue producing real estate, so you must wonder why residential properties get less stress than commercial property that gets put into Specialised Lending.

The PD scale-up is missing a systemic risk component that is not a spike in landlord defaults. It is an increase in rental property vacancy ratios.

Look at vacancy rates:

If an investment property is reliant on a tenant to cover the mortgage, usually interest-only, and the landlord doesn’t have a high capacity to cover the full mortgage payments themselves, then empty properties may lead to defaults.

So rather than looking at TTC PD, we should look at potential increases in rental property vacancy rates. Does a national movement from 2.5% to 12.5% seem appropriate for a 1-in-1000 risk event? We have seen unemployment rates move from 6% to 16%, so there is scope for at least a 10% increase in vacancy rates.

There is potential further stress in that a country-specific recession will have lower inbound migrants seeking work and expat communities might decline. Vacancy rates could increase further.

Added to this, rental prices will need to fall, due to excess supply of rental properties over demand. This is an unknown factor but will lead to further stress. As most investment property rental yields are below the mortgage interest rate, this is a dollar cost to the landlord’s income.

The owners of empty rental properties then face a dilemma. If they have a mortgage or higher loss to service, how will they pay for it? Relying on selling the property is not appropriate as 10% of other rental properties may be performing the same process at the same time.

Instinctively, 20% of investment properties becoming under severe stress feels about right. This is double the implied stress currently assumed on investor loans.

Serviceability is everything:

The above methodology is appropriate if the landlord is reliant on the tenant to cover the mortgage. If the landlord has a diversified source of other income, notably not just investment property, then you can assume they have the capacity to cover a single empty property.

The major issue with current serviceability calculations is they haircut the attainable rent by 20%. But as we described above, there could be an extra 10% of properties with no tenant and this is where the systemic risk is.

We expect ASIC and APRA to realise this risk at some point and tighten up the serviceability calculations so that investors reliant on filling a property will either not pass the serviceability assessment or they will be classified as Specialised Lending, which will have risk-weights 2 or 3 times higher and a mortgage rate several percentage points higher than owner-occupier home loans.

We look forward to these changes.


*Those that suggest this means there is lower risk in investor loans are incorrect. If expected losses do not appear, this is really a higher net income history rather than lower risk. Unexpected losses are the risk factor.


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Why Is There Regulator Panic?

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Panic is probably a little strong but APRA and ASIC are now appearing to take a much more vocal and active position on Australian housing risk. The RBA is also ready but whilst upward interest rate movement would reduce overheating Sydney and Melbourne markets, other aspects of the economy don’t need a rate hike.

Is there a bubble?

More people are saying there might be in Sydney and Melbourne, with another year of mid-teens house price increases. However, other fundamentals that should be a factor in house prices, namely wages, are at very low levels of growth.

There is a risk that this is credit driven price growth and we now believe there is a much higher risk of a large price correction.

Are interest rates to blame?

In part, yes. People base their ability to pay off a home loan by seeing a monthly mortgage payment. If they can pay that or cover it with rent from tenants, then it looks affordable. Interest rates are at an all time low, so unsurprisingly prices are at an all time high as affordability will always be stretched by those who want a house the most.

However, there are 3 things that make this a cyclical risk:

  1. Most of the debt is floating. Interest rates may and will increase due to the RBA or banks.
  2. A big proportion of the debt is interest only: the loan risk is staying there longer and borrowers are planning to not pay down debt in an orderly way (principal repayments might not be affordable in their eyes, be spent on other things).
  3. Rent isn’t covering the mortgage’s interest rates.

If we start to unpick these, we see that the regulators have allowed the proliferation of higher-risk borrowing.

Fixed is better than floating

There is no current long-term fixed rate mortgage market in Australia. The longest fixed period most banks offer is 5-years. This is not a long enough period for borrowers to pay down mortgage debt before the loan resets to a floating rate, meaning the borrower is still exposed to interest rate increases.

We need a 10-year fixed. We need longer. It’s a shame that the banking sector doesn’t understand the risk that not having this loan creates: banks believe they can just pass on interest rate increases to consumers without either higher defaults or a huge slump in consumer spending, which will lead to mortgage defaults as unemployment increases. This was one of the findings from APRA’s 2014 stress tests.

Interest Only is Subprime

The major problem with US subprime was that it relied on house-price appreciation to work. As soon as prices stopped increasing and teaser periods on Adjustable Rate Mortgages ended, there was a spike in defaults.

Interest-only investor loans are a similar risk. The borrowers have a negative rental yield as the mortgage rate is higher than the rental yield, so they only make money due to tax concessions and price appreciation. At 18.9% annual rate of increase, Sydney doesn’t have to wait too long before anyone living in their own home wouldn’t be able to afford their property if they were buying it today. Prices can’t increase forever

When prices stop rising, the trade unwinds or rental rates need to increase, leading to higher vacancy rates (people can’t afford the rent) or a diversion of money from consumer spending. Higher vacancy rates are what would lead to a huge correction in investor property portfolios. Higher rents, which cause consumer spending diversion, will lead to higher unemployment.

Serviceability is the key

We have no idea who is doing the serviceability assessment at the lenders but they clearly have an aggressive view on serviceability that is now a major driver for housing risks.

Providing floating rate debt with a buffer for 2 or 3% interest increases is simply not enough when we have seen interest rate cycles with 3, 4 or 5% overall increases in interest rates (look at the US Fed Funds Rate from 2004 to 2006 at +4.25%).

The key ingredient to a long-term fixed is that the serviceability risk is taken off the table: the interest rate can’t change. The risk with the loan can only reduce whereas floating or interest only loans can have higher risk as interest rates climb or the interest only period ends.

Will the RBA join the party:

In the long run, the RBA will have to assist in the unwinding of all-time low interest rates. However, it can’t increase interest rates with the all-time high debt load unless something happens:

  1. High inflation and high wage growth
  2. It actively tries to shift the floating rate debt to long-term fixed debt

And it is this second item that will eventually appear: the RBA will have to create a mechanism to control the longer part of the yield curve. However, the RBA, ASIC and APRA need to support the creation of a much broader wholesale market before this can happen and the banking system needs to understand the lower risk attributes of long-term fixed rate mortgages. We also need to hope that the non-bank sector doesn’t load up on the same risk and blow itself up in the process.

This also means regulators may have to actively support greater competition in the retail banking sector and ultimately reduce the sensitivity of consumers to interest rate increases.





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