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:
- Most of the debt is floating. Interest rates may and will increase due to the RBA or banks.
- 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).
- 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:
- High inflation and high wage growth
- 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.