Here's why the RBA's Financial Stability Review is a scarier document than it first seems

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The RBA’s Financial Stability Review (FSR) is an interesting mix of “nothing to see here, move along” and “this is a worry”.

That’s possible because while there is risk of problems in Australia housing and mortgage markets, as yet, no evidence has reared its ugly head.

The RBA and APRA are acting to ensure prudent lending and leverage in the market. And for the second FSR in a row, the RBA has dedicated a whole section to discussing what’s going on in the housing market, and what regulators are doing to cool the market and ensure financial stability is protected.

But the problem has never been regulation: It’s lenders seeking to grow their balance sheets by lending to as many customers as they can attract. It feels a lot like the pre-GFC days out there in mortgage land. The only things missing are the plethora of no-doc and low-doc loans, although in 2015, that’s not the issue, it’s the huge increase in interest-only loans, which don’t pay down the principal.

They are beloved by investors because they allow the tax benefits of negative gearing to be maximised, but of late have become increasingly popular with owner-occupiers.

The FSR says:

In liaison, banks have suggested that for owner-occupiers the trend rise in interest-only lending has been driven more by borrowers’ desire for increased flexibility in managing their repayments than affordability pressures. Some of this demand for flexibility has come from owner-occupiers who plan to later switch their dwelling into an investment property, at which point they will have an incentive to withdraw balances that they have accumulated in attached offset accounts.

I can’t help but be troubled by the inherent psychological expectation that property prices will always go up embedded in that statement.

Clearly borrowers think property prices will continue to rise, so that at some point in the future they will be able to move into a bigger property, capital gains tax free, because the current one is a principle place of residence. The current property they can then turn that into an investment property 100% geared for tax purposes, while at the same time taking the “equity” the owners have built up in an offset account with them to their new principle place of residence, then do it all over again.

I could discuss extensively this little bit of exuberance and its place in Sydney and Melbourne’s bull property markets, but the RBA has an explicit warning for lenders and property buyers who think along these lines.

Particular caution around collateral valuations is warranted in the current environment of declining property yields. Lenders should also be mindful of the collective effects of strong lending activity within particular market segments, even if individual borrowers appear to be of low risk.

At present the non-performing loans of the banking system remain low.

But, as owner occupiers take out increasing numbers of interest only loans – which retain a higher LVR through time than those loans where the principal is repaid – so the risk grows to the system and the housing market from an unexpected economic shock.

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