Why APRA’s home loan crackdown is unlikely to lead to US-style housing bust

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Australia’s banking regulator, APRA, is cracking down on riskier home loan lending.

Following the introduction of a 10% annual cap on investor housing credit in late 2014, it subsequently introduced additional restrictions on interest-only lending in March last year, announcing that these type of loans will be limited to 30% of total new mortgage debt.

It’s had a pronounced impact in recent months, seeing house price growth slow sharply in Sydney and Melbourne, two markets that were previously favoured by investors.

Given the crackdown was only implemented less that a year ago, it means many Australians with fixed-rate home loan facilities will be impacted by these tighter lending restrictions.

As Michelle Bullock, Assistant Governor of the Reserve Bank of Australia (RBA), noted earlier this week, “a large proportion of interest-only loans are due to expire between 2018 and 2022”.

Some of these borrowers will be able to rollover their loans into another fixed-rate facility, albeit likely at a higher interest rate given a recent lift in global bond yields.

Others, however, may not be afforded this choice, forced instead to switch to principle and interest loans as a result of APRA’s crackdown.

It means the cost to servicing a mortgage is about to become a lot higher for many borrowers, who will have to cope with higher interest rates and also having to pay down the balance of their loan.

Source: Capital Economics

For some, what lies ahead appears eerily similar in the lead up to the global financial crisis, specifically in the US.

It was triggered by the US housing market, sparked by raft of adjustable rate mortgages expiring from honeymoon interest rates leading to a sharp increase in servicing costs for borrowers.

Such was the lack of lending standards at the time that some loans were nicknamed “NINJA” loans, standing for no income, no job or assets, meaning many who couldn’t afford the additional payments simply abandoned their homes and walked away.

There were more than a few, helping to explain why it ended in the worst global economic downturn since the Great Depression.

While lending standards in Australia are of better standards than in the US of the time, at least in most people’s eyes, it’s understandable why some are concerned that a similar scenario could play out in Australia over the next few years.

Lending standards weren’t as robust as they now are, underpinning why APRA introduced tougher restrictions, and many borrowers are about to face a steep lift in borrowing costs.

Will that too create a banking crisis and sharp economic downturn as was seen in the US?

To Kate Hickie, Economist at Capital Economics, while such a scenario appears highly unlikely, it’s not to say there aren’t any risks, pointing out three specific factors that should be watched carefully.

What happens to credit availability, what happens to house prices and what happens to official interest rates.

“First, credit conditions clearly matter,” she says.

“It seems most likely that the regulatory restrictions placed on the provision of interest-only loans by APRA early last year will remain in place for some time yet.

“As such, credit conditions will probably be less favourable and so many borrowers won’t be able to take out another interest-only loan.”

This chart shows Capital Economics’ estimate for the percentage of outstanding interest-only loans expiring over the next five years.

Source: Capital Economics

And with house prices starting to ease in many capital city markets, Hickie suggests there is a risk that some borrowers may find themselves in negative equity depending on when and what price they bought their property purchase.

“This risk is most acute for those borrowers with a high initial loan-to-value ratio,” she says.

“If a borrower were to go into negative equity this would also clearly limit their ability to refinance. And it may well prompt them to sell their property, which would exacerbate any slowdown in the housing market.

“A lot of these borrowers may therefore have no choice but to start paying principal as well as interest.”

Of course, a lot will also depend on whether house prices continue to fall, and by how much, as these fixed-rate facilities expire.

The third factor is one that has been quite topical in recent months — the outlook for official interest rates.

Based on Capital Economics’ estimates, they could start to lift just as the bulk of interest-only loans expire.

“There is a risk that this will occur at the same time that interest rates begin to rise, ” Hickie says.

“We expect the RBA to begin to hike rates from a record low level of 1.5% in the second half of 2019 and to continue to raise rates throughout 2020 as well.

“So just at the time when the largest share of interest-only borrowers are set to start paying back interest and principal, they may also be hit by a rise.”

While all of these are valid concerns, and explain why the RBA is watching developments in this area closely, Hickie says there are a number of difference between Australia now and the US in the mid-2000s that suggest the risks of a banking-led economic downturn are minimal.

“Better lending standards in Australia mean that there is not the same systemic threat as there was in the US, and at this stage most borrowers still appear to be in a good position to be able to meet their repayments,” she says, noting that the share of non-performing mortgages in Australia remains very low.

“What’s more, there is less incentive to default on a loan in Australia compared with the US as mortgages here are recourse.”

Recourse loans allow lenders to pursue other assets held by the borrower in the advent of default.

Rather than triggering an Australian financial crisis, Hickie says the rollover of some interest-only loans into principal and interest facilities will likely have a mild economic impact.

“While it may weigh on consumption growth over the next few years as borrowers have no choice but to devote a higher share of their income to mortgage repayments, we estimate that at most it will take off around 0.2 percentage points from the annual rate of consumption growth,” she says.

So nothing to worry about then. We hope.