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Canadian Regulators Ups The Ante On Residential Mortgage Lending

According to Moody’s last Thursday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) notified the country’s regulated mortgage lenders that it will intensify its supervisory oversight of their residential mortgage underwriting practices.

In the past 10 years home prices in Canada have lifted more than in Australia, although the debt to disposable income ratio at around 155% is still lower than Australia (175%) but higher than the UK (~130%). The Canadian market is also exposed to the impact of future interest rate rises.

Moody’s says that Canadian housing prices have risen faster than most other industrialized countries, resulting in house price levels increasing substantially over the past 10 years to be among the highest in major industrialized countries (see Exhibit 2), and raising the risk of a price correction. Over the past 25 years, house prices in Canada have steadily increased, primarily in urban centres such as Toronto, Ontario, and Vancouver, British Columbia.

Canada-2The regulator vowed a heightened focus on income verification, mortgages with loan-to-value ratios of less than 65% (which OSFI indicated was a category in which underwriting practices are often less rigorous), stress assumptions related to debt-service ratios and the reliability of property appraisals. OSFI’s announcement is credit positive for Canadian banks because heightened regulatory scrutiny will force them to maintain or enhance existing residential mortgage underwriting controls and practices amid growing concerns about increasing household debt and elevated housing prices.

Residential mortgage debt, including home equity lines of credit (HELOCs), has doubled over the past decade. Canadian conventional mortgage debt, excluding home equity lines of credit (HELOCs), has grown at a compound annual rate of 7% over the past decade. Almost CAD1.6 trillion in mortgage debt, including HELOCs, was outstanding as of 31 March 2016, more than double the amount outstanding for the same period 10 years ago (see Exhibit 1).

Canada-1Over the past 25 years, Canadian consumer debt-to-income levels, which include mortgage debt, almost doubled and are at a record high. As a result, housing indebtedness has tracked closely to house price increases as borrowers take larger loans, while at the same time, incomes have not kept pace. These higher debt levels make Canadian consumers vulnerable to an employment or interest rate shock that would exacerbate their debt-servicing burden (see Exhibit 3).

Canada-3Of note, OSFI specifically indicated its interest in debt service ratios because current underwriting requirements may not adequately capture the stress effect of refinancing a mortgage into one with a higher mortgage interest rate. This is important because of the unique characteristic of a Canadian mortgage. A Canadian mortgage is structured as a balloon loan whereby the term (typically five years) is shorter than its amortization (typically 25 years). This means borrowers must periodically refinance their mortgages (see Exhibit 4), exposing them to changes in interest rates over the life of the mortgage. This refinancing risk is greatest for recent borrowers with high loan-to-value mortgages in a rising interest rate environment. OSFI noted that a rapidly rising interest rate environment would place considerable stress on existing debt service ratios, particularly on investment properties with rental income.


Australia could be about to lose its AAA rating, and here’s why

From The Conversation.

Australia’s AAA credit rating was under pressure even before the election and is now looking decidedly shaky. Ratings agency Standard & Poors has moved Australia’s rating outlook from “stable” to “negative”, due to debt and a poor chance of budget repair.

This follows warnings from the other major credit rating agencies – Moody’s and Fitch Ratings. The problem is budget repair will only become harder over the coming years, whatever the final numbers in the parliament.

On the parties’ approach to budget repair, the Coalition and Labor are virtually indistinguishable as far as the credit agencies are concerned. The May budget projected a deficit (in underlying cash terms) of A$37 billion in 2016-17, gradually falling to $6 billion over the four-year forward estimates.

Labor’s plan is to reduce the deficit from $39 billion to $11 billion over that time. Both Coalition and Labor forecast a return to surplus over the subsequent years and indeed quite large surpluses ten years from now. Budget repair on this scale was utterly implausible before the election and is fiction now.

The government’s so-called “zombie” budget measures were baked into its projections over the forward estimate period. These were mainly the cuts to university funding, family payments and the Pharmaceutical Benefits Scheme. None of these had any prospect of being legislated with the past Senate, never mind with a larger, more powerful set of crossbench senators.

The Parliamentary Budget Office estimates these “zombie” measures to be worth $8 billion in total over the forward estimates. This accounts for roughly half of the difference between the total projected deficits of Coalition and Labor over the same period.

In short, there is little or no prospect of achieving the budget repair that is a pre-requisite for maintaining Australia’s AAA credit rating. Both sides of politics need to spell out to all Australians what this means. The effect of a credit downgrade is like an income cut to households, businesses and government.

It’s similar to the effect of a decline in the terms of trade (relative prices of our exports), and also similar to a loss of national productivity. All of these things effectively reduce our national disposable income. We become poorer as a nation.

Foreign lenders use Australia’s credit rating to set the interest rates that they charge Australian borrowers, mainly governments and businesses. A lower credit rating triggers a larger foreign risk premium in the interest rate that they charge borrowers.

This flows through to the general level of interest rates in the economy, so all firms and households with debts face higher borrowing costs. This can lead to less spending and hiring of workers by firms, and less disposable income for those households.

The major credit agencies are huge private organisations entrusted with capital of shareholders. They make calls about credit ratings not for political purposes but on the basis of what is in the best interests of investors.

The credit agencies are simply making rational assessments. The probability of Australia eventually defaulting on its debt is extremely low, but it is not zero and it is rising, which is important.

The slightly higher risk of default would result in a small downgrade from AAA, as occurred in the 1980s, by the major credit agencies. In turn this would imply higher interest rates, as it did back in the 1980s.

Higher interest rates are definitely bad news for those borrowing. It’s not necessarily good news for those saving either because rates on saving do not increase as much as rates on borrowing.

Also, when rates on overseas borrowing go up because of a larger foreign risk premium in our interest rates, the Australian dollar is likely to fall, as it did dramatically in the 1980s, from US 72 cents to 60 cents in the space of three months. When the Australian dollar falls for this reason our international purchasing power is reduced.

This is quite different to what happens when the Reserve Bank raises interest rates through its control over the official interest rate. In that case the Australian dollar is likely to rise, in the short term at least, which increases our international purchasing power – we can buy more from overseas with our income.

The parliament is like the Roman emperor Nero: “fiddling while Rome burns”, an apt analogy since Europe is where we are slowly headed economically and that won’t be pretty.

Author : Ross Guest, Professor of Economics and National Senior Teaching Fellow, Griffith University

Household Debt Up Again

The latest RBA chart pack, released today includes data on household debt. Debt a a percentage of disposable income is up again, to an all time high. This is driven by flat income growth, and ever more home loan borrowing. Even after the May interest rate cut,  interest paid as a proportion of disposable income has risen.

household-finances(1)This is of course an average, and segmented data contains considerable variation.

Getting Government Debt In Perspective

A good piece in today’s The Conversation, examines the claim that the current government has lifted net government debt by $100 billion. This is proved to be correct, with caveats. However, some perspective is required in the debate. As highlighted in the piece, an important measure is debt to GDP. On that basis, on an international comparison, Australia is still well placed.

GDP Comparisons May 2016However, a recent report from LF Economics highlights that “while mainstream commentary and attention is firmly focused on public debt, the nation has accumulated a dangerously high level of private debt, including a moderately high level of external debt. Globally, Australia ranks near the top of indebted households. The exponential surge in mortgage debt issuance over the last two decades has generated the largest housing bubble in Australian economic history”. “Australia’s household debt ratio has grown above peaks established in countries where housing bubbles formed and burst, as in Ireland, Spain and the United States,” say report authors Philip Soos and Lindsay David. “So highly leveraged is the housing market that even small declines in residential land prices will have adverse consequences.”

Indeed, Australian households overtook the Swiss as the world’s most indebted this year, with outstanding debt equivalent to 125 per cent of GDP and no let up in sight. Combined owner-occupier and investor loans outstanding have risen from $1.2 trillion to $1.6 trillion in the past five years.

Here is the problem, the economic growth is being stoked by ever higher household debt, which is unsustainable. Why are we not getting better political discussion on this much more important issue during the election? The current economic path which has been set is unsustainable. The chart below makes the point – private debt should be the focus.

Australian Debt By CategoryAs we highlighted from the recent RBA chart pack, household debt to income is also sky high.

household-financesAnd here is data (from 2014) from the OECD showing the relative ratio of household debt to disposable income for Australia,  in comparison with other countries.

OECD-Debt-To-IncomeThe issue we SHOULD be talking about is the household debt overhang, and how we are going to deal with it. Government debt, in comparison is a side-show!

Household Debt Ratio Grinds Higher And Mortgage Discounts Rise

The latest RBA chart pack, just released, shows that household debt, as a percentage of disposable income continues to rise. Also from our analysis, banks are offering larger discounts again.

RBA data shows interest payments are below their peak, but are also rising (though the May cash rate cut will have an impact down the track as mortgage rate cuts come home).  However, given static incomes (which are for many falling in real terms), this debt burden is a structural, and long term weight on households and the economy, and is dangerous.  However low the interest rate falls, households will still have to pay off the principle amount eventually.

household-financesWe are also seeing some relaxing of lending standards now, as banks chase investor loans well below 10% growth rates, and continue to offer cut price loans for refinance purposes.  Average discounts on both investment loan have doubled.


GDP 3.1% But…

Latest ABS data shows that growth in the quarter was a strong 1.1% making an annual seasonally adjusted rate of 3.1%. However, the Net National Disposable Income (NNDI) measure shows another fall.

GDP-and-NNI-March-2016In other words, whilst we are exporting more volume – and this quarter liquid natural gas was a stand-out, this greater activity did not translate to national or household income. In fact, this continues to fall, as previously shown by the stagnant growth in real incomes. The Australian economy may be running fast, but is not creating more wealth for its residents. Not a pretty picture.

Standing back, you have to question whether GDP is a very useful measure in the current environment. I am sure there will be many who will use it to “prove” the economic miracle continues, but the truth is much more complex. In addition, GDP is decoupled from inflation when the main driver is exports, so this gives the RBA a headache as well. Cutting rates further is unlikely to address this problem.

The ABS said that the March quarter 2016 National accounts show the Australian economy growing by 1.1% in seasonally adjusted chain volume terms. The major driver of economic growth this quarter came from Exports which contributed 1.0 percentage point and Household final consumption expenditure contributing 0.4 percentage points.

The increase in Exports is reflected in the growth observed in Mining production (6.2%). Growth was also observed in the service industries of Financial and insurance services (1.8%), Accommodation and food services (1.5%), and Arts and recreation services (0.9%).

The largest detractor from growth was Private gross fixed capital formation which fell 2.2%, this was driven by falls in New engineering construction (-6.4%) and New buildings (-6.9%).

The Terms of trade fell by 1.9%, reflecting a fall in the price of exports relative to the price of imports.


In Australia, All That Glitters Isn’t Gold

From Bloomberg View.

If Australia is an economic miracle — the so-called Lucky Country, beneficiary of more than a quarter century of uninterrupted growth — then its banks are its most visible sign of strength. After a near-death experience in the 1990s, they’ve reformed and bounced back dramatically: Returns on equity now average around 15 percent, compared to single digits in the U.S. Share prices and dividends have risen strongly over the past decade. At around twice book value, market valuations are well above global levels.

In fact, though, this ruddy good health masks some deeply worrying trends. The balance sheets of Australia’s biggest banks are far more vulnerable than they may seem on the surface — and that means Australia is, too.

To most observers, this might sound alarmist. Scared straight after a mountain of bad loans nearly brought them down at the beginning of the 1990s, the banks reformed and minimized their international exposure, which meant they were insulated from the worst effects of the Asian financial crisis and the 2009 crash. Today they face little competition in their home market and have benefited tremendously from Australia’s strong growth, underpinned by China’s seemingly insatiable demand for the country’s gas, coal, iron ore and other raw materials. During the 2012 European debt crisis, Australia’s banks were worth more than all of Europe’s.

But Australian financial institutions have made the same fundamental mistake the rest of the country has, assuming that growth based on “houses and holes” — rising property prices and resources buried underground — can continue indefinitely. In fact, despite a recent rebound in Chinese demand, commodities prices look set to remain weak for the foreseeable future. Banks’ exposure to the slowing natural resources sector has reached nearly $50 billion in loans outstanding — worryingly large relative to their capital resources.

If anything, their exposure to the property sector is even more dangerous. Mortgages make up a much bigger proportion of bank portfolios than before — more than half, double the level in the 1990s. And they’re riskier than they used to be: Many loans are interest-only, while around 80 percent have variable rates. With a downturn likely — everything from price-to-income to price-to-rent ratios suggests houses are massively overvalued — losses are likely to rise, especially if economy activity weakens.

Australian banks are also more vulnerable to outside shocks than they may first appear. Their loan-to-deposit ratio is around 110 percent. Domestic deposits fund only around 60 percent of bank assets; the rest of their financing has to come from overseas. While that hasn’t been a problem recently, Australia’s external position is deteriorating. The current account deficit is expected to grow to 4.75 percent in the current financial year. Weak terms of trade, a rising budget deficit, slower growth and a falling currency are likely to drive up the cost of funds. If Australia’s economy or the financial sector’s performance falters, or international markets are disrupted, banks’ access to external funds could be threatened.

Risks to the financial sector should be getting far more attention than they are in Australia’s ongoing — and terrifically anodyne — parliamentary election campaign. Banks have grown immensely since the 1990s and now make up a much bigger part of the Australian economy. The top four are among the country’s largest listed companies, accounting for more than a third of total market capitalization. Their combined assets are around 130 percent of GDP.

Any pain they feel could thus spread quickly throughout the real economy. Falling bank stocks could well drive down share prices more broadly. Shrinking dividends — which have traditionally been quite high, around three-quarters of earnings — would hammer investors, especially self-funded retirees, and threaten consumption. An economy addicted to a ready supply of cheap credit would struggle to keep growing.

Meanwhile, the government’s options are limited. Cutting interest rates further to spur economic activity would risk worsening the housing bubble and adding to sky-high levels of household debt, already around 130 percent of nominal GDP and nearly 200 percent of household disposable income. Raising rates, on the other hand, could trigger defaults, especially on riskier loans such as those to property developers. Fiscal policy is similarly constrained: Increasing debt beyond certain levels would threaten Australia’s credit rating and thus banks’ access to offshore funding.

Pundits have been saying for years that Australia needs to diversify its economy, boosting services exports — primarily tourism, education and health — rather than continuing to depend on resources and debt-fueled property growth. Banks need to do the same, reducing their exposure to the housing market and the mining industry. At the same time, they should move swiftly to shore up their balance sheets, aggressively increasing bad-debt reserves, raising capital and gradually trimming dividends. Even their otherwise enviable luck can’t last forever.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Author: is a former banker, with more than 35 years of experience, and author of “Traders, Guns & Money” and “Age of Stagnation.” In 2014, Bloomberg named him one of the world’s 50 most influential financial figures.

Improving Consumer Outcomes and Enhancing Competition In Credit Cards

The Treasurer has released for public consultation the Government’s response to the Senate Economics References Committee Inquiry into matters relating to credit card interest rates.  The Government’s response outlines reforms to provide greater legislative protection to vulnerable consumers, to exert more competitive pressure on credit card issuers and to provide consumers with the information they need to make the best choices about how they use their credit cards.


There are currently around 16 million credit and charge card accounts in Australia (or 1.8 cards per household). Around two-thirds of outstanding credit card debt (by value) is accruing interest. This proportion has fallen over recent years (from above 70 per cent in 2011). The decline likely reflects that credit cards are an expensive form of credit and their relative price has increased in recent years as interest rates on other forms of credit — such as household mortgages and personal loans — have fallen. Increasing use of debit cards, and the growing availability of discounted balance transfer offers, may also have been important, whilst reforms enacted under the National Consumer Credit Protection Act in 2009 and 2011 may have contributed to improved repayment behaviour.

Available data indicate that the debt-servicing burden associated with outstanding credit card balances falls more heavily on households with relatively low levels of income and wealth. Households in the lowest income quintile hold, on average, credit card debt equal to 4 per cent of their annual disposable income, while those in the highest income quintile hold debt equal to around 2 per cent of disposable income. Low income households are also more likely to persistently revolve credit card balances (and, therefore, pay interest) than high income households.

Cards-Proposals-2The ABS’ Household Income and Expenditure surveys show that households in the lowest income quintiles also pay more in interest charges relative to their incomes than higher income households, although overall differences between quintiles are small. Households in the bottom two quintiles by net worth also pay the most in credit card interest relative to their income.

Cards-Proposals-3Although reliable data on the number of consumers that are in credit card distress are not publically available, a range of evidence supports the conclusion that carrying large credit card debt is a significant cause of financial vulnerability and distress for a small but sizeable subset of consumers.

Default rates on credit cards give a sense of the proportion of credit card balances that are in severe distress. Recent estimates from the RBA suggest that total (annualised) losses on the major banks’ credit card loan portfolios are around 2½ per cent.5 Other data suggest that many consumers struggle to make the required repayments on credit cards without necessarily defaulting. A 2010 survey by Citi Australia found that 9 per cent of respondents reported that they had struggled to make minimum repayments on credit cards within the past 12 months, with low-income earners being more likely to report this than high-income earners.

Compared to other types of loans, the number of consumers struggling to or failing to make the required repayment is likely to understate the financial distress associated with credit cards. Card issuers set minimum repayment amounts as a very small proportion of the outstanding balance, so that households making the minimum repayment will only pay off their balance over a very long period and incur very large interest costs. Making the higher repayments required to pay off their outstanding balance may be sufficient to cause financial distress for many consumers.

In giving evidence to the Senate’s inquiry into the issue, the Consumer Action Law Centre (Consumer Action) and the Financial Rights Legal Centre (Financial Rights) stated that credit card debt is the most commonly cited problem by callers to Financial Rights’ financial counselling telephone service. Consistent with this, Consumer Action’s telephone service is reported to receive at least 15 calls per day related to credit card debt, with over 50 per cent of callers having credit card debt exceeding $10,000 and 28 per cent with a debt of over $28,000. Credit cards are also the most common cause of consumer credit disputes received by the Financial Ombudsman Service — of the more than 11,000 consumer credit disputes received in 2014-15, almost half were about credit cards.  In contrast to the number of home loan disputes, which fell by 5 per cent over 2014-15, the number of credit card disputes rose by almost 4 per cent.

Apart from its direct financial impact, high and unmanageable credit card debt can have a significant impact on other indicators of wellbeing. An examination of financial stress amongst New South Wales households by Wesley Mission detailed the impact that financial stress can have on the household and individual, including impacts on physical and mental health, family wellbeing, interfamily relationships, social engagement and community participation. More than one quarter of respondents that identified themselves as having been in financial stress indicated that the experience had resulted in sickness or physical illness (31 per cent), relationship issues (28 per cent) or a diagnosed mental illness (28 per cent). While there are many causes of financial stress, Wesley Mission found that financially stressed households owed, on average, 70 per cent more in credit card debt than households that weren’t financially stressed.

In addition, the inflexibility of credit card interest rates to successive reductions in the official cash rate has prompted concern over the level of competition in the credit card market. Since late 2011, the average interest rate on ‘standard’ credit cards monitored by the RBA has remained around 20 per cent, at a time when the official cash rate has been reduced by a cumulative 2.75 percentage points. The average rate on ‘low rate’ cards (around 13 per cent) has been similarly unresponsive to reductions in the cash rate over the period.

Analysis conducted by the Treasury in 2015 showed that effective spreads earned by credit card providers have increased over the past decade. In particular, spreads increased substantially during the financial crisis and have remained high in the years since then.11 The increase during the financial crisis is consistent with a repricing of unsecured credit risk observed in other credit markets and economies. However, the fact that spreads have since remained very high (and have even increased a little further more recently) suggests limitations in the degree of competition in the credit card market and unsecured lending markets more generally.

Proposals For Consultation.

Credit cards are used by many Australians as a valuable tool for managing their financial affairs. The majority of Australians use their credit cards responsibly. There is, however, a subset of consumers incurring very high credit card interest charges on a persistent basis because of the inappropriate selection and provision of credit cards as well as certain patterns of credit card use. For this subset of consumers, credit cards may impose a substantial burden on financial wellbeing.

The Government finds that these outcomes reflect, among other things, a relative lack of competition on ongoing interest rates in the credit card market (arising partly because of the complexity with which interest is calculated). These outcomes also reflect behavioural biases that encourage card holders to borrow more and repay less than they would otherwise intend leading to higher (than intended) levels of credit card debt.

These views are consistent with the findings of the recent Inquiry into matters relating to credit card interest rates by the Senate Economics References Committee released in December 2015. On 18 December 2015, the Senate Committee released its report entitled Interest Rates and Informed Choice in the Australian Credit Card Market. The Government has carefully considered the recommendations made by the Senate Committee. This consultation paper also constitutes the Government’s response to that Inquiry.

The Government proposes a set of reforms that it considers are proportionate to the magnitude of the identified problems. It has drawn upon lessons and insights from regulatory developments in other jurisdictions as well as available empirical evidence, including relevant insights from behavioural economics. The Government has further drawn on evidence given by stakeholders at the Senate Inquiry hearings and its own consultation with card issuers and consumer representatives.

The proposed measures form part of a wider package of reforms that should improve competition and consumer outcomes in the credit card market. A number of aspects of the Financial System Program announced by the Government in October 2015 — including measures to improve the efficiency of the payments system and support access to and sharing of credit data — should also have a material and positive impact on consumer outcomes in the credit card market. There are already signs that reforms enacted in January 2015 to open up the credit card market to a wider pool of potential card issuers are beginning to have a positive impact on competition in the market.

Relatedly, on 19 April 2016 the Government released the final report of the review of the small amount credit contract (SACC) laws. Consistent with its approach to the credit card market, the Government wants to ensure that the SACC regulatory framework balances protecting vulnerable consumers without imposing an undue regulatory burden on industry. The final report made recommendations to increase financial inclusion and reduce the risk that consumers may be unable to meet their basic needs or may default on other necessary commitments. The Government is undertaking further consultation before making any decisions on the recommendations.

The Government recognises the importance of financial literacy in supporting good consumer outcomes in the financial system and is committed to raising the standard of financial literacy across the community. The Government provides funding to the Australian Securities and Investments Commission (ASIC) to lead the National Financial Literacy Strategy and undertake a number of initiatives to bolster financial literacy under the ASIC MoneySmart program.

The package consists of two phases. For Phase 1 (measures 1 to 4), the Government seeks stakeholder feedback with a view to developing and releasing associated exposure draft legislation in the near term. For Phase 2 (measures 5 to 9), the Government plans to shortly commence behavioural testing with consumers to determine efficacy in the Australian market and to ensure they are designed for maximum effect. Testing will be led by the Behavioural Economics Team of the Australian Government. The decision to implement these measures will be subject to the results of consumer testing and the extent to which industry presents solutions of its own accord. The Government intends to commence consumer testing in the near term and will report on the outcomes of that testing and make a final decision on implementation in due course.

Cards-Proposals-1The closing date for submissions is Friday, 17 June 2016.

RBA May Monetary Statement – Inflation Lower For Longer

The RBA has released its latest statement on monetary policy. Essentially, inflation will be lower for longer, and they see home lending still running at around 7% growth whilst competition to lend grows more intense.

The March quarter underlying inflation outcome was around ¼ percentage point lower than expected at the time of the February Statement.

The broad-based nature of the weakness in nontradables inflation and the fact that wage outcomes were lower than expected over 2015 has resulted in a reassessment of the extent of domestic inflationary pressures, leading to downward revisions to the forecasts for inflation and wage growth. Underlying inflation is now expected to remain around 1–2 per cent over 2016 and to pick up to 1½–2½ per cent at the end of the forecast period.

RBA-May-01Given data observed over the past few months, the recovery in wage growth and labour costs underpinning the inflation forecasts has been revised lower.

Within the household sector, they say that household consumption growth increased in the second half of 2015 to around its decade average in year-ended terms, driven by relatively strong growth in New South Wales and Victoria. Factors supporting the pick-up in consumption growth include solid employment growth and low interest rates, as well as the ongoing effects of lower petrol prices and a further increase in household wealth.

With growth in household disposable income remaining below average, the saving ratio has continued to decline.

Retail sales volumes grew at a similar pace in the March quarter as in late 2015, although other timely indicators of household consumption have eased of late. Motor vehicle sales to households have continued to decline in early 2016, though at a slower pace than in late 2015, and households’ perceptions of their own finances have declined of late, although they remain around their longrun average. However, in the past these indicators have had only a modest correlation with quarterly aggregate consumption growth. Liaison suggests that trading conditions in the retail sector have softened in recent months, but remain generally positive.

Conditions in the established housing market have stabilised somewhat over the past two quarters or so. Housing prices increased in the early months of 2016, after easing slightly in the December quarter of 2015. Auction clearance rates are above average in Sydney and Melbourne, although they remain lower than a year ago. The average number of days that a property is on the market is a little higher than the lows of last year, while the eventual discount on vendor asking prices is little changed. Housing turnover rates are below average.

Housing credit growth has eased a little in recent months, after stabilising in the second half of 2015. This follows an earlier period of rising credit growth, driven in large part by investor lending. This moderation has been consistent with the increases in mortgage interest rates implemented by most lenders towards the end of 2015 and the tightening of lending standards.

The pace of housing credit growth has eased in recent months, to around 7 per cent. This follows increases in variable lending rates by most lenders in late 2015 and measures introduced by the Australian Prudential Regulation Authority (APRA) to strengthen lending standards. In particular, loan serviceability criteria have been tightened by lenders, which reduce the amount that some households can borrow. Consistent with these developments, there has been a decline in turnover in the housing market, along with slower growth in the average size of loans. Net housing debt has continued to grow around 11/4 percentage points slower than housing credit due to ongoing rapid growth in deposits in mortgage offset accounts. Recent housing loan approvals data suggest that housing credit will continue to grow at about its current pace.

Prior to the May cash rate reduction, the estimated average outstanding housing interest rate had been little changed since lenders increased interest rates in the second half of 2015. Following the May rate reduction, banks have lowered their standard variable rates by 19–25 basis points.

More broadly, there are signs that competition for both owner-occupier and investor loans is intensifying. New loans are typically benchmarked to standard variable rates, with lenders then offering discounts below these rates. Over recent months, interest rate discounts for new owner-occupier loans have increased and may be offsetting some of the increase in standard variable rates last year.

Discounts for investors on variable-rate housing loans were reduced substantially last year but have increased in recent months. Fixed interest rates for housing loans continue to be priced competitively and, consistent with this, a higher share of mortgages has been taken out with fixed interest rates.

Since the introduction of differential pricing for investor and owner-occupier lending by most major banks in the second half of 2015, growth in investor lending has slowed considerably, while growth in owner-occupier lending has accelerated. As noted previously, a large number of borrowers have contacted their existing lender to change the purpose of their loan, while there has also been a surge in owner-occupier refinancing and a drop in investor refinancing with different lenders.

Conditions in the rental market have continued to soften. Growth in rents has declined and the aggregate rental vacancy rate has increased to around its average since 1990. While the recent increase in the national vacancy rate mainly reflects developments in the Perth rental market, growth in rents has eased in most capital cities.

Dwelling investment has continued to grow strongly, supported by low interest rates and the significant increase in housing prices in recent years. Investment in higher-density housing grew at close to 30 per cent over 2015, accounting for most of dwelling investment growth over that period. More recently, the amount of residential construction work still in the pipeline has continued to rise and points to further strong growth in dwelling investment. The pace of growth is likely to moderate, however, consistent with the decline in building approvals since last year.



Where Did The 10% Investor Mortgage Growth Speed Limit Come From?

An interesting FOI disclosure from the RBA tells us something about the discussions which went on within the regulators in 2014 and beyond, as they considered the impact of the rise in investor loans. Eventually of course APRA set a 10% speed limit, and we have see the growth in investment loans slow significantly and underwriting standards tightened.

Back then, they discussed the risks of investment lending rising, especially in Melbourne.

Macroeconomic: Extra speculative demand can amplify the property price cycle and increase the potential for prices to fall later. Such a fall would affect household spending and wealth. This effect is likely to be spread across a broader range of households than the investors that contributed to the heightened activity.

Concentration risk: Lending has been concentrated in Sydney and Melbourne, creating a concentrated exposure in these cities. The risk could come from a state-based economic shock, or if the speculative upswing in demand brings forth an increase in construction on a scale that leads to a future overhang of supply. In Sydney, the risk of oversupply appears limited because of the pick-up in construction follows a period of limited new supply and it has been spread geographically and by dwelling type. While the unemployment rate has picked up a little over the past 18 months, the overall economic environment in NSW is in a fairly good state. In Melbourne, there has been a greater geographic concentration of higher-density construction in inner-city areas. Some developments have a concentration of smaller-sized apartments that may only appeal to some renters, or purchasers in the secondary market. Economic conditions are not as favourable in Victoria and the unemployment rate is 6.8%.

Low interest rate environment: While a pick-up in risk appetite of households is to some extent an expected outcome given the low interest rate environment, their revealed preference is to direct investment into the housing market.  Historically low interest rates (combined with rising housing prices and strong price competition in the mortgage market) means that some households may attempt to take out loans that they would not be able to comfortably service in a higher interest rate environment. APRA’s draft Prudential Practice Guide (PPG) emphasises that ADIs should apply an interest rate add-on to the mortgage rate, in conjunction with an interest rate floor in assessing a borrower’s capacity to service the loan. In order to maintain the risk profile of borrowers when interest rates are declining, the size of the add-on needs to increase (or the floor needs to be sufficiently high).

Lending standards: In aggregate, banks’ lending standards have been holding fairly steady overall; lending in some loan segments has eased a little, while lending in some other segments has tightened up a bit. The main lending standard of concern is the share of interest-only lending, both to owner-occupiers and investors. For investors, 64% of banks’ new lending is interest-only loans and for owner-occupiers the share is 31%. The typical interest-only period is 5 years, but some banks allow the interest-only period to extend to 15 years. During this period, the loan is amortising more slowly than a loan that requires principal and interest (P&I) payments. If housing prices should fall, this increases the risk that the loan balance may exceed the property value (negative equity). There is some risk that the borrower could face difficulty servicing the higher P&I payments when the interest-only period ends, although this is typically mitigated by banks assessing interest-only borrowers on their ability to make P&I payments.

Of course the regulators found underwriting standards were more generous than they thought, at times in 2015 more than half of all new loans were investment loans, and recently banks have reclassified loans, causing the absolute proportion of investment loans to rise. Things were whose than they thought.

Next they discussed how to set the “right” growth rate:

How to calibrate the benchmark growth rate?  Household debt has been broadly stable as a share of income for about a decade. National aggregate ratios are not robust indicators of a sector’s resilience because the distribution of debt and income can change over time. But as a first pass, it is reasonable to expect that the current level of the indebtedness ratio is sustainable in a range of macroeconomic circumstances. Therefore there does not seem to be a case to set the benchmark growth rate significantly below the rate of growth of household income, in order to achieve a material decline in the indebtedness ratio. With growth in nominal household disposable income running at a little above 3 per cent, this sets a lower bound for possible benchmarks at around 3 per cent. Current growth in investor credit, at nearly 10 per cent, suggests an upper bound around 8 per cent to achieve
some comfort about the leverage in this market. Within this range, there are several options for the preferred benchmark rate for investor housing credit growth (including securitised credit).

a) Around 4½ per cent, based on projected household disposable income growth over calendar 2015. This could be justified as being consistent with stabilising the indebtedness ratio. However, it would be procyclical, in that it would be responding to a period of slow income growth by insisting that credit growth also slow. It would also be materially slower than the current rate of owner-occupier credit growth, which so far has not raised systemic concerns.

b) Around 6 per cent, based on a reasonable expectation of trend growth in disposable income, once the effects of the decline in the terms of trade have washed through. It is also broadly consistent with current growth in owner-occupier housing credit, which as noted above has not been seen as adding materially to systemic risk.

c) 7 per cent, consistent with the system profile for residential mortgage lending already agreed as part of the LCR/CLF process. Unless owner-occupier lending actually picks up from its current rate, however, the growth in investor housing credit implied by the CLF projections would be stronger than this. It is therefore not clear that these projections should be the basis for the preferred benchmark.

Staff projections suggest that only a moderate decline in system investor loan approvals would be required to meet a benchmark growth rate for investor housing credit in the 5–7 per cent range for calendar 2015. The exact size of the decline depends partly on assumptions about repayments through churn, refinancing and amortisation in the investor housing book. For a reasonable range of values for this implied repayment rate, and assuming that investor housing credit growth remains at its current rate for the remainder of 2014, the required decline in investor approvals is of the order of 10–20 per cent. This would take the level of investor housing loan approvals back to that seen a year ago. It is worth noting that investor loan approvals would have to increase noticeably from here to sustain the current growth rate of investor housing credit, even though the implied repayment rate is a little below its historical average. Since credit is not available at a state level, the benchmark can only be expressed as a national growth rate. The flow of loan approvals at a state level can be used as a cross-check to ensure that the benchmark incentive has had its greatest effects in the markets that have been strongest recently.

When the 10% cap (note this is higher than those bands discussed above) was announced, some Q&A’s provide some insights into their thinking.

Isn’t 10 per cent a bit soft?  We are not trying to kill the market stone dead. Investor housing credit is currently running at a bit under 10 per cent. Some lenders will have investor credit growth well below this benchmark anyway, so if all lenders do end up at least a little under this benchmark, which we hope they will, then aggregate growth in investor credit will be noticeably below 10 per cent. Setting a benchmark for individual institutions is not the same thing as setting it for an aggregate, and APRA has allowed for that.

Where did the 10 per cent benchmark come from?  This was a collective assessment by the Council agencies. We took the view that we did not want to clamp down on the market excessively. We also took the view that in the long run, household credit can expand sustainably at a rate something like the rate of trend nominal household income growth, maybe a bit more or less in shorter periods. Trend income growth is below 10 per cent, more like 6 per cent or thereabouts. But it was important to make an allowance for the fact that some lenders will undershoot the benchmark, so the aggregate result will likely be slower than that.

But isn’t household income growth likely to be below average in the next few years, because of the end of the mining boom?  Maybe, but we don’t want to be procyclical and clamp down on credit supply more when the economy growing below trend.

This of course confirms the regulators were wanting to use household debt as an economic growth engine (interesting, see the recent post “Why more-finance-is-the-wrong-medicine-for-our-growth-problem” )

We also see a significant slow down in household income growth, yet credit growth, especially housing has been stronger, creating higher risks if interest rates or unemployment was to rise. Raises the question, were the regulators too slow to act, and did they calibrate their interventions correctly? We will see.