UK Regulators Worry About 17% Housing Investment Loans

The latest Financial Stability report released by the Bank of England provides insights into the UK mortgage market, and some of the concerns the regulators are addressing. Of note is the information on “Buy-to-Let” loans, or Investment Mortgage Loans. Most striking is the strong concerns expressed about the rise to 17% of all loans being for this purpose. In Australia, by comparison, 35% of housing loans are for investment purposes. We also look at household debt ratios and countercyclical buffers.

Buy-to-let mortgage lending has driven mortgage lending growth in recent years.  Seventeen per cent of the stock of total secured lending is now accounted for by buy-to-let mortgages, and the gross flow of buy-to-let lending in 2015 was close to its pre-crisis peak.

The PRA conducted a review of underwriting standards in the buy-to-let mortgage market between November 2015 and March 2016. It reviewed the lending plans of the top 31 lenders in the industry, who account for over 90% of total buy-to-let lending. A number of lenders planned to increase their gross buy-to-let lending significantly, with overall planned lending in the region of £50 billion.

UK-BuytoLetGiven competition in the sector, this strong growth profile raises the risk that firms could relax their underwriting standards in order to achieve their plans. The review further highlighted that some lenders were already applying underwriting standards that were somewhat weaker than those prevailing in the market as a whole.

The draft Supervisory Statement aims: to ensure that buy-to-let lenders adhere to a set of minimum expectations around underwriting standards; and, to prevent a marked loosening in underwriting standards. It also clarifies the regulatory capital treatment of certain buy-to-let exposures.

At its March meeting, the FPC welcomed and supported the draft Supervisory Statement. The Supervisory Statement reflects microprudential objectives, aiming to reduce the risk that buy-to-let lenders make losses that can threaten their safety and soundness. From a macroprudential perspective, policies that prevent a slippage in buy-to-let underwriting standards should also reduce the threat of buy-to-let lending amplifying wider housing market risks. The FPC discussed that, although the 200 basis points increase in buy-to-let mortgage rates was lower than the interest rate stress applied to owner-occupied lending under the FPC’s June 2014 Recommendation, lenders tended to assess affordability for buy-to-let mortgages using interest cover ratios of at least 125%. In addition, loan-to-value ratios at origination in excess of 75% were less common in buy-to-let mortgages than in owner-occupied mortgages. Buy-to-let loans therefore typically started with a larger equity cushion for lenders, which reduced the associated credit risk in the first few years of the loan given that these loans were typically non-amortising. The FPC considered that no action beyond this was warranted for macroprudential purposes at that time. It will continue to monitor developments and potential threats to financial stability from the buy-to-let mortgage market closely, and stands ready to take action.

Another piece of data in the report is the household indebtedness. Worth comparing this with the RBA chart we highlighted yesterday, where the ratio in Australia is north of 175%.

UK-DebtMore broadly, The Stability Report highlighted the risks to the UK economy, especially around Brexit. The webcast is worth listening to.

Of note is that fact that the regulators reduced the UK countercyclical capital buffer rate from 0.5% to 0% of banks’ UK exposures
with immediate effect, reflecting heightened risk and the wish to encourage banks to lend.  Australia already has a zero percent buffer.

The FPC is reducing the UK countercyclical capital buffer rate from 0.5% to 0% of banks’ UK exposures with immediate effect. Absent any material change in the outlook, and given the need to give banks the clarity necessary to facilitate their capital planning, the FPC expects to maintain a 0% UK countercyclical capital buffer rate until at least June 2017. This action reinforces the FPC’s view that all elements of the substantial capital and liquidity buffers that have been built up by banks are able to be drawn on, as necessary, to allow them to cushion shocks and maintain the provision of financial services to the real economy, including the supply of credit and support for market functioning.

It will reduce regulatory capital buffers by £5.7 billion. For a banking sector that, in aggregate, targets a leverage ratio of 4%, this raises their capacity for lending to UK households and businesses by up to £150 billion.

In March, the FPC had begun to supplement regulatory capital buffers with the UK countercyclical capital buffer. This reflected its assessment that the risks the system could face were growing and additional capital was needed that could be released quickly in the event of an adverse shock.

At that time, the FPC judged that risks associated with domestic credit were no longer subdued, as they had been in the period following the financial crisis, and global risks were heightened. The Committee raised the UK countercyclical capital buffer rate to 0.5% and signalled its expectation that it would increase it further, to 1%, if the risk level remained unchanged. As set out in this Report, a number of economic and financial risks are materialising. The FPC strongly expects that banks will continue to support the real economy, by drawing on buffers as necessary.

Consistent with the FPC’s leverage ratio framework, the countercyclical leverage ratio buffer rate will also fall.

The Committee’s decision in March to raise the UK countercyclical capital buffer rate to 0.5% was due to take effect formally from 29 March 2017. However, as the Committee explained in March, there is an overlap between the risks captured by existing PRA supervisory capital buffers and a positive UK countercyclical capital buffer rate of 0.5%. The PRA Board concluded in March 2016 that, to ensure there is no duplication in capital required to cover the same risks, existing PRA supervisory buffers of PRA-regulated firms should be reduced, as far as possible, to reflect a UK countercyclical capital buffer rate of 0.5%, when such a rate came into effect.

The FPC has therefore accompanied its decision to reduce the UK countercyclical capital buffer rate with a Recommendation to the PRA that it bring forward this planned reduction in PRA supervisory capital buffers.

Recommendation: The FPC recommends to the PRA that, where existing PRA supervisory buffers of PRA-regulated firms reflect risks that would be captured by a UK countercyclical capital buffer rate, it reduce those buffers, as far as possible and as soon as practicable, by an amount of capital which is equivalent to the effect of a UK countercyclical capital buffer rate of 0.5%.

The PRA Board has agreed to implement this Recommendation. This means that three quarters of banks, accounting for 90% of the stock of UK economy lending, will, with immediate effect, have greater flexibility to maintain their supply of credit to the real economy. Other banks will no longer see their regulatory capital buffers increase over the next nine months, increasing their capacity to lend to UK households and businesses too.

Consistent with this, the FPC supports the expectation of the PRA Board that firms do not increase dividends and other distributions as a result of this action.

South Australian digital property market now live

From IT Wire.

Online property exchange PEXA says the introduction of legislation allowing online property conveyancing in South Australia makes buying and selling property in the state easier, with conveyancers, solicitors, banks, credit unions and mutuals now able to digitally exchange property.

The SA state government e-conveyancing legislation took effect on Monday after 150 years of “pen and paper” conveyancing processes.

PEXA chief executive Marcus Price says e-conveyancing will bring South Australian consumers fast, safe and efficient transactions.

“People buying and selling homes will increasingly become aware that there’s a better way to exchange property that diminishes delays and other pain points associated with manual settlements.

“I congratulate and thank Brenton Pike for driving this innovation and reform as SA registrar-general and, nationally, in his role as chairman of the Australian Registrars’ National Electronic Conveyancing Council.

“Going digital puts an end to costly cheques and piles of documents. Crucially, conveyancers and solicitors acting on behalf of buyers and sellers can say goodbye to sitting on hold in bank call centre queues and travelling to Grenfell Street to attend settlement.

“Like the ASX did for the exchange of shares, PEXA removes manual processes and paperwork when exchanging property. Land registries, financial institutions and practitioners all transact together, online via a secure platform with funds settling through the Reserve Bank of Australia.”

Price cites a Core Logic RP Data report valuing South Australia’s property industry at $228 billion, and says the industry now has an inclusive, collaboration tool that brings the conveyancing and legal profession unprecedented connectivity.

“Importantly, 80 financial institutions have signed up to PEXA. A growing number are now actively transacting. In addition, an increasing number of practitioners are inviting their peers to join the network. More than 2500 have signed up in the PEXA-ready states. This will increase with SA coming on board.”

Auction Volumes Down Last Saturday

According to CoreLogic, 70.7 per cent of capital city auctions were successful this week, according to preliminary results. This week’s result indicates an upwards shift in the auction clearance rate from last week, when 66.4 per cent of auctions were successful and is also higher than the clearance rate recorded over the first month of winter 2016 (67.1 per cent). The number of residential auctions held this week was 811, down substantially from 2,218 last week. At the same time last year, 1,674 capital city auctions were held with 76.8 per cent clearing.

20160704 capital city

Auction Clearances Still Buoyant

The latest data from APM PriceFinder shows that last Saturday, 2nd July, despite the election distraction, national clearances were at 70%, compared with 64.9% last week, though on much lower volumes for obvious reasons. Compared with this time last year numbers are down a little, but clearly there is still appetite for property.


Why rents will rise under Labor’s negative gearing proposal

From The Conversation.

In the current housing tax debate a number of studies have come out arguing that while prices will fall (by varying amounts) rents will not be affected. That rents will be unaffected is surprising and (in my view) wrong.

Outside of the heat of an election, the Henry Tax Review’s comprehensive review of the tax system argued for lower taxes on savings, a proposition that most economists would regard as unexceptional. (There is now a (small) school of thought arguing for higher taxes on savings but this author for one does not subscribe to that.)

Specifically, the Henry Review recommended the marginal tax rates on interest and rental income should be 40% lower; for example, the 35% and 45% income tax rates on labour income would be lowered to 21% and 27%. For property investors these rates would also apply to capital gains and net losses, thereby reducing the value of negative gearing.

For ‘ungeared’ investors (those who do not take on debt), the effective tax rate would be lower while for highly geared investors the effective tax rate would be higher, leading to less incentive to leverage (making the Reserve Bank of Australia happy). Overall, the effective tax rate for the “average” investor would be higher.

Now the Henry Review acknowledged that its proposed changes would, by lifting the user cost of capital of investors, lift rents. It therefore explicitly said that its proposed changes would need to be accompanied by measures to both lower the cost of housing by removing supply constraints, and to lift levels of rental assistance for households in the private rental market. In short, it did not see the increases in rents as immaterial.

If the increase in user cost of capital (on investors who are ‘geared’ by borrowing money to invest) with the Labor proposal is higher (roughly double), on what basis could rents not rise? It is not evident to me.

The key component of the user cost of capital, and the one which varies the most over time, is interest rates. When interest rates rise or fall, we expect prices to fall, or rise. But interest rates also change rents, since rent = user cost × value of house.

And what we also see is that a rise in interest rates causes the rent-price ratio (that is, the ratio of home prices to annual rent, also referred to as the rental yield) to rise, while a drop in interest rates will see it fall.

To illustrate, consider Melbourne for the period 1991-2014 when interest rates have fallen significantly and the rent-price ratio has followed suit. This has seen prices increase significantly (4.9% pa in real terms), and faster than the rise in costs (3.2%). In inner areas where there is a significant location premium (over living at the urban fringe), the rise in prices has been fastest (5.8%) as the value of that location premium has been bid up.

That is, most of the change in the rent-price ratio has come from rising prices. On the other hand, in the outer areas, where there is no location premium and the value of a house is the structure plus the cost of land, prices (3.4% pa) have moved in line with costs (3.2% pa) but rents have risen much more slowly (1.4%). That is, rents explain the decline in rent-price ratios.

So, while the assumption of most commentators is that price movements do the work in changing rent-price ratios, and that is so over the short term, over a longer time span, rents do some of the adjustment.

Changes in interest rates are uncontroversial. But the same principles apply to changes in tax if they change the cost of capital, which is why the Henry Review expected rents to rise.

In the case of the Labor’s negative gearing changes, the waters are muddied for some by its proposed exemption on new housing. A couple of points here. Firstly, ABS figures (see Table 8 from ABS5671.0 – Lending Finance, Australia) are quoted to suggest that investors’ purchases are 93% established housing, and only 7% new housing. This significantly understates the role of investors.

The NAB residential property survey has domestic investor purchases of new housing at about 20-30% – that is, domestic investors are already a significant component of the new market (adding to supply!).

Secondly, Henry also expected a change in the mix of landlords to consolidate from one with a large number of small landlords, to one with a smaller number of large landlords. More marginal investors – middle income/low wealth investors – will be the first to vacate the field as their entry point is typically cheaper, old stock not premium new stock.

High income/low wealth investors will have the option of new dwellings. High income/high wealth individuals will benefit from the higher rents and lower prices on established dwellings.

That is, the ownership of the dwelling stock (and tax benefit!) will shift to the top end of income earners. But it is not clear that the special treatment of new housing will add materially, if at all, to supply of new dwellings.

In short, the law of unintended consequences will apply. Logic says that rents will rise, and with the 30% renting in the private market skewed to low income earners, that means housing affordability will have declined for these people.

Author: Nigel Stapledon, Andrew Roberts Fellow and Director Real Estate Research and Teaching Centre for Applied Economic Research, UNSW Australia

Is The Root Cause Of High House Prices What You Think It Is?

A snapshot of data from the RBA highlights the root cause of much of the economic issues we face in Australia. Back at the turn of the millennium, banks were lending relatively more to businesses than to households. The ratio was 120%. Roll this forward to today, and the ratio has dropped to below 60%. In other words, for every dollar lent now it is much more likely to go to housing than to business. This is a crazy scenario, as we have often said, because lending to business is productive – this generates real productive growth – whilst lending for housing simply pumps up home prices, bank balance sheets and household balance sheets, but is not economically productive to all.

Lending-MixThere are many reasons why things have changed. The finance sector has been deregulated, larger companies can now access capital markets directly and so do not need to borrow from the bank, generous tax breaks (negative gearing and capital gains) have lifted the demand for loans for housing investment, and the Basel capital ratios now make it much cheaper for banks to lend against secured property compared to business. In fact the enhanced Basel ratios were introduced in the early 2000’s and this is when we see lending for housing taking off.

So how much of the mix is explained by tax breaks for investors? If we look at the ratio of home lending for owner occupation, to home lending for investment, there has been an increase. In 2000, it was around 45%, now its 55% (with a peak above 60% last year). This relative movement though is much smaller compared with the switch away from lending to business.  Something else is driving it.

RBA-Mix-HousingWe therefore argue that whilst the election focus has been on proposed cuts to negative gearing and capital gains versus a company tax cut, the root cause issue is still ignored. And it is a biggie. The international capital risk structures designed to protect depositors, is actually killing lending to business, because it makes lending for housing so much more capital efficient. Whilst recent changes have sought to lift the capital for mortgages at the margin, it is still out of kilter. As a result, banks seek to out compete for mortgages and offer discounts and other incentives to gain share, whilst lending to business is being strangled. This is exacerbated by companies being more risk adverse, using high project hurdle thresholds (despite low borrowing rates) and smaller businesses being charged relatively more – based on risk assessments which are directly linked to the Basel ratios. Our SME surveys underscore how hard it is for smaller business to get loans at a reasonable price.

The run up in house prices is a direct result of more available mortgage funding, and this in turn leaves first time buyers excluded from the market. But it is too simple to draw a straight line between negative gearing and first time buyer exclusion. The truth is much more complex.

We are not convinced that a corporate tax cut, or a further cut in interest rates will stimulate demand from the business sector. Nor will reductions in negative gearing help that much. We need to re-balance the relative attractiveness of lending to business versus lending for housing.  The only way to do this (short of major changes to the Basel ratios) is through targeted macro-prudential measures. In essence lending for housing has to be curtailed relative to lending to business. And that is a whole new box of dice!


Property price to income ratio is rising in Sydney, Melbourne and Canberra

From CoreLogic.

Utilising quarterly household income data from the Australian National University, CoreLogic has developed quarterly measurements of the ratio of property prices to annual household income.  This data is extremely valuable when looking to measure housing affordability.  The measure is available at a number of different geographies from SA2 regions (generally about the size of a suburb or group of suburbs) all the way up to GCCSA (capital city and rest of state) regions.  When looking at the analysis it is important to note that a higher ratio means housing is less affordable and a lower ratio indicates better affordability.

Chart 1
With property prices varying greatly between each of the capital cities it is interesting to note that the variation in household incomes in nowhere near as large.  In March 2016, Hobart had the lowest median dwelling price at $337,250 and Sydney had the highest median price at $775,000.  Meanwhile, household incomes range from as low as $1,175/week in Hobart to $2,118/week in Darwin.  Obviously the differences in property prices and incomes impact on housing affordability, so let’s take a look at each of the capital cities and the ratio of prices to income over time.

Outside of Sydney, Melbourne and Canberra housing affordability is improving with each capital city having a current ratio which indicates affordability has been worst in the past.  The problem is that almost 2 out of every 5 Australians live in either Sydney or Melbourne and these two cities have also been the epicentres of employment and economic growth over recent years.  Deteriorating housing affordability in Sydney and Melbourne impacts on significantly more people than deteriorating housing affordability elsewhere around the country.

This measure of affordability provides a high level overview of the relative housing affordability across the capital cities, but it is important to remember that geographically across each city the affordability story can be dramatically different.  Furthermore, this analysis does not take into consideration interest rates which can make housing affordability more affordable.  While interest rates are undoubtedly a consideration for buyers, they must also consider that interest rates can fluctuate dramatically over the life of a mortgage.

Capital City Clearance Rates Rise Again

According to CoreLogic, the preliminary auction clearance rate was recorded at 69.1 per cent this week, having risen from 67.4 per cent last week. This week’s rise represents a further improvement from the recent low of 65.7 per cent over the weekend leading up to the Queen’s birthday public holiday. There were 2,189 auctions held across the combined capital cities this week, up from 2,183 over the previous week. Auction performance remains well below the comparable week last year when 76.9 per cent of the 2,249 auctions cleared. For the tenth week in a row, Sydney recorded a clearance rate that was in excess of 70 per cent.

20160627 captial city

Today’s Auction Results Beat Last Week

The results from APM Pricefinder for 25 June 2016 are out, and nationally, auction rates were 70.9%, up from 68.3% last week. Sydney cleared 341 sales at 74.1%, whilst Melbourne sold 511 at 71.7%. Results are still strong, though still a little lower than this time last year.

APM-25-June-ChartThese results provide a leading indicator of property market activity based on a majority sample of auctions that take place every Saturday.


APRA eyes commercial lending

From Australian Broker.

Banking regulator APRA Is “dialling up” the scrutiny on banks’ commercial real estate lending after double-digit loan growth.

Charles Littrell, APRA’s executive general manager for supervisory support said the regulator was turning up the pressure amid fears of an apartment oversupply.

According to a report in The Australian, with estimates of a national oversupply of 70,000 apartments, Littrell said it was “not a bad time to be seeing banks strengthen the equity position in their balance sheet”.

Speaking at a Centre for International Finance and Regulation event yesterday, Littrell said commercial property had historically been what “goes wrong” for the banking system. Plus, there is now the added risk of becoming “so systemically concentrated”.

“In 1990 the four major banks had 40% of the banking market; now they’ve got 80%,” he told the event, The Australian has reported.

“They’re all in the same business model, they’re all hugely exposed to each other … and we don’t quite know what would happen if that business model gets whacked by external stress all at once.

“So there is a lot of conventional work at our end – focusing on sound lending and in fact now we’re dialling up our systemic supervisory focus on commercial real estate.”

Luci Ellis, the Reserve Bank head of financial stability, echoed APRA’s concerns. She told the event that commercial property and development was one area that lacked research since the global financial crisis to draw on.

“The thing that has tended to be the causal agent in a banking crisis, even though you saw something go wrong in housing prices, it was the property developers, it was the commercial real estate, these are the vectors of distress,” she said, according to The Australian.

According to Credit Suisse, total bank commercial real estate lending has boomed in the past three years, with exposures growing 10% to $214bn for the year to March, the highest rate of growth since the GFC.