10% debt servicing ratio would trigger mortgage delinquencies: ANZ

Household debt has increased to an all-time high - at a multiple of 1.7 times annualised household disposable income, the ANZ Bank has noted.

But household debt levels remain ‘comfortable’ given growth in household income, interest rate levels and household assets, says bank researchers, David Cannington and Katie Hill.

Their ANZ Research paper - headed Household Debt: A house of bricks or straw - concludes there is little sign of financial distress among households.

"Mortgage delinquencies are well below 0.5% of total mortgages and have been trending lower for most of the past year," Cannington and Hill wrote.

"Despite higher levels of debt, households’ ability to service their debt has improved markedly, primarily due to lower interest rates, with household interest payments as a proportion of income below long-run average levels," the report said.

But notwithstanding the current manageable levels of household debt and the current forecast of steady expansion in Australian medium-term economic growth, they suggest under certain economic stress conditions households could see a sharp increase in debt stress, primarily through mortgage default.

"Recent RBA research is consistent with our view that the most likely driver of mortgage defaults would be negative housing equity combined with a sharp increase in debt service difficulty, likely due to broad-based job losses and higher interest rates," Cannington and Hill wrote.

The report noted interest rates are a key variable driver of debt servicing ratios, and have been more volatile since the Global Financial Crisis, particularly to the downside.

"While we don’t expect interest rates to rise sharply in the coming years, and we have forecast 50bps of rate cuts in 2015 reflecting a subdued economic growth profile, we have modelled the impact of various monetary policy scenarios on the debt servicing capacity of households.

"Our general view is that, assuming no significant improvement in labour market conditions, debt servicing ratios around 10-11% would start to put pressure on mortgage delinquencies.

"However, interest rates and monetary policy do not adjust completely independently of economic and labour market conditions. In all likelihood, if interest rates were increasing it would be under a scenario of improved labour market conditions and high income growth. However, for the purposes of testing household leverage vulnerability to interest rates, all interest rate scenarios assumed the same income and credit growth assumptions, namely:

• "Continued weakness in disposable income growth with growth gradually improving to 5% by 2017 and stabilising thereafter; and
• "Annual household credit growth between 5-7%.

"The baseline scenario in the model assumes our current monetary policy view of 25bp cuts in March and May 2015, before the RBA begins a 100bp hiking cycle in 2016. Modelling suggests our baseline and baseline +50bps scenarios would see debt servicing ratios peak at manageable levels (8.6% and 9.4% respectively in 2017).

"It is only once the cash rate exceeded our baseline by 150bps (taking it to maximum of 4.5% in December quarter 2016) that the debt servicing ratio would be pushed beyond 10%.

"There are good reasons to expect households will be able to absorb higher debt servicing ratios more easily than in previous hiking cycles.

"Our recent research indicates households have opted to maintain elevated repayment rates in recent years and this behaviour has driven excess mortgage repayment rates to historical highs.

"In addition to higher mortgage repayments, balances in mortgage offset and redraw facilities have also increased.

"In fact, the RBA estimates that balances in mortgage offset and redraw facilities has increased to around 15 per cent of outstanding mortgage balances.

"As deposits in offset accounts are not officially measured as negative mortgage debt, standard statistical measures of household debt don’t fully reflect the improvement in household balance sheets, particularly in recent years.

"This more conservative household financial behaviour could provide a significant serviceability buffer in the next hiking cycle."

The report noted household’s inability to meet mortgage repayments would most likely be caused by an adverse shock to unemployment.

The research paper also provided some useful quantitative rules to assess the probability of mortgage distress. These include:

• The likelihood of missing a mortgage payment increases with the loan-to- valuation (LVR) ratio at origination, particularly high at an LVR ratio above 90%.
  
  
• Households with high debt servicing ratios are more likely to miss a mortgage payment. In particular, household debt servicing ratios (including principal repayments) of over 50% were 10ppts more likely to miss mortgage payments than households with debt servicing ratios under 30%.
  
  
• Households with a full-time employed primary income earner are 8ppts less likely to miss a mortgage payment than households with a primary earner that is not in the labour market.
  
  
• A greater proportion of households that miss payments have both high gearing and a high debt servicing ratio compared to households that have either high gearing or a high debt servicing ratio.
  
  
• Loans that are repaid quickly ahead of schedule are less likely to miss payments. Households that are making repayments ahead of schedule are 4ppts less likely to miss a mortgage payment, compared to households paying on time.

Source: RBA