High-risk interest-only loans could be Australia's 'sub-prime', warns institutional fund

Interest-only home loans could be "Australia's sub-prime”, an institutional investment fund has warned in spite of the recent steps by regulators such as the APRA to tighten lending criteria by banks.

Mortgage loans to young families, professionals and other over-extended borrowers that are to more than six times their household incomes could wipe out 20 percent of the major banks' equity base, according to an article in The Australian Financial Review based on institutional investment fund JCP Investment Partners’ study. 

Official estimates of average household indebtedness are depressed by the sizeable number of mortgages that are effectively full paid off, says the study.

The Melbourne-based fund said Irish-style housing losses for the bigger-than-recognised pool of riskier borrowers could wipe out half of the banks' equity capital.

Further, it warned that interest-only loans could become "Australia's sub-prime”, in a reference to the US sub-prime mortgage crisis that sparked the global financial crisis in 2008-09.

As regulators crack down on interest-only lending and the budget decision to introduce a tax on banks that will total $6.2 annually drives up the cost of loans, "only time will tell if such households can afford the mortgages they have”, the note said.

Recently, Reserve Bank of Australia Governor Philip Lowe echoed a similar sentiment, saying rising household debt had made the economy more vulnerable, and that it was unclear how stretched consumers might behave in a crisis.

It also follows a review by Australian Prudential Regulation Authority chairman Wayne Byres of bank capital requirements for housing exposures. APRA has clamped down on interest-only loans in a bid to cool the hot east coast property market.

It said interest-only loans must be restricted to 30 per cent of new residential mortgage loans. Interest-only lending represents nearly 40 percent of the stock of residential mortgage lending by banks.

Among the biggest concerns is the impact of households not being able to service their loans, for instance, as borrowing costs are reset higher or those with interest only mortgages are forced to repay the principal as well.

That creates a negative feedback loop – experienced by Ireland after the financial crisis – in which stressed borrowers slash their spending, in turn crunching the economy, driving up unemployment and adding to downward pressure on house prices.

"The long virtuous housing wealth cycle could easily transition to a viscous cycle," said JCP. "Smaller mortgages to deleveraging, flat to decreasing house prices and exuberant to melancholic animal spirits will likely expose much bad lending behaviour."

About half of all the nation's mortgage debt was in the hands of borrowers whose debt was more than four times larger than their gross income, said senior researchers Matthew Wilson and Craig Shephard.

The same borrowers had paid off less than half of their loans, the team found, based on data from several official and private sector sources that adjusted for changes in incomes and the collateral values of their homes.

The average loan-to-income ratio of these heavily indebted households was 6.4, or more than double the old banking "rule of thumb" that mortgage managers didn't lend more than three times a household's income "unless they were doctors".

Regulators might be taking false comfort from the large number of mortgages that were effectively fully paid off, as those households were flattering conventional system-wide measures of household indebtedness.

JCP has identified three classes of borrowers who posed the most risk to the system: professionals on high incomes who had borrowed big, young "pretenders" who had stretched themselves to get into property, and young families burdened with rising living costs.

Almost a third of the most highly geared borrowers were professionals with pre-tax incomes of more than $250,000. While they accounted for just 2 percent of total households, they held 17 per cent of mortgage debt, and an average mortgage worth $1.6 million. Half of these borrowers had an investment property loan.

Other young households – dubbed "pretenders" because they had taken on large debts relative to their incomes – were also at risk. This group tended to have average incomes of $110,000 but an average mortgage that was an "eye-watering" 7.4 times larger at $840,000.

The last group, young families, were slightly better placed with average incomes of $80,000 and average mortgages of $420,000.

While they are a small part of the loan book, their household stress could be high because there were "question marks surrounding treatment of expenses in home loan applications, and generally high costs of living,” it said.

"The old LTI ratio [of three times income] has left the banking lexicon exposing a risk that we may have over-capitalised incomes and hence over-extended credit into certain cohorts."

JCP estimated that 50 percent of the equity of Australian banks would be wiped out by soured loans to these high-risk borrowers.

Using less extreme loss assumptions, the banks could have 20 percent of equity wiped out, it said.

JCP used Ireland as a comparison because it experienced a sharp housing correction in 2008 because it was caught in the middle of the Anglo Saxon system of easy credit provision and the Roman system of strong creditor's rights.

In the more conservative scenario, JCP assumed that a 7.5 percent probability of a default and a 40 percent loss would result in the banks losing $24.2 billion on these loans to the high-risk cohort and $28.2 billion in total. That equated to about 17 percent of the $161 billion equity capital base of the banks.

Australians have continued to borrow at an alarming rate as owner-occupied loans grew at a 6 percent annual compounded growth rate, while investor loans grew by 8 percent.

Interest-only loans have increased from 30 per cent of all mortgage credit to 42 percent.

The fund identified several potential catalysts, including the corporate watchdog's legal action against Westpac over responsible lending.

That might prove to "the seemingly small shock" that forced lenders to request more information. That, in turn, could reduce the borrowing capacity of future buyers.

Another catalyst could be further the steps taken by concerned regulators to reign in a dangerous build up in household debt.

"Credit fuels a bubble, and its ultimate rationing and eventual withdrawal deflates it."

JCP's research adds to concerns of regulators such as APRA's Byres, Australian Securities and Investments Commission chairman Greg Medcraft and Dr Lowe.

The 18-year-old Melbourne-based investment company manages money for large institutions and is one of three Australian equities managers appointed by the Future Fund.