Largest regulatory credit crunch in 30 years could trigger 20% price fall

The largest regulatory credit crunch in 30 years will cause a further slide in property values, Endeavour Equity Strategy said in a detailed 30-page report.

Sydney and Melbourne house prices could fall by 15 to 20% in a repeat of the late 1980s and '90s, the equity research firm suggested citing evidence that about 40% of all mortgages were "non-prime."

It was based on the level of borrower's income relative to debts.

Endeavour suggested the crackdown on the use of measures that understated borrower expenses, and overstated their borrowing capacity, would reduce loan values by up to 30%.

"Our base case suggests expense ratios will increase sharply, serviceability ratios will decrease proportionately, and loan sizes and property prices will suffer in the order of 15 to 20% in real terms," the report said.

It written by Endeavour's Douglas Orr, and circulated to fund manager clients with a report appearing in The Australian Financial Review.

A fall in house prices would lead to a decline in building activity resulting in a "modest increase" in arrears as incomes tied to the sector fall.

"Lower house prices would reduce the ability for stressed borrowers to trade out or finance," the report said.

Endeavour called on the prudential regulator to force the banks to disclose metrics such as "debt serviceability to income ratios" and said the "commercially conflicted" Household Expenditure Measure, or HEM, used to assess borrower expenses boosted serviceability by 15% to 20%.

"Mandatory disclosure of serviceability metrics would achieve this and offset real concerns that the current regime allows banks to 'commission their own risk goal posts' – by relying on HEM," the report said.

Endeavour Equity Strategy was founded 15 years ago by Douglas Orr, a former ABN AMRO research analyst. 

"We see credit growth over the coming 12 to 18 months as likely flat to negative, margins under pressure, heightened legal risks and bad debts set to increase as equity turns negative for a significant portion of leveraged home owners and investors."

The report said a sample of 420 Westpac mortgages, made public as part of the Hayne royal commission, supported its prior view that 40% of all outstanding mortgage debt was "non-prime".

This was based on the "internationally accepted" measure of "non-prime" being a mortgage in which more than 40% of income was being used to service interest payments on debt.

"Non-prime mortgages areas have default rates three to five times higher in a downturn," Orr told AFR.

The Endeavour report described the banks' lending buffers as "illusory" because the HEM understated expenses for most households, and therefore overstated how much income borrowers had available to service debt even after a buffer was factored in.

The Westpac loan sample also showed the extensive use of the HEM to assess borrower expenses. In that loan sample, 97 out of the 100 loans originated by mortgage broker RAMS relied on the HEM, while 86% of Westpac's loans relied on the measure.

A more "realistic" assumption around living expenses would substantially reduce the funds available to service a loan to a household on $150,000 of annual income from $76,000 to $56,000.