Debt Bomb: Fears of housing 'fire sale' as interest-only loans roll into principal plus interest

A former RBA board member just laid out an interesting case for raising interest rates immediately

"To Warwick McKibbin, Australian National University economist and former RBA Board member, keeping official interest rates at record-low level for such a prolonged period of time will leave the Australian economy vulnerable when the next global downturn hits."

 

not sure if banks see it that way, for them the ability to repay every month from a regular income is more imp then the quality of asset in future.

 

My point is that by year 30, the rent far exceeds the interest. There is your income stream. And banks see rent as regular income.

Otherwise no one over 40 would be able to take out a 30 year loan. Except I am over 40 and just took out a 30 year loan. No problems at all.

 

bank takes a certain risk and allows some overlap in retirement but not much as they are in the business of certainty not the future potential of asset and its rent.

try taking a low lvr loan on an insignificant income,
even if rent on this will easily repay the loan and save some after all expenses banks would be very reluctant to issue the loan due to lack of other significant income.

 

So you say but a bank just gave me a loan that takes me well past retirement. Theory vs the real world. You have a good grasp of what a bank will do in theory. I have experience if what banks do in practice. I can confirm they definitely use rent in the income in servicing calculations. I didn't service without rent.

Edit: to clarify, this is not some small overlap. I will be around 80 when the loan ends. The bank didn't have any problem with that.

 

Debt bomb, debt bomb, you're my debt bomb. Baby you can turn me on.

 

I saw the thread and just thought the exact same thing. Debt isn't scary if you manage your risk.

I would sign the loan docs for a 40 year loan tomorrow, with the loan term ending when I am around 90. Why? I can instantly think of 3 post retirement exit strategies. I wonder if a non-property investor could do that?

 

I have given feedback to my lender that if they insist on shifting my loans from IO to P&I then they will eventually lose all their business with me. I could go to other lenders or accept the P&I regime, pay more tax and increasingly collect positive income stream from rentals into my golden years.

Alternatively, the lender should rethink. What would be the risk to the lender if I started the loan with the lender at LVR 70% and into my golden years, the LVR is receding to 0% corresponding to the loss of business! At the same time, further reducing the risk, my assets, noticeably houses in this case, and my income streams, which include the positive rentals increase. Would I be demonstrably a good risk customer after 15-20 years without any arrears, or one just to cut off as soon as possible under the new APRA regime?

There are signs that the lender is prepared to re-start loans for longer periods.

 

I think they would consider extending IO/resetting a loan if you still meet serviceability hurdles. The problem is most don't service anymore.

 

The lender will need to act responsibly and could only renew IO periods if you qualified. Otherwise they would open themselves up to risk.

 

In my opinion this misses the entire point. Your point is that 40 year loans are risky for the bank because of back end risk, how does the customer repay the loan after they have retired?

My view is that you have the risk the wrong way around. For a loan, the bank's risk is the front end risk (what happens in the first 5 years) and the back end risk is the customer's risk (what happens in the last 5 years)

Put it this way, if a customer defaults on a loan in the first 5 years of the loan, it is the bank's problem. If a customer defaults on a loan in the last 5 years of the loan, it is the customer's problem.

That's why a bank just gave me a loan where I have no demonstrated ability to make repayments for the last 15 years of the loan. Because if I don't make those repayments, it is my problem, not their problem.

Let's model the risk for $500,000 house purchase, 80% LVR, 4% P&I, 30 year term. I have been conservative and put the growth rate of the value of the property at 3% year on year, which means the value does not double in 20 years.

Loan value: $400,000
Interest rate: 4%
Repayment: $1,909.66
Property Value: $500,000
LVR: 80%
Loan Term: 30 years
Annual growth rate: 3% year on year

If the customer defaults on the loan in the first 12 months then the bank has a problem. The difference between the loan and property value is $100,000 at most. That in not much wiggle room from the bank's point of view. After a forced sale, legal fees, court costs, agent's commission, back interest etc, etc, the bank is likely to make a loss. The first 12 months of a P&I loan are definitely the most risky for the bank.

The numbers look better after 5 years. The loan balance is down to $362,491.49 and the value has increased to $562,754.41. That's $200,000 difference between the property value and the loan. After a forced sale, legal fees, court costs, agent's commission, back interest etc, etc, the bank is likely to make their money back and the customer may even end up with a little.

The numbers at the back end of the loan are completely reversed.

At 25 years, the loan balance is down to $105,252.25 but the property value should have risen to $1,016,397.05. The LVR has dropped to 10%. The bank won't care at that point if the customer defaults. The bank is certain to get their money back. It is very low risk from their point of view. The risk has transferred to the customer. They could lose an asset worth $1,000,000 over a $100,000 debt. If the bank forces the sale it is expensive and the sale price may not achieve what it would on the open market. The bank walks away with its money but the customer loses out.

It is up to the customer to manage their risk at that point. At worst, they have retired so could withdraw enough from super to pay down the $100,000 of debt.

So, is a 40 year loan really more risky for the bank? Let's see. Same property, same assumptions, 40 year term.

Loan value: $400,000
Interest rate: 4%
Repayment: $1,671.75
Property Value: $500,000
LVR: 80%
Loan Term: 40 years
Annual growth rate: 3% year on year

The risk for the bank in the first 12 months is the same. Very high.

The numbers after 5 years look worse than for a 30 year loan. The loan balance is still $377,975.15 (higher than a 30 year loan) but the value is the same as a 30 year loan at $562,754.41. That's on $184,779.25 difference, vs $200,000 difference on a 30 year loan. Definitely riskier for the bank.

In the last 5 years of the loan, the number are better for the bank and worse for the customer than a 30 year loan. At 35 years the loan balance is down to $92,142.83 but the property value should have risen to $1,365,952.65. The LVR has dropped to 7%. If the customer defaults the bank is certain to get their money back. It is lower risk from the bank's point of view than a customer defaulting in the last 5 years of a 30 year loan.

So, in a way you are right. A 40 year loan is riskier for the bank. But the risk is at the front end (first 5 years), not the back end as you thought.

The bank will be a lot more concerned about a customer's ability to repay a loan for the first 5 years of a loan than in the last 5 years of a loan.

Oh, and in 2014 Finder did an analysis of 40 year loans. The customer pays a lot more interest over the life of the loan. Good for the bank, bad for the customer.

"Data from financial comparison website Finder found there are 17 40-year home loan deals available on the market by seven lenders."​

Now 40-year mortgages on offer

 

It's not that bank doesn't like to issue loans, if it's up to them they will issue as much as they can to anyone willing to take. Banks recent lending restrictions are not out of choice but banks are rather forced to,
why do you think they are doing this?

Why do you think APRA sees IO loans as a risk even if monthly repayments are made?
after all, they can just keep extending io loans and keep collection interest forever.

After GFC most of the western households have deleveraged we on the other have increased out debts and to such an extent that it has started putting our entire financial system at risk.
APRA is not doing it because of any moral hazard, they are doing it because they are forced to do it by RBA, which if not done can risk losing total control of financial levers when its needed most.

APRA aims is to derisk the financial system as fast as it can, longer-term loans 40/50 yrs do not help in this pursuit it's just kicking the can further.

 

Completely unrelated to your original question. You have countered my argument with a completely unrelated argument.

What do you think? Is a 40 year P&I loan that crosses into retirement riskier for the bank?

 

Can you provide any reference to back up your point that most Western countries/societies have deleveraged after GFC. What I heard/read is different. Private debt has increased in a lot of countries due to low IR and QE environment. Property prices in major cities in the world have increased significantly, not just Sydney/Melbourne. There are articles quoted in the other thread talking about this. I can find if you want.

 

recent BIS quote, article link at the end

"Unlike most of the big advanced economies, which are in the midst of their upswings with some way left to run, the BIS warns that Australia, Canada and some Nordic countries may already be at or past the peak of their financial cycles.

These countries largely missed out on the "deleveraging" — or paying down debt — that occurred in many countries after the financial crisis.

In Australia, while businesses did reduce debt following the GFC, households did not, and instead ramped up borrowing as interest rates fell from late 2011 to buy houses and apartments, especially investors in Sydney and Melbourne.

"In some small, open economies not affected by the global financial crisis, house prices are high and also household debt is high," observed BIS general manager Agustin Carstens during a press briefing.

"There are signs of financial cycle-related imbalances in countries little affected by the crisis and financial cycles are turning in other economies.

"So the loose financial conditions during the last several years have contributed to increased vulnerabilities."

Australia's debt binge 'coming to an end'

 

Please read my earlier comments to get the perspective,
I am trying to understand and discuss 'systematic risk to the banking sector, measures taken and its effect',
one of the suggestions was longer-term loans to soften the blow.



PS:
I ask, reply, discuss ideas with members here (both bullish/bearish).
I am here to learn.

 

mmm

 

I understand that but I guess it doesn't look like a discussion. It reads like an argument except I don't know what we are supposed to be arguing about.

You posted a question: are 40 year loans a risk to the bank?

I provided a detailed argument that in my view the bank's risk is in the first 5 years of the loan and the borrower's risk is in the last 5 years of the loan. It is a detailed response that took a fair bit of effort to put together.

It appears that you dismissed the entire post with a single statement "it's not that the bank doesn't like to issue loans".

I have no idea if the post is useful or unhelpful. Did I waste my time compiling that information? Did it help your understanding? Was it useful? or did I waste my time posting it? Perhaps it didn't make any sense. I have no idea because instead of addressing anything in the post that I took time and effort to compile, you changed to topic to APRA, risk of IO loans, GFC and 50 years loans.

That is what makes it read like an argument and not a discussion. In a discussion a poster would provide feedback on what the other poster has posted. In an argument the other poster will ignore and change the topic.

I don't mind discussing systemic risk, which is a different topic. The post will take some time to compile and I am reluctant to do so if I am wasting my time.

 

In my opinion that is not true. Banks also have risk management.

Because they are being forced to?

Think of the financial system as a balance between investors, owner occupiers, interest only loans and principle and interest loans. In the last few years the system got out of balance: too many investors and too many IO loans. APRA has taken action to bring the system back to balance.

Well, not really. All loans have an expiry date, so "forever" is wrong.

I don't disagree with any of that.

That's definitely not true. They are trying to engineer a soft landing by derisking the financial system in stages.

Well, nobody is talking about 50 year loans but that aside, I disagree that 40 year loans have no place in derisking the financial system.

Think about investors in 2005 who took out interest only loans. By 2020, when we reach peak rollover of IO to P&I debt, their loan term may be only 10 years or 15 years. If they are forced to P&I with 10 years remaining or 15 years remaining but have to make P&I repayments on their full loan balance, how much will that be per month?

One option is to force them onto a 10 year P&I or a 15 year P&I, force them to sell or default and the bank sells. Does this option represent a risk to the financial system?

Another option is to let those people refinance to 30 years P&I even if they don't meet servicing requirements, because 30 year P&I repayments are much lower than 10 year or 15 year P&I repayments. Some may be able to meet repayments and some may not but there will not be mass forced sales with this option Does this option represent a risk to the financial system?

A third option is to allow those who don't meet servicing on 30 years P&I to refinance to a 40 year P&I because the monthly repayments are lower than 30 year P&I. If a borrower meets servicing at 40 year P&I and can make the repayments while paying down the loan, how is this a risk to the financial system? It achieves exactly what APRA is trying to achieve. "The can" is loan reverting from IO to P&I. 40 year P&I loans do not kick "the can" further. 40 year P&I loans are one solution to "the can".

Which option do you think represents the greatest risk to the financial system and which option do you think represents the lowest risk?

 

We are in process of refinancing all IO loans to P & I BUT for another 30 years, as it reduces payments and improves serviceability for other deals. Avoids horrid P & I bloodbath with just 15 years to pay down loans. We will be in 80's too, but Westpac said they are less concerned with age for investment properties as rental income is constant, and exit strategy is obvious - sell it.