Wake up Australia, we have a debt problem

Ten years ago, the biggest financial crisis in decades rocked the global economy. At its roots, the GFC begun with American borrowers getting loans they couldn’t afford & having their repayments increase with ‘adjustable rate mortgages’.

Fast forward ten years, we are replaying the start of their story. Thousands of Aussie borrowers are facing a repayment increase on their mortgages in the next 18-24 months. Most have no idea. Many won’t be able to afford it.

Australia, we have a debt problem.

In this post, we put a spotlight on the origins of our debt problem and explains how we got here. For background, in this earlier article, we explained how Australian interest only loan contracts work and how these loans will have a repayment increases in coming years.

How did Australia get into a debt problem?

1. Interest rate reductions & and a failure in lending market oversight (2011-2015)

The origins of our debt problem begin with interest rate reductions following the end of the mining boom. Naturally, the cash rate reduction incentivised Australians to take on more debt.


Source: RBA chart park

To safeguard against poor lending practices, APRA relied on lenders to stress test whether borrowers could afford repayments if interest rates rose by at least 2%. This stress testing would ensure that borrowers could afford future repayment increases.

However, lenders ignored this key pillar of lending regulation. They only applied this buffer to their own debt, not to debt that customers held with other banks. This loophole effectively allowed some borrowers to avoid ‘stress testing’ when obtaining a loan.

2. Big ramp up in lending & interest only lending (2012-2016)

With rates at record lows, and no one adequately supervising the banks, Australia’s household debt continued to grow between 2012-2015.


Household debt continued expanding from 2012 after a few years of slower debt growth between 2007-2011.

House prices begun rising & interest only loans had become increasingly popular. These are loans that borrowers don’t have to pay down for the first 5 years of their loan term. Thereafter, these loans have their repayments increase as they move back to principle and interest terms. On a $500,000 loan size, the repayment increase after 5 years is roughly $900 per month.


Nearly 50% of all mortgages written in 2014-2015 were interest only loans. Most of these will mature in 2019/2020.

3. A crackdown on lending policies & interest only lending (2015 & 2017)

Eventually, regulators started to get concerned about the rapid growth in residential mortgages & looked at how lenders were applying their lending assessments.

APRA soon realised lenders only stress tested some debts, assumed borrowers had unrealistically low living expenses, had no restrictions on interest only lending & didn’t advise borrowers that repayments increased in future years when interest only periods expire.


Source: Confidence Finance. The above chart shows how investors borrowing power fell following the first round of APRA changes in 2015.

4. Interest only periods expire & the repayment crunch begins (2018-2020)

The glut of interest only lending that was approved under poor lending practices has a potential cost. Borrowers that got those loans will be facing higher repayments when their IO periods expire. Many will not pass the new higher lending standards. Furthermore, over 25% of households have less than 1 months savings available to them to absorb repayment increases.


RBA data shows that over 25% of households have little to no buffers in place. If these households face repayment increases, it is unlikely they will be able to afford them.


Digital Finance Analysts have done some analysis on the volume of loans that do not meet current lending criteria. Note the black bars are for owner occupiers and blue for investors.

What options do borrowers have?

Borrowers on interest only loans that mature will fall into one of the following four categories, from best to worst;

1. Make the additional repayments when the loan converts to principle and interest repayments; borrowers can simply adjust their situation and make the additional repayments. Many borrowers have already begun preparing for changes and done this already.
2. Refinance their loan with a mainstream lender and extend their interest only term; this is only available to borrowers who can pass current eligibility criteria. As a guide, for every $1million in debt borrowers have, they will need an additional $40k in household income to support the same level of debt today vs 3 years ago. With little to no wage growth, many may no longer qualify.
3. Refinance their loan with a non-bank lender; for those who are desperate to maintain their interest only period but fail servicing with mainstream lenders, they can go to the non-bank lenders to secure a new IO period for another 5 years. These lenders have less restrictive lending criteria, but interest rates are usually 0.50-1% higher.
4. Sell; when all else fails, borrowers can sell their properties/investments. This is unlikely to lead to large scale losses for lenders or borrowers, as house prices have grown rapidly and data shows Aussie’s are on relatively low LVRs.

What should the regulators do about it?

Firstly, the regulators need to understand the size of the problem. This month the RBA and the IMF both dressed over Australia’s debt, looking at current financial stress indicators to play down any issues. Financial stability experts know this analysis is weak, as measures of financial stress lag well behind origination problems. Furthermore, many borrowers are completely unaware of their repayments rising (hence aren’t stressing about them!).

What the RBA, APRA & ASIC need to be doing is working out:

• When borrowers interest only terms expire
• Which of the four baskets above do these borrowers fall into

Only then can the size of the problem be properly quantified.

If this analysis reveals a big enough problem, regulators will need to devise a way to soften the landing. Here is a draft five-point plan to manage the market impacts:

1. Allow investment interest only loans to be extended without reassessing borrowers to new serviceability criteria. This pushes the problem down the road and spreads the timing of interest only expiries.
2. Allow lenders to re-issue 30-year loan term for borrowers whose interest only terms expire. This will help lower the repayment crunch as repayments will be over 30 years rather than 25.
3. Promote or incentivise non-banks to continue to provide solutions. Competitive pressure can help alleviate price gouging from smaller lenders.
4. Allow lenders case by case extensions to interest only periods where required.
5. As a last resort, consider further reductions in the cash rate or delays to upward movements to help manage the broader risk to the economy.

How likely is a ‘soft landing’?

Australian regulators have been facing a delicate balancing act managing the economy post mining boom. At this point in the economic cycle, the regulators job is to orchestrate a soft landing.

While the start of our story is like America in 07, the way this story unfolds will likely be far less dramatic.

High household debt is a threat to the economy and requires robust monitoring and management. To date, regulators have failed to appropriately acknowledge the size of the current debt problem.

Nonetheless, they have the tools in their locker & a proven track-record of success to suggest that Australia’s debt problem will end with a soft landing.

 

Does it matter if Australia has a debt problem? Borrowers only need to be concerned with their own debt issues.

 

There’s another category that borrowers fall into - refinancing existing debt to P&I over 30 years. Most property owners only have 2 or 3 properties and many will still have the borrowing capacity to do this.

 

I would amend this to read "they only applied this to NEW debt". It wasnt only OFI debt that went unbuffered. Existing debt held by the lender itself was also unbuffered. In other words, any existing debt, no matter who the lender was, was unbuffered.

 

Eloquent post- summarises what I have been saying for 2.5 years , nicely

Your conclusions are the same as the conclusions I came to back in 2015, and they are the reason why I believe there is a reasonable chance of cash rate reductions before the end of the year or in 2019.

As I have said for the best part of the last 3 years, the RBA's little brothers APRA and ASIC have a real conundrum ( as do the RBA just quietly) . We know what APRA wants to do, and that is to engineer a mass migration from IO to P&I over 5-10 years. That exercise is only 2.5 -3 years old and is only now starting to have an effect. It needs at least another 3 or 4 years to deliver what it needs to deliver - possibly longer. We also know what ASIC wants to do... justify its existence and improve its weak as P!$$ reputation by getting its teeth into "responsible lending" by ramping up pressure on mortgage brokers, aggregators and banks to do a much more thorough living expense assessment, budgeting assessment etc...

I would argue that both of these things are really needs ... they are both prudent and responsible and necessary - never mind the fact they are about 4-5 years too late, after the IO genie and extreme debt to income ratios got well well well out of the bottle. Never mind that it was the two four letter regulators who were completely zombie like at the wheel... the problem is what the problem is and the genie needs to get back in the bottle

So, the conundrum is.... do the regulators stay the course and pursue the mass P&I to IO migration in order to remove the HUGE systemic risk ( Waaaay too much IO lending) that they allowed to develop in a banking system that is completely and utterly dependent on wholesale funding, or do they cave in at the first signs of mass mortgage stress??

Do they stay the course with increasingly intrusive forensic styles of iving cost analysis, or cave at the first sign of mass mortgage stress???

In other words, having done the hard yards up until this point and started to steer the systemic risk off the table, do they stick with the plan , which is all about protection of the whole shebang? - and make no mistake, it really is the whole shebang - this country is totally reliant on foreign oil ( I mean foreign money) to keep its engine running - so if we get mass defaults and delinquencies it wont just be resi property that takes a bloodbath..it will be everything. The cost of Australia's oil ( I mean money) will skyrocket and there goes the ASX . every retirees annuity. every superannuation fund. every small business. commercial lending ...everything.... it will be nasty ....... or do they cower and kick the can down the road because too many people who have never seen anything but easy money being made in property, borrowed too much IO money and havent thought too long or hard about whether they could pay it off when it went to P&I ..?

The way I see it, the only way they can meet their objectives ( to get the genie back in the bottle and some systemic stability back on the table) AND keep the mortgage delinquencies at bay ( keeping the oil flowing at a regular price) is cash rate reductions or at least no cash rate increases.

Sure, Option 3 might warrant some consideration. Maybe they can give firstmac a bank licence and give resimac a banking licence and encourage other non bank lenders to get amongst it with Liberty and pepper like calcs , but lets be honest.... the top 5 non bank lenders represent maybe 40-50 billion capacity combined , in a 1.6 Trillion resi mortgage market. You would need 40 or 50 Libertys or Peppers or Firstmacs to even make a dent in just CBA's 300 Bn resi book and Westpac's 275Bn resi book...

And extending loan terms may as well.... but its not simple and would require a herculean administrative and IT recalibration. I'm not sure the banks have the systems to do it without causing all kinds of problems...

So its hard to come to any other conclusion than Option 5. The only really feasible soft landing strategy thats available to meet everyones objectives and needs is cash rate reductions...

 

Just out of curiosity, does anyone on this forum know what loan types Chinese residential property investors have with Australian banks?
Are they typical 5 years interest only, 25 years p&i? Are they going to hit the p&i cliff as well?

“Initially, and as far back as 2-3 years ago, the Australian Prudential Regulation Authority (APRA) expressed concern about how Australian lenders were heavily-weighted in lending to foreign investors.

They saw this as a major driver of unsustainable growth in the Australian real estate market.

However, what really broke the camel’s back was the large number of money laundering schemes identified.

Fraudulent bank statements, payslips and tax returns were being supplied to banks in order to qualify for these home loans.”

 

The funny thing is that these fraudulent loans are getting paid just fine. There’s no shortage of funds to pay even if P&I, from what I understand.

 

Yes. every lender that reported Chinese broker ( I mean borrower ) fraud also said that these loans had lower arrears and delinquencies than vanilla/blue chip/non fraudulent loans... I guess that once the loans were in place ( albeit using dodgy documents to get them approved) they were paid very diligently.

 

It's only when property prices fall that we see the full extent of any problems. When prices are rising borrowers sell and repay if they are in trouble. When prices are falling problems become more obvious.

 

I don't think the RBA will risk dropping the cash rate further.

Banks will need to reset IO loans to P&I over 30 years or even better, 35/40 years to lessen the load (depending on how old you are). That would be a better solution for all concerned.

Also, more competition by mainstreaming non bank lenders will somewhat keep interest rates in check.

I can foresee a period of pain and purging over the next 3 years, but the intensity, severity and duration of suffering will be in the bank's hands to decide.

 

But in a city like Sydney where many new FHBs are already in their early - mid 30's....

 

I'm not sure I agree with this, at least to some extent.

House prices, regardless of the micro an individual scales that are certainly important, do move on a macro scale. If there's a debt problem and a lot of people struggle with it, then a problem could certainly arise for others. If, say, you own in an area with a lot of very recent buyers, and a decent proportion of those buyers see prices stall either because the present owners have too much debt or because others aren't willing or able to take on higher debts, you're more likely to face discounting (both from owners needing to sell, and builders needing to ensure ongoing sales).

That's something you'd then have to compete with, and the prospect of little capital growth might affect your decisions about how to manage your own debts.

@Redom great post. On a soft landing, I certainly hope this happens. I do think regulators have been quicker off the mark than in Ireland. I think a hard landing, if it happens, will likely be contained to new development areas for the most part, so that's something people ought to watch. If someone owns great family homes, in well established suburbs, they are sitting in a much better position than someone who has bought into apartments, or new homes on the city fringe, where they'd be competing in a slowdown with more potential sellers needing to bring down prices.

Even in Ireland, most of the crash was concentrated in new developments, with many losing almost all of their value. Established areas in comparison did have a soft landing, and recovered within a few years, and even during the recession tended to attract great rental growth (with banks not wanting to lend, and a lot of would-be buyers deciding to wait for the proverbial bottom, the pool of renters for good houses sharply increased).

 

I leave the macro economics to the economists. All I need to know is whether I and my clients can borrow. It is true the overall picture will effect prices, but that is something out of my control.

Never the less it is still an interesting topic.

 

I think there are some key differences with the US situation with lower gearing and greater recourse for mortgage default in Australia. I agree that some people will have difficult in refinancing once their IO period expires, however it will be interesting to see how big of a percentage of the market this is and what the flow on impacts are.

 

I take a very simplistic/pragmatic view to all this. It doesn't matter. It won't affect me or if it does then it will affect probably every single investor so not worth worrying about it. As long as I operate within my own risk profile, choose assets in locations I am comfortable with (very strong OO, current and long term demand) and keep my own leveraging/buffers within my safe zones, nothing else matters to me. I truly believe keeping it simple and most relevant to your situation is best.

 

I'm no economist but there seems to bet lots of evidence of a crash at almost every point of the cycle
Before the melb and sydney booms there was all of these articles stating a crash too and look what happened.

Im not saying redoms info is wrong. But before the 90s crash , no one seemed to predict except those who predict a crash 24 hours a day.

I feel this time is no different. But it wouldnt surprise me if a semi crash happened as well.

Something has to give if any decent property within a reasonable distance to the city becomes unaffordable to the majority of the population

 

Winners and losers........nothing has changed, some investors will manage debt and pay attention to cash flow, while others will believe that booms will go on forever and eventually get caught at peak, holding the baby

Where's @euro73

MTR

 

There was a crash in the 90's???

 

Black Monday (1987) - Wikipedia

Only a small bump in the road..