The Reserve Bank (RBA) released its bi-annual Financial Stability Review (FSR) a few days ago.
The document provides a guide as to the RBA’s thoughts on the overall economy and potential risks.
As you’d expect, the residential housing market features heavily in their assessment of financial stability and I will delve into some of the key take-outs for the housing market from the document.
Housing loan performance
The report details that the share of non-performing banks housing loans (ie those housing loans which are at least 90 days in arrears on their repayments) was extremely low, recorded at around 0.6% in December 2014 which is down from a peak of 0.9% in 2011.
The lack of repayment distress across Australian bank mortgage portfolios is being supported by low interest rates which make servicing the mortgage debt easier.
The document also states that rising housing prices also make it easier for those home owners in arrears to sell rather than remain in arrears should they run into financial difficulty.
It is important to note that while as a general the statement about rising house prices making it easier to sell is true, the housing market performance varies greatly region-to-region.
Although selling a home in Sydney and Melbourne is relatively easy currently thanks to strong value growth and high levels of demand, housing market conditions in Perth, Hobart or Canberra are more challenging and it would probably be more difficult to sell a home in these markets.
Competition in the mortgage market
According to the Report competition has remained rigorous over the past six months.
There is plenty of competition amongst lenders and as a result they are offering attractive fixed rates and significant discounts of up to 100 basis points off their advertised variable rates.
The RBA has also noted targeted special rates as an example of short-term rate specials for those refinancing with lower LVRs.
Banks have also increased commissions being paid to their brokers.
As a result, refinancing activity has increased and around 40% to 50% of new housing loans are sourced from brokers.
The RBA does raise some concerns that the rising prevalence of the broker channel potentially creates risks, specifically that misaligned broker incentives could create higher levels of lending outside of their risk tolerance.
While APRA wrote to Authorised Deposit-taking Institutions (ADIs) highlighting its guidelines for sound residential mortgage lending late last year, the high level of competition across the banking sector may create issues, particularly in the investor space.
Given APRA has indicated that growth in investor housing credit should not be materially above 10% per annum, the significant competition in the market means that those who can’t source an investor loan from one ADI may still have plenty of other ADIs to choose from.
The RBA is reporting that serviceability and deposit criteria have been relatively unchanged over the past six months.
They acknowledge that some banks have recently applied stricter criteria for some inner-city unit markets and regional towns linked to the resources sector.
Despite the lending criteria being largely unchanged, the RBA acknowledge that low mortgage rates and the strength in demand from the investment segment have increased the macroeconomic risks from the housing market.
Once again they have acknowledged that investors may amplify housing price cycles and increase the potential for falls in the future.
They also note that the rising share of interest-only loans may also increase risks because there is a period over which the principal is not repaid leaving the household with more debt than they would have if they repaid both the principal and interest on the mortgage.
It should be noted that while interest rates are low everywhere and investor activity has increased in most states, the sharp rise in investor participation is most prevalent in Sydney and Melbourne.
These two cities have seen the strongest growth in home values over recent years, along with the most significant compression of rental yields which has resulted in these cities exhibiting the lowest rental yields across the capital city housing markets.
The risks of investors amplifying the market are greatest within these two cities, particularly given the strong value growth coupled with very low rental yields and high investor concentrations.
The FSR notes that investor housing credit has increased at an annualised rate of 10.5% over the past six months however, it is too early to expect a slowdown in investment lending just yet in response to APRA’s guidelines.
The reason being that the pipeline of pre-approvals was already in place before APRA wrote to ADIs in December highlighting a guideline of a cap of 10% annual growth in lending to investors.
The RBA notes that investors have contributed to fuelling the rapid growth in home values in Sydney however, the growth has been more moderate outside of Sydney.
The FSR states that periods of value growth also increase expectations for further price rises, creating even more demand.
A future fall in housing prices would reduce wealth and dampen spending for the broader household sector, particularly for those households with significant housing debt, not just for the investors who contributed to the upswing.
The RBA has also raised potential concerns that the surge in lending from the investment segment could lead to excessive new housing construction and a potential future glut in certain areas.
While the RBA points out there is little risk of this currently at a national levels, there are some areas of local vulnerability, namely inner-city units in Melbourne and Brisbane.
While the RBA has covered off on the risks surrounding heightened levels of investment lending quite well there are a few additional points that need to be made.
While investor activity is strongest in Sydney and Melbourne, these two cities already have the lowest gross rental yields.
This feeds in to the comment about amplifying the market but is important to understand; investors are chasing capital growth and having little regard for the returns.
Secondly, while there are concerns about too much new housing supply in inner-city Melbourne and Brisbane rental growth is already at its lowest level in more than a decade.
Although inner-city Melbourne and Brisbane are areas for concern, there is no mention of the fact that rental rates are already falling in Perth, Darwin and Canberra.
Furthermore, while both rents and the rate of population growth are falling in Perth there is simultaneously a record high number of dwelling approvals currently.
Although low interest rates and the high level of competition in the mortgage market could create risks, the RBA sees little evidence that lending standards have deteriorated.
The share of loan approvals above 90% LVR continued to reduce over 2014.
The RBA reports that this shift was led by those lenders that previously reported a higher than average share of these types of loans.
The profile of new lending indicates that households remain well placed to service their loans.
The area that the RBA points out as a concern is the increase in interest-only lending.
The rising level of interest-only lending to investors is consistent with tax deductibility of investors’ mortgage interest payments which act as a disincentive to pay down the principal.
The banks have suggested that the rise in owner occupier interest-only mortgages has been driven by the borrowers seeking greater flexibility in managing their repayments rather than affordability pressures.
Reportedly some of this demand is from owner occupiers who plan to switch their property into a rental property in the future.
The RBA also notes that many of these owner occupiers are building sizeable buffers in their offset and redraw facilities.
It should also be noted that in principle, interest-only loans should not increase borrowing capacity because consumer protection regulations imply that lenders should assess a borrower’s ability to service principal and interest payments following the expiry of the interest-only period.
ASIC is currently assessing compliance with this obligation through its review of interest-only lending.
Despite these considerations, interest-only loans – especially for owner-occupiers – pose greater risk to the financial system because they enable borrowers to pay down the principal more slowly than a conventional mortgage.
The RBA have spelled out a number of key areas of risk surrounding the residential mortgage market.
It is clear that the RBA along with APRA and ASIC are closely monitoring the overall market conditions and are on the lookout for risks and an easing of lending standards.
While each organisation has stated publicly their concerns and what they are going to do to allay those concerns, it seems unlikely that any significant changes to policies due to these risks for individual ADIs would be communicated publicly.
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