Interest-only mortgages have ballooned to $650 billion, 40 per cent of total loans.
There seems little doubt that housing will drag on Australia’s growth outlook through 2019. Indeed, growth in home lending and building activity has historically been the “tail that wags the dog” as far as Australia’s growth cycle (and sentiment) is concerned.
Yet much debate rages over whether the unfolding correction in housing is a more familiar periodic problem for year-ahead growth – or critically, whether it will drive a more sinister (potentially systemic) credit crunch that brings the economy to its knees. Will we see household wealth, housing prices and housing activity correct to multi-decade lows in the year ahead?
It’s appropriate to canvas both the “sanguine” and more “bearish” viewpoints on Australia’s residential outlook.
Under the more bearish housing scenario, prices are forecast to fall by 20 per cent from their peak (they are down less than 4 per cent to date), accompanied by a 20-30 per cent fall in new loan growth, a collapse in credit growth to zero and a significant retracement in household wealth that weighs on the broader economy, potentially tipping the economy into recession.
This is driven by housing valuations that are very expensive and debt levels that are high – prices have risen over recent years to more than six times annual income, well above global comparisons. Australian consumer debt levels have also risen to be among the highest in the world. With the share of income going to mortgage repayments already above average, despite record low interest rates, housing is vulnerable to even a modest rise in interest rates.
Further, interest-only loans have also ballooned. Over the past five years, interest-only loans amounted to $650 billion, 40 per cent of the total. The regulator has now limited this to 30 per cent but it has dropped to 15 per cent. Now, around $120 billion of these loans will revert to principal and interest each year until 2021, with repayments jumping 30-50 per cent for some borrowers. This will limit prospects for price gains and many mortgagors may be tempted to sell. More than half of housing investors own more than one property and more than 60 per cent are negatively geared, which means they are making a loss.
Another factor supporting a housing bear market is that regulatory pressure will constrain credit availability. After the Hayne banking royal commission, regulators will take a more rigorous interpretation of responsible lending requirements. According to UBS, the inability of lenders to rely on “poverty'” level expenditure benchmarks will lower borrowing capacity by as much as 30 per cent. Finally, the weakening of the housing cycle has not been driven by higher RBA cash rates denting demand, but largely reflects reduced credit supply (which will persist).
Conversely, under the more sanguine housing scenario, prices fall by up to 10 per cent from their peak, broadly in line with prior cycles. In this scenario lending drops 20 per cent (it has fallen 14 per cent), which further slows housing credit growth to around 3-4 per cent, a record low. Negative wealth impacts and slower construction activity are a problem for economy-wide growth, but do not deliver a systemic or recessionary event.
In support of this view, housing debt is being carried by those most able to afford it, Australia has not been unique in seeing debt-to-income ratios rise significantly, and debt is not as high when buffers in mortgage offset accounts are considered. Further, according to the Australian Bureau of Statistics, about 40 per cent of household debt is held by the top 20 per cent of the income distribution. This share has remained fairly steady for the past 20 years.
The regulator has also been tightening lending standards for several years, which should provide protection against a decline in house prices for both banks and households. Focus from the regulator has already led banks to improve underwriting standards, requiring more disclosure and limiting higher risk lending. According to the RBA, lending at high loan-to-valuation ratios has declined as a share of total loans.
Additionally, despite rising interest-servicing costs and reduced credit availability, a crisis is likely to require a significant rise in unemployment. An inability to service owner-occupier rather than investor loans will likely be needed to deliver significant forced selling and crisis. Unemployment has recently fallen to 5 per cent, a six-year low, while leading indicators of job demand for the year ahead remain strong. Immigration also continues to support population growth and housing demand.
The housing outlook warrants significant caution. The high level of household debt remains a vulnerability, particularly in the event of an adverse shock to the economy and the potential for loan defaults and weaker consumer spending to feed back into weak activity. But Australian banks have substantially strengthened their capital positions over the past decade. Lending standards have been more strictly applied over recent years and loans for high loan-to-value ratios have been reduced.
While the outlook is always uncertain, with the jobs market firm and no anticipated sharp rise in unemployment on the horizon, it seems more likely that weakening housing activity will remain a persistent and significant problem for growth over the coming year or so – with lower house prices and slowing loan growth – rather than developing into a systemic or recession-like event.
Scott Haslem is chief investment officer at Crestone Wealth Management.
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