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Mortgage Market....Feels the Pinch

After years of being accused of being asleep at the wheel, the government regulator charged with keeping Australia’s banks on the straight and narrow has woken with a nervous look in its eye.

The Australian Prudential Regulatory Authority (APRA) has hit the banking industry with two measures designed to ensure that Australia’s giant, wobbly edifice of mortgage debt doesn’t fall over.

In December, responding to the David Murray’s Financial Services Inquiry, APRA decided it was time to put the brakes on the boom in residential property investment.

At that time, the banks were lending money hand-over-fist to investors who used the funds to outbid owner-occupiers – by the end of 2014, more than 50 per cent of the value of loans advanced to buy houses went to investors.

APRA’s response was to order the banks to limit growth in investor loans to 10 per cent a year. The banks have done this by lowering loan-to-valuation limits, meaning investors have to find bigger deposits to buy a property.

Commonwealth Bank has even chosen to ignore the negative-gearing tax breaks available to investors when working out how much debt they can service – an artificial, but sound way to slow things down.

Together, these measures mean that would-be investors are now much more likely to be refused loans.

Putting a ‘speed limit’ on the growth in housing credit will help Australia to avoid the worst of a credit boom-and-bust as international economic conditions turn against us.

But is it enough? The Australian economy is entering a period of huge structural change, and unfortunately is doing so with record levels of household debt.

At present, all talk about interest rates is focused on how much further the Reserve Bank will cut its cash rate to shore up an otherwise weak economy.

But as explained previously, this is not all about the RBA. As the shockwaves from the Greek crisis subside, global investors are getting less keen on safe-haven bonds, and are looking for riskier but higher-yielding homes for their money.

As those safe-haven dollars disappear, the price of borrowing rises. For Aussie banks, that means a higher cost of funding the third of the mortgage money they source abroad.

While all that is happening, the China correction is pushing up the US dollar and will make the Aussie dollar weaker in the months ahead. Plus, weaker demand for Australian commodities will weigh on national income.

Back at the household level, that means more existing mortgage holders will struggle to service their debts. A nation with falling terms-of-trade, a falling dollar and flat-lining wage growth is not as safe a place to write mortgages as it once was.

APRA knows this, but does not state it explictly. Instead, it has released a study reappraising how well placed the banks are to deal with any downturn.

Officially, it’s a good time to do this because other banks around the world continue to tighten lending practices, so why not join them?

However the subtext is clear – as Australia enters difficult times, the last thing it needs is loose lending pushing up house prices and creating further imbalances in the economy.

So APRA is leaning on the banks to increase the amount of capital they hold against their massive mortgage books – the more capital they have, the more they can absorb bad loans.

This is really a story about the big-four banks, which have been holding less capital in reserve for each mortgage, on the basis that the ‘risk weightings’ of their mortgages are lower than those of their smaller, regional rivals.

Well they are and they aren’t – and we wouldn’t really find out until a financial crisis was tearing the sector to bits whether the big four have done their sums correctly.

The smaller regional banks have given their mortgages risk weightings that can be double the risk weightings used by the big four, and APRA has finally had enough of this exaggerated disparity.

It is asking the big banks to put aside at least an extra 200 basis points (2 per cent) in capital – in simplified terms, a bank with capital reserves of 8 per cent, would now have to put 10 per cent aside to cope with tough times.

APRA also wants the banks to reassess their risk weightings on the more precarious end of the mortgage scale.

Overall, these moves mean the big four will have to find $24 billion in extra capital over two years, and banks will be looking to claw back that cost.

They will shave a few basis points off deposit rates paid; they will shave a few off any rates cuts ‘passed through’ from the Reserve Bank; and they may shave a little off their dividends to shareholders.

The net effect will be a banking system in which credit growth continues to slow, where the ‘net interest margin’ on the existing loans is more important than ever-ballooning mortgage books; and hopefully … hopefully, we’ll have a more balanced financial system that won’t implode when things get tough, as they did in the US, Ireland and Spain during the GFC.

If APRA was asleep, it at least now has its eyes fixed firmly on a safer road. And that’s exactly what’s needed to get the Australian banking system and economy through the next few years.

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