Australian mortgage delinquencies will increase over the next two years as a record number of interest-only (IO) mortgages convert to principal and interest (P&I) loans, a credit negative for residential mortgage-backed securities (RMBS). Refinancing interest-only mortgages is also becoming more difficult, which will contribute to an increase in mortgage delinquencies.
» A record number of IO loans are scheduled to convert to P&I in the next two years. Banks originated a significant volume of IO loans in 2014 and 2015. The five year IO period for these mortgages will end in 2019 and 2020. When IO loans convert to P&I, borrowers have to make higher monthly repayments, which can lead to delinquencies.
» Delinquency rates increase after IO loans convert to P&I. Our data shows that the 90 days past due delinquency rate for mortgages that have converted to P&I from IO is 0.94%, double that of IO loans that have not yet converted and 0.24 percentage points higher than all securitised mortgages.
» Regulatory measures have curbed the origination of IO loans. This has made it more difficult for borrowers to refinance their loans at the end of the IO period. The more difficult refinancing conditions will contribute to an increase in mortgage delinquencies.
Interest-only loans to convert to principal and interest in record numbers, driving up delinquencies
Mortgage delinquencies will increase over the next two years because a record number of IO loans will convert to P&I loans. Higher mortgage delinquencies are credit negative for RMBS.
When IO loans convert to P&I, borrowers have to make higher monthly repayments. This “payment shock” can lead to mortgage delinquencies and makes IO loans riskier than P&I loans. IO loans typically have an IO period of five years, after which they convert to P&I. At current mortgage interest rates, monthly repayments on loans that convert to P&I from IO will increase by around 30%, which can lead to delinquencies.
The 90-days past-due delinquency rate for securitised mortgages that have converted to P&I after an IO period was at 0.94% in November 2017, double that of IO loans that have not yet converted and around 0.24 percentage points higher than the overall delinquency rate for securitised mortgages (Exhibit 1).
Banks originated a significant volume of IO loans in 2014 and 2015, which means a record number of these loans are scheduled to convert to P&I over 2019 and 2020, when the five-year IO period ends. IO loans accounted for more than 40% of all mortgages originated by banks for much of 2014 and 2015, with this figure peaking at 46% in June 2015 (Exhibit 2). The long-term average for the share of IO loans originated by banks is around 35%. The origination of IO loans dropped substantially after 2015 in response to regulatory measures introduced to limit the origination of riskier loans.
IO loans accounted for around 32% of all loans in RMBS deals on average as of November 2017. However, on an individual deal basis, the share of IO loans ranges from 0% to 50%. The degree to which individual deals will be exposed to potential delinquencies as loans convert to P&I from IO will depend on each deals’ exposure to IO loans and their IO period maturity profile.
In bank-originated RMBS, IO loans account for about 32% of all loans. Around 22% of the loans in bank-originated RMBS are due to convert to P&I in the next three years, with 6% due to convert in three to five years and a further 4% to convert after five years. In RMBS originated by non-bank financial institutions, IO loans account for about 24% of all loans. Around 12% of loans are due to convert into P&I in the next three years, with the remaining 12% due to convert in three to five years (Exhibit 3).
Mortgages included in bank RMBS deals are typically more seasoned when securitised than the mortgages in non-bank deals. IO loans in bank RMBS will therefore be converting to P&I sooner than loans in non-bank RMBS securitised at around the same time.
Refinancing interest-only loans has become more difficult
Regulatory measures introduced to reduce risks in the mortgage market have curbed the origination of IO loans, making it more difficult for borrowers to refinance their loans at the end of the IO period or extend the IO period for another term with the same lender. The more difficult refinancing conditions will contribute to an increase in mortgage delinquencies as the IO period on a record number of IO loans ends over the next two to three years.
In April 2017, the Australian Prudential Regulation Authority (APRA) placed a cap on IO lending by banks, requiring banks to limit such loans to a maximum of 30% of all new mortgages. In addition, APRA required lenders to ensure strong justification for any IO lending at loan/value ratios above 90%. The measures targeting IO loans followed a 10% limit on growth in housing investment loans by banks, which was introduced by APRA in December 2014. Housing investment loans typically have an IO period. Effective July 2018, APRA relaxed the 10% investment loan limit, but only for banks that can provide assurances about the strength of their lending standards.
Banks have also tightened loan serviceability criteria, resulting in a reduction, on average, in the amount they will lend, following a review of underwriting standards by APRA.
Non-banks lenders are not subject to APRA’s regulatory measures and have stepped up their origination of IO loans. However, because of funding constraints, non-bank lenders are unable to completely fill the gap left by banks pulling back from IO lending.
House prices will also be an important determinant of how mortgages will perform when IO periods end, particularly in circumstances when borrowers need to refinance, extend the IO term or sell their properties. If house prices are declining when IO loan terms end, this will increase borrowers’ loan/value ratios and further limit their ability to refinance or result in a loss upon the sale of the property. Australian house prices have declined by an average of 0.8% over the past 12 months after increasing by just over 30% over the previous five years.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
