RBA warns on speculation, lending standards

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By Leith van Onselen

The Reserve Bank of Australia (RBA) has today released its half-year Financial Stability Review (FSR), which suggests the RBA is fairly relaxed about the pick-up in house price appreciation and the strong growth in investor lending, but cautions that the situation could deteriorate:

The continued low interest rate environment, together with rising asset prices, has encouraged a shift in households’ preferences toward riskier, and potentially higher-yielding, investment options. In particular, there has been a marked pick-up in housing loan approvals to investors, as well as to repeat-buyer owner-occupiers (although there may be some misreporting that is suppressing indicators for the first home buyer category). Six months ago, a sharp increase in housing lending to these types of borrowers was underway in New South Wales but, more recently, prices and demand have begun to pick up in some other states (Graph 3.3).

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Housing demand has been particularly strong in Sydney and Melbourne and the strengthening in these markets is evident in a range of indicators (Graph 3.4). For instance, investors now make up more than 40 per cent of the value of total housing loan approvals in New South Wales – similar to the previous peak reached in 2003 – and the share is also approaching earlier peaks in Victoria. In addition, in Sydney the auction clearance rate remains at a historically high level and housing turnover (sales) has picked up since the middle of 2013. Improved market conditions are also boosting dwelling construction, particularly for higher-density housing in Sydney and Melbourne.

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Stronger activity in the housing market, particularly by investors, can be a signal of speculative demand, which can exacerbate property price cycles and encourage unrealistic expectations of future housing price growth among property purchasers…

More generally, an upsurge in speculative housing demand would be more likely to generate financial stability risks if it brought forth an increase in construction of a scale that led to a future overhang of supply and a subsequent decline in housing prices. At a national level, Australia is a long way from the point of housing oversupply, though localised pockets of overbuilding are still possible. While the recent pick-up in higher-density dwelling construction approvals in Sydney and Melbourne warrants some monitoring, the near-term risk of oversupply in those cities seems low. Indeed, concerns expressed by lenders about possible oversupply in the Melbourne apartment market over the past year seem to have lessened, despite rental yields there remaining quite low.

A build-up in investor activity may also imply a changing risk profile in lenders’ mortgage exposures. Because the tax deductibility of interest expenses on investment property reduces an investor’s incentive to pay down loans more quickly than required, investor housing loans tend to amortise more slowly than owner-occupier loans. They are also more likely to be taken out on interest-only terms. While these factors increase the chance of investors experiencing negative equity, and thus generating loan losses for lenders if they default, the lower share of investors than owner-occupiers who have high initial loan-to-valuation ratios (LVRs; that is an LVR of 90 per cent or higher) potentially offsets this. Indeed, the performance of investor housing loans has historically been in line with that of owner-occupier housing loans…

Available evidence suggests that there are two sources that are providing some additional demand for housing: non-resident investors and self-managed superannuation funds (SMSFs). Lending to these borrowers, however, remains only a small share of total housing lending…

On balance, therefore, while the pick-up in investor activity in the housing market does not appear to pose near-term risks to financial stability, developments will continue to be monitored closely for signs of excessive speculation and riskier lending practices…

The FSR does, however, warn lenders not to drop their lending standards:

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It will be important for financial stability that banks do not respond by unduly increasing their risk appetite or relaxing their lending standards. One area that warrants particular attention is banks’ housing loan practices… The pick-up in lending for housing would be unhelpful if it was a result of lenders materially relaxing their lending standards. Although current evidence suggests that lending standards have been broadly steady in aggregate, there are indications that some lenders are using less conservative serviceability assessments when determining the amount they will lend to selected borrowers. It is important for both investors and owner-occupiers to understand that a cyclical upswing in housing prices when interest rates are low cannot continue indefinitely, and they should therefore account for this in their purchasing decisions.

Although aggregate bank lending to these higher-risk segments has not increased, it is noteworthy that a number of banks are currently expanding their new housing lending at a relatively fast pace in certain borrower, loan and geographic segments. There are also indications that some lenders are using less conservative serviceability assessments when determining the amount they will lend to selected borrowers. In addition to the general risks associated with rapid loan growth, banks should be mindful that faster-growing loan segments may pose higher risks than average, especially if they are increasing their lending to marginal borrowers or building up concentrated exposures to borrowers posing correlated risks. As noted above, the investor segment is one area where some banks are growing their lending at a relatively strong pace. Even though banks’ lending to investors has historically performed broadly in line with their lending to owner-occupiers, it cannot be assumed that this will always be the case. Furthermore, strong investor lending may contribute to a build-up in risk in banks’ mortgage portfolios by funding additional speculative demand that increases the chance of a sharp housing market downturn in the future.

Personally, I am less sanguine about the risk outlook, given:

  • values are approaching all-time highs relative to inflation, GDP, and incomes;
  • the ongoing unwinding of the once-in-a-century commodity price and mining investment booms, along with the risk of a sharp fall in iron ore prices;
  • unemployment is at decade highs and likely to rise further, whereas income growth is likely to remain anaemic; and
  • the increasing number of property investors, which heightens downside risks from rising unemployment and/or when the market turns (especially amongst those who are negatively geared).
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For now, though, risks appear contained, with non-performing loans having fallen in line with the reduction of interest rates:

The non-performing share of banks’ domestic housing loan portfolios edged lower over the six months to December 2013, to 0.6 per cent. This ratio has declined from its peak of 0.9 per cent in mid 2011, aided by low interest rates and generally tighter mortgage lending standards in the period since 2008. The ratio of impaired housing loans has fallen slightly over recent quarters; the rise in housing prices appears to have helped banks deal with their troubled housing assets, with a number of banks reporting a reduction in mortgages-in-possession. NPL ratios for both the owner-occupier and investor loan segments have declined since 2011; these two loan segments have tracked each other closely over the past decade.

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About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.