RBA asleep at the wheel on household debt

By Leith van Onselen

The Reserve Bank of Australia (RBA) has released a new paper examining the household sector’s financial resilience to macroeconomic shocks, which draws upon data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey.

The key findings of the paper are as that Australia’s households are well-placed to manage their record high debt loads since the debt is generally held by those that are best capable of servicing it – i.e. higher income earners:

The model suggests that through the 2000s the household sector remained resilient to scenarios involving asset price, interest rate and unemployment rate shocks, and the associated increases in household loan losses under these scenarios were limited. Indeed, the results suggest that, despite rising levels of household indebtedness in aggregate, the distribution of household debt has remained concentrated among households that are well placed to service it. In turn, this suggests that aggregate measures of household indebtedness may be misleading indicators of the household sector’s financial fragility.

The paper uses a number of tables and data to support its findings, including the next one showing the slightly rising share of household debt in mortgages, especially investment homes:

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And the rising share of debt amongst older, wealthier cohorts (i.e. baby boomers):

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Household debt generally appears to have been well collateralised during the 2000s. The share of household debt secured by property rose slightly over the decade, to be nearly 90 per cent in 2010 (Table 2). About half of household debt was for the purchase of owner-occupier property (‘primary mortgages’). However, the rise in the share of household debt secured by housing was due to an increase in ‘other’ housing loans, such as second mortgages secured against owner-occupier property (e.g. home equity loans) and loans for the purchase of investment property.

The RBA paper also believes that financial health improved over the 2000s, given a “number of self-reported indicators of financial stress declined,
such as the share of households unable to make a bill, rental or mortgage payment on time”:

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Further, the share of households with negative financial margins fell over the decade from “12 per cent in 2002, 10 per cent in 2006 and 8 per cent in 2010” (see next chart):

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The RBA paper then undertakes two stress tests: one based on a “historical scenario” (modeled on the GFC experience) and another “hypothetical” scenario in which a global deterioration in economic conditions causes a significant downturn in Australia (see below table and chart).

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The results are as follows:

Under the historical scenario, the share of households with negative financial margins falls in all years by around 1 percentage point relative to the pre-stress baseline (Figure 9). This is due to the fall in interest rates, which more than offsets the rise in unemployment…

The hypothetical scenario is much more severe, along most dimensions, than the historical scenario. Accordingly, under this scenario, the share of households with negative financial margins increases by around 2 percentage points in each year, to a total of 13 per cent in 2002, 11 per cent in 2006 and 10 per cent in 2010 (Figure 11).

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Under this scenario, households in the middle of the income distribution and renters are the most affected (Figure 12). Households with younger heads are also affected, while household with older heads are not especially affected in any year, suggesting that the increase in indebtedness among these households through the 2000s did not significantly expose the household sector to additional risks…

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The results from the hypothetical scenario suggest that the household sector would have remained fairly resilient to macroeconomic shocks during the 2000s, and that the households that held the bulk of debt tended to be well placed to service it, even during macroeconomic shocks…

The RBA does, however, note some limitations with its analysis, including:

Household surveys may not adequately identify households with negative financial margins (for instance, because households tend to understate their debt and income).16 In addition, although efforts are made to ensure that the HILDA Survey sample is representative, households with precarious finances often do not disclose their financial position, while higher-income households are less likely to remain in the survey over time. Furthermore, household surveys such as this are generally only available around 12 to 15 months after fieldwork has been completed, reducing their usefulness as a real-time stress-testing tool…

The predictive ability of household micro-simulations is relatively untested. While these models have been established in a number of countries, none of these countries have had recent crises that emanated from the household sector.

Nevertheless, the RBA is happy with its results:

The results from the two stress scenarios considered – both of which incorporate a substantial increase in the unemployment rate and a substantial decline in asset prices – imply a high level of household financial resilience and limited expected loan losses for lenders. That said, the effect on expected household loan losses of a relatively severe stress scenario, under which unemployment rises, asset prices fall and interest rates are unchanged, increased over the 2000s, suggesting that the household sector’s vulnerability to macroeconomic shocks may have increased a little. However, expected loan losses are actually lower under the less severe of the two scenarios, which has rising unemployment and falling asset prices comparable to Australia’s experience during the financial crisis. This is due to the offsetting effect of lower interest rates, highlighting the potential for expansionary monetary policy to offset the effect of negative macroeconomic shocks on household loan losses.

I personally do not derive too much comfort from these results and believe that Australia’s mountain of household debt poses significant risks in the event that Australia experiences a deep and prolonged downturn.

As shown by Gerard Minack way back in his 2010 housing report, Australia’s household debt profile was very similar to the USA’s just prior to its housing bust (see next chart).

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And this lead Australia’s head of financial stability at the RBA, Lucy Ellis, to conclude at the time that US households’ exposure to mortgages did not pose significant risks and might even be desirable:

The resulting expansion in both sides of the household balance sheet is an important development for policy-makers to monitor, but it is probably not of itself a cause of financial instability…

Particularly in North American markets, simple ratios have given way to credit scoring and risk-based pricing, so that loan sizes and pricing are more closely tailored to individual borrowers’ circumstances. To the extent that this reduces the margin of safety for some borrowers who are now able to borrow more than the older practices would have implied, this might mean that more households are facing greater financial risks than previously. But overall, this easing of financial constraints is a reflection of their ability to repay and withstand those risks. Therefore it cannot be assumed that a shift away from the earlier lending practices based on rigid ratios implies that financial vulnerability has increased in any significant way…

[And] The most important lesson to draw from recent international experience is that a run-up in housing prices and debt need not be dangerous for the macroeconomy, was probably inevitable, and might even be desirable…

A particular concern in the Australian context is the huge rise in investor lending, most of which is negatively geared (see below charts).

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With Australia facing the prospect of heavy job losses as the mining investment boom unwinds and the car industry shutters, along with the weakest expected household income growth in at least 60 years (see next chart), there remains the ever-present danger that a significant chunk of Australia’s investment homes could be sold-off as investors seek to free themselves from their loss making properties.

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Just like in the US, everything is fine until it isn’t, and the RBA should be very wary of Australians increasing their debt loads and house prices into the biggest structural adjustment in decades.

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Unconventional Economist

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