The spooky mortgage risk signs our bankers are ignoring

Cross-posted from The Conversation:

I’m not normally a fan of parliament hauling private sector executives before them and asking thorny questions. But when the Australian House of Representatives did so this week with the big banks it was both useful and instructive.

And, to be perfectly frank, terrifying.

Let’s start with Westpac CEO Brian Hartzer. First, he confirmed the little-known but startling fact that half of his A$400 billion home loan book consists of interest-only mortgages.

Yep, half. Of A$400 billion. At one bank. Oh, and ANZ, CBA and NAB are all nearly at 40% interest-only.

Hartzer went on to make the banal statement: “we don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

So did it make sense for all those American mortgage lenders to lend to people on adjustable rates, teaser rates, low-doc loans, no-doc loans etc. before the global financial crisis?

Of course not. The point is that banks are not some benevolent, unitary actor taking care of their own money. There are top managers like Harzter acting on behalf of shareholders. Those top managers delegate authority to lower-level managers, who are given incentives to write lots of mortgages. And, as we know, the incentives of those who make the loans are not necessarily aligned with those of the shareholders. Those folks may well want to make loans to people who can’t pay them back as long as they get a big payday in the short term.

ANZ CEO Shayne Elliot repeated Hartzer’s mantra, saying: “It’s not in our interest to lend money to people who can’t afford to repay.” Recall, this is the man who on ABC’s Four Corners said that home loans weren’t risky because they were all uncorrelated risks (the chances that one loan defaults does not affect the chances of others defaulting). That is a comment that is either staggeringly stupid or completely disingenuous.

Messers Harzter and Elliot must take us all for suckers. They have made a huge amount of interest-only loans, at historically low interest rates, to buyers in a frothy housing market, who spend a large chunk of their income on interest payments. This certainly looks troubling. It may not be US sub-prime, but it could be ugly. Very ugly.

To put it in context, there appears to be in the neighbourhood of A$1 trillion of interest-only loans on the books of Australian banks. I say “appears to be” because reporting requirements are so lax it’s hard to know for sure, except when CEOs cough up the ball, like this week.

The big lesson of the US mortgage meltdown is that the risks on these mortgages are all correlated. If a few people aren’t paying back an interest-only loan, that is a fair predictor that others won’t pay back their loans either. Yet it seems Australian banks are a decade behind the learning curve.

The Reserve Bank cautions that one-third of borrowers don’t have a month’s repayment buffer. And where are interest rates going to go from here? Up. It is just a question of when. And when that does happen – or when the interest-only period on loans (typically five years) rolls off and principal payments start having to be made – watch out.

We should all remember that the proximate cause of the US mortgage meltdown was borrowers with five-year adjustable-rate mortgages (ARMs) that had huge step-ups in repayments and needed to be refinanced to be serviceable. When the market couldn’t bear that refinancing, defaults went up. Then the collapse of US investment bank Bear Stearns, then Lehman, then Armageddon.

Australia’s large proportion of five-year interest-only loans – turbocharged by an out-of-control negative-gearing regime – looks spookily similar.

It’s one thing for borrowers to do silly things. When it becomes dangerous is when lenders not only facilitate that stupidity, but encourage it. That seems to be what has happened in Australia.

And APRA’s “crackdown” and the Reserve Bank’s warning may be far too little, way too late.

We might stumble though this. I hope we do. But if so, it will be because of dumb luck, not good institutional and regulatory design. And definitely not because of good corporate governance.

Whatever happens, we should learn those lessons.

Article by Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

Comments

    • Yeah….it’s like saying fk we had a security breach at the airport…we’ve fixed it so no more bombs should be able to get through….but we’re f$&ked if we know how many are already on the plane…ok now would everyone please fasten their seatbelts…

  1. Remember Mr Grin the crocodile from Peter Pan who ate the clock.
    Whenever Mr Grin was around you could hear the clock ticking.
    Well there is tocking sounds coming from the banks!
    Westpac boss, Brian Hartzer recently let on, under mild torture, that half of his $400 billion home loan book consists of interest-only mortgages. $200 bill out of $400 billion for WBC.
    Meanwhile ANZ, CBA and NAB are all nearly at 40% IO as well.
    Well some say so what; Well, say the IO loans have a term of 5 years, which they generally do.
    Well, say they were taken out, say average 3 years ago, so the balance of the term is say 2 years
    So, well a small rise in interest rates could tip one million Australian households into financial stress.
    And the Reserve Bank tells us 1/3 of borrowers don’t have a month’s repayment buffer.
    And, where the cost of putting a roof over your head was 13 % of our spending ; is now near 20%.
    For at least 1/4 of the population they have no further money,
    Where the loans were made at the lowest rates since records were kept
    And repaying a mortgage and bills requires a couple, how about if they separate?
    In a housing market which has peaked, who will buy the IP?
    And in an employment market which is shrinking. Say 30% of jobs gone in 5 years. But where the govt says to suck it up.
    And the loans have to be converted to P&I loans say from say next year
    And the RBA says interest rates to go up in 2018

    WW what have i left out.

    • SoMPLSBoyMEMBER

      Great summary WW!
      One other ‘little known fact’ of the whole program is the expected naivety and nearly complete vulnerability of any single person when things go rotten. The kind, interested in your family, pillar of Strayan lending, commerce and dignified business( by day) easily turns from Dr Jekyll into Mr Hyde in a heartbeat.

      The list of illegal activities and corruption serves as a fortress of complexity that can rarely be conquered; even with a trained mercenary force as a potential ‘equal’ like a law firm can grab nothing but air. Good fn ‘luck’ if you’re a ‘privateer’ who thinks your ‘loss’ ( their gain) will evoke any sympathy and naturally, a restoration of your prior financial standing as ‘it’s the moral thing to do.”
      In it’s simplest form, borrowing with an IO loan against any equity asset is just speculation–no matter how hard the lenders try and equate this approach to ‘sensible’ and ‘prudent’ wealth accumulation.

      It will always carry enormous and potentially crushing risks that most will never understand. When the market goes against expectation and the underlying collateral appears to ‘temporarily’ ( or permanently) no longer represent security for the loan, whatever deal one thought they had that carried a firm handshake with a nice suit employed by a Pitt or Collins St representative, will now be administered by Mr Hyde and associates. The very real terror and shame that results, which incapacitates and distorts the logical thinking, is precisely the human behaviour that can be expected and it’s no match for the inexhaustible resources and patience of the firm. And, the firm will never lose like an individual loses; all the ‘safeguards’ and ASIC and APRA ‘this and thats’ are for their benefit only. It’s the marketing arms of the firms that have convinced the public that safety valves and protections exist for the little person.

      So, 50% of the loan book is IO. Pure speculation on both sides of the table yet one side has the ability to seize and liquidate the other’s assets if a trigger point is reached.
      We’ve seen this play before in the FP theatre and no one should be surprised when the sequel premieres over in the RE theatre of the absurd.

      So we don’t forget:
      http://www.smh.com.au/business/macquarie-private-wealth-the-silver-doughnut-that-left-a-hole-in-investors-nest-eggs-20140801-zzcst.html

      “Some gotta win, some gotta loooo-oose. Good time Charley’s got the blues”

      • You’re right about it being speculation, however I suspect most of them aren’t “speculators” but people who simply cannot afford to pay for a proper mortgage, which is even more scary. It would all work out great when prices rise as they have done or when it’s easy to refinance at a low rate in perpetuity… but those days seem to be leaving us.

      • SoMPLSBoyMEMBER

        @Zulu- Solid thought. Be great to see the breakout on that. At the ground level, it would appear that most purchasers have an idea that the gov’t is somehow responsible for ensuring said borrowers are ‘looked after’ inside of some bizarro social compact. In a way, they are right but equity assets sometimes bring surprises for many reasons.

    • What have you left out?

      The bit where these people on a razor’s edge pull the ripcord and get out, no damage done 😉

      … all at the same time, of course.

  2. ““we don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

    We prefer to lend to people who choose not to pay it back. That makes the most sense for us as they will be paying interest to us for ever.

  3. “we don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

    Lies. It makes perfect sense when you know your bank is too big to fail and will be bailed out by the taxpayer.

    Once you know that, the only behaviours that makes sense is to try to outcompete your peers for market share by being the most free and easy lenders on the block. Profits will be great as long as things are rosy – and if not? Well. Risk is the taxpayers’ problem.

  4. Jake GittesMEMBER

    And Westpac is looking for a Head of Strategy

    This role is responsible for leading the development of both tactical and long-term innovative strategies for the Home Ownership business to deliver growth and market leadership. The role will see you leading business & growth strategy, in addition to product, segment and customer strategies.

    This role reports directly to the Head of Home Ownership and is a critical role on the Home Ownership leadership team. To be successful in this role you must be an experienced strategic thinker with 5 years+ experience in similar or related business strategy roles. You must also have a deep understanding the home ownership operating environment as it relates to changing regulation, the political agenda, our competitors, markets and customer trends. You must also be able to thrive in a complex and constantly changing environment and formulate strategies and recommendations accordingly.

    https://www.seek.com.au/job/34606493?type=standard&userqueryid=77838e9f2cef4ec86e50aeedaf9c81a6-5090673

    • Mining BoganMEMBER

      That’s an old fashioned suicide mission, running headlong into a machine gun nest wearing nothing but runners and grenades.

      They’re looking for a fall guy for when TSHTF. “Wasn’t our fault, the new guy did it.”

      • Who was that (contractor) guy who blew up RIO?? Took all the blame
        How about that south african lady who blew up billabong, and the lady who blew up that dream world mob?
        Murray Goulborne Myer, Cudeco, , I’m gunna need a spread sheet for this.

    • billygoatMEMBER

      @ Jake Gittes

      “You must also have a deep understanding the home ownership operating environment as it relates to changing regulation, the political agenda, our competitors, markets and customer trends.”

      ‘the political agenda’
      THE POLITICAL AGENDA – SORRY FOR SHOUTING!!!!!!!!!!!!!!!!!!!!!!!!!!!!!

  5. The only thing to do with the IO loans is to refinance them with further IO loans at the current interest rates providing valuations and employment levels are the same. If any of those assumptions do not hold up……you all know the rest, it’s happened often enough already, ah?

  6. AlbyManglesMEMBER

    Let’s start with Westpac CEO Brian Hartzer. First, he confirmed the little-known but startling fact that half of his A$400 billion home loan book consists of interest-only mortgages.

    house prices have not moved much in southern Sydney for about 12 months, actually gone down a bit around hurstville, so how many people are underwater already, I don’t think many investors who have bought in the last couple years will even come close to getting their stamp duty back, people who bought 4 years ago will have covered their stamp duty of about 100 – 150k. when do people start thinking whats the point of paying all this interest

  7. Hartzer went on to make the banal statement: “we don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

    People who can just stretch to covering the interest payments by living off noodles, however, are very profitable and dependable customers.

  8. If rates go up say even 1% , we’ll probably see a high number of defaults. However, the debt levels are so high now interest won’t go up imo unless there us an external shock…in the mean time it immigration full gas! All the CB’s know this, all i’d be surprised if they deliberately crash the system.

    • Rates do not need to go up in order for defaults to start. In the US after the crash they were offering stupid low interest rates, like 3% fixed for 30 years, still didn’t help.

      Once it starts rolling, it will not stop. It will overshoot to the bottom before climbing up to the long-term average.

      The question, of course, is when.

      • Absolutely, Max. Funny how most people think if interest rates stay low everything will be fine. We have the same rates in Brisvegas, Darwin, Perth, mining towns and Nth Qld and what happened to that friggin’ lot, ah?

      • I agree Max and there are defaults now due to people loosing jobs, getting sick, an that’s happened to a few people I know. All, I was trying to say is that to see lots more defaults like in the US a shock will probably occur. I was actually living there at the time, and in my neighbourhood the foreclosure signs were there for years after.

  9. michael francis

    Makes you wonder if a borrower with both interest and principle repayments walks into a bank and says” I can’t afford this loan any longer”, and the bank responds “Don’t worry we will refinance it as an IO loan.” so they can keep a lid on defaults.

  10. Many loans are int only with offset abd people are paying back
    I’d say only a very small portion would be people who are only paying interest and can’t repay the debt.

    • Based on admittedly anecdotal evidence, mainly colleagues of mine on mid-high incomes, this is unlikely to be the case for an awful lot of people. IO is the only way they can afford to buy a house. Zero savings, credit cards and “no repayments for 24 months”-style purchases are the norm.

    • TailorTrashMEMBER

      If 40-50 % of all loans are intrest only then even a small part of that in trouble would not be awfully healthy for the banks ……..suspect it might be bigger than we think …..wonder why the banks don’t spruke that it’s all OK because strayans are savy and all have offset accounts ……

    • People stick money in offsets so they can fund future consumption and/or have a contingency whilst minimising their interest repayment. The reality is that these people cannot afford to pay off their principal with the bank, otherwise they would!, and fund their future consumption and/or have a contingency.

  11. “It’s one thing for borrowers to do silly things. When it becomes dangerous is when lenders not only facilitate that stupidity, but encourage it. That seems to be what has happened in Australia.”
    NONE of this can be done without the RBA facilitating the process with policy of negative RAT interest rates!!! So haul in the RBA as well.

  12. Great and clear exposition by Professor Holden, but he writes as though this is a suddenly discovered new thing. I’ve been reading MB for a few years now, and I could have written pretty much the same story 3 years ago based on that alone.

    • billygoatMEMBER

      I’ve been reading MB for a few years now, and I could have written pretty much the same story 3 years ago based on that alone.

      @LSWCHP
      Same here. Anyone with half a brain and their eyes open and perhaps with half an ounce of common sense could write the same thing (and yes being a reader of Macrobusiness.)
      The Australian economy, RE & Finance banks, govt etc are driven by greed, nepotism, cronyism, corruption, wilful ignorance and the proverbial ‘blind eye’
      In my opinion it is mostly by design, nevertheless anyone with basic grasp of maths & reading could work out whats happening or at least ask a few questions. I did!
      Although I found them mocked and myself shunned in polite society (REA & finance and generally well off people.)

      I believe my frustration and pure anger would prevent me from penning something articulate however the

  13. Poses systemic risk.

    Extraordinary that regulators and banks have let interest only lending get to such levels. Interest only in the U.K. represents 20% of the mortgage market, lower in the US where Federal regulators referred to interest only loans as “toxic” post housing collapse.

    • Even if IO is 20% in the UK, post-GFC you need to be able to demonstrate to the bank how you’ll repay the loan (e.g. put a corresponding monthly amount into mutual funds). Mathematically, there is no way the Aussie IO pool can be repaid. It’s extend and pretend.

  14. “decade behind the learning curve”

    I disagree with that comment. The banks learnt from the GFC that they are TBTF. They can focus on reckless lending to maximise profits (and bonuses) with the full knowledge that tax-payers will pick up the tab when it all turns ugly.

    • Bingo. And if the people are stupid enough to elect a government that sells their gas, let’s their banks annihilate them and gives everything else to China, they deserve to be weeded out of the gene pool.

  15. Probably worth keeping in mind that it’s been commonplace for years now to take out an I/O loan with full offset facility, practically mirroring (from the mortagee’s perspective) the mechanics of a P&I loan (ie: dump all your money into this account to offset your interest), while maintaining maximum flexibility for future negative gearing.

    This will skew the stats somewhat (I’m led to believe that “offset” accounts are relatively unique to Australia) – though I’m sure there’s still terrifying amounts of exposure.

    • My partner and I set up a loan facility when we were going to auctions earlier in the year, before we decided it was a mugs game and continued to rent. It was structured as an IO loan with an offset account, and we intended to pay it off very quickly, but we liked the idea that the money was available in the offset account if we needed it for an emergency.

      So I think we knew what we were doing, and there may be many others who did the same. On the other hand, there were recent reports on MB that a lot of mug punters may have IO mortgages without even knowing that to be the case, and I would not be at all surprised if this were true. The level of financial literacy and mathematical ability in Australia is staggeringly low.

      • What’s even more amazing, LSW is the number of people who blindly believe that property always goes up because of blah blah blah….. somebody should tell them about Google search……They probably will believe that pollies act in the best interest of the country and not in the best interest of getting reelected

    • Probably worth also keeping in mind several recent surveys stating a terrifying amount of people don’t even know they are on IO or what mortgage insurance does!

  16. Jumping jack flash

    The only measure of risk that is worth noting is LVR. And it is grand! Robust. Secure. Rock solid. As sure as an Irish housing development! No problems with the LVR, no sireeee!

    50% of the loan book might be I/O, but I’m sure its attached to houses that are well over the acceptable LVR, and then of course there’s mortgage lender’s insurance so the bank has no worries, mate.

    I believe Westpac insures itself… but that’s beside the point. It can do whatever it likes because nothing will happen.

    Every time someone takes on an even bigger debt mountain than the last guy and throws every cent of it into the vendor’s bank account in one go, all the houses rise in price and LVR improves.

    There simply is no risk. All this talk of risk and I/O is rubbish. If there are any problems with the debt, just sell the house its attached to, pay it back, and walk away debt free and rich… from someone else’s debt… someone who can manage an enormous debt mountain.

    There’s nothing as satisfying as throwing the largest pile of debt you can possibly carry, up the pyramid for the vendor to wallow around in like a pig. The vendor’s worked hard for that cash you know! They’ve toiled away for hours covering up all the cracks, and rot, and water stains, and mowing the lawn!

    • This is the thing… people with an ideological bent confuse a liquidity moment acerbated by aggressive short selling as an RE bubble pop.

      disheveled…. it could have been a simple S&L level event, but….

    • TailorTrashMEMBER

      ……and the smug look on the faces of those on the champagne Europe river cruise which has become a “rite of passage” for the children of the generation who died on Kokoda to defend Straya and is funded by the sellout of their homes …………how sad ………how sad indeed…….(metaphicaly speaking )

  17. anyone know where i can access a breakdown of loan book breakdown or mortgage (esp retail) of ach of the banks to various regions eg Vic NSW etc also particularly interested in the non big 4 – eg regional banks such as Bendigo etc. thanks in advance

  18. So for those of us that have sat on the sidelines watching the horror movie that is the australian housing market, while squirrelling away as much of our hard earned wages as we can….how do we protect ourselves against the grasping hands of bank failures?

  19. There are gonna be a lot of people doing the nudie run when this tide goes out…which no doubt it will….However as happened in Ireland, England etc…the rich and well connected will salt away their funds from the banks and taxman, declare bankrupt if necessary and not pay a cent…hand in the keys of the properties….wait a few years…buy distressed property with salted cash in wifes name or whoever and start the whole merrygo round again…Dublin house prices are now above the price they were when they crashed 10 years ago….people are getting very rich as the countries people are floundering…its just one serious reusa relations party after another…

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