When will falling house prices choke the banks?

To understand this question we first need some bank capital 101 from MB’s banking insider, Deep T:

There are two ways an Australian Deposit taking Institution (“ADI”) calculates capital to be allocated against a residential mortgage. Either in accordance with APRA’s APS 112 Attachment C or under Advanced Basel II methodology. Let’s address the rather simple APRA methodology first and then look at the implications of the advanced method.

My critics may be saying that I oversimplify. If it’s the simple truth then they’re correct but you can’t understand the bigger position without knowledge of the basic fundamentals. That’s where it starts.

My simple question is, how much capital does an ADI need to allocate to a mortgage over time? Let’s start with a $100 mortgage and the table below from APS 112 for standard mortgages.

The way ADI capital calculations are articulated, a 100% weighting on a $100 loan asset translates into $8 of capital but APRA weights standard residential mortgages as per Table 4 which shows a lower weight for lower LVR’s.

Therefore if a mortgage is standard and written at 95% LVR then the capital allocated is $100 *75%*8% = $6. On the basis that an ADI wants a 20% return on capital then a borrower pays $6*20%=$1.20 pa to the bank as a return on capital. We’ll not complicate matters by doing the calculation for mortgage insurance as this also involves calculating the capital required for the LMIs.

However, I will make the unsubstantiated statement that the total capital now in the system needed by both the ADI and LMI is at least equal to the amount required for an uninsured mortgage. However, for a very long time it was not and a significant arbitrage was in the system between ADI’s and LMI”s until 2008.

The definition of standard loan is as follows as referenced in APS112.

6. A standard eligible mortgage is defined as a residential mortgage where the ADI has:

(a) prior to loan approval and as part of the loan origination and approval process, documented, assessed and verified the ability of the borrowers to meet their repayment obligation;
(b) valued any residential property offered as security; and
(c) established that any property offered as security for the loan is readily marketable.

The ADI must also revalue any property offered as security for such loans when it becomes aware of a material change in the market value of property in an area or region.

Sounds reasonable enough, even the last sentence. But here lies the “arbitrage the system” opportunity that every banker dreams of. APRA in APS-112 have insisted that property is revalued by an ADI if “it becomes aware of a material change in the market value of property in an area or region”. I will express an opinion here that I’m sure APRA was trying to protect against properties falling in value but have left open the biggest game in town for all our banks.

Currently the major and regional banks use the services of the new technology of automated valuation models (AVMs) to revalue their mortgage books upwards to decrease their capital requirements. Has a light switched on yet as to why there has been such a dramatic rise in the use and media coverage of those property valuation spruikers. If anyone knows of one of those banks who do not use AVMs can you please let us all know.

So what is the effect of continually revaluing the properties upwards? Using our standard 95% LVR mortgage above, let’s assume a revaluation so that the LVR is now 85%. The capital required is now $100*50%*8%= $4 with a return on capital requirement of $4*20%= $0.80 pa. Quite a difference, and if we go one step further, then the result and achieve a 75% LVR then the capital is now $2.80 with a return requirement of $0.56.

So with roughly a revaluation of the property of 20% (ask any property spruiker, “That’s nothin’ mate!”) a bank can save itself $3.20 of capital per $100 of mortgage which can be recycled as capital to support another mortgage. Think about how that increase in both return on capital and funds allocated to another mortgagor slave is an absolute incentive for bankers to perpetuate the cycle up of house price valuations. Their reward? Huge bonuses based on what is in essence a positive reinforcement spiral where everyone pats each other on the back for what a great job they’re doing. Well at least, that is, until the money runs out.

This is an old post and it must be noted that the amount of capital reserved per mortgage has lifted post-Murray Inquiry. But the dynamics of “rehypothecation” – which is what this multiple levering of assets is called – remain intact.

The issue is that as house prices fall the process reverses. If the correction is long and deep enough, bank’s will have to begin to revalue their housing collateral downwards. Under the bank’s internal models, the capital requirement is set against the average loan-to-value (LVR) ratio across the mortgage lending book. So, if the prices of underlying asset falls, the average LVR will rise and the bank will need to hold more capital.

For now, as lending falls away and bank capital is contracting via equity falls, this is manageable. But, at a certain point, the collateral implosion and capital destruction will become material and start to inhibit lending all by itself. This is often called a “capital constrained” or “zombie” bank. At that point the banks will need to raise more capital by cutting profits, dividends or issuing equity which obviously leads to more equity falls. When does this point come?

The internal ratings of the banks are a black box so we don’t know. But it is fair to say that the Aussie banking system has never been tested by the kinds of deep and enduring price falls currently underway and forecast in Sydney and Melbourne. If they do fall 20% then I suspect that those triggers will be breached. There is also the issue that provisions for losses will rise making it worse. At which point one of two things will happen.

Either bank equities will crash and Australia enter a more severe credit crunch. Or, APRA will change the capital rules.

Or, perhaps most likely, both.

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