RBA’s dodgy negative equity analysis

Via the excellent Damien Boey at Credit Suisse:

We think that the RBA will cut rates, probably in 2H. For further discussion of this view, please see our recent article “Can you feel the tension at the RBA” dated 20 March 2019. But we also think that officials are thinking about monetary policy with reference to a bygone era. While the RBA is optimistic that rate cuts will actually mean materially lower effective borrowing costs for mortgagees, there are a number of reasons to think otherwise:

  1. Officials are now coupling the household cashflow boost from rate cuts with the prospect of AUD/USD depreciation. They are looking for reasons for why cuts might work, but they are not confident in any particular channel.
  2. The legacy of elevated interbank credit spreads, plus margin squeeze for banks coming from lower rates, are likely to limit pass through of cash rate cuts to mortgages. To be sure, interbank credit spreads have narrowed quite a bit recently. However, the level of spread represents the marginal funding cost, which should (and does) lead the rate of change in the average or total. Even after the narrowing of interbank spreads that we have seen, there is a pipeline of out-of-cycle rate hikes to reckon with.

We are also concerned about the quality of the RBA’s analysis of negative equity. In the recent Financial Stability Review, the charts suggest that negative gearing is not an issue in the key states of NSW and VIC. It seems to be only a material issue for WA. But:

  1. Every 1% decline in house prices causes a 2% decline in the average equity of borrowers. Therefore a 15% peak-to-current decline in Sydney and Melbourne house prices corresponds with a 30% decline in Sydney and Melbourne mortgagee equity. Even leaving aside distributional issues, this is a very large number.
  2. Distribution matters. The RBA numbers are highly aggregated, and therefore miss distributional issues. You would not be able to see the concentration of negative equity risk in NSW and VIC on the RBA’s numbers, because they are calculated across portfolios, rather than with respect to individual assets. Presumably, recent borrowers, those with interest-only loans and those of lower income and wealth cohorts are the ones facing negative equity at present.

It is a given that if unemployment rises, negative equity could be a problem. But it is an open possibility that negative equity, as it is concentrated, could be an issue in its own right, especially if cashflow constraints cause consumption growth to slow or weaken, leading to higher unemployment. And when it comes to valuing banks, investors certainly care about the equity of borrowers, regardless of the state of unemployment …

 Quite right. The lunatic RBA’s glass half full lens once again cracked.

To me this simply means that rates have to go deeper still.

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