Is Australia on the verge of a US-style subprime mortgage crisis?

30 July 2018
A surge in interest-only home loans due to reset as principal and interest over coming years has sparked fears that Australia is on the verge of a housing meltdown.

Interest-only loans

The Reserve Bank has warned that about two-thirds of the nation’s interest-only loans, worth about $360 billion, are set to roll over to principal and interest over the next three years.

That is $120 billion resetting to P&I each year by 2020 with monthly mortgage repayments to jump 30% to $40%, the RBA has said.

Research and consultancy firm Digital Finance Analytics has estimated interest-only loans to account for $700 billion of Australia’s $1.7 trillion mortgage debt.

Digital Finance Analytics Principal Martin North is one of a few forecasters to publicly predict that this could be Australia’s version of the United States’ subprime mortgage disaster that led to the Global Financial Crisis a decade ago.

Mr North said many borrowers would struggle with the higher repayments and would likely have to sell their homes.

However, four other economic experts told Canstar while the wave of expiring interest-only loans was likely to put more pressure on households, they believed it was unlikely to trigger a subprime mortgage crisis.

Here is what each had to say:

Steve Mickenbecker, Canstar Group Executive of Financial Services:

“For a subprime style crisis you need three conditions – borrowers who can’t afford repayments and default, the value of houses declining so that there is negative equity, and the prior conditions being widespread enough to threaten the viability of lenders, and maybe also triggering further asset devaluation. If the three conditions are not present, then characterising what we are seeing in Australia now as a subprime crisis is extreme.

“My view is that we are seeing a situation that will cause mortgage stress and defaults, with the accompanying financial and emotional damage at the personal level and some impact on bank profitability.  But not to the degree that it will threaten the system.

“The US sub-prime loans were written for people who could never repay interest, let alone principal and interest. In Australia, loans were approved for borrowers who could afford interest payments and for whom there was reasonable expectation based on history that they would be able to afford principal reductions five years on. By the time these loans change status to P&I, people have at least established the preparedness and capacity to make regular interest payments. The Australian credit book is far higher quality.”

Martin North, Digital Finance Analytics Principal:

“In the US, there were a lot of subprime low-end borrowers; lower socioeconomic groups, low income households. Here, we have the same issue with loans that should never have been made because there were never clear plans to repay those loans.

“If you go back 18 months, lending standards were much looser than they are now. There are going to be quite a number of households that will not meet the current interest-only criteria when they hit the five-year checkpoint. Those who can’t get a new loan will be forced to sell.

“I think about one third of those with a problem will be forced to sell and I’m expecting quite a hike in the number of investment properties being forced to sell over the next two to three years. A lot of the problems are in the major markets of NSW and Victoria and in the Brisbane apartment market. This is our equivalent of the GFC because effectively these loans should never have been lent in the first place. Some of those who will have to give up their properties will be first home buyers too.”

Shane Garrett, Housing Industry Association (HIA) Senior Economist:

“To sketch out a nightmare scenario you would first need mortgage repayments to go considerably higher than they are now. Secondly, you’d need people to be unable to service those mortgages, for example in the US people either lost their jobs or had a sharp fall in income. And thirdly, you would need the market value of homes to be much lesser than the outstanding loans.

“I think we have learned from the US. I think the banks have tested sufficiently to make sure people can afford their loans when it switches to P&I. Our labour market is solid and people’s home prices have gone up so much in Sydney and Melbourne in the past few years which means the loan balance would be met if properties had to be sold.

“For those reasons, I think chances of a subprime mortgage crisis in Australia are slim. One of the key protections built into Australia’s system is recourse loans. That means the borrower is liable for the entire value of the mortgage which the bank has lent to them.

“One of the problems in the US 10 years ago is that they had non-recourse loans where banks were only able to seize and sell the home and no more if mortgage repayments are not being met. That’s why people walked away when they couldn’t make their repayments.”

Diana Mousina, AMP Capital Senior Economist:

“AMP anticipates the housing market will be slow in Australia over the next two years. But interest-only loans expiring is only one of a combination of factors that will lead to lower house price growth. We think Sydney and Melbourne house prices are due for another four per cent fall this year and another five to 10 per cent fall next year.

“While there will be a decent amount of interest-only loans rolling over to P&I, it is not the most important factor driving the housing market. We are not so negative on interest-only loans because it is happening over a number of years. The impact is not going to happen right now, it will be gradual.

“The risk is you get a bear housing market, that is a decline in prices of more than 20 per cent year-on-year. We see prices declining from peak-to-trough by about 15 per cent over a number of years. Prices peaked in 2017 and we think the bottom will occur in 2020.

“We don’t see there being a big chance of a subprime mortgage type crisis in Australia because the type of lending here has been quite different to what happened in the US in the lead up to the GFC. But the housing market is one of the biggest risks to Australia’s economic outlook for now.”

Angie Zigomanis, BIS Oxford Economics’ Senior Manager:

“The lending in Australia is not subprime in the same way it was in the US. In the US, people were given a very low rate before resetting to the variable rate. I guess that’s where the comparison is now – people paying interest-only are now having to pay principal and interest because the banks are unlikely to roll over an interest-only loan again.

“There will be a group of people who will face increasing payments and the question is whether they’ll be able to do it. It will depend on people’s ability to refinance but given lending standards are higher, it might be harder for them to do that.

“It is not like everyone is going to be struggling. It is difficult to say how many will struggle and to what extent.

“For someone who bought in Sydney four years ago (and their loan is due to reset to P&I), if push came to shove, they could always sell and it won’t be a big deal for them because the value has gone up.

“But for someone who has bought more recently, for example an apartment where prices have fallen, then they could be in trouble. One protection our system has is recourse lending. The US had non-recourse lending in a number of states where as we have full recourse lending where people are obliged to settle. Recourse means the bank can chase your other assets.”

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