Interest-only loans, according to a report by JCP Investment Partners, could be “Australia’s sub-prime” as they proliferate through banks’ mortgage books and “across cohorts and circumstances”.
The report entitled Over Capitalised, Over Extended… LTI Overlooked? released earlier this week said that Australia’s banking system “looks vulnerable”, especially due to the fact that “the old loan-to-income (LTI) ratio has left the banking lexicon, exposing a risk that we may have over-capitalised incomes and hence over-extended credit into certain cohorts”.
“Understanding the borrower’s capacity to service as time moves on is paramount. Many bank bad debts are caused by future changes in borrower circumstances,” JCP said.
JCP highlighted that while a corporate loan book is reviewed annually, mortgages are generally not subject to the same level of scrutiny, even though the amount borrowed could be higher and the lender more exposed.
“Take the eventual transition from ‘interest-only’ to ‘principal and interest’; where does the borrower find the additional 40 per cent repayment obligation? The Australian credit system now looks over exposed to one asset class — the residential home.
“Given the dynamics of the Australian housing market over the last three to five years; low interest rates, proliferation of interest-only products coupled with low income and employment growth, the embedded risks in the mortgage system have increased materially.”
Further, JCP said that it suspects the ‘3x gross income’ rule has been “fundamentally breached” by banks.
“When one scrutinises the typical bank earnings release, the LTI ratio is not mentioned or disclosed... data from the RBA, HILDA, APRA and the major banks, plus our own proprietary sources confirm this.
“Indeed, we believe gross incomes could have been capitalised to well over 6x, which would partly explain the rapid increase in Melbourne and Sydney house prices. What is the difference between 3x and 6x? At least 15 years in repayment terms, assuming no material change in income and the level of interest rates. However, the Australian cash rate has never been lower than its current 1.50 per cent, and the rest of the developed world is beginning to move rates up.
“As exuberance towards the Australian home grew to now irrational levels, the old credit rules of thumb appear to have been left by the wayside. Banks talk about mortgage account numbers, but not values. Banks talk about LVRs, but not LTIs. Banks talk about averages, but not distributions. And banks talk about loss rates of a mere two basis points, but fail to capture a full credit cycle.”
Speaking to Mortgage Business, Angie Zigomanis, senior manager of residential property at BIS Oxford Economics, refuted JCP’s claims that interest-only loans are equivalent to the so-called “ninja” or ‘sub-prime’ loans involved in the GFC.
“I suspect [Australian] financial institutions are a lot more careful about these loans. In the US, a lot of these loans were being securitised and sold off the banks’ books… in this case, most of the banks are responsible for the lending, so you would assume on that basis that they are being more careful compared to what happened in the US,” Mr Zigomanis said.
AMP Capital senior economist Shane Oliver echoed these views, adding, “I think there's a big difference... these people who have got loans, they may be interest-only loans, but they have jobs, they're not bankrupts or people who could never get a loan”.
However, Mr Oliver emphasised that he wouldn’t dismiss the JCP report entirely. He explained that the risks identified by the report are valid observations.
“There are certainly risks there, and those risks pose a threat to our banks should something go wrong,” he said.
“The people who have interest-only loans have jobs, but the risk for them is if they’re not able to keep servicing their mortgage, or if something goes wrong, such as interest rates going up dramatically or they're forced to pay down their loans... I thought the banks would have been more careful, that they would have allowed for that, that at some point these people have to start paying their loans down.”
Like JCP’s discussion of loan to income ratios, Mr Oliver said that an appropriate test that could be added by banks in assessing customers for loans could be in terms of interest rate buffers, “such that if the interest rate rose by a certain amount, can the individual continue to make payments?”
“In Australia, we haven't traditionally done that because people's wages seem to rise as they become more senior... whereas in a world of lower wages growth and higher starting point debt-to-income ratios, then maybe there is a case for banks to impose a maximum debt-to-income ratio as one of the tests they apply in making loans.”
Similarly, BIS Oxford Economics’ Mr Zigomanis emphasised that the risks could potentially be minimised by banks ensuring that they are “much more prudent” when assessing the new round of borrowers that are coming through.
“To some extent, the ones that are already there, they're already exposed... but whether they enforce the switch perhaps from interest-only to principal and interest to help them pay down their loans, that may help as well,” he said.
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