NAB’s decision to limit loan sizes to eight times a borrower’s income is a significant development in a market slowly coming to terms with its own risks.
This week, the major bank announced that applications for interest-only and principal and interest loans will only be approved if they pass a loan-to-income ratio test.
If the LTI is greater than eight, brokers are not to proceed with the application, unless the customer’s financial position has changed.
In the UK, where LTI calculations are the norm, the Bank of England first introduced limits on high LTI mortgages in 2014. These measures meant that no more than 15 per cent of mortgages issued should exceed a loan-to-income ratio of 4.5. The actions were not reactive and few British lenders were impacted by the curbs.
Meanwhile, in Australia, the prudential regulator chose targeted investor loans as a way of managing risk. The impact of APRA’s 10 per cent investor lending limit has been significant for the banking community, with some lenders forced to pull out of the segment altogether, albeit for brief periods at a time.
The UK’s 4.5 LTI cap on 85 per cent of new lending is still in place. Back in June, Bank of England governor Mark Carney announced that the 4.5 ratio “insurance measures” will become “structural features of the UK housing market”.
Now Australia is on the LTI bandwagon, spearheaded by NAB, but according to Digital Finance Analytics principal Martin North, the domestic mortgage market is still far too risky.
NAB’s decision was driven by what it describes as “concerns about Australia’s household debt-to-income ratio, which has risen significantly over the past decade”.
“I wasn’t surprised that they have come out and said LTI will be on their agenda,” DFA’s Martin North said, noting that LTI is the best indicator of risk.
“LVR doesn’t tell you much, because as the value [of a property] goes up, the LVR goes down, so effectively the LVR gap just chases the market,” Mr North explained.
“In terms of the debt servicing ratio, that doesn’t really work either because it is based on what current interest rates are.”
From a risk perspective, these two widely used metrics don’t tell you much. Mr North said: “Loan-to-income is the critical one.”
However, the analyst admitted that he was “astonished” to find that eight times income was NAB’s hurdle.
“I see lots of evidence in my surveys of buyers, particularly in Sydney and particularly first home buyers, with an LTI of seven, eight, nine and over. Based on a scenario of interest rates going up 2 or 3 per cent, it shows that those above a loan-to-income ratio of five or six are significantly more at risk.”
As a principle, Mr North welcomes the move from NAB. “But as a benchmark, eight is very high,” he said.
Regulatory-driven credit tightening through pricing and policy changes has become the soundtrack of the Australian home loan market since 2015. NAB’s LTI move is the latest in a long line of changes intended to mitigate risk.
However, what concerns Mr North are the mortgages written before any of these measures were put in place.
“It’s the water under the bridge that’s the risk. All of my analysis says the highest risk is not from loans being written today. It’s the ones written over the last three to five years. That’s because the underwriting standards were far too generous and the expenses side in particular were a problem.”
Mr North said that he expects LTI will become more of a standard in Australian lending and that regulators may even make it a requirement.
[Related: Fresh warnings over rising debt levels]