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The next subprime mortgage crisis in the making

We’re not as immune from the mortgage lending laws that triggered the Global Financial Crisis as we might think.

It is a bit of myth that Australia dodged the global financial crisis because we had tougher lending standards than the United States, where ticking-bomb subprime mortgages were packaged up into toxic derivatives like collateralised debt obligations, slapped up with dodgy AAA credit ratings and on-sold to financial institutions investors all over the world.

OK, we didn’t yet have NINJA loans — mortgages made to those with no income, no job or assets — but that was probably more down to luck than good management. However, we did have a snowballing problem with subprime mortgages in Australia — low-doc home loans flogged to struggling borrowers by conflicted mortgage brokers — and we were lucky it didn’t do more damage. Lucky that our banks were well enough capitalised (propped up by the taxpayer through the deposit and wholesale funding guarantees) to ride out their bad debt problem. Lucky that emergency low interest rates post-GFC meant borrowers weren’t subjected to the big repayment resets from introductory honeymoon rates that — in the United States — caused the rise in defaults that started the crisis in the first place.

Also helping was a fundamental difference between the US and Australian mortgage markets: there, lenders do not have recourse to the borrower, so when the bank decides to foreclose, they wear any shortfall between the sale price and the value of the loan; here, if the bank does not recover the loan balance after a forced sale, the borrower in default remains liable for the shortfall. Australian mortgagors can’t walk away, so they have a real incentive to keep up with their payments. It is often said Australian families will go without food before missing a home loan repayment.

That is, if they can afford it. Swept under the carpet in Australia during the GFC was the prevalence of loan application fraud, a form of predatory lending that consumer advocate Denise Brailey has been campaigning to expose for years. A prime example was Mortgage Miracles — a large-scale scam in Western Australia in which borrowers (some on welfare) were given unaffordable bank loans after Mortgage Miracles’ highly successful mortgage broker Kate Thompson falsified income and asset information.

The transfer of responsibility for consumer credit laws was transferred to the Commonwealth under the National Credit Act 2010, with the Australian Securities and Investments Commission taking over regulatory responsibilty. ASIC’s view was that there was no systemic predatory lending problem in the banking system. One of the odder moments during the recent Senate inquiry into the performance of ASIC — which was rightly preoccupied with financial planning scandals in the Commonwealth Bank — came when Brailey appeared on the afternoon of February 20. ASIC chairman Greg Medcraft had appeared earlier that morning, in the main event. The committee members either had half an eye on the clock or were simply unconvinced by Brailey’s argument that there was still a systemic problem with predatory lending, particularly for investment.

CHAIR: You are saying there is a large, wide-scale problem. You have been sitting here for the last two days and, in particular, you would have heard the questions that were asked of the two consumer law centres, who deal all the time with people in the consumer credit, housing and insurance markets. Their advice to us was that the incidence of that type of problem was virtually non-existent.

Ms Brailey: Yes. Very worrying.

CHAIR: So how do you reconcile the reports of those grassroots consumer organisations with yours?

Ms Brailey: That might suggest that one of us is lying!

CHAIR: No, I am not suggesting anyone is lying.

Ms Brailey: Or misleading. They know about this. When I talk behind the scenes they all agree they know.

Senator WILLIAMS: Who is ‘they’?

Ms Brailey: Whether I am talking to ASIC commissioners or the Ombudsman, these people know what I am talking about.

Brailey runs the Banking and Finance Consumers Association, and her warnings cannot be dismissed. She has first-hand experience dealing with hundreds of victims of dodgy lenders and is right to sound the alarm. Continued low interest rates, upward-spiralling residential property prices propped up by self-managed super funds, and deteriorating lending standards are all adding fuel — and with that comes the risk of fire.

In May CHOICE warned against risky lending practices, with banks extending 40-year loans worth a terrifying 120% of the value of the property — so the borrower starts off with negative equity. Yes, it is tough for young borrowers to get into our inflated property market, but this sort of lending cannot end well. Better to fix the underlying problems in the housing market — like negative gearing, which undermines government revenue, entrenches advantage and pushes up prices artificially — than shovel young borrowers into a lifetime debt trap.

Yet we learned in this must-read piece a fortnight ago that the big banks are resisting the Australian Prudential Regulation Authority’s move to toughen up lending standards through its draft prudential practice guide for residential mortgages, which includes a bunch of good advice on how a borrower’s income is verified (especially when self-employed), proper use of interest rate buffers, how living expenses are estimated for the purpose of loan serviceability requirements, limitations on the use of lending policy overrides, and oversight of applications from third-party loan originators like mortgage brokers. For example: “a sound oversight process … would include ensuring that all material facts are contained within the application and that the borrower is not asked to sign incomplete application forms for later completion by the third party”. You don’t say!

APRA says loan to value ratios over 90% are associated with increased risk of loss; the guide warns against use of desktop or automated property valuations and states the bleeding obvious: “… attempts by an [authorised deposit-taking institution] or third-party lending staff to pressure valuers to over-value properties are an indicator of poor practice and improper behaviour”. The guide also calls for tougher stress-testing of loan portfolios, and recommends that mortgage brokers who originate bad loans should have their commissions stopped or wound back.

Conflicted mortgage brokers — paid with exactly the same up-front and trailing commissions that have been the long-running, underlying cause of a string of mis-selling scandals by financial planners over the past decade — have a direct financial incentive to maximise the volume of loans they originate. Now, five years after the GFC, with property markets booming and interest rates irresistibly low, the non-bank lenders are returning to the market. A sign came in July, with Mark Bouris’ Yellow Brick Road bulking up to take on the big banks, bidding $36 million for RESI Mortgage.

The Australian Bankers’ Association say APRA is being too prescriptive. They are wrong. We will have missed the lesson of the GFC if we just pat ourselves on the back. Loan standards must not be a casualty of a welcome renewal of competition. Already glowing from their wind-back of the previous government’s Future of Financial Advice reforms, the big banks chasing growth at all costs must be saved from themselves.

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  • 1
    Yclept
    Posted Friday, 1 August 2014 at 3:52 pm | Permalink

    the big banks chasing growth at all costs must be saved from themselves.

    Just as the taxpayer needs to be saved from them as well.

  • 2
    Dogs breakfast
    Posted Friday, 1 August 2014 at 4:02 pm | Permalink

    Agree entirely Paddy. We will be lucky if we don’t have a crisis, however the non-recourse loans of USA put more risk on the banks.

    Here the risk is with the householder, who is also the consumer, who will stop spending if it all goes pera-shaped, which will ratchet up unemployment, which will lead to more default, etc etc.

    Negative gearing, superannuation being used for direct property investment and other government policies supporting inflated house prices helps no-one, ultimately.

    I just the rubbish hits the fan before my kids enter the market.

    Where is government leadership on this?

    Why am I asking stupid questions?

  • 3
    64magpies
    Posted Friday, 1 August 2014 at 5:29 pm | Permalink

    No compliance, no government backed guarantees, at the very least.

  • 4
    AR
    Posted Friday, 1 August 2014 at 7:21 pm | Permalink

    Dogs - “pera-shaped’, the foul & toxic fruit resulting from negative gearing for houses bought to rent.

  • 5
    Peter Evans
    Posted Friday, 1 August 2014 at 7:51 pm | Permalink

    FYI Paddy, only 10 states in the US have non-recourse home lending. They are Alaska, Arizona, California, Hawaii, Minnesota, Montana, North Dakota, Oklahoma, Oregon, and Washington.

  • 6
    Graeski
    Posted Friday, 1 August 2014 at 10:02 pm | Permalink

    The LNP has only four strategies available to it for dealing with problems:

    (i) Reduce government expenditure on welfare or services
    (ii) Reduce salaries or working conditions of employees
    (iii) Sell off the country or parts thereof
    (iv) Provide benefits to the wealthy.

    If these four strategies - or some combination of them - do not provide a solution to a particular problem, then that problem is outside of an LNP government’s capability to solve.

    I don’t see how any of them can be used to resolve the issue described in this report. We’ll just have to learn how to live with it, then, I guess.

  • 7
    Alex
    Posted Saturday, 2 August 2014 at 11:58 am | Permalink

    Paddy, you state the case very well and very clearly. Let’s hope you’rre wrong about how much consideration is being given to the critical issues, but with this government’s emphasis on blindly reducing bureacracy, you’re probabaly spot on.

  • 8
    Barbara Bradshaw
    Posted Saturday, 2 August 2014 at 3:46 pm | Permalink

    It really helps to reduce regulatory resources. If / when it all goes pear shaped the regulators will be blamed. I would hate to have a million dollar mortgage if that happens whether or not the loan was an investment loan or for purchase of an average Sydney house to live in.

  • 9
    justin stanford
    Posted Monday, 4 August 2014 at 2:09 pm | Permalink

    Australia’s property market is overpriced. There is no doubt about it. A correction is inevitable. The three main drivers are negative gearing, direct superannuation investment and foreign ownership. If we can’t wind back this overheated market the only possible outcome is a massive correction. That is bad for everyone. The feature film ‘inside job’ recorded interviews with many US banking leaders and many of them clearly stated that the industry needs regulation, that they can’t be trusted to put responsible corporate behaviour above profits.

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