Banks were instructed by the banking regulator earlier this year to not pay dividends to their owners, but instead hoard those profits as defence against running out of capital. It sent a signal that the regulator was deeply concerned about the health of Aussie banks.
That rule has since been loosened, but the risks are far from over. Aussie households are hanging on for now, but as Christmas approaches income support will be removed and then early in the new year banks will start to demand loans once again be repaid.
So what will happen to Australian banks during this recession? They stand behind trillions of dollars worth of loans in this country, and many of those loans are still at risk. The biggest category of loans Australian banks own is mortgages, and they have performed so well for so long that it is worth worrying that banks may have become complacent.
With falling migration rates and a shrinking economy, it is rational to expect Australian house prices to soften. Louis Christopher, of property research firm SQM, has warned of a possible 30% fall. A sharp crash of that magnitude would be bad enough for Australian households, damaging their wealth and thereby affecting their spending, but it would be even worse if it propagates into a financial crisis that sends Australian banks to the wall.
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The next graph shows the share of mortgages in June 2019 where the owner owed the bank more than the house is worth, what they call “negative equity”. In rural Western Australia and Northern Territory, that figure was almost 30%. In Perth and Darwin, 20%.
The eye is drawn to those tall bars in the graph, but from the perspective of Australian banks’ balance sheets what matters much more is the short bars on the left. The share of mortgages in negative equity in Victoria and NSW is extremely small, despite the correction in house prices during 2017-18.
The idea that negative equity will spread to the capital cities and then bankrupt the banks is a popular one among a certain segment of gloomy forecasters.
Mortgage defaults hurt banks because they end up owning an asset that is worth less than the loan on that asset, and they make a loss. Defaults have actually been fairly rare in Australian history, largely because house prices have risen so steadily. If house prices enter a broad-based correction, what will happen?
If house prices tumble, do people immediately default? New research from the Reserve Bank of Australia suggests it is more complicated than that. Using a dataset of nearly three million loans, including mining regions with high instances of default, they find very little evidence people default “strategically” on their mortgages.
“Early studies focused on ‘strategic defaults’, framing mortgage default as a rational response by borrowers to negative equity,” writes the study author, Michelle Bergmann.
“As more loan-level data became available, empirical studies called the predictions … into doubt. Far fewer borrowers defaulted than … predicted, even at very high values of negative equity.”
People might owe more than the house is worth, but we keep paying that mortgage off anyway. Defaulting is not costless — it means you have to move house, it harms your reputation and it does horrible things to your pride. People generally want to hang on to that house.
“The median US non-prime borrower did not strategically default until negative equity reached 70%,” writes Bergmann.
Mortgage default requires a “double trigger” says Bergmann. Owing more than the house is worth is not sufficient for people to default. Neither is losing income. But when both are present, the risk of default goes up enormously.
The next graph shows what happens to loans which are already in arrears. They might foreclose, be repaid (by selling the asset) or “cured” which means the repayments get back on track. The horizontal axis shows the loan-to-value ratio (LVR). At the right hand side is a loan to value ratio of 150+, which implies owing 50% more than the house is worth.
It turns out that if you owe $1.5 million on a house that’s worth $1 million and your repayments are already in arrears, you have an over 50% chance of defaulting — being foreclosed. Then the bank owns the house and it has to deal with the loss.
What we need to be worried about is a double hit — if house prices start to fall, then the newest loans will sink into negative equity. If unemployment is also high, some home-owners will be unable to repay. Some of those loans will satisfy the “double trigger” criteria and will default.
This is not America in 2008. The housing bubble can, potentially, pop without creating a financial disaster. But if employment crashes in the same places where house prices are tumbling, then we need to be extremely cautious.