Australian Banks Could Finally Head Down Under

Wall Street Journal Sept. 15, 2017 5:58 a.m. ET

Jacky Wong

Investors have been calling the Australian housing market a “bubble” for years, yet prices keep charting higher. The market, though, could finally be about to turn south. That won’t be pretty for the country’s banks.

The property market has been skyrocketing Down Under—prices in Sydney have gone up 80% since 2012 while in Melbourne they have gained 54%. In turn, houses have become unaffordable for many Australians as prices keep outpacing income growth. An average home in Sydney now costs more than 12 times the median income there, according to research firm Demographia.

To keep houses within the reach of buyers, banks seem to have loosened their lending standards. Home lending is big business for Australian banks—more than half of their loan books consist of residential mortgages, amounting to $1.2 trillion, a figure that has risen 47% in the past five years. Analysts say much of this new lending has been dubious: Around a third of Australian mortgage applications contain inaccurate information, resulting in around $400 billion of so-called Liar Loans, according to UBS.

Many home buyers have also been taking out interest-only mortgage loans, meaning borrowers don’t need to repay the principal for a certain period, usually five years. Nearly 40% of outstanding home loans are interest-only. The risk is that borrowers will be unable to repay these loans once their interest-only period expires.

This is fine as long as the property market keeps going up, as homeowners can sell their houses to cover loan repayments. Once the market stops rising, though, it will become much harder for stretched households to avoid problems.

Australian regulators are trying to cool the property market, by reining in the use of interest-only loans. But they face another difficulty. Tightened capital controls in China have dampened property demand in Australia, previously a popular venue for Chinese buyers. Direct overseas property investment from China plunged 82% in the first half globally, according to Morgan Stanley ,with investors there finding it harder to get their money out of the country.

Little wonder, then, that Australian house prices are starting to slow—they were flat month-on-month in major cities in August. That, in turn, could hurt banks’ earnings as loan growth slows and provisions start to rise.

Australian banks, though, are still trading at a premium to their peers in other countries: The four biggest Australian banks on average trade at 2.1 times tangible book value, much higher than, say, J.P. Morgan Chase , which trades at 1.7 times.

The country’s largest bank by market value, Commonwealth Bank of Australia , looks the most vulnerable. It is the most expensive of the big four, at 2.5 times tangible book. Aside from housing-market worries, it has recently been embroiled in a probe related to money laundering.

Shorting Australian banks has long been a “widow-maker.” Now, though, it could finally be a winning trade.