Interest-only loans growing threat to banks

The Australian 12:00am December 15, 2017

Michael Roddan

The threat posed by riskier interest-only loans to the stability of the financial system is growing, analysts say, as consumer spending and economic growth is squeezed by low wages and regulatory clampdowns on lending.

Rather than an outright bursting of the housing bubble, Morgan Stanley analyst Richard Wiles said interest-only loans were the “weak spot” in the $1.7 trillion housing market.

Borrowers with interest-only loans, which don’t require any payment of the loan’s principal for about five years, save less of their income than households with regular mortgages, and they were “more likely to sell their property if rates rise”, he said.

The prudential regulator has told banks to restrict interest-only lending to 30 per cent of new business, down from about 45 per cent, as borrowers of these loans are inherently riskier. Banks have responded by raising rates on interest-only loans by about 90 basis points in a bid to dampen demand.

“Unintended consequences are a greater risk than direct credit losses in housing,” Mr Wiles said, in a wideranging report on the end of the 25-year bull market in the mortgage system.

“Higher mortgage rates and tighter lending standards increase the risk of unintended consequences, including more pressure on household cash flows, weaker economic growth, higher non-housing loss rates and lower house prices,” he said.

UBS analyst Jonathan Mott also issued a lengthy report on the headwinds facing the housing market. He said “lax mortgage underwriting standards”, combined with the coming rise in mortgage repayments on interest-only loans — monthly repayments jump by between 30 and 60 per cent at the end of the interest-only period — pose the largest threat to the housing market.

“We have been concerned for sometime about weak mortgage underwriting standards across the banks,” Mr Mott said. “This is consistent with APRA’s ongoing focus on sound lending standards whereby it is paying close attention to two main areas: living expenses and knowledge of borrower’s financial commitments and total indebtedness.”

It is believed that many borrowers entered into interest-only mortgages not long before APRA began to force banks to lift lending standards. The bulk of these loans are expected to mature in 2020, which worries analysts because of the likely inability of many of these borrowers to repay the loans if they cannot refinance on an interest-only basis.

UBS economist George Tharenou revised downward his expectations for the strength of the local economy. He said although job growth is booming, the relationship to wages growth is “broken” in a “structural and persistent” way.