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Australian Banks And The APRA Impact

Feature Stories | Apr 05 2017

How will further lending restrictions now imposed by APRA impact on bank earnings and the housing market?

– Crack-down on interest only loans
– Further repricing likely
– Earnings impact a balancing act
– More pressure on lofty housing market

By Greg Peel

Ever tried to catch a bubble? Any small child could tell you it’s an impossible task. But it’s the task APRA has taken on as fears grow among the RBA, ASIC and Treasury that Australia’s housing market may be heading for inevitable collapse. Or at the very least, a pullback that would significantly impact on the Australian economy.

The latest data show Australian dwelling prices rising at an annual rate of 13%, with Sydney prices rising 19% and Melbourne 16%. The bulk of new mortgages are going to property investors, ahead of owner-occupiers, and very few are going to first home buyers. This is the biggest problem for politicians, being housing affordability.

Many policy measures have been touted as a possible way to improve housing affordability, but most suggestions around stamp duty and negative gearing would only see a pass-on into prices anyway, unless they are specifically limited to first home buyers. Suffice to say, the government really has no idea what to do.

Australia is currently suffering record low wages growth, largely as a result of a distinct shift to part-time work from full-time work in the economy. The RBA could address the problem, and a flow-on into weak consumer spending, by lowering rates. But households are already carrying record levels of debt. A rate cut would further fuel this bubble and the housing bubble to boot. So the RBA is hamstrung.

Why are investors so keen on Australian property (not counting foreigners who just think it would be a nice place to live and have the money)? We can cite a record low cash rate, an investment alternative, being the stock market, that has gone nowhere for years, and the lure of rising property values. The latter is of course a self-feeding beast.

On the other side of the equation is supply, and here we find a similar self-feeding beast. Economists had been expecting runaway property development to cool by now, and indeed had expected a -1% fall in building approvals in February. They rose 8%. There are fears of a glut of apartments. New apartment approvals rose 11%.

APRA took its first step in trying to rein in investor lending for housing by imposing a cap on banks’ new investor loan growth of 10%. It worked, to begin with, but house prices just continue to go up. Investors are back again, happy to pay higher rates and higher prices.

Repricing Benefits

The banks have recently undertaken a round of out-of-cycle mortgage repricing, meaning they have increased the rate on variable mortgages irrespective of no change to the RBA cash rate. The increases to investor rates have been greater than those to owner-occupier rates in order to stifle marginal demand and keep investor loan growth below the required 10%. The banks were either prompted into raising by, or using as an excuse, the rate increase implemented by the US Federal Reserve last month.

The Fed rate hike, and promise of more to come, will eventually raise bank funding costs when next the banks issue bonds in the US. These are most often five-year maturities. As the US continues to tighten, the pressure will be on the RBA to ultimately follow suit lest the Aussie collapse as a result. But currently the RBA would rather be cutting than hiking and it would like to see the currency lower than where it is now.

In other words, the banks have bought themselves some time. Their bottom lines stand to benefit from increased rates in their mortgage back-books (existing variable mortgages) and by imposing greater rate increases on investors they are complying with APRA demands of lower growth and managing, for once, to avoid the ranting and raving of politicians.

Has anyone heard one typical outburst of bank bashing from the pollies over this latest round of mortgage price hikes?

It remains to be seen just what impact these higher rates will have on new investor demand. But APRA has decided not to wait to find out. Currently the signs are that Australia’s investor-driven housing bubble is showing no sign of deflating.

Playing it Safe

One option open to APRA would have been to further limit investor loan growth, say to 5% from the current 10%. Bank analysts have considered such a move a possibility for some time. But the problem is, apartment blocks take a long time from the point of approval to the point of completion and settlement of sales. This lag means settlements from the peak period of apartment construction are just now being reached.

To that end, APRA suggested on Friday that the current 10% cap on investor loan growth was “continuing to provide an appropriate constraint in the current environment, balancing the need to continue to moderate new investor lending with the increasing supply of newly completed construction which must be absorbed in the year ahead”. To further tighten restrictions would be to risk increased settlement defaults and reduced demand for new apartments that could set off a cascade of falling prices.

That would signal the beginning of the end of the housing boom, perhaps destructively so. The housing sector has almost single-handedly kept Australia’s economy growing through the cycle of a significant decline in mining investment. There is no sign on the horizon of mining investment turning around again. There are now signs the housing market is cooling.

Morgan Stanley calculates some 45% of the market capitalisation of the ASX200 is in some way connected to housing. We can start with the developers and banks and move all the way down the chain from building material suppliers to the retailers of furniture and televisions. Not only is this 45% at risk were the housing bubble to spectacularly burst, it is well accepted an economy is more likely to grow when consumers believe their wealth to be growing, and the most valuable asset of the average consumer is property.

So what could APRA do?

On Friday the regulator played its master stroke, deciding not to go after investor lending in general but the types of loans that are popular with investors. In particular, interest-only loans.

The average owner-occupier is hoping to eventually own their home outright and as such take out a mortgage for which they pay both principal and interest, typically with a 20-25 year maturity. But investors are not typically looking that far ahead and hope to “flip” their property down the track for a tidy profit. They are not making a killing on rent, which is the other reason one would invest in property.

A principal and interest loan (P&I) does not actually reach the point of reducing principal until later in the life of the mortgage. In early years, borrowers are simply paying interest. So for both reasons, investors prefer interest-only loans (IOL). Indeed, some 65% of investors.

Between the GFC of 2008, in which the stock market lost half its value and the RBA began madly cutting rates, to 2014, when APRA first began tightening lending standards ahead of imposing the 10% investor growth cap, IOLs grew as a proportion of new mortgages from 30% to 45%, Ord Minnett notes. When the restrictions were imposed, that level fell back to 35%, however the recent resurgence in investor demand has seen a return to a level of 40%.

APRA has now imposed a growth cap on new IOLs of 30%.

The GFC came about largely as a result of the collapse of the US housing market, but the Australian housing market was not an innocent choir boy either. As is typical in boom times, bank lending standards were lax, and in order to compete with each other then banks continued to offer loans requiring lower and lower levels of deposit, in other words loans with high loan-to-value ratios (LVR). Citi notes the proportion of loans with LVRs of 80% or above has halved from 40% pre-GFC to 20% now.

But that’s still 20%. And the risk of a low deposit, or high LVR, is compounded if that loan is also interest-only. To that end, APRA has added to its IOL 30% growth cap by insisting strict internal limits must be placed by banks on IOLs with LVRs of 80% or greater and “justification” has to be provided for loans with LVRs of 90% or more.

Furthermore, banks have been urged to review mortgage serviceability (the capacity of the borrower to make monthly payments) to ensure buffers are appropriate for the current conditions.

And finally, while leaving the 10% cap on investor loan growth in general untouched, APRA has qualified that cap by insisting loan growth must be “comfortably below” 10%.

APRA is good on the qualitative stuff. Caps of 10% growth here and 30% there are indisputably quantitative, but exactly what is “comfortably below”, how strict are “strict” internal limits and exactly what levels of serviceability are required?

And what, exactly, is meant by “unquestionably strong”, with regard bank balance sheets? APRA threw that one out there a couple of years ago and has still not answered the question.

APRA Measures Please The RBA

The implication here is the banks must be proactive in tightening investor lending or else APRA will tighten the screws even further.

The RBA is pleased with the new measures APRA has imposed, to the extent of making note in yesterday’s policy statement:

“Growth in household borrowing, largely to purchase housing, continues to outpace growth in household income. By reinforcing strong lending standards, the recently announced supervisory measures should help address the risks associated with high and rising levels of indebtedness. Lenders need to ensure that the serviceability metrics that they use are appropriate for current conditions. A reduced reliance on interest-only housing loans in the Australian market would also be a positive development.”

RBA governor Philip Lowe continued to praise APRA’s decision when making the speech at a board dinner last night:

“Like the earlier ‘speed limits’ on investor lending, these new requirements should help the whole system pull back to a more sustainable position. A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience. With interest rates so low, now is a good time for us to move in this direction. Hopefully, the changes might encourage a few more people to think about the merit of taking out very large interest-only loans when interest rates are near historical lows.

“So the RBA welcomes these latest changes.”

So will investors, as Dr Lowe suggests, rethink the risks they are undertaking? The risk to the banks is that these latest measures substantially reduce further demand for investor loans.

Bank analysts do not believe demand will be substantially reduced, rather marginally reduced. UBS, for one, is assuming the reduction to 30% IOL growth from 40% will see half of the difference, being 5%, take on a P&I loan instead and only the other half giving the game away. The latter would likely be multiple property speculators relying on interest-only and high LVRs, UBS suggests.

Deutsche Bank expects a “large proportion” of prior IOL borrowers will switch to P&I instead. On that basis, and other brokers concur, APRA has come up with just the right formula. Risk will be reduced across lending books but bank earnings will not be significantly impacted as a result. Nor will new restrictions be the trigger for a housing market collapse. Deutsche is forecasting a reduction in loan growth of 5% in FY18 and 4.5% in FY19.

So how will this impact on bank earnings?

Time Will Tell

As Citi suggests, the measures are likely to further fragment the already dislocated market and they could prove to be either positive or negative. The need to comply with new IOL restrictions will provide the banks with further repricing opportunities, brokers attest, and thus another increase in net interest margins beyond that provided by recent repricing initiatives. On the other hand, demand for new loans will abate.

Citi believes it will be six to twelve months before the ultimate impact is clear. Among the Big Four, Commonwealth Bank ((CBA)) and Westpac ((WBC)) currently hold the highest level of IOLs, Macquarie notes, both close to 40%, while ANZ Bank ((ANZ)) is at 37% and National Bank at 32%. Hence NAB has the easiest task among the four of cutting back to the new 30% restriction.

The next question is: will APRA’s new measures actually work? The prior 10% cap on investor loan growth in general only worked for a brief period.

Morgan Stanley believes APRA’s measures reflect a level of caution and could struggle to have a sustained impact on investor lending growth or the rise in household leverage. However, there was clearly an upswing in investor activity over the summer, the analysts note, and investor appetite should be tempered by the banks’ recent repricing of mortgages and the rationing of IOLs that is to come.

UBS suggests that if these new measures don’t lead to a slowing in Sydney-Melbourne house price rises, further policies may be implemented, such as higher capital requirements for riskier loans. Morgan Stanley goes a step further:

“Looking further out we see it as very likely that the next (more permanent) round could be through increases to risk weights for investor lending, potentially as soon as mid-year.”

It is at this time the broker believes APRA will finally qualify “unquestionably strong” capital requirements, despite the negotiations over new Basel IV requirements being beset with disagreement and delays.

Morgan Stanley is also concerned that the level of restrictive measures continues to build as the housing cycle begins to show signs of stress, citing recent stories in respected publications such as “Brisbane apartments offered at 39pc discount in disputed fire sale” and “Off-the-plan buyers seeing losses and lacklustre growth”.

Macquarie is of a similar mind, believing ongoing tightening of lending standards, coupled with a rising global rates outlook, suggests near term risk around the housing market appears to be increasing. Because of this risk, and given relatively full bank valuations, Macquarie remains Neutral on the sector.

Citi remains cautious, given the recent rally in bank shares prices driven by the round of mortgage repricing.

Morgan Stanley is Underweight the banks, noting valuations are at a peak while growth seems hard to come by. The broker also advises limited exposure to those other sectors impacted by a housing slowdown – developers, building materials and consumer discretionary.


FNArena last published an update on the banking sector on March 23 (Australian Banks: Risks And Valuations), in the wake of earnings updates and prior to the recent round of mortgage repricing. At that point, bank share prices were trading 4-6% above consensus target prices.

In FNArena’s experience, when the banks start to pull away from target prices a correction will inevitably follow, unless analysts are given cause to raise their target prices. Bank share prices are no higher than they were, in a response to said mortgage repricing. But analysts have also responded by raising their targets.

The net result is bank share prices are still 4-6% above consensus targets.

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