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Four property market red flags to watch: Editor's note

Lewis Jackson  |  22 Jul 2022Text size  Decrease  Increase  |  
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Big rallies on the ASX and around the world this week as US earnings defied doomsayers and Russia resumed gas deliveries through Nordstream 1. Sentiment remains in the toilet. A closely watched fund manager survey from Bank of America is “max bearish”. Is it time to get greedy now everyone is fearful? I don’t know, and neither do you. Timing the market is a bad idea—top or bottom. Disagree? Get in touch: editorialAU@morningstar.com.

Safe as houses?

As I discussed last week, people are worried about the housing market. In Australia, New Zealand and Canada, some of the world’s frothiest housing markets are deflating, raising fears that falling property prices and higher mortgage repayments will tip precarious borrowers and their tottering loads of debt onto the rest of the economy.

Enter Reserve Bank deputy governor Michele Bullock, trotting out on Tuesday what is likely to be the bank’s housing market talking point for the foreseeable future: Keep calm, carry on, most borrowers will be fine.

The argument goes like this. Most mortgagees have big buffers of savings (thanks to the pandemic) and even bigger buffers of equity (thanks to wild house price growth). The most indebted tend to be wealthier and thus more able to service debt. In sum, while the repayment shock will be an unpleasant jolt for most, fatal electrocutions will be few and far between.

Here’s four reasons to be more concerned.

First, focusing on the households who will sail through mostly unscathed is a red herring. Most people survive crises. Systems implode under the weight of the most vulnerable.

At the height of the Great Depression in the 1930s, unemployment peaked around 20% in Australia, and 25% in the US. During the worst economic crisis in modern history, four-fifths of workers kept their jobs. Mortgage delinquency rates in the US peaked at 11.4% in 2010 after one of the most severe housing crises in history. Spain’s epic housing bust saw delinquencies hit 13.6% in 2014, according to Statista.

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A tenth of mortgages in delinquency is a catastrophe. Once unemployment or delinquencies hit double digits and keep rising, societal collapse beckons.

What number should worry us? No one is sure, but it could probably be counted on two hands, says Paul Ryan, a senior economist at REA Group and formerly of the Reserve Bank:

“It’s the 64-million-dollar question in financial stability,” he says. “What is the number you need to worry about? There is a proportion of people, it’s probably in the single digits, that would cause issues for the financial system.”

So how many households look precarious? Half of Westpac home loan customers by account balance are less than a month ahead on repayments. About a quarter of them are precarious new borrowers. At Commonwealth Bank, a third of the home loan portfolio have less than a month of buffers, and similarly, a quarter of that number are new borrowers.

“That’s enough of a share of people that you’d start to worry about the delinquency rates,” says Ryan.

Second, many of those precarious households will soon experience a major repayment shock.

I pointed out last week that the Reserve Bank’s scenario analysis from April 2022—which modelled a 2% jump in interest rates—was dangerously out of date. They must have been listening. Bullock revealed new figures showing should rates rise by 3%, about a third of variable-rate borrowers will see repayments jump by more than 40%. Given the Reserve Bank's analysis excludes split loans, there's reason to believe these numbers could be higher.

Some of these borrowers will also be those with the fewest buffers. It doesn’t need to be many to get nervous.

The shock will be harsher for those who hoovered up fixed-rate loans during the pandemic. Most of the loans will expire over the next 18 months and the Reserve Bank estimates just under half will see repayments soar between 40% to 60%.

Fixed-rate borrowers could jiggle the plug in the economic bathtub. The Reserve Bank rightly points out these households have months to prepare for higher rates. But millions of borrowers setting money aside for a rainy day has an economic cost. Every dollar stashed would otherwise have paid wages at cafes or cinemas.

Third, even those who do have savings buffers may not use them all. The Reserve Bank touts the $260 billion in household savings as a bulwark against the upcoming mortgage repayment shock. But Ryan says households who find themselves struggling to pay bills won’t burn savings indefinitely. They’re more likely to downsize and put more pressure on part of the property market, or slash spending, potentially pushing up unemployment.

“Borrowers get to a point. We can’t pay our mortgage. We’ve got savings but this isn’t tenable long term. That’s when they start to think about how they can resolve that situation."

Finally, Bullock’s modelling doesn’t account for the risk of higher unemployment, arguably the most important contributor to mortgage stress. The omission is somewhat understandable: Few mortgages will survive the loss of a primary breadwinner. Why model a comet strike? It will be messy.

Clearly the Reserve Bank is alive to the unhealthy feedback loops between the housing market and the economy. Here’s Bullock wrapping up her address:

“Having a job is the best way of ensuring that you can continue to meet repayments on your loan. How much the Board decides to raise rates will depend on developments in the economy, including how borrowers respond to higher rates. And we will continue to assess where the risks might materialise.”

Even if Armageddon is avoided, mortgage stress is bad news for Australian investors, leveraged as they are to banks. Evictions are lengthy, expensive and ugly. Banks have every incentive to help struggling borrowers by pausing or temporarily lowering repayments. Profits will take a hit.

More from Morningstar

Catch up on what happened this week in the usual place. For analysis on the ANZ-Suncorp tie up, my colleague Nicola has you covered.

Seven months into a declining share market means one thing: time for fund managers nursing big losses to wheel out the mea culpas. After months out in the cold, team transitory is back, with a series of argument for why inflation has peaked. Whether the peak is now or later this year, rates are set to stay high. For those wondering how to invest in this environment, Morningstar has some tips.

Speaking of investment help, we published a cheat sheet to investing in Australian hybrids, the asset class that is part bond and part stock. Looking for equities to park some cash? Our colleagues in the US have put together a two-part series on how to play the ongoing shift from goods to services spending.

Enjoy the weekend.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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