Australia’s central bank warns house prices could threaten the country’s financial stability. Reserve Bank of Australia Deputy Governor Michele Bullock provided an update on housing this week. She warns that the quality of borrowers has deteriorated as they gain more weight. As the share of these borrowers increases, so does their risk. The central bank warns that this may pose a risk to financial stability and, therefore, it will monitor them closely.

Heavily indebted mortgage borrowers are on the rise

The Reserve Bank sees two risks forming around banks and households. With regard to the bank, housing represents about 60% of outstanding loans. Concerns had germinated between 2014 and 2017 about a deterioration in the quality of borrowers. However, the country solved this problem with various tightening measures. It worked until the pandemic.

Recently, Australians have taken on more and more debt to buy a home. The share of mortgage loans with a debt-to-income ratio (DTI) greater than 6 now represents more than 20% of arrangements. The deterioration is similar to the trend in Canada, after the low-rate housing boom caused by the pandemic. The Reserve Bank said it was monitoring the situation closely. Strangely, this is also what Canada said.

Households lose flexibility and become more vulnerable as their debt increases

A more direct risk for households is also forming: a lack of financial flexibility. Most household debt is related to real estate, and it takes a lot of debt to buy at these prices. More debt is more difficult to bear in an emergency.

“Households that have borrowed a lot to buy a house relative to their income could, if there is a shock to their employment status or income, find themselves unable to continue to repay their loans,” Bullock said.

If a person has been forced to sell their home with a mortgage that is less than the value of the home, they can still sell. That’s why you see few flaws during a bubble – if you have problems, you can just sell and come away with a profit. It’s not because owners never go bankrupt. This is because it is easy to come away with a better result, also known as “self-healing”.

Heavily indebted borrowers with little equity are a whole different story. If prices fall sharply, they have negative equity. This would require supplementing with money that they don’t have before selling.

“If the home has dropped significantly in value since they took out the loan, they won’t be able to ‘heal themselves’ that way,” she said. “Under these circumstances, banks would suffer losses and if there are enough of them, as in the GFC, there could be a substantial impact going from households to banks.”

These two risks are the result of the same problem: heavily indebted households. “… There is a lot of international and national evidence that suggests that heavily indebted households are more likely to reduce their consumption in response to income or wealth shocks,” she said.

The reduction in consumption tends to amplify economic shocks, by suppressing the income of producers. This can lead to fewer jobs and less income, which affects the economy. If that happens, a home price correction can turn into a much bigger cross-industry problem.

“A large number of heavily indebted households reacting in this way to an economic downturn or falling house prices could amplify the economic shock,” she said. “A boom in the real estate market, accompanied by an increase in real estate debt, could therefore make the economy more sensitive to downturns.”

Despite the tone, the central bank says it is not worried about a housing bubble. They are simply monitoring heavily indebted households, to see if action needs to be taken. “Whether or not it is necessary to consider macroprudential tools to deal with these risks is something that we are constantly evaluating. “

Like this post? Like us on Facebook for the next one in your feed.