What banks & housing markets in Sydney and Melbourne are facing in 2019.
As investors are fleeing Australia’s housing bust, sales of new houses have plunged to record lows, and home prices in the Sydney and Melbourne metros have dropped 12% and 9% from their respective peaks in mid and late 2017. Combined, the two metros account for about two-thirds of residential property value in Australia. A two-decade-long housing boom, interrupted by only a few minor dips, led to two of the most magnificent housing bubbles in the world, and they’re not “plateauing” or anything.
The over-ripe bubble was pricked not by rising interest rates – the Reserve Bank of Australia’s policy rate remains at record low – but when bank regulators finally started to crack down on some of the bank-lending shenanigans required to inflate that kind of bubble, and when the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (RC) was established in December 2017 to investigate those shenanigans and then started “revealing an epidemic of crime.”
“The financial regulators, APRA and ASIC, have now been sufficiently embarrassed by the findings of the RC to force banks to adhere to responsible lending obligations,” writes Lindsay David, of LF Economics, in a report on the headwinds that the market and the banks face in 2019. The regulatory crackdown “restricts lenders’ ability to conduct business as usual,” he says, and this has “resulted in a credit squeeze.”
Speculative investors who purchased more recently have been impacted the most. Some of them may try to sell either because they fear further price drops, or because they “have been caught out in the tsunami of IO [Interest-Only] loan resets.” But selling at survivable prices will be tough, as buyers at those prices have evaporated, “primarily due to stricter loan serviceability requirements,” as a result of the regulator crackdown, writes Lindsay David who has for years been warning about mortgage fraud and the now unfolding housing bust in Australia.
“These developments risk turning the current minor credit squeeze into a looming credit crunch,” he says in the LF Economics report.
The “so-called ‘property bloodbath,’” he writes, “is the inevitable outcome of the irrational exuberance driven by debt-financed speculation that has seduced and mesmerized a large proportion of society into becoming over-leveraged.”
And the report points out how some of the banking shenanigans contributed to the bubble on the way up, and how curtailing them is contributing to the downturn now:
Australia’s house price growth model revolved around Ponzi-like leverage, with lenders systematically accepting the unrealized capital gains of a property as a substitute for a cash deposit to borrow to purchase another property during the boom period. This has resulted in many property purchases using 100% financing, forming a clearly excessive cohort of speculative buyers that otherwise wouldn’t exist if lenders had adhered to responsible lending obligations.
The declines in Sydney and Melbourne house prices since the peak in 2017 have diminished some of the unrealized capital gains, leaving speculative property buyers, particularly those who recently purchased, at or close to negative equity. Without enough unrealized equity to make a large so-called cash deposit, this cohort of buyers will increasingly be shunted to the sidelines with no ability to purchase.
The report by LF Economics then lists a slew of headwinds that will put further pressure on this still over-inflated market as it heads lower and on the banks. Here are some of them, quoted from the report:
Mortgage application rejections: The rate of rejections has skyrocketed by over 1,000%, half of all new applications are rejected, 90% of those with pre-approval have their loan sizes reduced and refinance rejections have increased from 5% in 2017 to 40% in 2018. This is the outcome of the RC prompting lenders to abide by responsible lending obligations. With credit becoming tighter, rejections are likely to keep on rising, causing some potential borrowers to wait on the sideline.
Interest-only-loan reset shock: Approximately A$120 billion in IO loans will reset to principal-and-interest (P&I) loans over 2018, 2019, 2020, and 2021, tapering off thereafter. Banks and regulators have already softened their stance on these borrowers, allowing some greater time to sell [the property] or extending the IO period for a while longer. Nevertheless, with debt repayments rising anywhere between 20% to 50% upon conversion to P&I, many recent borrowers will be placed under considerable financial stress.
Class action lawsuits: A supportive legal and financial environment for class action lawsuits has hit fertile grounds with the RC revealing widespread criminality and misconduct in the financial services industry. Driven by the profit motive, experienced litigators will fund numerous class-actions on behalf of those harmed by the industry. In doing so, this may bring more criminality to light, reduce industry profitability, and force banks to adhere to the rule of law in a way the captured regulators have not done in decades.
Foreign buyer exodus: China is the largest source of foreign investment into the housing market, in terms of both the number of purchases and value of investment. With China’s central government ramping up capital controls to stem the outflow of capital and imposing jail time for those facilitating such flight, purchases of new and established dwellings have fallen considerably. Furthermore, there is mounting evidence the Chinese government is now forcing the sale of properties owned by nationals and repatriating foreign currency back to the homeland. This will particularly affect the off-the-plan apartment complex market.
Rent slowdown: The annual growth in nominal rents is very low and negative in real terms. Sydney is particularly affected given that nominal dwelling rent growth is falling by -3% annually and more so in real terms. With current construction rates delivering a considerable flow of new houses and units, nominal rents will continue to decline into the near future, harming the balance sheets of investors, especially those who are heavily negatively-geared [investors with rental properties that have negative cashflows whose only hoped-for benefits are capital gains and full tax deductibility of losses].
Construction faults: With the Opal Tower and aluminum-cladding scandals, the media and public have become more aware of the veritable plague of construction defects within the mass of apartment complexes and townhouses…. OTP [Option to Purchase contract] buyers may choose to relinquish their deposit rather than purchasing a potentially defective dwelling and bearing the future costs of rectification. In some cases, rectification costs are greater than the purchase cost of the complex, leading to an expected negative value.
Expense benchmark crackdown: The RC indicated that lenders could not rely solely on expense benchmarks such as the HPI, HEM and internally-derived estimates [to determine if ongoing household expenses render a loan unaffordable]. Lenders must perform due diligence and obtain verified expense information from borrowers. This will significantly reduce the maximum loan size that can be originated, given such benchmarks have woefully underestimated actual expenses of borrowers, often by half or more.
Comprehensive Credit Reporting: CCR is currently 50% active and will be 100% active by July 2019 as lenders are obliged to provide relevant borrower data to credit agencies…. It also allows lenders to see any and all existing debts of borrowers which may have been previously unavailable or hidden.
Bank funding and capital raisings: International money markets have provided remarkably affordable funding, enabling lenders to originate large and risky loans. But they now face cost pressures. If house prices continue to fall, there are risks of credit downgrades stemming from lower profitability and rising non-performing loans (NPLs). This will likely cause wholesale funding costs to rise, particularly short-term rollovers and future hybrids, or other capital offerings despite backdoor coverage by the RBA. APRA is also requiring the major banks to raise tens of billions of dollars more to boost Tier 2 capital buffers, diluting earnings.
For 2019, LF Economics anticipates nominal house prices (not adjusted for inflation) to drop between 15% and 20% in Sydney and Melbourne, on top of the drops suffered in 2018 and 2017. “While forecasts of -20% falls in a calendar year alone may be dramatic, some commentators will point to the significant run-up in prices over the years,” Lindsay writes. “This fails to note that housing is not a simple unleveraged ETF; it is a highly-leveraged play, amplified by fraudulent lending practices and Ponzi finance, with implications for financial stability on the downside.”