Borrower vulnerability at ‘unprecedented levels’

The credit rating agency said that while Australia’s banks still have strong balance sheets and loan books, there are risks embedded in the housing market that pose an increasing credit challenge.

Moody’s noted that rising property prices have contributed to declining affordability and an all-time high aggregate housing debt level of 140 per cent of disposable incomes.

At the same time, the mortgage market is becoming distorted, with investors buying in increasing numbers and first home buyers finding it harder to enter the market.

“These trends pose a threat to Australian banks because they increase the risk of an eventual correction in the housing market,” Moody’s said.

“While we expect such an adjustment to be gradual, execution risk is significant and the likelihood of an outright house price correction is rising.”

Moody's admitted that interest rates remain low and more banks are fine-tuning their underwriting discipline and capital adjustment.

“However, the longer-term sustainability of their housing portfolios could be masked by current record-low interest rates,” the agency said, adding that high levels of household indebtedness further expose the economy to the risk of a sharp house-price retrenchment.

“Both historically and in comparison to other OECD countries, Australian borrowers’ vulnerability to economic shocks is elevated and unprecedented,” Moody's said.

Mortgage delinquencies are currently low, but these are expected to deteriorate when and if interest rates return to historical averages.

One issue to watch is the extent to which the growth in household debt and house prices is accompanied by loosening mortgage underwriting standards, according to Moody’s.

“We view the 2014 and 2015 origination vintages as weakening the quality of bank portfolios,” the agency said.

“The increasing proportion of investment and interest-only loans is likely to, over time, lead to structurally higher levels of delinquency.”

Moody’s expects the banking industry to meet the challenges posed by current housing market trends by strengthening its capital framework and mortgage risk weights.

This would help address “the potential underestimation of required capital” under the current regime, it said.

“In Australia, which has experienced uninterrupted growth since 1991, capital models, calibrated on historical data, may be understating the true ‘through-the-cycle’ risk,” Moody’s said

“For instance, residential mortgage risk weights have seen a secular downward trend over the past five years, a trend that is in our view hard to justify given the absence of significant changes in the quality of origination post-crisis and the building tail risk in the housing market.”