Is a great wave going to swamp Australia’s housing market?

Australia’s tumbling housing prices are sending more and more mortgage holders underwater. A small but growing share now owe the bank more than their properties are worth, i.e. they have “negative equity”.

The Reserve Bank of Australia is highly alert to the risks of negative equity and just published an extended analysis of it. Among that analysis was the following graph, which shows the loan-to-value ratio (LVR) of Australian mortgages. Those with a ratio above 100 are underwater, or in negative equity. The graph shows that negative equity is more prevalent now than in February 2018.

When I look at this graph I can’t help but see a “great wave” looming up and threatening to break over the Australian economy.

Negative equity is problem both for individual mortgages and for financial stability, as the RBA explains:

A borrower having difficulty making loan repayments who has negative equity cannot fully repay their debt by selling the property. Negative equity also implies that banks are likely to bear losses in the event that a borrower defaults.

Australians who get into negative equity are more likely to default on their loans, leaving the banks with the problem. So negative equity is likely to be bad for the health of our banks, which is not great news considering how much of the Australian economy they constitute, not to mention their oversized share of our sharemarket.

The good news is loans in negative equity remain low in most of Australia. With most loans requiring a 20% deposit and house prices having fallen less than that in Sydney and Melbourne, most of the country is still above water. It is only WA and NT — where house price falls have been going for years — that have significant problems, as the next graph shows.

Unemployment

“Evidence from Australia and abroad suggests that borrowers who experience an unexpected fall in income are more likely to default if their loan is in negative equity.”

That’s the RBA again, with an implicit warning — we won’t get defaults unless we also get “an unexpected fall in income.” Where could that fall come from? A sharp uptick in unemployment. And here’s where it gets complicated.

Falling housing prices could themselves generate economic weakness that causes rising unemployment. It might be because we spend less at the shops when our asset values are falling. Or it might be via a fall in construction employment. But the risks are entangled. The further house prices fall, the bigger the chance of rising unemployment, and the higher the level of both negative equity and of defaults that make the economy worse.

GFC redux?

However, Australia is not likely to see a repeat of the US housing crash, in which banks became insolvent and needed bailing out. For one thing, our mortgages are structured differently. We have what they call full-recourse loans. In America, borrowers who got behind on their loans could just hand the house back to the bank and walk away. Here you have to keep paying or actively default. Another reason not to expect a huge financial crisis is that our financial regulations were designed and implemented with the GFC in mind.

But you can have plenty of economic problems without financial contagion affecting our big, well-regulated banks. There’s always a lot of smaller lenders and property businesses that could end up in strife.

So will the great wave break over us, and put lots of mortgage holders underwater? There’s two things to watch – unemployment and house prices. If the former goes up as the latter continues to sink, that could eventually capsize our long run of stability and growth.

Do you think mortgage lending is a threat to the economy? Write to boss@crikey.com.au with your full name and let us know.