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Michele Bullock, the Assistant Governor, Financial System of the RBA spoke of The Evolution of Household Sector Risks. Risks  in the residential real estate market appears to be currently low she said.

Household Debt and Ownership

Bullock said that the Australian banks are well capitalised following a substantial strengthening of their capital positions over the past decade.  While rising household debt is a risk widespread financial stress among households is not imminent she said.

At the current time banks' mortgage risks appears to be currently low with arrears rates on housing loans remaining very low. That being said Bullock did acknowledge that some households are feeling the pressure of high debt levels.

Bullock said there are a number of reasons why the debt situation is not as severe as the numbers suggest. There are only a  relatively small share of borrowers that are finding it hard to service principal and interest loans.  Significantly a large proportion of debt is held by households with ability to service it.

Potential vulnerabilities

This high level of household debt relative to income raises two potential vulnerabilities. First, because mortgage lending is such an important part of bank balance sheets in Australia, any difficulties in the residential mortgage market could translate to credit quality issues for banks . And since all of the banks have very similar balance sheet structures, a problem for one is likely a problem for all.

Graph 3: Banks’ Domestic Credit

This graph shows the share of banks' domestic credit as a share of total credit over the past couple of decades. Australian banks have substantially increased their exposure to housing over this period and housing credit now accounts for over 60 per cent of banks' loans. So the Australian banking system is potentially very exposed to a decline in credit quality of outstanding mortgages.

The risk that difficulties in the residential real estate market translate into stability issues for the financial institutions, however, appears to be currently low. The Australian banks are well capitalised following a substantial strengthening of their capital positions over the past decade. While lending standards were not bad to begin with, they have nevertheless tightened over the past few years on two fronts.

The Australian Prudential Regulation Authority (APRA) has pushed banks to more strictly apply their own lending standards. And APRA has also encouraged banks to limit higher risk lending. Lending at high loan-to-valuation ratios has declined as a share of total loans, providing protection against a decline in housing prices for both banks and households. And for loans that continue to be originated at high loan-to-valuation ratios, the use of lenders' mortgage insurance protects financial institutions from the risk that borrowers are unable to repay their loans.

Overall, arrears rates on housing loans remain very low. But the second potential vulnerability – from high household indebtedness – is that if there were an adverse shock to the economy, households could find themselves struggling to meet the repayments on these high levels of debt. If they have little savings, they might need to reduce consumption in order to meet loan repayments or, more extreme, sell their houses or default on their loans.

This could have adverse effects on the real economy – for example, in the form of lower economic growth, higher unemployment and falling house prices – which could, in turn, amplify the negative shock. So what do the data tell us about the ability of households to service their debt? This graph shows the ratio of household mortgage debt to income (a subset of the previous graph on household total debt) on the left hand panel and various serviceability metrics on the right hand panel (Graph 4). The mortgage debt-to-income ratio shows the same pattern as total household debt-to-income – rising up until the mid-2000s then steadying for a few years before increasing again from around 2013. The dashed line represents the total mortgage debt less balances in ‘offset’ accounts. This shows that taking into account these ‘buffers’, the debt-to-income ratio has still risen, although not by as much. So households in aggregate have some ability to absorb some increase in required repayments.

Graph 4: Household Mortgage Debt Indicators

In terms of serviceability, interest payments as a share of income rose sharply from the late 1990s until the mid-2000s reflecting both the rise in debt outstanding as well as increases in interest rates. Interest payments as a share of disposable income doubled over this period.

Since the mid-2000s, however, interest payments as a share of income have declined as the effect of declines in interest rates have more than offset the effect of higher levels of debt. Indeed even total scheduled payments, which includes principal repayments, are lower than they were in the mid-2000s, as the rise in scheduled principal as a result of larger loans was more than offset by the decline in interest payments.

The risks nevertheless remain high and it is possible that the aggregate picture is obscuring rising vulnerabilities for certain types of households. Interest payments have been rising as a share of income in recent months, reflecting increases in interest rates for some borrowers, particularly those with investor and interest-only loans. Scheduled principal repayments have also continued to rise with the shift towards principal-and-interest, rather than interest-only, loans.

There are therefore no doubt some households that are feeling the pressure of high debt levels. But there are a number of reasons why the situation is not as severe as these numbers suggest.

Source RBA

Under the Sunburnt Sky .....

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