Investors should look out the housing window

Wayne Byres, the chairman of the Australian Prudential Regulation Authority (APRA), has some bad news for property investors: further regulation to curb property market risks are on their way.

Last week APRA announced that it would introduce lending limits on interest-only loans. Under the new guidelines interest-only loans would be restricted to 30 per cent of new loans issued; down from its current level of almost 40 per cent. Australia's use of interest-only loans is unusual by international standards.

Investors disproportionately favour interest-only loans. Around two-thirds of new investor lending is in the form of interest-only loans, which allows the investor to take greater advantage of tax concessions such as negative gearing. For owner-occupiers, interest-only loans account for around one-quarter of new lending.

These new guidelines will exist in conjunction with the existing speed limit placed on investor credit growth of 10 per cent. Furthermore, APRA would prefer that credit growth remains comfortably below that 10 per cent benchmark, although it is unclear what ‘comfortably below' actually entails. 

These steps have been taken to reduce the financial risks associated with Australia's $6.4 trillion residential property market. Tighter lending standards on interest-only loans will raise the cost of investment for property investors. But since most investors take advantage of interest-only loans for tax reasons rather than necessity, I don't anticipate that this regulatory change will hit the market significantly.

Raising the capital bar for lenders

However, perhaps the most important development occurred this week when Byres signalled that the major banks may be forced to raise billions in new capital to address risks in the property market.

“If we are going to put an increasing number of eggs into a single basket, we'd better make sure that basket is an unquestionably strong one,” Byres said earlier this week.

The concern is understandable and existing measures, such as the 10 per cent limit on investor credit growth, hasn't been sufficient to curtail financial system risks.

“Those measures had a positive impact but at the same time the risk environment certainly hasn't moderated,” Byres said. “House prices remain high; household income growth remains subdued; the already high ratio of household debt to income has got higher”

One way in which the health of the financial sector can be strengthened is via requiring banks to hold greater capital against their mortgage assets. This effectively reduces the leverage that the banks can use to generate assets and profits.

This should raise a red flag for investors. Higher capital requirements are likely to weigh on house price growth – that is, house prices growth will be softer than it would be under lower capital requirements – as well as reduce the return on equity (ROE) generated by the major banks.

Only a week ago I addressed this very issue when I discussed the recent decline in the major banks' ROE (Why bank returns will get slimmer; March 28). It is already unlikely that going forward the major banks will be able to achieve the ROE that many investors have become accustomed to; further increases in capital will only push ROE lower again.

The recent announcements from APRA and its chairman comes against a backdrop of increased scrutiny of the property market by the other key regulators: the Reserve Bank of Australia (RBA) and the Australian Securities and Investment Commission (ASIC).

RBA governor Philip Lowe noted that households are coping reasonably well with higher debt levels.

“Arrears rates remain low and many households have built up sizeable buffers in mortgage offset accounts,” Lowe said in a speech earlier this week. “At the same time, though, slow growth in wages is making it harder for some households to pay down their debt.”

Meanwhile, ASIC chairman Greg Medcraft is concerned that some borrowers will never be able to pay down their principal on interest-only loans.

“Our biggest concern is just warning people that interest rates will go up and you need to be really careful about assessing whether you can really afford that mortgage and if you've an interest-only loan,” Medcraft said. 

The combination of rising debt levels and higher dwelling prices, against the backdrop of low wage growth and a soft economy, has been discussed at length by the Council of Financial Regulators. Chaired by Lowe this council brings together the heads of the RBA, APRA, ASIC and the Australian Treasury.

Their official position is the policies announced by APRA, but it is clear that each of these institutions has a role in actively discussing these issues and where possible influencing investor decisions. In the coming months we will see a fair bit of ‘jawboning' from our federal regulators.

Investors have ignored such discussions in the past – with low interest rates and expectations of capital gains holding greater sway on investor decisions – but with each new regulation we inch ever closer to a market correction.

Add in increasing speculation on a housing bubble, and that the Sydney and Melbourne property markets are in their fifth year of rapid growth, and you have a recipe for a swift turnaround.