Will APRA follow in the BoE's footsteps to reduce mortgage risk?

In a neat coincidence, within hours of Moody’s credit ratings agency warning that Australia’s residential property market appears to be over-heating, the Bank of England has moved a step closer to taking direct action to control riskier lending for the first time in more than three decades.

Overnight the UK central bank’s financial policy committee issued a consultation paper in which it set outs the rules that will direct and enable the UK Prudential Regulation Authority and Financial Conduct Authority to ensure that mortgage lenders don’t lend more than 15 per cent of their new home loans at loan-to-income ratios of more than 4.5 times.

It also instructs the regulators to ensure lenders stress-test new loans by assessing whether borrowers would still be able to afford their mortgages if at any point during the first five years of the loan rates were three percentage points higher than at the time of the loan’s origination.

The BoE’s concerns are near-identical to those that have been voiced here. The ultra-low interest rate environment coupled with a constricted supply of new housing, population growth and the growing presence of DIY investors and foreign buyers is driving up the prices of established homes -- and is leading to higher loan-to-valuation and loan-to-income ratios.

Only last month the Australian Prudential Regulation Authority issued a draft prudential practice guide for residential mortgage lending in which it referred to the environment of strong pricing pressures in some housing markets and very active competition  between lenders. It reminded lenders of the importance of maintaining lending standards in the face of competitive pressures.

The BoE’s concerns have been sparked by the rates of growth in higher loan-to-income ratios in the UK, particularly in London. In the year to March, 20 per cent of lending in London was at ratios of 4.5 times or more.

As with other financial regulators in developed economies, the BoE is worried that a rapid build-up of household debt will eventually create economic instability and the risk of financial crisis.

Given that mortgage rates around the world are generally at historic lows because of the unconventional monetary policies that have been pursued by the US, Europe and Japan since the 2008 crisis, there is a legitimate concern that as rates eventually normalise borrowers who can service their loans at today’s rates are going to come under severe pressure.

Putting a ceiling on the proportion of riskier loans is, as the BoE said, a form of insurance against the possibility that the strength of the housing market turns out to be stronger than expected -- and therefore that the proportion of vulnerable households rises too far.

New Zealand, Norway, Sweden, Switzerland and Canada have already introduced restrictions of high loan-to-valuation ratios because of their concerns about housing bubbles forming. A cap on loan-to-income ratios is probably a more effective macro-prudential tool than loan-to-valuation restrictions, given that valuations are inflating today but could deflate significantly in a housing market crisis.

APRA has so far resisted calls for it to impose macro-prudential measures here, preferring to remind the banks of the need to lend prudently.

Conventionally the Reserve Bank would have responded to the surge in house prices and mortgage lending by raising interest rates. But with the economy weakening and significant restructuring occurring as the resources investment boom wanes and the dollar remaining stronger than it would like, that’s not regarded as a palatable option.

In the longer term, state governments need to do something about the constraints on the supply of new housing stock and the rising cost of that stock as cash-strapped governments push the associated infrastructure costs back, through developers, to new home buyers.

In the near term, however, unless the market starts to cool and/or banks start to pull back their loan-to-valuation and loan servicing ratios, APRA will be tempted to emulate its peers offshore and impose its own restrictions on their lending to reduce the risk of a housing market crisis that can only increase the longer this period of low rates and rising house prices continues.