In 2014 the Australian Prudential Regulatory Authority (APRA) became concerned after observing a build-up of risks in the Australian housing and lending markets. As a result it introduced a range of non-traditional measures to help cool an overheated market and moderate risky bank lending. Its first step was to make the big banks unquestionably strong by increasing their capital adequacy requirements. The Tier 1 capital requirement was raised to 10.5%. The second was to place a limit on the growth of investor lending to 10% annually and cap the growth on interest-only loans to 30% of new mortgages. These measures have scaled back risky interest only lending and have improved the quality of loans across the board. Macro prudential tools employed by APRA and ASIC have so far proven successful. Australian banks are in a much better position to deal with adverse shocks than they were a few years ago.

Since then we’ve been watching closely policy changes enacted by APRA, ASIC and the findings of the Royal Banking Commission. The warning signs are all still there, a combination of an explosion in debt and banks carrying over 60% of this debt on their balance sheets. With interest rates at record lows, it’s only a matter of time until they rise. This could trigger a shock to mortgage borrowers and to banks. Mortgagees that have taken out large loans may find themselves stuck with repayments they cannot afford creating a domino effect that could cripple the banking system. It’s this very debt explosion that has transformed Australia into one of the most indebted countries in the world. We have a household debt to income ratio of 205% at $2.466 trillion. For every $1 of income that’s $2 of debt. But the good news is, this figure is slowly retreating.

The recent review conducted by the Royal Banking Commission on residential mortgage serviceability added to our concerns about the vulnerabilities in the banking system. The risk is, Australian banks have been lending large amounts to people without properly assessing their serviceability. This was further highlighted by a number of examples that came out of the review. Banks failed to verify borrower’s incomes and living expenses properly. They were relying on a general benchmark and financial positions were being falsified in order to pass mortgage assessments. This means, a significant proportion of the bank’s loan book could be of lower quality then first assessed making the risk of external shocks a lot higher.

Our other concern is APRA’s limit on interest only loans could have a knock on effect. This speed limit on investor lending was a necessary approach to put a stop to the speculative nature of property investing. Over the years, people have become more and more comfortable in borrowing huge amounts to pay for a house with the same dollar income i.e. leverage. Whilst these interest only limits have had the desired effect, interest-only borrowers may face further stress when these loans convert to principle and interest. Approximately $400bn in interest only loans are due to convert to principle + interest over the next four years. The economic consequences of these loans converting to principle & interest could be significant and are an unknown.

As Warren Buffet once said it’s “only when the tide goes out do you discover who has been swimming naked”. Meaning it’s only once we have a property collapse will this problem really be exposed. Of course by then it’s all too late. So it’s pays to be safe than sorry. The crackdown on bank lending to riskier investor and low-deposit borrowers is starting to bite and is clearly working. The Royal Banking Commission has triggered a significant tightening of income and expenses assessments by the banks making it harder to over leverage. This is a positive thing. Banks had been underestimating living expenses in their assessment of mortgage applications. About 90% of mortgages use the Household Expenditure Measure which is a basic lifestyle benchmark used for expenses. Now banks will be forced to conduct reasonable inquiries to calculate living expenses. It’s a game changer.

Banks are deleveraging and trying to raise the quality of their loan books. The curtailing of interest-only loans seems to have restrained investor demand at a time when Sydney and Melbourne house prices were soaring.

The property market is cooling.

Home prices across Australia’s major cities fell for the eighth straight month. Sydney fell -0.2% and Melbourne fell -0.5% during the month of May. The median property price in Melbourne now stands at $717,020 and Sydney at $871,454. Last week the clearance rate stood at 59.7% was across Australia’s capital cities down from the 60.3%. Melbourne fell to 60.9% and Sydney 62.7%. In contrast, last year Melbourne was 74.2% and Sydney 72.7% last year. As banks get tougher on how they assess borrower’s income and living expense levels, we can expect buyers to retreat and Melbourne and Sydney property prices to follow suit. Some economists are predicting a further 5%-10% in property price falls this year. After nearly a decade of running super-hot, risky lending is finally done and that’s a good thing. With the brakes now firmly on, sentiment for investment into the housing market is starting to wane and we should start to see a reduction in the high household debt ratio.

Low interest rates and easy money has left us with the highest debt in the world. Had we allowed this to continue, it would have left us highly vulnerable to any adverse external shocks. A substantial rise in interest rates would have been enough to cause an economic downturn. Residential property poses the biggest single risk to our economy and it can’t continue unabated anymore. There are however early signs that these risks are starting to subside as lending restrictions start to take effect. Bank are deleveraging and strict lending regulations are starting to bite. While there is a long way to go, the risky lending and property pendulum is swinging in the right direction and that’s a good thing.