A significant group of borrowers are at serious risk of default, but Australian banks will be able to comfortably survive any losses, argues the Reserve Bank.
The RBA's latest Financial Stability Review (FSR) is under intense scrutiny, with banking failures overseas raising concerns globally, and rising interest rates continuing to put pressure on many households and businesses.
The bank has updated modelling previously undertaken in its last FSR in October about how households are coping with the 3.5 percentage points of interest rate increases imposed by the RBA since May last year.
Given that last year's modelling assumed a cash rate of around 3.5 per cent and the latest model uses a 3.75 per cent cash rate, it is unsurprising that the results remain very similar.
"In the baseline scenario, the share of borrowers with negative spare cash flow – that is, those whose scheduled mortgage repayments and essential living expenses are projected to exceed their household disposable income – would reach around 15 per cent by the end of 2023, with many of these borrowers already projected to be in this position," the RBA noted.
This "baseline scenario" also assumes that unemployment rises only slightly from current levels, that incomes rise by 4.25 per cent and living costs increase 4.75 per cent this year.
Canberra-based public servant Tess and her family are among those feeling the pressure.
Having been eroded by soaring inflation and big rises in mortgage payments, her part-time wage and her husband's full-time salary are not covering what they used to.
"For us, it's sitting down and saying, 'OK, we're going to not go to the major supermarkets, we're going to cut back on brand-name things, we're going to skip anything that's considered discretionary'," she told The Business.
"And that's tough, especially with little kids."
Despite being a dual-income family on solid pay packets, they have rapidly shifted from being comfortable to feeling like "there isn't really a lot of padding" in their life.
"It's getting to each pay cheque and going: 'OK, pay that bill and pay that bill and how much have we got left?'" Tess explained.
"I don't think I've ever like spent this much time looking at the finances and really saying, 'Can we afford life insurance? Can we afford to go to the dentist?'
"I kind of feel like our income is reasonable. I don't know what's happening to people that are on a lower income – it must be really, really hard for some of those people."
'Adverse scenario'
But things could get even worse.
The bank also modelled an "adverse scenario" where, even though rates remain at 3.75 per cent, unemployment climbs a couple of percentage points to 5.5 per cent by year's end, underemployment also rises 2 percentage points and both wages growth and inflation are lower than the baseline forecast, by 0.75 and 1 percentage point respectively.
"In the adverse scenario, the share of borrowers experiencing negative spare cash flows by December 2023 would increase slightly to 17 per cent," the bank forecast.
The Reserve Bank has consistently drawn comfort from data showing that more than 60 per cent of all loans had balances in offset and redraw accounts equivalent to more than three months of their scheduled repayments and almost half had buffers equivalent to more than a year.
However, that leaves around 40 per cent of loans with prepayment buffers of less than three months.
The Reserve Bank has again acknowledged that this could leave a substantial group of borrowers who will run out of savings to keep paying their mortgages, even if they slash their discretionary spending.
"Around 9 per cent of borrowers would still be at risk of depleting their savings [by mid-2024], even if they reduced their non-essential spending by relatively extreme amounts (40-80 per cent)," the RBA cautioned.
This proportion increases only slightly to around 10 per cent in the adverse scenario, indicating that it is not necessary for the economy to deteriorate to put many borrowers into serious trouble.
Beyond mid-2024
Moreover, the Reserve Bank has only considered what happens until the middle of next year, not what would occur if interest rates remain at their current levels, or higher, for a longer period.
"The analysis only considers households' buffers until mid-2024; a prolonged period of high interest rates, inflation or unemployment beyond that horizon would result in more households eventually exhausting their savings buffers," the bank acknowledged.
The bank also revealed that many borrowers will be trapped as "mortgage prisoners" unable to refinance their loans to seek lower interest rates because they no longer meet current serviceability tests at higher interest rates.
"Estimates suggest around 16 per cent of existing loans are unable to meet serviceability assessments conducted at current interest rates."
The RBA emphasised, however, that it believes its estimates around negative cash flows are conservative, with many households having enjoyed larger income increases, having a greater ability to cut expenses and/or having a larger pool of savings outside of their offset and redraw accounts.
On the other hand, the research only looked at variable mortgages, with around 880,000 fixed loans set to come off generally ultra-cheap rates below 2 per cent onto variable rates typically well above 5 per cent over the course of this year.
Betashares chief economist David Bassanese said RBA research into fixed mortgages, published last month, shows they will add 0.7 of a percentage point to the average mortgage rate paid by home loan borrowers over this year and next.
"The wall of expiring fixed-rate mortgages over the coming two years will be equivalent to around one third of the 3.5 per cent increase in the official cash rate already seen over the past year – or around five further 0.25 per cent rate increases, for a cumulative effective official cash rate rise of 1.25 per cent," he noted.
"Given this lagged policy impact, it's little wonder the RBA this week announced a pause in hiking rates."
Lower income households more at risk
What is crystal clear from the bank's research, though, is that it is lower income households likely to bear the brunt of any wave of defaults.
"As lower income borrowers tend to have lower spare cash flows and hold lower savings, they are generally more at risk of seeing their expenses exceed their income and their savings buffers being insufficient to weather periods of stress," the RBA noted.
"First home buyers and borrowers with high debt relative to their income are also more at risk of having insufficient buffers if their spare cash flow becomes negative."
The Reserve Bank noted that rate increases to date have already pushed almost half of low-income households into one of the widely accepted definitions of mortgage stress.
"The share of low-income mortgagors (defined as the bottom quartile of mortgagor incomes) devoting more than one-third of their income to servicing their housing loan has increased from around one-quarter before the first increase in interest rates in May 2022 to around 45 per cent in January 2023," the report noted.
By way of contrast, only about 5 per cent of borrowers in the highest income quartile fall into this category.
Low-income households are more at risk of losing their job if the RBA's adverse scenario with rising unemployment and underemployment comes to pass.
The lowest fifth of borrowers by income are at least twice as likely to lose work and the second lowest group one-and-a-half times more likely to fall into unemployment as the 60 per cent on higher incomes.
And relatively few households can sustain their mortgage through an extended period of unemployment.
"More than 80 per cent of households that experience job loss would have negative spare cash flows. Around half of households that lose a share of their hours would have negative spare cash flows," the RBA found.
"Around half of mortgagor households that experience job loss would have sufficient buffers to sustain their essential spending and minimum mortgage repayments for more than six months if they were to retain their current levels of non-essential spending. If affected households were to cut their non-essential spending by 80 per cent, this share would increase to 60 per cent."
Little risk to banking sector
Whatever happens in terms of defaults though, the Reserve Bank and banking regulator APRA see little risk of major losses to the banking sector, with most home loans still well backed by the value of the underlying property.
"If housing prices fell a further 10 per cent from January 2023 levels, the share of loan balances (by value) in negative equity is estimated to rise to 2 per cent," the FSR noted.
"Around 90 per cent of these loans (by number) in negative equity have lower prepayment buffers and would therefore be at a higher risk of default if these borrowers became unable to service their debts."
It is that 2 per cent of loans that could generate losses for the banks and mortgage insurers if they were to default while in negative equity – where the outstanding debt is worth more than the sale price of the property.
