Managing Home Loan Credit Risk in Changing Interest Rate Environments

Kadre Article Series – Perspectives on Credit and Risk in Australian Financial Services

Welcome to Kadre’s – article series ‘Perspective on Credit and Risk in Australian Financial Services’ where, the Kadre team will provide leading commentary, reflecting on their collective experience, to help Chief Risk Officers navigate the permanent white water of the Australian Financial Services environment.

Managing Home Loan Credit Risk in Changing Interest Rate Environments

In this article, we are looking at how changing interest rate environments may affect credit risk for financial institutions particularly with respect to home loan portfolios over the coming 12 months. By analysing recent data published by APRA, RBA, ABS as well as public disclosures by lenders and other industry participants, we provide our perspective across three important questions:

1. What is the current data telling us?
2. Where do the future risks lie?
3. What can Chief Risk Officer’s do to mitigate future risk in their home loan portfolios?

At a high level, the mortgage portfolios of most lenders are in good shape. Delinquency levels are at an all-time low and many de-risking strategies have been put in place to offset some of the obvious risks in the current economic environment.

According to a recent Fitch Report, mortgage arrears are at their lowest levels in two decades as record-low unemployment continues to offset the Reserve Bank’s efforts to cool the economy. Their analysis shows that Australia’s 30-day mortgage arrears is down seven points quarter on quarter to 0.82 per cent in the three months to June 30. Ninety-day arrears fell by four points to 0.4 per cent quarter on quarter, and late-stage mortgage arrears are expected to be broadly stable in 2022.

However, these aggregate metrics do not tell the whole story. Instead, the good risk segments may be masking high risk segments of vulnerable or financially distressed customers. The challenge for Chief Risk Officers is in identifying and quantifying the subsegments and then setting strategies that are appropriate for both the customers and the organisation.

Looking at sub-segments within home loan portfolios

On one-hand we have customers who took out home loans during 2021 and 2022 when house prices peaked and interest rates were at their lowest ever levels. These customers could be particularly vulnerable to rising interest rates and inflationary pressures.

As has been well publicised, the Reserve Bank signalled that interest rate would not rise until 2024. Consequently, many customers in this vulnerable segment would not have anticipated that interest rates would go up until 2024 and many may now be approaching small repayment buffers and zero or negative equity.  Additionally, there is another vulnerable segment from the pre-2021 vintages that had marginal capacity on loans written on lower fixed rates that will be rolling onto higher rates over the coming couple of years. This could create repayment challenges and financial distress for some customers.

On the other hand, there are customers who are well in advance of their contractual repayment schedule and have strong equity in their residential property. These are the customers who, while interest rates were low, continued making repayments that were higher than the minimum requirement. With low unemployment and historical increases in house prices, these customers are generally doing well.

When looking at averages of arrears, default rates, credit scores, LVR and DTI, mortgage portfolios appear to be performing strongly. But delve a little deeper and it may tell a different story.

Loans written before 2020 will have had a considerable increase in equity from rising house prices and natural amortisation of their loan balance. Additionally, these loans are likely to be well in advance of their repayment schedule and have large buffers of repayments.  Vintages from this era are likely to be low risk (and worth retaining where possible).

Loans written through 2020 to late 2021 were dominated by very low fixed rates and generally assessed on an interest rate buffer of 2.5%. Many of these fixed rate loans were for terms between three and four years meaning that the low fixed rates will expire between now and 2024. These customers will face interest rate increases in the range of 3-4% which will challenge their ability to meet higher repayments. Fortunately, some of these customers will have benefited from substantial rises in house prices and therefore may be able to sell their house at a profit if they cannot qualify for a refinanced loan or suffer financial distress.

Loans written in 2022 will likely have been assessed with a repayment buffer of 3% following APRA’s advice to ADIs mandating they increase their buffers from October 2021. However, many of these customers are facing an environment of increasing interest rate and inflation. Additionally, most will have suffered falling house prices which will limit their ability to sell at a profit or refinance their loan. Many of these customers will not have the benefit of payments in advance, particularly those purchasing a property (as opposed to those refinancing an existing loan).

How will those risks affect individual banks?

Each bank will have varying degrees of low-risk and high-risk segments within their portfolio. Depending on loan acquisition strategies and timing of mortgage growth initiatives, the average or aggregate credit portfolio performance may be masking some potentially latent emerging risk issues.

Certainly, for some banks it appears the risk may be significantly higher overall than for others.

The APRA MADIS statistics provide housing growth information for the banking sector. Loans of the major banks, mutuals, second tier and other banks, highlighted that several institutions have experienced growth of 7.25% over the last 12 months. While growth rates of individual ADIs may be due to mergers and acquisitions, a number have had organic growth of up to 30% or more. Whilst we are not definitively saying that these portfolios are riskier, they have grown during a period of ultra- low interest rates and at the peak of house prices.  These institutions should be more conscious of credit risk in their mortgage portfolio and be performing relevant portfolio analysis in areas such as vintage, roll-rate, score distribution, dynamic LVR, payments in advance etc and using stressing testing (or scenario testing) models to identify and quantify those segments that are most at risk.

Growth in Home Loans Since March 2020

Conversely, some banks who have NOT grown as quickly will have a greater proportion of customers who are in advance on their repayment. They will have a higher number of customers who have taken advantage of falling rates to pay in advance with the RBA quoting 50% of variable rate Owner Occupiers^[1] having accumulated more than 2 years’ worth of prepayment at current rates and CBA, for example, stated in their recent results that 34% of their home loan portfolio is over 2 years in advance.

Mortgage stress is not yet evident in banks arrears, default or losses. In addition to record low delinquencies^[2] the RBA stress testing of their Securitisation data base suggests only 0.4% of Mortgagees would be in negative equity as a result of 10% House Price Depreciation (HPD) ^[3]. However, the stress test is for an average portfolio and as can be seen in the APRA MADIS data above, some lenders have rapidly grown their portfolios during the period of low rates and high house price appreciation. It is likely that these portfolios will be disproportionately affected.

It is also important to recognise that portfolio stress is not just about negative equity. Customers default when they are unable to make repayments, not when their debt exceeds the value of the property. Given the customer harm and operational cost lenders ought to worry about any customer defaulting, even if they won’t lose money – and even so, they tend to lose money even if there is marginal equity as sales of Mortgagee in Possession houses tend to realise lower than market prices.

Balancing the risk – how will de-risking strategies hold up in an inflationary environment?

Buffers and floors have played a part in helping all banks avoid lending to customers with marginal capacity, including APRAs increase in the buffer from 2.5% to 3% in October 2021. Additionally, Loan to Value Ratios (LVRs) are in a much better position with the percentage over 90% LVR having fallen to around 7% from a peak of ~22% in 2009/10^[4].

In many cases the current performance paints a positive picture due in part to these de-risking strategies. Negative equity is negligible, and delinquency is at record lows.

So, with many of the de-risking strategies put in place already going someway to alleviating the stress, the extent of the pressure of future risk will depend on the speed and level of interest rate rises and consumer price inflation.

With that in mind, let’s take a look at what is happening in the wider economic environment.

A look at the recent economic statistics

• Whilst the recent rate increases have begun to impact Home Lending – evidenced by New Loans dropping by 8.5% in the month of July and 11.3% during the last 12 months as well as House Price drops in all Capital Cities other than Darwin (Corelogic)^[5] – it is yet to show evidence of impacting consumer demand for goods and services with CPI rising to 6.1% and Retail Trade up 1.3% in the month and 16.5% in the year.
• Further Wage increases are 3.3% for the June Qtr and 6.8% over the year and unemployment is at 48-year lows at 3.4% down from 7.5% a year ago.^[6]
• The Cash Rate has risen from 10bps to 235bps, meaning the repayments on a $350k mortgage could equate to an increase of $4,980 a year. If it went up to 325bps the increase would be as much as $7,404*
  (ref: https://moneysmart.gov.au/home-loans/mortgage-calculator#repayments, assumes all the cash rate increase is passed along).
• Digital Finance Analytics, an independent financial consultancy, estimates that 47 per cent of households in NSW and 48 per cent in Victoria are already suffering mortgage stress, defined by their outgoings (excluding one-off discretionary items) exceeding their income. It’s much higher in Tasmania at 62.2 per cent.

The muted impact of rate rises on consumer demand and (relatively) high CPI suggests further Cash Rate increases as the RBA attempts to control inflation within their desired range. ANZ are forecasting a Cash Rate of 3.35% and the futures market 3.55% ^[7], up from the current 2.35%.

Movement of the Cash Rate Since January 2020

Obviously, whether these rate rises will actually curb inflation is crucial to alleviate borrower stress, but so too is the time it takes for these actions to take effect. Prolonged inflationary pressure will erode savings, further challenge those with marginal capacity, and leave the market less equipped to deal with uncertain, evolving, global conditions.

Given the above statistics, there is an obvious risk that highly indebted, low-income customers will find it increasingly difficult to service their debt at a time when house prices are depreciating. They are not only impacted by rising interest rates but also much higher inflation rates.

So, how will banks be impacted by the changing interest rate environment and how can they best mitigate future risk within their home loan portfolios?

Whilst the majority of banks will be unlikely to suffer losses while house prices remain high compared to the size of the loans, individual customers will suffer hardship, so all banks will need to consider what they do about that. Do they foreclose and risk poor publicity and the potential to adversely affect the housing market? Or do they not foreclose and suffer the capital cost of holding onto non-performing assets in a depreciating housing market?

Importantly, banks that have experienced high growth in recent times will be affected even more by these customer hardship challenges as they will have a high proportion of their portfolio written in very low-rate environments. So, it is even more imperative for them to undertake effective analysis and apply stress testing scenarios at a segment level and develop solutions to alleviate future risk and exposure.

Kadre’s 3-Step Process to Mitigate Home Loan Risk

The following is our 3-step process to help Chief Risk Officers mitigate risk within their home loan portfolios:

1. Analyse key segments of your portfolio – Identifying, quantifying the magnitude and performance of high-risk segments is a good place to start. Customers who are highly indebted are vulnerable to interest rate increases. A DTI (Debt to income) measure is a good proxy for highly indebted customers. Within the high DTI segment identify further high-risk sub-segments. For example, taking segments with low Net Income (Income less expenses) at the time of application; First Home buyers, Fixed Rate customers due to roll off in the next couple of years, and potentially high LVR customers (and certainly those with combinations of the aforementioned).
2. Develop Stress Testing models and scenarios – to model the effect of potential economic conditions on your portfolio, stressing the identified potentially vulnerable segments in particular – remembering the challenge will be with ‘edge cases’ not portfolios in aggregate. It is essential to really understand the portfolio, running through stress scenarios that address these particular challenges:
   What was the repayment capacity at the time the loan was originated? What has been the subsequent change in CPI? What has been the subsequent change in debt repayment? What’s the likely change in their income?
   Then, you can analyse all those things together and apply some forward thinking. Good historic data is integral to this process and then there will need to be some assumptions made on CPI and salary by considering the recent economic statistics. The key here is to address stress testing models at a more granular segmented model because it’s not going to affect everyone in the same way it has historically.
3. Evaluate your Originations and Collections policies – Consider your customer contact centres and resourcing with regard to your Credit Risk appetite and the stress tests outputs. Start thinking about what the operational credit policy changes that are needed to be applied to either stop the adding to the risk or mitigating the contingent risk in your existing portfolio.

In conclusion, whilst aggregate and average portfolio metrics currently may not present an obvious concern to the executive team, recent changing interest rate environments coupled with inflationary pressures will create challenges for many customers. Consequently, certain segments are going to be disproportionately affected by repayment stress. Over the last few years most lenders have applied prudent policies that will mitigate the worst of the potential impact; however some lenders may struggle if they have grown significantly in recent years and have substantial exposure to highly indebted and low capacity customers! All lenders will have segments of customers who are adversely impacted and who will require help. This presents a more finessed challenge for Chief Risk Officers. They will need to start segmenting their portfolios, perform stress tests to get ahead of the game and devise nuanced mitigations that address the specific needs of the affected customers!

^[1] Michelle Bullock 19th July 2022 https://www.rba.gov.au/speeches/2022/sp-dg-2022-07-19.html

^[2] https://www.fitchratings.com/research/structured-finance/australias-mortgage-arrears-at-record-lows-in-2q22-on-low-unemployment-02-09-2022

^[3] Michelle Bullock 19th July 2022 https://www.rba.gov.au/speeches/2022/sp-dg-2022-07-19.html

^[4] Michelle Bullock 19th July 2022 https://www.rba.gov.au/speeches/2022/sp-dg-2022-07-19.html

^[5] https://www.corelogic.com.au/news-research/news/2022/home-value-index-housing-downturn-accelerates-as-falling-values-become-more-widespread

^[6] https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/consumer-price-index-australia/jun-2022

^[7] https://www.abc.net.au/news/2022-07-25/the-number-of-australians-at-risk-of-mortgage-stress/13987158