Risky bank loans now in regulation authority's sights
As widely expected, the Reserve Bank board has again left the official cash interest rate unchanged at 2.5 per cent.
Despite the Australian dollar remaining higher than is desirable after a substantial fall in the iron ore spot price, it now appears unlikely that the Reserve Bank will reduce short-term interest rates below current levels. This is supported by industry speculation that no changes will occur until next year when the Reserve Bank may start increasing rates again.
Although markets have wrongly predicted rate movements in the past, financial institutions are now offering fixed rate loans at bargain basement levels. So competitive is the market that the big four banks are offering attractive fixed loans to borrowers using shares as collateral for margin loans.
In the past, the cost of margin loans was considerably higher than for comparable residential property loans. But as the risks of property loans increase with rising residential prices in the major locations, the banks are now competing more aggressively to lend against quality shares on relatively conservative loan valuation factors.
There are reports emerging that the property regulator, the Australian Prudential Regulation Authority, is making life more difficult for lenders funding purchases made with high loan valuation ratios. These high LVR loans are offered only when the borrower is prepared to take out mortgage insurance to cover the risk of default.
As property prices rise, the risk of providing mortgage insurance rises. Apparently APRA is closely monitoring the capital reserves of companies offering mortgage insurance to prevent major problems in the event of a steep fall in property prices.
Nevertheless, the regulators are less concerned about the possibility of property price falls than their counterparts in Britain who, as reported in The Economist, are requiring British financial institutions to undertake stress tests of the implications of a 35 per cent fall in residential property prices.
As sensible borrowers understand, historically low interest rates and high loan valuation ratios can be a potentially lethal combination. The greatest risk is that interest rates rise and property prices fall potentially leaving the borrower with negative equity in their home.
There's some good news being reported by lenders. Existing borrowers have been applying the savings in interest costs from lower rates to reduce their outstanding loans as quickly as possible. This reduces the risks, especially when property prices have been rising.
APRA is targeting the right segment of the loan market by focusing attention on new high LVR loans to control the overall risk levels of our financial institutions.
At a personal level, making hay while the sun shines by reducing outstanding borrowings as quickly as possible is an excellent way of lowering the cost of any future increase in interest rates.