Financial Stability Review – September 2008Household and Business Balance Sheets
After several years of strong growth in spending and increases in debt, the household sector has entered a period of consolidation. The recent slowing in consumption and reduced demand for credit has occurred against a background of softer growth in real incomes and some decline in household wealth. There has been some rise in arrears rates on household loans, particularly in certain parts of the country, but the overall arrears rate remains low by historical and international standards. In the business sector, the various indicators continue to suggest that most balance sheets are in fairly good shape, although there are a relatively small number of companies – those that are highly leveraged and that are more exposed to declining asset valuations – that have found the current financial environment particularly challenging.
Average nominal income per household continued to grow at a robust pace, of a little under 7 per cent, over the past year. This is around the same as the average growth rate over the previous three years, during which the aggregate rate of household saving increased. But higher inflation has meant that growth in real income per household has slowed. Reflecting tighter monetary policy and earlier increases in debt, growth in real income after interest payments has slowed even more, to 1.2 per cent over the year to the June quarter 2008 (Table 12). These developments have contributed to the recent weakening in consumption.
Many households have also recently experienced falls in their wealth, after a long period over which wealth rose steadily. The value of housing assets – which represent nearly 60 per cent of the value of the household sector's total assets – declined slightly in the first half of 2008, with established house prices flat or falling across most capital cities. Household wealth has also been negatively affected by substantial declines in share prices; according to investment research firm Intech, the median superannuation fund return for the 2007/08 financial year was −8 ½ per cent, the weakest outcome for at least two decades.
As a result of these developments, aggregate household net worth is estimated to have fallen since the beginning of 2008, representing a notable departure from households’ experience over the past decade, during which net worth grew by an average of around 10 per cent per annum. As a ratio to household disposable income, the net worth of the household sector is estimated to have fallen from 670 per cent at end December 2007 to 615 per cent at end June 2008 – around its level in early 2005 (Graph 47). Household gearing ratios, in turn, increased a little in the first half of 2008, after being broadly steady for a couple of years.
Reflecting the tighter financial conditions, the appetite for further borrowing by the household sector has diminished and consumption has been weak. Housing credit – which accounts for the bulk of household borrowing – grew at an annualised pace of 9 per cent over the six months to July, down from around 12 per cent over the year to July 2007. This is around its slowest pace since the mid 1980s (Graph 48). Growth in personal credit has seen an even more marked slowdown. In response to share market price declines and volatility, households have reduced margin loan debt by 19 per cent over the year to July, in contrast to average growth of around 40 per cent over the three years to December 2007. Households have also slowed their use of credit card debt, with growth over the year to July of around 8 per cent, compared with average growth of 12 to 13 per cent over the previous two years.
Notwithstanding the change in the financial environment, there has been only a modest increase in arrears rates on household loans, which remain low both by historical and international standards. For housing loans on banks' domestic books (which account for around three quarters of all outstanding housing loans), the proportion of loans that are in arrears by 90 days or more was 0.41 per cent at June 2008, up a little from the end of 2007 but unchanged from a year ago (Graph 49). In contrast, the arrears rate on prime securitised housing loans is higher than a year ago, at 0.57 per cent as at June 2008. This likely reflects the lower average credit quality of these loans with, for example, the share of low-doc loans in the pool of securitised loans higher than that for loans on banks' balance sheets. In addition, there is some evidence that the arrears rate on prime, fully documented loans made by some non-ADI lenders (that relied heavily on securitisation) is higher than that for many bank lenders (see below).
As would be expected, arrears rates across loan types reflect the underlying risk characteristics of these loans. For securitised prime full-doc loans, the arrears rate has increased by around 15 basis points over the past year, to 0.5 per cent in June 2008 (Graph 50). The arrears rate on securitised prime low-doc loans (where borrowers can provide less evidence of debt-servicing ability) is higher than for full-doc loans, and has increased by around 20 basis points over the past year, to around 1.2 per cent in June. In contrast, for non-conforming loans – which are typically made to borrowers with poor credit histories – the arrears rate is both much higher than for other loans, and has risen by more, increasing from 7.1 per cent to 8.5 per cent over the year to June 2008. It is, however, important to note that these loans account for less than one per cent of the total value of outstanding housing loans in Australia.
Across all housing loan types, it is estimated that around 17,000 borrowers are 90 or more days behind on their mortgage repayments. This compares with an estimate of around 15,000 borrowers that were 90 or more days in arrears earlier in the year.
In analysing how arrears rates vary across the country, the main source of information is data from securitised loans. As noted above, interpretation of these data has recently been made more complicated by the lack of securitisations over the past year. Notwithstanding this, it is clear that arrears rates on prime loans remain considerably higher in NSW than in the other states, largely reflecting the relatively weak economic conditions and housing markets that have prevailed in some areas of that state (Graph 51). The arrears rate is notably higher in western Sydney, where there is a relatively large share of indebted households with high mortgage-servicing ratios and where house prices remain below the peak reached in early 2004 (Graph 52). Nationwide, the six areas with the highest arrears rates (on prime loans) are all in western Sydney, while a number of other regions in NSW are also showing relatively high arrears rates (Graph 53).
The available evidence suggests that newer lenders seeking to increase their market share, in part through looser lending standards, were particularly active in many of the regions with poor loan performance. In western Sydney, for example, mortgage originators appear to have comprised a greater share of lending than for Australia as a whole. For securitised prime full-doc loans made by these lenders in this area, the arrears rate is currently around 1.65 per cent, which is considerably higher than the average arrears rate for other lenders (Graph 54). In particular, the aggregate arrears rate on securitised prime full-doc loans made by Australian-owned banks in western Sydney is currently around 0.85 per cent. A comparison of arrears rates for all loans – that is, including low-doc and non-conforming – shows an even greater divergence in arrears rates across lender types.
The impact of declining lending standards, particularly in parts of NSW, is also evident in the experiences of different loan cohorts over recent years. For loans taken out at the start of this decade there has been little variation in arrears rates over time (Graph 55). But as property prices in Sydney began increasing rapidly, many borrowers turned to lenders that allowed higher maximum loan-to-valuation ratios or higher permissible debt-servicing ratios in order for them to borrow larger amounts. This period also saw the expansion of low-doc lending: as a share of new loans nationwide, low-doc loans are estimated to have grown from 4 per cent in 2002 to 8 per cent in 2006. For many, the increased risk involved in such loans was perhaps perceived to be mitigated by the prospect of further house price growth. Much of this non-traditional lending was enabled by the expansion of mortgage broking, and concerns remain about brokers’ remuneration structures (high upfront and low trailing commissions). In a small number of instances some lenders engaged in predatory lending practices.
In the event, Sydney house prices reached a peak in late 2003 (and early 2004 in western Sydney), and loans originated in NSW in 2004 subsequently experienced the worst arrears rate of any loan cohort. While arrears rates on loans originated in the years since then have been somewhat lower, they are still well above those of loans originated early in the decade. With the exception of parts of Melbourne, most regions outside of NSW have not seen this pattern; for the rest of Australia as a whole, loans extended since 2002 have only slightly higher arrears rates than do loans extended in 2002.
The increase in arrears rates between 2004 and 2006 in NSW and, to a lesser extent, in Victoria, led to a sharp rise in applications for property repossession between 2004 and 2006 in those states. There has also been an increase in repossession applications in south-east Queensland. More recently, however, the rate of repossession applications has shown little change (Graph 56). The one exception is Western Australia, where there has been a sharp rise in repossession applications over recent months, consistent with increasing arrears over the past year. This follows the recent decline in house prices in Western Australia after several years of rapid growth.
Other indicators of the state of household finances also suggest that, while household finances are not as favourable as they were a few years ago, there has not been a significant deterioration in the ability of households, as a whole, to meet their financial obligations over the past year. While arrears rates on credit cards and other personal loans have shown a slight upward trend since the middle of the decade, they are currently around, or not much above, the same level as a year ago (Graph 57). Similarly, the growth in credit card cash advances over the past year remains low, and the proportion of credit card balances accruing interest has remained steady over the past few years between 76 and 78 per cent (Graph 58). And as noted above, the growth in credit card debt outstanding has slowed over the past year. Together, these developments suggest little increase in households’ reliance on credit cards for short-term cash flow management. Other evidence also suggests there has not been a significant increase in the extent of more severe financial stress among households in 2008: the number of personal administrations (including bankruptcies) has risen only moderately (mainly due to increases in NSW); and the number of applications for the early release of superannuation benefits is broadly unchanged.
Overall, household finances in Australia continue to be in much better shape than those in a number of other countries, where arrears rates and rates of property repossession are, in some cases, many times higher than in Australia.
At the aggregate level, most indicators continue to suggest that business finances remain in good shape, though firms with complicated and/or highly geared balanced sheets, and those exposed to declining asset valuations, have come under pressure.
Over the year to the June quarter 2008, aggregate profits were up 14½ per cent, with profits as a share of GDP at its highest since the 1970s (Graph 59). This outcome has been boosted over recent years by the strength in mining profits, which grew at an annual average rate of 27 per cent between 2003 and 2008. Profits in the rest of the corporate sector have also fared quite well, with average annual growth of 7½ per cent over the same period.
The strength of profits over recent years has increased the scope of businesses to fund investment expenditure from internal resources, with retained earnings having averaged 9 per cent of GDP since 2003, up a little from the previous decade and nearly double the average over the 1980s (Graph 60). This has meant that, although spending on investment is at historical highs as a share of GDP, the amount of external funding needed has been much less than during other periods of strong investment, such as the mid to late 1980s. The bulk of the required external funding has been in the form of net debt raisings, with only limited net equity issuance – in contrast to the experience of the 1980s, where equity raisings played a larger role in meeting businesses’ funding requirements. Notably, in recent years, new borrowings had reached levels well in excess of the additional funding necessary for aggregate investment expenditures, with some businesses building up significant holdings of liquid financial assets.
Among listed non-financial companies, the pace of debt raisings outstripped the accumulation of retained earnings and new equity raisings between 2005 and end 2007, resulting in an increase in aggregate gearing. Since the end of 2007, however, gearing levels have been stable, with the aggregate ratio of debt to the book value of equity (excluding the effect of a large debt raising by Rio Tinto) currently around 70 per cent. Although this is higher than a few years ago, it is only a little above its average of the past 15 years (Graph 61). As discussed below, much of the increase in the gearing of non-resource companies over the past few years has been driven by the activities of utilities and other infrastructure firms. Some non-listed companies have also increased their gearing, in part reflecting the marked increase in leveraged buyout activity in 2006. And, as discussed in Box A, gearing of listed property trusts (LPTs) rose over the past few years.
While, at the aggregate level, gearing for listed non-financial companies has increased only moderately in recent years, a relatively small number of listed companies have borrowed more heavily, which has been reflected in a widening in the distribution of gearing across firms. As an illustration, among the largest listed non-financial comppanies, the gearing ratio of the company at the 90th percentile increased from around 120–140 per cent earlier in the decade to around 175 per cent at present (Graph 62).
Some highly geared companies have proved vulnerable to the tightening of financial conditions. The balance sheets of some entities holding utility and other infrastructure assets have been of particular concern to investors, with share prices of many of these companies falling markedly over the past year (Graph 63). The requirement to refinance a substantial amount of debt in the next couple of years, at what may be significantly higher spreads, has raised concerns about the ability of these entities to maintain distributions to investors; there have also been concerns over asset valuations, as well as the complexity of some related entities’ corporate structures.
Share prices for many other non-financial companies have also declined over the past year, reflecting global events and concerns over the outlook for profits during a period of slower economic growth. Non-resource companies’ share prices have declined by 24 per cent since June 2007. These price declines come after a period of strong earnings, which has seen the price/earnings (P/E) ratios of these companies decline to levels well below their longer-run averages (Graph 64). In contrast, investors remain more optimistic about the profit outlook for resource companies, with share prices of these companies broadly unchanged since June 2007, leaving this sector's P/E ratio only a little below its average for the past decade and a half.
As with infrastructure companies, many LPTs have experienced large share price declines over the past year, with this sector as a whole down 38 per cent since June 2007. As discussed in Box A, these share price falls have been driven by a range of concerns, including: the sustainability of higher levels of gearing; the impact of higher debt-servicing requirements on distributions to investors; and the prospect of downward asset revaluations. These factors have also curtailed banks' willingness to lend for commercial property purposes, with many property-related firms reporting difficulties in obtaining funds, including much stricter terms on loans for development. The recent slowdown in commercial property lending comes after several years of very rapid growth in banks' lending to this sector. Over the year to March 2008 (the most recent data available), banks' lending for commercial property rose by 28 per cent, with lending for office property growing by 38 per cent.
Although concerns about the availability of debt financing and tighter financial conditions have been felt most acutely in property-related sectors, the broader business sector has also registered some of these concerns over the past year. Since end July 2007, interest rates on large and small business variable-rate loans have increased by around 140 basis points. Although the aggregate interest-servicing ratio for larger businesses has increased to its highest level since the early 1990s, it remains well below the peak around that time; interest payments were equivalent to 24 per cent of profits in the June quarter 2008, compared with a peak of 62 per cent in 1990 (Graph 65). In contrast, the interest-servicing ratio for unincorporated enterprises is high by historical standards, and is currently only a little below its peak around 1990. Survey data, as well as liaison with businesses, indicate there has been an increase in the share of firms that view the level of interest rates and, to a lesser extent, the ability to raise funds from financial institutions, to be a constraint on investment. To date, however, aggregate investment spending has remained strong.
As well as some firms finding it more difficult than a year or so ago to raise funds from intermediaries, companies that usually access capital markets have found non-intermediated debt raisings to be more challenging than in the past. Only a small number of bond issues have occurred in the domestic market in 2008. While some large, well established companies have been able to raise significant amounts of funds in offshore wholesale markets, activity over the past year has been sporadic and issuance has not been sufficient to offset maturing debt securities; total non-intermediated debt funding declined by 2 per cent over the year to July 2008. Large businesses continue to have access to institutional funds through syndicated loans, with aggregate syndicated loan approvals over recent months only a little below average monthly amounts over the past few years. Whereas over the past couple of years corporate acquisitions accounted for a significant share (around a half) of new syndicated loans, recent approvals have largely been for capital expenditure or for general corporate and refinancing purposes.
Partly driving larger businesses’ concern about the availability of finance has been the decline in foreign banks' activity in the Australian market. In the June quarter, net new lending to businesses by foreign banks contracted slightly, after a number of years in which lending growth by these banks had been particularly strong, associated with the strength in acquisitions and investment activity by businesses (Graph 66). Lending to large businesses by Australian-owned banks surged in the second half of 2007, reflecting acquisition and investment activity, and also re-intermediation. Although net new lending has recently slowed significantly, it remains around the levels seen earlier in the decade. Lending to smaller businesses – which is almost all undertaken by Australian-owned banks – has slowed a little, but remains broadly in line with levels seen in recent years.
An important factor underpinning lenders’ willingness to extend credit to businesses is the continued good financial health of this sector. Business failure rates remain around the levels of recent years, having picked up only a little in the first half of 2008, and are below the levels of the early and mid 1990s (Graph 67). And, for the most part, the quality of business loans on banks' balance sheets remains very strong by historical standards. Although recently there has been an increase in the arrears rate for loans to incorporated businesses, up from 0.7 per cent in December 2007 to 1.2 per cent in June 2008, this largely reflects the problems in property-related businesses (Graph 68). The arrears rate on loans to unincorporated businesses has not risen over the past year, notwithstanding some movements from quarter to quarter. For both types of businesses, the current arrears rates are similar to those in 2003 and 2004.
Part of the explanation is also technical. The arrears rate on securitised loans in earlier years may have been held down by the strong growth of such loans, as only mortgages not in arrears are securitised. With securitisation having slowed recently, this effect has weakened.