Transcript of Question & Answer Session The Limits of Interest-only Lending

We’ve got some microphones at the back of the room. Do we have any questions for Christopher?

Hi. It just strikes me that APRA and maybe the Reserve Bank were thinking that the banks were lending too much in terms of interest only, and rather than tighten the regulations on them, it’s been passed on to the mums and dads to pay the extra interest on interest-only debt, at a time when they’re having their families and they need the income more, they’re the ones that seem to be penalised for this, not the banks. I don’t really understand that, I’d just like your views on that.

Sure. So what APRA did and what the Council of Financial Regulators sort of came up with was essentially two things. One was a tightening in lending standards, which is to apply to new borrowers to make sure those new borrowers were really going to be able to service their loans over the whole life of the loan. So that was the first thing, and they’ve done that in a number of different ways. I’ve talked about some of them. The other thing though, they wanted to do is sometimes those things can take some time to have a bit of an effect and gain some traction, so at the same time APRA placed this limit, this 30 per cent limit on the share of new lending that could go via any one bank to an interest only loan, so that 30 per cent limit was placed there, and so that had fairly immediate effect. Now, what the banks chose to do was to obtain that slower growth by putting an extra price, raising the interest rate on interest only loans. So that’s what the banks chose to do, rather than to sort of ration it out and say well, you’re one of my borrowers who can get an interest only loan, but you’re not, and not change the price. So they chose to do that.

They also chose to change interest rates on their whole back book, which provided incentive for existing borrowers to come along and switch their loans. Now, one of the things that we understand the banks did was they were quite vigorous in contacting their existing customers who were on interest-only loans and saying, yes, you’re paying a higher price now, but we’ll make it easy if you have a mind to switch to a P&I loan, to go back on a lower interest rate, essentially, not have to pay this higher rate that I showed you. One of the reasons they did that is because the customer may have thought to do that themselves, but what they’d do is pick up the phone, perhaps go to their broker or go to another bank to ask them about that. So the banks were going to their existing customers and doing that, and then they were reducing the cost of moving those loans, making it much easier for customers to switch their loans, to refinance out of the interest-only loan into a P&I loan and face a lower price.

So the banks allowed that to happen, and I think that’s why there’s so many people who adjusted in the past year. They saw the price going higher, they made the adjustment. Maybe some didn’t want to do that, maybe some found that tricky. Maybe they might have found the higher payments, a bit harder, on a P&I loan, because you have to start as soon as you switch to make those higher payments. But as best we can tell, the number of those borrowers facing significant difficulties is relatively small in facing that change.

It’s a very interesting presentation, but I’m a person who came through the’80s when interest rates went from 18 [per cent] to 21 per cent. That’s scarier than anything you’ve presented here, I can tell you, and particularly in the middle of a wages freeze that went for 18 months and you’ve got a young family and things are not looking good. Interest-only loans were confined to high net worth individuals back in that period. But the result of that was the banks called you in and said, "Well, how much can you pay? Because we don’t want you to fail." And so they’d work out a system of – and they extended the loan from 20 years to 30 years, and you paid that. Eventually the house got sold, they got their money back and everything carried on.

I guess my observation is perhaps you could be jumping at shadows a bit in terms of every borrower failing with an interest-only situation and is there a halfway house at the end of the interest-only period of five years? You have the graph where you’ve got a principal amount of money coming up. If you go back to that graph.

This one?

That one, yeah. Okay, it’s a differential between the two interest rates, but why can’t you gradually increase the principal repayment and decrease the interest payment slower over the years? When you get out to 30 years, that interest payment’s coming off to nothing, and principal’s almost maximised. Who says you’ve got to go up that high in the first five years, the next five years? Why couldn’t you make it more payable? Get it under the 6 per cent, and gradually give people a chance to adjust over time, rather than hit them with a shock?

Well, I think the important thing partly is that if a customer is sort of understanding the interest-only loan properly, and the bank’s explaining it clearly, one, it shouldn’t be a shock. I think it might be, because some aren’t necessarily fully understanding what they’re getting into. What you’re suggesting, I think you sound like you’re putting a plug for a new product for banks, and maybe they could come up with that, where they just stagger the increase in the principal payments.

[inaudible] All I’m saying is that there’s got to be a modicum of common sense applied to what may be a problem in a few cases. Investors would love you for putting up the interest rates, that’s just a bit more tax money made. That’s great. So 60 per cent of them are applauding you. The ones who aren’t happy are the owner occupiers, or some of them, because the high end net worth but couldn’t care either, really. It’s a few people, only a few people, in that owner occupier space, who have got the problems, and it’s largely too, it’s a Sydney, Melbourne problem. It’s not the rest of Australia. And so, I’m just worried.

Well, I think what the point of my talk was to suggest that most people are managing this transition pretty well, and non-performing loans overall over the past year when a lot of people have been switching haven’t really changed very much, certainly not in New South Wales and Victoria. Some of the slight increase in non-performing loans has occurred in WA and Queensland, in parts where economic conditions have been less favourable. So I think people have been managing it reasonably well, and most people are quite aware that this is coming and they’re planning for this. They’re managing their transition well, and we haven’t seen a big drop off in, say, household consumption, as I suggested. It’s actually gone up over the year. But again, I don’t think that was an argument to say we shouldn’t have done it now, in fact, it sort of says well, we’re reducing the risk of a bigger problem building further down the road when economic conditions and interest rates may be less favourable for borrowers. So I think that was the sort of point I was trying to get across.

Hi. I’m just wondering what kind of interest rate projection was used for this analysis, and do you think whether interest-only loans are P&I loans, which one would be more affected by potential increases in interest rates?

Well, we did what we would normally do, and certainly in this case it’s very simple. I have assumed no change in interest rates over the course of the next few years, and all this does is just say, in this graph here for example, let’s assume when they go from the representative interest rate, the current interest-only loan is having to pay to what a P&I loan is, so it’s just slightly smaller. In terms of whether a change in interest rates might affect that differential between the two, I’m not so sure. We’re seeing a few instances recently where banks have in response to dropping well below the overall, if we look on the left-hand side, the overall flow here of new loans going to interest-only loans as a share of all loans that the banks are extending, that’s well below that 30 per cent, that brown line on the left-hand panel for total. Banks have a little bit of room where they can increase the growth of interest-only lending, and we’ve seen at the margin a few adjustments in the prices, which is sort of facilitating that for new interest-only borrowers. Some fixed rate loan products, for example, have come off a little bit in the interest-only space, but I’ve said nothing about the future for interest rates.

Hi there. With regards to interest-only loans, did you look at the distribution of specifically owner occupier interest-only loans across different income groups? So are low-income groups more likely to have interest-only loans, or is it pretty much concentrated to only the higher income groups?

That’s a good question. I think to the extent that they’re more likely to be for investors than for owner occupiers, you can see that here, and the investors, not all of course, but many have slightly more income than the owner occupiers who are getting these. So I suspect if you just looked at the broader averages, you’d find the income levels, at least for investors, being a little bit higher. Remember, of course, not everyone has to get exactly the same size loan, so if you’ve got a lower income, you might still get an interest-only loan, but just get a smaller loan, a more modest loan, to buy a smaller house with. But it’s a good question. I’m not particularly sure of the exact answer, though. I think there’s a question on table six.

Prior to this recent tightening, do you think that the banks were too loose with interest-only lending, to let it reach 40 per cent of all mortgages, and why is it only in recent years that this has been dealt with in such a strict way?

I think the thing that’s concerned the Reserve Bank and the regulators is when we get a combination of things, when we get a combination of a low-interest rate world, quite a lot of competition amongst the banks to make loans. The possibility that lending standards might be weakened in that competitive environment, that debt levels are high and rising, and house prices have been growing strongly. The combination of all of those things raises concerns, particularly for the health of household balance sheets. And at that time, some of the things you look for in that situation are things that are growing quite fast, things that are new, things that are untested, and these were one aspect of that. Prior to this, back in 2014, the thing that was just growing quite fast was investor lending overall. Now, a large part of that, a significant share of that, more than 50 per cent, was on interest-only terms.

So first, we looked at the thing that was growing particularly fast, investor loans, and then realised also, even when that was tightened up a little bit, when this 10 per cent benchmark was placed on the banks, then interest-only lending was still growing quite strongly, including to owner occupiers. And I explained the clear motivations for investors to having them, and there are good motivations for owner occupiers to have interest-only loans as well. But you do want people, ultimately, to be repaying the principal, and that’s what the concern was, and it was the environment I think which drove that growth, and then we were responding to that environment, the regulatory community was.

So do you think that the banks were too loose with that lending?

I think if you look at APRA when they looked more deeply at lending standards and ASIC as well had a role to play here, when they looked more closely, they thought there were possible improvements the banks could make and APRA, indeed, went through and acted to ensure that they were lifting their lending standards. I think that’s had a noticeable effect, so for example, we see less high loan to valuation ratios loans being extended, just as one example.

So you’ve covered the impact of the changes on existing loans in the housing industry. I was just wondering whether you’ve considered the impact on the inflow of investment into the housing sector as a consequence of these changes? So, the distinction there being the impact of those currently with an interest-only loan as opposed to that higher effective interest rate restricting investment into the sector.

Yeah, look, I don’t think the higher interest rate has had a significant effect. I think it’s caused this switching across to P&I loans more than otherwise would be the case. My sense is that investments picked up, the pipeline of new building, particularly of higher-density apartments and the like coming through, has been building up to pretty high levels, and investment has picked up on the back of that. That extra supply has been recognised by people, including in the building industry and by some of the banks, and the household sector, and they’re sort of recognising there’s a lot of supply coming through that has to be absorbed, so that’s just causing them to think about what’s an appropriate price to pay in that environment. What’s an appropriate amount to borrow, what’s a sort of loan product I might want that suits that? And I think a number of things have come together and I don’t think there’s one causal effect that’s driving everything.

For example, loan approvals, that’s the flow of new loans, started to drop off a few months ahead of APRA even sounding out this thing on interest-only loans. So at the turn of 2016 into early 2017, loan approvals started to come off a bit. There was a little bit of a softening there in the demand for credit well ahead of these moves. So I think there are other things, a broader assessment by households, by developers, of the situation in housing markets.

Just in regard to assessments and loans at the moment. So correct if I’m wrong, I just want to understand the science behind the figures, because an average market rate will be 3.9-4 per cent, give or take, in the interest-only or P&I. Where you’re now assessed at mid-sevens?

Right. Seven is the minimum.

Seven minimum, 7.5? So what will be the short term future? Will that adjust accordingly, say if RBA lift the base rate, will that assessment rate jump? And how is that as a mechanism for controlling them?

That’s a good question. My broad understanding of the mechanism, and it’s fairly broad, because it’s not my area of expertise, is that yeah, at more normal interest rates at the higher levels of interest rates, there’s a buffer the banks apply. So when a customer walks in the door, they don’t assume rates will be at this level forever, particularly when they’re low. So what they do is they say, "How much can you afford to pay comfortably? We’re going to test you against a higher interest rate, not the current one we’re going to give you," and based on that they’ll make a decision as to whether to extend the loan and how much to give you. So yes, if rates move up, at the moment it’s sort of set at the minimum seven percent in the serviceability assessments, but there’s also a buffer of about two percentage points, so if the average loan rate’s moving up, they’ll be adding on to current rates and it’ll move above seven in time.

Is that APRA induced, or is that a …

That’s APRA requiring the banks to make a careful assessment of the borrower’s capacity, because you don’t want to assume the borrower’s always going to be able to pay that low rate for the life of a 30-year loan, when rates are particularly low.

There was one more question we’ll squeeze in.

Sophia Rodrigues from MNI. You’re expressing confidence that this transition will be managed, and yet you say that you’re monitoring this closely, so is it because of the fact that interest rates are likely to go up in the next three years, and if so, how much will this influence your monetary policy?

Well, there’s quite a lot in that, Sophia, so I think the point about monitoring it closely, that’s the one I’d rather emphasise, and that’s just to say, look, these are estimates, and we do our liaison regularly with the banks to see how things are going and we monitor aggregates, important aggregates, things like non-performing loans for example. And we just don’t want to assume that all of those forecasts and the outlook is perfectly well known by us at any time. And we know this is a point of potential stress, particularly because the borrowers, as I suggested, a lot of people have shifted voluntarily away from interest-only loans to P&I. So the ones that are left are ones that perhaps weren’t feeling as able to take on those higher payments right now. Maybe they were happy to do that. Maybe they want to keep these even, despite the higher interest rates on them, for good reason, because it suits their circumstances. Perhaps they’re an investor, they want those tax benefits and they’ve made the assessment that that’s in their interests, but the pool that’s left behind may be ones that struggle a bit more than those that have done the transition in the past year. It’s just something that we want to keep our eye on just to see how things are going. Okay, thanks.

One last question.

Yeah, thanks Chris, just changing topic a little bit, having someone from the Reserve Bank here today, it would be remiss not to ask about the expected movement in interest rates. Interested to hear your views around timing and movement.

Well, I can’t say much about the timing, I can say a little bit about the timing and a little bit about the likely direction. I’ll just reemphasise I think what we’ve been saying for a while, what the Governor has made very clear, is that what we’ve seen is a gradual decline in the unemployment rate over recent years and at least we’re forecasting that that continues to decline, but only gradually, so there’s an improvement and it’s gradual. The same is true for inflation. A gradual rise, and it’s expected to continue to rise, but gradually. So the fact that there’s progress, that there’s improvement there, suggests to us that the next move in interest rates by us is likely to be up, not down, but the fact that it’s gradual means there’s no particular rush to do that. That’s probably the best way I can summarise things. Okay. Thank you.