Financial Stability Review – March 2008 Household and Business Balance Sheets

As noted in the most recent Statement on Monetary Policy, the Australian economy has grown strongly over recent years and this has underpinned favourable conditions for the household and business sectors. There have been substantial gains in the household sector's net wealth and business profitability has been strong. Reflecting these developments, the share of households and businesses not able to meet their debt obligations remains at low levels. Despite this overall positive picture, there are nonetheless pockets of stress in both the household and business sectors, with tighter credit conditions placing greater pressure on some balance sheets than has been the case in the recent past. In the business sector, those firms whose balance sheets are highly geared and who have been reliant on short-term funding have been particularly affected.

Household Sector

Over recent years, the household sector has benefited from favourable labour market conditions and strong income growth. The unemployment rate is currently at its lowest level in over 30 years, and in 2007, real disposable income per household increased by 6 per cent, around the fastest rate in nearly two decades (Graph 40). This strong growth in disposable incomes mainly reflected solid gains in both employee and investment incomes, as well as lower taxes.

The household sector has also benefited, for more than a decade, from strong growth in its net asset position. Household net worth in the September quarter 2007 (the latest period for which figures are available) was equivalent to almost 7 times annual household disposable income, up from around 5 times in the mid 1990s (Graph 41). With the value of household assets increasing broadly in line with household debt over the past couple of years, the overall household gearing ratio has been broadly steady at around 17 per cent over this period, after having increased substantially over the previous decade.

Growth in the value of households’ non-financial assets – largely housing – has picked up over the past 18 months, as housing markets in a number of areas of the country have strengthened. Nationwide, average established house prices rose by 12 per cent over the year to the December quarter 2007, well above the average annual growth rate of around 4 per cent seen over the previous three years. Growth in prices over 2007 was stronger in most capital cities; the exception was Perth, where prices were broadly flat after particularly strong rises in the previous three years.

The value of households’ holdings of financial assets also increased strongly over the year to September 2007, rising by 17 per cent, well above the average annual increase of 11 per cent recorded over the past decade (Table 10). This increase largely reflected valuation gains flowing from strong asset markets, though net inflows into superannuation were also sizeable, boosted by a surge in contributions in the June quarter ahead of the introduction of lower limits for concessional taxation of contributions on 1 July 2007. More recently, the value of households’ financial assets has been negatively affected by weakness in the share market, with the ASX 200 index down by 24 per cent since the end of October 2007.

Reflecting these generally favourable conditions over recent years, housing loan arrears remain at levels that are low by both historical and international standards. Indeed, over the second half of 2007, arrears rates fell slightly, after having increased from record lows over the previous three years. As at end December 2007, the ratio of the value of non-performing housing loans to total housing loans on banks' domestic books stood at 0.32 per cent, unchanged from a year earlier (Graph 42). Of these non-performing loans, most were well covered by collateral.

The 90-day arrears rate for housing loans that have been securitised was also broadly unchanged over 2007, and stood at 0.40 per cent in December. The arrears rate on securitised loans has, on average, been a little higher than that for loans on banks' balance sheets, partly reflecting the higher share of low-doc loans in the securitisation pool. For low-doc loans, the 90-day arrears rate was 0.70 per cent in November 2007, more than double that for prime full-doc loans, but broadly around the level of a year ago (Graph 43). In contrast, the arrears rate on non-conforming loans – which are made to borrowers with poor credit histories – has risen significantly over the past few years to stand at 7.25 per cent. These loans, however, account for less than one per cent of outstanding housing loans in Australia.

The available data suggest that, in recent years, the average outstanding balance on housing loans that are in arrears has been higher than the average outstanding balance on all housing loans. This is partly due to the fact that loans that are larger at origination have tended to have higher arrears rates than smaller loans. In addition, as discussed below, the arrears rate has been higher in New South Wales than in other parts of Australia, with loans in this state tending to be for larger amounts than the national average. As a result, the number of housing loans 90-days past due as a share of the total number of housing loans is smaller than the comparable figure for the value of housing loans (Graph 42). It is estimated that, at present, around 15,000 borrowers are more than 90 days behind on their mortgage repayments, while an additional 25,000 are between 30 days and 90 days in arrears.

The general pattern of housing loan arrears having moved sideways over the past year is also evident in personal and credit card loan arrears (Graph 44). As at December 2007, the non-performing rate for personal loans was 0.8 per cent, and for credit cards the equivalent figure was 1.0 per cent.

Although the aggregate data continue to suggest that household finances are in sound shape, experience varies widely across households and across regions, with housing loan arrears noticeably higher in NSW than in the other states (Graph 45). Within NSW, the increase in arrears rates has been highest in western Sydney, where economic conditions have been relatively weak, house prices have been under downward pressure, and the share of households with high owner-occupier debt-servicing ratios is considerably greater than in other parts of the country. Arrears rates in this part of Sydney increased markedly over the period from 2003 to mid 2006, but like much of the rest of the country have since moved broadly sideways (Graph 46). In contrast, there have been falls in arrears rates in a number of other parts of Sydney over the past year or so, and in some areas they are only slightly above the very low levels of  2003.

The pick-up in the arrears rate in NSW since 2003 has resulted in a rise in the number of court applications for property repossession although, consistent with a levelling out in the arrears data, the rate of applications for repossession did not increase further over 2007, with recent monthly data suggesting a small decline (Graph 47). A broadly similar pattern is evident in Victoria, the only other state for which data are currently  available.

The ratio of repossession applications in NSW to the dwelling stock is presently more than double that in the mid 1990s, with this increase larger than can be accounted for by the change in the arrears rate. This apparent change in the relationship between repossession applications and arrears is partly explained by the emergence of some non-ADI lenders that are more likely than ADIs to seek repossession. It is also likely to reflect differences in housing price dynamics in these periods: the weakness over the past few years in some housing markets has increased the likelihood that a borrower experiencing difficulties is unable to clear their debt by selling the property, which in turn has increased the likelihood of repossession. Consistent with this, APRA data show that almost two thirds of lenders’ mortgage insurance claims in the year to June 2007 were from NSW (including ACT), despite this state representing only one third of these insurers’ premium revenue.

The general increase in arrears rates since their trough around 2003 partly reflects the greater availability of credit over the past decade. The easing of credit standards over this period meant that many borrowers who in the past may not have been eligible for a housing loan have been able to obtain finance, and many others have been able to borrow larger amounts. One consequence of this is that for any set of economic and financial conditions, arrears rates are likely to be higher than in the past.

Looking forward, an increase in arrears is likely due to both the further working out of this structural adjustment, and the recent tightening of financial conditions for the household sector. Since July 2007, interest rates paid on new prime full-doc loans and new prime low-doc loans have increased by about 125 basis points and 140 basis points, respectively, while rates for more risky non-conforming loans have risen by around 210  basis points.

These tighter financial conditions have contributed to a slowing in the overall pace of household credit growth. Borrowing for housing – which accounts for around 86 per cent of household debt – increased by 11½ per cent over the year to January 2008, down from 13½ per cent growth in the previous year, with recent data on housing loan approvals suggesting that a further slowing in credit growth is likely (Graph 48).

Personal credit has grown at a broadly similar rate as housing credit recently, although the various components of personal credit have shown distinctly different patterns. Year-ended growth in credit card debt was 9 per cent in January 2008, close to the slowest rate of growth in nearly 15 years. In contrast, growth in margin debt (which accounts for around one-fifth of personal credit, but only 3 per cent of total household debt) was particularly strong up until June 2007, when six-month-ended annualised growth peaked at around 65 per cent (Graph 49). Subsequently, substantial falls in share prices in the September quarter, and more recently, have contributed to a marked fall in the growth of outstanding margin debt. Recent developments have also seen a significant rise in the frequency of margin calls: the number of calls roughly doubled in the second half of 2007, with partial data suggesting there has been a further sharp increase since the beginning of 2008. While margin calls have caused financial difficulties for some borrowers, relatively few households are affected, with data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey indicating that only 3 per cent of households held margin debt in 2006. Margin loans are also relatively conservatively geared on average, at around 40 per cent.

The recent tightening in household financial conditions is evident in surveys of consumer sentiment which have shown a significant decline in the proportion of households that are optimistic about their current and future financial circumstances; higher interest rates, rising fuel prices and the weaker share market have all likely weighed on consumer confidence. Rising interest rates have also seen a greater number of households opt for fixed-rate loans – in recent months around one quarter of the value of new owner-occupier housing loans were taken out at fixed rates, an historically high share (Graph 50).

With growth in outstanding debt exceeding that in income, and interest rates rising, the ratio of aggregate household interest payments to household disposable income has continued to rise (Graph 51). The ratio is likely to have reached around 13 per cent in the March quarter 2008.

These higher interest payments will clearly have a negative effect on some households, and trends in household finances will warrant especially close monitoring in the period ahead. The rise in the aggregate interest‑payment ratio does, however, overstate the rise in the average interest‑payment ratio for individual indebted households; this latter ratio is currently around the same level as in the late 1980s (Graph 52). The rise in the aggregate ratio partly reflects a rise in the proportion of households with owner-occupied debt, most notably among older age groups, who appear more willing to carry debt later in life than was the case with previous generations. It also reflects a rise in the share of households with investor loans; according to HILDA Survey data, the proportion of households with investor housing debt rose from 8 per cent to 10 per cent over the four years to 2006.

Assessments of how the household sector's capacity to service debts is changing through time also need to take into account the ability and willingness of households to spend a greater proportion of their income on housing as income and wealth increases. As incomes rise, a household with a given debt-servicing ratio will have a larger absolute amount of income left over after debt repayments to meet other living expenses. This means that an increase in the debt-servicing ratio does not necessarily imply greater financial strain, thereby lessening the usefulness of historical benchmarks defining housing stress. Estimates from the HILDA Survey indicate that, after subtracting debt repayments (interest and principal repayments, including any excess repayments), real median disposable income of households with owner-occupier debt increased by an average rate of around 1¼ per cent per annum over the four years to 2006, despite strong growth in housing credit and rising interest rates.

Assessments of the state of the household sector's finances also need to take into account the large differences in the financial positions of different households. The most comprehensive data currently available are from the HILDA Survey, for 2006. This survey includes a number of questions seeking to ascertain households’ own perceptions of their finances. While the results suggest that at any point in time a small proportion of households is always under financial strain, this fraction has declined steadily over recent years (see Box C).

The HILDA Survey also provides details of how gearing and debt-servicing ratios vary across households. In 2006, around 14 per cent of households with an owner-occupier mortgage reported a debt-servicing ratio of greater than 40 per cent, up from 9 per cent in 2002 (Graph 53). It also showed that almost half of households with mortgages over their own home had debt-servicing ratios of less than 20 per cent. In terms of gearing, in 2006 only 12 per cent of owner-occupier households reported that their outstanding mortgage debt was greater than 80 per cent of the value of their home, with 52 per cent reporting gearing ratios below 40 per cent (Graph 54). Among investors, gearing ratios are typically higher, although gearing has generally declined since 2002.

As noted earlier, recent falls in equity and other financial prices have negatively affected the value of households’ financial assets. Over the past decade or so, there has been a substantial increase in the household sector's holdings of market-linked financial assets, particularly equities and superannuation, increasing the household sector's exposure to financial market volatility. At the end of September 2007, holdings of equities and superannuation were equivalent to around 250 per cent of annual household disposable income, up from around 100 per cent in 1990 (Graph 55). In contrast, currency and deposits – the value of which typically does not vary with market valuations – have risen only slightly relative to income since 1990, and were equivalent to around 65 per cent of disposable income as at September 2007. Since expected capital returns on market-linked assets are higher than those for currency and deposits, these changes in asset composition could be expected to contribute to increased household wealth over time, as well as allowing for greater diversification of households’ investment portfolios. Nonetheless, the increased holdings of market-linked financial assets raises the possibility that periods of sharp adjustment in financial markets – such as that seen recently – have a larger effect on household confidence and spending than has been the case in the past. For further details on the household sector's exposure to market risk see Box D.

In summary, the recent tightening of financial conditions and weaker financial asset markets are putting more pressure on many households’ finances than has been the case in recent years, a period in which the household sector has benefited from strong growth in incomes and wealth. Looking ahead, arrears rates on loans could be expected to increase somewhat from current levels, which are low by historical and international standards. Household finances overall, however, remain in sound shape, although there are continuing pockets of stress. In the months ahead, the Reserve Bank will continue to closely monitor developments in household balance sheets, both at the aggregate and disaggregated level.

Business Sector

Like the household sector, the business sector in Australia has benefited from favourable economic and financial conditions over recent years. As a result, at the aggregate level, business balance sheets are in healthy shape, profitability is high, and both debt-servicing requirements and arrears rates are at relatively low levels. Notwithstanding this positive picture, the recent sharp increase in financial market risk aversion and higher funding costs have created difficulties for some firms, particularly those with highly leveraged balance sheets, and those that have relied heavily on short-term funding.

The strong overall position of business balance sheets in recent years has been underpinned by strong profit growth, with profits of the non-financial business sector trending up as a share of GDP, to currently stand at around a multi-decade high (Graph 56). Over the year to the December quarter 2007, profits grew by 7 per cent, which is around the average rate of growth for the past decade. Within the total, there has recently been a fall in profits of the mining sector although, as a share of GDP, the sector's profits remain at a high level. In contrast, profits of the non-mining, non-farm sector of the economy have increased strongly recently, rising by around 11 per cent over the year to the December quarter.

For a number of years, the strength in profits allowed the business sector to finance high levels of investment with only limited recourse to external funding. But more recently there has been a substantial increase in businesses’ utilisation of external funds, particularly debt. Over the year to the December quarter 2007, external funding accounted for around 60 per cent of new business finance and was equivalent to 15 per cent of GDP, up from 6 per cent in 2003 (Graph 57). While some of this increase in total funding has been used to finance a further pick-up in the ratio of investment to GDP, there has also been a substantial increase in businesses’ holdings of financial assets.

These aggregate data, however, disguise quite different trends across sectors. In particular, the very high levels of profits (and hence retained earnings) in the mining sector had led to a marked reduction in this sector's leverage over recent years. In late 2007, however, Rio Tinto's debt financing of its takeover of Alcan saw this trend reverse. Abstracting from this transaction, there was still an up-tick in gearing, but it remains at relatively low levels (Graph 58).

For listed non-resource companies, the strength of business credit has been associated with an increase in gearing over recent years. While there has been a general trend towards higher gearing levels, a substantial part of the increase in aggregate gearing for non-resource companies has been due to the growth in utilities and infrastructure companies. Whereas a few years ago these companies accounted for only around 18 per cent of total debt being carried by listed non-financial companies, as at December 2007 this share had increased to around 25 per cent. Moreover, these companies are much more highly geared than other non-resource companies, though given the nature of their businesses they would appear to be relatively well positioned to service these larger debt burdens.

Over the year to January, business credit increased by 24 per cent, its fastest rate since the late 1980s (Graph 59). Part of this recent rapid growth is accounted for by large businesses turning to banks for funding, with conditions in capital markets making it difficult to raise non-intermediated debt. Reflecting this, data from APRA indicate that the outstanding value of banks' business loans that are greater than $2 million rose by 41 per cent over the year to December 2007, compared with much slower growth for loans of smaller sizes (Table 11). Conversely, over the second half of 2007, there was minimal issuance of corporate bonds which, together with maturities of existing debt, resulted in a fall in the stock of non-intermediated debt. The decline in the second half of the year was equivalent to 2 per cent of GDP, the biggest decline in over 20 years. Nonetheless, taking account of both intermediated and non-intermediated debt funding, it is estimated that business debt increased by around 19 per cent over the year to January 2008.

Banks' business loan interest rates have risen considerably since mid 2007, with these increases having been broadly in line with banks' increased funding costs in wholesale markets. Rising interest rates, together with strong growth in business borrowing, has resulted in a modest rise in the ratio of non-financial businesses’ interest payments to profits over the past two years. While this ratio is currently around its highest level in a decade and a half, it remains well below the levels seen in the 1980s.

Reflecting the generally positive conditions of recent years, arrears rates on banks' business loans have trended down, and are at low levels. As at end December 2007, around 0.9 per cent of banks' business credit was non-performing, down from 1.3 per cent four years earlier. This decline is largely accounted for by lower rates of arrears on loans to corporations, with arrears rates for loans to unincorporated enterprises broadly unchanged over this period (Graph 60). Further, the bankruptcy rates for corporations and unincorporated enterprises remain around their long-run averages, and there has been no default on a (rated) corporate bond since 2004.

Despite evidence that the overall financial position of the business sector is strong, there has been a sharp repricing of corporate debt, consistent with developments overseas. Credit default swap premia have widened considerably since the end of October 2007, as have corporate bond spreads, and are now significantly higher than levels seen in 2001 and 2002 (Graph 61).

The change in the financial environment over the past six months has had a significant effect on some firms’ ability to obtain finance, and the terms under which others are able to obtain funding. Companies that have relied on short-term debt to finance balance-sheet expansion and/or that have developed complex structures and engaged in significant financial engineering are being forced to simplify and de-leverage their balance sheets. A number of these companies have had difficulty making the changes required by lenders and investors, and have suffered very large declines in their share prices. However, an examination of listed companies’ balance sheet data suggests there are relatively few firms that have both high gearing and a high proportion of debt that is short term. An analysis of more than 300 listed companies with assets in excess of $100 million as at December 2007 shows that, among those with a debt-to-assets ratio in the top quintile (around 40 per cent or greater), less than 20 had short-term debt in excess of 50 per cent of total debt.

As well as sharp increases in corporate bond spreads, there have been significant falls in the share prices of listed companies in the past six months. While these declines have been partly due to overall financial market turbulence, they also reflect increased uncertainty regarding earnings prospects. Since the end of October 2007, share prices of both resource companies and other non-financial companies have fallen by a little under 20 per cent (Graph 62). However, even after these sharp declines, share prices of resource companies are still over 25 per cent higher than at the start of 2007, and price/earnings ratios for this sector are only a little below their longer-run averages (Graph 63). In contrast, share prices of other non-financial companies are around 9  per cent below where they started in 2007, and the current price/earnings ratio for these companies is well below the average since the mid 1990s.

One market that will bear close watching in the period ahead is the commercial property market. Office vacancy rates are low across the country, and prices and rents have increased sharply (Graph 64). The pressures are particularly pronounced in the Perth and Brisbane markets where there is currently very little vacant office space available. Average rents in both cities for prime office space are now more expensive than in Sydney, increasing the possibility of a correction at some point in the future (Graph 65). The tightness has prompted a noticeable pick-up in actual and planned construction, with the office supply in each of these cities projected to increase by an average of 8 per cent in each of the next three years, compared with average annual stock additions of 2 per cent over the past decade. Nationally, office construction investment as a share of GDP is at its highest level for more than a decade and a half, although well below the very high levels recorded during the second half of the 1980s.

Associated with the strength of the commercial property market, bank lending for office property increased by 36 per cent over the year to September 2007 (the most recent data), a significantly faster rate of growth than for aggregate business credit. As at September 2007, banks' lending for office buildings comprised 7½ per cent of outstanding business credit, compared with 3½ per cent a decade ago. As noted in The Australian Financial System chapter, the share of banks' commercial property lending that is impaired picked up slightly over the year to September 2007, but remains low by historical standards. More recently, liaison has suggested that bank financing for commercial property developments is becoming more difficult to obtain than had previously been the case.