RDP 2020-03: The Determinants of Mortgage Defaults in Australia – Evidence for the Double-trigger Hypothesis 8. Conclusion and Policy Implications

This paper uses a new two-stage hazard modelling strategy to investigate the determinants of mortgage defaults in Australia and finds some evidence to support the double-trigger hypothesis. The main drivers of entries to arrears are ability-to-pay shocks, such as unemployment, while prepayment buffers reduce the probability that an ability-to-pay shock causes a borrower to enter arrears. The extent of negative equity is strongly correlated with whether a loan in arrears transitions to foreclosure.

From a policymaker's perspective, these estimates provide some clarity around the risks in the Australian mortgage market and the relative importance of ability-to-pay and equity factors for mortgage default. Since unemployment spells and reductions to income appear to be the key macroeconomic drivers of arrears, the unemployment rate and net income should be considered key variables when evaluating financial stability risks and in setting stabilising macroeconomic policy. Results regarding riskier loan characteristics and debt serviceability ratios may also have implications for lending standards policies, although this paper cannot provide policy recommendations as it does not consider the costs and benefits of changing lending standards. The main role played by housing prices is in loan losses given default, where a borrower already facing an ability-to-pay shock becomes more likely to enter foreclosure if they have negative equity. Prolonged periods of negative equity may in themselves also increase foreclosures as borrowers face a baseline probability of experiencing an idiosyncratic shock (such as illness). While this suggests that policies aimed at lowering LVRs at origination can be useful in reducing the probability that borrowers experience negative equity and thereby lower the risk of foreclosures, this must also be weighed against the costs of tightening credit supply – which is left to further research. Overall, the results in this paper imply that policies that promote a low unemployment rate and stable macroeconomic environment play a critical role in lowering the rate of mortgage defaults.