RDP 2020-03: The Determinants of Mortgage Defaults in Australia – Evidence for the Double-trigger Hypothesis 1. Introduction

Mortgage defaults can have huge personal and financial stability costs. Understanding their determinants is important for understanding the risks associated with mortgage defaults, and how these can be mitigated. Yet there have been few studies of the determinants of mortgage defaults in Australia, likely reflecting relatively low default rates and the absence of widespread stress events for periods when detailed data has been available. The determinants of mortgage defaults are likely to be similar in Australia and overseas, but differing legal and institutional frameworks mean that we cannot assume that they will be the same.

In this paper, I examine the determinants of mortgage defaults in Australia using a new loan-level dataset that captures instances of regional downturns. Regions that were highly exposed to the mining industry experienced housing and labour market downturns alongside the winding down of the mining investment boom. Led by property price falls, some mortgages located in these regions fell into negative equity, particularly those in regional Western Australia and Queensland. While examples of localised stress may differ from a nationwide stress event, they likely provide the best possible estimates of credit risk during a period of stress in Australia.

Understanding the risks during a downturn represents a significant advance for the Australian mortgage default literature. Previous studies, such as Read, Stewart and La Cava (2014), find evidence that loans with higher debt serviceability (repayment-to-income) ratios and riskier borrower characteristics are more likely to enter arrears, but their conclusions regarding equity are limited by a lack of loans with negative equity in their sample. Using US data, Gerardi et al (2008) highlight the importance of taking into account negative equity in models of loan default. They also show that, in the absence of a nationwide downturn, using data covering a regional downturn can be an effective way of evaluating the determinants of defaults.

Recent overseas research has emphasised the role that economic and housing market conditions can play in mortgage default, and has supported the ‘double-trigger’ hypothesis as a theoretical explanation (Foote and Willen 2017). This hypothesis states that most foreclosures can be explained by the combination of two triggers. The first is a change in the borrower's circumstances that limits their ability to repay their mortgage (such as becoming unemployed or ill); the second is a decrease in the value of the property that causes the loan to fall into negative equity. Both triggers are needed. With only the first trigger, the borrower may enter arrears but can profitably sell their house to avoid foreclosure. With only the second trigger, the borrower can continue to repay their mortgage.

I use a novel two-stage modelling approach to test the double-trigger hypothesis in Australia. The first-stage models entries to arrears and the second-stage models transitions from arrears to foreclosure. Because the double-trigger hypothesis implies two steps in the path to foreclosure, it is important to appropriately model each step (as opposed to the more common approaches of combining the steps in a single-stage model or of only examining the first step). To the best of my knowledge, this is the first paper to use this approach to test the double-trigger hypothesis.

The model results are consistent with the double-trigger explanation for mortgage defaults. I find that entries to arrears are predominantly explained by ability-to-pay factors. Variables that reduce borrowers' ability to service their mortgages substantially increase the probability of entering arrears. These factors include unemployment (proxied by regional unemployment rates), increases to required repayments, debt serviceability ratios, repayment buffers and variables correlated with income volatility. For example, a 4 percentage point increase in the regional unemployment rate is estimated to double the risk of a loan in that region entering arrears (although the risk typically remains at a low level). While negative equity appears to play some role in loans entering arrears, its main role is in determining the transition of loans from arrears to foreclosure – loans that are deeply in negative equity being around six times more likely to proceed to foreclosure, all else equal. A strong economy and low unemployment rate are therefore pivotal for keeping the rate of mortgage defaults low.