More than half of the at-risk borrowers bought at or close to the peak of the recent property boom when lenders were competing to build market share by offering cheap loans and easy terms, the analysis states.
That means borrowers will have built up little equity or have lost equity during the recent downturns, which have already seen prices fall more than 10 per cent.
Martin North, principal of Digital Finance Analytics, an independent financial consultancy, estimates about $120 billion interest-only loans will be up for renewal this year.
“People continue trying to talk down this issue,” Mr North, who agrees with Morgan Stanley’s analysis, said. “But it will not go away.”
It comes as Commonwealth Bank of Australia, National Australia Bank and ANZ are warning mortgage brokers, who account for about 60 per cent of new loans, about tougher lending conditions in “line with its responsible lending obligations”.
Lenders are under growing pressure to improve their lending practices, particularly how they scrutinise lender applications and reimburse mortgage brokers, after the Hayne royal commission revealed systemic problems.
The Australian Securities and Investments Commission’s new prescriptive lending guidance warns the controversial household expenditure used to check borrowers’ capacity to repay a loan is too low and not an appropriate estimate of loan applicants’ living expenses.
In addition, the federal government has told the banks and regulators there will be a fresh industry inquiry in three years to ensure they have improved their behaviour and are treating customers better.
Standard & Poor’s, the rating agency, is warning banks will act in a “very cautious and conservative way” over the next two years because of the increased regulatory and shareholder pressure to boost responsible lending and minimise systemic risk.
“So even if there there is no change in regulation, we believe the banks will … be cautious, and as a response there will be some depression on credit growth, which is already depressed compared to what we have seen in the past couple of years,” according to Sharad Jain, director of financial institutions ratings.
“We see a scenario where there is rapid unwind [of housing] as most plausible scenario for what can go wrong for banks in Australia,” he said, adding that prices will continue to fall.
The sober assessment came after fellow ratings agency Fitch Ratings downgraded its outlook on NAB’s long-term default rating from “stable” to “negative” on Friday. This reflected the “risk that NAB’s focus on remediating issues and changing culture means its ongoing operations may not receive sufficient management time, resulting in a weakening of NAB’s earnings relative to peers,” Fitch said.
The Morgan Stanley analysis revealed tighter credit conditions, potential deterioration in housing sentiment and pressure on household finances with more than six-in-10 respondents having issues getting a mortgage over the past year.
About 80 per cent of interest only borrowers and 70 per cent of investors found banks either limited credit or refused loans.
Nearly half of interest-only borrowers would prefer a principal and interest loan but were either refused by the bank or could not manage the higher repayments.
“These trapped borrowers make up 11 per cent of all mortgage holders and appear higher risk,” the analysis warns.
Typically, they have higher leverage, higher debt-servicing, lower savings and a more optimistic price outlook.
When their fixed term ends a “significant portion” will be forced to sell if they cannot extend their loan or sell the property if they are unable, or unwilling, to switch to a principal and interest loan.
“This will put further pressure on an already deteriorating housing market,” it states.
“Given their apparent higher risk, while they remain active borrowers, they are likely to have a higher chance of default or arrears.”
Nearly half spend an amount equivalent – or more – than their income, one-in-three spend more than half of income on repayments and only 14 per cent expect prices to fall.
Major lenders are currently writing to mortgage brokers advising about increased scrutiny of borrowers.
For example, NAB is changing to credit policy “to ensure responsible lending” while ANZ has sent brokers detailed updates on verifying loans, “enhanced inquiries” into borrowers’ future finances and more details about their financial circumstances.
A borrower with an interest only loan pays only the interest, which means monthly repayments are lower than principal and interest. They typically have a term between one and five years.
About $706 billion of loans were written at the peak of the recent residential real estate property boom between 2014 and 2015, when property prices in major cities were fuelled by record low interest rates, easy credit and optimism, according to separate analysis.
Major lenders competing for market share offered cheap introductory interest only fixed rate terms, other financial incentives, such as waiving fees, and were accommodating in their scrutiny of a borrowers’ income and expenses.
But regulators imposed lending caps after warnings from the Reserve Bank of Australia about record levels of household debt increasing financial vulnerability to a change in personal circumstances or sharp economic deterioration.
They also found that fewer than half of borrowers have plans about how to repay the principal.
An increasing number of borrowers facing refunding pressure are turning to regulation-lite shadow banks that are two-and-a-half more times likely to approve a home loan than a big four competitor, according to Canstar, which monitors rates and products.