RBA warns prudent mortgage lending vital in housing downturn

Luci Ellis, head of the financial stability department at the RBA, says home mortgage markets with prudent lending standards do not generally pose risks to financial stability. 

Speaking at the Australian Mortgage Conference 2012 in Sydney today, she told delegates it was not unusual for housing prices to fall, especially if they had been booming previously, or if the economy has turned down. 

“But for that to translate into a big upswing in mortgage defaults, the economy generally has to have weakened first,” she said. 

While Ellis says there is no reason why Australia should follow the same path as the United States, where the collapse in housing prices was accompanied by a rise in mortgage defaults, she says Australian mortgage lenders need to refrain from easing lending standards the way they did in the United States. 

“And so far, you have been refraining. It is a key difference between the two countries, and it motivates the title of my talk today: [Prudent Mortgage Lending Standards Help Ensure Financial Stability],” she says. 

In her talk Ellis sought to clear the misconception that all of lending in the US is non-recourse explaining that the “law in in most US states allows lenders to sue for any remaining shortfall from the proceeds of sale of foreclosed homes”. 

“Instead of imagining a ‘ruthless defaulter’ who walks away from their financial obligations, we need to focus more on capacity to pay and how it can decline. 

“The reality is that things can happen to people that make it difficult to repay their loans – their relationships break down, or they lose their jobs, or a member of the family becomes too ill to work or even dies. 

“We economists and credit risk modellers speak euphemistically of idiosyncratic shocks, but this is what we mean. Financial stability policymakers cannot legislate away these individual setbacks, but we can be alert to circumstances that could make them more common or more damaging,” she said. 

Ellis says policy makers and lenders “need to be alert to falling housing prices, but we also need to keep them in perspective”. 

“There still needs to be an underlying problem with the borrower’s ability to repay before they default. 

Ellis says the RBA does not think it is sensible to “rely on simple rules like a ratio of loan amount to income”, acknowledging that “many Australian lenders sensibly take borrowers’ other obligations and expenses into account when determining how much debt can be serviced, and thus how much they will lend”. 

“Both lenders and policymakers need to think about more than just the explicit loan terms. 

“We must consider the variability of those terms, and of the circumstances of the borrower,” she says. 

“For example, does the borrower have an unusually volatile income or employment history? And have both the borrower and lender allowed enough of a margin to cope with interest rate changes? 

“We must also consider who has the option to vary those loan terms. Australian borrowers’ tendency to repay ahead of schedule is a good example of this. And we must consider whether and how the lender can verify that the information they base their decisions on is true.”