Recent stress-testing of Australian banks by the Australian Prudential Regulation Authority showed they would survive, though their capital would be sorely tested.

This analysis did not take into account an important feedback loop: the erasure of the equity of heavily mortgaged borrowers.

The AFR reports an AMP study:

AMP Capital’s head of credit markets Jeff Brunton said official stress tests did not account for the impact on ­mortgages that did not default and that a severe fall in house prices could push more than 50 per cent of borrowers into negative equity, forcing the banks to raise an amount of capital far greater than losses from defaults, in order to reassure investors the bank was safe.

The research reinforces concerns expressed by APRA chairman Wayne Byres that the nation’s banks are ill-prepared to respond to and recover from a housing-induced crisis.

The banks will have enough capital to deal with the mortgages and the corporate borrowers who default, but they will then be left with a financial system that has got a high loan-to-value with many Australians in negative equity positions,” Mr Brunton told The ­Australian Financial Review.

The standard stress tests don’t require additional capital for those mortgages that don’t default but change dramatically in loan-to-value terms because of that stress event, and I continue to worry that international investors would have a different view and require more capital to be ­generated in the system.” 

An updated AMP white paper expected to be published by the end of the year said a 40 per cent fall in house prices – the same number used by APRA in its recent stress tests – would leave more than half the non-defaulted mortgages in negative equity and about one-sixth with LVRs over 140 per cent.

Quite so. Prosper has been banging on about this for years. Its warnings were initially ignored and then contested by RBA’s Luci Ellis.

Let there be no doubt about the agony negative equity imposes on the over-borrowed in a land price downturn. They are utterly, utterly trapped.

First, the household must make mortgage repayments toward an asset worth less than the debt. They are not buying their freedom and capitalising wages, they are bleeding before the imminent prospect of personal bankruptcy.

Second, They cannot reset their affairs by selling – that too would crystallise bankruptcy.

Third, This situation can go on and on and on. The US land crunch of 2008-12 put 30.9 per cent of all households with mortgages underwater a full five years later.

Yet all APRA examined was the banks. The AFR:

AMP estimated late last year banks would need to raise about 70 per cent of their market capitalisation but in such a scenario would be forced to pay deep discounts to a crisis-prevailing, ­crisis- level price which would be “akin to a permanent write-down.

The international experience is clear that once the loan-to-value goes significantly against you, that most ­providers of capital worry about the standing of your financial institutions,” Mr Brunton said.

Earlier this month, Mr Byres revealed findings of bank stress tests that modelled the impact of horror scenarios such as a sharp economic downturn and a 40 per cent house price fall. Banks would lose about $170 billion over five years but their tier-one common equity capital ratios would stay above APRA’s 4.5 per cent minimum .

Mr Byres criticised the banks, saying disaster contingency plans they were asked for were “not completed, in our view, with entirely convincing answers”. He said it was unclear if a bank could reasonably operate in an impaired state that would arise from a stressed scenario and was disappointed at “a very light linkage” between banks’ mitigating actions in the face of a crisis, and their recovery plans. He also worried the banks’ key ­contingency plan – to raise new equity – may test the market’s capacity if more than one bank was stressed.

Murray is suggesting, as others are, that you need enough capital to be able to deal with adverse situations without having to rely on the government. That’s clear but what is not clear is the amount of capital, the length of time and the types of risks banks can continue to take on their balance sheets.” 

What we are trying to call for is that we have time as a nation to control our destiny.

The era of negative equity would be accompanied by very wide gross bank margins (the difference between deposit rates and mortgage rates plus costs) as banks simultaneously struggle to write off bad debts, rebuild capital, incentivise investors and reassure bond-holders. Mortgage customers are definitely at the bottom of this pecking order and will be treated with breathtaking ruthlessness.

Meanwhile, the spivs and shirkers who make good livings on fees and commissions putting innocent homebuyers into over-priced housing by pretending this was the path to riches will vanish into the ether.  It’s the free market, y’know.  Nyuk Nyuk Nyuk.

If all this economics sounds difficult, America’s Horse With No Name might give you an idea of the staggering personal costs ahead.