Should children play with interest-only fireworks?

Investor interest-only loans are a key risk factor threatening to destabilize Australia’s mountain of private debt, according to investment firm Standard Life Investments, a keen observer of interest rates.

IO loans are often associated with thin equity buffers, risky investment strategies and the aggressive pursuit of capital gain over income.

Standard Life says:

“Much of this growth has been underpinned by booming housing markets, which are difficult to control with interest-rate policies alone. Indeed, this is especially challenging in the current environment, with the loose policy required to address sluggish growth and inflation risks exacerbating financial imbalances.

“In recent years, central bankers across developed Asia have sought to prevent excesses through a wide range of macroprudential policy measures. The results have been mixed.

“In Australia, policymakers have been locked in a battle against household leverage for many years, with household debt-to-GDP rising above 120% – ranking number one globally.

“In particular, the Council of Financial Regulators and the APRA have been vocal of late about the risks posed by interest-only loans and investor lending.

“According to the recently published Financial Stability Review, interest only (IO) loans account for 23% of total owner-occupied loans, but a striking 64% of investor loans. It is the recent uptick in these IO loans, particularly the latter category, which has caught the regulator’s eye

“The concern is well founded. Given their structure, IO loans result in a higher average level of indebtedness over the life of the loan than a typical principal and interest payment loan.

“Consequently, borrowers are more susceptible to falling into negative equity in the event of a housing price decline, while higher required payments at the end of an IO loan period increases the risk of default.

“…the persistence of IO and investor loan growth is likely to continue to increase vulnerabilities in the Australian housing market.

Let there be no mistake: IO loans are a time-bomb.

All are term loans that automatically convert to principal and interest three to five years down the track. Financiers assure borrowers when these loans are written that they can simply re-finance when the IO period ends.

Well, yes they can… if the new valuation, recent rental history and current personal income stack up – and there is financier appetite for IO loans.

Many negatively-geared residential property investors in WA, NT and North Queensland would struggle to match the euphoria of a few years ago. Prices are down, rents are down and wages have taken a hit.

Equally, high-income earners in Melbourne and Sydney are also surprisingly exposed.

The big four banks recently hiked the interest rates on IO loans and APRA announced it wanted the proportion of IO loans reduced from 40 per cent to 30 per cent of loans, on ‘systemic risk’ concerns.

So for those unable to refinance, their loans revert to P&I. Cash outflows increase markedly and the principal element is not tax deductible.

This is a giant squeeze of allegedly sophisticated investors and will prompt forced selling.

The blind pursuit of ground rents in the midst of a land bubble with big debt can only be described as foolhardy. Pull up a chair and watch the fireworks.

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https://prosper.org.au/2017/04/20/should-children-play-with-interest-only-fireworks/