Ethics & Governance
Can the interest only bomb be defused?
BY

Interest only mortgages boomed in the U.S. in the 1920s.  What followed was the Great Depression.  They re-emerged Stateside in the early 2000s.  What followed was the GFC and the Great Recession.  In Australia interest only loans account for around 35% of the system's mortgages.  But Australia is different right?  Lenders may have better security.  The borrowers, though, are similar and some could face challenges when they are called to repay the principal on these loans.  In Spectrum's view, the Australian residential property market is a large debt-fueled financial bomb.   This bomb will not necessarily explode.  To diffuse the situation requires APRA to up the ante on banks de-risking and hope the market backdrop remains benign.  Else, the faint tic toc sound at present could get somewhat louder. 

And the property party goes on

Interest only loans and those which are negatively geared are made when the borrower is confident of capital gains.  These loans are granted at low interest rates due to the lender's confidence that the risk of loss is low.   Both parties largely got it right in Australia for the best part of the last 25 years.

In finance, history influences expectations.  The more recent the event, the stronger the influence.  The longer the pattern, the greater investors' confidence of its continuation. 

The long lasting buoyant residential property market in Australia has driven, what we see as, undue confidence from borrowers, lenders and regulators in recent years.  The large use of interest only mortgages is perhaps the best indicator of blue sky group think from property market players.

In conservative banking times, a loan is supposedly only granted when you could prove no need for it.  Now it appears almost anyone in Australia can get a loan to purchase property - even if you agree you can't pay back the principal from your current cashflows.

Two factors compound our concern.  A study by ASIC found in Dec 2014 that interest only loans were larger than principle and interest loans - hence suggesting the easier the repayment terms the more that was borrowed.  It is also found the majority of interest only mortgages came via brokers.  Given our concern for the overall quality of broker-originated loans this may compound the risk.

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