One in five borrowers is ‘screwed’

Australia has among the highest unit wage cost growth in the developed world, combined with comparatively loose monetary policy. Whereas peer central banks have their cash rates way above their “neutral” estimates, the Reserve Bank of Australia’s target is just 30 basis points above neutral (recall that Aussie banks have not passed on about 60 basis points of the RBA’s rate increases and that hikes here have possibly less impact on inflation than they do overseas).

On October 25, we get the September-quarter inflation data, which our modelling suggests should print at 1.1-1.2 per cent, conspicuously above the RBA’s circa 0.9 per cent forecast. This would undermine the idea that inflation is mean-reverting and compel the RBA to upgrade its forecasts. It would also boost the probability of the central bank nudging up its cash rate further to bring it into line with peers.

The RBA is a national treasure in terms of the research it consistently produces. This was showcased once again via its influential Financial Stability Review. Media commentators and the RBA celebrated the fact that about 87 per cent of all borrowers have enough income to meet their debt repayments after accounting for essential living expenses (assuming no more increases).

The flip side of this coin is that 13 per cent of all borrowers have negative cash flows (or cannot afford to make their debt repayments after living costs, including private health and school fees). This is up from a mere 3 per cent of borrowers in 2022.

If the RBA were to lift its cash rate to 5.1 per cent in line with peers, it judges that 17-18 per cent of all borrowers would have negative cash flow (technically, there is scope to reduce outlays by relying on public rather than private health/education).

The RBA notes, as we have done, that borrowers do have the benefit of large cash buffers accumulated during the pandemic, which they can draw down on to meet repayments until these excess savings are exhausted.

Our analysis indicates that while the US buffers will disappear within months, much larger Aussie surpluses will not be eroded until late 2024. But while the RBA and media are crowing about how Aussie households and businesses can comfortably wear higher interest rates, which is true, the tails of this distribution are still getting crushed.

Arrears spike

Our analysis of the latest monthly insolvency data from ASIC casts this into sharp relief. In August, 817 Aussie businesses went bust in seasonally adjusted terms, the highest since 2015. The key, however, is the direction of the trend line: insolvencies look like they are heading a lot higher.

We are also seeing a structural break in the delinquencies reported on home loans issued by banks as opposed to non-banks. The 30-day arrears rate on bank home loans that have been securitised (sold) has bumped from 0.6 per cent to 0.8 per cent (hedonically adjusted). Yet if we look at prime loans issued by non-banks, the 30-day arrears rate has spiked by 50 per cent from 0.89 per cent to 1.34 per cent.

If one examines sub-prime home loans originated by non-banks, the news is worse with the 30 days arrears rate leaping from 2.5 per cent to almost 4 per cent.

This very much accords with the RBA’s research on riskier borrowers. Whereas 13 per cent of Aussie borrowers have negative cash flows net of essential living expenses, this jumps to an incredible 49 per cent of borrowers with high loan-to-income (LTI) ratios and 32 per cent of borrowers with high loan-to-value ratios (LVRs). “These borrowers are much more likely to struggle to meet their essential spending needs,” the RBA says.

And for all the talk of the fixed-rate mortgage cliff being a myth, it is presumptuous to make that claim. The RBA advises that most borrowers who took circa 2 per cent fixed-rate loans have yet to roll to the floating rates that will radically increase their repayments: specifically, 55 per cent remain fixed.

Sanguine central bank

Although more than 80 per cent of fixed-rate borrowers have spare savings to cover more than three months of scheduled mortgage repayments, and about two-thirds have savings to cover at least 12 months of repayments, almost one in five fixed-rate borrowers do not.

In the RBA’s sanguine words, “there is also a smaller share of fixed-rate borrowers (less than 20 per cent) who will roll off onto higher interest rates with much lower savings buffers, equivalent to less than three months of scheduled mortgage payments”.

You can, therefore, spin this two ways: either most borrowers are fine or there are one in five who are screwed. In particular, the RBA assesses that 18 per cent of fixed-rate borrowers will have negative cash-flows once they roll to variable, assuming no more hikes (this number is 7 per cent of borrowers if one uses a narrower definition of essential expenses excluding private health and school fees).

The RBA also expressly warns about the coming high-risk debt default cycle and pain for non-bank lenders that have financed dodgier businesses and households, as we have done.

“After a period of fewer business failures, bankruptcies have risen in a range of economies, including Australia, Europe and the United States,” the RBA says. In fact, US bankruptcy filings are at their loftiest levels since 2010.

Non-bank lending risk

“Consistent with rising bankruptcies and tighter credit conditions, default rates have increased for market-based corporate debt, with vulnerabilities more pronounced for lower grade corporations,” the RBA continues.

“Lower grade corporate debt is characterised by more variable-rate lending, including for leveraged loans [private debt] in Europe and the United States, and is dominated by sectors exposed to cyclical trends, such as consumer products, real estate, and media and entertainment.”

“Default rates on speculative-grade debt have increased to be above pre-pandemic levels in Europe and the United States, and default rates are higher for variable-rate borrowers.” Beyond spiking defaults, recovery rates on senior secured private loans in the US are at their lowest levels on record as a result of lenders financing businesses with over-inflated valuations.

The RBA extended its warnings to specifically focus on Aussie non-bank lenders, declaring that “the outlook for non-banks’ housing loan quality is more challenging than in recent years”.

“In an effort to rebuild margins and lending volumes, liaison discussions indicate that some non-bank lenders are relaxing serviceability requirements and targeting higher risk borrower segments, such as those with less documentation about their finances,” the RBA reveals.

“At the same time, some non-banks have found it difficult to retain credit-worthy borrowers who have sought to refinance their loans on highly competitive terms with banks,” it says.

“A weakening in lending standards and overall loan quality could lead to more risk concentrating in a part of the financial system where regulators have less oversight. Housing loan arrears for non-banks have risen by more than for banks (to levels recorded just before the pandemic), partly because they lend to borrowers who are more sensitive to economic conditions, such as the self-employed.”

It is prudent to remain liquid and capitalise on high risk-free rates right now.