Why home lending will prove the key driver of property prices in 2019

The answer to the big question of “What will happen to the property market this year?” is dependent on the answer to another question, “What’s in store for home lending in 2019?”

It’s well understood that home lending activity is a driver of property price growth and last year we saw how changes to bank lending can reverberate through our capital city housing markets. We expect banks and borrowers will change their behaviour again this year and below we’ll discuss four potential developments that it would be wise to keep an eye on.

But to fully understand their impact, it’s worth reviewing the closeness of the relationship between home lending and prices.

Home lending and property prices

There is a close relationship between home mortgage lending and property price growth in the short run, with changes in lending often leading changes in price growth.   

There is also a close relationship between property price growth and the change in the growth rate of the stock of housing credit.

Housing finance growth and housing credit “acceleration” both indicate that property price falls will continue in 2019. If these measures stabilise, this could indicate property prices will bottom out.

Home lending declined in 2018 due to tighter lending conditions and lower investor demand

New home loan lending declined significantly in 2018, with the value of lending to owner-occupiers and investors falling 10 per cent and 23 per cent respectively over the year to November 2018 (see graph). New lending has fallen most dramatically in NSW, Victoria and Western Australia over the past year, particularly to investors.

Three major factors contributed to the significant decline in home lending in 2018.

First, APRA required banks to verify the expenses of mortgage applicants more closely, rather than rely on spending benchmarks, which reduced borrowing capacity. APRA’s actions in 2018 followed a series of interventions aimed at slowing lending to property investors and improving lending standards. APRA removed some of these restrictions in 2018 after lending had fallen well below these caps and lending standards had improved.

Second, banks became more cautious in their lending activities due to the public spotlight of the Financial Services Royal Commission that began in early 2018. In the expectation that the royal commission will recommend more rigorous lending rules, banks preemptively tightened lending standards, particularly the verification of living expenses, throughout 2018.

Third, as sentiment turned and property investors saw poor prospects for capital gains, investors became less keen to borrow. This contributed to new investor lending falling dramatically. As mortgage rates did not increase sharply in 2018, this shows the decline in bank lending was not solely due to tightening of the supply of new home loans (although rates did increase at the end of the year due to banks passing on higher funding costs). 

Four key things to watch that will influence home lending in 2019

1) The recommendations from the Financial Services Royal Commission in February

The Financial Services Royal Commission is due to publish its final report in February. It is likely that the report will recommend that banks need to make more inquiries when verifying potential borrower’s expenses and incomes. The interim report criticised banks for failing to verify an applicant’s actual expenses because banks claimed it was “too hard” and too costly.

In response to the royal commission’s findings and pressure from APRA, banks tightened their income and spending assessment practices throughout 2018, which contributed to maximum loan sizes falling. So only if the royal commission’s recommendation regarding expense and income verification is stricter than what APRA has already directed banks to do, and further than banks have anticipated and implemented, will bank lending slow further in 2019 due to tighter lending conditions.

Other changes also have the potential to slow home lending a little. The royal commission will also likely recommend changes to how mortgage brokers are paid, to stop brokers from being incentivised to offer larger loans. Banks are also introducing comprehensive credit reporting, which allows third parties to check on a borrower’s overall financial situation when assessing a loan application.

2) How banks respond to conflicting pressures

How banks respond to pressure from the government, the public and the regulators will be an important driver of home lending in 2019.

On one hand, the banks are being encouraged to not tighten lending any further.

The Treasurer stated in December that “banks need to balance their responsible lending obligations with the need to keep credit flowing providing much-needed access to finance for families and businesses”.

In the Council of Financial Regulators’ (CFR) first publicly released statement in December 2018, it stated that “members agreed on the importance of lenders continuing to supply credit to the economy while they adjust their lending practices … an overly cautious approach by some lenders to incorporating relevant laws and standards into loan approval processes may be affecting lending decisions”.

And the RBA governor has expressed concern that banks are becoming too risk-averse in their lending practices.

Some commentators are also speculating whether APRA’s requirement that banks test the serviceability of a mortgage applicant using an interest rate of at least 7 per cent could be lowered, particularly if the RBA cuts the cash rate.

But in the opposite direction, banks are under pressure to keep a tight leash on mortgage lending.

The public’s angry response to the findings from the royal commission has seen banks become increasingly risk-averse. Westpac is facing allegations of breaching responsible lending laws by not making ‘“reasonable inquiries” about an applicant’s expenses and how banks need to use this information. This case, scheduled to be heard in May, will provide further guidance to banks about how to comply with responsible lending laws.

3) Whether the RBA cuts rates

Financial market expectations that the RBA will cut rates have increased over the past couple of months.

While the RBA has maintained a relatively optimistic outlook for the economy, the financial markets and many economists now expect that the RBA will cut rates in 2019 or 2020. The market implied forecast for the cash rate has changed from an expectation in November 2018 of a cash rate increase in early 2020 to the expectation of a cash rate cut in late 2019 or early 2020 (see graph).

Downward revisions to GDP growth, weak inflation, falling house prices, a housing construction slowdown, declining consumer confidence and a slowing global economy are all signs that the Australian economy may slow in the year ahead.

If the RBA does decide to cut the cash rate to give the economy a boost, it is likely that there will be two cuts, bringing the cash rate down to 1 per cent from 1.5 per cent. The RBA may also cut the cash rate just to offset out-of-cycle mortgage rate increases.

A reduction in the cash rate could potentially be the trigger to turn around property market sentiment and encourage property investors back into the market.

4) How prospective borrowers respond to the new home lending environment

Potential borrowers have taken time to adjust to the more stringent mortgage application process. More home loan applicants are being rejected by banks. And as it now takes longer to get a loan, some potential buyers have missed auctions, which has probably been a contributor to low auction clearance rates.

Closer expense verification has contributed to banks reducing maximum loan sizes by about 20 per cent.

However, RBA research shows that only about 10 per cent of borrowers actually took out loans at or close to the maximum amount they are offered by their banks, with most borrowers taking out loans well below the maximum amount they could potentially borrow.

So the reduction in the average maximum loan size of approximately 20 per cent in 2018 does not automatically mean that actual loan sizes have fallen by that amount. It’s possible that in response to the new lending environment, a higher percentage of new borrowers may take out the maximum (or close to) amount of credit they are offered, as they know banks are being more cautious.

But given the slowdown in bank lending that occurred in 2018, it is likely the reduction in maximum loan sizes has had an impact on actual loan sizes for borrowers, particularly for investors.

Consumers have taken time to adjust to this new reality of closer inspection of their income and living expenses and longer approval times, which likely contributed to low housing turnover in 2018. It’s likely that potential borrowers will adjust to the new lending conditions in 2019.

If demand for loans picks up, perhaps triggered by the RBA cutting rates which improves sentiment and increases the chances of capital growth, home lending should bottom out and perhaps start growing at a modest pace in the year ahead.

How 2019 will likely play out

Banks look to have reached or are close to reaching a “new normal” of tighter lending standards and consumers are also slowly adjusting, although investors remain reluctant to borrow.

Unless the royal commission recommends much stricter requirements above and beyond what banks implemented in 2018 in response to the royal commission’s interim findings and APRA’s instructions, home lending may be close to bottoming out and housing credit growth may stabilise.

If this occurs, home lending should provide some support to property prices in the year ahead.