Are Australian’s at risk of a systemic default event caused by COVID-19?
The current state of the Australian Economy has been looking particularly grim when considering the widespread financial struggle that has occurred as a direct result of COVID-19. This comes despite the sweeping changes that have been put in place to curtail this impact:
- The RBA reduced the cash rate to a historic low of 0.25% in March and has kept it at 0.25% since.
- The Australian Government has introduced measures to prop up Australian families and businesses .
- The banks have offered historically low Fixed Rates
- The banks have offered financially stricken Australians the opportunity to defer there loans, at first for 6 months, and have since then extended the deferral period.
While these actions certainly have saved many families in the short term, it is likely that for some it will only have postponed their inevitable default. So now we must question, when JobKeeper, JobSeeker, and the mortgage deferrals end, will widespread defaults be inevitable?
First off, we must question why borrowers default on their mortgages.
Is it a change in their circumstances that means they can no longer meet their monthly repayments?
Or is it when their home is worth less than their mortgage?
Or… is it both?
Knowing the answer to these questions is important for understanding the risks associated with economic and financial shocks. For example, these results can provide a framework for understanding some of the financial stability risks associated with the COVID-19 pandemic. And understanding the precise nature of the risks can suggest policy responses that might mitigate some of these risks.
Michelle Bergmann explored these questions in her 52 page research report published by the Reserve Bank of Australia.
Her research suggests that both are necessary for a default to occur. This notion can also be put more simply when rationalised using real world scenarios. When a person is no longer able to meet their monthly repayments, they can sell their property for a profit and avoid foreclosure. Where a person as a mortgage that is of higher value than their home, they can continue to pay their mortgage. When both occur, a person is unable to meet the payments of their mortgage, and the bank is also unable to recuperate the value of the loan through the sale of the home and therefor the borrower defaults.
An example of this occurred in Australia when the Mining Investment Boom came to an end. Mortgages in mining regions were exposed to weaker housing and labour market conditions which resulted in higher default rates because this economic scenario presented the exact two conditions which are required for a default to occur. While examples of localised stress may differ from a nationwide stress event, they likely provide the best estimates of credit risk during a period of housing stress in Australia.
- Reductions to income appear to be the key driver of entries to arrears and unemployment appears particularly important. Borrowers whose incomes were likely to be more volatile were also more likely to enter arrears.
- Increases to required loan repayments also increased the probability of borrowers entering arrears.
- Borrowers who had built up large excess repayment buffers and who had lower repayment-to-income ratios were significantly less likely to enter arrears. These borrowers may be better able to withstand a reduction to their income for a period of time, for example, by drawing down on repayment buffers or savings.
Also consistent with this hypothesis, transitions from arrears to foreclosure are predominantly explained by negative equity. Low regional housing turnover rates, which may be associated with difficult selling conditions, also increased the probability that a loan transitioned to foreclosure.
So, is systemic default inevitable?
To determine if widespread defaults are inevitable, we have to consider how capable Australian’s are at paying off their mortgages in the current economic climate, and how are house prices faring at this point.
- 55% of Families with a mortgage are receiving some form of financial support.
- 22% on JobKeeper
- 15% on JobSeeker
- 15% on the dole
These support systems are all slated to end, or be significantly reduced by January. With the only support system left standing in January being the dole which will only be paying out $282.85 per week, down from $557.85 per week.
While these support systems were allowing struggling families to maintain their mortgage, many of these families will no longer be able to meet the costs of their mortgage once support is taken away. With that established, we must now consider whether housing prices are expected to go down.
So with house prices down in at least 3 of Australia’s capital cities, and with the end no where in sight it may be that prices continue to drop to levels low enough for many families to have larger mortgages than their house value, ultimately leading to a default.