Bye bye buffers and hello to the mortgage cliff

Profit results show banks, just like homeowners, had no idea rates would fly so high – and there’s going to be trouble.

Volatility will not end until the RBA governor suggests the peak of the interest rate cycle is within view.

The problem with the RBA’s deeply unpopular view that rates are going to stay higher for longer is that the so-called “mortgage cliff” suddenly looks a lot more daunting.

The mortgage cliff, of course, refers to the 800,000 people who are going to come off fixed-rate mortgages to find that the RBA has lifted rates nine times since they fixed during the pandemic and their new mortgage rate could have tripled to about 6 per cent.

Many in the market have expected the mortgage cliff to not amount to much. They pointed to how variable-rate mortgage holders had been taking their rate increases on the chin with little signs of a spending slowdown.

But signs of trouble broke through in the set of big bank results released this week.

Specifically, Westpac’s update on Friday suggested that nearly half its entire home-loan book was signed off based on interest rate buffers that are going to be broken. More than $200bn worth of home loans were approved on ­assumptions that interest rates would peak at a lower point than we are now rolling towards.

Put simply, when official rates were near zero, banks assumed that rates would top out near 3 per cent when they judged the serviceability of a loan. The official rate is already higher than those assumptions, and Westpac itself expects the cash rate will now peak at 3.85 per cent.

It’s the latest sign the system is beginning to strain. But the signals were there. The bigger-than-expected inflation print for January was underestimated by almost everyone – except, it seems, RBA governor Philip Lowe.

Then in recent days we had news of the savings rate: the amount people are putting away in savings has reversed dramatically. We are nearly back to pre-pandemic settings already.

Reserve Bank governor Philip Lowe. Picture: Gary Ramage

This does not mean that accumulated savings have slid back to pre-pandemic levels, but people are no longer saving much and this will hit as mortgage costs rise.

It’s a turning point for sure – and it’s a matter of how much worse it gets. How will higher-than-expected interest rates hit homeowners and investors? The repercussions are at every level. If you look at property developers, the notion of interest cover is suddenly back on the table – can you cover your interest payments two times over? The ratio has not changed but the amount of money it takes to satisfy the ratio has soared.

Homeowners face a broadly similar scenario – what seemed to make sense a few years ago has suddenly become a problem.

At the very least, the worsening rate outlook pushes out a rebound in the housing market – because it pushes out any prospect that rates will be cut.

Many had expected rates could be cut by the end of this year, but now the forecasts for any easing in rate settings are moving into 2024.

Coupled with the news that banks were too generous on their serviceability guidelines, the dreaded beast of negative equity has also reappeared in the market.

A homeowner faces negative equity when their mortgage is bigger than the value of their home. It means the homeowner is in a bind: they must either dig themselves out through paying the mortgage and waiting for a recovery, or they become a forced seller.

Industry estimates put the number of homeowners in negative equity just now at about 120,000. This is not a big number in absolute terms – there are more than six million mortgages in the market. But the very existence of negative equity as a factor in house prices is more unwelcome news.

What’s more, the negative equity cohort is going to get bigger every time the RBA puts through another rate rise, and those most affected are going to be the youngest homeowners – often first time buyers – in the larger cities.

It’s what Paul Bloxham at HSBC called pandemic aftershock: in the depths of the pandemic crisis, the government threw money at the banks to help them cushion the economy. In doing so, rates – which were already very low – were artificially pushed down further.

With the RBA’s Lowe telling all and sundry during the pandemic that rates would not rise for two years, mortgage holders made the entirely sensible move to fix. The long-term average market share for fixed rates is under 20 per cent. During the pandemic the number doubled to 40 per cent.

HSBC chief economist Paul Bloxham.

Which brings us back to the “mortgage cliff”. All of these fixed loans must now roll off – the peak will be in September. This is the single biggest test in the housing market. What happens here will dictate what happens across the wider market in the months ahead.

Until this week the housing market had appeared to be stabilising, especially clearance rates. But we are now back on the wall of worry. The volatility will not stop until the day Lowe – or his replacement – suggests the peak of the interest rate cycle is within view.

How far will house prices drop? We know they have already fallen nearly 10 per cent peak to trough. You can get estimates that suggest the drop could be as bad as 25 per cent if you search widely. The only thing we know for sure is that if rates have an extra leg of upward pressure, the housing market has an extra leg of downward pressure.

However, there is one factor that is being underestimated. The vacancy rate in the capital cities has reversed course in recent weeks, moving back down to 1 per cent in January, according to the SQM group.

These rock-bottom vacancy rates occurred before the immigration gates reopened. Also keep in mind that from China alone there are 40,000 students expected to return to Australia this year. They will immediately put further pressure on rent prices, as apartment vacancy rates and even student accommodation vacancies are ­severely low.

As Torie Brown, executive director of student accommodation at the Property Council, put it this week: “There are zero vacancies in some cities such as Brisbane and other centres are filling up fast.”

As the rent crisis worsens, anyone who can possibly buy a house is going to do it – not because they want to chase a rebound in the market, rather the logic of buying their home will outweigh having to pay rents that are rising by 25 per cent a year.

Of course, this will only be the fortunate ones who can collect enough for a deposit, but it is the segment that will ultimately lead the market out of its downturn.

For homeowners, investors and even the RBA, there is no post-pandemic playbook. None of us have been here before.

Originally published as Bye bye buffers and hello to the mortgage cliff