Builders a sitting duck as bank inquiry train comes hurtling down the track

Builders and developers are oblivious to the banking royal commission’s threat to the foundations of their business.

Builders working at a residential construction site in suburban Sydney. (Picture: ISABELLA LETTINI)

Very few builders and developers in the housing industry have any idea that that they are in grave danger of being hit by a high-speed train.

I have been in touch with two of the top five non-apartment builders in Australia and neither realised that the Royal Commission was threatening to go after the banks over unfair lending practices if they keep lending to homebuyers on the basis of false living expense estimates.

One of the builder developers, who is in the top three, was beaming as he explained he had just had a wonderful month, particularly in outer suburban Melbourne and rural Victoria and said he believed Brisbane would be the next market to move.

The APRA-Reserve Bank-ASIC measures, including clamps on interest-only loans, higher investor rates etc, had stopped prices escalating but did not kill the market.

Both builders explained that the majority of the outer suburban and rural houses they sell are funded on loans that represent 95 per cent of the value of the property. To get to that level the brokers and the banks sometimes turned a blind eye to income boosts while almost all loans have low estimate of borrower living expenses. In Victoria this has created huge outer suburban/rural demand and the price of land has risen by up to 50 per cent in some areas which is boosting the cost of dwellings.

When I explained to the builders that, while the Royal Commission had not made a recommendation, the line of questioning in the hearings indicated that many of the loans banks make to home borrowers have become potentially extremely dangerous for the banks.

Because the banks had not checked borrowers routine expenditure levels but instead used a formula that was producing unrealistically low expenditure levels, they were in danger of being engaged in irresponsible lending and could be breaking the law. If house prices fall then the banks could be liable for the loss.

For earlier loans there is a buffer created by house price rises but those loans taken out recently with 95 per cent of the value borrowed require only a 5 per cent dwelling price fall to send the borrower into negative equity territory.

The builder/developer paled as he explained that if bank lending levels were slashed then the industry would be hit hard. Developers who have bought large tracts of land at recent high prices could go to the wall.

Banking Royal Commission

What it means for the banks

Opposed by the banks right up until the moment they asked for it in November, the commission presents both obvious dangers and hidden opportunities to the sector.

Their already-battered public reputations have taken further hits and commissioner Kenneth Hayne has mulled the prospect of tighter regulation.

Some of the worst areas exposed by the commission so far - particularly the commissions paid to car dealers and mortgage brokers - are areas where some banks would like to see a crackdown, but lack the guts to take action that would put them in danger of losing market share.

New regulations cutting mortgage broker commissions, for example, would allow the banks to compete on a level playing field while crushing an industry they have allowed to steal away half of all home loan sales.

Westpac has announced that it is now determining real living costs rather than using the formula. In response to my comments, an ANZ spokesman said: “We significantly increased the number of questions we ask relating to customer living expenses in December last year (to a level similar to what Westpac has recently done).

“This has been initially been rolled out for home loan applications made direct to ANZ and will be expanded to personal loans and credit cards.”

The question at issue is just how far this will cut back lending. We know that about one third of mortgage holders are struggling to make payments despite high employment and low interest rates. And among the $1-million-plus borrowers, I am aware of a number who are really finding it tough and now that dwelling prices are falling, particularly in Sydney (10 per cent falls in the harbour city are common) this is creating misery among borrowers, which dissuades others from making the same mistake.

It will take a while before we can determine how assessing realistic living expenditures cuts back the amount banks will lend on housing.

Global investment house UBS believe most of the banks have been using a HEM measurement of living expenses that produces a living expenses estimate of around $32,400. A more realistic living expenses estimate is between $50,000 and $88,320 for people on incomes of between $80,000 and $200,000. Talking to younger people over the weekend those UBS living expenses estimates look realistic — they might even be in the low side.

On the basis of the UBS realistic living expense estimates, the borrowing level for a couple on an $80,000 income falls from $337,985 to $195,912; for those on a $125,000 income the borrowing level falls from $643,892 to $465,615 and the borrowing limit for a person on a $200,000 income falls from $1,144,225 to $792,804. That totally changes what people can pay for a dwelling.

And for investors thinking of jumping in they know that the frontrunner to be Prime Minster, Bill Shorten, is promising higher capital gains taxes and to remove the ability of buyers of used dwellings to claim negative gearing. For those investors buying dwellings now there is a very good chance that should they want to sell, the environment for the buyers will be totally different so prices will fall.

UBS believes that the consequent house prices falls from all the measures will not cause huge losses for the banks but what will hit them is the collapse of building developers who have paid too much for land.

Nevertheless, if dwelling price falls gather momentum, then APRA and the Reserve Bank may need to step in to avoid carnage in the building development industry and the myriad of tradespeople who rely on the industry.

But it would go much further and state government revenues — led by Victoria and NSW — would be greatly reduced and they would need to back track on their hiring sprees and increased spending.

But it also affects Federal Government revenues, although mining revenues are now starting to rise.