Changes in society undermine the financial pillars

The financial community pillars, which have dominated Australia for the past decade, are under extreme threat.

Sydney and Melbourne prices have already gone up substantially, so banks will not suffer huge losses. Picture: AAP

The financial community pillars, which have dominated Australia for the past decade, are under extreme threat. A very different Australia will emerge to the one where these pillars underwrote booms in building, retail, education and banking. Other areas of the community will need to replace them.

Unless there is a dramatic and unlikely change in the threats, we are entering an era where dwelling prices will fall, particularly in Sydney and Melbourne; property investors using interest-only loans face bigger repayments; where the rents in many areas of the retail industry will decline; where the boom in many building trades will subside; where banking will become much more the province of lawyers and bank regulators; where the Australian Taxation Office takes a greater interest in the detail of loan applications for dwelling loans; and where Chinese investment in dwellings and support of Australian tertiary education is greatly reduced and finally migration subsides.

What leads me to those conclusions?

First, a dramatic, out-of-left-field change of direction at the royal commission into banking. That is followed by revelations by Sydney apartment developer Meriton that Chinese investment has slumped; indications from universities that the government attacks in China are having an impact, albeit small at the moment; the increased regulation of banks by the Australian Prudential Regulation Authority; the links between one or two banks and the Australian Taxation Office; the fall in migration from the latest statistics; and finally, but importantly, research by UBS (on the banking sector) and Macquarie (on the retail space).

It’s only when you look at these events in totality that you realise the scale of the threats to our ­pillars.

So let’s start with the royal commission. I remember last year talking separately with two bank CEOs who reckoned there was nothing a royal commission would discover that was not known. It shows how completely unprepared the banks were for what would come out of the royal commission.

Before the royal commission, they had before them the research by UBS, which showed that many bank customers were fudging their income levels to gain home loans — the so-called “liar loans”.

Each bank had devised a way of explaining or denying these loans but underlying their explanations was the fact that they were comfortable with the vast bulk of the borrower income levels.

Given it is not until dwelling prices fall that these problems will come to the fore, that remains an unresolved matter.

But it has been overtaken by a challenge to the banks that came completely from left field. The royal commission discovered that when it came to living expenses, a vast number of loan applications had been approved without a detailed examination of each borrower’s actual costs.

Instead, a formula was used that had living expenses at a hopelessly inadequate level.

We don’t know what the royal commission will conclude, but from remarks being made it looks like by failing to check those borrower expense levels the banks were undertaking irresponsible lending and therefore breaking the law.

If the people lose money they may be able to sue the banks! The legal firms that specialise in these areas are jubilant. But for people to lose money dwelling prices must fall and, for many, prices in Sydney and Melbourne have risen 20 per cent to 30 per cent over the past few years.

Westpac is the first bank to realise that the royal commission looks like changing the business of banking in Australia. Westpac has instigated a detailed set of questions, which enables it to determine the real living expenditures of borrowers. All the other banks will follow in some form or other. Not to follow would be very dangerous.

And just to really alarm many homebuyers, particularly investors, some banks plan to check the income levels that homebuyers claim with the tax office. Just between you and I, that’s the building industry equivalent of an exocet missile. (As long as the potential borrowers know that is what is going to happen, then I have no problem with the ATO here. It’s all about truth.)

The global investment house UBS has been leading the research on the looming bank problem and they point out that while over the longer term demand and supply plays a key role, on a week-to-week basis, the amount a person or couple is prepared to pay is the sum of the deposit they have available and what the banks are prepared to lend them. If the banks cut the amount they are prepared to lend then prices will fall because buyers’ available cash is reduced. And that has already started, as a result, in the restrictions and higher interest rates on investor loans and a general tightening including a more careful lookout for “liar loans”.

But, according to UBS, that’s nothing compared to what will happen when all the banks follow Westpac in responding to the sentiments being expressed at the royal commission.

The ANZ told the royal commission that in about three-quarters of its loan applications it used what is called the HEM benchmark. The base level of that benchmark calculates the so-called “basic” living expenses at about $32,400 for a couple with two children. It’s clearly a totally unrealistic amount especially as, adjusted for inflation, it stays at that level for the length of the loan.

It is highly likely that banks will move from the unrealistic “basic” expense level to the so-called “lavish HEM” of around $58,000. UBS say that is still too low and UBS assumes that if a couple earning $125,000 is put through a Westpac-style wringer their real living expenses will come out at around $68,000, taking into account that half of mortgage borrowers have private school fees. Under the old scenario, a couple earning $125,000 could borrow $644,000 or 5.2 times their income. Accordingly, with a $100,000 deposit they would pay up to $744,000 for an outer suburban house in Melbourne or Sydney. Under the new expenses scenario the bank will only lend them $466,000. So, again on the basis of a $100,000 deposit, they can only pay $566,000 for that same house — a fall of $178,000, or 23 per cent. Sellers will refuse to sell at those levels, so there will be supply constraints. Nevertheless, if the living expense clamps are strict there will still be a big dwelling price fall — and much more than the 5 per cent fall AMP is forecasting.

I have always believed that if we started to see a widespread dwelling price fall approaching 10 per cent, the banks and the bank regulators would lift the clamps and hose the market with money. But the idea of “responsible” lending brings in the lawyers.

Because Sydney and Melbourne prices have already gone up substantially and people will try very hard to maintain payments in residential houses, while investors often have used their residential house as security, banks will not suffer huge losses but they will stop growing.

Building activity will fall sharply until land prices come down to make new houses affordable. And that causes big losses in smaller enterprises and developers and it’s in that area where banks will suffer the biggest losses.

As the market falls and the Chinese students are curtailed there will be screams for better relations with China. None of this is good news for Malcolm Turnbull.

In retail, Macquarie has calculated the amount of retail space that is going to come on to the market because about 22 retailers have gone into liquidation or announced store closures this year. Macquarie says 227,000sq m of lease space in malls and other centres is being vacated. In addition, Toys ‘R’ Us and Babies ‘R’ Us are letting go some 117,000sq m — a total of 344,000 sq m in vacancies in malls and shopping centres. Yet just as people are pushing up values of outer suburban real estate they are also buying retail properties. Both sets of buyers are taking risks unless they are buying unique properties.