Outside the Major Banks, which have more diversified businesses with capital markets and corporate lending activities, most smaller ADI’s (banks) have balance sheets largely composed of residential mortgages. Banks generally fail for one of two reasons being a lack of liquidity (where they cannot obtain the usually short term funding they need to sustain their generally longer term lending) and for solvency reasons (where the value of their liabilities begins to approach the value of their assets leaving them too little equity to keep operating). Often banks fail as investors fear they are becoming insolvent and therefore refuse to fund them causing them to actually fail for liquidity reasons (a “run on the bank”).
In the short term, the RBA has taken action providing all ADI’s with access to funding to ensure no solvent ADI in Australia fails due to a lack of liquidity. However, because of their balance sheets, the medium term risk to all ADI’s is a sharp and sustained fall in house prices combined with mortgage holders being unable to meet their obligations. This could ultimately result in losses for the ADI lenders if the value of the defaulting mortgagee’s house does not cover the size of the loan after repossession costs.
The level of house prices is also closely tied to borrowers not defaulting on their mortgages as in a rising market any borrower who cannot meet payments simply sells the property and walks away with a profit; but in a declining market borrowers are far less inclined to see a large part of their home equity lost in a sale and once they find themselves in a negative equity situation they have no financial incentive to voluntarily sell because they walk away still owing the bank and lose the possibility of a recovery in house price value and the place in which they live.
The COVID-19 crisis has created a novel situation in the Australian housing market that has never previously occurred so the outcomes are difficult to predict. Further, unlike the share market, the housing market is largely illiquid and opaque so actual price movements are not always recognised immediately and the effect of leverage in the form of many houses being mortgaged magnifies both gains and losses. Ultimately, the level of house prices is determined by the relative numbers of buyers and sellers in the market and so demand and supply pressures are key.
It is unlikely there will be any bad loans or mortgage defaults before September while the government mandated “mortgage holidays” are in place, but the ultimate driver of mortgage defaults will most likely be the unemployment rate and this is the variable investors should closely monitor as it has the capacity to lead to sharply lower house prices if there is a wave of forced sellers coming to the market. Even if house prices fall, if mortgage holders keep meeting their repayments this does not become a problem for the lending ADI; rather it is the combination of a borrower being unable to meet repayments and the value of their home falling below the value of their loan that causes problems (which are generally exacerbated by any repossession process).
Nearly all ADI’s are well capitalised at this point and they can withstand a far greater rate of loan losses than have been experienced in recent years. The potential problem as laid out above is apparent and so management should have time to plan for the situation and take appropriate steps. It is for this reason we believe if there is going to be a problem, it is likely a longer term one and so no ADI is immediately threatened and therefore all shorter dated investments in all ADI’s should be secure.