Why banks should avoid a big wave of mortgage defaults

As interest rates take off and inflation picks up steam, one of the sharemarket’s biggest fears is that our major banks will be left holding the bag with hefty mortgage bad debts and loan defaulters.

This is a key reason why big-four bank share prices plunged between 13 and 19 per cent last month, amid the broader Australian Securities Exchange selloff.

On face value, these fears make sense, given the banks’ massive mortgage portfolios, the inflated housing market, and the nation’s high level of mortgage debt. However, recent analysis makes a convincing case that bank profits are unlikely to be smashed by a rising tide of mortgage customers who are unable to repay their home loans.

There are several reasons for this: the likelihood of household belt-tightening, high savings levels, low unemployment, and the large provisions for bad debts that the banks are already holding.

As household budgets face a squeeze from higher inflation and rising interest rates, the Reserve Bank has tried to calm the market’s nerves by pointing out that “the average customer” is well ahead on their mortgage repayments, and that households have stockpiled more than $250 billion in savings.

All true, but it’s not the “average customer” that the market worries about, it is borrowers who are deemed riskier, such as those with big debts or irregular incomes.

Jarden chief economist Carlos Cacho has crunched the numbers on how the borrowers most heavily in debt – more than six times their annual income – would fare if official interest rates rose from the current 0.85 per cent to 2.5 per cent, as many analysts expect they could.

He says repayments for this group could jump to as high as 50 per cent of their income, and many would ultimately “struggle.” Even so, he is not overly worried about sharply increasing mortgage defaults.

Cacho points out that when banks approve a loan, they assume that, if necessary, the borrower could cut their spending to a bare minimum, captured by a statistical tool called the Household Expenditure Measure (HEM).