Last week’s dual announcement by Westpac (WBC.AX) of an increase in its mortgage rates and the capital raising of $3.5 billion is still being digested by market participants. Our view is that all of the banks must raise substantially more capital to make themselves bullet proof in the event of a residential property market correction that could occur with or without a recession.
WBC’s announcement was peculiar in one specific regard. They increased their dividend (which flows capital out), at the same time as declaring its desire to raise more capital (capital flows in). WBC will pay out $2.9 billion (pre-DRP) and seek $3.5 billion back. It is not underwriting, its DRP (dividend reinvestment plan) and it fast tracked its capital raising announcement and dividend announcement to head off the activities of hedge funds that were attacking the bank’s share price. After dividends and DRP, we estimate that WBC will raise about $1.6 billion net.
Westpac’s capital decisions in the face of hedge fund activities amplify the chaotic environment that exists in Australian financial markets at present. However and more importantly, it pre-empts the growing risk of a residential property correction. To see this more clearly, we can look at some key RBA charts to illustrate the issues.
First, the extraordinary rise in Australian household debt is shown below. It shows how Australian banks have been able to aggressively grow their assets and therefore their profits over the last decade. Bank assets have grown faster than bank capital due to their advantageous use of risk weighted capital ratios.
Household Finances
Figure 1. Household Finances
Sources. ABS; RBA
However, we need to dig a bit deeper to see the real issue that is developing in the household sector that has borrowed excessively from banks who hold residential property as security.
Disposable income for households after tax and before interest is estimated to be $1.1 trillion in 2015. Therefore mortgage debt is approaching $1.8 trillion to generate the 170% ratio. Some 85% of this debt is provided by the big major 4 banks that have levered their balance sheets using risk weighted capital ratios.
The rise in household debt has been offset by historic low mortgage rates and thus the amount of income being devoted to interest payments as a percentage of income has fallen.
But the above chart is misleading. This is because it includes the income of 60% of households who do no have mortgages.
By recasting the above numbers we can estimate the real level of mortgage stress in Australia. Thus, if 40% of households have mortgages than we can estimate that 40% of $1.1 trillion of income is servicing mortgage debt.  On this basis the 8% interest/income ratio becomes 20% for those who have a mortgage. Indeed we suspect the ratio is higher for first time buyers because they normally have lower average income. It could be even higher for households who have purchased in Sydney in the last year.
The next chart shows the extent of price rises in residential property in Sydney and Melbourne. The price rise in Sydney of 30% in just a few years have moved prices to historically high levels when measured against average after tax income. This leads us to the conclusion that the real risk for banks is in that part of their mortgage book that has been created in the last few years. If there is a price correction or an increase in unemployment that causes defaults, it is in the recent loan book that will suffer the biggest losses and stress.
Housing Prices
Figure 2. Housing Prices
Source. CoreLogic RP Data; RBA
The next chart gives us a hint as to why residential prices will correct in the coming year. The chart shows the lift in residential construction has become firmly focused on high density housing in major cities. This focus means that the supply imbalance between demand and supply that was driving prices higher will soon be balanced.
Private Residential Building Approvals
Figure 3. Private Residential Building Approvals
Source. ABS
Importantly the regulatory moves by APRA and the RBA on bank lending to property investors have seen an adjustment to the split of loan approvals. Recently owner occupiers (including first home buyers) have moved again above investors in loan approvals. The chart below indicates the rapid growth in investor loans as residential property prices moved substantially higher in Sydney and Melbourne.
Housing Loan Approvals
Figure 4. Housing Loan Approvals
Sources. ABS; RBA
Arguably it was investor activity and non-resident buying that was pushing residential prices higher. The role of banks in feeding this demand is not in doubt and the crucial issue at this point is the quality of the lending by banks as residential prices spiralled higher. The raising of capital by the banks under direction of the RBA and APRA suggests there is a concern amongst the regulators.