Fresh financial hit for first-home buyers with upcoming changes from APRA

The banking regulator, APRA, is proposing to raise “risk weights” for high loan-to-valuation (LVR) loans from 1 January 2023.

This change will probably make it more expensive to take out a mortgage at a high loan-to-valuation (LVR) ratio.

First-home buyers will be more affected by this than other borrowers, as they typically have higher LVRs.

APRA is looking to change how banks assess mortgage risks

APRA has proposed changing the “risk-weights” for residential mortgages.[1] APRA published the proposed rules for consultation late last year, with the aim of finalising the rules this year, before they come into force 1 January 2023.

Risk weights are one of the pillars of modern banking regulation.

The idea is that banks’ assets (e.g. your mortgage or a loan to a business) are counted differently based on how risky they are. The riskier the asset, the higher the risk-weight, and the more equity a bank must have as a buffer.

Equity is one of two ways banks can fund themselves (think like shares and retained earnings). The other way is debt. Your deposits at a bank are debt; so are bonds and short-term bills.[2]

The key feature of equity is that it doesn’t have to be paid back, and thus acts as a buffer against losses.

This buffer matters.

If losses on loans are too large, and the buffer of equity to absorb the losses too small, depositors and bondholders may get concerned about the ability of the bank to pay back its money. This can lead to bank runs and financial instability. This has happened many times in history and usually leads to recessions.[3]

This is why modern banking regulation (and APRA, which oversees banks) exists: to avoid banking crises and the associated recessions.

The change will make interest rates more responsive to the mortgage’s LVR

The new rules will make risk weights more sensitive to the mortgage’s LVR at origination, as the chart below shows.[4]

The upshot is that mortgages to owner-occupiers with an 80-100% LVR will attract higher risk weights than they do currently, even if the borrower has lender’s mortgage insurance.

The good news for some owner-occupiers is that low LVR mortgages will attract lower risk weights; under the current rules, loans below 80% LVR are all treated the same. Loans to investors, or interest-only loans, will also attract higher risk weights at almost all LVRs.

This change is designed to reflect the fact that high LVR mortgages are riskier.

APRA data shows that borrowers with high LVR mortgages at origination are more likely to go into arrears.[5] And banks are more likely to lose money if forced to foreclose on a high-LVR mortgage because the size of the mortgage was close to the value of the house to begin with.

This change could make high-LVR mortgages more expensive

This change means banks will need to have a bigger buffer of equity for high-LVR mortgages than they do today.

Equity is an expensive way for banks to fund themselves, which means that this proposed change will make high-LVR mortgages more costly for banks.[6]

Banks will probably pass on that increased cost to borrowers.

This means high-LVR borrowers will probably pay a comparatively higher rate than they do today; in contrast, low-LVR borrowers may be able to get a cheaper rate.[7],[8]

That hasn’t really been the case in the past. Banks charge only a little more for mortgages that are over 80% LVR (around 7 basis points for the past few years). That premium has widened to almost 20 basis points recently, which could presage these changes APRA is proposing.

First-home buyers will be most affected by the change

Higher rates for high-LVR mortgages will hurt first-home buyers.

First-home buyers are much more likely than other borrowers to take out high-LVR mortgages. The chart below, from a recent RBA Bulletin article, shows that nearly three-quarters of first-home buyer mortgages in January 2022 had an LVR of 80% or above. Just one-third of other owner-occupier loans were.

For many first-home buyers, saving a deposit is the constraint on home ownership, particularly as house prices have surged. That’s why low-deposit/high-LVR mortgages are more common for these buyers.

By making high-LVR mortgages more expensive, APRA’s proposed change could make having that deposit even more important.

[1] A complicating factor is that these risk weights are for the “Standardised Approach”. Not all banks use the Standardised Approach; banks can instead opt to use “internal ratings based” risk weights, where the bank chooses its own risk weights to apply to different assets based on the bank’s own risk modelling. Nonetheless, these are supervised by APRA, so the standard risk weights will provide a guide.

[2] Collapsing bank balance sheets to debt versus equity is over-simplified, and there is a continuum of instruments. As an example, banks can issue equity-like securities (called Contingent Convertibles or CoCos) that count as equity for regulatory purposes. Like bonds, these pay a set rate of interest and pay back the principal at maturity, but do not have to be paid back if the bank’s ratio of equity to debt falls below a certain (defined) threshold.

[3] This happens because depositors stop lending to banks, that means banks can’t lend to businesses and households and that makes the whole economy (which relies heavily on bank credit to work day-to-day) seize up.

[4] These risk weights will apply to any “Standard eligible mortgage”: this will apply to most owner-occupier mortgage other than no- or low-doc loans. It means the bank holds a registered first mortgage, and has documented, assessed, and verified the borrower’s ability to pay.

[5] To be clear: that doesn’t necessarily mean higher LVRs cause default, just that it is related; the sorts of borrowers taking our high LVR differ, possibly in unobservable ways, from those taking out though high-LVR mortgages.

[6] A great deal of complexity sits under this statement. The cost of debt funding is the interest rate the bank pays. This is quite low. For instance, 6-month bank-accepted-bills – a form of short-term debt issued by banks – are just 0.25%, and long-term bank bonds are under 2%. Deposits are even cheaper for banks – online savings accounts are currently paying 0.05%. The “cost” of equity is the expected return investors need to invest in and hold bank equity. It is not directly observable, but estimates for Australia are typically in the 10-15% range (substantially higher than the cost of debt). A wrinkle is that, in economic theory, this distinction is meaningless. Issuing more equity makes debt safer and so lowers the cost of debt; in theory this means the cost of funding is invariant to the choice of capital structure (Modigliani and Miller 1958). In practice, this is not how banks (or the entire field of corporate finance) behaves, so let’s ignore that discussion for our purposes.

[7] This is relatively speaking: the RBA is likely to raise interest rates before these changes come into effect, which will raise mortgage rates for all mortgages.

[8] This hasn’t really been the case in the past. Mortgages with LVRs above 80% for owner occupiers have had only a 0.05% premium compared to mortgages with LVRs under 80%. That has changed a bit recently, which could presage what is to come with these forthcoming changes.