It was short, but sharp, and really shook up the financial sector. But the banking royal commission is disappearing in the rear view mirror faster than a financier’s Ferrari.
Nowhere is this more apparent than in home lending — the foundation stone of the housing market, upon which rests much of the Australian economy.
The Government chose not to implement many of Kenneth Hayne’s proposals to limit commissions and conflicts of interest in the mortgage broking sector; the bank regulator APRA chose to backpedal on its own interest rate floors by lowering them and increasing the amount people can borrow; now the Federal Court has shot down ASIC’s responsible lending case against Westpac.
In short, the Australian Securities and Investments Commission argued that an automated loan assessment system used by Westpac between December 2011 and March 2015 approved more than 260,000 home loans by using an expenses benchmark — the Household Expenditure Measure (HEM) — rather than looking at how much the customers reported they actually spent.
In most cases, customers declared they spent less than the HEM (virtually a statistical impossibility), so the use of the benchmark actually meant they could borrow less.
However, in thousands of cases, customers were given loans that they could only afford the repayments on if they cut back on their previous spending levels.
ASIC’s argument was, essentially, that Westpac should have been using, or at least considering, potential borrowers’ declared expenses in considering whether a loan was suitable.
It’s an argument that found a lot of sympathy from former High Court justice Kenneth Hayne at his banking royal commission.
But it didn’t wash with Federal Court judge Nye Perram.
Superficially, the legal logic from Justice Perram is impeccable — the National Consumer Credit Protection Act requires lenders to make reasonable inquiries about their customers’ financial position. Westpac did that.
It requires lenders not to make loans that create financial obligations that consumers will be unable to comply with, or could only meet with “substantial hardship”.
The corporate regulator ASIC offered no evidence that any of the customers approved for home loans by Westpac using the automated system in question either defaulted or suffered substantial hardship in avoiding default.
Justice Perram ruled that the adequacy of the HEM was an irrelevant issue, because either the law said the bank needed to use actual customer expenses or it didn’t. He found the latter.
Home buyers can ‘make do’ to get a bigger loan
Again, there is some superficial appeal in Justice Perram’s reasoning for why actual expenses are not relevant to assessing the suitability of a loan, with his culinary example garnering the most headlines.
“I may eat Wagyu beef everyday washed down with the finest shiraz but, if I really want my new home, I can make do on much more modest fare.
“Knowing the amount I actually expend on food tells one nothing about what that conceptual minimum [of how much one can spend without going into “substantial hardship”] is. But it is that conceptual minimum which drives the question of whether I can afford to make the repayments on the loan.”
If the message wasn’t clear, Justice Perram rammed it home with further metaphors about luxury travel, wine and food.
“The fact that the consumer spends $100 per month on caviar throws no light on whether a given loan will put the consumer into circumstances of substantial hardship.”
The judgment, tellingly, summed it up thus:
“With knowledge of the consumer’s declared living expenses, one may well be able to discern that a consumer will have to trim their sails if the loan proceeds. But there is arguably a conceptual gulf between a trimming of sails and poverty.”
But Justice Perram fails to explicitly address that “conceptual gulf” in his judgment. On the legal front, he never explicitly defines what “substantial hardship” means.
Yet, throughout the judgment, Justice Perram implies that it is around a poverty level of living and that this is so regardless of the pre-existing circumstances of the borrower.
Perhaps this is so, yet without explicitly defining substantial hardship based on the intentions of the Parliament in drafting the legislation, this seems no more than his assumption.
Homebuyers’ spending cuts could lead to recession
From a policy point of view this poverty level definition is troublesome.
Do we want a situation where all home loan customers are offered loans so big that the repayments would force them to live on the border of poverty?
Is it realistic for a bank to assume that high income households would be willing, or even able, to slash their standard of living to well below that of someone on a typical income?
If banks are legally allowed to offer loans based on a miserly standard of living, do they have a legal obligation to warn prospective customers about the type of spending cuts they’d have to make if they took out the maximum loan offered?
If this judgment stands, there is every chance that the competitive pressures on banks to drive lending growth in a weak economic environment will see them regress back towards the loose lending standards earlier this decade, which are resulting in higher default rates than loans issued after the bank regulator APRA started clamping down and ASIC made noises about responsible lending.
From an economic perspective this could be as much of a disaster as having lending standards that are too tight.
Banks giving people property loans so large that the repayments left them just above the poverty line is one of the reasons why Australia has stratospheric levels of household debt — around 200 per cent of household incomes — a major vulnerability that could, if our luck runs out, spark a banking crisis and recession.
Even without such an extreme event, recent Reserve Bank research shows that high debt levels result in lower levels of consumer spending.
Giving middle and higher income people home loans with repayments that force them into poverty line levels of spending is only going to worsen already anaemic household consumption that is a key factor behind Australia’s weak economic growth.
That Wagyu steak is a farmer’s income, the wine a vintner’s. The first class airfare to the US may be on an Australian airline.
Ultimately, if our mortgages keep growing faster than meagre wages growth and eventually mortgage interest rates fall as low as they can go, then household spending restraint could also tip Australia into recession.
And who are the main beneficiaries if we resume giving people bigger home loans by assuming they’ll slash their spending to afford them?
Number one are the banks earning interest off those loans. Real estate agents earning bigger commissions on more expensive sales. And, of course, existing home owners, especially investors, who see further increases in the value of their property.