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Bank lending is becoming more risky

Statistics published recently by the Australian Prudential Regulation Authority show that banks wrote $10.8 billion in loans with a loan to valuation ratio (LVR) of 90% or higher. These loans accounted for over 14% of all housing approvals, and may help explain the strong rise in house prices in Australia’s biggest cities in recent months.

This data is backed up by a survey from Digital Finance Analytics showing that Westpac (ASX: WBC) and ANZ  (ASX: ANZ) have increased their average LVR over the September quarter. National Australia Bank (ASX: NAB) said recently that there had been no change to its average LVR.

Although the balance of supply and demand is the main determinant of the cost of housing, there are other important factors at play. Buyers’ willingness to borrow and the banks’ willingness to lend are particularly important. If all buyers were unwilling to borrow more than 50% of the cost of the house, then house prices would fall. Therefore, property prices will generally rise if buyers are borrowing a higher proportion of the amount paid. Household debt is currently about 95% of GDP. This figure is historically high — as recently as 1995 it was closer to 60%

This suggests that the ability of Australian households to borrow more is under pressure, and this has implications for the banks. Commonwealth Bank (ASX: CBA) is the Aussie bank with the most exposure to household debt, and largest share of the mortgage market. If Australians are unable to continue to increase their borrowing, then Commonwealth will find it harder to grow profits.

As the average LVR increases, so too does the price buyers can afford pay for property. In turn, these higher prices translate to increased value of properties. This higher ‘valuation’ increases the value of the ‘V’ in the LVR equation. As a result, a similar house on the same street will go for a higher price, assuming the same LVR.

For example, imagine that Number 9 Leverage Street is up for auction, and is valued at $1 million. Carl and Sarah have saved up $100,000 thinking that they need a deposit of at least 10%. However, before the auction the bank informs them that they can borrow up to $1 million, and because they really want the house, they end up paying $1.1 million (borrowing $1 million).

As a result, when the house next door, Number 11 Leverage Street, is valued six months later, it is considered to be worth $1.1 million. Just like Sarah and Carl, Nadia and Brendan have saved a $100,000 deposit. To their surprise, the happy couple are allowed to borrow up to $1.1 million (because their bank is keen to take more of the mortgage market). They count themselves lucky to win the auction with their maximum price of $1.2 million. The other residents of Leverage Street are pleased that property in the area is appreciating in value so quickly.

Foolish takeaway

House prices simply cannot indefinitely increase relative to average income. While this does not mean that houses are currently overpriced, it does mean that banks will find it harder to grow profits once the enthusiasm for borrowing wanes. Furthermore, banks do run the risk of making unwise loans, and shareholders won’t know about this until it is too late.

Banks are very popular at the moment, and are priced as if nothing will go wrong in the economy. While it’s a safe bet that households will continue to form, it is not safe to assume property buyers will continue to be willing to borrow higher and higher proportions of the value of their property.

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article

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