Definitions of financial stress are many and varied. One definition could be where a household fails to pay its bills or scheduled debt repayments on time because of a shortage of money. This is quite narrow – it captures only those households for which stress has already manifested in missed payments.
A much broader definition of financial stress might be a situation where financial pressures are causing an individual to worry about their finances, or where an individual cannot afford ‘necessities’. These definitions might be good leading indicators of failures to meet debt repayments or defaults. So there is a role for a variety of indicators of stress.
One way of thinking about financial stress is in terms of a spectrum or a pyramid, running from mild stress to severe stress (Graph 1). At the mild end, the base of the pyramid, people may perceive that they are financially stressed when they have to cut back on some discretionary expenditure, such as a holiday or a regular meal out. Slightly further up the pyramid, they may not be able to pay bills on time, or might have to seek emergency funding from family. At the top of the pyramid – severe financial stress – a household might be unable to meet mortgage repayments or ultimately be facing foreclosure or bankruptcy.
The pyramid is wider at the bottom than the top reflecting the fact that there will always be more households in milder stress than in severe stress. For some households experiencing milder stress their circumstances might deteriorate and they will move to a more severe form of financial stress. But some others might continue to restrain spending on discretionary items so as to meet essential payments. Others might experience a change in circumstances that improves their financial position.
Most people don’t consciously set out to put themselves in a position of financial stress. Sometimes people might choose to stretch themselves initially in taking out a loan, perhaps even putting themselves into mild, temporary financial stress. But they would typically be doing so on the expectation that it will become more manageable over time as their income rises.
More serious financial stress often only comes about by a combination of what turns out to be excessive debt and changed circumstances. A level of mortgage debt that looked manageable when it was taken out might become unmanageable if, for example, the primary income earner of a household becomes unemployed. Or if life circumstances change, such as through ill health, the birth of a child or breakdown of a relationship.
So what do conditions in the housing sector over the past few years suggest about the potential for financial stress? You are all familiar with the broad story. House prices have been rising rapidly, particularly in Sydney and Melbourne. At the same time, household mortgage debt has been rising while incomes have been growing relatively slowly. As a result, the average household mortgage debt-to-income ratio has risen from around 120 per cent in 2012 to around 140 per cent at the end of 2017 (Graph 2, left panel). Furthermore, the increasing popularity of interest-only loans over recent years meant that by early 2017, 40 per cent of the debt did not require principal repayments (Graph 3).
A particularly large share of property investors has chosen interest-only loans because of the tax incentives, although some owner-occupiers have also not been paying down principal. This presents a potential source of financial stress if a household’s circumstances were to take a negative turn.
This is where lending standards come in. There is always a balance to be struck with lending standards. If they are too tight, access to credit will be unreasonably constrained, potentially impacting economic activity and restricting some households from making large purchases that they can afford. If they are too loose, however, borrowers and lenders could find risks building on their balance sheets which, if large enough, might have implications for financial stability.
In response, a number of measures were implemented by APRA and ASIC to strengthen mortgage lending standards. These measures have helped improve the quality of lending over the past couple of years. But there is still a large stock of housing debt out there, some of which probably would not meet the more conservative lending standards currently being imposed. How large a risk does this pose to financial stability? It depends on a number of things, including how lax the previous lending standards were, how much of the stock was lent under less prudent standards and the repayment patterns of borrowers. One way of assessing the risk though is to look at the level and trajectory of mortgage stress.
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