50pc property slump would see 57,000 in negative equity

That seems a lot but don't worry Norman Chan – even such a deep downturn would not undermine the stability of the city's banking system

PUBLISHED : Wednesday, 06 February, 2013, 12:00am
UPDATED : Wednesday, 06 February, 2013, 6:13am

Norman Chan Tak-lam is a worried man.

Addressing a Legislative Council panel on Monday, the head of the Hong Kong Monetary Authority complained that household debt level was close to a record high relative to the city's gross domestic product, and warned that "the overheating property market" is the biggest single threat to Hong Kong's economy.

His remarks were interpreted as a heavy hint that the HKMA might impose even tighter restrictions on mortgage borrowers in an attempt to reduce the risk.

Despite his concern, Chan isn't remotely bothered about the hardship families might face if they get too deep into debt. That's not part of his job. What Chan is worried about is the strength and stability of Hong Kong's banking system.

He's made that clear repeatedly. He described his first round of mortgage restrictions, introduced in October 2009, as "prudential measures designed in the interest of maintaining banking stability".

The second batch in August 2010 consisted of "further measures to safeguard banking stability".

The third round in November the same year was intended "to make our banking system more resilient to shocks". And the last, in June 2011, was "necessary to safeguard banking stability".

It's good to know that Chan is on the lookout for potential dangers. But it also helps to have an idea just how big the potential risks might be.

First, it does indeed look likely that Hong Kong's household debt edged up to around 60 per cent of GDP at the end of last year, roughly equal to its level in 2001 and 2002.

But if Chan is concerned about banking system risks, he should probably be looking elsewhere. As a proportion of total bank lending, loans to individuals fell to just 22.4 per cent last year, the lowest since 1998 (see chart).

At the same time it is doubtful how big a threat Hong Kong's elevated property market really poses to the city's banking system.

The US Federal Reserve has hinted strongly that it is not going to raise interest rates for another 2 1/2 years.

But even when mortgage rates do begin to go up, the impact should be supportable. Since August 2010, banks are supposed to have conducted stress tests to ensure that even with a 2 percentage point rise in mortgage rates - almost a doubling from current levels - debt service costs will take up no more than 60 per cent of their customers' monthly income.

Of course, when interest rates begin to go up, it is likely that property prices will start to fall. But even a deep slump in prices is unlikely to inflict much damage on the city's banks.

That's largely because leverage levels among mortgage borrowers are relatively low. Over the last couple of years the average loan-to-value ratio among new borrowers has been just 55 per cent, with the maximum loan size fixed at 70 per cent of a property's value.

As a result, lenders have a generous cushion to protect them before sliding prices push borrowers into negative equity, where the size of their mortgage exceeds the value of their home.

Knowing the average loan-to-value ratios for new loans over the last few years, and assuming a normal distribution of loan values about the mean, for any fall in prices we can estimate how many families would end up in negative equity.

The results are encouraging. If prices were to fall 20 per cent from their current levels - roughly the magnitude of the price fall during the financial crisis of 2008 - then no one would find themselves underwater (well actually, four families would, by my estimate).

If prices fell by a third, putting them back where they were in mid-2010, then almost 900 families who bought last year would be pushed into negative equity. And if prices were to fall by half, dropping back to their January 2009 level, the number of borrowers in negative equity would soar to more than 57,000.

That sounds a lot. But it's only just over half the number of Hong Kong households that found themselves in negative equity at the bottom of the last big property slump in 2003.

And even at the worst of that bear market, the proportion of borrowers who fell more than three months behind with their payments never exceeded 1.5 per cent.

So at this point, not even a deep 50 per cent slump in Hong Kong home prices would seriously jeopardise the stability of the city's banking system.

Still, it's good to know Norman's doing his job.