House prices could fall more than 30 per cent as the country plunges into a "deep recession" if disgruntled borrowers launch class actions against the major banks for breaching responsible lending laws, new analysis suggests.
The worst-case scenario is one of five outlined by UBS analyst Jonathan Mott in a client note this week, "Catching a falling knife", in which he warned the outlook for the banking sector had "not been as challenged since at least 2008".
"The recently completed bank reporting season suggests the outlook for the banks remains challenging," Mott said.
"However, we believe the rapidly deteriorating housing market is a signal of even tougher times ahead."
The total 2017-18 cash profit for the big four banks was down 6.5 per cent to A$29.5 billion ($31.4b), while lending grew at a sluggish 3.1 per cent.
Prices in Sydney and Melbourne fell again in October to be 8.2 per cent and 4.9 per cent down from their respective peaks in August and November 2017, while the combined capitals were down 4.6 per cent over 12 months.
UBS said the housing credit squeeze over the past six months was spreading into owner-occupier lending, and further tightening would be "almost inevitable" after stricter debt-to-income requirements are implemented after the banking royal commission.
The upcoming federal election is expected to reduce housing credit demand due to Labor's planned changes to negative gearing and capital gains tax breaks. Ongoing costs from lawsuits, fines and refunds will also weigh on the banks.
Mott's five scenarios for the future of the Aussie market are "strong economy", "muddle through", "housing correction", "credit crunch" and "deep recession and mis-selling litigation".
In the first scenario the housing market is "through the worst", while the others forecast peak-to-trough house price declines by 2020 of 5 per cent, 10 per cent, 20 per cent and 30 per cent-plus respectively.
UBS last week downgraded its forecasts by 4 per cent to be "now broadly reflective" of scenario three, or a housing correction. But Mott said the risk of the credit squeeze "turning into a credit crunch is real and rising".
A credit crunch could occur if the royal commission "insists the banks 'obey the law' and ensures the banks must fully verify all borrower income and expense documentation" at the same time as the prudential regulator enforces a hard cap on lending at six times debt-to-income ratio.
"With households now expecting prices to fall, demand for housing falls sharply," Mott said. "Sentiment in the housing market turns from FOMO (fear-of-missing-out) to FONGO (fear-of-not-getting-out). Changes to negative gearing and CGT (capital gains tax) relief exacerbate the problems."
In this scenario, the Reserve Bank would be forced to cut rates but little of that flows through to borrowers as banks' margins come under pressure and defaults begin to rise.
Mott's "hard landing" scenario is similar, except many borrowers who now have negative equity in their homes "claim their mortgage was mis-sold as it did not comply with responsible lending".
In this possible outcome, a number of class actions are launched and borrowers join en masse. Many struggle as interest-only loans convert to principal and interest and go into hardship.
"They claim they are either entitled to an interest rebate on the proportion of the mortgage which was mis-sold (above what would have been lent responsibly) or debt forgiveness for this proportion of the mortgage," he said.
Litigation and compliance costs spiral out of control, cost-cutting programs are insufficient to offset the damage and profits fall sharply. Bad loans rise sharply to between 100 and 200 basis points as "unemployment rises and Australia falls into a deep recession for the first time in 27 years".
Risk-weighted assets rise, placing the banks' tier-one capital ratio — a key measure of financial strength — under pressure. Banks are forced to suspend dividend payments and raise equity at a discount.
"In this extreme scenario, investors would question the value of the banks' tangible assets with share prices trading at a material discount to book value," Mott said.
UBS's worst-case scenario beats the previously most bearish forecast by AMP Capital chief economist Shane Oliver, who believes a 20 per cent fall is now likely due to a "perfect storm" of factors.
Morgan Stanley, which predicts falls of 15 per cent, last month warned Australia "leads the world in dangerous debt" and was facing a collective wealth wipe-out of A$700b.
Deloitte Access Economics partner Chris Richardson was more optimistic, predicting another 5 to 10 per cent in Sydney and Melbourne but arguing it was the "house price fall we had to have".
Labor plan 'very risky'
Releasing its 2019 Boom and Bust report today, SQM Research said its base case was for dwelling prices to fall 3 to 6 per cent.
The research firm said its base case assumed no change in interest rates and a Labor win at the next federal election, with declines of "at least" 12 to 17 per cent in the two largest capitals by the end of 2019.
If negative gearing and capital gains tax changes come into effect on July 1, 2020, declines "could be in the order of 20-30 per cent" in Sydney and Melbourne, SQM Research managing director Louis Christopher said.
"The looming changes of negative gearing and capital gains tax are increasingly weighing on investor sentiment," he said. "Quite frankly implementing these changes during a housing downtown is very risky and may trip the economy into a recession."
Christopher said the range of the decline would depend on "when, if and how" the RBA responded to the downturn, the effect on the broader economy, any out-of-cycle interest rate rises and if Labor's tax changes are implemented.
Labor's plan is to restrict negative gearing to newly built properties, but "grandfather" existing arrangements.
"If the RBA does not respond and/or the banks lift interest rates again in 2019, it is possible the peak to trough falls in Sydney and Melbourne could be even more than this negative range," he said.
"But we do take the view that the downturn in Sydney and Melbourne will be a significant negative for the overall economy, and so the central bank will eventually respond at some point and cut interest rates."
The Coalition has warned Labor's plan will crash the housing market and drive up rents. Labor has dismissed the attacks as a "scare campaign", citing analysis from the left-wing Grattan Institute showing its policies would only have a "modest impact" on house prices.
Bruce McWilliam, a media mogul and prolific property investor, told The Australian Financial Review Labor's plan "made no sense at all".
"I think it is unfair to treat property investing different from other forms of investing. Property investing is available to everyone, like plumbers, not just the top end of town," McWilliam said. "Labor's changes are elitist and under them, only rich bankers can negatively gear shares."
He warned the changes could have a negative impact on renters as well. "I remember back when Keating knocked out negative gearing, rents went up, and that's a fact of life," he said.
Realestate.com.au chief economist Nerida Conisbee echoed warnings about rising rents. "We will see less rental housing and rents will go up," Conisbee said.
"Almost all of our rental housing is provided for my mum and dad investors. If you have fewer mum and dad investors, there will be less rental housing. In places like Sydney, where rent's already very expensive, it will be challenging."
Conisbee said the property market "did look very unfair for first home buyers" but had "really turned" over the last year.
"When the negative gearing policy was announced we did have a red hot housing market, and there were concerns about there being too many investors," she said. "Now investors have backed off very quickly, because they're finding it difficult to get money."
RiskWise chief executive Doron Peleg has warned the negative gearing changes will create a "two-tier" property market, immediately reducing the resale value of investment properties.
"Let's say you buy a new car tomorrow morning and with that car you get a lot of financial benefits, like a five-year warranty, five years free service and roadside assistance and a 50 per cent discount on fuel," he said.
"But if you sell the car to me I can't get those benefits, they're gone, not transferred with the car. Even if you bought the car for A$40,000, if you try to sell it to me obviously I won't be able to pay the same amount of money. It's the exact same thing with negative gearing."
In other words, the tax benefits are "priced in" to the property's sale value. "Obviously if the buyer is an investor he doesn't see those financial benefits and will be willing to pay less," Peleg said.
RiskWise is predicting total price declines in Sydney and Melbourne of 15 to 20 per cent, assuming Labor implements its plan in 2020, but doesn't believe a full-blown collapse of 30 to 40 per cent is likely.
Peleg said federal regulators and the RBA would step in before that happened. "No one has an interest in seeing a full collapse of the property market," he said.
In a statement, Shadow Treasurer Chris Bowen said "property research spruikers" like Christopher needed to "stop making economically irresponsible claims".
"SQM's Louis Christopher's 'analysis' seems to be projecting falls of 12 per cent under current policy settings," he said.
"And that's fine, with no discussion around what is driving that like APRA's macroprudential measures as championed by Josh Frydenberg — but in his view, a further 3 per cent fall in house prices under Labor's reforms would trip the country into recession."
Bowen said "only a few years ago" Christopher was supporting Labor's reforms to negative gearing, "so what's changed?"
"Economists without a vested interest agree that our plan is a responsible way to ease pressure in the housing market, to make sure that everyone is competing on a level playing field."