Who Benefits from Australia’s Liar Loans?

• One in five loan applications are liars’ loans
• How to inflate a housing bubble
• Who is to blame for Australia’s liar loans?

Nick Hubble

Dear Reader,

Back in 2012, I first began researching Australia’s secret sub-prime scandal. I alleged that Aussie lenders routinely manipulate mortgage applications to get their borrowers past lending standards.

We got a letter from the regulator over my claims. And so I turned them into a PhD research project and thesis, seeking the protection of academia. That didn’t go so well.

After four years of approvals and just months from completion, the university pulled the plug on my work. The royal commission’s discoveries had confirmed that my topic ‘wasn't theoretical enough’. In other words, I had uncovered some very painful truths that nobody wanted to be associated with exposing now that they were international news.

This week, the Australian Financial Review (AFR) continued the long-running trend of discovering the obvious about Australia’s lending:

‘One in five Australians have fibbed to the bank when applying for a loan in order to avoid being knocked back by the lender, raising concerns about the return of “liar loans” in a surging housing market.

‘Slightly more than 40 per cent of lies when applying for home loans involved understating living costs, says a new survey by Experian, the world’s largest consumer credit reporting agency.

‘This month’s survey of 1000 Australians also found almost a third of consumers who lied understated their living costs when applying for a loan (28 per cent of fibs), while 21 per cent of untruths involved overestimating income.

‘Investment bank UBS created shockwaves in 2018 when it warned of a boom in “liar loans” after finding about a third of borrowers gave information that was not “completely factual and accurate” to the bank during a loan application. That figure rose towards 40 per cent in 2019.’

This rather goes against the narrative of lenders verifying borrowers’ claims, doesn’t it? I mean, it’s tough to lie about your income if you have to prove it with documentation that lenders check. But, if they don’t check, then people lie.

My research always focused on lenders doing the dodgy deed of misrepresenting borrowers’ financial positions on their loan applications. Which begs the question: How many more loan applications have lies that borrowers don’t know about, and that the survey didn’t pick up on? My research suggests a lot.

But why would lenders not check their borrowers’ application documents? And why would lenders fudge their applicants’ claims to get them past the lenders’ lending standards?

The answer, my incomplete PhD concluded, was simple: If you assume house prices rise, the whole dodgy charade need never become a problem. Like a game of musical chairs where the music doesn’t stop, everyone can keep dancing.

The reason Australia’s secret sub-prime scandal…I suppose it’s not very secret anymore…but the reason it happened is the presumption of house prices bailing out all possible actors in the equation.

For example, the banks’ collateral in mortgage lending is the house. If house prices rise, the value of the collateral in their lending agreement is rising. If the borrower defaults, the chances of the bank actually losing money is minuscule.

But the chance of default is even lower because the person who borrowed more than they could afford will likely just sell the house before they default and profit from the whole scheme.

It’s a win-win, plus fees and commissions.

That’s what mortgage brokers told themselves based on my PhD research. Fudging people’s loan applications wasn’t just a white lie to help borrowers get over the line but a way to help them grow their wealth. To get on the housing ladder and grow equity.

The power of house prices on the way up is enough to cover up the dodgiest of lending. We will never know just how bad the liar loans problem is because it so rarely gets exposed. Only when house prices fall, and borrowers and lenders are left out of pocket as a result do we discover cases of liars’ loans.

‘It’s only when the tide goes out that you find out who has been swimming naked’, to paraphrase Warren Buffett. But, if you assume this won’t ever happen, the game of musical chairs can continue indefinitely, enriching anyone who is game enough to get an unaffordable loan from a lender who will fudge their application for them or ignore the obvious fudges.

Rising house prices were, of course, the assumption in the US too. When Federal Reserve Chair Ben Bernanke was asked about house prices in 2006, here’s how things played out:

‘Interviewer: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying, “Oh, this is a bubble, and it's going to burst. And this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

‘Bernanke: Well, I guess I don't buy your premise. It's a pretty unlikely possibility. We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don't think it's gonna drive the economy too far from its full employment path, though.’

Bernanke argued house prices couldn’t possibly do what they ended up doing.

The rest, as they say, is history.

I’ve always enjoyed it when people say that nobody predicted the housing bubble bursting, given the interviewer in 2006 said, ‘We have so many economists coming on our air saying, “Oh, this is a bubble, and it's going to burst. And this is going to be a real issue for the economy.”’

The question now is whether the same sub-prime crisis plays out in Australia. We certainly have the ingredients. A house price bubble, systemic liars’ loans and artificially low interest rates. That was the cocktail that drove the sub-prime boom and its subsequent bust in the US.

But it never seems to happen in Australia, does it? The bust. House prices just keep rising. And the government is doing what it can to keep the music going. The AFR story continues:

‘Treasurer Josh Frydenberg is trying to repeal the laws, with the support of the RBA, amid concerns the responsible-lending obligations have evolved into an unwieldy compliance task at the expense of free-flowing credit.’

If one in five borrowers fib to their bank, maybe the compliance task is not wieldy enough…

Forgive me for being cynical about whether lenders really want to reject loan applications. Because my PhD research revealed that banks employed people who couldn’t speak English to check loan documentation, and when loans were denied because of insufficient income, it was just marked up by the lender…

The government knows house prices must rise, or the whole scheme collapses in impressively spectacular fashion. And so the constraint of responsible lending obligations must go, in favour of ‘free-flowing credit’.

Whether the need to keep housing momentum going means a collapse is on the cards eventually, or house prices will continue to grow ever more absurd as governments and central banks push them even harder, I don’t know.

The prospect of inflation bailing out not just liars’ loans but governments from their impossible levels of debt are now on the cards. And if that happens, buying a house with more debt than you can afford is a good idea…

My PhD research also dug into who is to blame for all this. Where does the presumption of rising house prices come from in the first place?

My argument was that central banks’ ability to bail out borrowers with interest rate cuts lay behind the presumption. Should house prices dip, central banks will just lower rates to prop them up again. Thus, it’s a one-way bet.

In a free market for money, the interest rate would call out the liars’ loans because they are higher risk. But in a central bank price fixed market, interest rates are cut to keep the music going. Nobody ever needs to sit down. If anyone looks tired, the central bankers just jump into spike the punchbowl with lower rates to restart the party.

Over the past decade and a half, investors have learned that predicting the course of financial markets is only half the game. You also need to anticipate the reaction of central banks and governments, as well as who wins between Mr Market and Mr Central Banker.

In a world of government and central bank intervention, it is rational to lie on your mortgage application, borrow more money than you should, buy a house you can’t afford and profit from the backstop which central banks and governments give you.

Of course, over time, this corrupts the economy and productivity. But at least homeowners will be rich…

Until next time,

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend