A slump in house prices coupled with an increase in household debt could spell trouble for Australian banks, according to a leading credit rating agency.
Banks in Australia, as well as those in Canada and Sweden, face increased risk of a house price drop that could lead to higher loan losses, according to a report released by Moody's Investors Services on Monday.
With Australian households now among the most highly indebted in the world, they would have greater difficulty coping with adverse economic developments, Moody's vice president Francesco Mirenzi said.
"The risks to banks have risen a lot in the last couple of years, becauses households have taken on more debt," he said. "People have overextended themselves."
Moody's believes the housing market may already be turning in Sweden, where house prices have risen 144 per cent since 2000. However it expects Australia and Canada, which saw respective growth of 113 per cent and 115 per cent, to continue to see growth over the next 12 to 18 months, albeit at a slower pace.
"We expect across all three countries that markets will see house prices flatten or fall in a mild way," Mr Mirenzi said.
"If that happens with an economic impact like people losing their jobs or rising interest rates...we're going to see more people unable to pay their mortgages."
If there was a substantial correction, the report said safeguards, such as full recourse loans and stringent underwriting practices, would ensure banks suffered limited losses on mortgages - which account for 63 per cent of the banking system's total loans in Australia.
However banks would be exposed to second order effects, such as a drop in consumer sentiment and losses on corporate and consumer loans.
"If it becomes harder for people to pay their mortgages... people have to cut back on spending and that's transmitted to the wider economy, through less money being spent on retail and goods and services, and that affects business."
However he pointed out profits of the banks would likely be sufficient to absorb any loan losses as the impacts of a house price drop of 5 to 10 per cent would be "pretty manageable".
Price drops could have a real negative impact on the spending habit of mortgage holders, said Sarah Hunter, head of Australian Macroeconomics at BIS Oxford Economics.
"The issue with a big correction is that your mortgage is what it is in Australia, regardless of how prices change," she said.
"If prices drop and your mortgage is more than what the house is worth, than can weigh on households and how much they spend."
However Ms Hunter said it was unlikely that Australia would see a price correction big enough to put the banks at real risk.
"The chance of us seeing the size of a correction that would overcome the protections and buffers banks have in place is really, really low," she said.
"At a national level, I think we'll see an average of a 5 per cent [house price] decline over the next 18 to 24 months," she said. "To get the banks into trouble you're looking at a crisis like decline of 30 per cent or more."
She noted curbs to interest-only loans introduced by The Australian Prudential Regulation Authority (APRA) earlier this year were helping to reduce the vulnerability of banks.
AMP Capital's chief economist Shane Oliver said even a significant house price fall of 20 per cent would need to be matched with the unemployment rate rising to seven per cent or higher to pose serious risk to the banks.
With banks protected from negative equity by full recourse loans, he said it was rising unemployment - which would leave more people unable to pay off any debt left after selling - that would cause problems.
Mr Oliver said there was no doubt the level of household leverage in Australia - at 212 per cent of net disposable income in 2015 - would exacerbate any price declines.
"Australia was once at the very low end of household debt for OECD (Organisation for Economic Co-operation and Development) countries, now we're near the top, and that brings a degree of vulnerability to the house hold sector."
The story Potential house price drop poses risk for Australian banks: Moody's first appeared on The Sydney Morning Herald.