The dramatic warning echoes concerns raised by Reserve Bank of Australia governor Philip Lowe this month that rising household debt had made the economy more vulnerable, and that it was unclear how stretched consumers might behave in a crisis.

It also follows a review by Australian Prudential Regulation Authority chairman Wayne Byres of bank capital requirements for housing exposures, given the "notable concentration in housing", announced at The Australian Financial Review Banking and Wealth Summit last month.

Among the biggest concerns is what may happen when households feel they can no longer service their loans, for instance, as borrowing costs are reset higher or those with interest only mortgages are forced to repay the principal as well.

That creates a negative feedback loop – experienced by Ireland after the financial crisis – in which stressed borrowers slash their spending, in turn crunching the economy, driving up unemployment and adding to downward pressure on house prices.

"The long virtuous housing wealth cycle could easily transition to a viscous cycle," said JCP. "Smaller mortgages to deleveraging, flat to decreasing house prices and exuberant to melancholic animal spirits will likely expose much bad lending behaviour."

Debt-to-income ratios blow out

The fund's senior researchers Matthew Wilson and Craig Shephard found that about half of all the nation's mortgage debt was in the hands of borrowers whose debt was more than four times larger than their gross income.


The same borrowers had paid off less than half of their loans, the team found, based on data from several official and private sector sources that adjusted for changes in incomes and the collateral values of their homes.

The average loan-to-income ratio of these heavily indebted households was 6.4, or more than double the old banking "rule of thumb" that mortgage managers didn't lend more than three times a household's income "unless they were doctors".

Regulators might be taking false comfort from the large number of mortgages that were effectively fully paid off, as those households were flattering conventional system-wide measures of household indebtedness.

Three risky borrowers

JCP identified three classes of borrowers who posed the most risk to the system: professionals on high incomes who had borrowed big, young "pretenders" who had stretched themselves to get into property, and young families burdened with rising living costs.

Almost a third of the most highly geared borrowers were professionals with pre-tax incomes of more than $250,000. While they accounted for just 2 per cent of total households, they held 17 per cent of mortgage debt, and an average mortgage worth $1.6 million. Half of these borrowers had an investment property loan.

Other young households – dubbed "pretenders" because they had taken on large debts relative to their incomes – were also at risk. This group tended to have average incomes of $110,000 but an average mortgage that was an "eye-watering" 7.4 times larger at $840,000.


The last group, young families, were slightly better placed with average incomes of $80,000 and average mortgages of $420,000.

While they are a small part of the loan book, their household stress could be high because there were "question marks surrounding treatment of expenses in home loan applications, and generally high costs of living."

JCP, which says it is "underweight" in its holdings of bank stocks relative to the benchmark ASX index and isn't "shorting" the big lenders, argues the financial system looks "vulnerable" because old lending disciplines had been dispensed with.

"The old LTI ratio [of three times income] has left the banking lexicon exposing a risk that we may have over-capitalised incomes and hence over-extended credit into certain cohorts."

Governor Philip Lowe used a recent speech to dismiss the significance of the neutral rate's inclusion in the July minutes. Bloomberg

Bank equity wipe outs

JCP calculated how the banks' balance sheets would handle an 2008 Irish-style loss on the high risk loans. It estimated that 50 per cent of the equity of Australian banks would be destroyed by soured loans to these high-risk borrowers.


Using less extreme loss assumptions, the banks could have 20 per cent of equity wiped out, it said.

Ireland, which experienced a sharp housing correction in 2008, was a fair comparison because it was caught in the middle of the Anglo Saxon system of easy credit provision and the Roman system of strong creditor's rights.

In the more conservative scenario, JCP assumed that a 7.5 per cent probability of a default and a 40 per cent loss would result in the banks losing $24.2 billion on these loans to the high-risk cohort and $28.2 billion in total. That equated to about 17 per cent of the $161 billion equity capital base of the banks.

While the financial crisis of 2008 halted the growth of household debt in most parts of the Western world, Australians have continued to borrow at an alarming rate as owner-occupied loans grew at a 6 per cent annual compounded growth rate, while investor loans grew by 8 per cent.

Interest-only loans have increased from 30 per cent of all mortgage credit to 42 per cent.

The fund identified several potential catalysts, including the corporate watchdog's legal action against Westpac over responsible lending.

That might prove to "the seemingly small shock" that forced lenders to request more information. That, in turn, could reduce the borrowing capacity of future buyers.

Banking insiders have calculated that the combination of the $6 billion bank tax, capital adequacy requirements, loan restrictions for investors and a raft of regulation imposed to stave off calls for royal commission, are the equivalent of a 3 percentage point decline in return on equity. Chris Pearce


Another catalyst could be further the steps taken by concerned regulators to reign in a dangerous build up in household debt.

"Credit fuels a bubble, and its ultimate rationing and eventual withdrawal deflates it."

JCP's research adds to concerns of regulators such as APRA's Mr Byres, Australian Securities and Investments Commission chairman Greg Medcraft and Dr Lowe.

Britain legislates lending rules

The JCP team noted that British banks now reported their mortgage exposure on an LTI basis and regulators had enforced a rule that mortgage lenders could not extend a loan that was more than 15 per cent above a 4.5 times loan-to-income measure.

For instance, ASX-listed British lender Clydesdale disclosed that about 25 per cent of its home loans had an LTI above four times.

JCP said it believed that gross incomes could have been capitalised to well over six times loan to value ratio, which added 15 years to repayments.

"As exuberance towards the Australian home grew to now irrational levels, the old credit rules of thumb seem to have been left by the wayside."

The 18-year-old Melbourne-based investment company manages money for large institutions and is one of three Australian equities managers appointed by the Future Fund.