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Report warns higher rates means higher defaul -

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SHANE MCLEOD: As the Reserve Bank prepares to announce its latest decision on whether to raise
interest rates, a new report is warning higher rates will lead to rising defaults on home loans in
the Australian mortgage market.

The report by investment bank JP Morgan and Fujitsu Consulting found housing affordability has
barely improved, despite interest rates being near 50 year lows.

And households remain highly indebted with first home buyers borrowing on average 25 per cent more
than they did before the global financial crisis.

Martin North from Fujitsu Consulting told Sue Lannin that house prices here remain among the most
expensive in the world.

MARTIN NORTH: In Australia, the average price compared with income, is a lot higher than the UK or
the US or almost any other Western country. And what that means is that most people have to pay
more than they would in those other markets.

So affordability at low levels of interest rates are roughly along term levels, that's what the
Reserve Bank says, but of course as rates go up then affordability will deteriorate quite rapidly.

SUE LANNIN: The Reserve Bank last week talked about the risk of a housing bubble. Is there a risk
of a housing bubble in Australia?

MARTIN NORTH: Well it depends how you define a bubble. If you look back since 1990, house prices
have moved up dramatically and consistently, with a few wobbles. We've seen areas of the market
move up very quickly. So, for example, the first home owner grant stimulated the bottom end of the
market.

I don't think we're in a bubble. I think it's a much more fundamental economic question, which is,
what is the right supply and demand equilibrium point in the housing industry? I think at the
moment, we've got the situation where we have a lot of demand and we haven't got enough supply, and
therefore long term rates are high, prices are high, and what that means is not so much a bubble as
a longer term economic challenge.

SUE LANNIN: Now we know that interest rates are going to rise. What does that mean for the people
who got into the market while rates have been at 50 year lows?

MARTIN NORTH: I think for some of them they will begin to feel the pain of rates moving up. Now,
sensibly the banks pulled back on their loan-to-value ratios and there was also a lot of
communication with potential borrowers about think about what happens when rates go up. But people
will be shocked and surprised.

And, you know, long term, you've got to expect rates to go up 1.5 to 2 per cent, and that's going
to be a very considerable pain point for many people. I think in 18 months to two years time we may
well see some of those first time buyers worrying about whether they can make the repayments and
thinking about what they should do.

SUE LANNIN: Will it be a substantial number that face default?

MARTIN NORTH: Well the Reserve Bank said 25,000 have defaulted over the last 12 months. Our own
modelling suggests if rates go up a couple of per cent that could get up to about 35,000 to 40,000.
So still not big numbers absolutely, but for every one of those households who actually are in
default they are 100 per cent in default.

SUE LANNIN: Now when interest rates do rise, do you think the banks will follow the Reserve Bank
changes or will they move above the Reserve Bank's changes?

MARTIN NORTH: I think you can probably expect the banks to follow any upward movements from the
Reserve Bank unless there's a competitive reason why they would not want to for a little while.

SUE LANNIN: Are we out of the woods yet?

MARTIN NORTH: It's too soon to say that we're really out of the woods. You can see some glimpses of
hope however we are part of a global financial situation that is still not fixed. There's got to be
global movements in terms of taking out some of this stimulus, there's 17 trillion of funding
thrown into the banking system globally that's got to be unwound in some way. I think this is a two
to three year thing, not an 18 month or even six month thing.

SHANE MCLEOD: That's Martin North from Fujitsu Consulting talking there to Sue Lannin.