If the housing bubble bursts economy will come tumbling down
The Australian 12:00am April 8, 2017
Adam Creighton
If Australia’s debt-fuelled housing boom proves to be a bubble and pops, it will be one of the biggest and most devastating crashes. No major country’s fortunes are so entwined with property as Australia’s. It also would be entirely self-inflicted, an inevitable reckoning from many years of perverse government regulations that induce banks to issue excessive quantities of cheap mortgages.
More than a fifth of the country’s economic growth during the past four years, excluding resource exports, has been home building, spurred on by rising house prices, strong population growth and ultra-low interest rates, on which almost 600,000 jobs depend. And rising real estate prices have underpinned the confidence that has fuelled strong household consumption growth.
Whether this turns out to be the economy’s Achilles heel is hotly debated — indeed, Australians’ confidence in property as a good place to invest has edged up to a three-year high, according to a National Australia Bank survey released yesterday, despite increasingly strident warnings from commentators.
To be sure, this is a NSW and Victorian problem — prices in other state capitals are relatively stagnant, and in big regional towns such as Broome and Rockhampton they have fallen — but Australia’s two sprawling urban giants mop up well over half the market.
Few dispute that a sharp drop in property prices coupled with a recession would obliterate the finances of Australian households, banks and governments, and send unemployment soaring, as such combinations did in Spain, Ireland and the US, and Japan and Sweden a generation earlier.
“The lesson is things can get ugly in a hurry if there’s very high leverage,” says James Kahn, a New York-based economist who has examined housing crises globally.
“Remember Fed chairman Ben Bernanke said the risks were ‘contained’ before the US crisis,” he tells The Weekend Australian.
High-profile mainstream figures are speaking out. David Murray, former Commonwealth Bank and Future Fund chief, said this week that a repeat of Australia’s 1890s depression — when a debt-fuelled real estate frenzy destroyed the financial system — couldn’t be ruled out. Greg Medcraft, head of corporate watchdog Australian Securities and Investments Commission, speaks openly about a housing bubble that could grievously threaten the economy.
“No, I haven’t changed my mind,” he tells The Weekend Australian. Sydney and Melbourne house prices have risen a further 19 per cent and 13 per cent, respectively, since then. “We were not trying to pick the top in terms of price … (but) if you look at Ireland, Spain and the US, house prices peaked shortly after building approvals started to turn down sharply. We’ve seen a peak in Australian building permits,” he says. Indeed, Australian building approvals, his canary in the coalmine, peaked in early 2015 and have been falling since.
Barely 2 per cent of houses and apartments change hands each year, but the prices paid reflect what people think the entire stock of dwellings is worth. Could Australian home values be a mirage? The facts are sobering.
Melbourne and Sydney house prices have increased about 100 per cent since 2008; Australia’s household debt (most coming from foreigners) has been rising about three times as fast as wages for almost a decade and is set to surpass 190 per cent of gross domestic product soon, the highest in the developed world. About 40 per cent of the $1.65 trillion in mortgages outstanding are interest only, suggesting borrowers’ expectations of capital gains underpin their investment strategies. “No other banking system I’ve seen is so exposed to housing lending. It is the only game in town in Australia. Most Aussie wealth is tied up in housing, and then in shares of banks that lend to homebuyers,”
On the other hand, local regulators and bankers point to banks’ very low loan delinquency rates, especially in wealthier areas in Sydney’s east and Melbourne’s south where the mortgage debt burdens are heaviest. On standard measures of financial resilience, Australia’s big banks score highly too.
And Australia’s weather, lifestyle and relatively strong economic growth are making our real estate more accessible to more people as the costs of international travel diminish, a fact borne out by the second fastest rate of population growth in the OECD, a 34-nation club of rich countries.
Former Macquarie University economics professor Peter Abelson, in unreleased work commissioned by the NSW Treasury, found last year that boosting housing supply in Sydney would do little to affect prices. “There’s a lot of econometric evidence from Australia and elsewhere that shows a 1 per cent increase in housing stock would reduce house prices by only 3 per cent,” he says.
New supply also tends to be concentrated in areas where people don’t necessarily want to live. During the two years to October 2016, for instance, only 42 and 72 new dwellings were built in Sydney’s expensive Woollahra and Manly, respectively. Meanwhile, 4834 and 4022 new dwellings, respectively, were built in cheaper Blacktown and Parramatta.
But Australia’s house price and household debt boom is simply an acceleration of a trend that began in the late 1980s, when the trajectories of house prices and credit — here and across rich countries — decoupled from other relevant economic factors, such as incomes, rents and wages, as LF Economics’ charts starkly show.
Why did this happen? Bank regulators in 1988 signed up to what’s known as the Basel Capital Accord, a byzantine set of prudential rules for banks that are predicated on regulators’ superior knowledge of risk, and the assumption that bankers won’t game the rules for their personal financial benefit. The influence of negative gearing and capital gains tax concessions add fuel to Australia’s property fire, but they pale in comparison to this powerful if obscure set of rules, which have become even more complex.
The Basel rules arbitrarily deem certain loans safe, such as issuing mortgages to households and lending to governments. The details are complex; but in effect banks are required, for a mortgage, to maintain only about a quarter as much equity as they would need to maintain for a business loan of the same amount.
Equity is more expensive for banks than deposits, on which they pay little interest because they are guaranteed. In other words, a dollar of shareholders’ funds can be leveraged about 50 times for a mortgage but only 12.5 times for a business loan. So naturally banks everywhere have expanded into more lucrative home loans and lending to governments, such as Greece, starving businesses of credit.
Business loans made up more than two-thirds of all outstanding loans in the late 80s. Since then they have steadily shrivelled to less than a third of the $2.67 trillion of outstanding loans in this country. The net result has been to pump up household debt and house prices, which has probably made us poorer. As Reserve Bank governor Philip Lowe noted in a speech in 2015, “It is arguable that the main impact of higher land prices is not really to increase our national wealth but to change the distribution of that wealth.” That is, a higher cost of housing shifts wealth from those who don’t own it to those who do.
The economic distortion by government for home loans doesn’t stop there. “If there is any implicit promise from the government to bail out banks then they will be able to underprice risk, charge lower interest rates,” says Kahn. Capitalism, which is meant to weed out unproductive and damaging businesses, tried to destroy mega-banks’ business models of extreme leverage in 2008 and 2009. But governments and central banks wouldn’t let it, propping up these gigantic limited liability companies with a raft of direct and implicit subsidies.
Even in Australia, the Rudd government guaranteed banks’ liabilities in 2008 at the first whiff of trouble.
“The real underlying question nobody seems to be asking is how on earth are our banks still able to attract low-cost funding for their operations when they are handing out eye-watering mega loans to speculators who have no mathematical ability to repay their loans if the housing market turns south,” says Lindsay David, macroeconomic researcher and founder of LF Economics. They can because banks’ creditors, such as depositors, know that, unlike creditors of other types of businesses, there is a very high chance they will get their money back regardless of what banks do.
This phenomenon creates a huge subsidy, which is manifested in interest rates that are lower than they would otherwise be (and a much larger financial services sector), and hence more debt and higher house prices.
Set against the Basel accord, the Australian Prudential Regulation Authority’s recent tweaks to rules, depicted in the press as a crackdown on risky lending, won’t have much effect. In late 2014 the banking regulator imposed a speed limit on the growth in the value of investment housing loans — about $570 billion are outstanding — of 10 per cent. Last week, concerned about the increase in house prices, it imposed a new rule: insisting the share of new mortgage loans that are interest-only fall from 40 per cent to 30 per cent.
“I have not been able to find anyone to tell me the positive attributes of interest-only loans,’’ says Alex Joiner, chief economist with $75bn fund manager IFM Investors. Australia’s share of interest-only loans is far higher than in other developed countries.
“Our financial regulators cannot raise interest rates or eradicate toxic interest-only period loans altogether without sticking a dagger into the Australian economy,” says David, possibly the housing bubble Cassandra. He regularly produces charts and analysis suggesting Australia’s property-debt dynamics are out of kilter with economic reality.
Tepper is in a similar camp, arguing Australian regulators are too complacent, captured by the large banks even. “The Bank of Spain did roadshows defending their banks in London, highlighting the strength of the Spanish financial system and attacked me and other critics. Needless to say, Spanish banks were ultimately bailed out at large cost to taxpayers,” he points out.
Having sailed through the financial crisis thanks to China’s insatiable demand for our resources, Australians are yet to experience a sharp fall in house prices along the lines of what happened in the US, Spain and Ireland. The belief house prices always go up or at worst, flat-line, is ubiquitous.
In their magisterial book on financial crises, This Time is Different, Harvard professors Ken Rogoff and Carmen Reinhart mention Australia only twice, briefly, for its 1890s depression and the failure of a few state banks in the 1990s. Let’s hope we don’t feature more in the next edition.