Since launching The Unconventional Economist in May, I have written eight housing-related articles focusing on the key drivers and consequences of the Australian residential property bubble.
Before moving on to other topics, I thought it would be useful to provide a re-cap of the key themes raised in my earlier posts and offer some practical policy solutions aimed at:
- making Australia’s housing market more affordable;
- improving the safety and stability of Australia’s financial system; and in doing so
- help to safeguard the Australian economy from the kinds of debt deflation and deleveraging currently being experienced in other developed economies, including the USA and the Eurozone.
Anatomy of the bubble:
My previous posts explained in detail the two major causes of Australia’s housing bubble, namely:
- The increase in the availability of housing finance following deregulation of the Australian financial sector in the mid-1980s, which has enabled buyers to borrow large sums and pay high prices (see Blowing Bubbles and Housing Affordability: Then and Now).
- Excessive speculation by property investors, fuelled by Australia’s overly generous taxation concessions on property investment (see Negative Gearing Exposed).
These two factors have combined to create a positive feedback loop between lenders and borrowers, thereby fuelling Australia’s house price bubble.
As shown in Chart 1, house price growth tracked incomes growth until Australia’s financial markets were deregulated in the mid-1980s and lending and funding constraints were removed. Following this point, house prices and incomes began to decouple.
The growth of house prices relative to incomes exploded post-2000 as mortgage lending boomed, fuelled by a decline in lending standards (including lower deposit requirements) following intense competition from the non-bank lenders, as well as heavy offshore borrowing by the Australian banks (totalling around $500 billion currently). Over a similar time frame, the banks significantly increased the proportion of loans channelled into housing, with housing loans increasing from around 35% of total lending in 1990 to 56% in 2010. These changes both increased the pool of potential home buyers and significantly increased the amount of funds available to be lent.
For their part, investor appetite for housing began to grow in the 1990s as the Baby Boomer generation – the largest generation in history – began to reach peak earnings age (45 to 55 years). They began buying up investment properties en masse as a way of both minimising their tax (via negative gearing) and ‘saving’ for retirement. Excessive speculation in the Australian property market is evidenced by a number of indicators, including:
- investor’s share of total mortgages increasing from 14% in 1990 to around 30% currently;
- yields on rental houses decreasing from around 8% in 1987 to around 3.5% currently;
- the number of property investors increasing by 35% between 1999/00 and 2007/08, from 1.28 million to 1.73 million;
- total net rental income from investment properties decreasing from +$219m in 1999/00 to -$8,628m in 2007/08; and
- the proportion of property investors declaring losses increasing from 54% in 1999/00 to 69% in 2007/08.
A key problem with this explosion of negatively geared property investment is that the overwhelming majority of home purchases by investors (over 90%) are for pre-existing (second-hand) dwellings. As a result, this property investment is simply adding to housing demand and pushing-up house prices, without increasing the supply of rental properties relative to rental demand (since the purchase of a pre-existing dwelling by an investor simply displaces a potential owner-occupier) or putting downward pressure on rents. A comprehensive examination of the effects of property investment on housing affordability and the rental market is provided in Negative Gearing Exposed.
A nation of debt zombies:
The post-2000 explosion of Australia’s house prices relative to incomes has caused housing affordability to plummet and significantly increased debt burdens (see Housing Affordability: Then and Now). This worsening affordability is evident by a number of indicators, including:
- the ratio of house prices to incomes increasing from around 3.0 times in the 1970s and early 1980s to around 7.5 times currently (see Chart 1);
- the ratio of mortgage interest payments to disposable incomes (averaged across the economy) increasing from under 4% in the 1970s to 9.0% currently, after reaching 11.4% when interest rates peaked in September 2008; and
- Australian mortgage debt increasing from around 32% of household disposable income and 12% of GDP in 1990 to 138% and 89% respectively as at the end of 2009.
Australia’s economy now vulnerable:
Whilst the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is immense, the Australian banks’ model of borrowing heavily offshore (via wholesale debt markets) to pump housing has the potential to significantly destabilise Australia’s financial system and damage Australia’s future growth prospects.
As discussed in Blowing Bubbles:
“Australia’s ability to sustain current house prices, let alone further price increases, rests with the willingness of other countries to continue lending our banks money. But in times of crisis, such as when Lehman Brothers collapsed, foreigners tend to zip-up their wallets, leaving our banks, house prices, and broader economy exposed to a sudden liquidity shock as the banks are unable to roll-over their foreign borrowings (let alone increase them).
Few people realise that the Australian Government’s October 2008 guarantee of bank funding and deposits was issued after the larger banks made it clear to the Government that they were facing extreme difficulty in rolling over their wholesale funding, meaning that they would have to immediately withdraw credit from the Australian economy and would eventually face insolvency. So while it might be true that Australia’s banks managed credit risk well, avoiding the excesses of the sub-prime lending prior to the onset of the GFC, their heavy offshore borrowing created a liquidity risk that also rendered them too-big-to-fail, eventually leading to the Government’s funding guarantee. Hence, whilst North American and European banks became insolvent on the asset side of their balance sheet, due to holding dodgy loans and derivatives, our banks also faced insolvency, except that it was on the liability side of their balance sheet.”
The banks’ increasing focus on housing lending, whose productive contribution to Australia’s economy is low overall (and zero in the case of lending for pre-existing housing), in place of more productive business lending, is also reducing Australia’s potential productive capacity and future growth prospects. These issues were recently acknowledged by National Australia Bank’s Group Executive, Business Banking, Joseph Healy::
“The distress experienced by many banks around the world was as much related to poor funding models exacerbated by rapid growth as it was to poor credit decisions. The crisis…highlighted that rapid growth requiring a high dependence on wholesale funding wasn’t necessarily a prudent way to run a bank.
A system structurally biased towards lending for housing – 57 per cent of all lending now is for housing against 35 per cent for business loans – isn’t necessarily playing its most productive role in the economy, particularly when one considers the state of both the housing markets and household debt levels.
The risks of such distortions could be magnified in the event there was another crisis that froze wholesale debt markets or…it transpired that the appetite for Australian bank debt among offshore investors wasn’t limitless.”
A greater role for regulation:
Given the major role that excessive credit has played in creating Australia’s housing bubble, and that the Australian banking sector faced insolvency requiring a Government bail-out during the GFC (via the bank funding and deposit guarantees), there is a clear role for greater regulation of mortgage lending to prevent the excesses that lead to asset bubbles. One solution is to introduce macro-prudential measures aimed at strengthening the resilience of Australia’s financial system by mitigating the build-up of excesses in credit growth and asset (house) prices. Possible measures could include:
- Setting maximum loan-to-value ratios (LVRs) for property lending. These measures assist in limiting a lender’s exposure to a property market downturn and limits highly-leveraged property purchases. LVRs could, for example, be set at 85% (requiring a minimum 15% deposit) when a cash deposit is used and 50% when non-cash collateral (e.g. another property) is used in place of a cash deposit.
- Placing limits on the ratio of debt service to income for housing lending. This measure would reduce the likelihood of borrower default and limits highly-leveraged property purchases. For example, a 30% limit would permit a household with a gross income of $100,000 to borrow a maximum of $428,500 at a 7% interest rate, whereas a 40% limit would permit the same household to borrow a maximum of $571,500 at a 7% interest rate.
- Placing limits on the amount of loans that can be extended against short-term funding sources, such as at-call deposits, and term deposits and wholesale funding with less than 12 months term-to-maturity. These types of measures: reduce the tendency of lenders to rely on short-term or unstable funding markets to support rapid lending growth; reduces the likelihood of experiencing a liquidity crisis like Australia’s banks experienced during the GFC; and reduces the overall amount of leverage in the financial system.
Macro-prudential measures, such as those described above, offer a number of addition benefits beyond simply improving housing affordability, increasing financial system stability, and reducing systemic risk. First, they could improve the function of monetary policy, since using interest rates in response to an asset bubble/bust is a blunt instrument that can have unintended consequences in other parts of the economy. Second, fixed measures, such as maximum LVRs and debt service to income ratios, tend to be more binding during a credit boom, when banks seek to expand property lending, than in a bust, when heightened risk aversion reduces their propensity to extend loans with high LVRs or debt service ratios.
Had such macro-prudential measures been in place globally during the 2000s, it is possible that the GFC would never have taken place, since the kinds of speculative housing lending undertaken in the United States and Europe would not have been possible. It is also likely that Australia’s house prices would never have surged like they did post-2000, since access to credit and the ability to undertake highly leveraged purchases would have been muted. Houses would now be much more affordable as a result.
That said, implementing these measures domestically in the current climate would be risky, since they would lead to an immediate contraction in housing lending, resulting in a house price crash and a severe economic contraction. For this reason, it would be wise to implement such measures after Australia’s house prices have corrected with the goal of preventing future housing bubbles. The political climate post-correction would also likely be more amenable to change since attitudes towards housing speculation and leverage would likely become more conservative.
In any event, the next Australian Government should immediately undertake another Financial System Inquiry (FSI) to examine some of these financial stability issues. The previous Inquiry (the ‘Wallis’ Inquiry), completed in 1997, never envisaged systemic risk engulfing financial markets as well as intermediaries, as occurred during the GFC. Nor was the Basel Committee’s idea of macro-prudential regulation (discussed above) ever considered. Furthermore, the Government’s October 2008 decision to guarantee bank funding and deposits completely ignored one of the original FSI’s key recommendations – that no government would ever guarantee any part of the financial system. The long-term implications of using the Government’s balance sheet as role of guarantor of last resort for the banks’ wholesale debts is also unclear and needs to be comprehensively examined by such an inquiry.
Negative Gearing Exposed proposed some practical modifications to Australia’s negative gearing rules that would remove excessive speculation (and demand) from the housing market, boost housing supply, whilst reducing the tax revenue forgone by the Government:
“Negative gearing’s cost to the Government and impact on house prices would be greatly reduced if, from a certain date in the future, it was retained on newly constructed dwellings but abolished where an investor purchases an existing (‘second-hand’) dwelling. In this way, pre-existing investment property owners would not be disadvantaged and, over time, tax deductible interest would begin to fulfil its economic purpose of encouraging real investment – the production of new housing supply – as new investors enter the housing market. Such an approach, once understood, would likely be supported by the home building and property development industry because it promotes higher building levels. Further, the increased housing supply would be likely to increase the availability of rental properties and lower rents.”
Two other areas worthy of consideration are eliminating inefficient transaction taxes, such as stamp duty, in exchange for implementing a broad-based land tax.
Stamp duty, which is levied on the buyer of residential properties and often totals tens-of-thousands of dollars, severely distorts the housing market by creating a mis-match between demand and supply. This mis-match occurs because it discourages people from moving house to more appropriate accommodation when their circumstances change. For example, empty nesters are encouraged to remain in their large family houses in order to avoid paying stamp duty if moving to more suitable accommodation (such as apartments and townhouses). As a result, newer families are excluded from ‘family friendly’ neighbourhoods with good amenities. Stamp duty is also highly inequitable since it severely punishes those that need to move due to changed circumstances (e.g. starting a family, job relocation, etc). Abolishing stamp duty would, therefore, encourage more efficient use of the existing housing stock and assist in alleviating housing shortages.
Land taxes, which are levied on the unimproved value of land, offers a number of benefits over stamp duties (see Tax me, please for a more detailed analysis):
- Land taxes discourage speculation and land banking, thereby increasing the competitiveness of supply in the land market and reducing the potential for housing shortages.
- Owners of land in urban areas would have more incentive for subdivision, and increasing density, to avoid this tax. In fact the economic success of Kong Kong, Taiwan and Singapore has been attributed to high land taxes – a path that Korea is keen to follow.
- Land taxes are difficult to avoid, and administratively simple. Further, tax evaders could have their land compulsorily acquired.
- Land taxes provide incentives for government to improve infrastructure and community facilities, since any investment by government would be captured in higher dwelling prices, thereby yielding the government additional land tax revenue.
Unfortunately, these changes to property taxation are, for the foreseeable future, as likely to be implemented by government as me becoming the front-man of Pearl Jam. In the Federal Government’s response to the Henry Tax Review, it announced that it would never change Australia’s negative gearing or CGT rules. And the states are equally unlikely to give-up stamp duties in exchange for implementing a broad-based land tax, even though it would be more economically efficient and equitable.
However, these measures might become politically palatable down the track once a housing correction has taken place and attitudes towards speculation and debt become more conservative.
A Macroeconomic Examination of Housing Supply (Parts 1 and 2) examined the importance of the supply-side of the housing market in determining house prices. The key findings from these articles were as follows:
- When land supply is not regulated and is free to adjust to changes in demand, price volatility is reduced. Therefore, increases (declines) in housing demand are more likely to result in sharper increases (falls) in house prices when supply is constrained (i.e. housing shortages exist) than when land supply is not regulated.
- Contrary to the common belief that Australia’s perceived housing shortage puts a floor under house prices and would thereby prevent similar price falls to those experienced overseas, the opposite is in fact true. House price falls would be more severe if housing shortages exist.
- The macroeconomic evidence on the contribution of supply-side constraints (housing shortages) on Australia’s house price growth is inconclusive. Whilst tight housing supply goes some of the way to explaining the price out-performance of Brisbane and Perth – which have experienced high population growth and relatively low levels of dwelling construction over the past 40 years – Sydney has experienced the lowest house price growth of all state capitals over this 40 year period, despite having the greatest housing shortage and lowest level of new dwelling construction. Further, both Adelaide and Hobart have experienced robust house price growth despite having the lowest population growth of all state capitals, the highest level of new dwelling construction, and minimal, if any, housing shortage as measured by the Housing Supply Council.
Of course, any efforts to make the supply-side of the housing market more responsive would be welcome and might help reduce house price volatility and prevent the development of boom-bust property cycles. Unfortunately, the required reforms to planning processes as well as urban infrastructure development and funding models are inherently difficult to implement since they often require agreement from multiple levels of government and tend to face strong opposition from local communities opposed to further development (e.g. NIMBYs).
Storm clouds gathering:
In my opinion, an Australian house price crash is inevitable and cannot be avoided. The fact is that house prices relative to income as well as household debt levels have simply become too high to be sustained, and all it will take is either a change of sentiment, a deterioration of Australia’s economy, another global credit shock, or shifting demographics to bring house prices down. If there is one thing that the GFC highlighted, it was that asset markets are fluid and can change course abruptly and viciously.
In the context of Australia’s housing bubble, prices have risen largely because of the ‘got to get in now’ mentality. As prices began to appreciate strongly from 2000, driven largely by an influx of investors and easy credit, more and more people became attracted to purchasing (investing in) houses, pushing prices up further and attracting even more people into the housing market. Eventually, however, excessive leverage will see this positive feedback loop unravel. Investors will likely start selling (or at least stop buying) and as the number of properties on the market begins to increase and prices begin to fall, the ‘got to get out now’ mentality will begin to take hold. Ultimately, the number of people exiting the market could develop into a stampede, and the Australian housing bubble will burst.
These dynamics have constituted almost every asset bubble/bust to date, from the Japan’s lost decade, to the mid-1990s Asian Financial Crisis, the 2007/08 global commodity bubble/bust, and the current US and European housing market crashes. There is absolutely no reason to believe that this time is different and Australia will somehow escape a similar fate.
So what are the key risks facing Australia’s housing market? Well there are several, some short-term and some longer-term.
First, as highlighted on numerous occasions by fellow economics blogger Delusional Economics (for example, see here, here, and here), Australia is heavily leveraged to China and any slow down in the Chinese economy will likely translate into lower prices for Australia’s two largest exports – iron ore and coal – along with other commodity exports. Should commodity prices fall significantly, it follows that less money will flow into the Australian economy, resulting in lower spending, a contraction in aggregate demand, and higher unemployment. A slowdown of China’s economy is likely since its two major export destinations – the US and Europe – are facing an extended period of sub-par economic growth cause by deleveraging following the GFC, as well as ageing populations. To date, China has relied on massive government stimulus to keep its economy growing strongly, but there is a limit to how long it continue with this approach.
The second major risk for house prices is that world credit markets freeze, thereby dramatically increasing Australian banks’ cost of wholesale funding and/or reducing their ability to raise funds offshore. Recent analyses by investment banks Credit Suisse and Goldman Sachs estimate that the Australian banks will need to raise between $100 billion and $170 billion of term wholesale debt in the 12 months to March 2011, of which about $78 billion would be the refinancing of existing borrowings that mature.
“According to Credit Suisse, the refinancing challenge over the next five years amounts to about $420 billion, with CBA and Westpac accounting for about $240 billion of that. The average term of the majors’ debt is only about 2.8 years.
Goldman estimates that if there were 8 per cent loan growth and no growth in deposit funding relative to the status quo, the banks would need to raise $416 billion in five year’s time. If, as is more likely, deposits in the major’s part of the banking system grew by 6 per cent, they would still need to raise $272 billion in five year’s time. That’s additional to the borrowings that will need to be refinanced.”
The banks’ wholesale funding task will be both difficult and costly since they will be competing with up to $US5 trillion of existing European bank funding that will mature and have to be refinanced by European banks over the next three years, about $US3 trillion of it by the end of 2012. Our banks will also have to compete to raise funds in capital markets against sovereign governments to fund the measures they took in response to the GFC (see here for more details).
Let’s also not forget that the Basel Committee on Banking Supervision is examining adding a layer of counter-cyclical capital buffers to bank capital adequacy requirements in order to mitigate against excessive credit growth and systemic risk.
With all of these factors combined, it will be difficult, if not impossible, for Australia’s banks to continue to increase lending for housing. As such, the prospect of continued house price growth is minimal, since continued price appreciation relies on ever-increasing credit growth and household debt levels. Even maintaining current house price levels will be difficult in this new credit-constrained environment.
Even if Australia miraculously manages to dodge the above economic bullets, house prices will still come under enormous pressure. This is because for house prices to continue rising, investors and owner-occupiers must continue to believe that capital appreciation will be sufficient to cover the negative income return from owning residential property. This situation is clearly unsustainable. Once the expectation of continued strong house price growth disappears, households will likely start reducing their borrowings (deleverage) and prices will correct.
Finally, one of the key drivers of Australia’s strong house price growth has been the Baby Boomer generation’s rampant buying of investment properties to fund their retirement. But with the Baby Boomers soon to enter retirement, it follows that their appetite for investment properties will shrink, thereby removing one of the key demand-drivers of house price growth. Further, because higher investment yields can be earned by placing their funds in a bank term deposit than can be earned via rent, it is likely that many Baby Boomers will sell their property investments to fund their retirements. This process of property divestment is likely to accelerate once the Baby Boomers realise that there is little prospect of continued high capital appreciation.
The bottom line is that Australia’s housing market is in a fragile state. Storm clouds are gathering and it is only a matter of time before the bubble bursts. You have been warned.
Till next time.