Guest Post: It’s a question of fundamentals

As you can imagine we are a bit busy this weekend; so we have opened the blog to a guest post. Peter W is someone who has left many interesting and educated comments on this blog, so we contacted him to see if he wanted to post an article with a round-up of his ideas.

Peter describe himself as an impassive local observer of ‘Extraordinarily Popular Delusions and the Madness of Crowds’

Please enjoy his post on credit and housing.

It’s a question of fundamentals

Here is a fundamental question for all the spruikers…
What is the difference between ‘an investor’ and ‘a speculator’?

Given that the Australian housing market price increased in aggregate, from $2.5 trillion in 2005 to $4 trillion in 2010, a price gain of $1.5 trillion (10% p.a. compound)

Why is ‘investor credit’ collapsing?

Surely if you can generate an 8 – 10% compound gain in the past 5 years as you did over the past 20, ‘investor credit’ should be at the same 20 – 25% p.a. credit growth levels as 1990 – 2005

The answer of course is that ‘investors’ buy housing (or any other asset for that matter) because the cash-flows determine value i.e. the lower the price the higher the cash flow and the higher the price the lower the cash flow.

‘Speculators’ buy because the price is going up and sell because the price is going down.

In terms of money… ‘Investors’ out weight ‘speculators’ by a huge factor. But if it were not for speculator credit being included in the ‘investor credit’ category, ‘investor credit’ would be significantly negative. ‘Investors’ possess the bulk of national wealth because they are reasonably intelligent.

So prepare for lower clearance rates and a further retreat of ‘investor credit’ and ‘investors’ from the housing market.The only people left in this bubble are the speculators and struggling owner occupiers.

As ‘investors’ pumped credit into the housing market over the past 20 years housing prices far outstripped wages and therefore rents which is why rental yields have fallen to 3%.

This has created a self-fulfilling decline in the attractiveness of housing as an ‘investment’ that even ‘investors’ have recognised (The speculators have not worked this out… YET)

After putting in a stellar effort of 20 – 25% credit growth in the decade and a half prior to 2005 the trend decline in ‘investor’ credit is heading to zero in the very near future!

This leaves ‘owner occupiers’ as only source of new housing credit and net housing buyers. With new housing credit growth only supported by the ‘owner occupier’ population growth and overall wages growth, it’s very likely that new housing credit will decline to 6% per year or less.

6% net credit growth on the existing $807 billion of ‘owner occupier’ credit is $48 – $50 billion per year. Assuming 25 year housing turnover rates and 1.8% new dwelling construction rates per year, roughly $232 billion of housing will come to market for sale each year at present prices.

The existing debt on the entire housing market is ($1157 billion / $4000 billion) roughly 29%.

So the $232 billion of annual housing coming to market, has roughly $67 billion of existing credit (29% LVR), and is seeking to find a sale from buyers only willing to add an additional $48 – 50 billion of new credit, for a total of $117 billion of credit.

LVR ratios change from 29% for ‘the sellers’ and with $50 billion new credit, leverage is increased to 65% for ‘the buyers’ to reach present sale prices, it’s only possible for ‘the buyers’ to purchase $180 billion of this $232 billion of housing stock coming to market each year, leaving $52 billion of housing stock unsold, or roughly 100,000 houses (1.25% of total stock)

Given the long term track record of house prices following annual new credit growth, price gains will be very subdued at best… Unless the price does as it has always done in the past… track annual new credit growth.

$50 billion of annual new credit growth implies housing will slowly fall from $4 trillion to $2.5 trillion a 37.5% fall in house prices and this MAY happen over many years BUT…

When house prices do start to decline, do you think ‘investors’ (read speculators) will be at all interested in creating more credit to engage in a 4% negative gearing loss as prices fall?

Of course not.

What ‘investors’ (read speculators) will do is reduce their level of credit which will subtract additional credit from the $50 billion the home owners MAY possibly create.

A subtraction of credit by ‘investors’ (read speculators) of just 2% (1 investor in 50) would subtract $7 billion (2% of $350 billion) from annual new credit

That would put new credit growth at close to $40 billion which implies housing falling 50%.

The 20 year trend for housing credit growth.

The Australian government has been trying to prop up credit growth since the down trends in credit creation became obvious 2006

The Australian government is not winning!

The long term link between house prices and credit creation…

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  1. Construction has dropped to near record lows. Why? New home sales have dropped. Why? Inventory is piling up on the market. Why? The government introduced and then boosted an FHB grant to boost demand. Why would they do that, doesn't demand already exceed supply? The answer to these questions is simple, because the demand wasn't real. There was NEVER A SHORTAGE TO BEGIN WITH. Demand had been artificially generated and brought forward by loose credit and rampant speculation. While the property bubble expanded, increasing numbers of houses were allocated to risky speculation instead of shelter, causing vacancy to drop and give the illusion of a shortage. Total demand exceeded that necessary for shelter due to speculative hoarding meaning almost 10% of dwellings were held empty and now this enormous supply of empty dwellings is going to flood the market as previously delusional owners wake up and realise the party is over!

    Andrew B
    Global House Price Crash Blog

  2. Leith van Onselen

    Nice work Peter. Your analysis certainly supports the contention of the contrarian blogger community.

    Remember, also that the Baby Boomers are entering retirment and will need to cash-out their housing assets to fund their retirement. They currently hold around half the housing stock and have been a key driver of house price growth over the past 20 years. Expect them now to become a drain on house prices going forward.

    This article explains the Baby Boomer's situation well: Baby Boomers, Retirement & Asset Prices

  3. Interesting article, Peter. Cheers…

    I like your "new credit" approach in the context of total market size.

    Would be really interested to see how the numbers change if you assume a more aggressive housing turnover rate… I know that the average mortgage is re-financed every 5 years, and suspect that homeowners turn over their property more often than every 25 years (due to changes in family size, etc). If that is the case then the $$ volume of stock hitting the market each year will be even higher!!

    I also agree with Leith's comment regarding the impact of Baby Boomers' retirement… They will be pulling a huge chunk of capital out of the system as they retire – and I think it's worth noting that they are pulling out EQUITY (ie. cash), which then needs to be replaced by more DEBT to simply maintain the status quo!

  4. Sam


    To 'pull out cash' (equity) which is a deposit [M1] you need to find someone to create credit which is [M3].

    Credit creates deposits

    In the absence of an 'arms length' buyer the only other alternative you have is to create your own [M3]

    'Its called equity mate'… That CBA [M3] marketing pitch will haunt the CBA into future history books!

    Banks will not extend unlimited credit if the 'arms length' market price for housing assets is falling.

  5. Anyone have an email contact for Steve Keen?

    Steve is about to win the bet!

    Australians and the Australian Govenment are unfortunately about to loose the bet.

  6. What the Government, the RBA, the bank spruikers, and the RE industry have not considered is…

    If the fundamental cause of declining new credit creation is a high market price @ 2005, then the policies all these institutions have pursued to date, have driven prices 60% higher.

    Driving prices higher is obviously driving NEW credit creation lower…

    Pretty simple

    Then the market collapses

  7. FWIW

    Bank CEO's, senior bank executives and all senior bank managers should have all their assets and the assets of their associates (associate is a well described term in the Corporations Laws) frozen if this housing market collapses causing the economy to collapse.

    We need a Government that will jail bank executives for 'control fraud'.

    I would define control fraud as…

    Paying wages and bonuses from a banking institution in excess of all the losses assumed by Government as a result of an institutional banking failure in aggregate prior to the banks collapse.

    No heads I win, tail you loose

  8. FWIW

    Another take on 'control fraud'…

    If I can see that a loan at an LVR of 65% at the present market price has a high risk of becoming an LVR of 130% because the asset market is hghly likely to subsequently fall 50% then why should bank executives and managers get paid with bonuses?

    An LVR 65% loan should not be issued at 7.75% interest, it should be issued at 15%+ because of the risk of loss

    This is what the game of banking is all about… Risk management… charging an appropriate risk premium for all the risks of loss.

    If you walk away with wages and bonuses and in retrospect demonstrate you have totally failed to manage all the risks then you are willfully committing a fraud…

    Control fraud

    This does not happen to the same degree with the insurance industry.

    The insurance industry has 10 years of statutory liability and the ultimate losses from premiums written are only known at the passing of 10 years… That is how long insurance shareholders have to wait to know if their managers and underwriters were 'duffers' or understood risk.

    The same standards should apply with banking executives and managers…

    Hold all wages and bonuses in reserve for 10 years and then determine what excess losses to charge against their poor risk management.

  9. Birch Creek Trader

    I heartedly agree with your last paragraph Peter – bank managers and their loan staff/managers have a completely asymmetric payoff when it comes to loan origination and remuneration.
    Nice post!

  10. Peter, do you have your personal blog? I am struggling to understand the numbers you come up with in the following paragraph: “LVR ratios change from 29% for ‘the sellers’ and with $50 billion new credit…”