The Days of Easy Credit are Numbered

Back in December, I wrote the following:

In the early-1990s, non-bank lenders entered the Australian mortgage market and began raising funds via securitisation on wholesale debt markets. The rise of these non-bank lenders caused an intensification of competition amongst mortgage lenders. With no formal regulator and no rules outside of regular trade practices and corporations law, they led the decline in Australian credit standards by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (sub-prime) loans just before the GFC intervened.

Faced with this new competitive threat, Australia’s banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore, much of it short-term. Gone were the days of requiring a minimum 20% housing deposit and restricting home loans to an amount that could be repaid with 30% of a household’s gross earnings. Instead, banks accepted 5% housing deposits and lent households an amount that, after loan repayments, left them with just enough money to ensure that they stayed above the Henderson poverty line.

The massive increase in the availability of credit sporn from this increased competition, combined with unresponsive housing supply, has resulted in the housing bubble that Australia experiences today….

The funding models used by the banks and non-bank lenders alike to fund housing were found to be unsustainable after the GFC. Both the banks and non-banks had a dangerously high reliance on short-term wholesale funding, which seized-up amid heightened risk aversion during the GFC. The non-banks and many smaller APRA-regulated institutions were also heavy users of securitised debt markets, which similarly froze-up post GFC. As such, the Government was called upon to guarantee banks’ wholesale funding and buy up to $16 billion of residential mortgage-backed securities (RMBS) in order to ensure that credit continued to flow into Australia’s housing markets, thus keeping the housing ponzi alive.

Today, we received further confirmation in the Fairfax press that the pre-GFC practice of banks borrowing heavily offshore to feed Australia’s housing bubble is becoming unviable.

JANUARY and February are usually the biggest months for banks to raise funds on global markets, but pricing for debt has skyrocketed since the end of last year.

This does not bode well for home owners. Banks are likely to come under further pressure to continue raising interest rates — even if the Reserve Bank keeps rates on hold.

Intense competition for funds from cash-strapped European governments and other banks has been increasing borrowing costs on global markets. The banks commonly blame this for forcing interest rates higher on loans….

Credit market jitters — mostly linked to lingering concerns of default by Portugal, Greece and Ireland — have coincided with the period that is traditionally the busiest for Australian banks borrowing from wholesale markets.

Australia’s big banks will need to borrow more than $130 billion from local and overseas markets in the next year to help fund their lending books. Global pension funds, including Australian superannuation funds, are the biggest investors in bank bonds.

But billions of dollars in funds already raised by banks including Commonwealth, ANZ and National Australia Bank since the start of the year have been costing more than this time last year….

Locally, Commonwealth Bank has the biggest requirement from wholesale markets, eyeing more than $50 billion over 2010-11. Westpac is looking to raise as much as $35 billion and NAB is looking to borrow up to $30 billion. ANZ plans to raise $20-$25 billion…

Greg Canavan from the Daily Reckoning today published some nice analysis of the funding pressures now facing Australia’s banks and the implications for house prices and the Australian economy.

The banks are now competing for capital with bankrupt governments. Markets are demanding a higher rate of interest to lend to these governments so in turn, the banks need to pay more.

After many years of not caring, debt markets are starting to price risk sensibly…

This has important implications for the Australian banking sector and the economy. A higher cost of credit means we probably won’t see a rebound in lending anytime soon. Banks won’t expand their balance sheets, which means their share prices will stagnate.

Even worse though, the higher cost of credit will hurt the property sector. Over the past decade, cheap and plentiful credit has propelled the property market higher and higher. Based on capital city prices, Australian residential property is one of the world’s most expensive.

But with credit now coming at a higher cost, you will see house prices begin to fall. Residex recently reported that Australian capital city house prices fell an average of 1.1% in December, with year on year gains of 5.1%.

That annual gain is less than the cost of funding, so in real terms property investors are going backwards.

Remember, property is a highly geared investment, so even small falls can have a major impact on investors’ equity.

This will put further pressure on the banks and balance sheets of a highly indebted household sector.

The equity market is not the only asset class topping out. Residential property is joining in. Will there be a crash though? Maybe. But we think that will only happen if unemployment starts to rise.

The two income household is one of the major drivers of property prices. As long as there is employment income to service debt, you probably won’t see major price falls.

But here’s a twist. Australia’s extremely low unemployment rate has come at the expense of declining productivity. We may be near full employment, but as a group we’re becoming less productive.

A big part of the reason for this is that Australia has over invested in property, an unproductive asset. The balance sheets of the big four banks are overwhelmingly tilted towards residential property. As a percentage of Australian assets, the average is somewhere around 65 per cent.

So the majority of money borrowed by banks (from you, the depositor, and overseas lenders) goes into housing. This does not increase our productive capacity.

Along with the benefits of the China boom, this is why there is fear of a wages breakout in Australia. And this is why Glenn Stevens at the RBA still has his finger on the interest rate button despite numerous signs of a weak domestic economy.

Wealth is many things but it’s not higher asset prices pushed up by cheap credit. Tops are beginning to form. It’s time to be conservative.

Nicely put Greg. I agree with everything that you have said except for one point: that Australia needs unemployment to rise before house prices will fall. This certainly was not the case in the United States, where house prices fell for a year before unemployment began to rise (see below chart).

The reason why falling house prices would likely lead rising unemployment is actually quite logical. When house prices rise, Australians feel richer, which spurs consumer confidence, spending and employment growth. A positive feedback loop often develops whereby households take on more debt, causing housing values to rise further and the process of confidence, spending and employment growth to repeat.

But home values and debt levels can only rise so far and, sooner or later, the process of debt feeding asset prices feeding confidence, consumer spending and employment growth goes into reverse (i.e. deleveraging). House prices stop rising (or fall) and highly-indebted households begin to reduce their spending and repay debt. Sectors reliant on consumer spending contract and unemployment rises. Consumer confidence falls, leading to further frugality, house price reductions and job losses.

I believe Australia is currently at the early stages of such a deleveraging process.

Fellow blogger, Financial Follies, appears to share similar sentiments. Today he wrote an excellent article on some of the risks facing the Australian economy. Here is some of what Financial Follies had to say:

…You might have read reports of a recent study by the IMF, which surprisingly concluded that Australian house prices were only mildly overvalued. The IMF argued that there were solid fundamental reasons for Australia having the most expensive property prices in the world. And one of the key reasons they cited is the massive rise in Australia’s terms of trade.

You can see from the chart below that, indeed, inflation-adjusted house prices have basically increased in line with Australia’s terms of trade over the past two decades.

This raises an obvious question. If you agree with the IMF’s logic, doesn’t this imply that house prices have to fall when the once in a generation boost to the terms of trade reverses?

Now, Australia’s terms of trade has gone through long rises and falls over history without huge problems. And a decline in the terms of trade wouldn’t necessarily have to be a big problem if Australia had invested the proceeds of the current boom productively. But instead, Australians have turbocharged the boom by taking on record levels of personal debt (see below), mainly to purchase houses. And the Australian banks are financing a good part of this mortgage debt not through deposits, but through a potentially unstable source of funding: the international bond markets.

So we are now left very highly leveraged, and the valuation of the biggest asset that most Australians own (their houses and investment properties) as well as their ability to service this debt (and the banks’ willingness to keep extending credit) is dependent on the continuation of the commodity boom. The enormous level of personal debt means that Australians today are highly vulnerable to potential shocks in the economy, whether from a slowdown in China, or from higher interest rates.

The chart below, from an excellent post at, shows just how unbalanced the Australian economy has become over the past two decades. You can see that in 1990, the majority of Australian bank lending was being channeled into business investment, or investment in Australia’s future productive capacity. But over the past two decades, the portion of bank credit allocated to business investment has steadily shrunk. In place of this, we have seen massive growth in property-related lending, to the point where one in seven Australians today owns one or more investment properties.

In essence, Australians have been behaving as if the commodity boom and the days of easy credit will last forever. Nobody can predict the timing, but they won’t. Now, that doesn’t have to mean disaster, but we’re kidding ourselves if we think the adjustment is going to be easy.

As explained by the above bloggers, there are clearly significant downside risks to the Australian economy and housing market. Anyone extrapolating the past decade’s performance into the future is likely to be sorely disappointed.

Cheers Leith

Leith van Onselen

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.


  1. Australian house prices have grown in line with Australian debt for a long time. If you look at the chart of debt vs GDP alongside the house price chart here…

    Debt/GDP & House Prices

    … it's very clear where the ramp-up in credit has been going. There's no doubt Australia is hurtling towards peak debt, and when the limit is hit then massive deleveraging is the only option. Remember, debt needs to increase for house prices to rise. Standing still isn't an option. It's like throwing a ball into the air, it goes up and up and up and for a brief second it stops (and that's when the spruikers will scream the loudest about new paradigms and permanently high plateaus) but then gravity wins in the end and it all comes crashing down. Australian house prices can't defy gravity forever. Debt and houses prices will fall, it's a matter of when, not if!

  2. CDS on debt of Australian banks on the move.

    "We strongly recommend watching for signs of a prospective funding problem for Australia's banks.

    They are exposed to one of the most egregious housing bubbles ever – and they receive most of their short term funding (to the tune of nearly $400m.) from overseas sources. This is a potentially highly explosive situation."

    "This needs to be watched very carefully – we regard credit risk pricing on Australia's banks as a 'canary in the coal mine'."

    And for those interested, several other references are made to Australian banks in various posts at the above site.

  3. Financial Follies

    Leith — Thanks for the plug! I like your explanation of the positive feedback loop going into reverse via deleveraging. As we're seeing in the US, deleveraging is a pretty long and painful process. I know we bloggers write about this a lot, but I get the sense that Australia on the whole is still massively complacent about the risks…

  4. Greg Canavan says " The two income household is one of the major drivers of property prices. As long as there is employment income to service debt, you probably won’t see major price falls." … However in the USA unemployment did not rise until after house prices fell … UNEMPLOYMENT was not what drove house prices down in the USA & it will not be what drives house prices in Australia down.

    In the US house prices stagnated & then fell cutting off peoples ability to draw down on the equity in their homes. This resulted in a drop in consumption & a rise in unemployment.

    The fact remains House prices fell first then unemployment went up. Anyone looking at unemployment being a indicator for house prices falling are going to be blindsided by a fall in consumer spending that is happening in Australia today?

    US Unemployment numbers in 2006 were under 5.0% in 2007 they were under 5.0% House prices by now were dropping like a rock causing a fall in consumer sentiment & spending …. unemployment in the USA did not go past 6% till August 2008 & by then house prices were deeper in negative equity than than Grand Canyon …. the point is it was not unemployment that caused it …

    Be careful in Australia Retail spending has plummeted & confidence is down clear warning signs we are following the US

    Link to US Unemployment numbers & dates:

  5. Sorry Leith … I read up to here … " But here’s a twist. Australia’s extremely low unemployment rate has come at the expense of declining productivity." …
    then wrote my previous comment, only to realist later in your post you address the issue…

  6. Complacency always ends with a rude shock.When it happens here in this example we will inevitably be treated to the usual "but who could have known?"

  7. Hi Leith, (and like minded bloggers)
    Thanks for all these posts as i can see with my own eyes here in Sydney, retailers with up to 70% off sales, houses that have sat unsold for about 4 months and now the prices dropping. We all know that real unemployment is more than 5%. I don't think there will be as many new cars sold this year either and oil prices are starting to rise even with our high dollar. I know the situation in Ireland very well….will we be hit as hard in Aus..who knows but even half a hit would be a worry. Along with all the other issues we manufacture very little here now and thats a crying shame for us all, especially our young people…Cheers
    RM Sydney

  8. Deleveraging has surely begun.

    Look at the last 3 months of sales volumes in Melbourne.

    Now that is ugly.

    Couple that with listings in FHB areas like the one linked below and you wonder how well this might end. Compare current listings to 2008 where there was a well defined slump that prompted $2B of direct and probably $15B of indirect fiscal stimulus to support the industry (not to mention the monetary hit as well)

    Great comments folks.

  9. well we all know that Australia is different

    I'm expecting the average bogan here to start calling the banks bad names and scream for "greater competition"

    most have this idea that competition improves the breed without having a clue what it actually costs to run the Melbourne Cup or grasp that its the losses at the betting which actually fund it.

    That's ok … only other "loosers" don't win


  10. jimbojames1, in isolation those two graphs could only give half a story and it could be good or bad. But rising prices, falling sales volumes and rising stock on the market?!! Now what happened in other developled nations when those same three things happened simultaneously? Despite my personal circumstances (keep renting or take on a mega mortgage) I like the idea of the bubble deflating over time and thereby minimising the damage to middle Australia's wealth and our overstretched financial system.

    So I don't like the look of those graphs, not one bit… (((*worried*)))

    The soft landing scenario currently being chanted by the spruikers is looking less likely as time goes on. I may yet run over and join the bear camp.

  11. Torchwood, I thing the soft landing option would require the market to behave in a rational and emotionally controller manner. If fundamentals had anything to do with it, i'd be inclined to believe it.

    But, over the past two years in particular, fundamentals, rationality and calculated emotions had nothing to do with it. It was driven in the first instance by fiscal and monetary stimulus, followed by the inevitable fear and greed. That fear of missing out works just the same on the way down and with Government now looking for ways tax and save, the stimulus bucket is empty.

    The two charts I posted say it all really. Unprecedented low decade long sales volumes (by a material margin), coupled with an explosion of listings, yet no real sign of price attenuation. Either there are thousands of owners in that FHB suburb fishing for a good price or they have a genuine reason to sell. The market better hope it's the former.

  12. Leith

    good post as always.

    am wondering if you have read a GMO quarterly letter from Oct 2010 that Jeremy Grantham wrote? I was reading this the other day and it gave a good description and analysis of the 'wealth effect' you mention in this post.
    Well worth a read if you have the time.


    Justin S