The Economist: Bricks and Slaughter

The Economist has published an excellent article entitled Bricks and Slaughter (h/t Financial Insights for the link). It is part of a series by the Economist exploring the lessons to be learned from the global housing bubble.

Below are some key extracts; although I recommend that you read the article in full for yourself.

A sharp turn in the property cycle is a serious matter. The five big banking blow-ups in the rich world before the latest crisis (Spain in the 1970s, Norway in the 1980s and Sweden, Finland and Japan in the 1990s) had property at their heart. Banking crises in the developing world have also tended to happen at the peak of housing booms or just after a bust in prices…

Why is property so dangerous? One obvious answer is the sheer size of the asset class… Property is so big that when credit conditions loosen it is likely to absorb a lot of the extra liquidity; and when something goes wrong the effects will be serious.

An even bigger reason to beware of property is the amount of debt it involves… In many pre-crisis housing markets buyers routinely took on loans worth 90% or more of the value of the property. Most had no way of bringing down their debt short of selling the whole house…

With only a small sliver of their own capital to protect them, many owners were quickly pushed into negative equity when property prices fell. As borrowers defaulted, the banks’ losses started to erode their own thin layers of capital. “Banks are leveraged and property is leveraged, so there is double leverage,” says Brian Robertson, who runs HSBC’s British and European operations and used to be the bank’s chief risk officer. “That is why a property crash is a problem for the banks.”

Property bubbles almost always start because fundamentals such as population growth, interest rates and economic expansion are benign… These fundamentals explain why many market participants are able to persuade themselves that huge price rises are justified and sustainable…

For the lenders, property is attractive in part because it attracts lower capital charges than most other assets. That makes sense—the loan is secured by a tangible asset that will retain some value if the borrower defaults—but it can also lead to overlending. Indeed, one of the bigger ironies of the property bubble was that lenders and investors probably thought they were being relatively prudent…

Collateralised lending offers a degree of protection to the individual lender, but it has some unfortunate systemic effects. One is the feedback loop between asset prices and the availability of credit. In a boom, rising property prices increase the value of the collateral held by banks, which makes them more willing to extend credit. Easier credit means that property can sell for more, driving up house prices further. The loop operates in reverse, too. As prices fall, lenders tighten their standards, forcing struggling borrowers to sell and speeding up the decline in prices. Since property accounts for so much of the financial system’s aggregate balance-sheet, losses from real-estate busts are likely to be synchronised across banks.

Borrowers, too, contribute to the inefficiency of property markets, particularly on the residential side… Unlike other assets, housing is seen both as an investment and something to consume… This mixture of motives can be toxic for financial stability. If housing were like any other consumer good, rising prices should eventually dampen demand. But since it is also seen as a financial asset, higher values are a signal to buy… the experience of buying a home is a largely emotional one, similar to that of buying art. That makes it likelier that people will pay over the odds…

Once house prices start to rise, the momentum can build up quickly… The value of any particular home, and the amount that can be borrowed against it, is largely determined by whatever a similar house nearby sells for. One absurd bid can push up prices for lots of people.

As prices rise, property is arguably more likely than many other asset classes to encourage speculation. One reason is that property is so much part of everyday life. People do not gossip about the value of copper and tin, but they like to talk about how much the neighbour’s house went for. They watch endless TV shows about houses and fancy themselves as interior designers, able to raise the price of their home with a new sofa and artful lighting. Eventually the temptation to take a punt on property becomes overwhelming…

Even the risk-averse may well respond to rising prices by entering the market… People [have] an incentive to buy early in order to protect themselves against the risk of future price increases that would make houses unaffordable…

The Economist has once again fired a great big warning shot across the bow of Australia’s housing bubble.

In particular, the section on collaterlised lending is highly relevant to Australia’s banks, which have continually expanded their residential loan books on the back of rising housing values, increasingly funded via heavy offshore borrowings in the wholesale debt markets (see Deep Throat’s article, The Capital Rort, for an in-depth explanation of how Australia’s banks have used collateralised lending to bolster their mortgage lending). And with such a high exposure to residential mortgages, Australia’s banks are now at risk of incurring heavy losses in the event of a significant housing correction.

The Economist’s explanation of bubble psychology also has clear parallels to Australia, particularly the rampant buying of negatively geared investment properties by speculators, as well as the ‘panic buying’ by first time buyers after the stimulus-induced house price surge in the wake of the GFC.

One area where the Economist article perhaps goes missing is that it does not mention the role played by artificial supply restrictions (e.g. strict planning/zoning laws) in creating housing bubbles. As explained in previous articles (for example here and here), the US housing bubble was confined to jurisdictions with unresponsive supply caused largely by artificial regulatory constraints, whereas those with lighter land-use regulations never experienced a bubble/bust.

Below is an audio interview with the author of the Economist article.

Cheers Leith

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Unconventional Economist
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  1. Leith, you’re just about the only commentator to suggest there might be problems on both the demand side and supply side. Everyone else is in one camp or the other. i.e. Its either 100% a demand problem or 100% a supply problem.

    The truth is probably somewhere in the middle, but people can’t let go of their ideological biases.

    • Thanks Lorax. The Keen vs Joye debate a few weeks back really highlighted your point. Both made valid arguments about the causes of the bubble (Keen: demand-side and Joye: supply-side), but each dismissed the other’s position. Yet both arguments are equally valid.

      • Re supply side constraints and price, the rent to buy ratio in country towns would be a very interest test of your thesis. I have shopped for a house in small towns with zero/negative population growth with plenty of empty blocks. The market are highly illiquid with prices locked to a 5% return.

        • Steven. Australia’s country towns are all subject to strict planning/zoning, just like in the cities. As such, housing supply in regional areas is also unrsponsive to changes in demand. Try buying a residential block for close to its rural value in a country town – you can’t. The difference in value is due predominantly to planning/zoning.

      • I don’t know that they’re equally valid — I tend to think the demand side has a bigger role to play — but I do find it amusing and frustrating how both sides completely dismiss the other sides view.

        Its a bit like the government interference vs financial deregulation debate on the causes of the GFC. It was probably a bit of both but neither side will admit that.

      • I looked at the supply side It seems to me that there was no problems on the supply side quantities. We were building for decades much more than we actually need. Housing bubble in Australia is not caused by limited supply, because we already have huge oversupply. It is caused by supply side manipulators (local councils and big developers).

        In Texas, place that you like to use as an example, less new homes was built (1.05m homes between 2001-2006 on 2.4 million new residents) than in Australia (940k new homes 2001-2006 on population increase of 1.3m new residents) or California (1.06m new homes on 2.1m new homes during the same period), still prices in Texas remained steady during this period compared to huge gains in Australia or California. Why?

        Well, I think that the reason is not how many new homes are built or how much of the new land was developed, but the way how it is done. In Texas almost everybody can buy agricultural land, develop it and build a house. None can sell a new home with large profit because there is alternative for everybody to do it by themselves. That’s why new home prices are just slightly higher that cost of development. In Australia and California regulation is different and residential development business is highly manipulated and done by privileged business in cooperation with the local councils. People are forced to pay price they ask because it is almost impossible to do it yourself. Price of a new home is significantly higher that cost of development. That’s why lend developers and local councils are earning huge profits from new housing developments.

        • Thank you raveswei. In one comment you have distilled exactly the argument that I have been trying to make on this blog. Supply-side constraints have little to do with the quantity of homes built compared with new population. It is about the regulatory barriers in place that prevent affordable new supply from being added quickly in response to demand. In Texas and other places with competitive land-use regulations, there are minimal barriers to turning farm land into new housing. Accordingly, land prices are always affordable, since the land market is competitive and contestable. By contrast, in places with prescriptive land-use regulations (e.g. planning/zoning, etc), there are artificial barriers in place that prevents farm land from being converted into new housing, which causes high land (house) prices.

      • If it is supply, why is there so many vacant units and empty blocks in my neighborhood? Get rid of negative gearing and FHBs will see affordable housing return. China busting will enforce some of this in any case, less we get another scheme from the government, and who knows maybe $30K this time round?

  2. From the article “Up, up and away with the fairies”

    Made me think about:

    “Appreciating what we as a species can and can’t do well. When we are likely to
    make sound decisions and when we are likely to make a hash of them – requires
    moving past the idealisation of economic man and into the more sticky territory of
    human psychology”
    Kluge: The Haphazard Construction of the Human Mind, Gary Marcus

    Above Taken from Behaviour: Bear, bull or lemming?

    A Lloyd’s Emerging Risks report.

  3. Three ingrediants of market bubbles:
    “Innovation, speculation, and delusion have come together in bubble after bubble, says Financial Analysts Journal editor Rodney Sullivan.”


    A good short primer on bubbles with video and also a transcript bar on the video.

    Three ingrediants and the cook is belting the vanilla essence. Way to go.

  4. On the supply side, note that banks need very high pre-sales percentage (off-the-plan sales) as a pre-condition for them to project finance the development of apartments/units.

    While this may not cause supply constraint, it has led to developers targeting overseas investors for off-the-plan purchases, because no local investor worth his/her salt will buy off-the-plan. Lately, banks have woken up to a new problem were overseas investors go AWOL at settlement time (started in Gold Coast) and hence limited foreign pre-sales to 20%. However, big developers like Meriton do not rely on bank finance.

    Also these overseas investors *cough* Chinese *cough* have a fetish for leaving their investments empty to maintain their brand new condition.

    So now we are in a peculiar place where we don’t really know if there really is local demand for these units.

    • Agree that Chinese investors are doing this Mav, but i don’t think it’s a “fetish” for new houses as such.

      I think a lot of them are using Aus real estate as a store of value (a la gold) rather than an investment to provide yield. They’re wary of high volatility in their equity and property markets and are funneling cash out into more stable economies so even if it all falls down at home they have solid assets over here they can either move into or sell.

      Whether they’re going to get burnt or not here is another matter..

      • p.s. it also aids in the immigration process. And property in the right zone (near Scotch, Carey etc in Melb) is also a bonus when you send your kids out here for their education

        • And how does owning residential property here help in immigration? There are no points for that in the immigration visa points system.

          • Not sure of the exact detail but there’s a scheme where if you buy a resi property and a business that employs at least 2 aus citizens then you qualify for residency/citizenship. Its a big marketing boost for developers on the outskirts of melb atm.

          • I can’t find any reference about getting 28 points in . The REA is obviously bluffing.

            It does say the about the business owner visa:

            “The net value of your (or you and your partner’s combined) personal and business assets in Australia has been at least AUD250 000 throughout the 12 months immediately before you apply.”

            Sounds like another PR visa rort – this time its rich foreigners buying businesses/houses instead of poor students doing chef/hair dresser courses.

      • I understand that it is not a fetish. I am even fine with the “real estate as a store of value” concept. Though I find it a bit questionable, given the bubble we have. “real estate as a destroyer of value” is more like it.

        As I said earlier, can you even dream of building a factory (a capital asset like RE) and not putting it into productive use so that it retains its “brand new” condition? I find that a bit insane.

        Besides, From a practical standpoint, a house tends to fall apart when it is not in use, no matter you hire an army of maids to maintain it. All manner of vandals – both human and animal – tend to gravitate towards unoccupied houses.

        • I’m not recommending it as an investment strategy, just my 2c on why they’re doing it.

          Remember it’s within living memory for a lot of chinese that Mao took over and stripped everyone of their wealth and assets. My guess is they’re stashing a small chunk of their portfolios in hard assets overseas while they can, just in case there’s a economic/political bloodbath at home.

  5. Strange you should mention that, Mav. There is a house a few doors from me that sold to (probably Chinese or Malaysian) buyers last year that has been empty for well over 6 months – it went for a bit over 1 mill. Starting to look a bit derelict now but obviously the owners don’t even care about trying to get rent… they mustn’t need the money! The question is, how many other properties are perpetually empty with foreign absent owners?

  6. There is one next door to my mates place in Glen Waverley in Melbourne that was bought buy a Singapore businessman, but nobody lives there. He pays someone to mow the lawns once a fortnight, and someone to vacuum inside once a month.

    Has gone as far as telling his neighbours it is an ‘investment’ and the local agents advise against renting it out because it will devalue the property and make it harder to sell quickly if you need to (if you have a tenant on a lease and you need to sell, then you potentially wipe out some people who would buy wanting to move in straight away…).

    • That letter is a classic. Please don’t worry Mr Peterson. Nothing has gone wrong so far so nothing can ever go wrong.
      Clearly Australia is different!

  7. And the $100B of extra Foreign borrowings and equity raisings they did overseas, plus the $50 odd Billion dollar swap the RBA did with the Fed didn’t help at all ????????????????????????????????????????

  8. Leith,

    “Expectations of higher prices explain why bubble-era buyers were more willing to buy risky mortgage products and take on ever greater quantities of debt”

    Or, to say that another way, banks more willing to provide greater quantities of debt to bubble-headed buyers explain expectations of higher prices…

    Whilst this article is a realistic view on property I think that with all that has gone on, in the United States particularly, it is a very light-weight piece. The Economist has not covered itself with glory, calling a top in residential real estate since 2002. By crying wolf they have made your job harder. By not pointing the finger at the banks and regulators they are missing the systemic idiocy under which we live.

    Which leads me to…the unit of measure you use for Australian houses…the $A. Inflation in commodities (and houses) are only a bubble if faith is maintained (or restored) in the currency. We have entered a period of demand for hard assets. It remains to be seen whether Australia has skipped the deflationary bust before the crack-up boom.

  9. “Pro cyclical”.

    That word was used by the OECD in their report last year, “Bird’s Eye View of OECD Housing Markets”, which is also an excellent read.

    They commented that regulations in many countries tend to be pro cyclical.

  10. I don’t have the same regard for the Economist that it holds for itself. However, after reading its property bubble article I got the impression the author had left lots out due to lack of space which is perhaps why it seems a bit lightweight.

    That said I’ve only just come acros this blog inpart as I think about and research buying a house in Melbourne as an expatriate who has lived in London for nigh on 20 years. In this time I’ve see two property price crashes here in the UK, this one and the early nineties. Like Australia, no one (including myself) in the UK thought property would ever dive but once it happened people adjusted their outlook fairly quickly (which is perhaps a British thing). I’m wondering if people in Australia would also adjust their attitudes if prices crashed e.g. can anyone tell me if people on the Gold Coast have adjusted their attitudes since prices fell there or are they waiitng for free money to return?