Defending the bubble by Leith van Onselen

In March 2011, HSBC’s chief economist, Paul Bloxham, made the following claims in relation to Australia’s housing bubble:

Without some reversal of these structural changes [lower interest rates, better-anchored inflation expectations, and increased availability of housing credit] – which is a virtual impossibility – we do not expect Australian housing prices to fall.

Indeed, we expect them to track sideways in the short term and then rise in line with household disposable incomes – consistent with recent history.

Australian house prices then preceded to fall throughout 2011:

Last week, Bloxham released a new report looking at Australia in 2012 and arguing, among other things, that there is no Australian housing price bubble. The following extracts of Bloxham’s argument are taken from this Property Observor article.

The first reason, according to Bloxham, is the well trodden argument that Australia’s household debt, although high, is concentrated with those that are most capable of servicing/repaying it:

First, although aggregate household debt is high in Australia, it is well-allocated to households that can afford to service it. Around three-quarters of household debt in Australia is held by the top two income quintiles (Chart 32). These households also typically have significant equity built up in their properties and assets. Indeed, a significant proportion of this debt is held against a second property, to take advantage of the mortgage deductibility on investment properties. Around one-fifth of Australian households have a second dwelling.

He also notes that the debt-to-income rate has been broadly steady for the past five years, and has been declining modestly over the past year.

“Despite the decline in housing prices last year, non-performing housing loans also remained a very small share of total loans and significantly lower than in other developed countries.”

Mr Bloxham might not be aware that prior to its bubble burst, the US had a similar concentration of housing debt in high income groups, according to Morgan Stanley:

I also find Mr Bloxham’s faith in property investors curious in light of the following facts:

According to the most recent Australian Tax Office (ATO) statistics, there are 1.7 million property investors in Australia, 1.1 million of which are negatively geared;
Aggregate annual rental losses reported to the ATO totalled 6.5 billion, or around $4,000 per property investor. Those investors holding negatively geared properties lost on average $10,000.
According to the Australian Bureau of Statistics (ABS), nearly three quarters of Australia’s second homes (by value) are held by those aged 45 or older, with the baby boomers holding over half of these properties.

Given that the baby boomers are gradually moving into retirement and will lose the taxation benefits associated with negative gearing once retired, combined with the fact that most investors are losing money on their investments and that the outlook for property is flat to falling, what’s to stop Australia’s loss making investors from selling down their holdings and putting significant downward pressure on house prices?

In my view, investors are a far bigger threat to the Australian housing market than owner-occupiers as they are likely to be less emotionally attached to their property and are more likely to cut-and-run. Perhaps Bloxham should read these two recent Federal Reserve papers (here and here) on the significant role played by housing investors in the recent US housing bubble/bust.

The second reason Bloxham provides for why Australian housing is not a bubble is the tired claim that Australia’s housing supply is running below demand:

On the second point of housing supply, Bloxham says construction of housing is still “well below the cumulative demand that exists”.

“Most industry estimates suggest a shortage of around 100,000 homes, which is over two-thirds of one year’s production. While population growth has slowed to be in line with growth in the number of dwellings, construction has yet to catch up with the demand overhang.”

Lastly, he says there are significant constraints in the supply of additional dwellings close to the urban centres, and thus within a reasonable distance to employment in the urban centres.

“For these ‘high-quality’ dwellings there is strong demand and limited supply. Supply is constrained by zoning regulations, a lack of willingness of local governments to allow further urban infill in the major cities, and the lack of quality transport infrastructure.

“Despite its artificial nature, this is still a constraint. Unless this constraint is lifted – which seems unlikely to occur rapidly – the supply of dwellings close to urban centres will remain low relative to demand, supporting prices,” he says.

Basic economics tells us that strict land-use (planning) regulations steepens the supply curve, which makes house prices far more sensitive to changes in demand and increases the likelihood of the housing market experiencing boom/bust price cycles as demand rises/falls. Tight planning and unresponsive supply does not necessarily mean that prices will be supported; rather that price falls will be exagerated if/when demand collapses. This is a topic that I have written about many times before, for example here and here.

To illustrate my point consider the San Francisco Bay Area, which I have chosen as a case study because:

it is one of the mostly highly desirable places to live in the United States, if not the world;
it is coastal, like Australia’s major cities; and
it has one of the strictest planning systems in the United States, with the eight counties in the San Francisco Bay area in the mid-1970s drawing urban growth boundaries that excluded most of the region from development, as well as lengthy planning delays, NIMBYism, and significant development costs being commonplace.

As shown by the below chart, San Francisco’s dwelling construction rate has also trended down at the same time as its population has risen:

Yet San Francisco’s home prices have collapsed – down by 40% – since 2006:

Using Bloxham’s logic, this should not have happened as San Francisco’s demand has been running ahead of supply!

Finally, Bloxham argues that the main risk to house prices is rising unemployment:

Bloxham says the main risk to the housing market is a sharper increase in unemployment, which he says is the “typical trigger of rising loan arrears”.

But, he says, the RBA has a powerful tool for providing support for the housing market and employment.

“While we expect the unemployment rate to rise further from here, we expect it to peak around the middle of the year, before falling as expected RBA rate cuts provide support for the economy.”

While I agree with his argument that unemployment is key, it should be noted that the sharp falls in employment that occured in other nations – the United States, the United Kingdom and Ireland – all occured after house prices began falling. Further, with the large lay-offs looming across the financial sector, retailing, manufacturing and potentially the construction industry, Australia’s unemployment is likely to get worse before it gets better.

None of this means that the Australian housing bubble will imminently burst, supported as it is by 140 year terms of trade highs. But it certainly does mean that it is a bubble.

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