Cross-posted from Martin North’s DFA blog.
In an address yesterday to the CITI Residential Housing Conference in Sydney, Luci Ellis, Head of Financial Stability Department at the Reserve Bank spoke about housing in the context of the financial system. Quite a bit of the speech covered aspects of relative population density, demand and supply. However, to towards the end of the speech, she spoke more broadly. I highlight some of the statements in bold.
“Our low-density cities have developed out of a postwar vision of Australian cities, of detached houses on quarter-acre blocks. State and Federal War Service Homes programs were designed on that vision; planning regulation enforced it. As a mode of living, low-density suburbia has its advantages. But it does mean that distances are greater and almost every trip requires a car. The only alternative offered at the time of our first mass suburbanisation seemed to be the ‘tower in the park’, Le Corbusier’s utopian dream of apartment living. But the reality turned out to be a nightmare of social isolation for the public housing tenants in those developments.
Let me be clear that I am not saying that the low-density, detached housing option should be phased out. It is the preferred choice of many households, but it is not for everyone. In the end, the aim should be to provide better choices, and a wider range of choices. I’m hopeful that the future brings Australians a wider range of places they would be happy to move to; different housing types for different family sizes and life stages; and a greater confidence that centres outside state capitals can offer the strong job markets and scope for entrepreneurship people need, and housing at a price they can better afford. That way, people can see an upswing in housing prices in the larger centres and say, ‘I don’t have to buy into that. I don’t have to stretch my finances’. Australian household finances are not looking that stretched at the moment, and we’d like to see it stay that way.
As we have said many times in the past, the 15 years or so to about 2005 saw housing prices rise noticeably faster than incomes. This was in large part a transition to a new equilibrium of lower inflation and interest rates, and thus higher debt and housing prices relative to incomes. That transition is over now. Housing prices are therefore going to be cycling around a slower trend than they did in the past. There will be more periods where prices are falling a little in absolute terms.
At an individual level, this means that there is less scope for rising markets to cover over your mistake if you fall in love with a property and overpay for it. At an aggregate level, it means there is little room for another round of property exuberance of the type we saw just over a decade ago, in 2002 and 2003. Australia managed to have its housing boom end without a major disaster. Plenty of other countries weren’t so lucky. Usually it’s the property developers that are the source of loan defaults and financial instability, not the households with mortgages. But an overstretched household sector is hardly a good environment to have if something should go wrong elsewhere in the economy.
That is why the Reserve Bank and the Australian Prudential Regulation Authority (APRA) have emphasised loan serviceability so much of late. Lenders have become more sophisticated in the ways they assess households’ capacity to repay mortgage loans. Most of them have moved beyond a crude approach of applying a blanket repayment-to-income test (APRA 2013). They are now more likely to take people’s actual living expenses into account, not just some version of the Henderson Poverty Line. After all, it doesn’t seem reasonable to expect people to have a poverty-level lifestyle to pay off a million-dollar home. Importantly, lenders are now more likely to apply an add-on to current interest rates when calculating the repayment they use in their serviceability tests. So as interest rates fall, the maximum size of loan that borrowers are offered does not increase as much, if at all. This is a prudent practice and, at the margin, it has probably reduced the risk in the mortgage book.
It’s fair to say that serviceability calculations are binding for first home buyers and less binding for trade-up buyers and investors. So it’s no surprise that as interest rates have fallen, it’s the trade-up buyers and investors whose demand has increased. Meanwhile first home buyers will feel squeezed out. This is probably more a cyclical phenomenon than a structural one. It is still probably quite disheartening for potential first home buyers. As such, it would not be a good outcome if they responded by overstretching themselves to try to get into the market during upswings. As well as being against first home buyers’ own long-run interests, that would increase risk in the financial system. As experience overseas has shown, you do nobody a favour by trying to solve an affordability issue by making it easier for people to borrow more than they can reasonably service.”
We highlighted the issues around affordability buffers recently, in the light of changes in the UK. We also made the link between income levels and low growth in housing credit.
I find it interesting that the speech made no reference to the hot investment sector, as highlighted in the bank’s recent Financial Stability Review.
“the investor segment is one area where some banks are growing their lending at a relatively strong pace. Even though banks’ lending to investors has historically performed broadly in line with their lending to owner-occupiers, it cannot be assumed that this will always be the case. Furthermore, strong investor lending may contribute to a build-up in risk in banks’ mortgage portfolios by funding additional speculative demand that increases the chance of a sharp housing market downturn in the future.”
So, recent warnings now about investment lending and first time buyer lending. The RBA appears to be expecting a potential correction in house prices, and a consequential impact on financial stability. As one of the drivers has been too low interest rates, and an attempt to stoke the property market, it seems to me they continue to be stuck in the middle. If a correction does occur, and I think it will, I suppose the RBA will be able to cite their recent statements as evidence we were warned. But they have the keys to the car, so is warning of hazards ahead enough?