Will Australian house prices be bad, ugly or disastrous?

Via Ian Verrender at the ABC:

Celebrated physicist Isaac Newton had a chequered career as a monetary mandarin and investor.

As Master of the Royal Mint, he helped reform England’s currency, the pound sterling, clamped down on counterfeiting and, in 1717, accidentally moved Britain to its first ever gold standard.

His record as an investor, however, wasn’t quite so illustrious.

Newton lost a fortune — around 20,000 pounds — in one of history’s most notorious market collapses, the South Sea Bubble, when the South Sea Company, primarily a slave trader, collapsed in 1720.

If only he’d remembered his early work as a physicist and applied his revolutionary theories on gravity to markets.

In an eerie parallel, Australian real estate, particularly in Sydney and Melbourne, now appears to be succumbing to Newton’s third law; that for every action, there is an equal and opposite reaction.

What goes up, must come down.

Last week, Sydney’s property market experienced its 12th straight month of declines while falls in Melbourne accelerated, sparked a flurry of warnings of impending doom.

The question now is: will the housing bubble deflate or burst?

The good

Aussie real estate has endured prolonged periods of decline before.

The two most severe, in the early 1890s and the 1930s were associated with severe global recession. The recovery was long and painful.

But there have been plenty of other periods where domestic property prices have dropped significantly without causing a broader economic Armageddon. In fact, since 1980, we’ve endured at least half a dozen such downturns.

Those declines generally have been modest — less than 10 per cent — and followed significant price gains.

Effectively, they were blips or plateaus in a long and steady climb and most were caused by a jump in interest rates.

The Federal Government and the Reserve Bank both are praying for a similar result this time. There’s some evidence to back up their optimism.

Here’s a brief list:

• The global economy, led by the US, is strengthening
• Local employment, a key factor, has been strong
• Our economic growth has been surprisingly good, jumping to 3.4 per cent in the June quarter
• Our dollar, currently threatening to slide below $US0.70, has been a potent force in protecting the Australian economy

And there is virtually no prospect of the Reserve Bank raising interest rates for at least another year.

The bad

We are now a full year into what so far has been an orderly correction, delivering what many Australians were demanding: more affordable housing.

That’s a decent period of time. But still the declines continue and there is every reason to expect they will fall further for an extended period.

Investment bank Morgan Stanley, like many forecasters, reckons we will see falls of 10 per cent, as a “base case”.

For the most part, the decline is being driven by credit restrictions. Less available cash for borrowers means less demand for housing. That means lower prices. And the man bearing the brunt of the ire from the real estate and financial world is Kenneth Hayne.

New home buyers’ credit crunch

There’s no doubt the Royal Commission into Banking Misconduct has caused a wholesale rethink within the industry as lax and irresponsible lending practices have been jettisoned. That can only be a good thing.

The blame for our current situation should be sheeted home to those who turned a blind eye to the rotten state of Australian banking, not those who have attempted to clean it up.

The east coast housing construction boom was created by a Reserve Bank keen to ward off an economic slowdown as the mining construction boom in the west rapidly wound down.

As rates were slashed, it refused to restrain real estate through macroprudential controls, opting to let the property boom rip.

The end result? Five years of profligate lending that has Australian households vying for top place as the world’s most indebted, at 130 per cent of GDP and 200 per cent of household income. Most of that borrowed cash was poured into real estate.

Australians have been able to keep on top of such a potentially punishing debt burden simply because interest rates have been at record lows.

But that tide is turning. While the Reserve Bank has no plans to raise domestic rates any time soon, it may be overtaken by global events.

The US has raised rates eight times in the past few years. It raised them again a fortnight ago and another is likely before year end.

Our major banks all borrow offshore. They will continue to pass on those higher costs, regardless of Reserve Bank movements, just as they did recently.

That doesn’t bode well for Australian households.

The ugly

The biggest threat to our housing market is unemployment.

Employment growth until now has been solid and, so far, there’s been only a modest uptick in loan delinquencies, concentrated for the most part in the mining states of Western Australia and Queensland.

But what happens if the downturn in east coast property prices brings the housing construction boom to a shuddering halt? Undoubtedly, there will be a large spike in unemployment. And that means increased housing loan defaults and further pressure on real estate following forced sales.

In that scenario, housing prices nationally would certainly fall well below the 10 per cent decline for which most are hoping, leaving many who bought a home in the past two years with debts greater than the value of their property.

Those fears were fanned late last week when building approvals for July crashed 9.4 per cent, led by a sharp drop in unit approvals. As a monthly number, the statistics are highly volatile. But there’s no doubting the trend is down.

Developers, fearing a worsening glut, clearly have begun to scale back their plans. That’s not surprising, given apartments overtook stand-alone houses for the first time in 2014 as the construction frenzy gathered pace.

That glut, according to Morgan Stanley, is likely to persist for several more years which alone would keep pressure on prices.

The other great unknown is the extent to which investors will dump properties if prices continue to slide. At the peak, investor loans made up nearly half of all property lending. That’s now collapsed with tighter restrictions on interest-only loans.

Unlike homeowners, who will do almost anything to keep a roof over their heads even if they are unemployed, investors are more likely to be motivated by a desire to minimise losses. So far, that has not occurred. But a sustained drop in prices could become a negative feedback loop as investors bail out.

According to Wayne Byers, the head of the banking regulator APRA, if the worst case scenario unfolds and prices drop as much as 35 per cent, its stress testing shows the banking system will remain intact, although individual banks will incur heavy losses.

“Credit growth appears to be slowing somewhat at the moment but that is not surprising in an environment of softening house prices and rising interest rates,” he told an Australian Business Economists gathering in an upbeat speech back in July.

Let’s hope his faith in our banks is on more solid ground than the Royal Commissioner’s confidence is in APRA’s ability to regulate them.

To seven internal shocks hitting house prices will see prices keep falling:

• macroprudentials two and three;
• royal commission;
• bank rate hikes;
• oversupply and immigration cuts;
• election and negative gearing reform;
• withdrawing Chinese investors.

I see a -15% fall on these forces alone. There is no way the economy can take that so the RBA will be forced to cut next year offering a brief respite

That’s before we get to the next global shock which will expose the RBA as out of ammunition with the Treasury a little better but also constrained. That adds another -15% downside risk.

The right question to ask is will Australian house prices be bad, ugly or disastrous?