Update 1 April 2017: I wrote this almost two years ago now, but it still feels relevant. I wanted to tighten it up a bit in terms of predictions; but I’m conscious that Robert Schiller managed to call the housing market a few years too early in the US. So, let me say that I expect articles to talk about the ‘housing crash’, and for apartment prices in Sydney and Melbourne, to decline significantly or stay flat for an extended period, from at least December 2021.
Original post published 15 May 2015:
There’s a lot of speculation about whether Australia’s housing market is overheated. It makes me wonder whether, in a few years (if I had to pick numbers I’d say 1-5), we’ll start to see articles about ‘why the housing crash was inevitable’. For me, that’ll be the marker of when the bubble has burst (obviously, assuming we have a bubble; the balance of the evidence suggests to me that we do, at least in some parts of the country).
Given that, I wanted to think about what the articles might say. Are there factors right now that will seem ‘inevitable’ in retrospect?
Disclaimer: Before I go any further, I should say that this isn’t financial advice, and if you’re making an investment decision you shouldn’t draw on this, but should seek independent (not because I’m not, but because so much of the industry isn’t), professional advice. I’m not an accountant, lawyer, or financial planner. And I don’t work in the industry or own a house.
I started by looking – is anyone talking about this already? There’s a little bit of material out there. Google shows:
- a piece on The Conversation by Phillip Soos, who is Australia’s biggest housing bear. He may be proved right, but even if he isn’t, he’s likely to keep saying the same thing. His piece is worth reading regardless, just for the link to a 2004 article predicting a US housing crash.
- a piece at an AFR magazine summarises some of the credit/monetary policy factors.
- Greg Jericho, who I usually find a good read, talks about ‘a housing bubble in danger of bursting‘
- A writer at the Business spectator talks about an ‘inevitable decline‘ in Sydney (writing in 2013), and a more recent article talks about ‘rampant house prices‘
- A 2014 article by Paddy Manning at Crikey talks about a ‘crisis in the making’
- Oh, and the chairman (not CEO) of ANZ said a correction is ‘inevitable‘. So there’s that.
Those are all pieces worth reading. But I want to step back and think about the bigger picture for a moment. If we do start to see articles that talk about the inevitable housing crash, what factors will they identify? Here are a few of my picks:
- Expectations by home-buyers that house-prices will always go up
- A financial sector that benefitted significantly from the housing market
- Tax policies that encourage speculation
- Monetary policy that all-but guaranteed a housing boom, and
- Poor regulation of the banking sector.
Expectations of house price increases
So, this is a huge one. I think there is a widespread expectation at the moment, in Australia, that houses are a good investment. I’m honestly sitting down to right this because I walked past a bank branch today and saw an ad that mentioned getting a ‘foot on the property ladder‘. That is definitely the wrong metaphor for investment, particularly investment in a lumpy, non-liquid asset.
Houses have some degree of risk, and there’s a real chance that prices will go down. Now, there are good reasons why people might think house prices will always go up – in Australia, for several decades, they have. This speech by Luci Ellis is a great explanation of the structural factors that drove that upwards trend. But those trends were largely one-offs, and they’re not a guarantee.
More persuasive, for me, is the arbitrage argument. If house prices are guaranteed to go up, then it’s free money; people will keep buying houses, until there’s no longer a guarantee that they’ll keep going up in price.
UPDATE: I finished reading Robert Schiller’s Nobel Prize lecture, which doesn’t directly relate to the topic, but when he touches on it, it addresses why people can maintain what I’m happy to call ‘unfounded’ beliefs for so long:
Whatever price people generally have come to accept as the conventional value, and that is embedded in the collective consciousness, will stick as the true value for a long time, even if the actual returns fail for some time to live up to expectations. If an asset’s returns are carefully tabulated and disappoint for long enough, people will eventually learn to change their views, but it may take the better part of a lifetime. And many assets, such as owner-occupied homes, do not have unambiguously measured returns, and a mistaken “conventual valuation” based on a faulty popular theory can persist indefinitely. The presumed investment advantages of, say, living in an expense land-intensive single family home near a big city rather than renting a cheaper and more convenient apartment in a high-rise there may just not exist, and most people will never figure that out. (p. 26; in referring to ‘conventional valuations’, one of the factors that he makes it clear he’s including later is failing to control for inflation).
Skewed incentives in the financial sector
This is a big one, and I’m not sure where to start. I think it’s fair to say that the Australian banking sector, and financial sector more generally, relies heavily on the housing market. Our banks are extremely profitable by international standards, and they’re heavily exposed to the housing market. It’s in their interests to get as many people into the most expensive properties they can, because it means bigger mortgages. In a market that has been profitable for years, banks have done well collecting a reasonable proportion of that profit.
There’s been plenty of outcry about the standards of financial planning in Australia (although we still don’t have a financial inquiry). But from some of the reading I’ve done, I think the mortgage broker market, though it may have been cleaned up a little, certainly had poor incentives, and to some extent still does.
Tax policies that encourage speculation
There’s a ton of stuff out there on negative gearing. I don’t think all of it’s as well explained as it could be, but the gist of it is out there. My take is essentially that negative gearing relies on an expectation of future house price increases (see above), and for the period that that’s been happening, it’s been an incredibly successful tax strategy for a number of people. However, as the Henry Review and others have pointed out, it effectively encourages investment that relies on asset prices rather than underlying income; effectively, making Keynes’ beauty contest even worse.
If you need evidence of the fact that the tax incentives are distorted, it’s in the instances where people are investing, negatively geared, rather than buying a home live in. Because investing in one is cheaper than buying outright. I’ve had people say to me it’s cheaper for them to live in a different home than the one they rent; and while it’s difficult to get figures, there are a few instances (including a recent briefing by Commbank) that mention this issue. For me, that’s a canary in a coal-mine indicator.
When the cash rate is at a historic low of two per cent, money is cheap. Granted, this one’s more complex than some of the others. Australia’s monetary policy is effectively determined overseas, or at least heavily influenced by monetary policy in other countries. Which puts the RBA in an awkward position, when it’s struggling to get the currency down to what it estimates is fair value.
Having said which, the RBA’s cuts have inevitably stoked an already hot housing market. I don’t have the expertise to weight the broader macroeconomic implications, but the risks in relation to housing are obvious; I suspect they will be even more so in retrospect.
Banking sector regulation
This one is also a big one, and to a certain extent ties in with the financial sector point I mentioned above. There are a few things that come to mind for me.
One is the risk weightings. Banks (ADIs more generally) are to some extent actually quite regulated; Basel III sets risk weights, which are enforced by APRA. But there are questions about if the risk weights are the right ones, and whether APRA could be pushing banks harder. Some of the Basel III weights are based on very strong assumptions about how safe mortgages are (the don’t require banks to hold as much capital to cover them).
And even though APRA’s found the banks aren’t very well prepared in its stress testing, it doesn’t seem like it’s doing much. It’s tried applying limits to investor housing, but at least some banks have breached those. It’s hard to know from outside the actual situation, but it seems like APRA could be doing a lot more. Oh, and there’s yet to be a response on a few key recommendations from the Financial System Inquiry, including particularly the one about capital requirements.
So, all those things are factors that I think will seem even more salient if someone has to look back, and explain how we ended up with a housing crash.
And what context will they be writing from? Here’s where we get even further into speculation. I want to acknowledge that I’m guessing here – but having said that, I think making testable hypothesis is a good idea. So I’ll guess that, depending on how far housing prices correct:
- Sydney will definitely see house price declines/flat periods – possibly other capital cities including Melbourne/Brisbane/Perth. It’s harder to know what happens outside capital cities – the markets are different there.
- Depending on how bad it is, it has broader implications. There are a few possible mechanisms:
– Loan contingency- some loans are backed by guarantees from other mortgages; effectively linking the loans, so that a default on one loan ricochets outwards.
– Banks – if they’re struggling, they may tighten up lending in general, reserving cash. That has implications for the economy. While our banks have increased their deposit funding, they still depend to some extent on borrowing from offshore, which is a big deal.
– Households – a lot of our spending is driven by the value people they have from increasing house prices. If house prices start to fall, so does our sense of economic security, and whoosh, their go the animal spirits (euphemism for confidence by consumers).
That’s probably enough unfounded speculation for me. In conclusion, I think this stuff is interesting, important, and worth thinking about.