This Time Had Bet­ter Be Dif­fer­ent: House Prices and the Banks Part 1

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Before the US house price bub­ble burst, its banks and reg­u­la­tors claimed (a) that there wasn’t a bub­ble and (b) that, if house prices did fall, it wouldn’t affect the sol­vency of the banks.

The same claims are now being made about Aus­tralian house prices and Aus­tralian banks. On the for­mer point, Glenn Stevens recently remarked that:

There is quite often quoted very high ratios of price to income for Aus­tralia, but I think if you get the broad­est mea­sures coun­try-wide prices and coun­try-wide mea­sure of income, the ratio is about four and half and it has not moved much either way for ten years.

That is higher than it used to be but it is actu­ally not excep­tional by global stan­dards.
(SMH March 16th 2011)

On the lat­ter, APRA con­ducted a “stress test” study of Aus­tralian banks in 2010, with the stresses includ­ing a 30% fall in house prices over 3 years:

Table 1: APRA Stress Test Table, APRA Insight 2010/2, p. 9

2009/10 2010/11 2011/12
GDP growth (%) (-3.0) 2.1 3.5
Unem­ploy­ment (%) 9.8 10.8 10.7
House Price Growth (%) (-11.8) (-12.1) (-1.7)
Com­mer­cial office prop­erty growth (%) (-21.5) (-9.4) 1.5

APRA’s con­clu­sion was:

The main results of the stress-test for the 20 ADIs, taken as a group, are as fol­lows:

  • none of the ADIs would have failed under the down­turn macro­eco­nomic sce­nario;
  • none of the ADIs would have breached the four per cent min­i­mum Tier 1 cap­i­tal require­ment of the Basel II Frame­work; and
  • the weighted aver­age reduc­tion in Tier 1 cap­i­tal ratios from the begin­ning to the end of the three-year stress period was 3.1 per­cent­age points. (APRA Insight 2010/2, p. 10)

So there’s noth­ing to worry about then? No bub­ble to pop, and no prob­lems for the banks if house prices fall any­way? In this post I’ll con­sider the argu­ment that there is no bub­ble because changed eco­nomic fun­da­men­tals jus­tify Australia’s rel­a­tively high house prices. In the next I’ll con­sider what the pop­ping of the bub­ble could mean for Aus­tralian banks.


Glenn Stevens’ claim that the house price to income ratio was “about four and a half” was almost cer­tainly rely­ing on research by Ris­mark. Ris­mark MD Chris Joye recently asserted that the house price ratio in Aus­tralia was 4.6, and though he con­ceded this was some­what high, he argued that it was jus­ti­fied by changes to eco­nomic fun­da­men­tals. He ridiculed the claim, made by The Econ­o­mist on the basis of a com­par­i­son of house prices to rents, that Australia’s house prices are 56% over­val­ued:

The Econ­o­mist does not ques­tion whether the old hous­ing ratios might be non­sen­si­cal to today’s home own­ers as a result of:

  • Fun­da­men­tal changes in the struc­ture of the econ­omy wrought by the fact that inter­est rates over the past 15 years have, on aver­age, been 43 per cent lower than inter­est rates in the 15 years that pre­ceded that period;
  • The fact that aver­age infla­tion since the mid­dle of the 1990s has been 55 per cent lower than infla­tion in the 15 years prior; or
  • The fact that the rise of two-income house­holds and the female par­tic­i­pa­tion rate in con­cert with a near halv­ing in the nom­i­nal cost of debt might have trig­gered a once-off upward increase in house­hold pur­chas­ing power, and hence hous­ing val­u­a­tions… (Chris Joye, A prop­erty bub­ble long shot, Busi­ness Spec­ta­tor March 25 2011)

For­mer RBA staffer and now HSBC econ­o­mist Paul Blox­ham was equally adamant: Aus­tralian house prices are a tad high, but they are jus­ti­fied by changed eco­nomic fun­da­men­tals over the last 15 years:

… a large struc­tural adjust­ment that occurred in the Aus­tralian hous­ing mar­ket between 1997 and 2003… involved lower inter­est rates, bet­ter-anchored infla­tion expec­ta­tions, and increased avail­abil­ity of hous­ing credit. With­out some rever­sal of these struc­tural changes – which is a vir­tual impos­si­bil­ity – we do not expect Aus­tralian hous­ing prices to fall…

Since late 2003 the dwelling price to income ratio has been broadly sta­ble at between 3.5 and 4.5 and has aver­aged 4 (see chart)…

We view the risk of a sharp fall in hous­ing prices as very low. (Paul Blox­ham, The Aus­tralian hous­ing bub­ble fur­phy, Busi­ness Spec­ta­tor March 18 2011)

Fig­ure 1: Rismark’s Dwelling Price to Income Ratio Chart

In other words, this time is dif­fer­ent.

They would say that, wouldn’t they?

The “this time is dif­fer­ent” argu­ment asserts that lower inter­est rates, lower infla­tion and higher income per house­hold (and more income earn­ers per house­hold) means that though the house prices to income ratio might higher than before, it’s noth­ing to worry about.

Tell that to a would-be first home buyer who’s con­tem­plat­ing tak­ing out a mort­gage. In 1992, the aver­age mort­gage for a First Home Buyer was $ 71,500. It is now $274,000.

Fig­ure 2: Aver­age First Home Mort­gage and Mort­gage Inter­est Rate

The “no bub­ble” argu­ment asserts that this has been coun­ter­bal­anced by the fall in inter­est rates—which were 12% then and are 7.8% now. So the aver­age first home buyer’s mort­gage is 3.8 times higher than it was two decades ago, while inter­est rates are 2/3rds what they were then. Does one—along with changes in income and demographics—counterbalance the other?

Not on your life: the increase in debt and debt ser­vic­ing has far out­stripped all the fac­tors that Joye and Blox­ham rely upon to argue that Australia’s house prices are not in a bub­ble.

I want to make this case slowly, so that you can see each step in the argu­ment, so let’s first look at the weekly inter­est and loan repay­ments on a typ­i­cal 25-year First Home hous­ing loan. Back in 1992, the weekly inter­est bill was $165; now it is $420—2.5 times as high. Repay­ments were $174; now they are $490—2.8 times as high.

Fig­ure 3: Inter­est up 2.5 times, repay­ments up 2.8 times

So have incomes risen suf­fi­ciently to mean that this almost three­fold increase in debt ser­vic­ing costs over 20 years is no big deal?

Not if you’re a wage earner! Aver­age before tax wages have risen from $505 a week in 1992 to $996 a week at the end of 2011—so they have almost dou­bled. Using an aver­age tax rate of 28%, that gives the aver­age wage earner $777 after tax a week today, ver­sus $394 back in 1992.

Fig­ure 4: Aver­age wages have risen by 97% since 1992

While wages have risen, the 2.8 times increase in loan repay­ments means that mort­gage pay­ments on an aver­age first home loan have gone from tak­ing 40 per­cent of after-tax income of the aver­age worker in the 1990s to 64 per­cent now—after reach­ing a peak of 74 per­cent in late 2008 before the RBA slashed inter­est rates (the ratio fell to 53 per­cent, and it would have fallen fur­ther had the First Home Ven­dors Boost not caused house prices to sky­rocket again).

In the early 1990s, a young wage earner could aspire to financ­ing a house pur­chase using his or her income alone. Now, that’s out of the ques­tion.


He’s a (young) Working Class Man Renter…

This is what the “no bub­ble” pro­po­nents don’t get: high house prices have become a class and age issue. If you’re a young “work­ing class man” on the aver­age wage, you can no longer afford to enter the hous­ing mar­ket in Australia—since the aver­age first home loan would con­sume over 60 per­cent of your after-tax wage.

Even if you’re a “young work­ing class cou­ple”, the cost of ser­vic­ing a mort­gage from wage income alone is pro­hib­i­tive. In the 1990s, a cou­ple (where both earned the aver­age wage) had about 80% of their income free for other costs after pay­ing the aver­age First Home mort­gage. The rapid esca­la­tion in house prices after Howard dou­bled the First Home Own­ers Grant in 2001 drove this down to under 65 percent—and most wage-earn­ing cou­ples sim­ply don’t have that much head­room in their bud­gets. They can’t pay the rates, the food bill, the petrol, and the edu­ca­tion fees, with less than three quar­ters of their after-tax income.

Fig­ure 5: Max Headroom–disposable income after pay­ing the mort­gage plum­mets as prices rise

Faced with this level of poten­tial debt-ser­vic­ing costs, young would-be house-buy­ers are giv­ing up on the dream of home ownership—and its atten­dant night­mare of debt peon­age. They’re also sign­ing up in droves to call for a polit­i­cal cam­paign against house prices by GetUp: see the Anti-FHOG, Anti-Neg­a­tive Gear­ing, and Buy­ers Strike cam­paign sug­ges­tions (and read David Llewellyn-Smith’s excel­lent piece on it in the Fair­fax press too).

A “Buy­ers’ Strike”, whether orga­nized or not, is what will end the Ponzi Scheme of debt-inflated house prices, because like all Ponzi Schemes it only con­tin­ues to work so long as new entrants out­weigh those try­ing to cash out.

Those who are try­ing to cash out—existing house own­ers who are sell­ing as spec­u­la­tors, or sell­ing to real­ize a paper cap­i­tal gain and upgrade to a more expen­sive house, or sell­ing an invest­ment prop­erty to fund their retirement—are now sell­ing into a dwin­dling mar­ket.

The first effect of this imbal­ance between demand and sup­ply is an increase in the time to sell, and in the num­ber of unsold prop­er­ties on the mar­ket. The sec­ond effect is a mod­er­ate fall in prices, once sell­ers who have to sell real­ize that they have to take a hair­cut. The third effect in Aus­tralia may well be an increase in sales by prop­erty spec­u­la­tors, if they see their cap­i­tal gains dimin­ish­ing the longer they hold on to their “invest­ments”.

The Scheme could be kept alive by a reduc­tion in inter­est rates to entice new buy­ers into the market—Australia’s float­ing rate mort­gages make it much eas­ier for the Cen­tral Bank to manip­u­late mort­gage rates here than in the USA—but even there, there’s a limit. To get mort­gage pay­ments back to 20% or less of the after-tax income of a cou­ple earn­ing the aver­age wage— with­out mort­gage lev­els falling, and hence house prices falling—the mort­gage inter­est rate would need to fall to 3%. This would require the RBA to drop its cash rate to zero from its cur­rent level of 4.75 per­cent.

Even if it does do that, it will take a very long time to do so—remember that Australia’s Cen­tral Bank was still rais­ing inter­est rates well into the GFC (it increased the cash rate to 7.25% in March 2008, and only start­ing cut­ting it in Sep­tem­ber when the cri­sis was already a year old). Mort­gages and house prices will have plenty of time to fall before that hap­pens.

Fig­ure 6: Australia’s Cen­tral Bank rate is almost 5% higher than the USA’s

This raises two ques­tions: how much could house prices fall, and what could be the impact of a fall on the financiers of this Ponzi Scheme: the banks?

I’ll con­sider the sec­ond ques­tion in a post next week; for now let’s do some­thing the “no bub­ble” crowd reg­u­larly refuse to do, and con­sider long-term data on house prices and incomes.

Fighting Magoo-nomics with long-term data

I some­times feel like I’m fight­ing Mr Magoo when I debate the non-bub­ble set: they choose a short-term data set and then tell me that what I’m pre­dict­ing can’t hap­pen because it has never hap­pened before. Yet there is long-term data to show that it has hap­pened before. They either ignore it, or find rea­sons to dis­miss it because it doesn’t meet their qual­ity stan­dards.

This is self-serv­ing. Older data will almost always not meet mod­ern stan­dards, sim­ply because it is old and, in most cases, sta­tis­ti­cal prac­tices have improved over time (one obvi­ous excep­tion to this is gov­ern­ment report­ing of unem­ploy­ment and infla­tion, where stan­dard have been dropped for polit­i­cal expediency—see Roy Morgan’s fig­ures on the actual unem­ploy­ment rate in Aus­tralia, and John Williams’ “Shad­ow­stats” infor­ma­tion on actual unem­ploy­ment and infla­tion in the USA). But the data exists, and unless it is out by a huge mar­gin, the infor­ma­tion it con­tains is worth con­sid­er­ing.

Joye’s points above about inter­est and infla­tion are a case in point here: “inter­est rates over the past 15 years have, on aver­age, been 43 per cent lower than inter­est rates in the 15 years that pre­ceded that period… aver­age infla­tion since the mid­dle of the 1990s has been 55 per cent lower than infla­tion in the 15 years prior”. That’s all true—but if you look back fur­ther in time, inter­est rates and infla­tion were lower in the 1960s than they are today. In the 1970s, though inter­est rates were higher than today, they were lower than the rate of infla­tion, so that the real inter­est rate was neg­a­tive.

Time Period Nom­i­nal Mort­gage Rate Infla­tion Rate Real Mort­gage Rate
1960–70 5.37 2.43 2.94
1970–80 8.62 9.76 –1.13
1980–95 12.71 6.69 6.02
1995–2011 7.55 2.78 4.77

If Joye and Bloxham’s “struc­tural changes mean this time is dif­fer­ent” case was valid, then mort­gages and house prices should have been higher rel­a­tive to incomes in the 1960s than today (let along the 1970s!) because inter­est rates and infla­tion were much lower then than now.

And were they? Here we have to do some detec­tive work, to com­bine the very brief ABS time series on house prices (which starts in 2002) with longer term house price esti­mates for Syd­ney and Mel­bourne put together by Nigel Sta­ple­don of UNSW (which starts in 1880 and ends in 2005). Though put together with very dif­fer­ent method­olo­gies, the over­lap is good for the 3 years they share in common—especially for Mel­bourne.

Fig­ure 7: Two meth­ods for esti­mat­ing house prices with com­pa­ra­ble results

It’s also pos­si­ble to derive an implied ABS median house price for Syd­ney and Mel­bourne by com­bin­ing the ABS’s median house price index data—which goes back to 1986—with its price data from 2002 on. Stapledon’s data also fits this series very well—again, espe­cially for Mel­bourne.

Fig­ure 8: They’re also con­sis­tent over the last 25 years when com­bined with ABS Index data

Given this close cor­re­spon­dence, I’m will­ing to use Stapledon’s data as a rea­son­able guide to what median house prices were before the ABS began col­lect­ing house price index data.

Fig­ure 9: Esti­mated median prices for Syd­ney and Mel­bourne using Stapledon’s data till 1986 and ABS after­wards

Now we can com­bine this data with ABS and RBA data on dis­pos­able incomes, pop­u­la­tion and the num­ber of dwellings to see how the ratio of house prices to dis­pos­able income has fared over time.

Fig­ure 10: A tripling of house prices com­pared to incomes over the last 50 years

There are var­i­ous prob­lems with this com­par­i­son:

  • It com­pares median house prices to aver­age incomes, and there­fore under­states the median to median (or aver­age to aver­age) com­par­i­son by about 25 per­cent;
  • The ABS Index only cov­ers free-stand­ing houses, thus over­stat­ing (prob­a­bly also by about 25 per­cent) the median price level by omit­ting cheaper apart­ments;
  • It doesn’t account for dif­fer­ences in aver­age dis­pos­able incomes by city, thus over­stat­ing the ratio for Syd­ney and Mel­bourne, but under­stat­ing it for the other cities.

But over­all it’s a rea­son­able guide to some­thing we des­per­ately need more infor­ma­tion on, and the over-time com­par­isons are valid. An aver­age-income house­hold could have pur­chased the median house in Syd­ney with less than 2 years of dis­pos­able income in 1960; it now takes over 6 years—and at the peak, it took 8 years.

What’s more, the ser­vic­ing cost of this debt was lower in the 1960s than it has been for the last decade, because mort­gage rates were 30% lower back then.

So much for Stevens’ claim that “the price to income for Aus­tralia … is about four and half and it has not moved much either way for ten years”. The myopic focus of “no bub­ble” com­men­ta­tors on the last 10 years of data ignores a bub­ble that, since 1985, has dou­bled the rel­a­tive cost of buy­ing a house. Since the early 1960s, when the old­est Baby Boomers were buy­ing their first prop­er­ties, it has tripled the cost.

To restore the house price to income ratio that applied in 1985, before this bub­ble really took off, house prices would have to fall by 50 per­cent com­pared to incomes.

The final refuge of bub­ble deniers is a claim that I’ve heard much less of in recent years—after the US Bub­ble clearly burst in 2006—but which is still worth address­ing: that house prices always rise faster than con­sumer prices over the long term. The best empir­i­cal retort to this is the price index com­piled for Amsterdam’s most expen­sive canal from 1628—just before the Tulip Craze began—till 1973. There were lengthy peri­ods where prices gen­er­ally went down in real terms, and equally lengthy peri­ods where they went up. It was pos­si­ble to be born when a long term slump began, and die at a mature age believ­ing that house prices always fall; and ditto for believ­ing, from your own expe­ri­ence, that they always rise. But over the very long term, there is no trend.

Fig­ure 11: Ams­ter­dam prices; booms and bust over 350 years, but no trend

Driving Miss Bubble

There were two main dri­vers of this bub­ble: a finan­cial sec­tor that makes money by cre­at­ing debt, and a gov­ern­ment sec­tor that has (to some extent unwit­tingly) used asset price manip­u­la­tion as a cheap means to stim­u­late the econ­omy.

The impact of the gov­ern­ment is obvi­ous when you over­lay the First Home Own­ers Grant over the house price to income data.

Fig­ure 12: The FHOG lifts prices and stokes the debt-dri­ven econ­omy

Sta­tis­ti­cally, its impact sticks out like a sore thumb as well. Between 1951 and when the FHOG was first intro­duced (in 1983), the aver­age quar­terly change in real house prices was 0.07 percent—or effec­tively zero. After it, the aver­age quar­terly change was just shy of 1%. When the Scheme was in oper­a­tion (it was not in oper­a­tion dur­ing the 1990s), the rise was 2% per quar­ter; on the two occa­sions when the Grant was dou­bled, real house prices rose by 3 per­cent per quar­ter.

Nor­mal Stats Before FHOS After FHOS All Data Dur­ing FHOS Between FHOS peri­ods When FHOS dou­bled
Mean 0.07% 0.95% 0.47% 2.17% 0.26% 3.10%
Min –5.53% –3.73% –5.53% –2.26% –2.26% –0.92%
Max 3.91% 7.86% 7.86% 7.86% 2.95% 4.93%
Std. Dev. 1.73% 2.17% 1.99% 2.71% 1.27% 1.83%
Count 131 108 240 25 50 7

On all but one occa­sion, the Grant was used as a macro­eco­nomic tool—a cheap way of boost­ing the econ­omy dur­ing a down­turn, whether actual or feared (the one other time—when Howard revived it in 2000—it was as a “tem­po­rary” sup­port to the build­ing indus­try when the GST was intro­duced; that tem­po­rary sup­port has now lasted almost 12 years).

The Grant works because the rel­a­tively small gov­ern­ment grant is lev­ered not once, but at least twice. Firstly the First Home Buyer’s bor­row­ing capac­ity is boosted by the lender’s Loan to Val­u­a­tion Ratio—so $7,000 to the bor­row­ers becomes some­thing north of $50,000 for the ven­dors with today’s sky-high LVRs. Then the ven­dors use the addi­tional cash they received as increased deposits for their next pur­chase.

The banks are happy to fund this process, because they make money by cre­at­ing debt, and are there­fore always look­ing for avenues by which it can be cre­ated. When bor­row­ing is based upon expected future income, or even aimed at fund­ing con­sump­tion today, cre­at­ing addi­tional debt is hard. But if bor­row­ers can be per­suaded that there’s money to be made by bor­row­ing money and spec­u­lat­ing on asset prices, there is—for a while—an easy means to cre­ate more debt.

Ever since 1990, that’s been the secret to both the house bub­ble and the prof­itabil­ity of Aus­tralian banks. They’ve made their money by financ­ing Australia’s prop­erty bub­ble; they started to do so the moment the pre­vi­ous spec­u­la­tive bubble—the one that gave us Alan Bond and Christo­pher Skase—died out; and, though the spin is that the USA had irre­spon­si­ble lend­ing while Australia’s lenders were pru­dent, mort­gage debt grew three times more rapidly in Aus­tralia than in the USA, and reached a peak 18 per­cent higher than the USA’s.

Fig­ure 13: Aus­tralian banks have been respon­si­ble lenders? Com­pared to whom?

The growth of this debt is what really drove house prices higher, and now that our mort­gage debt to GDP ratio is start­ing to turn, so too are our house prices—just as in the USA.

Fig­ure 14: Ris­ing debt drove the US bub­ble up, and slow­ing debt caused it to burst

The only thing that delayed this process in Aus­tralia was the last gasp of the First Home Ven­dors Scheme under Rudd, which turned a nascent decline in Australia’s mort­gage debt to GDP ratio into a final fling of the debt bub­ble. Had the trend con­tin­ued, the mort­gage debt to GDP ratio would have fallen about 2 per­cent. Instead it rose over 6 per­cent, inject­ing about $100 bil­lion of addi­tional debt-financed spend­ing into the Aus­tralian econ­omy. It was a major fac­tor in Australia’s appar­ently good per­for­mance dur­ing the finan­cial cri­sis, but as one my blog­gers remarked, it worked by “kick­ing the can down the road”.

Fig­ure 15: The same dynamic is play­ing out in Aus­tralia, though delayed by the FHVB

We all know what hap­pened to the US finance sec­tor after the US house price bub­ble burst. In the next post I’ll con­sider what could hap­pen to Aus­tralian banks as our bub­ble ends.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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