Don’t Put Your House on it

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Don’t Put Your House on it

What happens if Australia’s property market goes in a similar direction to that of the United States and, increasingly, the United Kingdom? The implications for the American and British banking systems have been far reaching with both economies in, or teetering on the edge of, recession. Will similar problems start to beset the Australian banking system and, by extension, the Australian economy?

Possibly not. On the face of it, house prices are extremely high, 30 per cent above the 80 year average. Australian house prices are among the most expensive in the world. According to the consultancy Demographia, they are in the “severely unaffordable” range, when compared with median household incomes: about a fifth more expensive than houses in the United Kingdom and almost double American prices (on the relative measure). Viewed purely as a financial asset, a severe correction seems almost certain.

Yet there are a number of countervailing forces. One is a shortage of housing supply, exacerbated by high levels of immigration into Australia’s capital cities. Another is that housing loans in Australia are not non-recourse loans as they are in America. This means that in America lenders can hand back the keys to a house and all they have is a bad credit rating. In Australia, defaulters still owe any money that is not recouped by the sale of the house. Accordingly, they stay as long as they can in the house. Better to be indebted and in a home than indebted and homeless.

The effect of Australia’s unusually generous negative gearing laws also favours property as a financial asset, reducing the likelihood of a sharp fall. But with more than a million households predicted to experience some kind of mortgage stress, according to Fujitsu Consulting, the possibility for a sharp sell-off certainly exists.

If there is a sharp downturn in housing, it could set off a negative spiral by forcing banks to reduce lending to accommodate weaker asset prices, which in turn would contribute to weaker asset prices. The possibility exists of something akin to a credit squeeze. In the short term, the four main banks have been lending aggressively to soak up the market share vacated by the non-bank lenders and regional banks. They now dominate most of the new lending.

But this process is almost over, and the banks are now moving into a deleveraging phase to reduce their exposure. At the moment, the leverage ratio of Australian banks is 18 times equity, the highest level since the Asian financial crisis and “entirely inconsistent with a slowing economy”, according to a report by Goldman Sachs JBWere.

The report estimates that if the value of assets on balance sheets for all financial intermediaries were to fall by 0.5 per cent, or bad debts rose by 0.5 per cent, then the leverage ratio of banks would rise. This could mean that the cycle of easy money leading to a bubble in the property market could turn into its opposite: restricted or expensive money that ends up pricking the property bubble.

If property assets on banks’ balance sheets were to fall sharply – be it houses or commercial property – the leverage ratios would rise even higher. That would encourage banks to reduce lending, something they are already intent on doing (despite their leverage ratios being much more healthy than their American or British counterparts).

Goldman Sachs estimates that just reducing banks’ current leverage from 18 back to a more acceptable 16 times would require credit to slow by $180 billion. If the value of their assets were to fall sharply because of a sharp property price fall, or because their bad debts continue to spiral – both the Australian and New Zealand Banking Group (ANZ) and the National Australia Bank (NAB) recently reported billion dollar write downs – then the credit taps could be turned off even more aggressively.

Australia’s stock of wealth is skewed more towards property than in the United States. The so-called “wealth effect”, where rising house prices give owners the impression that they are rich, encouraging them to consume more aggressively, is more applicable to Australia than America. Accordingly, a sharp fall in house prices would probably have a more depressing effect on consumer sentiment and the overall economy.

The total value of shares on the Australian Securities Exchange is about $1.5 trillion. The total value of Australia’s 8.3 million dwellings is $3.7 trillion. In the United States the value of houses and shares is more in balance. The stock market is worth $US15 trillion, while the housing market is worth about $US20 trillion. In the United Kingdom, the stock market is only about a third of the value of housing, which is over $9 trillion, and so a “negative wealth effect” would be felt more keenly.

Look closer and more than a third of the capitalisation of the Australian stock market is accounted for by the financial sector (including property trusts). These companies derive a substantial portion of their business from property lending. The conclusion? Australia is not so much riding on the sheep’s back as on the roof of stellar house prices.

The mining boom in Australia is being depicted as an epochal shift in Australia’s industry base. Less noticed is that it follows another profound change in how the Australian economy is structured. Over the last two decades, the industrial economy has been replaced by a financial economy. “We have made money for each other by borrowing and building houses and taking fees off that,” says one fund manager. “It equals a balance of payments problem.” Capital, especially banking capital, was kept thin, mainly through the use of off-balance sheet mechanisms.

This shift to the financial economy has in Australia been inseparable from the rising value of property, and it poses a threat to the banking system. It is true that domestic banks have mostly avoided the excesses of sub-prime mortgage lending and the credit crisis that are crippling the American financial system and increasingly harming British banking.

Australian lending practices have for the most part been more sane. The big write-downs by the NAB and the ANZ, big as they are, can justly claim to be on the margin. If many American and European banks were so aggressive in writing off their exposures to collateralised debt obligations and other forms of securitised instruments, they would probably no longer be in existence.

The heavy dependence of Australia’s capital base on property still makes Australian banking, and the economy, vulnerable to a downturn in prices. Australia’s financial system may have avoided the post-modern absurdities of the current global credit crisis, with its blizzard of meta-instruments underpinned by Triple-A ratings that apparently are not worth the rating agency they are written on. The NAB’s 90 per cent write-down of $1.2 billion of securities backed by US home loans was all theoretically Triple-A debt.

But the financial system is still vulnerable to a more conventional credit squeeze because of a fall in property values. The rise in local house prices cannot be divorced from the series of global asset bubbles that have emerged since 2001 as a result of the US Federal Reserve’s loose monetary policy, sparked by its efforts to avoid Japan-style deflation. This led to an era of cheap debt that Australian financial companies, particularly real estate property trusts, exploited aggressively.

It also led to many Australian businesses profiting from borrowing and investing in property. JP Morgan analyst Brian Johnson notes that the surge of business lending since 2002 is not explained by concomitant increases in capital expenditure or inventory build up. Instead, the debt was channelled into  commercial property on an increasingly geared basis, pushing yields on commercial property at the end of 2007 down to historical lows compared with interest rates.

That game is well and truly over. But it only serves to further underline how dependent the Australian economy has become on its property bubble.

On the face of it, Australian banks are not especially vulnerable to a run on housing. A “stress test” by the investment bank UBS, for instance, recently concluded that there would only be total major bank mortgage losses of approximately $1 billion if there is a recession similar to that now afflicting the United Kingdom. UBS suggested that the Commonwealth Bank would have possible losses of $300 million, the NAB and ANZ $250 million and Westpac $200 million.

But if there is one lesson from the global credit crisis, it is that assumptions about risk management are not always reliable. In fact they can be downright dangerous. Nasty surprises can and do occur, and the easy ride of the last five years seems to have turned vicious.

The “finance economy” that has so benefited the Australian stock market and Australian economy appears to be at the end of its run. Until the credit crisis, property was scarce, and capital and most consumers goods plentiful.

Now, capital is scarce, although arguably housing property is also still scarce in Australia. However, new scarcities are emerging that will shift attention away from property. Most obvious are price rises in fuel and food, but increasingly energy will become problematic. The notion that nothing is safer than “bricks and mortar” seems to have run its course, and the stresses on Australia’s financial system may prove to be severe.