Guest Post: Reflections on Australia's Housing Bubble

Submitted by Leith van Onselen

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Read more at Australia's Housing Bubble



Blowing Bubbles

I watched an interesting interview with Jim Chanos on the Chinese Property Bubble. Jim Chanos is an American hedge fund manager of Kynikos Associates, a New York investment company that is focussed on short-selling (profiting from the fall in the value of an asset).


Mr Chanos rose to fame in 2000-01 when he identified flaws in Enron Corporation’s accounts, resulting in management significantly overstating the company’s earnings. Chanos began short selling Enron and made massive profits as the company’s stock declined from $90 in August 2000 to a low of nearly $1 near the end of 2001. Chanos’ ability to find and then exploit the fraud at Enron has made him somewhat of a celebrity in the financial press.

In his latest interview, Chanos warns that China is experiencing a severe real estate bubble and is headed for a crash; rather than the sustained boom that most mainstream economists predict.

Chanos first defines what he means by a bubble: a debt fuelled asset inflation where the rental income does not cover the debt expense incurred to purchase the asset. In other words, ‘Ponzi finance’ that requires the ‘greater fool’ and ever-increasing levels of debt to perpetuate it.

After watching Chanos’ interview, I thought I’d examine how Australia’s residential housing market stacks up under his definition in order to determine whether we are experiencing a speculative housing bubble or asset inflation based upon sound fundamentals.



Up, Up and Away:

Anyone under the age of 40 and living in an Australian capital city knows first hand that it is becoming increasing difficult to find a decent, reasonably priced home within a reasonable commute to work. We’ve all watched in amazement, disbelief or dread as we, our friends or family are priced-out of the housing market or take on mortgages the size of a small African nation simply to put a roof over our head. But how expensive have Australian house prices become? Where has the money come from? And is this house price growth sustainable?

To answer the first question, Chart 1 plots average Australian established house prices (sourced from the Real Estate Institute of Australia) against average Household Disposable Incomes (HDI) and Average Full-Time Ordinary Earnings (AFTOE).

As you can see, the ratio of house prices to average earnings started at around 2.5 times HDI and 3.7 times AFTOE in 1986. This ratio increased slowly from the mid-1980s to 2000, rose rapidly from 2000 to around 2004 and then settled at around 6 times HDI and 7.7 timed AFTOE in 2008/09.

While you can argue about the choice of house price data and income measures, the fact remains that the trend in prices is clear – housing has become far more expensive overtime and Australians are now required to dedicate a much larger proportion of their lifetime’s earnings to purchase a home.



Buy now, pay later:

Since the growth in house prices has significantly outpaced the growth in incomes, it follows that rising debt levels have been the key contributor to rising house prices in Australia, since the only way to purchase something that you cannot afford through income is to borrow the difference. Chart 2 uses RBA data to plot the level of mortgage debt against HDI and GDP.

As with Chart 1, Australian mortgage debt has increased significantly from around 32 per cent of HDI and 12 per cent of GDP in 1990 to 138 per cent and 89 per cent respectively at the end of 2009.

Based on the above data, we can confidently conclude that Australia’s house price growth has been debt-fuelled, thereby fulfilling the first criterion of Chanos’ bubble definition.


If you can’t buy it, rent it:


So what about the second part to Chanos’ bubble definition – the requirement that the rental income does not cover the debt expense incurred to purchase the asset, thereby requiring ‘Ponzi finance’ and ever-increasing levels of debt to sustain asset (house price) growth?

To determine whether this part of Chanos’ definition has been met, Chart 3 uses ABS data to plot the growth in real (inflation-adjusted) house prices against the growth in real rents. For this criterion not to hold, we would require rents to have increased at roughly the same rate as house prices such that rental incomes broadly cover the cost of debt repayments.

Ouch! According to the ABS, real rents have increased by only 14 per cent since 1987 while real house prices have risen by a whopping 163 per cent over the same period! It is no surprise then that yields on rental houses have plummeted from around 8 per cent in 1987 to around 3.5 per cent currently (Chart 4).

Remember that the rental yields shown above are before deductions for property expenses such as rates, land tax, maintenance and agents fees. If you take these costs into account, then current net rental yields would likely be tracking around 2.5 per cent, well below the current discount variable mortgage rate of around 7 per cent. Put another way, the average new housing investor would incur a pre-tax income loss of around 4.5 per cent on every dollar invested in housing!



The data, therefore, strongly suggests that the Australian housing market is being underpinned by Ponzi finance, whereby investors and owner occupiers are leveraging up to buy property in the hope of achieving rapid capital growth (in the case of investors) or ‘getting in’ before prices increase further (in the case of owner occupiers). With the significant negative income returns from residential property, the only way that house prices can continue to increase faster than incomes is if buyers continue to believe that prices will rise and that large capital gains can be made by selling the same asset to other buyers (the ‘greater fool’). Such a scenario requires ever-increasing debt levels, which is clearly unsustainable.



This hypothesis is broadly supported by this recent investigation by the Economist, which found Australia’s housing market to be the most overvalued in a sample of 20 countries using an average price-to-rents methodology. Similarly, the IMF recently found the Australian housing market to be amongst the most overvalued in the OECD based on price-to-rents and price-to-incomes


Aussies love a punt:


So who is to blame for the rising debt levels and spiralling house prices? Is it the property investors encouraged to pile into rental housing by Australia’s peculiar tax laws? Is it owner occupiers that simply expect too much and are willing to pay any price to buy the home of their dreams? Or is it the banks for providing easy credit?


In my opinion, all factors are to blame. It is certainly true that investors have significantly added to housing demand and prices over the past two decades, as evidenced by investors’ share of total mortgages increasing from around 14 per cent of total mortgages in 1990 to around 30 per cent currently (Chart 5).

And thanks to negative gearing - which allows landlords to deduct interest and other expenses against other income for tax purposes, without limit - the number of property investors claiming rental losses has skyrocketed. According to the 2007-08 Australian Taxation Office Statistics, there were around 1.7 million property investors claiming deductions in 2008. Of these, 1.2 million, or 69 per cent of property investors (1 in 10 taxpayers) claimed net rental losses, with total net rental losses equalling a massive $8.6 billion! By comparison, there were around 1.1 million property investors claiming deductions in 1995-06, with 56 per cent of these claiming net losses.



The impact of negative gearing on encouraging property speculation was also compounded by the Howard Government’s decision to halve the rate of capital gains taxes in 1999. Taken together, these two tax measures enable property investors to partly socialise any losses incurred through holding investment property, whilst privatising any gains achieved through capital appreciation.



Of course, some increase in investors was to be expected, even without the generous tax concessions, given the Baby Boomer generation – the largest generation in history – began to hit peak earnings age (45 to 55 years) from 1990. And as the Boomers and others realised that they had not saved enough for their retirement, they began buying up investment properties on masse as a way of catching up in a hurry, helped along of course by a proliferation of tacky property investment seminars marketing slogans like: “THIS WEEKEND CAN MAKE YOU A MILLIONAIRE” and continuous segments on tabloid television showing every man and his dog making fortunes on the back of property.




Keeping up with the Joneses:



Owner occupiers don’t escape blame either. Thanks to our unspoken desire to impress our neighbours, colleagues and friends, there has been a remarkable increase in the size of our homes. According to Clive Hamilton’s book Affluenza, and reiterated in Ross Gittins’s book Gittinomics, between 1985 and 2000, the average floor area of new houses increased by almost a third, while the average number of people per house has decreased from 3.60 in 1960 to around 2.56 in 2008 (see my previous post). So we, as a society, have been prepared to pay more for larger, better quality homes; although, some of this increase in the size (price) of our houses has been partly offset by a reduction in the size of the average block of land.



The Baby Boomers reaching peak earnings age from 1990 is also likely to have significantly increased demand (and prices) for owner occupier homes, since many in this demographic would have traded up to their most expensive (‘peak’) home over this period.



Finally, we cannot forget the significant role that government policy – in particular the introduction of the First Home Owners Grant in 2000 and the more recent First Home Owners Boost – played in enticing first-time buyers into the market and significantly boosting housing demand. Combined with elevated levels of competition from property investors and runaway house prices, first time buyers have increasingly felt the need to leverage up with debt in order to ‘get on the property ladder’ before prices rise beyond their reach.



If you can’t borrow the money, you can’t pay a high price:


While there are many factors that have increased the demand for housing - such as tax concessions, subsidies paid to first-time buyers, and Baby Boomer Demographics – in the end, the extra demand for housing can only feed into higher prices if credit is readily available, enabling buyers to borrow large sums and pay high prices. Put simply, the supply of credit is the crucial ingredient to sustaining high house prices.



As explained in the excellent book, The Great Crash of 2008, it was the rise of the non-bank lender in the mid 1990s - raising funds via securitisation activities on the wholesale debt markets - that initially caused an intensification of competition among mortgage lenders (Chart 6 tracks their growth against bank mortgage lending). It was these non-bank lenders, whom have no formal regulator and no rules outside of regular trade practices and corporations law, which led the decline in Australian credit standards from the mid 1990s by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (subprime) loans just before the Global Financial Crisis intervened.

Faced with this new competitive threat, the banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore. Gone were the days of requiring a minimum 20 per cent deposit and the banks funding their loan portfolios from domestically sourced funds (mostly deposits); instead, 5 per cent deposits became commonplace funded increasingly by the banks issuing bonds to foreigners.

As shown in Chart 7, the percentage of bank liabilities funded from foreigners has increased from just over 5 per cent in 1989 to around 22 per cent currently, totalling nearly $500 billion! Over the same period, the banks increased the proportion of loans channelled into housing, with housing loans increasing from around 35 per cent of total lending in 1990 to 56 per cent in 2010.

Anyone seeking an answer as to why Australia owes so much money to foreigners only has to look to the contemporary banking model of borrowing offshore to pump up housing (Chart 8).

With the banks awash with funds - sourced from both domestic and foreign sources - and with a higher proportion of bank assets (loans) being directed into housing, is it really a surprise that house prices and household debt has exploded over the past two decades?



The key risk is that Australia’s ability to sustain current house prices, let alone further price increases, rests with the willingness of other countries to continue lending the banks money. But in times of crisis, such as when Lehman Brothers collapsed, foreigners tend to zip up their wallets, leaving our banks, house prices, and broader economy exposed to a sudden liquidity shock as the banks are unable to roll-over their foreign borrowings (let alone increase them).



Few people realise that the Australian Government’s October 2008 guarantee of bank funding and deposits was issued after the larger banks made it clear to the Government that they were facing extreme difficulty in rolling over their wholesale funding, meaning that they would have to immediately withdraw credit from the Australian economy and would eventually face insolvency. So while it might be true that Australia’s banks managed credit risk well, avoiding the excesses of the sub-prime lending prior to the onset of the GFC, their heavy offshore borrowing created a liquidity risk that also rendered them too-big-to-fail, eventually leading to the Government’s funding guarantee. Hence, whilst North American and European banks became insolvent on the asset side of their balance sheet, due to holding dodgy loans and derivatives, our banks also faced insolvency, except that it was on the liability side of their balance sheet (a more detailed discussion of this issue is provided in the book, The Great Crash of 2008).


Bubble Trouble:


Contrary to popular opinion, the Australian housing market is currently in a fragile position. With Australian household’s already up to their eyeballs in debt and housing finance falling (particularly amongst first-time buyers), it is difficult to see how prices and debt levels can continue their upward trend. Even without an external shock, such as a China slowdown or a liquidity crisis that prevents the banks from rolling over their offshore debt, for prices to continue rising, investors and owner occupiers must continue to believe that capital appreciation will be sufficient to cover the negative income return from owning residential property. This is clearly an unsustainable situation and once the expectation of continued strong house price growth disappears, households will likely start to reduce their borrowings (deleverage) and prices will correct.



A greater concern is that an external shock leads to a steep rise in unemployment and/or a credit crunch. If such an event occurs, we can expect a house price crash and a prolonged period of debt deflation, similar to the experience of the USA and Europe following the GFC.



Although it won’t admit it, the Government is aware of these risks, which is why it implemented policies to sustain the housing bubble during the GFC, including: the First Home Buyers Boost; liberalised foreign investment rules; funding for mortgage securitisation by non-bank lenders; bank deposit and wholesale funding guarantees; and the current massive immigration program. These policies are clearly aimed at increasing housing demand and ensuring a steady supply of credit – the two key ingredients for continued growth in house prices and debt. But most of these policies are likely to work only once and have merely delayed the inevitable correction we have to have.



For their part, the banks are continuing to channel funds into housing. Following the GFC, the large banks cut lending to business and apartment developers (thereby reducing supply), and instead directed these funds to purchasers of existing dwellings. Further, after realising that households had reached the limits of their debt servicing capacity, ING – Australia’s fifth largest lender – is now preparing to issue never-ending mortgages that have no fixed term and no requirement to repay any capital along the way, in a bid to reduce monthly loan repayments (see here for details). We can expect other lenders to follow suit in a desperate bid to encourage households to continue borrowing larger sums in order to sustain our overinflated house prices.



The government and banks will no doubt try anything to keep the housing Ponzi scheme alive and prevent the housing bubble from bursting. But for how long can the Australian housing market defy gravity?





Banking Bunkum


The banks are getting desperate.


First, ING – Australia’s fifth largest lender – announces that it will begin issuing never-ending mortgages that have no fixed term and no requirement to repay any capital along the way, in a bid to reduce monthly home loan repayments and increase the size of housing mortgages.
Now, with the Australian economy experiencing a private sector recession, households already up to their eyeballs in debt, and housing finance falling, the banks have begun talking up the housing market in a desperate bid to ease concerns about the sustainability of Australia’s house prices and increase households’ appetite for borrowing.

The latest piece of spruiking comes from ANZ’s Property and Financial System Research team, who have released a report presumably aimed at countering recent analysis by the Economist, IMF, and Demographia, arguing that Australian house prices are severely overvalued.

This is what the ANZ team has to say on the Australian property market:

"International comparisons of house price to income ratios have been widely used to suggest that Australian house prices are significantly overvalued. These analyses are not only dangerously simplistic but explicitly ignore a key component of the housing affordability equation – interest rates.
Simple house price to income ratios have been widely used to suggest that Australian house prices are significantly overvalued. These arguments centre around the concept of ‘mean reversion’ i.e. elevated house price to income ratios must revert to their long term historical average for ‘affordability’ to be ‘sustainable’.

However, as a measure of housing affordability, house price to income ratios are very misleading as they completely ignore interest rates. Ultimately, housing affordability comes down to debt servicing costs of which interest rates are a key driver. This not only means that house price to income ratios are fundamentally flawed as a measure of housing affordability but also makes intertemporal and cross border comparisons of these ratios next to meaningless.

In Australia, the house price to income ratio rose from an average of around 3 in the 1980s to an average around 5 since late 2003.
That is, the median house price in recent years represents 5 times the average household’s annual disposable income compared to 3 times in the 1980s
However, the major reason for this has been a structural (read permanent) reduction in interest rates. Mortgage interest rates in Australia in the 1980s averaged around 14%, however, since 2000 the average has been close to 7%. This reduction in mortgage interest rates has effectively been capitalised into house prices.

The halving of mortgage interest rates almost fully explains the measured rise in the house price to income ratio leaving the house price to income ‘mean reversion’ argument appearing myopic at best. Housing affordability and the sustainability (or otherwise) of current house price levels are extremely complex issues and drawing conclusions from simplistic aggregate metrics such as house price to income ratios is very unwise."


Lies, damn lies and statistics:

Money Morning Editor, Kris Sayce, has already provided a good rebuttal of the ANZ’s comments in his 1 June 2010 newsletter. However, I have my own significant concerns with the ANZ’s analysis.

Firstly, why has the ANZ chosen the period 1980 to 2010 to compare mortgage interest rates? Why not choose a longer timeframe, say from 1960? What difference would a longer time period make?

Well, as it turns out, choosing a longer time period completely discredits the ANZ’s argument that mortgage interest rates have halved, thereby justifying the near doubling of house prices-to-income levels. To prove this point, Chart 1 plots Australia’s standard variable mortgage interest rates from 1960 using RBA data.

As you can see, average mortgage interest rates in the 1960’s (around 5.5%) were below the average rates in the 2000’s (around 7%). Even rates in the 1970’s (around 9%) were only a little higher than those of the past decade.

So, based on the ANZ’s logic that low rates justify higher house price-to-income levels, why weren’t house prices far more expensive in the 1960’s and similar in the 1970’s?

Further, with interest rates lower in nearly all advanced economies (see the ANZ’s own chart), why aren’t other countries house prices even more over-valued than Australia’s? Clearly other factors are responsible for Australia’s extraordinary house price growth, such as easy credit - fuelled in part by heavy offshore borrowing - and an explosion in household debt levels (see my previous post).



It seems the ANZ has deliberately chosen the highest period of mortgage interest rates ever experienced in Australia to justify its argument rather than undertaking a more objective analysis.



What’s important is the amount of interest and principal that you pay:


“Ultimately, housing affordability comes down to debt servicing costs of which interest rates are a key driver”. No argument here. But the ANZ’s report infers that actual mortgage repayments as a proportion of incomes in the 1980s were similar to today, thanks to the near halving of interest rates over this period. Nothing could be further from the truth.


Chart 2 again uses RBA data to plot the ratio of average mortgage interest payments to household disposable income.

As you can see, mortgage interest repayments have increased significantly from 4.9% of income over the second half of the 1980s to 9.2% over the second half of the 2000’s! So despite lower interest rates, thanks to our much higher house prices today’s households are sacrificing nearly twice as much of their take home earnings to cover their mortgage interest repayments compared to households in the mid-to-late 1980s.

Let’s not forget that the RBA’s data, used in Chart 2, does not include the repayment of loan principal. When added to the above analysis, housing affordability now compared to the 1980s is even worse! To highlight this point, let’s compare 30-year principal and interest (P&I) loan repayments on a $300,000 mortgage at 7% interest versus a $150,000 loan at 14% interest (i.e. twice the loan size but half the interest rate).

The P&I repayment on the $300,000 mortgage is $1,996/month versus $1,777/month for the $150,000 mortgage. This difference of $219/month relates to extra principal repayments arising from the higher starting loan balance.

The point is that when it comes to assessing housing affordability, the crucial issue is how much P&I households actually have to pay, not the prevailing level of mortgage interest rates. In this regard, Australian housing affordability has clearly worsened substantially over the past decade.



Beware the Property Spruiker:

The ANZ’s motive in talking-up the Australian housing market is understandable. Since 56% of the Australian banks total lending is directed toward housing, the banks are heavily reliant on increasing mortgage debt to sustain their profit growth. At the same time, the security over their assets (loans) depends heavily on the value of the underlying houses on which they have lent. These two factors combined means that the banks are highly exposed to any change in sentiment that causes: (1) a reduction in mortgage lending; and (2) a correction in house prices.

Even so, these motivations do not excuse ANZ from releasing such a shoddy and misleading report.





Negative Gearing Exposed


In a previous post, Blowing Bubbles, I contended that Australia’s housing bubble has been caused, to a large extent, by investors piling into housing on the back of overly generous tax concessions. Given the interplay between investment housing and rental availability and affordability, I thought a detailed examination was warranted of the merits of investment property tax concessions, most notably negative gearing.



While it is clearly the case that Australia’s taxation system has artificially increased the demand for housing, thereby putting upward pressure on house prices, the proponents of these tax concessions contend that any tightening of existing tax rules would significantly reduce housing supply and increase rental costs. To quote the Minister for Housing (Unaffordability), Tanya Plibersek, on this matter:


“…any change in negative gearing would be a disaster for rental availability in this country….If we changed negative gearing we would see disastrous effects for renters in Australia.”


So is the Minister correct? Would changes to negative gearing reduce rental supply and affordability? Does negative gearing and its partner in crime, the 1999 halving of the capital gains tax (CGT) rate, increase the housing stock and reduce rents? Does society benefit from these tax concessions, despite their significant cost to Government revenue and their artificial stimulus to house prices?


Before we examine some of these issues, let’s first review some history.


A quick primer:


Negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. A negative gearing strategy can only make a profit if the asset rises in value (capital gains) by enough to cover the shortfall between the income and interest that the investor suffers.

Under Australia’s taxation system, negative gearing rules allow investors in both property and shares to write-off the cost of borrowing used to acquire an asset as well as other holding costs against all income, not just the income generated by the asset. At the same time, following changes to CGT in 1999, capital gains earned on assets held for more than 12 months are taxed at half the rate of other income.

According to the Reserve Bank of Australia, "the taxation treatment [of residential investment property] in Australia is more favourable to investors than is the case in other countries". In Australia, there are no restrictions on the ability of taxpayers to negatively gear investment properties. That is, there are no limitations on the income of the taxpayer, on the size of losses, or the period over which losses can be deducted. By contrast, in the United States and Canada, there are limitations placed on negative gearing, whereas it is not permitted at all in the United Kingdom.

In July 1985, as part of a broader tax reform package, former Treasurer Paul Keating 'quarantined’ losses from negative gearing by stopping them from being deducted against other income. However, after intense lobbying by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, Treasurer Keating restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.



A costly policy reversal:

The reintroduction of negative gearing in 1987, in concert with the halving of the CGT rate in 1999, led to a surge in property investment in Australia. As shown in Chart 1, the number of property investors rose by 35% between 1999/00 and 2007/08, from 1.28 million to 1.73 million.

Of greater concern to taxpayers, total net rental income from investment properties has decreased from +$219m in 1999/00 to -$8,628m in 2007/08 (Chart 2). Further, the proportion of property investors declaring losses increased from 54% in 1999/00 to 69% in 2007/08. Assuming that the average marginal tax rate of property investors is 30%, negative gearing cost the Government around $2.6 billion in foregone tax revenue in 2007/08, meaning that average Australians are massively subsidising property investors.

The impact of the increase in property investment on Australia's house prices can be seen in Chart 3. Despite flat rental growth, house prices surged from 2000 as investors piled into investment property on the back of the new tax rules that enabled them to partly socialise income losses from holding investment properties (via negatively gearing), whilst privatising more of the gains achieved through capital appreciation (via the CGT concession).

This increase in property investment in Australia was also assisted by a significant increase in credit provision to property investors. From the mid-1990s, investors were permitted to purchase an investment property via accessing equity in their own home, without having to contribute any cash up front. Lending criteria on investment loans were also relaxed and became much the same as loans to owner occupiers, as did the interest rate charged. Lenders also began competing aggressively for investment loans and offered products specifically designed to attract investors, such as the split-purpose and interest only loan.



By contrast, prior to the mid-1990s, investors typically had considerable difficulty obtaining finance for an investment property, often having to rely on both their own savings and funding from non-bank sources. Investors were also typically charged a significantly higher interest rate than for owner occupiers.



This increase in credit provision for property investment is evident in Chart 4, which shows borrowings for investment properties growing at a faster rate (17% per year) than borrowings for owner occupied properties (12% per year). Accordingly, the share of investment loans has grown from around 14% in 1990 to around 30% currently.

According to the RBA, the terms at which investors can access finance in Australia are also more generous than in comparable countries. Typically, interest rates are higher for investors than for owner occupiers in these countries, and stricter lending criteria applies. Not surprisingly then, the share of investor mortgages in comparable countries is in the single digits, compared to the 30% share in Australia.



Impact on the rental market:



So having established that tax-fuelled property investment has been a key contributor to Australia's inflated house prices and costs the Government (taxpayer) billions of dollars in foregone tax revenue, the question remains as to whether these tax concessions increase the availability of rental properties and reduces rental costs?



To answer this question, let's first examine the claim by the property industry that the 'abolition' of negative gearing by the Hawke/Keating Government in July 1985 caused investment in rental accommodation to dry up and rents to rise. Chart 6 uses Australian Bureau of Statistics (ABS) data to plot real (inflation-adjusted) rents for the Australian mainland capital cities. The first vertical dotted black line shows the beginning of the ban on negative gearing (July 1985), whereas the second vertical dotted black line shows its re-introduction in September 1987.

According to the ABS data, following negative gearing's abolition, rents rose in both Sydney and Perth, were flat in Melbourne and Adelaide, and fell in Brisbane. But if it was true that the abolition of negative gearing caused rents to rise, shouldn't rents have risen Australia-wide since negative gearing affects all rental markets? Clearly, based on this evidence, the properties industry's claim about the impact of negative gearing on rents are false.



My conclusion is supported by Saul Eslake, former Chief Economist at the ANZ, using different rental data. According to Mr Eslake: "It's true, according to Real Estate Institute data, that rents went up in Sydney and Perth. But the same data doesn't show any discernable increase in the other State capitals. I would say that, if negative gearing had been responsible for a surge in rents, then you should have observed it everywhere, not just two capitals."



So having debunked the link between negative gearing and rental costs, what about the claim that negative gearing increases the supply and availability of rental accommodation? If this claim was correct, we would expect to see a high proportion of investor borrowings being channelled into new housing construction. Investors who buy existing homes do not increase rental availability since they do not add to overall housing supply and merely turn homes for sale into homes to let. They also do not address the shortage of rental accommodation, because the reduction in the supply of homes for sale throws potential owner-occupants onto the rental market.



In order to examine the effect of property investment on the rental market, Chart 6 uses RBA data to plot the percentage of investor mortgages going to existing dwellings versus new construction.

As you can see, the share of investment in new construction has fallen for the past 25 years, from around 60% in the mid-1980s to around 5% currently. So despite the favourable tax treatment provided to property investors in Australia, for every 20 investment homes purchased in 2010, only one is a new dwelling that has actually added to housing supply and rental availability.



The data on new home construction by investors is even more damning. As shown in Chart 7, there was a surge in investor loans for second-hand properties from around 2000 onwards, coincident with the reduction in CGT. By contrast, loans for new construction have remained relatively flat for the past 25 years. As a comparison, the ratio of investor lending for existing dwellings to new dwellings was around 2:3 in 1985; 7:1 in 2000; and 15:1 in 2010.

A failed policy:



Based on the above evidence, there is clearly little merit in Australia's tax concessions for property investment. Negative gearing and the CGT concession do not provided any incentive to invest in new housing because they are available for both existing homes as well as new ones. And since these concessions do not increase housing supply, they also do not put downward pressure on rents.



Rather, the increase of investment in existing dwellings has merely significantly added to housing demand, reduced housing affordability, and displaced potential owner-occupiers, forcing them onto the rental market. While the cost to the taxpayer is immense, the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is even greater.



The situation that has arisen in Australia, where a substantial part of the population never own their own home or have to go deep into debt to achieve home ownership, makes a complete mockery of claims about 'rising living standards' and Australia having a 'strong economy'. Successive governments have allowed an appalling situation to develop in Australian society, and new approaches are desperately needed.



A better approach:



Australia's current system of negative gearing is a key factor behind the housing affordability problem in Australia. It has encouraged a flood of investors into the established housing market, it has not contributed to housing supply or rental availability or affordability, and it costs the Government billions of dollars of foregone tax revenue each year. Housing affordability will never be properly addressed in Australia until significant changes are made to negative gearing.



Negative gearing's cost to the Government and impact on house prices would be greatly reduced if, from a certain date in the future, it was retained on newly constructed dwellings but abolished where an investor purchases an existing ('second hand') dwelling. In this way, pre-existing investment property owners would not be disadvantaged and, over time, tax deductible interest would begin to fulfil its economic purpose of encouraging real investment - the production of new housing supply - as new investors enter the housing market. Such an approach, once understood, would likely be supported by the home building and property development industry because it promotes higher building levels. Further, the increased housing supply would be likely to increase the availability of rental properties and lower rents. Of course, those groups with a direct interest in long-term house price appreciation would strongly object to such an approach including, perhaps, many current Australian home owners who (wrongly) perceive that their wealth is increased when their home value rises.



Tax purists might also disagree with such a change to negative gearing on the basis that it is wrong to discriminate among financial assets. My response is that housing is an entirely different type of asset from other financial assets, like shares. Firstly, housing is a social asset and shelter is a basic human need. Second, those buying other financial assets are bidding against other investors that can also access interest deductibility. However, with housing, the main other bidders are owner-occupiers that do not have access to this advantage (interest deductibility). So we are not comparing 'apples with apples' with regards to housing versus other financial assets.



Change ain't easy:



Of course, discussions about changing negative gearing are for now academic, since the Rudd Government recently announced, in response to the Henry Tax Review, that it would never change Australia's negative gearing or CGT rules.



While it won't admit it publicly, the Government is concerned that changes to tax concessions could lead to a stampede from property by investors and cause a bursting of Australia's housing bubble. Finance Minister, Lindsay Tanner, said as much in a recent interview on Lateline:



" The key reason why governments of both persuasions have not interfered with negative gearing is of course that that any dramatic change in the overall investment framework could lead to a stampede of people out of property, which could lead therefore to dramatic drops in prices which of course you’re seeing in other economies around the world and you see the economic devastation that flows from that."



So, despite the Government and many mainstream economists arguing that Australia's high house prices have been caused by a 'lack of supply' (housing shortages), the truth is that prices have risen largely because of speculation from housing investors combined with easy credit from Australia's lenders. And no government wants to spoil the party or have the bubble burst on their watch, despite pretending to be concerned about housing affordability.



Instead, I am left wishing that I could buy a time machine, travel back in time, and reverse those two fateful policy blunders - the reintroduction of negative gearing in 1987 and the CGT reduction in 1999. Then, maybe, Australia's house prices would still be affordable, households would be less indebted, and a large chunk of the population currently stuck in rental accommodation would be home owners instead. If only...




Housing Affordability: Then and Now


In a previous post, Blowing Bubbles, I contended that it is the increase in the availability of housing finance in Australia that is the major factor behind Australia's high house price growth:




"While there are many factors that have increased the demand for housing - such as tax concessions, subsidies paid to first-time buyers, and Baby Boomer Demographics – in the end, the extra demand for housing can only feed into higher prices if credit is readily available, enabling buyers to borrow large sums and pay high prices. Put simply, the supply of credit is the crucial ingredient to sustaining high house prices."



This post examines in greater detail the history of mortgage lending in Australia and the impact that financial deregulation and the free-flow of mortgage credit has had on house prices and housing affordability.



A Short History of Mortgage Lending:



Prior to the financial deregulation of the mid-1980s, bank mortgage lending was heavily regulated. Interest rate controls were in place and bank loans were rationed and only available to the most creditworthy of borrowers. Banks were restricted to lending up to 80 per cent of a property's valuation and the female partner's income was not considered when calculating a borrower's repayment capacity. As a result, single woman had little likelihood of obtaining housing finance. Borrowers were also required to have a long-standing relationship with the bank as well as a long savings history to show where the deposit came from.



Interest rate ceilings were imposed on both bank loans and deposits, which limited the banks' ability to raise interest rates in line with inflation. Therefore, when the oil shock hit in the early 1970s, banks were unable to raise interest rates, resulting in bank mortgage interest rates being below the rate of inflation (see Chart 1). On the flip side, bank depositors had the unfortunate experience of having the real value of their savings eroded by inflation.

Whilst the banks provided the lion's share of mortgage lending, borrowers that failed to meet the banks' strict eligibility criteria were required to obtain finance from less heavily regulated non-bank sources, such as life insurance companies and pension funds, which grew to fill the gaps caused by the restraints on banks. These lenders typically charged higher interest rates than the banks.



In the first half of the 1980s, regulations that undermined efficiency, such as interest rate controls and lending restrictions, were abolished. In 1983, the Australian dollar was floated and exchange rate controls were lifted, allowing the free-flow of foreign capital into Australia. Foreign banks were also invited to establish trading operations in Australia in 1985, which bolstered competition.



In 1992, mortgage originator Aussie Home Loans was established and began raising funds via securitisation on wholesale debt markets. Aussie was soon joined by a number of other non-bank lenders that raised funds by securitisation. It was the rise of these non-bank lenders in the mid-1990s that initially caused an intensification of competition among mortgage lenders. With no formal regulator and no rules outside of regular trade practices and corporations law, they led the decline in Australian credit standards from the mid 1990s by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (sub-prime) loans just before the Global Financial Crisis (GFC) intervened.



Faced with this new competitive threat, the banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore. Gone were the days of requiring a minimum 20 per cent housing deposit and the banks funding their loan portfolios from domestically sourced funds (mostly depositors); instead, 5 per cent housing deposits became commonplace funded increasingly by the banks issuing bonds to foreigners.



Housing Credit and House Price Growth:



The deregulation of the financial system and the growth of securitisation and foreign borrowing led to an explosion of credit growth that has fed into higher house prices. This relationship between credit growth and house prices is represented by Chart 2, which plots the value of bank owner-occupied mortgage lending against median Melbourne house prices as provided by Abelson & Chung (2004) and the Australian Bureau of Statistics (ABS Catalogue 6416.0).

As you can see, mortgage lending has increased exponentially since the mid-1980s and this growth of credit has been matched by a similar rise in house prices. We can conclude, therefore, that house price growth and mortgage lending growth are inextricably linked.



Housing Credit and Housing Affordability:



The link between the growth of housing credit and declining levels of housing affordability is also strong. Chart 3 plots Melbourne house prices against single average full-time incomes. As you can see, income growth tracked house price growth up until the mid-1980s. However, following financial deregulation, and the growth of mortgage lending thereafter, house price growth began to diverge from income growth. In particular, the growth in house prices relative to incomes exploded post-2000 as mortgage lending boomed fuelled by intense competition from the non-bank lenders as well as heavy offshore borrowing by the Australian banks.

This decline in housing affordability is further evidenced by the ratio of house prices-to-incomes, which rose from around 3.0 times in the 1970s and early 1980s to around 7.5 times currently. Admittedly, the growth of two-income families would also have contributed to the growth of the house price-to-income ratio, since this ratio has been measured against single average earnings.



One limitation of price-to-income analysis when assessing housing affordability is that it does not account for changes in mortgage interest rates, which effects borrower's ability to service their mortgages. Chart 4, therefore, uses RBA data to plot the ratio of average mortgage interest payments to average household disposable income.

As you can see, the ratio of mortgage payments to income rose considerably from under 4% in the 1970s to a peak of 11.4% in September 2008. This ratio has since settled at 9.0% as at March 2010 following the steep reduction of mortgage interest rates following the onset of the GFC. Further, despite mortgage interest rates (currently around 7%) being significantly lower than the 17% peak of interest rates in 1989, Australian borrowers are dedicating 50% more of their disposable income to service their mortgage (9.0%) than was the case in 1989 (6.0%).



Based on the above analysis, we can confidently conclude that the increase in credit availability since the financial deregulation of the mid-1980s has made housing far more expensive compared with incomes and has, therefore, led to a significant deterioration of housing affordability.



The 1970s: A Golden Era to Purchase a Home:



The situation currently facing new home buyers is even worse when compared with the circumstances that many of their parents faced when purchasing their first home in the 1970s. To illustrate this point, consider the following case study of an average Melbourne house purchased by the average family in 1972. Coincidentally, 1972 also happens to be the year that my parents purchased their first home in Melbourne.



The particulars of this case study are shown below. For simplicity, I have assumed that the loan is interest-only. The house price data has been sourced from Abelson & Chung (2004), whereas the income and interest rate data has been sourced from the RBA.



Average single income (1972): $5,073 per year

Median established house price (1972): $15,000

Bank standard variable mortgage interest rate (1972): 7.0%

Interest payment as a percentage of income (1972): 21%


Now remember that in the 1970s, bank mortgage interest rates were regulated and set below the level of inflation. The labour market was also heavily regulated such that wages were adjusted upwards with inflation, meaning that average income growth was consistently above the level of mortgage interest rates. This situation is shown in Chart 5.

Because interest rates were set below both the rate of inflation and wages growth, home buyers in the 1970s had the advantage of having their mortgage debts 'inflated away'. To illustrate this point, first consider the interest costs on the $15,000 home purchase versus the growth of incomes (Chart 6).

Whilst the interest cost as a percentage of income was initially 21% in 1972, this cost quickly fell to only 10% by 1979 due to the interplay of high inflation, high income growth, and low mortgage interest rates.



The situation that faced the 1972 home buyer was equally beneficial when comparing the house cost to income growth. Chart 7 plots the initial $15,000 house cost against average incomes.

Once again, because of high inflation and wages growth throughout the 1970s, average full-time earnings had caught-up with 1972 house prices in only 8 years!



The key point to take away from this case study is that the rationing of credit throughout the 1970s provided highly affordable housing to first-time buyers. Although loans were more difficult to obtain, high inflation and low interest rates effectively 'inflated away' borrowers' mortgage debts. In this regard, the 1970s was a dream time to purchase a home, provided you could obtain the credit.



Current Home Buyers Not So Lucky:



Now let's compare the 1972 Melbourne home buyer to a home buyer in 2010. The particulars of this case study are shown below. Once again, for simplicity, an interest-only loan is assumed. The median house price comes from the ABS whereas the standard variable mortgage rates and average income data comes from the RBA.



Average single income (March 2010): $64,223 per year

Median Melbourne established house price (March 2010): $487,400

Bank standard variable mortgage interest rate (March 2010): 6.9%

Interest payment as a percentage of income (March 2010): 52%

Average income growth over the past 10 years was 4.5% per annum and the average variable mortgage interest rate over this same period was 7.26%. Chart 8 projects these rates 30-years into future to show the expected mortgage interest cost as a percentage of income.

Similarly, Chart 9 plots the 2010 house cost against projected (4.5% p.a.) income growth.

Due to higher starting house prices, low inflation, low income growth, and positive real interest rates, today's home buyers cannot expect to have their mortgage debts 'inflated away' like in the 1970s. Instead, they face a prolonged period of higher interest payments and lower disposable income. This is because average mortgage interest payments as a percentage of average incomes will always remain higher for longer in an environment of positive real interest rates and low inflation.



Further, because of low income growth, following the movement to a low inflationary environment, a mortgage taken out in 2010 is still likely to remain a large mortgage in 10 years time.



All that glitters is not gold:



What should become increasingly clear after reading The Unconventional Economist is that, when it comes to housing, nothing is what it seems. In particular:





It is the demand for, and supply of, credit that is the key determinant of house prices. Whilst demand-side factors such as tax concessions, benign economic conditions, and population growth might increase people's willingness to borrow for property, ultmately, if you cannot obtain the finance, you cannot pay a high price. Similarly, tight housing supply would have little impact on house prices when credit is not readily available.

Lower interest rates and easy credit do not make houses more affordable. Rather, they quickly get capitalised into house prices, increasing the amount that home buyers must borrow.

When examining interest rates and their effect on housing affordability, it is real interest rates (i.e. the mortgage interest rate less inflation) that matters. Whilst mortgage interest rates averaged a seemingly high 9% in the 1970s, due to high inflation (averaging 11%), real interest rates were negative, resulting in borrowers' mortgage debt being 'inflated away'.

Importantly, be very weary of offers of more credit and the promise that it will "improve housing affordability". Any scheme that increases home buyer's borrowing capacity, such as shared equity loans and the Never Ending Mortgage, will instead fuel further house price growth, thus eroding affordability.

Beware the property spruiker. Always be sceptical when reading property-related articles in the press, or when listening to politicians talk about housing affordability. Whilst they might, on the surface, sound reasonable, they are often talking their own book. Instead, think critically about their motives and who their constituents really are.



Bringing it Home

Since launching The Unconventional Economist in May, I have written eight housing-related articles focusing on the key drivers and consequences of the Australian residential property bubble.




Before moving on to other topics, I thought it would be useful to provide a re-cap of the key themes raised in my earlier posts and offer some practical policy solutions aimed at:



making Australia's housing market more affordable;

improving the safety and stability of Australia's financial system; and in doing so

help to safeguard the Australian economy from the kinds of debt deflation and deleveraging currently being experienced in other developed economies, including the USA and the Eurozone.


Anatomy of the bubble:



My previous posts explained in detail the two major causes of Australia's housing bubble, namely:



The increase in the availability of housing finance following deregulation of the Australian financial sector in the mid-1980s, which has enabled buyers to borrow large sums and pay high prices (see Blowing Bubbles and Housing Affordability: Then and Now).

Excessive speculation by property investors, fuelled by Australia's overly generous taxation concessions on property investment (see Negative Gearing Exposed).

These two factors have combined to create a positive feedback loop between lenders and borrowers, thereby fuelling Australia's house price bubble.



As shown in Chart 1, house price growth tracked incomes growth until Australia's financial markets were deregulated in the mid-1980s and lending and funding constraints were removed. Following this point, house prices and incomes began to decouple.


The growth of house prices relative to incomes exploded post-2000 as mortgage lending boomed, fuelled by a decline in lending standards (including lower deposit requirements) following intense competition from the non-bank lenders, as well as heavy offshore borrowing by the Australian banks (totalling around $500 billion currently). Over a similar time frame, the banks significantly increased the proportion of loans channelled into housing, with housing loans increasing from around 35% of total lending in 1990 to 56% in 2010. These changes both increased the pool of potential home buyers and significantly increased the amount of funds available to be lent.



For their part, investor appetite for housing began to grow in the 1990s as the Baby Boomer generation - the largest generation in history - began to reach peak earnings age (45 to 55 years). They began buying up investment properties en masse as a way of both minimising their tax (via negative gearing) and 'saving' for retirement. Excessive speculation in the Australian property market is evidenced by a number of indicators, including:



1. investor's share of total mortgages increasing from 14% in 1990 to around 30% currently;

2. yields on rental houses decreasing from around 8% in 1987 to around 3.5% currently;

3. the number of property investors increasing by 35% between 1999/00 and 2007/08, from 1.28 million to 1.73 million;

4. total net rental income from investment properties decreasing from +$219m in 1999/00 to -$8,628m in 2007/08; and

5. the proportion of property investors declaring losses increasing from 54% in 1999/00 to 69% in 2007/08.

A key problem with this explosion of negatively geared property investment is that the overwhelming majority of home purchases by investors (over 90%) are for pre-existing (second-hand) dwellings. As a result, this property investment is simply adding to housing demand and pushing-up house prices, without increasing the supply of rental properties relative to rental demand (since the purchase of a pre-existing dwelling by an investor simply displaces a potential owner-occupier) or putting downward pressure on rents. A comprehensive examination of the effects of property investment on housing affordability and the rental market is provided in Negative Gearing Exposed.



A nation of debt zombies:



The post-2000 explosion of Australia's house prices relative to incomes has caused housing affordability to plummet and significantly increased debt burdens (see Housing Affordability: Then and Now). This worsening affordability is evident by a number of indicators, including:



the ratio of house prices to incomes increasing from around 3.0 times in the 1970s and early 1980s to around 7.5 times currently (see Chart 1);

the ratio of mortgage interest payments to disposable incomes (averaged across the economy) increasing from under 4% in the 1970s to 9.0% currently, after reaching 11.4% when interest rates peaked in September 2008; and

Australian mortgage debt increasing from around 32% of household disposable income and 12% of GDP in 1990 to 138% and 89% respectively as at the end of 2009.

Australia's economy now vulnerable:



Whilst the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is immense, the Australian banks' model of borrowing heavily offshore (via wholesale debt markets) to pump housing has the potential to significantly destabilise Australia's financial system and damage Australia's future growth prospects.



As discussed in Blowing Bubbles:



"Australia’s ability to sustain current house prices, let alone further price increases, rests with the willingness of other countries to continue lending our banks money. But in times of crisis, such as when Lehman Brothers collapsed, foreigners tend to zip-up their wallets, leaving our banks, house prices, and broader economy exposed to a sudden liquidity shock as the banks are unable to roll-over their foreign borrowings (let alone increase them).



Few people realise that the Australian Government’s October 2008 guarantee of bank funding and deposits was issued after the larger banks made it clear to the Government that they were facing extreme difficulty in rolling over their wholesale funding, meaning that they would have to immediately withdraw credit from the Australian economy and would eventually face insolvency. So while it might be true that Australia’s banks managed credit risk well, avoiding the excesses of the sub-prime lending prior to the onset of the GFC, their heavy offshore borrowing created a liquidity risk that also rendered them too-big-to-fail, eventually leading to the Government’s funding guarantee. Hence, whilst North American and European banks became insolvent on the asset side of their balance sheet, due to holding dodgy loans and derivatives, our banks also faced insolvency, except that it was on the liability side of their balance sheet."



The banks' increasing focus on housing lending, whose productive contribution to Australia's economy is low overall (and zero in the case of lending for pre-existing housing), in place of more productive business lending, is also reducing Australia's potential productive capacity and future growth prospects. These issues were recently acknowledged by National Australia Bank’s Group Executive, Business Banking, Joseph Healy::



"The distress experienced by many banks around the world was as much related to poor funding models exacerbated by rapid growth as it was to poor credit decisions. The crisis...highlighted that rapid growth requiring a high dependence on wholesale funding wasn’t necessarily a prudent way to run a bank.



A system structurally biased towards lending for housing – 57 per cent of all lending now is for housing against 35 per cent for business loans – isn’t necessarily playing its most productive role in the economy, particularly when one considers the state of both the housing markets and household debt levels.



The risks of such distortions could be magnified in the event there was another crisis that froze wholesale debt markets or...it transpired that the appetite for Australian bank debt among offshore investors wasn’t limitless."



A greater role for regulation:



Given the major role that excessive credit has played in creating Australia's housing bubble, and that the Australian banking sector faced insolvency requiring a Government bail-out during the GFC (via the bank funding and deposit guarantees), there is a clear role for greater regulation of mortgage lending to prevent the excesses that lead to asset bubbles. One solution is to introduce macro-prudential measures aimed at strengthening the resilience of Australia's financial system by mitigating the build-up of excesses in credit growth and asset (house) prices. Possible measures could include:



Setting maximum loan-to-value ratios (LVRs) for property lending. These measures assist in limiting a lender's exposure to a property market downturn and limits highly-leveraged property purchases. LVRs could, for example, be set at 85% (requiring a minimum 15% deposit) when a cash deposit is used and 50% when non-cash collateral (e.g. another property) is used in place of a cash deposit.

Placing limits on the ratio of debt service to income for housing lending. This measure would reduce the likelihood of borrower default and limits highly-leveraged property purchases. For example, a 30% limit would permit a household with a gross income of $100,000 to borrow a maximum of $428,500 at a 7% interest rate, whereas a 40% limit would permit the same household to borrow a maximum of $571,500 at a 7% interest rate.

Placing limits on the amount of loans that can be extended against short-term funding sources, such as at-call deposits, and term deposits and wholesale funding with less than 6 months term-to-maturity. These types of measures: reduce the tendency of lenders to rely on short-term or unstable funding markets to support rapid lending growth; reduces the likelihood of experiencing a liquidity crisis like Australia's banks experienced during the GFC; and reduces the overall amount of leverage in the financial system.

Macro-prudential measures, such as those described above, offer a number of addition benefits beyond simply improving housing affordability, increasing financial system stability, and reducing systemic risk. First, they could improve the function of monetary policy, since using interest rates in response to an asset bubble/bust is a blunt instrument that can have unintended consequences in other parts of the economy. Second, fixed measures, such as maximum LVRs and debt service to income ratios, tend to be more binding during a credit boom, when banks seek to expand property lending, than in a bust, when heightened risk aversion reduces their propensity to extend loans with high LVRs or debt service ratios.



Had such macro-prudential measures been in place globally during the 2000s, it is possible that the GFC would never have taken place, since the kinds of speculative housing lending undertaken in the United States and Europe would not have been possible. It is also likely that Australia's house prices would never have surged like they did post-2000, since access to credit and the ability to undertake highly leveraged purchases would have been muted. Houses would now be much more affordable as a result.



That said, implementing these measures domestically in the current climate would be risky, since they would lead to an immediate contraction in housing lending, resulting in a house price crash and a severe economic contraction. For this reason, it would be wise to implement such measures after Australia's house prices have corrected with the goal of preventing future housing bubbles. The political climate post-correction would also likely be more amenable to change since attitudes towards housing speculation and leverage would likely become more conservative.



In any event, the next Australian Government would be wise to immediately undertake another Financial System Inquiry (FSI) to examine some of these financial stability issues. The previous Inquiry (the 'Wallis' Inquiry), completed in 1997, never envisaged systemic risk engulfing financial markets as well as intermediaries, as occurred during the GFC. Nor was the Basel Committee’s idea of macro-prudential regulation (discussed above) ever considered. Furthermore, the Government's October 2008 decision to guarantee bank funding and deposits completely ignored one of the original FSI's key recommendations - that no government would ever guarantee any part of the financial system. The long-term implications of using the Government's balance sheet as role of guarantor of last resort for the banks’ wholesale debts is also unclear and needs to be comprehensively examined by such an inquiry.



Tax reform:



Negative Gearing Exposed proposed some practical modifications to Australia's negative gearing rules that would remove excessive speculation (and demand) from the housing market, boost housing supply, whilst reducing the tax revenue forgone by the Government:



"Negative gearing's cost to the Government and impact on house prices would be greatly reduced if, from a certain date in the future, it was retained on newly constructed dwellings but abolished where an investor purchases an existing ('second-hand') dwelling. In this way, pre-existing investment property owners would not be disadvantaged and, over time, tax deductible interest would begin to fulfil its economic purpose of encouraging real investment - the production of new housing supply - as new investors enter the housing market. Such an approach, once understood, would likely be supported by the home building and property development industry because it promotes higher building levels. Further, the increased housing supply would be likely to increase the availability of rental properties and lower rents."



Two other areas worthy of consideration are eliminating inefficient transaction taxes, such as stamp duty, in exchange for implementing a broad-based land tax.



Stamp duty, which is levied on the buyer of residential properties and often totals tens-of-thousands of dollars, severely distorts the housing market by creating a mis-match between demand and supply. This mis-match occurs because it discourages people from moving house to more appropriate accommodation when their circumstances change. For example, empty nesters are encouraged to remain in their large family houses in order to avoid paying stamp duty if moving to more suitable accommodation (such as apartments and townhouses). As a result, newer families are excluded from 'family friendly' neighbourhoods with good amenities. Stamp duty is also highly inequitable since it severely punishes those that need to move due to changed circumstances (e.g. starting a family, job relocation, etc). Abolishing stamp duty would, therefore, encourage more efficient use of the existing housing stock and assist in alleviating housing shortages.



Land taxes, which are levied on the unimproved value of land, offers a number of benefits over stamp duties (see Tax me, please for a more detailed analysis):



Land taxes discourage speculation and land banking, thereby increasing the competitiveness of supply in the land market and reducing the potential for housing shortages.

Owners of land in urban areas would have more incentive for subdivision, and increasing density, to avoid this tax. In fact the economic success of Kong Kong, Taiwan and Singapore has been attributed to high land taxes - a path that Korea is keen to follow.

Land taxes are difficult to avoid, and administratively simple. Further, tax evaders could have their land compulsorily acquired.

Land taxes provide incentives for government to improve infrastructure and community facilities, since any investment by government would be captured in higher dwelling prices, thereby yielding the government additional land tax revenue.

Unfortunately, these changes to property taxation are, for the foreseeable future, as likely to be implemented by government as me becoming the front-man of Pearl Jam. In the Federal Government's response to the Henry Tax Review, it announced that it would never change Australia's negative gearing or CGT rules. And the states are equally unlikely to give-up stamp duties in exchange for implementing a broad-based land tax, even though it would be more economically efficient and equitable.



However, these measures might become politically palatable down the track once a housing correction has taken place and attitudes towards speculation and debt become more conservative.



Supply-side stasis:



A Macroeconomic Examination of Housing Supply (Parts 1 and 2) examined the importance of the supply-side of the housing market in determining house prices. The key findings from these articles were as follows:



When land supply is not regulated and is free to adjust to changes in demand, price volatility is reduced. Therefore, increases (declines) in housing demand are more likely to result in sharper increases (falls) in house prices when supply is constrained (i.e. housing shortages exist) than when land supply is not regulated.

Contrary to the common belief that Australia’s perceived housing shortage puts a floor under house prices and would thereby prevent similar price falls to those experienced overseas, the opposite is in fact true. House price falls would be more severe if housing shortages exist.

The macroeconomic evidence on the contribution of supply-side constraints (housing shortages) on Australia's house price growth is inconclusive. Whilst tight housing supply goes some of the way to explaining the price out-performance of Brisbane and Perth - which have experienced high population growth and relatively low levels of dwelling construction over the past 40 years - Sydney has experienced the lowest house price growth of all state capitals over this 40 year period, despite having the greatest housing shortage and lowest level of new dwelling construction. Further, both Adelaide and Hobart have experienced robust house price growth despite having the lowest population growth of all state capitals, the highest level of new dwelling construction, and minimal, if any, housing shortage as measured by the Housing Supply Council.

Of course, any efforts to make the supply-side of the housing market more responsive would be welcome and might help reduce house price volatility and prevent the development of boom-bust property cycles. Unfortunately, the required reforms to planning processes as well as urban infrastructure development and funding models are inherently difficult to implement since they often require agreement from multiple levels of government and tend to face strong opposition from local communities opposed to further development (e.g. NIMBYs).



Storm clouds gathering:



In my opinion, an Australian house price crash is inevitable and cannot be avoided. The fact is that house prices relative to income as well as household debt levels have simply become too high to be sustained, and all it will take is either a change of sentiment, a deterioration of Australia's economy, another global credit shock, or shifting demographics to bring house prices down. If there is one thing that the GFC highlighted, it was that asset markets are fluid and can change course abruptly and viciously.



In the context of Australia's housing bubble, prices have risen largely because of the 'got to get in now' mentality. As prices began to appreciate strongly from 2000, driven largely by an influx of investors and easy credit, more and more people became attracted to purchasing (investing in) houses, pushing prices up further and attracting even more people into the housing market. Eventually, however, excessive leverage will see this positive feedback loop unravel. Investors will likely start selling (or at least stop buying) and as the number of properties on the market begins to increase and prices begin to fall, the 'got to get out now' mentality will begin to take hold. Ultimately, the number of people exiting the market could develop into a stampede, and the Australian housing bubble will burst.



These dynamics have constituted almost every asset bubble/bust to date, from the Japan's lost decade, to the mid-1990s Asian Financial Crisis, the 2007/08 global commodity bubble/bust, and the current US and European housing market crashes. There is absolutely no reason to believe that this time is different and Australia will somehow escape a similar fate.



So what are the key risks facing Australia's housing market? Well there are several, some short-term and some longer-term.



First, as highlighted on numerous occasions by fellow economics blogger Delusional Economics (for example, see here, here, and here), Australia is heavily leveraged to China and any slow down in the Chinese economy will likely translate into lower prices for Australia's two largest exports - iron ore and coal - along with other commodity exports. Should commodity prices fall significantly, it follows that less money will flow into the Australian economy, resulting in lower spending, a contraction in aggregate demand, and higher unemployment. A slowdown of China's economy is likely since its two major export destinations - the US and Europe - are facing an extended period of sub-par economic growth cause by deleveraging following the GFC, as well as ageing populations. To date, China has relied on massive government stimulus to keep its economy growing strongly, but there is a limit to how long it continue with this approach.



The second major risk for house prices is that world credit markets freeze, thereby dramatically increasing Australian banks' cost of wholesale funding and/or reducing their ability to raise funds offshore. Recent analyses by investment banks Credit Suisse and Goldman Sachs estimate that the Australian banks will need to raise between $100 billion and $170 billion of term wholesale debt in the 12 months to March 2011, of which about $78 billion would be the refinancing of existing borrowings that mature.



"According to Credit Suisse, the refinancing challenge over the next five years amounts to about $420 billion, with CBA and Westpac accounting for about $240 billion of that. The average term of the majors’ debt is only about 2.8 years.



Goldman estimates that if there were 8 per cent loan growth and no growth in deposit funding relative to the status quo, the banks would need to raise $416 billion in five year’s time. If, as is more likely, deposits in the major’s part of the banking system grew by 6 per cent, they would still need to raise $272 billion in five year’s time. That’s additional to the borrowings that will need to be refinanced."



The banks' wholesale funding task will be both difficult and costly since they will be competing with up to $US5 trillion of existing European bank funding that will mature and have to be refinanced by European banks over the next three years, about $US3 trillion of it by the end of 2012. Our banks will also have to compete to raise funds in capital markets against sovereign governments to fund the measures they took in response to the GFC (see here for more details).



Let's also not forget that the Basel Committee on Banking Supervision is examining adding a layer of counter-cyclical capital buffers to bank capital adequacy requirements in order to mitigate against excessive credit growth and systemic risk.



With all of these factors combined, it will be difficult, if not impossible, for Australia's banks to continue to increase lending for housing. As such, the prospect of continued house price growth is minimal, since continued price appreciation relies on ever-increasing credit growth and household debt levels. Even maintaining current house price levels will be difficult in this new credit-constrained environment.



Even if Australia miraculously manages to dodge the above economic bullets, house prices will still come under enormous pressure. This is because for house prices to continue rising, investors and owner-occupiers must continue to believe that capital appreciation will be sufficient to cover the negative income return from owning residential property. This situation is clearly unsustainable. Once the expectation of continued strong house price growth disappears, households will likely start reducing their borrowings (deleverage) and prices will correct.



Finally, one of the key drivers of Australia's strong house price growth has been the Baby Boomer generation's rampant buying of investment properties to fund their retirement. But with the Baby Boomers soon to enter retirement, it follows that their appetite for investment properties will shrink, thereby removing one of the key demand-drivers of house price growth. Further, because higher investment yields can be earned by placing their funds in a bank term deposit than can be earned via rent, it is likely that many Baby Boomers will sell their property investments to fund their retirements. This process of property divestment is likely to accelerate once the Baby Boomers realise that there is little prospect of continued high capital appreciation.



The bottom line is that Australia's housing market is in a fragile state. Storm clouds are gathering and it is only a matter of time before the bubble bursts. You have been warned.