Australia’s Big Short
“Anyone can see that there’s a real-estate bubble… there’s always markers… average take-home pay is flat, yet house prices are soaring… these houses are debt, not assets.” — Michael Burry (played by Christian Bale)
It’s February 6th 2016, and two things have just happened. First, I witnessed a two bedroom apartment 7KM from Melbourne’s CBD sell for $865K, and second, I saw Michael Lewis’s new film, The Big Short, at the Sun Theatre.
It clicked.
The cinema was packed, and the audience was enthralled. The film’s message was clear: don’t trust the banks and don’t assume they know what they are doing. Yet, upon leaving the cinema, I overheard a bizarre conversation. “How could this happen?” said the person, “America” was their friend’s response. They went on… “It can’t happen here though, our banking sector is much more regulated”.
I was shocked. Yet, walking out, all I could hear was more of the same. The reality of the film was being ignored.
I couldn’t resist. I stopped a lady to find out her opinion. “Do you think this is happening here?” I said. “No, not at all.” she responded. I disagreed.
In the past month alone, Melbourne’s house prices rose 2.5%.
Australia’s house prices are rising at unprecedented rates. Lending is sky-rocketing, cash is cheap and supply is growing. Yet, rental growth is the lowest on record, investors are leaving the property market on mass, wage growth is flat and unemployment is rising. So where is this extra money coming from?
Debt.
“These houses are debt, not assets.” The price of Australian property is being inflated by increased debt. An all-time low in the RBA cash rate has made debt more affordable. Houses haven’t suddenly become worth more, people can simply borrow more, so they pay more. Owner occupied debt is at an all-time high, having risen 35% in the past two years alone.
The average loan size has also risen sharply, increasing by 13% in the past 12 months. Whilst the total value of all dwelling stock—the actual combined value of all houses in the country—rose by 11% in the same period. Ultimately, the increase in the price of a home is explained by the increase in the amount that someone is able to borrow. The two are correlated.
Here’s how it happens…
Imagine a young couple, let’s call them Sally and Tom, are looking to purchase their first home. They have typical savings, earn typical incomes, and are looking for a typical suburban home. They attend a few inspections, find a house they like and are quoted $500K by the agent. They approach the bank, get pre-approval for a purchase price of $550K and excitedly attend the auction. The auction begins at the asking price, and very quickly bids are being placed well in excess of their $550K budget. The property sells to another party for $650K.
Sally and Tom quickly realise that the only way they can afford the home they want is by borrowing more from the bank. First mistake. They approach their bank manager who fiddles with some models, and reissues the pre-approval with an increased purchase price of $650K, and increased repayments. The house hunting begins again.
After a few weeks of inspecting properties Sally and Tom find a home that ticks all of their boxes. It’s quoted at $520K, and with their $650K pre-approval in hand, they confidently attend the auction. Very quickly, the auction reaches $550, then $590, then $620, then $650… Sally and Tom stop bidding and the property eventually sells for $700K.
Again, Sally and Tom approach their bank manager who eagerly increases their pre-approval, raises their repayments, adds on lenders mortgage insurance (just incase), and Sally and Tom are back on the market ready to buy. The bank manager can justify these increases because, at a 4.5% interest rate, Sally and Tom can service the loan. Second mistake.
This process continues until Sally and Tom eventually purchase. They, like thousands of other couples, now have a home (and a loan) that can only be considered affordable so long as the interest rate—currently at an all time low—doesn’t change. But it will.
Jumping back to the movie for a moment, there’s a key scene that becomes relevant to us right now. The scene involves Selena Gomez explaning how synthetic bonds were created during the 2007 global financial crises.
A similar phenomena is currently taking place here in Australia. However, rather than bankers making bets on synthetic CDOs, we have home-owners making bets on the interest rate. Increasingly, people are taking out loans at the upper end of what they can afford to make repayments on. They do this under the belief (or ignorance) that interest rates are always this low, won’t change, and will remain at 4.5% for the life of a 30 year loan.
Snap.
What breaks this system? The winning streak ends when interest rates go up. The moment the cost of cash increases, loan defaults increase, the price of homes fall (because people can’t borrow as much anymore) and supply increases (because people can’t afford their repayments and have to sell).
Is this realistic?
Yes, and it’s already begun. Sydney’s property market is already contracting. Wage growth remains flat. Investors are leaving the property market (because returns are too low). Rental growth is at an all time low. Supply of property is at an all time high and national underemployment and unemployment is rising.
Mortgage delinquency and defaults are predicted to rise, albeit slowly. US unemployment has fallen below 5% for the first time in 8 years. This fact, most importantly, will cause the cost of money outside of Australia (the place where our banks get their loans from) to go up… again.
The most likely scenario is that the the banks put their interest rates up despite any move from the RBA. This will be caused by an increase in the price of debt on international money markets, largely driven by the US Federal Reserve. The banking regulator APRA is aware of this and, in July 2015, ordered the big four banks to increase their cash reserves (liquidity).
Where does this leave us?
I’m not proposing that the entire Australian economy will collapse in the same way that the United States economy did in 2007. However, I do believe that there will be a correction in property prices. The sub-prime mortgage crises was driven by people who were taking out home loans on the basis of artificially affordable (low) ‘introductory home loan rates’, the moment the rates went up, the properties became unaffordable, because the debt was un-servicable. The current, all-time-low RBA cash rate is Australia’s version of the sub-prime introductory discounted rates. Eventually our rates will go up, and eventually people will not be able to service their debt.
What happens then?
1Phase one of this bubble is almost complete. It involves the price of property increasing to un-justifyiable levels, purely driven by the ease-of-access to increased debt. Properties then take on an artificial value, far removed from the underlying value of the asset. Simply put, people are purchasing a $5 note for $8 purely because they have $8, despite the true value of the note not changing. During this phase the market rises, but in our case, that rise is nearing it’s end.
2The second phase involves a contraction. It will be driven by a reduction in the supply of cash, and an increase in the cost to borrow. People won’t have as much money at auctions, so houses will sell for less. Meanwhile more and more people will need to sell (due to unserviceable debt), so supply will increase. During this phase the market will stall/plateau.
3The third and final phase is a correction (also known as a crash). As more and more of the properties being put on the market in the second phase fail to sell, fear will set in. Supply will continue growing (from foreclosures) and demand will reduce as people opt to ‘wait out the crash’. Prices will continue to fall, and the flames of fear will be fanned so long as interest rates continue to rise.
Why will this happen? Because the RBA allows interest rates to stay low so long as the inflation rate of goods and services stays low. Not property. In the past year, inflation of goods and services has been steady at around 2%—no reason to put interest rates up—whilst inflation of property is at 10%.
Will the entire market be affected by this? Yes, the Perth property market is a prime example. Property prices are down roughly 10% across the board. Apartment values are at a 10 year low, whilst the median value of a house is getting closer to it’s 2010 price point. Perth’s property prices were driven by a mining boom. Not dissimilarly, the property prices in the Eastern states are being driven by a debt boom.
My advice?
There is only one way all of this will end—a correction (a property crash). The RBA is responsible for this rapid escalation of debt. Eventually they will have to put the cash rate up. For every month they delay, more and more people will take on excessive debt obligations. For every month they delay, the correction is only going to be more severe.
What type of drop in prices should we expect? Based purely on removing the portion of current purchase prices that is being paid for purely by these increased debt levels, we will likely see a 15% correction. That means the 2 bedroom apartment I saw sell for $865K on the weekend will only cost you a tidy $750K. The correction will begin the moment interest rates go up.
Who loses?
The banks? No. The banks have learned from the last time this happened. The banks have learned how to protect themselves better. They have:
- Enforced a 80% loan value ratio (LVR), meaning property prices could fall 20% and the banks wont lose.
- Forced lenders mortgage insurance on anyone above the 80% LVR threshold.
- And… if property prices do fall below the 80% protection buffer, the Government will bail them out. The RBA’s Committed Liquidity Facility will provide emergency cash up to $300 billion at the tax payers expense.
No, the banks won’t lose out. The people will. Imagine the following scenario. Pre crash, Sally and Tom purchase a house for $750K with $150K savings, and a $600K loan). Post crash, Sally and Tom have a house worth $600–650K, a loan worth $600K and zero-to-no equity.
The banks are fine, they still have a property that, if sold, could pay down the loan. No, the part of the equation that has become the victim of the correction is the savings of Sally and Tom (and therefore their equity). The house they live in is now 95%+ debt. Not an asset. Debt, not an asset.
My advice? International money markets will force interest rates to go up whether the RBA likes it or not. The property boom is nearing it’s end and property prices will fall in the next 12 to 18 months. Buy now and you’ll lose. Wait, and you’ll win.
