B Invested

THERE’S NO USA STYLE AUSTRALIAN HOUSING BUBBLE

There has been much debate in the media recently about whether Australia is in the midst of a USA style housing bubble. But does Australia’s property market really bear any resemblance to that of the US before it crashed and caused the global financial crisis? By examining some of the most detrimental causes of the US financial crisis and comparing them to current conditions in Australia, it becomes clear that the two countries, despite being tied together in a globalized economy, are actually worlds apart.

HOW THE US BUILT A BUBBLE THAT WENT BUST

Housing bubbles are as flimsy as they sound. They build up without solid foundation. Their growth is encased only by a thin, yet beautiful, membrane. They float ever higher, taking those invested in them to new heights, before – pop! A gust of wind breaks their rainbow coloured shell, leaving all that once lay within hopelessly exposed to the elements – and to gravity.

HOW DO THEY GET CREATED?

Let’s go back in time ten years to the United States of America. According to The Financial Crisis Inquiry Commission Report, during this time, the US was in the midst of an impressively large scale housing bubble that was “fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages.” In 2011 – just five years later – more than 26 million Americans were out of work and about four million families had lost their homes due to foreclosure, with another four and a half million facing the same fate. The Report says, as of 2011, almost $11 trillion in household wealth has been lost due to the bubble burst, and that, “the impacts of this crisis are likely to be felt for a generation.” But for this generation of Americans, the question should not be, “why?”, it should be “how?”

DEREGULATION AND THE “SHADOW BANKING SYSTEM.

Following the Great Depression, depository banking in America was heavily regulated by Congress and the Federal Reserve. Interest rates were capped to restrict competition between financial institutions.

In the 1970s, investment banks, such as Merrill Lynch, began to compete with depository banks, offering “money market mutual funds.” These allowed bankers to buy and redeem shares daily, offering higher interest rates than what depository banks were allowed to pay. The catch? They were not regulated or protected in the same way as ordinary banks. Despite this, Americans took to these Wall Street firms with such gusto that ordinary banks came close to collapse. This was the rise of the “shadow banking system” in the US.

From the 1980s onwards, America’s banking system underwent considerable deregulation in order to prevent depository banks from going bust. One of the most notable changes, according to US economists, was the Gramm–Leach–Bliley Act of 1999 which allowed commercial and investment banks to merge. In 2004, the US Securities and Exchange Commission relaxed the net capital rule. This allowed investment banks to increase the level of debt they took on, encouraging lending which spurred the housing bubble. It also allowed for voluntary regulation.

VOLUNTARY REGULATION – WITH FREEDOM COMES RESPONSIBILITY.

Voluntary regulation meant that investment banks did not have to follow a set of guidelines as defined by US Congress. Instead, they could choose an independent regulator whose guidelines reflected their business practice most seamlessly.

According to The Financial Crisis Inquiry Commission Report, when voluntary regulation was introduced, self-preservation was assumed to be the driving motive behind the investment banks’ business practices – that is, banks were expected to follow their own set of guidelines that would protect them from taking on too much risk and then collapsing under strain.

What actually happened, according to the report, was “a race to the weakest supervisor.” The report says this lack of regulation allowed a “lack of transparency” within financial institutions – detrimental since the banks were also taking on excessive risk. It also says that the whole crisis could have been avoided if the Federal Reserve had set “prudent mortgage-lending standards” in order to “stem the flow of toxic mortgages.”

As Eleanor Roosevelt said, “With freedom comes responsibility.” Before the GFC, US investment banks had the freedom to choose whatever guidelines suited them best – whether they were responsible or not. They chose high risk and high gains instead of long-term sustainability. With this choice, they dragged millions of borrowers and shareholders with them.

CASTING OUT THE SHADOW IN AUSTRALIAN BANKING

When it comes to Australia’s shadow banking system, there is no comparison. According to the Reserve Bank of Australia, in its March Quarter Bulletin for 2015, the shadow banking system here is relatively small when compared with the global average. It has also undergone a considerable decline since the GFC, while traditional banks (deposit taking institutions) have increased their asset positions. Why is this good news? The lending practices of depository banks are shaped by the prudent guidelines set by APRA (the Australian Prudential Regulatory Authority).

WHY APRA IS A GOOD THING

APRA is kind of like a strict parent. They restrict. They say no. They warn about consequences – and they do all of this, not because they have a power complex, but, because they want you to survive… They aim to protect you so you will live, and thrive in the best possible health. APRA wants this for the Australian Banking system and the economy at large. They set standards of responsible lending in order to protect banks from collapse, encouraging self-preservation with a gentle, yet firm, regulatory hand.

THE AUSTRALIAN STANDARD – PRUDENT REGULATION

Over the past couple of years, APRA has tightened lending standards  in order to protect lenders and borrowers. Much of these restrictions have been aimed at reducing lending to investors. Since the restrictions were introduced, lenders have set a 10 per cent benchmark for investor housing loan portfolio growth within their mortgage books. They have also tightened serviceability requirements. These include: calculating affordability with an interest rate buffer of at least two percentage points above the standard rate, trimming back uncertain income sources, and increasing expense calculations above actual borrower expenditure. Some lenders have reduced the allowable period for interest-only components of loans and reduced the maximum loan to value ratio to 80 per cent.

These changes have been put in place in order to ensure that lenders do not approve loans to borrowers unless they can afford to pay them back – especially if interest rates go up or their living expenses increase. All these measures mean borrowers are not taking on more risk than they can manage, steering the sector well away from housing bubble territory.

Imagine if the US had restrictions in place 15 years ago…

THE EFFECT OF SUBPRIME MORTGAGES IN THE US

In 2006, the US mortgage market stood on wobbly ground – almost a quarter of which was subprime.

Subprime borrowers are those who may have difficulty paying their mortgage. They borrow against poor collateral (deposits and assets) – increasing the risk for lenders. To reflect this risk, interest rates are set at a higher rate than a standard loan – a factor which may actually make it more difficult for the borrower to pay down their debt. The Financial Crisis Inquiry Commission Report, states that the subprime share of the entire mortgage market in the US surged before the financial crisis. In 2003 it was at 8.3 per cent. In 2006, however, it stood at a whopping 23.5 per cent!

The report also states, between 2001 and 2007, the amount of mortgage debt per household rose by more than 63 per cent “even while wages were essentially stagnant.” It says, some borrowers chose “option ARM” loans – adjustable rate mortgages that allowed them to make repayments so low that their mortgage balances actually rose every month. The report states that in 2005, 68 per cent of option ARM loans issued by Countywide and Washington Mutual had either low or no documentation requirements attached to them.

In addition to this, the Commission report states that “suspicious activity reports” related to mortgage fraud increased 20-fold between 1996 and 2005, again doubling in the next four years to 2009. Also, the percentage of borrowers who defaulted on loans within the first few months of taking them out almost doubled from mid 2006 to late 2007. The commission report concludes, “they (the defaulting borrowers) likely took out mortgages that they never had the capacity or intention to pay,” and that “lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities.” In the US, defaulting borrowers are not legally required to pay back their loans.

Excessively risky, or down-right irresponsible? You be the judge. Any way you see it, these figures could not be replicated in the Australian market – not with the uniformity of lending standards introduced by APRA and the shrinking state of the shadow banking system.

CAPITAL LEVERAGE RATIOS

According to the Financial Crisis Inquiry Commission Report, in 2007, the USA’s five major investment banks – Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley – were operating with capital leverage ratios as high as 40 to 1. What does this mean? It means for every $40 worth of assets they held, there was only $1 worth of capital to cover loss. This thin veil of capital protection was not limited to non GSEs. Fannie Mae and Freddie Mac, the two US Government sponsored enterprises, had a combined leverage ratio of 75 to 1.

AUSSIE BANKS HAVE INCREASED THEIR CAPITAL POSITION

According to the RBA’s 2016 Financial stability review, the major Australian Banks have raised close to $5 billion of common equity since October last year. This has increased the major banks’ CET1 capital ratio to about 10 per cent of risk-weighted assets, which is well above the minimum benchmark of 8 per cent. In addition to this, banks using the IRB approach to credit risk have reported leverage ratios close to 5 per cent, which is above the current benchmark of 3 per cent. Unlike US investment firms in 2006, Australian Banks are not skating on thin ice and have sufficient capital buffers in place against their borrowing.

SO, WHAT’S WITH THE PRICE HIKE IN AUSTRALIA THEN?

Property prices in Australia, especially in Sydney and Melbourne, have undergone considerable growth in recent years. According to Bob Birrell and David McCloskey from The Australian Population Research Institute, the median house price in Sydney is currently worth around 12.2 times the median household income.

But, does this price hike mean we are in bubble territory? Property expert and co-founder of strategic property investment company Binvested, Nathan Birch, says, “No.” He has spent the past 13 years building a property investment portfolio of more than 200 properties and has seen the highs and lows of interest rates, global financial duress and housing demand.

He says, the driving force behind recent price hikes has been severe under-supply due to population growth. He says, since Australia is a young country, with limited infrastructure, a growing population is required in order to fund infrastructure growth through tax. “The Government needs people to move into the country to pay taxes,” he says. “From that perspective, I don’t see anytime in the near future that we will see people slowdown from coming into the country.”

The problem with consistent population growth, however, is finding enough housing for everyone to live in.

HOW MANY HOMES ARE WE SHORT OF?

According to studies conducted by ANZ Bank in March this year, Australia is short of around 250,000 places to live. In NSW, population growth and increased demand is currently outstripping a boom in new construction. The study suggests that even though around 56,000 new homes are set to be built, growing demand of 63,000 new dwellings will create a shortfall of 7,000 homes before the end of the financial year.

When added onto the existing shortage, this makes 99,137 homes altogether. The shortage will go beyond 100,000 during the next financial year and reach almost 115,000 the year after that. In an article written by Jessica Irvine for the Sydney Morning Herald, ANZ Senior Economist, David Cannington says “The amount of downward pressure in prices will be limited by this significant undersupply of houses,” explaining, “on current construction levels in NSW, and if there were no additions to the underlying requirement for households, then you’d still be building for three years before NSW was in balance.”

This severe housing shortage is distinct from the US housing market at the time of the GFC, where there was a significant oversupply that only worsened when troubled home-owners rushed to try and sell.

SO WHAT IF PRICES DO GO DOWN?

While we don’t have a crystal ball we can take a look at the current environment, the factors influencing prices and follow a logical path of reason.

And even if Sydney prices did go down dramatically, the number of people currently locked out of the housing market will pounce at the opportunity to buy. What will this new level of competition do? You guessed it, it will drive up prices yet again.

So are we likely to experience a housing bubble assuming current conditions prevail? No, at worst there may be a slight correction of a few per cent in some areas. For this reason it is important for property investors to buy below market value so that they make money on the way in and have a buffer. Investing with this strategy means that investors are not only getting in ahead from day one, but are also protected.

IN A NUTSHELL?

In the lead up to the GFC, the US had an oversupply of houses, a large subprime share of unstable mortgages which were unable to be repaid from the beginning, lax lending regulations under which borrowers could pay so little that their balance would increase each month, no legal requirement for defaulting borrowers to pay off their loans and a dominant shadow banking system. Mortgage fraud had increased 20-fold over the space of nine years and investment firms were operating on extremely thin capital which together resulted in the inflated housing bubble and burst we saw.

In contrast, Australia currently has a small shadow banking system that is undergoing a state of decline, strong asset growth within its banks (which are holding more capital to protect against loss than required), prudent mortgage lending standards that encourage industry-wide uniformity and an under-supply in housing that has produced consistent demand due to population growth. Serviceability requirements currently enforced by the banks include an interest rate buffer to make sure borrowers can still make repayments if rates rise, expense calculations that often sit above the borrower’s actual expenses and income assessments that discount the value of rental income and other uncertain income sources. Aussie borrowers who default on their loans still have to pay them back.

While it’s easy for some parts of the nation to feel like all hell is going to break loose after the recent property market growth it’s important to keep in mind that recent price growth does not mean a market is in a bubble. A housing bubble occurs when prices move away from long term average trajectories, however markets like Sydney and Melbourne have just caught up to their average long term pattern after a period of below average low growth.

So hopefully you see now that despite the doomsday screechers crying foul over recent inner city townhouse prices, Australia is in fact not in danger of a housing bubble.

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