The Chopping Block?

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Real­i­ty came to Real­i­ty TV in Aus­tralia last week, when 3 of the 4 prop­er­ties in the much-hyped “Flip that House” pro­gram The Block failed to sell at their nation­al­ly tele­vised auc­tion. A 400 per­son live audi­ence, watched by over 3 mil­lion TV view­ers, could­n’t entice more than one per­son to part with mon­ey rather than eye­balls. As the SMH observed:

What­ev­er the lure of a celebri­ty house, the would-be buy­ers in Fitzroy Town Hall were just as jit­tery as the would-be buy­ers at any oth­er auc­tion in recent weeks. (“Auc­tion fail­ure shocks The Block”, SMH August 22)

The remain­ing three prop­er­ties sold in the week after the sale, but at a sub­stan­tial loss com­pared to the ini­tial pur­chase prices plus the sums expend­ed on them by the 4 cou­ples in their 2 months of tele­vised ren­o­va­tions (and let’s not men­tion the adver­tis­ing bud­get).

So is the chop­ping of The Block a sign that the days of ever-ris­ing house prices are over? Not if you lis­ten to Chris Joye (“Prop­er­ty’s fine fore­cast”, Busi­ness Spec­ta­tor 25th August 2011). The medi­an fore­cast of the “21 lead­ing mar­ket econ­o­mists” he polled was for 5% growth in nom­i­nal house prices per annum for the next ten years, which Chris notes would sug­gest “that they will like­ly be 55 per cent high­er in 10 years’ time”.

Good luck with that. As Chris notes, my fore­cast was­n’t includ­ed, but it should be no sur­prise that I expect a fall in house prices of about 40% over the same time peri­od.

I dif­fer with the 20 who pre­dict­ed pos­i­tive price growth for one sim­ple rea­son: I focus on the role of debt in dri­ving house prices. Hav­ing argued that debt drove prices up over the last 15 years, I now expect debt to dri­ve them down again.

The mech­a­nism is simple—but it’s not part of con­ven­tion­al “Neo­clas­si­cal” eco­nom­ics, which is why Chris and his sur­veyed mar­ket econ­o­mists don’t con­sid­er it. Aggre­gate demand is the sum of income plus the change in debt, and this is spent on both goods and ser­vices and assets. There is thus a link between the change in debt and the lev­el of asset prices (and the frac­tion sold, and the quan­ti­ty pro­duced, but I’ll focus just on just house prices for now).

Going one step fur­ther, the change in aggre­gate demand is the change in income plus the accel­er­a­tion of debt. There is thus a link between the accel­er­a­tion of debt and the rate of change of house prices. If this rela­tion­ship is strong, then ris­ing house prices require that the rate of growth of debt ris­es over time.

So just how strong is the rela­tion­ship? Using the RBA’s data on mort­gage debt from 1992 till now (there was a break in the series in 1991) and the ABS House Price Index, the cor­re­la­tion between accel­er­at­ing mort­gage debt and the change in real house prices is 0.42 and high­ly significant—see Fig­ure 1.

Fig­ure 1: The Mort­gage Debt Accel­er­a­tor and change in real house prices

The accel­er­a­tion in mort­gage debt has been volatile, but on aver­age pos­i­tive. For two decades, mort­gage debt has accel­er­at­ed at 0.5% of GDP per annum. Can that con­tin­ue for the next ten years?

No way. That sus­tained accel­er­a­tion of debt has caused mort­gage debt to ris­ing dra­mat­i­cal­ly, from less than 30% of house­hold dis­pos­able income in 1991, to a peak of 135% of dis­pos­able income ear­ly in 2011 (see Fig­ure 2).

Fig­ure 2: A 4.5 times increase in mort­gage debt com­pared to dis­pos­able income over 2 decades

That’s a 4.5‑fold increase over 20 years, com­pared to the 50% fall in mort­gage rates across the same peri­od.
Sim­ply pay­ing the inter­est on out­stand­ing mort­gage debt now con­sumes over 8% of house­hold dis­pos­able income, ver­sus 4% back in 1991—and less than 2% in the 1970s.

Fig­ure 3: A four­fold increase in mort­gage ser­vic­ing vosts since 1980

The sit­u­a­tion is worse when debt repay­ment is tak­en into account. The cost of pay­ing a 25 year vari­able rate mort­gage on the aver­age First Home Loan has risen from 45% of Aver­age Week­ly Earn­ings (AWE) in 1991 to 63% now—and it peaked at 74% of AWE before the “unex­pect­ed” Glob­al Finan­cial Cri­sis forced the RBA to dras­ti­cal­ly cut rates in 2008.

Fig­ure 4: It now takes 2/3rds of the aver­age wage to become a First Home Buy­er

Chris real­is­ti­cal­ly observes that house­hold lever­age can’t rise any fur­ther, but implies that this is neu­tral for house prices. But sta­bil­is­ing debt is not neu­tral for house prices: since debt lev­els have risen till now, a sta­ble debt lev­el in the future means decel­er­at­ing debt and falling house prices. Fig­ure 5 shows that the decel­er­a­tion (on an annu­al basis) began in Octo­ber 2010, and it has gath­ered pace since.

Fig­ure 5: Mort­gage debt decel­er­at­ing

If rather than sta­bil­is­ing debt, Aus­tralian house­holds start to reduce their debt as US house­holds have done (see Fig­ure 6), then house prices would need to defy the grav­i­ty of decel­er­at­ing debt to keep ris­ing at the 5% nom­i­nal rate (rough­ly a 2% real rate) that Chris Joye pre­dicts for the next decade.

Fig­ure 6: Mort­gage debt in the USA is now falling

Of course, this is Aus­tralia, where the world is upside down: maybe “this place is dif­fer­ent”?

It will need to be, if the US post-Bub­ble expe­ri­ence is any­thing to go by. The rela­tion­ship between mort­gage debt accel­er­a­tion and change in house prices has held up through the ups and the downs of the US mar­ket since 1986 (with a cor­re­la­tion of 0.78)—see Fig­ure 7. The US expe­ri­ence since 2006 shows what is like­ly to hap­pen here as the debt bub­ble that fed the hous­ing bub­ble final­ly comes to an end.

Fig­ure 7: Debt accel­er­a­tion deter­mines change in US house prices

The final retort to the argu­ment that house prices will crash here as they have else­where is that there has­n’t been a bub­ble here, so a crash can’t hap­pen. Chris acknowl­edges that house prices have risen faster than dis­pos­able income per house­hold in Aus­tralia, but attrib­ut­es that to ratio­nal rather than bub­ble fac­tors:

By way of his­tor­i­cal con­text, dis­pos­able income on a per house­hold basis has aver­aged a healthy 5.8 per cent per annum over the last 10 years, and 4.9 per cent per annum over the past 18 years.

Yet for a range of rea­sons that I have explained many times before – includ­ing the once-off, 40 per cent plus reduc­tion in nom­i­nal inter­est rates over the 1980 to 2011 peri­od – his­tor­i­cal house price appre­ci­a­tion has con­sis­tent­ly out­per­formed dis­pos­able income growth.

For exam­ple, we esti­mate that between 1982 and 2011 medi­an Aus­tralian house prices rose at a 7.7 per cent com­pound annu­al growth rate. (“Prop­er­ty’s fine fore­cast”, Busi­ness Spec­ta­tor 25th August 2011)

First­ly, as not­ed ear­li­er, a 40% fall in inter­est rates can’t explain the 4.5‑fold increase in the house­hold debt to income ratio. Sec­ond­ly, the argu­ment that debt lev­els have risen because inter­est rates have fall­en can’t explain why debt lev­els were much low­er in the 1960s when inter­est rates were also low­er than today. If house­holds respond­ed ratio­nal­ly to the fall in rates by increas­ing debt lev­els in the 1990s, why did­n’t they respond ratio­nal­ly to the increase in rates dur­ing the 70s by reduc­ing debt lev­els?

Mort­gage debt almost dou­bled as a per­cent­age of house­hold dis­pos­able income from the mid-1970s till the ear­ly 1990s, even though inter­est rates (adjust­ed for infla­tion) increased from minus 4% to over 10% across that peri­od. The debt ratio also increased from 75% to over 120% between 2001 and 2008, when real mort­gage rates rose from 0.5% to 6.4% (see Fig­ure 8).

Fig­ure 8: Mort­gage debt rose before real inter­est rates fell

Rather than changes in debt lev­els reflect­ing ratio­nal, equi­lib­ri­um respons­es to changes in inter­est rates, the growth in mort­gage debt was the fuel for a Ponzi Scheme that has pro­pelled house prices far faster than incomes have risen.

Bubbles upon Bubbles

There have been 3 big bub­bles in Aus­tralian hous­ing in the last 50 years, all dri­ven by accel­er­at­ing lev­els of pri­vate debt: the late-60s to ear­ly 70s bub­ble focused on Syd­ney; the 1988 bub­ble when the 2^nd incar­na­tion of the First Home Ven­dors Scheme trans­ferred spec­u­la­tion from the bust­ed stock mar­ket into hous­ing; and our cur­rent one since 1997, which has been dri­ven by accel­er­at­ing mort­gage debt and gov­ern­ment policy—by both Lib­er­al and Labor—with the First Home Ven­dors Scheme being used to give the econ­o­my a sharp stim­u­lus to avoid reces­sion.

Fig­ure 9: Bub­bles upon bub­bles in Aus­tralian hous­ing

These bub­bles have been built on each oth­er only because the debt has con­tin­ued to accel­er­ate. But now that Aus­tralia has reached a mort­gage debt to GDP ratio that exceeds the worst ever expe­ri­enced in the USA (see Fig­ure 10), the days of accel­er­at­ing mort­gage debt are over—and so are the days of prices ris­ing faster than incomes.

Fig­ure 10: Mort­gage debt grew faster in Aus­tralia than in the USA

Even to sim­ply elim­i­nate the impact of the last bub­ble that began in 1997, prices would need to fall 40 per­cent (com­pared to incomes) from their cur­rent lev­els. Aus­tralia is now start­ing to expe­ri­ence the same process of debt delever­ag­ing and falling house prices that Amer­i­ca has been mired in for the last five years. The one sav­ing grace we have is China—so long as Chi­na con­tin­ues to grow and dri­ve demand and prices for our raw mate­ri­als. But as recent eco­nom­ic data has indi­cat­ed, even Chi­na may not be enough to stop unem­ploy­ment ris­ing in Aus­tralia, now that Aus­trali­a’s debt dri­ven love affair with house prices is on The Chop­ping Block.