So recently I blogged about some of the common myths surrounding the Australian housing market. That post also hinted that I believe our housing market is entering a very fragile phase, where finally, after many false prophecies of collapse, our luck might finally run out. I am predicting that the Australian housing market will enter a volatile period within the next 9-12 months, with a drop of approximately 20-40% in the next two to three years after that. And I’m going to borrow the theory of an obscure and oft-forgotten 1960’s economist by the name of Hyman Minsky to explain exactly how this housing market bubble will pop and collapse.
This man’s ideas have never really been applied to a housing market though, dabbling predominantly in the world of finance. However, I believe that the financialisation of the housing market in Australia means that the leap between his theory and the housing market in Australia can be made. Let me quote BBC News to give you a brief introduction to this man:
American economist Hyman Minsky, who died in 1996, grew up during the Great Depression, an event which shaped his views and set him on a crusade to explain how it happened and how a repeat could be prevented…
Minsky spent his life on the margins of economics but his ideas suddenly gained currency with the 2007-08 financial crisis. To many, it seemed to offer one of the most plausible accounts of why it had happened.
He referred to his theory as the Financial Instability Hypothesis (FIH), and argued that lending goes through certain stages in a capitalist economy. Considering housing in Australia is no longer just a roof over your head, but rather seen as an investment and an asset, it’s easy to apply his different approach to finance to the housing market here. This is how it flows:
1. THE HEDGE POSITION: Your expected inflows are expected to be less than your committed outflows for the foreseeable future. You’re good.
2. THE SPECULATIVE POSITION: Your committed outflows are larger than your inflows, but enough to pay interest. You must refinance to pay the principal. You’re playing with fire, but still… you’re good.
3. THE PONZI POSITION: Your interest payments are greater than your inflows. You’re fucked.
I’m going to outline the steps below, and explain how they can be applied to what we have seen, and what we are currently seeing in the Australian housing market.
PHASE I: RECOVERY
This is the first stage, when banks and borrowers are cautious. They’re usually cautious because the inherent contradictions of capitalism have once again fucked things up, the housing market is a shambles and everybody is broke. You can take your pick which economic downturn you’d like to focus on. For example, since the U.S developed the beginnings of its capitalist economy in the early 19th Century, the country has experienced a moderate to serious economic downturn in 1836, 1839, 1845, 1836, 1845, 1847, 1857, 1860, 1865, 1869, 1873, 1882, 1887, 1890, 1893, 1902, 1907, 1910, 1918, 1921, 1926, 1929, 1937, 1945, 1949, 1953, 1958, 1960, 1969, 1973, 1980, 1990, 2001, and 2007. In nearly every single case, Australia’s economy crashed too. The ones I’ve highlighted in bold were particularly bad. I don’t know about you, but that doesn’t look like a successful economic system – in fact the only guarantee you can garner from those dates is that at some stage it will crash spectacularly again.
So what happens next? Well after the initial crash most lenders, banks, CEO’s, business leaders and investors are hesitant and cautious. They’ve been burnt – their world is now a shaky and scary place and they’re careful where they invest their money. There’s a strong memory of the last crisis, a high value on liquidity and generally a low risk appetite across the market. But let’s not worry about them for the moment – let’s go back to the household. In Minsky’s model the whole economy is essentially a network of financial interconnections. So for example, your typical household looks like this:
Expected Inflows – Labour income (i.e. your job), property income (i.e. capital gains, if you decide to sell, or rent if you’re a landlord)
Assets – Your house, your super, possibly some shares and bonds, and your bank deposits
Expected Outflows – Necessities, other goods & services, taxes
Liabilities – Your credit card, the mortgage and possibly some student debt
Firms and banks generally have the same structure, and need to balance inflows and outflows. Now, within this recovery phase the household will have expected inflows that are expected to be greater than the committed outflows. Remember, after a financial downturn the average household has been burnt too – those who survived (i.e. didn’t go bankrupt of have their house re-possessed) are just thinking about getting to the next pay-check; they’re super cautious too.
In the case of Australia, we can trace the PHASE I related to our current housing bubble all the way back to the end of the so-called ‘recession we had to have‘ back in 1990. For a lot of people my age (late 20’s) this marks the period when their parents tried to enter the housing market for the first time – and many got burnt. Interest rates went up to 17%, the economy nose-dived and unemployment spiked. Many people lost their first house and were thus forced to declare bankruptcy. At the time, it was the biggest contraction of the Australian economy since the Great Depression. I’m going to pinpoint that 1991 was the commencement of PHASE I, which stuck around for a couple of years.
PHASE II: TRANQUILLITY
In this period the ultra-caution is starting to wear off. So I’m going to say our PHASE II started in about 1992-1993. Households that managed to get through that crisis start getting a bit of confidence back. In fact, many households and banks (keep in mind the so-called ‘big 4’ banks in Australia had to be bailed out by the government in 1989) start actively seeking more financial assets – such as bonds, shares or other investments. Businesses find the cost of borrowing lower, so they start investing more. This in turn has a feedback loop – demand rises, incomes rise, profits rise and the cycle starts all over again. Hakuna matata! In the case of the Australian housing market, I would say this was between the period of 1993 to 2001. Near the end of this phase property sale proceeds subject to Capital Gains Tax reduced from 100 to 50 percent (for property held at least one year), while 100% of costs remained deductible. With the mining boom also starting to take off, the scene was set for PHASE III.
PHASE III: BOOM
By this stage, it’s been over 10 years since the recession of 1990. The memory of the previous crisis has all but faded. People who were only very young at the time of the last crisis are now formally entering the job market and the housing market – they have no personal recollection of what happened last time. They don’t give a shit, and why should they? Things are looking well and truly rosy by the time we enter PHASE III. In this period, there’s an even lower value on liquidity and a much higher appetite for risk. There’s a much higher rate of investment and a larger ratio of speculative investment overall. Again, the feedback loop is still there, but now it’s going into hyper-drive – higher demand, higher incomes, higher profits. Hakuna matata, what a wonderful day!
PHASE III is unique in that this is where it should have quickly evolved into PHASE IV & V. Look to the housing markets of Ireland, the UK, Spain and the U.S to get an understanding of what happened elsewhere.
PHASE IV: PEAK
Things start getting truly crazy by this time, but everybody is getting so cashed-up (especially the banks, CEO’s, investors and those who already own assets) that nobody stops to question the insanity of it all. These higher profits can now be seen as long term trends. Ask anybody in their 50’s how much they bought their first house for – and then how much it’s valued now. They’ll most likely tell you with a big shit-eating grin on their face that it’s at least doubled in value (with supposedly no end in sight). The only reason that houses have reached those levels within PHASE IV is that these properties have morphed from being dwellings (i.e. a place to seek shelter and/or raise a family) into investments. Thus, these investments increase in evermore speculative lines, usually in sync with a boom in the sharemarket (and the market overall). More of these houses take on speculative positions, with some investors deliberately moving into Ponzi positions. Why would they do this? Well because they’re expecting capital gains. The rationale is this: Buy at $1.2m and sell at $1.4m just six months later, making a cool $200,000 in the process. You’re a sucker if you don’t get involved! This is why, despite the ludicrous prices for housing across Australia at the moment, many of my friends have decided to formally enter the housing market now. Big, brand new houses too – in fancy new shiny suburbs. My parents have gotten in on the craze too, getting an investment property and putting in a granny flat out the back. I can guarantee that they made these massive investments on the belief of big windfalls in the future.
So lets look at the stats. From PHASE I to PHASE IV, “the average house price in the capital cities is now equivalent to over seven years of average earnings; up from three in the 1950s to the early 1980s”. Within my city of Sydney, it is now 12 times the average income to buy a standard house! To put that in perspective, it’s technically bubble territory when it’s more than 3 times the average income.
PHASE V: CRISIS
As noted in my last post, there’s usually some ‘canary-in-the-coalmine’ signs that things are starting to turn sour. I used the (somewhat extreme) example of Moranbah in central QLD, where prices have dropped by more than 70% from their peak just a few years ago.
What my critics must concede is that most of the investment that happened in that town was Ponzi in nature – investors were barely paying the interest on properties and expanding their housing portfolio’s as quickly as possible.
When PHASE V finally does kick in, some of these so-called Ponzi investments self-destruct. You can see this happening right now in Melbourne’s high-rise apartment market, which has fallen by 30% by some estimates. The same papers that were championing the DIY housing and investment culture are now screaming that the Australian housing market is at least ‘40% overvalued‘ whilst noting that Sydney home values have just had their single largest quarterly drop in seven years. The next time you hear someone say there’s a housing shortage, remember that there are 90,000 houses sitting empty – just in Sydney! In fact, recent data just out indicates that we now have the fastest rate of bankruptcies across the country since the dark days of the GFC. These messages will slowly start to filter though to the masses. Then, panic will start to kick in.
Confidence will thus be shaken across the economy, with the rising value of liquidity heralding a flight to safety (usually cash or gold – or in the case of wealthier investors as can be seen in the case of the so-called Panama Papers, taking their money off-shore). In this particular instance, interests rates set by the RBA will most likely drop. But considering they are already at historic lows, this will do nothing but further stoke the panic. Moreover, as we’re witnessing right now, the commercial banks are increasing their interest rates irrespective of the RBA. Why? Because as banking analyst and APP Securities managing director Brett Le Mesurier recently stated,
The cost of funds is increasing because there’s a perception that there’s greater risk in the world. Cost of funds, credit risk, price of risk are all related to perceptions of risk.
When PHASE V truly takes hold (this may be sparked by another crisis in the Chinese stock or housing markets, a credit-crunch in the Eurozone [or possibly a Grexit or Brexit?] or a further collapse of commodity prices [maybe even the collapse of a major resource company]) the RBA will most likely drop interest rates (but as stated, that will do little) whilst the big 4 banks will chuck them up precipitously. This will be because our banks are heavily reliant on the international credit market to maintain liquidity. After the banks were hammered a couple of weeks ago and ANZ had $6 billion wiped off it’s value in just two days, the Sydney Morning Herald recently pondered if it was actually even worth ‘buying bank shares?‘ If the Australian economy starts (or is perceived) to be in trouble, the international credit market will be less likely to lend to the big 4 banks, meaning interest rates will have to go up to reflect the higher costs of lending. It’s the text-book example of a credit crunch.
That is when shit will truly hit the fan. Australian’s have the unenviable title of the largest mortgages, largest household debt and largest personal debt in the world. Even a small shock to the economy will mean that the number of people defaulting on their mortgages will rise considerably. Many of the houses bought in the latter stages of PHASE III and PHASE IV have now been pushed into Minsky’s Ponzi position, because of the rising costs of refinancing. The feedback loop starts kicking in the other way now – more investment failures and mortgage defaults. Then demand drops, incomes drop, profits are decimated and debts start to build up. Hakuna matata – and the circle of life starts rapidly going in reverse. I’m predicting that PHASE V will happen by the end of this year.
THE END: STABILITY BREEDS INSTABILITY
This is where I personally think that Minsky’s FIH really shines. He reckoned that stability was ultimately… destabilising. As famed American economist Laurence Meyer has pointed out,
a period of stability induces behavioural responses that erode margins of safety, reduce liquidity, raise cash flow commitments relative to income and profits, and raise the price of risky relative to safe assets–all combining to weaken the ability of the economy to withstand even modest adverse shocks.
One comeback I frequently get when talking about the perils of our current housing bubble is the uninterrupted growth in real estate prices for over a quarter of a century. Why listen to the doomsdayers’ now? I think this argument is irrelevant. As the old adage goes though, the bigger they are the harder they fall. Just a few days ago it was revealed that a secret report in 2007 (just before the GFC kicked off) by the banking regulator ASIC showed that lax lending standards threatened to push ‘the number of borrowers who could not pay their home loans to dramatic and unprecedented levels that could have caused a serious recession and a banking crisis‘. Experts are now saying that we dodged a bullet back then – ironically by making the situation worse for us today. A classic and disastrous example of kicking the can down the road.
MY CONCLUSION. MY REPUTATION.
So there you have it. Over two posts, I’ve de-constructed every argument against the infallibility of Australia’s housing market, followed up by this post where I argue how, why and when the bubble will burst. I know this is a ridiculously bold claim I’m making here, and even as I type these words a voice in the back of my head is telling me how wrong I am about all of this. To be honest – I hope I’m wrong. Nobody but a select few cunning investors ever benefit from a housing market collapse. If I’m right, many of my friends, and possibly even members of my own family – will lose everything. This country’s wealth, reputation, confidence and social fabric will be deeply eroded.
But looking at the evidence, its hard not to see that Minksy’s words are growing truer by the day. Stability breeds instability, and we’ve had a lot of the former. Get ready to say hello to the latter.