A plague on Aussie housing

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Another indicator is the rising levels of household debt used to speculate on housing prices. Household debt is overwhelmingly composed of mortgage debt, whereas personal debt is a small fraction. Figure 4 shows the recent and considerable increase in the household debt to GDP ratio, peaking at 97 per cent in 2010 when housing prices did the same. The ratio has fallen slightly to 93 per cent, which may explain the falls in property values over the last two years, including the historically-low growth in housing finance data (Housing finance misses expectations in November, January 14).

A troubling fact is that almost 60 per cent of investor loans are interest-only (25 per cent for owner-occupier loans), signifying the speculative motive of property owners.

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Lastly, a classic sign of a bubble is the price to rent ratio. The reason why this metric is often used in housing analysis is because debt speculation affects capital values, not rental incomes (the latter is determined by wages and population growth). Given that the denominator (rents) tends to remain stable over the long term, it is the numerator (housing prices) that comprises the deciding variable. The following figure illustrates the uptick in the ratio commensurate with the boom in housing prices as shown in figure 1. From the trough in 1997 through to 2011, this ratio indicates an overvaluation of 44 per cent, similar to the figures that were recently released by The Economist. The largest surge occurred post-WW2 when the government released price controls on housing, but took until the 1970s to remove all controls on rents.

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Minsky's financial instability hypothesis can help to integrate the occurrences seen in the data. The speculative financing phase likely corresponds to the 1996-2000 period, as housing prices steadily increased but rental income still covered mortgage interest repayments and rental expenses. This relationship, however, broke down from 2000 onwards as housing prices rapidly escalated. Investors were then dependent upon rising capital values in order to realise a profit at sale and to cover the cost of mortgage debt.

This resembles the terminal Ponzi phase, where housing prices and the household debt to GDP ratio have boomed while net income losses have escalated. Accordingly, by these measures, the evidence suggests that the residential property market is currently experiencing a bubble, with prices detached from fundamental valuations. This appears to be the largest bubble on record, orders of magnitude larger than all preceding bubbles. When it does burst, heavily indebted property owners (recent home-buyers, negative gearers) will experience financial trouble, including the economy at large.