How to fix the housing market's ills

Imposing maximum loan-to-valuation and debt-service-to-income ratios may reduce the risk for our banking system and give the RBA more flexibility to act when house prices inevitably fall.

Housing is a big deal. It is the biggest purchase that most of us will make in our lifetimes.

It is also the most dangerous.

The Australian housing market is worth over $4 trillion and housing debt accounts for over 90 per cent of all household debt and around 60 per cent of all household wealth. Our investment profile flies in the face of all investment advice. As a nation, our wealth is woefully concentrated.

To borrow a dreaded phrase, the Australian housing sector is ‘too big to fail’. The sector is a systemic risk to the broader economy and, even if you do not believe that we have a bubble, the risk of a downturn is such that you should at least favour mitigating the potential fallout of that risk should it eventuate.

From the outset, I must acknowledge that I don’t buy into the bubble narrative. House prices are high but they have moved in line with income growth over the past decade. House prices in Sydney, our most expensive city, are in real terms below their level a decade ago. Income growth over the next few years should ensure that the current level of house price growth will not be sustainable.

In addition, household leverage has yet to pick up (despite historically low interest rates), and prospective first home buyers are increasingly ambivalent about entering the market. Foreign investors and self-managed superannuation funds are speculating on housing, but on balance it does not appear to be a conducive environment for a sustained housing boom.

But the outlook for housing is always risky. We have experienced 22 years of uninterrupted economic growth, living up to our ‘lucky country’ moniker, but that will end eventually. It will be at that point that housing stops being a driver of growth and becomes a noose around our collective necks. 

Realistically, all it will take for house prices to fall significantly is the underperformance of the non-mining sector over the next few years. The circumstances for this are already in motion, with the exchange rate ‘uncomfortably high’ and uncertainty surrounding the Fed’s taper. If the Australian dollar does not depreciation then we may face the most arduous economic conditions since the early 1990s and a housing market to match.

Recently, the Reserve Bank of New Zealand launched policies designed to slow risky lending due to concerns that their market had become overheated. The New Zealand housing market bears a striking resemblance to our own, and as such we should monitor what impact these regulations have. If successful, the RBA and APRA should follow suit to mitigate the risk of a housing downturn.

Research shows that a range of macroprudential measures, such as maximum loan-to-valuation ratios, debt service-to-income ratios and limiting a bank’s real estate exposure are all associated with either reducing the rate of growth of house prices or housing credit. Requiring a 20 per cent deposit on a $500,000 home is a lot less risky for a bank and borrower than a 5 per cent deposit on the same home.

Macroprudential regulations are designed to protect the banking system as a whole, rather than a specific borrower. A home loan from one lender is cut up, twisted, flipped and turned around before being sold off to other lenders as collateral on other loans. Given the sheer size of mortgages in Australia, our housing market, much like those in the US and Europe, poses a systemic risk for the broader economy. Our regulation on mortgage lending should reflect this.

Macroprudential polices would also provide greater scope for the RBA to lower interest rates in order to boost other sectors of the economy. At the moment the RBA finds themselves between a rock and a hard place: they want to boost spending but lowering rates increases the possibility of a housing market boom. That greater policy flexibility might be awfully useful in 2014.

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