The banks' delicate property balance

One of the biggest question marks facing Australia in 2012 is whether global banking turbulence will affect Australian property prices. The international bears say we are very vulnerable. For example, the International Monetary Fund says that Australian house prices are overvalued by between 10 and 15 per cent. The Economist magazine reckons the overvaluation is closer to 50 per cent. By contrast, Business Spectator columnist Christopher Joye from Rismark believes our dwellings are not overpriced (Disposable house price myths, December 20).

The last word we got from 2011 was RP Data-Rismark November capital city home value index, showing a rise of 0.1 per cent in November – its first lift in 11 months.

The factor to watch in 2012 is the willingness of our banks to lend. The tightening of Australian bank lending for housing is one of the reasons we have seen a small fall in the housing market in 2011. If banks were to tighten further there would be a more marked decline.

Of course, closely related to the availability of bank lending is the level of employment. If there is a rise in unemployment and therefore a rise in problem housing loans, not only will it tighten bank lending, but it will also increase the supply of houses as people can't keep up with their mortgages.

The banks' lending criteria is also closely related to the level of interest rates. If rates rise, banks become more cautious because people can't afford to repay the loans. Urged on by our politicians, Australians have come to link Reserve Bank official interest rates with the level of home loan rates.

There is grave danger that in 2012 this nexus will be broken.

Historically, Australian banks have made substantial profits by borrowing money on the overseas wholesale market and using that money to fund about 40 per cent of our home loans. European banks are headed for a substantial money squeeze and that may spread to the US, particularly if US state and local governments get into trouble. If that happens then Australian banks will have to either pay the going wholesale rate, bid up the local deposit interest rates to attract local savings or curtail their lending.

Each of those alternative actions will affect the value of Australian dwellings. One of the looming dangers in the banking sector is the exodus of European banks from Australia.

As they withdraw funds from a large number of medium-sized businesses, those enterprises will lower employment levels, although the accelerated mining boom will take up a lot of the slack.

The aim of Australian banks in 2012 will be to attempt to take advantage of the sharemarket turbulence to entice people to put money in bank deposits and without paying substantially higher interest rates.

If they can do that, it will contain the higher interest rate pressure and be of great value to the dwelling market.

Banks have to be careful because if they take actions that reduce the value of dwellings by a substantial amount, they will in turn cause a big rise in bad debts as people throw in the towel and the subsequent foreclosures create bank losses and further house price declines. Accordingly, if banks are smart enough to understand these forces, they should be able to restrict any housing decline to relatively small amounts.

But there is an Australian dwelling factor outside of our banking system and domestic economy.

Mainland Chinese have dominated the purchases of inner Sydney apartments and, to a lesser extent, Melbourne apartments. In the last month or so the Chinese have halved their buying of apartments and if that accelerates, it will push down the prices of apartments in our two major cities (primarily in Sydney). We could be looking at a 10 per cent fall. In turn, that will spread to apartment blocks outside the inner city and ordinary houses. But again the effect is manageable.

The greatest danger is that a sizeable proportion of the multitude of inner Sydney and Melbourne apartments that have been bought off the plan by mainland Chinese are not consummated and the Chinese simply walk away and accept the loss of their deposit.

That will create a pall of unsold dwellings over the Melbourne and Sydney markets in much the same way as contracts reneged in the Sunshine and Gold Coast have affected property values.

The Chinese have honoured almost all contracts to date but we all need to understand that there is a danger. Australia has one of the best banking systems in the world because we have not gambled with depositors' money as occurred with European and US banks.

But that doesn't mean we don't face important challenges in 2012.

Tomorrow, we will talk about US housing.