Housing bubble has RBA backed into the corner

If you can believe the real estate spruiker, emergency low interest rates have put a fire under Australia’s housing market. And as Australia already suffers the side effects of a large housing bubble developed over the past decade, investors will need to use extreme caution as signs emerge Australia’s central bank has just lost control of monetary policy.

Housing bubbles around the world were created early last decade by an abundance of cheap credit, the very same conditions present today. Government policy from both sides prevented a long overdue correction in our overheated housing market (‘PM appeals in vain to the shafted generation’), but the effects of an unsustainable domestic economy persist and have forced the RBA to drop the official cash rate to an emergency low of 2.50%, a level not seen in 60 years.

A change to the official cash rate has, to date, had little stimulatory effect. In the years leading up to the global financial crisis, Australian households had consumed more than they earned and accumulated debt at alarming rates. The collapse of Lehman Brothers five years ago – last week, signalled a new age in Australia where prudent households used falling interest rates to pay down their debts at a faster pace.

Data from the RBA last week suggests between 50 and 90 per cent of the 2.25 percentage point savings on interest rates have been used to make prepayments on mortgages around the country and goes some way in explaining why retail spending remains in the doldrums. But not everyone has mortgages. The falling cash rate has also had a significant impact to savers with money in the bank, especially retirees who now have less income and have been forced to cut back on spending putting more pressure on a deteriorating domestic economy.

Investors’ lead Mortgage Credit Growth

In recent months there has been an up-tick in credit growth for residential mortgages. According to AFG, Australia’s largest mortgage broker, investors comprise of 36.7 per cent of new home loans in August. In contrast, first time buyers now make up only 11.3 per cent of the market.

In NSW last month, investor loans made up a unprecedented 49.5 per cent of mortgages processed – the highest level of investor activity ever recorded for any state according to AFG.

AFG’s General Manager of Sales and Operations, Mark Hewitt says “With property prices starting to rise, and rates set to remain low for a while yet, a lot of investors are anticipating the next property cycle.”

Wealth Disaster

For some investors, the tiny returns on cash have ‘forced’ them to seek greater yields in the property market. It is believed a reasonable portion of the investor activity is the Self-Managed Superannuation Fund (SMSF) sector. In September 2007, legislation came into effect allowing SMSF the ability to leverage up to purchase property in the fund.

Led by endless number of “super” spruikers (‘The stampede into property by self managed super funds is a risky business’), Mum & Dad SMSF investors are being coaxed into investment structures they don’t understand and this has led many experts including the regulators to worry about this growing trend. For those that know what they are doing, they have worked out there is only one thing more tax effective than negative gearing, and that’s investing in property through their SMSFs.

Loans in SMSF must be non-recourse, but depending upon the diversification of the fund, some super funds could lose substantial wealth if Australia’s property bubble were to correct. This no doubt would anger younger generations who are not only locked out of housing, but will be paying increased taxes to fund the pensions of those who will have recklessly lost their superannuation.

Currency Wars: USA 1, AUST 0

Capital inflows from the mining boom and the perception Australia has a miracle economy has seen the Australia dollar surge in recent years. The persistently high Australian dollar along with high energy and labour costs have made Australia uncompetitive on a global stage and have been slowly hollowing out the Australian economy. According to the ABS, jobs in the manufacturing sector are now at its lowest level since records started in 1984. The story is not much better in retail and tourism. Rising unemployment could be a real challenge for a housing bubble built upon perceived perpetual growth.

A decision by the US Fed this week not to scale back their 85 billion a month stimulus program sent the Australian dollar back over 95 cents. The RBA has a target to bring the Australia dollar down to 85 US cents and this may force the hand of the RBA to further slash interest rates in the coming months to bring the Australian cash rate closer in-line with world interest rates, and prevent a greater inflow of capital into Australia, causing rise of the Aussie.

“It’s a disaster”

If the residential property market is “hot” now, can you imagine what another rate cut or two will do to it?

Robert Mead, Pimco’s head of portfolio management in Australia calls it a disaster. He told the AFR, “If the only impact from stimulatory policy elsewhere in the world is to inflate our residential prices, it’s a disaster,”

And how far will the RBA go to hit their target of 85 cents?

Tony Adams, Colonial First State’s head of global fixed interest rates and credit told the AFR, “The RBA is after 85c but I don’t think they are going to get there.”

Macroprudent Controls

So, it was quite timely for the International Monetary Fund (IMF) on Monday to release its report titled “Key Aspects of Macroprudential Policy.”

In announcing the report, José Viñals remarked “Policymakers learned the hard way that systemic risks could not be addressed through the traditional mix of macroeconomic policies”

“A new approach was needed to fill the policy gap and ensure financial stability in both advanced economies and emerging markets.”

Following the move by New Zealand’s central bank in August to clamp down on risky lending (‘RBNZ takes action to limit damage from housing bubble’), there has been some discussion if the same policies should be applied here. The Australian Prudential Regulation Authority (APRA) has written to banks warning about relaxing lending standards (‘With record low rates and pent up demand fuelling prices, APRA’s putting lenders on notice’), while it works out how to best proceed.

The banking lobby has naturally fired back, suggesting any tightening of lending will push first home buyers out of the market, not that there are many left! Applying Loan-Value-Ratio (LVR) limits on mortgages may also have little effect with SMSFs who are only able to borrow up to 80 per cent. Maybe the correct course of action is to reverse legislation allowing super funds to leverage into the property bubble? But if negative gearing is a sacred cow, one wonders if allowing super funds to leverage into asset bubbles will also be untouchable?

Who is going to act first? Time is ticking.

» The stampede into property by self managed super funds is a risky business – The Business (ABC), 17th June 2013.
» Mortgage Index September 2013 – AFG, 2nd September 2013.
» With record low rates and pent up demand fuelling prices, APRA’s putting lenders on notice – The Business (ABC), 11th September 2013.
» IMF takes aim at housing bubbles – Australian Financial Review, 17th September 2013.
» RBA watchful as cheap money heats housing market – The Australian, 18th September 2013.
» Regulators should target loan serviceability to head off trouble – The Australian, 19th September 2013.
» Australian dollar climbs to three-month high and shares jump after US Fed maintains stimulus – The ABC, 19th September 2013.
» Home owners use interest rate cuts to pay down mortgages – The Age, 20th September 2013.

» IMF Executive Board Discusses Key Aspects of Macroprudential Policy – International Monetary Fund, 16th September 2013.
» Making Macroprudential Policy Work – International Monetary Fund, 16th September 2013.