The Known Knowns of Housing Markets
Perhaps Australia’s largest collective investment and certainly its most discussed market, is residential housing. There are plenty of pundits, commentators and self-interested voices arguing about what will happen next. Housing markets are large, significant and of course widely studied. The Reserve Bank of Australia (RBA) is perhaps the nation’s principal student of housing markets.
In early September, the RBA’s Head of Financial Stability Department, Luci Ellis, spoke at a Real Estate Symposium at the University of New South Wales. Her published speech was titled ‘Property Markets and Financial Stability: What We Know So Far’.
The following are edited extracts of the fifteen-page speech, which includes insightful commentary on the psychology underpinning property purchases.
Ms Ellis commenced by stating the obvious, that “Financial stability and property markets are inextricably linked. It's an important topic, and yet there is still so much to learn.” But, she said, its not entirely unknown territory because “… we already know quite a bit about property markets and financial stability. … There is still a lot we don't know; yet sadly, some lessons we already know risk being forgotten.”
As well as its enduring nature a critical characteristic of property is that it is “fixed in place”. Commenting that “… the lesson from past booms as well as recent times is that it’s place – location – that really matters.” This creates a challenge because “the supply of good locations is more or less fixed in the short term. So any sizable boost to demand cannot be fully absorbed by more supply. The newly built property is simply not the same as the existing stock, because it is somewhere else”.
Market responses have seen supply increase in sought after locations through the construction of inner city apartments. However, this serves to make existing detached houses in those areas even scarcer. This is reflected in prices where for example detached homes in the inner areas of Melbourne or Sydney are considerably higher than outer areas. Similarly capital city housing price growth is higher for detached homes than apartments.
Tellingly, “…over the longer term the set of good locations does change.” For example, that includes improved transport infrastructure and changes in community preferences reflected in the gentrification of areas.
Reframing the language of ‘boom and bust’ in Australia’s residential dwelling market, Ms Ellis said “…property is prone to ‘hog cycles’ and ultimately to overhangs of excess supply.” In addition, “…acquiring a particular property and the housing or commercial accommodation services it provides is a large upfront cost. Accordingly it makes sense to make that acquisition with some leverage. … the highest leverage can be obtained when borrowing is secured against property.”
There is however, a potential problem with this leverage, which was described this way: “… we have a set of related assets – land for development, existing housing and the various segments of commercial property – that will inherently experience strong, but perhaps temporary, price increases in the face of increases in demand.”
Making matters worse, there are factors outside the housing market that can have a significant influence. These include “… different average rates of inflation involve different average nominal interest rates and different rates of decline in the burden of a fixed-repayment mortgage.”
“Describing the characteristics that cause lenders to exercise caution, Ms Ellis said: “The property is the security, the collateral that can be claimed if the borrower does default. Contrast this with an equity claim on a company, such as collateralises a margin loan. The market value of that claim is generally more volatile in the short term than the price of property, which is one reason why a lender might want to limit leverage more.”
“So we know that sluggish supply can create boom–bust dynamics in a property market. And we know that these asset classes are particularly amenable to leverage. Is this enough to create systemic risk to financial stability?”
Overall, the RBA distills the significant risks based on: “…features we see as posing systemic risk … size, interconnection, correlation and procyclicality.”
“The size aspect is obvious. … the housing market is large: housing is a large fraction of household wealth;...” and so “…if the mortgage book is large enough… even moderate losses would exacerbate an initial downturn that started somewhere else.”
“The sheer size of these asset classes helps explain their interconnection with the financial system, another aspect of their systemic risk. … Property-related exposures of various kinds are often large parts of bank balance sheets.”
“...Correlation, without direct connections, is another. … property markets are thoroughly correlated. Sure, every property is different. … much of what drives the change in property prices is common to all – interest rates, incomes, lending standards, supply responses.”
“But if there is one aspect of systemic risk that makes property markets especially important for financial stability, it is procyclicality.”
“What many people implicitly have in mind when they talk about procyclicality is something even more specific: positive feedback. … An example would be if investors sell an asset after its price falls, inducing further sales and falls in their price.”
Summarising on what is known, Ms Ellis went to the core of concern about a possible housing bubble and its consequent failings: “…there are strong correlations between strong upswings in credit, measured in a variety of ways, strong growth in property prices, and subsequent bad events. What isn't yet settled is whether the credit causes the prices, the property markets drive the credit, or whether either of these is the decisive factor in generating economic downturns or financial distress.”
Discussing the role of lenders, she said, in somewhat colourful language for a central banker: “Without an existing corporate culture about risk, often without a prudential supervisor to enforce those standards and practices, without ‘skin in the game’ in the form of their own balance sheet absorbing that risk, the new wave of US mortgage lenders slid inexorably into a stance of utter imprudence.”
And finally, commenting on why the RBA is a reluctant interventionist, Ms Ellis said: “… we risk forgetting that credit is not an amorphous blob. It embeds an agreed flow of payments [and] … a complex set of contract terms. These contract terms touch on the resulting credit risk at many points: not just the collateral posted and how it is valued, but the assumptions about serviceability, the length and flexibility of the loan term, the rate of amortisation required or allowed and so on. In other words, lending standards are multidimensional. Excessive focus on one dimension to the exclusion of others, could in some cases be counterproductive.”
The full text of the speech can be found here.