How Australia's banks could trigger a property crash

Greg Hoffman

August 2, 2010

Comments 49

If you're a dyed-in-the-wool property bull who hates seeing a negative thought written about property prices, stop reading now; what follows will only upset you. But if you're open to considering alternative views, please read on.

First, let me make it clear that I'm not making a prediction about a setback in the Australian property market. To insist that prices must fall seems as foolish to me as ignoring the possibility of a fall altogether. What follows is simply an observation about a potential risk, alluded to in a speech given by Phil Coffey, Westpac's chief financial officer.

In a presentation to the Australian Banking & Finance Capital Markets Forum last week, Coffey touched on the risks:
''Notwithstanding our strong credit ratings and our healthy relationship with global investors, at some point, institutional investor appetite or concentration risk may become a constraint. It is unusual and untested for an ongoing current account deficit to be funded so much by the majors of a banking system.''

These candid comments point to an inversion of the argument frequently advanced by banking bears: that falling property prices could cause enormous problems for the banks. There's certainly truth to that position but what Coffey is alluding to implies the opposite. Risk also lies in the exposure of our banks to offshore funding; that it may, in fact, be this reliance on offshore funding that triggers a property market meltdown.

Traditionally, banks use depositor funds to finance their lending. Yet that's no longer the case in this country (see Bank headlines you won't want to see). Australian banks now finance much of their lending from offshore because our national thirst for credit outstrips our collective ability to fund it. And, in exhausting our domestic savings pool, our banks have headed offshore to fill the breach, rather than curtail their lending.

Coffey, perhaps unwittingly, is inviting us to consider what might happen to the costs of servicing our mortgages and other loans if our foreign benefactors lose the will to extend further credit at some point. He politely described this disaster scenario as a ''constraint''.

We saw how our banks reacted to the reduced availability and increased cost of wholesale funding during the credit crisis of 2007, the forerunner to the global financial crisis. Credit was rationed and higher funding costs were passed on to borrowers. That provided a small dress rehearsal for what might happen if the cost of the banks' funding were to rise sharply, or dry up altogether, as a result of ''Coffey's constraint''.

A$ risks

Any such loss of confidence or appetite for Australian credit by international investors would most likely be accompanied by a loss of confidence in our currency. Again, we've had a fairly recent preview of this in late 2008 when the Aussie dollar plunged from more than 90 US cents to just 60 US cents in three short months. It's not popular to say, but several key parts of the Australian economy are dependent on the continued confidence of foreign investors.

The nightmare scenario goes something like this: International investors refuse to extend our banks credit at a reasonable price. This forces the banks to pass on additional costs to their customers and, in some cases, refuse credit.
These tight credit conditions could squeeze property developers and highly-geared property investors alike. Many developers would be forced to offload housing stock quickly- by reducing sale prices - to raise cash to repay their loans as they fell due and/or cover the increasing costs of their debt.

Ordinary property investors would face a similar squeeze; seeing prices fall and facing growing debt-servicing costs. Some would be forced to sell into a falling market, pushing prices even lower.

In effect, we'd witness the reverse of the positive feedback loop we've seen in the property market for many years. Instead of positive sentiment driving prices higher, negative sentiment, a lack of available credit and higher interest costs would push prices lower.

Again, this disaster scenario is not a prediction -it isn't even likely. The chances of this playing out as described are remote indeed. Our Reserve Bank, for one, has a few shots in its locker. But you only have to look at the US or Japanese housing markets to realise that once people's confidence is broken, low interest rates can only do so much.

The events of the past few years have shown that most of us are prone to underestimating our exposure to low probability/high impact events (see Nassim Taleb's book The Black Swan for more on this topic). Australian banks' reliance on foreign funding may well be one of those factors that seems all too obvious a risk in hindsight but nobody bothers to raise beforehand. With thanks to Phil Coffey, consider it raised.

This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website. For more Intelligent Investor articles click here.

49 comments

All rational people know that the value of Australian property can only rise. History has proven this - prices double every seven years. It takes guts to invest, however the rewards are infinite.

Commenter

Rodan

Date and time

August 02, 2010, 10:56AM
A bit like the rational Americans, Spanish, English etc; "you can never loose money on property"

Commenter

Thoughtful

Date and time

August 02, 2010, 11:38AM
Rodan - you're obviously joking. Good one.
Greg, brave story written exactly like i'd expect it would. I love the way the media refuses to admit the massive problem in this country at the moment...because no-one wants to be responsible for the ensuing panic.
Heres the facts: Ignore Demand vs supply article. Ignore all the little arguments you people have made to keep this rediculously inflated housing bubble going. The demand in this country was brought forward by an almost embarrassing lapse in rules of credit. Cheap credit = demand. Those days are now over, and the banks have made it obvious that rates are heading north. But thats not the thing that will pop this bubble. What is, has already started happening.
>3 years ago, everyone was talking on the streets about housing being the guaranteed way of making money. People were panic buying because they didn't want to be left out of the market forever. "it'll be like europe". etc etc.
Talk on the street now is how people would be crazy to buy into this. We've now seen what happens - US being the worst case scenario, the UK, Ireland, and now Canada all collapsing. It's NOT different down here. It's already happening.

Commenter

Geoff

Location

Brisbane

Date and time

August 02, 2010, 11:34AM
All rational people know that the market cannot go up forever, and that some point it must come down.
It takes guts to write an article such as this highlighting the systemic risks and negative feedback loops.
True investors know when their asset holdings have passed fair value and sell before bubbles burst. This is how wealth is retained, not merely created through paper profits.
It takes courage to sell when many are spruiking things can only get higher, but that courage has endless rewards of selling at the top and buying at the bottom.
I wonder how many dyed in the wool 'property investors/speculators' have this courage?

Commenter

JC

Date and time

August 02, 2010, 11:30AM
The premise of this argument is that lack of international funding leads to property developers triggering a drop in house prices. Surely though, the majority of property developers are into building apartments. So, therefore, wouldn't apartment prices drop instead of house prices?
One would say that, since the Australian economy is doing so well, that this scenario will never take place. The dollar drop in 1998 was due to global fears that resources would plunge in price. Is there still that fear in the world? Not at the moment. If anything, resource prices are predicted to go up. Whilst this is the case, Australian property prices will never crash.

Commenter

DeeK

Date and time

August 02, 2010, 11:24AM
All rational people? Some rational people know that past events shouldnt be relied on to predict future events. It's the drivers of those events that need to be understood and whether the same fundamentals are likely in the future. The artical clearly communicated that things have changed but that the future outcome is uncertain. I'm a little uncomfortable about that having a large mortgage and having hoped for significant capital gains but not ignorant enough to conclude that all will be rosy because I want or need it to be and anyone who thinks differently is irrational. That would be the height of irrationality.

Commenter

Kyuss

Date and time

August 02, 2010, 11:50AM
Don't see what one wants to see - see the facts. The chance of collapse is not "unlikely", in fact, it is a certainty, though the timing is not always clear.
Hyman Minsky describes 3 major phases of an economy, starting with strict lending and ending with lax lending. Right now we have lax lending and easy credit.
It is cheap credit that is proping up property prices, not demand for housing. The end of cheap credit always occurs because credit cannot forever become cheaper.
One day, maybe not tomorrow, but one day, credit will cost more and that is when asset prices will adjust downwards. That time has arrived for the US and Europe. And that time will come for Australia when a small event like the flap of butterfly wings in Singapore sets off a chainreaction, leading to more expensive credit in Australia.
The natural conclusion of capitalism is not forever towards greater efficiency, it is towards chaos if not regulated properly. And the banking industry has not been regulated properly.

Commenter

Lloyd

Date and time

August 02, 2010, 12:11PM
Nop, here is different. House prices always go up. House prices going down now means that prices will go up in the future.
Since I've start to write this message, the houses went up 10%

Commenter

houseUp

Date and time

August 02, 2010, 12:19PM
The first statement in these comments is a brilliant piece of sarcasm that catches the irrational essence of the "infinite" magic pudding mentality that has driven Australia's property market to it outer limits. Well done, RODAN!

Commenter

Crash Likely

Location

Magic Pudding

Date and time

August 02, 2010, 12:19PM
If property prices double every 7 year that means the average house will be about 16 million by 2050 a sobering thought for once grandchildren. Wages will either catch up or prices will come back to a level wages can afford. I think the Rudd government did a fantastic job avoiding the GFC and did a stella job propping up the Australian housing market, only problem is that it was a temporary fix and I have a strange feeling the real pain is just on the horizon for those people that have put themselves in too much debt. I just pray the great Australian dream does not become the great Australian disaster.

Commenter

Crash or correction done deal

Location

Melbourne

Date and time

August 02, 2010, 12:45PM