House as Bank

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Here’s a riddle for your Thursday: how much of Australian retail consumption has been/is being supported by high house prices?

It’s a little research project we’re working on and if you have any suggestions, don’t be shy about sending them into to dr@dailyreckoning.com.au. Why bother?

It’s a given that increases in household wealth support higher consumer spending. For one, when people see their share portfolios or housing investments go up, they are, in fact, richer on paper. This may give them more disposable income to actually spend. Or maybe they just feel richer and spend more freely (the wealth effect).

But one thing we recall seeing at the peak of the U.S. housing bubble is a massive increase in borrowing against home equity. Home equity lines of credit (HELOCs) were a popular way for lenders to expand the lending boom and for borrowers to “cash in” on rising house values to support consumption. The house was an ATM.

Is that true in Australia? We’re looking for evidence that either confirms or refutes the thesis. But we’re having a hard time finding credible data. One area that you might look at, based on the U.S. experience, is refinancing activity. Why?

As rates bottomed in the U.S., and then as the fear that rates would rise took hold, millions of people refinanced their homes to take advantage of low rates. Often the refis captured much higher house prices, which meant the new mortgage was larger than the old mortgage, albeit it a lower interest rates (and much less actual equity for the borrower).

Many mortgage providers offered cash-out refinancing options which allowed you to “extract equity” from your asset, an asset which was rising in value anyway. A telling sign of the top in U.S. home prices was when refi activity eclipsed new mortgage finance. There weren’t as many new buyers. Just existing buyers trying to reshuffle the financing furniture in order to support consumption and put off the mortgage day of reckoning.

Granted, we have no idea if anything like that is happening yet in Australia. But we’re having a look. In the meantime, median house prices were up 3.1% in the June quarter, according to data from the Australian Bureau of Statistics. The year-over-year gain in capital cities, according to the ABS was 18.4%.

That data is in conflict with data from RP Data Property reports. The RP data showed just 0.1% rise in house prices in the June quarter and a 0.7% fall in prices for the month of June alone. The RP data includes units and townhouses as well as stand-alone homes. That drop, if confirmed, would be the first monthly drop in 17 months.

Of course you know our position on the whole thing: Australian house prices are just one of many manifestations of leveraged asset bubbles worldwide that are now deflating with the credit depression. It has to make Aussie banks incredibly nervous.

On the one hand, they have large exposure to commercial and residential real estate. On the other, much of their domestic lending is dependent on wholesale borrowing internationally, where the cost of capital is going up faster than the Reserve Bank is raising the cash rate. And there’s an election this month, which makes it really hard to raise mortgage rates independent of a hike in the cash rate without inviting a “super profits” tax down on your head from agile political pick pockets.

But for all this worry that falling asset prices will lead to falling retail spending, lower GDP growth, and bigger government budget deficits, by far the most interesting housing bubble going right now is in China. Chinese regulators are instructing banks to conduct an honest-to-goodness stress test in which banks reckon the impact of a 60% fall in residential house prices.

Wow! Sixty percent? That travishamockery of a European stress test didn’t even assume a default on sovereign debt, just lower growth and falling bond prices. The Chinese appear to be seriously wondering what would happen if a large portion of last year’s $1.4 trillion in new lending turns out to be lost or non-performing.

Bloomberg reports that, “A deep slump in China’s property market may further slow the nation’s economy, which grew at a less-than-forecast 10.3 percent pace in the second quarter. China is still the fastest growing major world economy. Concern that China’s economy may cool due to a real-estate slump erased an early rally in U.S. stocks.”

The prospect of loan losses as a result of house price crash in China would be bad news for Chinese banks. And while we concede there’s probably a lot we don’t’ know about the Chinese property market, Caixin analyst Andy Xie reckons there are enough empty apartments in China to house nearly 200 million people, which is a lot of people and suggests a lot of bad loans.

Of course, only in China could you say that it may be possible to absorb that amount of space through internal migrations off the farm and into the city. In other words, if you really worked at it, you could say that that much surplus housing inventory isn’t an issue in a country that has so many people on the move. Sooner or later someone’s going to buy it and move in, right?

We’ll see about that. But in the meantime, the issue for Australian investors – and companies like Rio Tinto, which is set to spend nearly a billion dollars expanding its iron ore capacity in the Pilbara – is whether China’s housing boom has been boosting demand for coal and iron ore and what would happen to that demand if the boom goes bust.

Remember, last week we relayed the startling statistic that Chinese banks could struggle to recoup nearly 23% of the loans made to finance local government infrastructure projects. This aspect of China’s credit boom may have been even more supportive of base metals and iron ore prices. And if it goes, then the index of commodity prices published by the RBA this week (with a heavy bias to the contract prices of coal and iron ore) might look more like a “M” this time next year.

RBA Index of Commodity Prices

If you read the RBA release you’ll see that the big increase (51%) in the index is largely based on estimated increases in iron ore, coking coal, and thermal coal prices. It’s an expectation that things will keep chugging along. These estimates, in turn, are used by both political parties in Australia to estimate the amount of revenue generated by royalties and/or the Mineral Resource Rent Tax. Both parties reckon a return to surplus based on the increases in commodity prices.

Hmm. Has anyone reckoned what would happen if prices fell as they did in 2008 and beyond?

Granted, with oil hovering at US$82, gold nearly $1,190, and speculators in the position to take advantage of easy money in the US and Japan to invest in higher yielding assets, it may not seem like commodity prices can actually fall. But if the big driver behind commodity prices for the rest of this year is speculation and not fundamental demand (because bubbles are popping all over the joint) then would you be an investor in resource shares right now, or just another speculator?

Mind you, there’s nothing wrong with speculation, as long as you know that’s what you’re doing. It’s when the price signals you’ve been given turn out to be bogus (because of funny money) that many people find out they were actually speculating and not really investing. See Bill’s note below on prices.

All that said, we reckon shares would certainly be a better inflation hedge than bonds over the long term. But you might have to wait an awfully long time for a rebound in corporate earnings to start pushing share prices up. We meant to expand on this discussion this week with a look at various “alpha” and “beta” strategies for the share market. But we’ve almost run out of week.

For now, we’d say that all this anxiety about deflation and falling prices and the inability of monetary policy to produce inflation is just a prelude. The inflation will come when the Fed finds unconventional ways to get money into people’s pockets by by-passing the banks altogether. There are ways. And then? Stay tuned!

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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10 Comments on "House as Bank"

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89peterg
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I basically only read DRA and SMH, this is where I got my info for a previous comment. (I am lazy and dont go to source info like ABS).

http://www.smh.com.au/business/home-prices-drop-after-17-months-of-gains-20100730-10yup.html

I expect a flattening out of house prices. I dont expect the big crash just yet, Australia is just too dreamy and perfect and lucky for that kind of reality check. we’d sooner sell the farm (and mining companies) to foreigners than cut down on consumption or go back to making things.

thor
Guest

Just made a graph of lending for Refinancing versus Renovations (1995-2010):
http://bubblepedia.net.au/tiki-download_file.php?fileId=60

Lending for Refinance, Owner occupier (new and existing) and Investor (new and existing) are currently running at about $3B, $13B and $7B respectively, with only investor debt accelerating. Must be all those tax deductions. Lemmings of the world unite.

Biker Pete
Guest

89peterg: “I expect a flattening out of house prices.”

Yeah, we do too, Peter. We figure it will continue to around February ’11… and then go nuts (in WA, anyway). What you’ve got is irreplaceable.
Hang onto it at all costs… .

Trying to figure out the 89 prefix. Makes _no sense_ whatsoever… .
Enlighten us!~ :)

Biker Pete
Guest

Dan D: “…there are enough empty apartments in China to house nearly 200 million people, which is a lot of people and suggests a lot of bad loans.”

Yes, if you ignore the facts that: a.) many Chinese pay cash; b.) they’re happy to have these units sit vacant.

Now, you _know_ a.) and b.). This information comes from DR. Why choose to ignore it?

I concede that it must be incredibly difficult to maintain the company line, when all the data suggests otherwise. But why obfuscate like this?
It’s too obvious!~ :)

bearamundi
Guest

It’s a little bit like Alzheimer’s I guess. As we age we can start to wonder if we are losing our minds. If we wonder about this, then there is a good chance we don’t have it…..

Ned S
Guest

Never confuse Alzheimer’s with Oldtimer’s – One is where you relieve yourself in the laundry tub because it is white and sort of about the right height and you were thinking about something important at the time – And the other is where you have absolutely NO recollection of doing it? … :( … :)

Biker Pete
Guest

_Both_ had a good laff at that one, Ned!~

Her downstairs is still chuckling… .

89peterg
Guest
Bp, the 89 thing had me going as I didnt think I had given that out here when you mentioned it a few months back, that I thought you were a stalker, then again you know where I live? [maybe posting after wine is the key]… then I noticed that I put the 89 in front on my Linux machine, but my evil windows machine just had the right one.. nothing in it, just a number to stop the hackers (and stalkers) for another purpose, accidentally put into this blog. on the other hand ’89 is when I went half… Read more »
Pat Donnelly
Guest
I haven’t posted here for a while. I began to get negative comment. Australia is different but not immune to fundamental economic forces. What happened in the USA was planned to extract Aas much $ as possible before the depression that they knew was coming. We do not do that in Australia! Interest rates have never been artificially low in Australia. However, you neglect some factors that may lessen your argument but should be taken into account to be completely balanced? One: Land is a key determinant of housing availability. Development charges and planning directives mean that this is in… Read more »
Biker
Guest
Some fair points, Pat. I really only disagree with your last five words. What I do see as a new trend, is the slow take-up of new developments, even in WA, where we’re poised for growth in 2011 – 2012. I think our developers themselves are confused and very troubled by this. In WA, some of them have undoubtedly jumped the gun, developing new estates so far from CBDs you have to question their intellect. All it would take is a 20% rise in oil… and they’d crash. A mate of mine, here, claims that in time, they’ll populate these… Read more »
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