The system view of Australian house prices

All facets of Australian housing get a lot of media attention and has done so for as long as I can remember.

In my opinion Australia has completely fractured its economy with the obsession and, slowly but surely, perverse systemic evolution has occurred to support ever growing prices of a non-productive asset.

Australian Housing is an “unquestionable” asset class that now burdens the economic, social and political system of Australia. Australia House prices are so engrained in the national psyche that any suggestions of price falls are often met with what only be described as an evangelical and cult-like response.

There is a plethora of social comment on the impacts Australian house prices, so I do not intend to cover this angle, but what I will say is it is considerably harder for a young Australian today to secure housing than it was in the past decades and anyone who says otherwise is lying to you, and probably themselves.

In terms of economic methodology, the entire situation is a disaster. This is nothing like the situation a country that targets GPECS would find itself in.

From an economic system perspective, 99% of the sphere of commentary is about the demand side , predominantly immigration, supply constraints, negative gearing and capital  gains. Again, this has been well covered across the media and other sources, so I won’t cover it  here, but only to say that giving tax breaks and other subsidies to investors that are not available to young families for housing is just grossly stupid an inequitable policy.

What I do want to talk about is he distortion of the economic landscape that is very rarely mentioned.  From a whole-of-system perspective, Australian housing has grown like  cancer with its hidden tumors now invading all forms of policy and regulation, much of which is never spoken about, isn’t understood and/or goes undetected. 

Let’s start with Super.

The Australian superannuation system  is basically a forced retirement savings scheme for Australians in which employers must pay a proportion of wages directly into employees retirement fund. It has evolved over many decades and is seen as a “world class” system . It is underpinned by what is now called the “super guarantee”. 

There are significant issues with the system , it like housing policy has grown in inequity over the years, and it is rather unclear that it is delivering the originally intended outcomes. But I will have to leave that to another post.

What it does mean is that there is a huge, guaranteed and ever-growing investment fund that sits aside the Australian economy. But in Australia, a capital shallow country with a relatively small population, where to invest ? 

And this is where the problems begin. 

Overall a national forced retirement investment fund is a great policy, but once you scratch beneath the surface you start to see what is happening, namely this:

The highest allocation to equities at around 50% (same as the US) of the 22 countries,

with Switzerland and Netherlands as low as 33% and Japan 30% .

And if you look at the asset allocation of a default option in an Australian super account you will see why.

So everyday a not insignificant percentage of private sector income is added to the pile and, via asset allocation, ends up in the Australian equity market with a smaller proportion, but still rather large amount, buying bonds.

As I said above , Australia is capital shallow so there isn’t a large innovative industrial base to invest in so the inevitable outcome is extraordinary valuations of the banking system operators (ADIs).

Capital flowing to banks supports their ability to lend. As there is limited productive investment in the country this leads to the only other possible outcome. An incentive to massive private sector lending into a speculative asset class, in Australia’s case, driven by many factors ,  it landed in housing.

So captured super drives unproductive loans.  Now for the tumor in the banking system.

As I posted back in the Macro 101 series banks have capital requirements that are in place via  regulation to insure banks have necessary capital to buffer themselves for losses.  Do not confuse this with Lending Mortgage Insurance(LMI) , which is another disaster to discuss another day, this is internal capital the banks must hold against its assets i.e. loans.

There have been global efforts after the GFC, through Basel , to attempt to raise standards, but these are mostly to do with reporting rather than serious changes in methodology.  There are now slight differences in the required capital structures for banks and a slight increase in the percentage of capital required against risk weighted assets. But on a whole I consider Basel to be  lipstick on a pig.  So why do we care ?

As per the above chart banks need to hold around 9% capital vs asset. On the surface a bank needs $9 of capital to support $100 in loans. Seems reasonable ? But here is the kicker. 

If you bother to read the APRA's actual documentation on capital adequacy you will stumble across this chart.

And this point.

19. An ADI must calculate the RWA of an on-balance sheet exposure by multiplying the current book value of the exposure (including accrued interest or revaluations, and net of any provisions for defaulted exposures, partial write-off or associated depreciation) by the relevant risk weight. 

So, as you can see, the lower the LVR of the loan (House price vs loan value) the less capital that is actually required to back it up and the ADI must continually updates its "current" exposure to risk weighted assets. 

In layman's terms ,in regards to residential property loans, this means "constantly re-evaluation the value of the housing market and if by some luck the value of housing has increased then the banks need less capital to back it up". 

So there you have it.

Captured Super drives loans, loans drive property prices, and by some "interesting" macroprudential ruling , property prices drive the need for less capital which drives more loans which drives property prices. And remember it is all there to pay for he retirement of Australians.

Without even mentioning all of the demand side policy ( measurably high immigration, limitation of supply via many factors, capital gains, negative gearing , first home buyer grants etc ) the system is already designed to push prices every higher. And, as you can see from above, all the risk lands on the Australian public because all of this is "too big to fail". 

It isn't "a" system, it is "the" system. 

More on that in another post.