Australian Housing: Flying Too Close to the Sun? There's a key point to draw from that, and that is that bubbles and the aftermath of bubbles are completely to do with credit phenomenon or phenomena I should say. So credit conditions drive the bubble up so to speak, and credit conditions bring it back down again. Hi, I'm Joe Walker, host of the Jolly Swagwan Podcast and I'm joined today by Michael Schneider. Michael, thanks for coming. Good to see you, Joe. Great to meet you finally after we were connected by Grant Williams, the man himself. Yes. I've had an opportunity to listen to your Real Vision interview with Grant from 2016, it was a great conversation and a lot has changed in the intervening three years. I want to talk to you about that, but the first thing I wanted to ask you about was just the virulence and degree of ferocity involved in the Australian housing debate. I mean, is this something new you've remarked upon before? I find it almost ridiculously tribal, and not just in the cesspit that is Twitter but also even in the mainstream media, bulls and bears. It's a very emotionally charged debate. It sure is, and you only have to go to an auction to see exactly how emotional the housing market is. Yes. I mean, it's interesting in the sense that it hasn't been a linear set of experiences in the last couple of years. We've had, obviously, the Royal Commission that certainly restrained and identified some malfeasance that was going on and misincentivization that was going on in the lending side of things. So that was, obviously, a key component to sort of turbocharged that downward movement in the property market but equally, we've had the withdrawal of mainland Chinese investors by and large. So that was a convergence at the same time and then you had APRA that decreed that interest-only lending must revert back to 30 percent of all lending. So you had, really, a confluence of events that certainly all of a sudden converged into a serious retraction in house prices in the latter part of last year. What's your sense of the role that foreign buyers played in the Australian housing market? Recently, I went on Martin North's show for digital finance analytics and I drew a contrast between two different sources. On the one hand, the Treasury, Chris Walker an analyst at the Treasury published a study where he showed that the contribution of foreign investors to price rises in Sydney and Melbourne during the last cycle, 2012 to 2017, was very limited. I think they were responsible for about $80-$122 of the price rises per quarter when the overall price rises per quarter were in the range of $12-$13,000. So a very small impact and then when you juxtapose that, if you talk to the average Australian and you ask them what they think is influencing house prices. Typically, the first thing anyone says is the Chinese buyers. So there seems to be a perception and reality gap here if we assume that the Treasury analysis is on point, but what do you think the the actual role of foreign buyers has been in the market? I mean, I think that's a good point. Firstly, I think that it was fairly idiosyncratic in terms of where the Chinese buying was. In Melbourne for example, you had fairly Chinese-centric suburbs that had disproportionate price increases as a result of that. Other places like Eastern suburbs as well had a disproportionate amount of price increases on the back of that, but other areas like the Western suburbs, Southeastern suburbs I think were largely untouched. But I can see an argument though for a scenario where that causes a ripple effect. So if the more affluent suburbs are having a disproportionate amount of Chinese buying, that should filter through to some of the more middle-class suburbs. Let's go back to circa 2017 just before the downturn which we've just recently escaped. I mean, there's a sense in which you can read Charles Kindleberger and then see signs of mania everywhere in your own times and no one in a bubble or otherwise ever thought he was crazy, but it's very fashionable to kind of tete-a-tete manias of the past and to look for signs of mania where they might not exist. Were there any incontrovertible signs of irrational exuberance in your mind in the Australian housing market around 2017? I can think of one in particular. A colleague of mine, his grandmother-in-law passed away around that time and so her house was being auctioned in a suburb called Turill, and the agent, the realtor was just about to knock down the price for sale, and literally a black Mercedes pulled up and a Chinese guy got out and offered $500,000 more than the price is about to be knocked down for and wrote a check accordingly for that. So that's probably one anecdote that stands out but there's a million others in terms of valuations and particularly how much a lot of properties were going about the reserve price. Yes, it strikes me that as much as the foreign buyers were there during the last cycle, it's really a domestically driven story, isn't it? Yeah. I think to your point about Kindleberger as well, I think there's a key point to draw from that and that is that bubbles and the aftermath of bubbles are completely to do with credit phenomenon or phenomena I should say. So credit conditions drive the bubble up so to speak, and credit conditions bring it back down again. So to your point, I would agree with that. So riffing on that for a moment, do you think the credit supply shock that was the Banking Royal Commission is still the credit supply shock that it was, have we escaped that now? What are credit conditions like at the moment? I think that you can divide that into two parts. The verification process is clearly tightened up although I've seen reports recently that suggests that it hasn't tightened up in terms of disclosure or full disclosure on loan applications. So I think maybe I'm a bit more circumspect about how tighter the verification processes have been since pretty much August-September last year, and equally, you have to look at the availability and the demand for credit. So the thing that I would certainly draw attention to there is that private sector credit is going backwards at an increasing rate. So if you're looking at a backdrop of credit conditions, certainly demand for private sector credit is shrinking and that suggests that the consumer is tapped out. The mortgage is, really, at some kind of leverage ceiling. So again, whilst we've had a bounce in the last six months or so, or even less than the last six months, so I think that's been certainly quite idiosyncratic but it's also been against the backdrop of broader downturn in macroeconomic conditions as well such as retail sales, vehicle sales are down eight percent year-on-year, even SUV vehicle sales finally turned negative in June of this year. So the macroeconomic backdrop I think is very noteworthy in that sense. Should we expect consumers to start spending again as household balance sheets repair with this house price recovering? You would think so prima facie, but again, you're not seeing that in the credit numbers, you're not seeing that in private sector credit, so it either suggests that if credit demand on the private sector is decreasing and again at an increasing rate, then that suggests the demand is not there or supply is not there or a combination of both. I tend to think it's more demand is not there. So we've spoken before by e-mail and you've shared with me a really insightful sequence to a housing bust and how it flows through to the consumer balance sheets to the economy indicators that we can identify along the way in that sequence. Can you just give us an outline of that and then talk about where Australia stands on this trajectory at this moment. Yeah. I'll start with another anecdote which I think might be useful. In about, I think it was February last year, so almost two years ago. I was driving my daughter back from a sporting event and there's a bunch of people gathering around the corner for an auction and my daughter said, "What's that dad?" I said, well, come with me and I'll will show you. So I explained to her what an auction was, and to the uninitiated, it's almost like a religious cult in Melbourne or Sydney. But what struck me at the time was, I would have typically, for that part of the neighborhood, I would have expected four or five times as many people at the front of the auction and I would have certainly have expected a far greater number of offshore buys to be present at the auction as well. So that was just a reference point that I put in the back of my mind, and then I went to a few other auctions, and there was a pattern emerging as well. So then to me, that was getting back to your point about credit conditions. Clearly, there was some impact in credit availability such as interestingly lending being withdrawn or reduced by at the decree of opera. That pattern was pronounced more by obviously the Royal Commission and the findings of the Royal Commission. So that to me was a very much a severe retardant to credit availability around the middle of last year or at least in the first six months of last year. So that followed through subsequent to the end or the conclusion of the Royal Commission. Then you saw a scenario where the lagging indicators have started catching up, such as GDP. Obviously, retail sales and vehicle sales in particular were very much either flat lining or in significant decline. But then the lagging indicators towards the end of last year caught up, and so you're seeing a scenario now where GDP for example is barely above stall speed. Which is precisely what you would expect in this kind of environment with house prices falling. Then you rely on that with a couple of other points on the structure of the Australian economy or at least the Australian labor force. Something like 40 percent of the Australian labor force is on the part-time or contract. So if you keep getting and back to your other point about full record landing. If you kept getting belt tightening because the consumer is either tapped out or is struggling with mortgage repayments and delinquencies and provisioning is suggesting that that is the case, that the consumer or the mortgagee always becoming squeezed. So this structure is that if you start seeing any downturn in the economy from here, in my view and last I think two weeks ago, we got a glimpse of that, we had the worst unemployment results in something like seven, eight months. So if the employment market is at the effect of declining GDP rights, then that has to again have a ripple effect on the labor force, and you've got something like 11 or 12 percent of the labor force is tied up with construction, particularly pertaining to residential housing. So again, the structural backdrop to the Australian housing market is far more worrying than what front page attention seems to be giving to it. Auction results, they're typically around 40 percent below the levels of the peak of the market in 2016/2017. The price rise is very idiosyncratic in terms of the suburbs that they particularly occurring in. They're not occurring in the Western suburbs of Sydney, and they're not occurring in the Southeastern suburbs of Melbourne. So whilst there has been quite a pronounced recovery in some suburbs, it's most definitely not unilateral, and to use Marten's data as well which I use quite vigorously. His metric is that lending conditions tightened past August last year by something like 40 percent. Since the incoming government turned that around or at least loosened some of the lending requirements and lending ratios in May, June this year, you've certainly had a turnaround where in Marten's view, 15 percent of that 40 percent of restraint has certainly mitigated the credit availability. But again, I look at the logic tests on these, and there's two things that really spring to mind. One is that, if this recovery and property prices is as sustainable as we're seeing in the broader media, then the Reserve Bank should be tightening interest rates not lowering interest rates. So that's something that's very key in terms of how I look at things. Equally, if there is a recovery that is sustainable, then we're seeing that against the backdrop of rising delinquencies, rising foreclosures, benign retail sales, negative vehicle sales. So you're seeing it against the backdrop which doesn't suggest that a sustainable housing recovery is in place. So the damage done by the price falls between 2017 and 2019 could feed back into house prices again under these conditions of macro-economic weakness? We have a logic tests that I apply to these is that, at the peak of the property, boom for one of the better word, the median debt-to-income ratio in Sydney was eight times, in Melbourne that was seven times. So my view is, unless we go back to that, which I find difficult to believe will occur, unless we go back to those types of leverage and credit availability, then I just don't see how a sustainable recovery is in place. Particularly again, referring back to private credit, I think that's really important. So last year, a looming threat, many people were pointing to in the Australian residential housing market, was the $120 billion of interest only loans that would be rolling over per year from 2018-2021. Is that shaping up to be the screw tightening threat that it looks like it was going to be? You could argue that it hasn't been, and I think to be fair in defense of that argument, the median or average interest only lending ratio at the moment is around 37, 38 percent that are the most recent data that I've seen. So you could argue that going from 30 percent to 37, 38 percent of total line books, certainly takes some of the sting out of the impact of those interests only rollovers. However, the average at the peak of the market was around 45 percent. So again, to look at the data that's out there and forget for a moment the euphoria that is beginning to appear in mainstream media. I think it's really important to pay attention that we haven't gone back by any metric, we haven't gone back to the euphoria in terms of lending and credit availability that we saw in 2016 in particular. Another thing that's worth paying attention to as well, back on the provisioning and on the logic test of all this, 2.4 percent of national Australia banks lending book is at currently aligned evaluation in excess of 100 percent. Now, their provisioning is a fraction of 2.4 percent. So I still ask the question, where if these were such a strong recovery, why isn't reserve bank tightening interest rates? Another vulnerability in the Australian banking system has historically been the banks reliance on offshore wholesale funding. Back in 2006, a team of IMF economists actually came down under, and the key conclusion from their report was that this was the Achilles heel in the Australian banking system. That reliance on offshore wholesale funding, was that ever properly addressed by governments and regulators in the aftermath of the 2008? To what extent is that still a vulnerability? Certainly, the amount of deposits that were taken post 2008 have alleviated some of that pressure as you describe it. But again, I look at this from a second derivative perspective, and what I mean by that is that no matter what the government or the regulators or the central bank does in terms of arresting or seeking to arrest any further downturn in housing, you're going to run up against a weaker currency. So it becomes a negative feedback loop in terms of the banks seeking funding from offshore and pound for pound, we are one of the biggest importers of banking capital in the world. So you have that problem where should there be any disturbances in offshore funding markets in my state and you've got a central bank that is more than happy to use the currency as a risk shock absorber for implementation of policy. Then, it does put more pressure on the banks going forward, all other things being equal. How do you see the next 12 months playing out? At least from my perspective, I think the most important piece of data to look at is whether or not the recent downturn in the unemployment rate, or at least the downturn in the employment market I should say, is the start of another trend. So when you've had GDP growth slowing for something like the last three or four quarters. Then if that starts permeating through the labor market, then we're going to see further arrears, further delinquencies, and further foreclosures. So again, not a lot has to go wrong, at least from here and for another 12 months and I think it's very difficult to expect a nice model through scenario. If there's any hint of a sustainable increasing in the unemployment rate. Hypothetically, what would the Australian regulators, central bank, governments need to do to ensure that we don't say that start to arise? Yeah, I think a different way of saying the same thing is what would be the lag time of any policy responses. So remembering that unemployment is a lagging indicator and GDP growth is a lagging indicator. If you start seeing policy responses at a point where again it's quite paradoxical, when we're talking about a housing recovery, and yet we're also talking about policy responses and declining interest strikes that suggest that this housing recovery isn't really sustainable. So there's an implicit message in there I think. But I think the key question to ask, is of any policy responses, what is the lead time before the economy benefits from any of those? So for example, you might say we might have a fiscal response which might mean directing a lot of resources towards infrastructure. To get major projects up and running is not going to happen in a month, or three months, or four months, those things take 18 months, two years at least. So if the economy is going to be impaired, and without a quick lead time for any policy responses and the quick late time responses are typically interest rates, and maybe some regulatory looseness around the ages. But they've pretty much play those cards. I've often said that predicting Australia's housing cycles is as much a matter of political economy as it is of economics because there is this on-clad consensus on the part of governments and the central bank that higher home prices are important. It's very hard to predict cycles when there is that sort of political environment. Not many people saw the removal of the minimum serviceability buffer by Opera. Not many people saw that coming, and yet that's pretty crucial in this recovery. I just wonder if you could riff with me some of the different levels and tools available to pump the housing market again if things start to go wrong, we could say three year or 40 percent mortgages. Does a bank still got room to cut rights to 0.25 percent, which Phillip Lloyd told us is the new lower bounds. We could potentially say unconventional monetary policy even on the reserve banks recently said that that's very unlikely. Opera Australia's macro-prudential regulator could look to loosen lending standards further, the federal government could introduce a first home buyers grant to end all first home buyers grants. How do you grapple with the sheer political will power to support home prices? How does that play into your faces looking forward? To answer the last point first. I think all first time buyers grant does, has increased the price of a house by that amount of the grant. So I think that's a completely ineffective policy tool. It just makes housing more expensive all other things being equal. Secondly, I think that the short term gratification benefits or at least the short term gratification instruments that policymakers in the government for that matter would be looking to implement have largely been played and to your point, certainly that serviceability lacks laxness that was implemented by Opera has had a very good short-term effect. I don't think there's many other policy measures that don't have a long lead time. Again, the key thing around this is, if there is a backdrop of increasing unemployment over the next 12-18 months, then there's not many policy tools that I can think of short of negative interest rates, that could be put in place to arrest again a negative feedback loop that increasing unemployment would bring. So you think this recovery is pretty temporary? I think an awful lot of things have to go right from here, and unfortunately, at least as I look at it. Unfortunately, the things that have to go right, we have to go back to those credit conditions that we had in 2015, 2016. So if government and policymakers are willing for that to happen and bearing in mind it became a political issue two or three years ago, so it would involve 180 degree turn by the government in particular to say that we're okay with looser lending standards, we're okay with seven or eight times debt to income ratio across the main or at least the most popular cities in Australia. To me, that's asking for a lot to say that we were wrong, we thought lending conditions are too lose, now we think that's okay. So that's a big turnaround in my view. Again, I think you need a lot to go right for this to be more sustainable and against the backdrop of that close to zero interest rate, against a backdrop of increasing risk of the budget deficit in the event of putting more resources into this housing market. It creates a confluence of situations that make it very difficult to engineer a sustainable property recovery the moment showed of just going back to the wild west scenario that we had play Royal Commission. The next logical question I suppose is how would you trade this? There doesn't seem to me to be a big short trade in Australia, there are those opportunities to exploit asymmetric derivatives. But have you thought about ways to make this derivative if that thesis doesn't play out? Yeah, I think the key point you touched on before that is particularly lost on a lot of offshore investors who have been watching this very closely for a number of years, is that when you have a full recourse lending, the mortgagee big borrowers instills before they default on their mortgage, and that creates two scenarios. Scenario number 1 is that it can become a waterfall event for the broader economy. So everything's fine until it's really not fine. So that's one kind of context around the impact of the full recourse lending. It's fantastic until it's not, and when it's not it's really bad. The second thing around that is that you can't have a scenario where in a full recourse lending where you get this belt tightening, if you get a very leveraged consumer or mortgagee that really does tighten the belt. Again, the microeconomics indicators are saying the debt still implies. That hasn't recovered with the housing market. So if you get a situation such as that it becomes a sequential series of events that unfold, and you're seeing it across a number of different touch points within the economy. As I said, we've touched on retail sales, we've touched on vehicle sales. You're were also saying it was in the supply and demand of apartments in major Australian cities as well, you're starting to see a lot of very large development projects 300, 400, 500, 600 units per development that are on the marketing complete. So that means that the demand is quite saturated or at least by very large amounts of supply that all of a sudden aren't going through a full sales process. So you've got an inventory of apartments that are increasingly building up here and the demand is going in the other direction. So that's the second part of that. Then you start seeing it as we are evidentially, we're starting to see that coming through in bank provisioning, bank delinquencies, and arrays and things like that inarguably they're increasing now. So again, if we've got a full recourse lending market here that is becoming or showing increasing signs of being exhausted in terms of household finances. Then, the repercussions as I said tend to go through sequentially. So the next thing is and as we saw in the last bank reporting season now bank dividends are being cut. So if you've got bank dividends being cut, retirees are in a more awkward situation due to living off a lower yield given the importance of that bank dividend to the Australian superannuation market. You've got a scenario where these things unfold again, fairly iteratively. So we've seen the first three or four iterations of this I believe such as I said with developers now banks cutting dividends and if that is in my view coming through in the broader GDP numbers, and again, I think it's really silent to pay attention to the unemployment numbers that come out in the next few months. Do you think the central bank is alive to these issues? I really don't know. If you look at the Fed in 2006/2007. If they were looking for signs of impairment or that they were looking for signs of excessive credit conditions or excessive supply of credit. The signs were there. But it appeared that I didn't really start paying attention to those signs until things got pretty bad. I don't think the reserve banks in that same situation with our blind side or at least not open to the possibility that things would have gotten out of hand. But equally and I guess the last couple of easing suggests that they are very much on top of this in terms of the risks to the broader economy. But again, I just wonder if it's too late. I just wonder if monetary policies are very blunt instrument. The time it takes to work its way through the economy. I mean we've seen it in the housing market no question. In the broader economy it's not heating the micro economic data, as we touched on before. So yeah I think it's a fairly blunt instrument and the closer it gets to zero the blunter it becomes. I want to jump back to something you mentioned a little bit earlier, and that is recourse lending. I just find this so funny. Many very smart people working in finance who are sanguine or bullish about the property market. Site recourse lending as a feature not a bug. As something that means that we're not going to have an American style housing crash because people can't do the jingle Mao where they send the case back in the post to the bank. We want to say the full closure right picking up. We want to say price falls exacerbated through that negative feedback loop. It's so interesting to me because there are so many examples of housing markets and major housing busts that have featured recourse lending, Ireland, Spain, even particular states in the United States: Florida and Nevada we've recourse states and they had among the highest foreclosure rates. But if you go back further still, Japan, Sweden, Finland in the '90s. So I mean it's not a panacea that immunizes you from a major downturn in the residential property market. Ironically, recourse lending maybe shouldn't make people more concerned because banks feel like the collateral is there. They are a little more risky perhaps in their lending, but also to the extent that people will fight as you say to continue paying back their mortgage because it is full recourse. What that does to aggregate demand is truly horrifying. That balance sheet recession territory which is a major historical turning point in the life of a nation. I think that's a super important point. If you look at the think the worse four performing states in the US in the sub-prime crisis are all full recourse lending. Exactly. So I think that's a really key point that is lost in Illinois, both in the states and here as well. It just reminds me like just when you were speaking of the old [inaudible] how did you go bankrupt sir, very slowly and then very quickly. I think that's what happens in a full recourse lending market. It becomes intact or remains intact, but when it becomes unbuttoned, it becomes a real crisis because you've basically used all your bullets as certainly as a mortgage and equally within the banking system and bearing in mind bank provisioning is still very very low. So if you do get that kind of waterfall event, and again, another analogy I think which was really important back in 07-08 was mortgage-backed securities. You had a lot of modeling that was done on the economy doing all the things that it should do rather than than things that are the effect of a change in conditions. There structured products were built that, if you have seven defaults on a mortgage-backed portfolio, that's okay out of a 100, if you have eight, it's a disaster. I think that's a great illustration of how full recourse lending can take things intact for longer. But when it becomes unglued, it becomes really badly unglued. So you're obviously reasonably bearish on the Australian housing market and the Australian economy. What would it take for you to change your mind? What indicators over the next 12 months would require you to adjust your thesis? Yeah, it's a good question. I think I'll go back to the point about how do you, how do you fix a bubble, and it's really don't let one happen in the first place. When you start seeing some of the lending ratios that we touched on earlier. It shouldn't have been allowed to get to that point in the first place. I think now as we saw in Ireland, as we saw in the US, as we saw in Spain that once it takes hold, it's fine as long as the underlying collateral keeps increasing in price. But again, the leverage, this is the other thing that I find quite fascinating in a very unfortunate way, is we've had house prices triple in Australia in give or type the last 15, 16 years. House prices have tripled, GDP hasn't tripled, wages haven't tripled, but you've had housing prices triple because purely and simply as you touched on before, it's been a credit phenomenon. So my view is that once you let things get fundamentally out of hand or disproportionate to long-term structural trends such as GDP growth, then there's not much you can do about it once things go into reverse, once the underlying collateral stops going up sustainably. You've had here getting back to my earlier point is that we've had house prices triple here, but household balance sheets have become more fragile. So you haven't had a situation where the average Australian is being able to cash in on the underlying collateral tripling in a very short amount of time. It's been a green light to use leverage more and more buy another investment property, buy the his and hers BMW, great better holidays. So household balance sheets have hollowed out. So that to me means that if you end up going back to or reverting to any kind of main reversion then you can't do it without pain. It's very hard to grow your way out of this two percent GDP every year. So unfortunately I can't think of too many other alternatives, the only other alternative I can think of is inflating LY out of this mortgage debt that we've accumulated in Australia over a long period of time. But as I was saying at the moment inflation is a very hard thing to generate. So the problem being is that inflation has occurred in asset prices as opposed to consumer prices. So and you could argue the measurement of consumer items is perhaps distorted as well. But yeah, I think once these things get going they're pretty hard to end in a very orderly and painless way. That one will be a good point to finish on that. Michael, this has been fascinating. Thank you so much for your time. Absolute pleasure. Thanks Joe. Cheers mate. Welcome to the end of the video. We know that on average 85 percent of you who start a video on Real Vision, finish it. That's extraordinary. 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