The Next Bubble Coming From Down Under

The Motley Fool's Global Gains team will be heading to Australia next week to search for great investing ideas from Down Under. The country holds an enormous amount of natural resources that will be in demand for years to come, as countries like India and China build out cities to house tens of millions of new residents.

While this megatrend provides a good place to look for long-term investments, nothing is ever as easy as it seems. One major wrinkle in the Australian investing story, according to Steve Keen, Associate Professor of Economics and Finance at the University of Western Sydney, is an enormous housing bubble in Australia. That sounds kind of familiar.

Given what we saw here in the U.S. when our real estate bubble popped, we thought it might be a good idea to talk to Professor Keen, and so we will. If you'd like to get our notes and impressions from that meeting, as well as from over a dozen meetings with Australian companies, just enter your email address in the box at the bottom of this page.

To whet your appetite for our trip, here's a few quick-hit answers Professor Keen was kind enough to provide us on why we should be concerned about Australia's housing market.

You have long been saying that Australia is facing a housing bubble, and in the past year, people like respected investors like Jeremy Grantham have joined you. Is Australia's housing bubble bigger than the one in the U.S.?

The Australian housing bubble is categorically larger than the U.S.A's, though in standard bubblology talk, the main reason that it is -- that it was less a matter of oversupply and far more a pure speculation on prices -- is touted as one of the reasons that "Australia is different" and a crash won't happen here.

The chart below presents house price indexes for the U.S. and Australia, set with a base year of 1986. It's now obvious that nominal house prices in Australia have risen far more than in the U.S. during that time: a nearly sixfold increase, versus a peak of about a 3.5-times increase in the U.S. -- which has now fallen to less than a 2.5-times increase after the U.S. bubble burst in 2006.

From the graph, it looks like Australian home prices saw a bit of a correction in 2008, but then it reversed. Was this just a blip, or does it lend credence to the idea that Australia is somehow different?

The vertical dotted lines mark the beginning (B) and end (E) of the Australian government's contribution to this Ponzi Scheme, the most recent incarnation of its "First Home Owners Scheme," which gives first home buyers a cash grant toward their first purchase that is then levered up by a bank loan when they go shopping. For this reason I call it the "First Home Vendors Scheme," since the real recipients of the government largesse are the vendors who sell to these new entrants.

When the "Global Financial Crisis" loomed (as the "Great Recession" is called Down Under), the then-Rudd Labour Government doubled this grant to A$14,000 for an existing property, and tripled it to A$21,000 for a new one, in what they called the First Home Owners Boost, and which I nicknamed the First Home Vendors Boost (FHVB). The scheme, which began in October 2008, was supposed to last eight months but was extended to 14 months because it was "so successful."

So you're saying government stimulus has essentially prolonged the bubble (that doesn't sound familiar at all). If the government is set on seeing home prices continue to rise, what, in your view, would trigger a correction?

Ponzi schemes ultimately fail under their own weight, because they involve paying early entrants more than they put in, while producing no profits with high running expenses. A debt-financed Ponzi Scheme can however appear to work for a long time, because the price of the object of the Scheme -- in this case house prices -- can rise so long as debt levels per house rise faster still.

Just as in America, rising mortgage debt was the real fuel for rising house prices. Though Australia didn't have as widespread a subprime phenomenon as the U.S., and many more mortgages are held on the books of the banks, the level of mortgage debt actually rose faster and higher in Australia than in the U.S.

What will bring this bubble undone is its very success: Having successfully driven house prices skywards, the cost of entry into the market is now prohibitive so that the flow of new entrants is drying up. Since the Scheme depends on a constant flow of new entrants, this alone will bring it unstuck. A gauge of just how difficult it is to get into the market is given by looking at the ratio of the average first home loan to the average income -- when most first home buyers are going to have an income below the average.

The average first home loan has risen fourfold in the last two decades, from A$75,000 to almost A$300,000.

This rise has far outstripped increases in wages. In 1994, the average first home loan was 3.1 times the average before tax yearly wage income. Now it is 5.6 times as much, and it briefly reached 6 times annual income during the frenzy caused by the Rudd Government's doubling of the First Home Owners' Grant.

So the bubble will collapse because it has been too successful -- and the government's doubling of the First Home Owner Grant has added to this because it encouraged new entrants who may have waited till 2011 to buy in during 2009 instead. There are now fewer first home buyers entering at the bottom of the pyramid, which is usually when the Ponzi scheme collapses.

On top of this, there are the usual "exogenous" factors: further increases in interest rates by the RBA, and the prospect of a slowdown in China. While I don't know enough about China today to make an informed comment here, my feeling is that China's growth can't be sustained, and that Australia's economic performance is particularly susceptible to a change in our fortunes with China.

One of those tragic romances you hear about, eh? China helped pull you through the Global Financial Crisis, but could also lead to your own Australian Financial Crisis. If this were a work of Shakespeare, pretty much everyone would die. Since it isn't, who would get hurt the worst if the bubble pops?

The most obvious losers from a price downturn will be the buyers enticed into the market by the government's subsidies, many of whom began with 5% equity and who can therefore be easily thrown into negative equity territory by even a small price fall.

This won't lead to "jingle mail" defaults in Australia because our housing loans are full recourse. But since a trigger for the downturn will be a decline in aggregate demand as the wealth effect turns negative, unemployment will rise -- certainly in NSW and Victoria that don't directly benefit from exports to China -- and this will cause forced sales, though a lesser rise in bankruptcy sales than in the U.S.

The second obvious group of losers will be the banks themselves, who have dramatically increased their share of profits via the huge increase in mortgage debt. A decline in mortgage originations will reduce their profitability, and their solvency since mortgages now constitute the more than a third of total bank assets and over half of all banks loans.

Australian banks assert that they are well capitalized and that a downturn in house prices would have little impact on their liquidity, let alone their solvency. That claim has proven false after the fact of a property price crash everywhere else on the planet, and I expect Australia to be no different.

That is a lot to think about, especially when considering investing options. Thank you very much for your time, Steve, and I look forward to talking more in Australia.

If you'd like to hear more of Steve's thoughts on the Australian housing bubble, be sure to check out his blog at http://www.debtdeflation.com/blogs/. Also, to keep up with the Global Gains team as they venture through Australia, enter your email address in the box below in order to receive their free dispatches from the road.

Nate Weisshaar is a senior analyst on the Global Gains team. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy thinks bubbles taste like bath time.


Read/Post Comments (9) | Recommend This Article (18)

Comments from our Foolish Readers

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  • Report this Comment On February 09, 2011, at 3:49 PM, slpmn wrote:

    So, let's say worst case, the housing market collapses in Australia leading to a great recession in that country. What will the impact be on the economies of China and the surrounding asian countries? I would assume negative, but how negative?

  • Report this Comment On February 09, 2011, at 4:01 PM, TMFTheSnake wrote:

    slpmn

    I view it the other way around. Australia is riding the resource boom and probably can until China (and to a lesser extent India) slows.

    Even if the Australian housing sector collapses, it would have little impact on China as Australia is a minor export market for China and Australian miners could pretty much go on working without feeling the effects of a housing collapse.

    There may be a greater effect on smaller neighboring countries, but I picture it like this: Australia is water skiing behind the Chinese boat. If the skier falls, it has little effect on the boat, but if the boat slows, the skier sinks.

  • Report this Comment On February 09, 2011, at 7:33 PM, mrCatfish wrote:

    Canada is right behind Australia on this one... Vancouver being the third-least affordable city in the world, I think that Sydney and some other OZ city are #1 and #2.

  • Report this Comment On February 09, 2011, at 8:09 PM, WhereIsSafe wrote:

    What I'm worried about is the effect of the housing crash on the Australian share market. With it being dominated by the big 4 banks and the increased collapse of consumer spending affecting many other listed all-industrial companies it would appear the ASX will be in pain also. I'm wondering what's safer - diversified resources shares or just go cash for a while. All I want to do is protect my money and I'm not too confident jumping on the gold bubble - although if the US economy collapse means we go back to a gold standard - that might be a good thing. A conundrum to say the least!

  • Report this Comment On February 09, 2011, at 8:51 PM, Nexus321 wrote:

    Australia is like Ireland - everyone has been busy buying property off each other using debt that was created via the banks borrowing debt overseas - like Ireland. Many of the deluded now think they are really wealthy (on paper - like Ireland) until sentiment, interest rates rise and the economic cycle goes negative. What were positive investments in a rising market suddenly look bad in a declining market. I think Australia may have 'Dutch Disease' - booming resource sector, rising currency, shrinking productive sectors and wasteful public sector spending.

    It is inevitable that Australia will experience financial calamity but perhaps not in the same style as the US, UK, etc. We have gone higher (Rudd's stupid propping up of the housing market) and further into debt - mortgages, business loans, credit card, loans to buy shares, etc. Global interest rates will rise to try and damp down inflation caused by the US printing money and shortages of commodities and this will be amplified in a negative way by the debt levels.

  • Report this Comment On February 09, 2011, at 9:57 PM, Zugersee wrote:

    The one thing you may want to also factor in to your equations is the relative interest rate.

    I'm not disagreeing that the bubble exists and it is a big bubble but - comparing the interest rates would give you a bit of a clearer picture.

  • Report this Comment On March 06, 2011, at 6:34 PM, DankCastle wrote:

    Australian housing is vastly, dramatically overpriced, by all reasonable measures. Unchecked commodification of shelter for the population has been caused by misguided governments failing to regulate the housing market while encouraging the use of tax loopholes like negative gearing and permitting over-leveraged speculators to bid up asset values so the govt can benefit from huge intakes of land tax, rates and stamp duty. The recent analysis by The Economist is right on the money, and you can see from the chart gallery below (including two charts from The Economist house price web tool) just how overvalued Australian housing really is.....

    <a href="http://s4.zetaboards.com/Australian_Property/pages/gallery&q... Housing Bubble Charts</a>

    12 months ago there was complete denial that real estate was in trouble, but now the realization is beginning to dawn on many that something terribly serious is about to occur in Australia. The spruikers maintain faith in a soft landing, but they're straight out of luck this time. The bigger the boom, the bigger the bust, and the property boom that began in Australia in the nineties evolved into the greatest real estate bubble known to mankind. The bust that's coming will be a doozy. As 2011 unfolds the spruikers will come to understand that real estate in Australia is dead for generations. For anyone who's interested in reading some excellent blogs about the Australian property bubble I highly recommend the blogs hosted on the Australian Property Forum.....

    <a href="http://s4.zetaboards.com/Australian_Property/pages/blogs&quo... Property Bubble Blogs</a>

    During the next two years we can expect to see vacancy rates and inventory levels surge to unprecedented levels as house prices collapse by up to 40 or 50% in most parts of Australia. This might sound extreme, over the top. But how over the top were the 200% to 300% rises in house prices we saw over the past decades. A 50% fall is nothing in the scheme of things, it just brings prices back to a fair level. House prices always revert to the mean and Australia is no different. All the nonsense dreamed up by spruikers about shortages and population growth, it's all just hot air, designed to breath more life into the bubble. A vain attempt to blow new life into a dying bubble justifying more unsustainable price increases to already exorbitant asset prices. But the air has run out. Consumers are tapped out. There is no more money left. The bubble is dead. Long live the new new paradigm, where an average family can finally afford a decent home in Australia. It's been a long time coming, but soon it will be time for the bears to party. Bring it on!

    Dank Castle

    <a href="http://s4.zetaboards.com/Australian_Property">Credit Crunch Forum</a>

  • Report this Comment On March 06, 2011, at 6:36 PM, DankCastle wrote:

    Australian housing is vastly, dramatically overpriced, by all reasonable measures. Unchecked commodification of shelter for the population has been caused by misguided governments failing to regulate the housing market while encouraging the use of tax loopholes like negative gearing and permitting over-leveraged speculators to bid up asset values so the govt can benefit from huge intakes of land tax, rates and stamp duty. The recent analysis by The Economist is right on the money, and you can see from the chart gallery below (including two charts from The Economist house price web tool) just how overvalued Australian housing really is.....

    http://s4.zetaboards.com/Australian_Property/pages/gallery

    Australian Housing Bubble Charts

    12 months ago there was complete denial that real estate was in trouble, but now the realization is beginning to dawn on many that something terribly serious is about to occur in Australia. The spruikers maintain faith in a soft landing, but they're straight out of luck this time. The bigger the boom, the bigger the bust, and the property boom that began in Australia in the nineties evolved into the greatest real estate bubble known to mankind. The bust that's coming will be a doozy. As 2011 unfolds the spruikers will come to understand that real estate in Australia is dead for generations. For anyone who's interested in reading some excellent blogs about the Australian property bubble I highly recommend the blogs hosted on the Australian Property Forum.....

    http://s4.zetaboards.com/Australian_Property/pages/blogs

    Australian Property Bubble Blogs

    During the next two years we can expect to see vacancy rates and inventory levels surge to unprecedented levels as house prices collapse by up to 40 or 50% in most parts of Australia. This might sound extreme, over the top. But how over the top were the 200% to 300% rises in house prices we saw over the past decades. A 50% fall is nothing in the scheme of things, it just brings prices back to a fair level. House prices always revert to the mean and Australia is no different. All the nonsense dreamed up by spruikers about shortages and population growth, it's all just hot air, designed to breath more life into the bubble. A vain attempt to blow new life into a dying bubble justifying more unsustainable price increases to already exorbitant asset prices. But the air has run out. Consumers are tapped out. There is no more money left. The bubble is dead. Long live the new new paradigm, where an average family can finally afford a decent home in Australia. It's been a long time coming, but soon it will be time for the bears to party. Bring it on!

    Dank Castle

    http://s4.zetaboards.com/Australian_Property

    Credit Crunch Forum

  • Report this Comment On March 06, 2011, at 7:12 PM, Chowboy100 wrote:

    Our problem is exacerbated by persistent inaction from all levels of government in Australia to anything about being proactive about planning for housing lot development and infrastructure.

    Instead of being re-active to demand, their persistent over-use of prescriptive planning has caused a massive undersupply in housing.

    It's not being re-active toward demand (compared to the opposite in the US). 20 years ago Sydney released around 10,000 lots annually that figure is close to 2,000 now.

    Coupled with an increase in demand side incentives = ONE MASSIVE HEADACHE!

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