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.
Sources: Case-Shiller Index, Australia Bureau of Statistics.
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.
