Will the bubble end?

I’d like someone to explain to me what happens to house prices and our economy when interest rates inevitably rise again.

When interest rates rise, so will house repayments for most people, even those on fixed mortgages will have less than 5 years respite at the most, but what will the consequences be? Investors will need more money to service their loans, but negative gearing will give them a larger tax break, and they can always put up rents. Owner occupiers, however, may be pushed beyond their capacity to service their mortgage ending in forced sales or foreclosures.

What I want to know is how the market will react in the scenario where we begin to see an increase in the number of people who can’t afford their mortgage? Will we see the bubble burst, with all of the flow on effects that we’ve seen in the US, UK and Europe, or will the equity rich investors simply concentrate the ownership of real estate further still and continue the bubble?

The combination of negative gearing, combined with the capital gains tax discount, seems to me to be distorting the market so much that my latter scenario doesn’t seem implausible. Would the banks tighten up lending if they saw more defaults, or would they double down on investors in an attempt to save the value of their assets? At what point would propping up the market become untenable? How much worse would the collapse be then?

The Australian real estate market looks to me like a financially ruinous game of chicken. If I’m wrong, I’d like to know why. If I’m right I’d like to know how the hell to get out of the way.

One thought on “Will the bubble end?

  1. Hi Dave, thought I’d be the first to try to comment here. While I do have an economics degree, I don’t consider myself an expert, especially in housing markets, but I do like to read what others have to say. There’s such a wide range of opinions on this that it’s hard to know where to start.

    Some of the most fun to read are the guys that subscribe to the ‘this is the greatest bubble in living memory and when it pops we’ll be ruined’ camp. They also make some compelling arguments (e.g. http://www.macrobusiness.com.au/2015/06/the-housing-crash-we-had-to-have-a-gen-y-perspective-on-the-bubble/ or http://blog.australiaboomtobust.com/wp-content/uploads/2015/06/LF-Economics-Submission.pdf). But of course there’s plenty who say it’s not a bubble too.

    My thoughts are if it looks like a duck and quacks like a duck then it’s a duck, and this definitely has all the characteristics of a bubble. The thing is, nobody knows when a bubble will pop, what will trigger it, and what will happen when it pops. Also, no two bubbles are the same, so looking for historical precedents is tricky.

    The biggest worry for me is the amount of speculation going on in Australian property markets. Speculative investment is what leads to the really rapid growth in prices, but speculators are also the first to jump off when things look shaky. The more speculators in the market, the shakier it becomes. And the trigger for them to leave might be something entirely outside the housing sphere – e.g. a Chinese share market crash.

    An unexpectedly rapid rise in interest rates could also have obvious implications, not only for the extra stress on mortgage holders, but also because it could lead to a shift in investment strategies from speculators. Personally I think the threat of inflation is being overlooked at the moment. Oil and other commodities are at or near long term lows, and if these turn around (especially in combination with a falling currency) inflation could start to climb rapidly, and the reserve bank would have to act quickly to stomp out that brush fire.

    Australia is particularly vulnerable due to the concentration of the bubble in two key markets, and the importance of the big four domestic banks in our share market and economy, meaning there are really strong linkages between our housing performance, corporate profits and economic outcomes. There are some vicious feedback loops in there.

    We’ve already seen a little correction, with the NAB, CBA, WBC and ANZ all down between 10% and 20% since mid-April, which might be a little canary in the coalmine if you’re looking for one.

    In terms of what they’d do if the bubble popped, well I don’t think they’d have many options. They would foreclose a lot of houses, tighten lending to avoid further bleeding, and put their hands out to the government for a massive bailout. And the government, of course, would shovel as much taxpayer money into their coffers as possible on the pretence of avoiding a financial catastrophe.

    In the meantime, no government wants to this to happen on their watch, so they will do everything they can to keep the bubble inflated (negative gearing and tax concessions will definitely stay), and there’ll be a lot of finger pointing along the way. Both major parties will blame each other as they always do.

    If you want to know how to get out of the way, I would avoid buying into the Melbourne or Sydney markets (not that ‘normal’ people can do that anyway), avoid buying investment property, pay down any mortgage debt you have now as quickly as you can while interest rates are low, and make sure any super or other investment money you have is allocated fairly defensively, including plenty in cash (not bonds), and a decent proportion in markets outside Australia, as much for the foreign currency holdings as anything.

    The idea of the bubble ‘bursting’ is misleading, by the way. House prices tend to fall slowly from their bubble peaks, with speculators jumping off on the way down, leaving owner occupiers carrying the can with a house worth much less than when they bought it, while their tax money gets siphoned off to deal with the problem.

    Longer term, the fact that much of our most valuable housing stock is in low lying coastal regions will also be a major problem but that’s a story for another time.

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