You could be mistaken for thinking we didn’t each have a part to play in the Global Financial Crisis. It wasn’t that long ago Kevin Rudd was saying “As Prime Minister I will not sit idly by and watch Australian households suffer the worst effects of a global crisis we did not create.”

But the cause is closer to home than we think.

The Great House Bubble

Despite real estate agents and industry lobbyists shamelessly spreading the concept that house prices double every 7 to 10 years, sadly this is nothing but lies. But as they say there is "truth in marketing" and you certainly can’t say they haven’t marketed Real Estate well – just too well, and now we are paying the costs.

House prices in fact, do not increase in the long term faster than inflation. Historically, you don’t buy houses for capital appreciation, but rather rental yield.

The chart above shows over 100 years of "Real" house prices, that is, prices corrected for inflation. Both the United States and Australia is featured. As you can see, over the long term house prices don’t really do anything.

What happens from the late 1990’s onwards in enough to scare anyone.

The driver of this bubble is still open for debate. After tech wreck the U.S. Federal Reserve dropped interest rates quite sharply. Rates didn’t drop nearly as much in Australia and our boom appeared to start some ten years earlier, so while some analysts suggest low interest rates were the cause, the jury is still out. What is more concerning is the implications.

Implication of Rising Housing Costs

Now what are the implications of rising housing costs? I use the term rising housing costs as this covers both mortgage repayments and rents. As the first part of this crisis developed, it was rising housing asset prices and associated mortgage repayments having an effect on household budgets.

During the later part of the crisis, landlords decided to increase rents at a pace which far exceeded wage growth, hence the same repercussions shifted into rental households and remain a real threat today.

Household Debt

Money doesn’t grow on trees, so as house prices continued to accelerate, homeowners needed to borrow more. It doesn’t take a highly educated economist from the treasury to work out that household debt must go up.

If you look closely at the real house prices for Australia, you will see the first part of the housing boom started in the late 1980’s and never fully corrected. This is the same time household debt started to adjust its trajectory for the moon.

In the 1980’s for every dollar earned, the average Australian household had about 40 cents of debt. By the time household debt reached orbit in 2008, the average Australian had debts totaling a fraction less than $1.60 for every dollar they earned.

Household Savings

Just as household debt skyrocketed, household net savings went through the floor. In the 1980’s Australia was a nation of savers, putting about 10% of household income under the pillow for a rainy day.

By 2002, the average Australian household was actually spending more than they earned and household net savings went negative. This continued for a number of years.

Mortgage Repayments

Unfortunately there is no free lunch in life. As house prices went up and along with it debt levels, so did mortgage repayments. Below is a graph of interest payable on dwellings as a percentage of household net income.

The figures represent the aggregate of all Australians, hence why the figures appear low. But it’s not the actual values that are of interest, but the step rise from 2001 to 2008. Payments shot up from under 4% to over 10%, a rise of 150%.

Household expenditure

The following chart shows the Average Household Expenditure for 03/04 financial year taken from the ABS Household Expenditure Survey (6530.0). In 2003/04 the largest household expense was food and non-alcoholic beverages, followed closely by housing costs. The housing cost category includes rents, rates and interest payments on mortgages.

Below is another chart for the same year – 2003/04. What we have done is simplified the chart by grouping some of the categories into discretionary spending, that is spending that we have some choice on, like recreation, miscellaneous goods and services, household furnishings and equipment, alcoholic beverages and tobacco products, clothing and footwear and personal care.

This leaves categories such transport, medical care and health expenses and domestic light and power as necessary services. You could argue that if need be, you could leave the car at home and take public transport, cancel your private health insurance and live in the dark, but you get the picture.

Remember by 2003 we were actually spending more than we earned. Now as much as we would like it to, money doesn’t grow on trees and the average working family has probably eroded any savings by now. If house prices rise faster than household income, like has been the case for the past decade, something must budge in the household budget.

Let’s increase housing expenses. We have already decided there are some fixed expenses in our budget which will not change (not really true, both petrol (transport) and private health insurance premiums have gone up more than inflation).

So what budges in the budget? Discretionary Spending.

It simply means as housing expenses continue to outpace household income, households must cut back on discretionary spending.

Now let’s fast forward a couple more years and with rapidly rising house prices, let’s make housing costs 50% of the household budget. Now, don’t laugh. Housing stress is considered when the household spends more than 30% of income on housing expenses. Many new buyers took out 100% loans, so it’s not unreasonable for more recent purchasers to be paying this, if not more.

In a recent Melbourne Institute study, it was found in the “mining boom state”, 18% of Western Australians paid between 26% and 50% of their income in debt repayments. These figures were for March 2009, after rates have been cut by more than half, but it would be fair to say than many households have chosen to keep paying down debt at the old rate of payment.

Rising housing costs strangle discretionary spending and the broader economy

So it should now be easy to visualise the repercussions of house prices outpacing household income growth year in, year out for a decade, and why historically house prices only increase in line with inflation or wage growth in the long term. Australia is not alone. Most OECD countries were caught up in this bubble.

But why hasn’t the effects of this been felt earlier?

As house prices increased in the early part of the cycle, we saw household savings deteriorate. Temporary relief was sought by channeling money that would otherwise be spent i.e. the 10% of the household income, into housing.

After 2002, the net savings ratio went negative. So rather than cut back on discretionary spending to make the household budget balance, we started using debt as a means to continue our spending excesses.

Then there is a phenomenon called the wealth effect. As house prices rose, those owners felt wealthy and had a tendency to spend more. In reality, the capital gain is not realised until you sell the asset at a price agreed between you and the buyer. Before then, the price of the asset may deflate. Yet many households have already spent any gains they have made from their housing assets as they are continually told house prices only go up and hence there must be little risk.

Hence a good part of all the unrealised or artificial housing capital gains have flowed into the economy and helped drive (or overdrive) consumption. The excess consumption of households spending beyond their means helped to bolster the domestic and global economies.

Closer to home, the extra retail spending required extra shop assistants. The cuppa chino and newspaper before work supported the café, just like the eating out at restaurants supported the chiefs and waiters. The kitchen and bathroom renovations required extra tradespeople and well you get the picture.

Further abroad, the spending on the latest consumer gadget or flat screen telly did wonders for the Chinese economy, and as that boomed, they brought our resources to build factories and homes.

We now have a considerable problem on our hands. Not only do we have to cut back on spending and live with in our means, we also have to start paying down some of this mountain of debt we have in our names. For every dollar a household spends in paying down debt, is one more dollar not spent in the economy supporting jobs. It’s a double whammy.

The journey ahead - 2009 onwards

The journey ahead still remains cloudy thanks partly to interference from governments.

The housing market remains the key to the problem. The longer house prices remain artificially high in comparison to household incomes, the more households will need to spend on this expense, and hence the less money that can be spent on other goods and services underpinning domestic jobs.

The quicker we can get house asset prices versus household income back to historic trend, the quicker this crisis will pass, freeing up important money to be spent as discretionary spending.

Many OECD countries have the same problem than us. As you can see from the real house price graphs featured earlier, the U.S. housing bubble has popped and U.S. house asset prices are 27% down from the peak of the bubble. The sooner prices get back to a healthy trend, the quicker they can move into recovery and get back on their feet.

Time to pick and choose: Housing or Jobs

In Australia, our Government is playing a game of tug of war.

One aspect of the economic security package has seen the introduction of the First Home Owners Boost (FHOB), an incentive to encourage first home buyers into the market by giving them extra grants on top of the existing first home buyers grants. If you build a new house, first home buyers get an extra $14,000. If purchasing an existing home, it is $7,000.

If you want to measure the success of this package by the number of First Home Owners signing up, then it’s one thing that Real Estate Agents don’t need to lie about – there is a subprime frenzy out there as buyers, some of which are bidding up prices more than the grant is worth, just so they don’t miss out.

But economically, how is propping up the housing market helping our recovery? Are we just delaying the inevitable, while at the same time encouraging a new generation of home buyers into so much debt, they won’t be ready to stimulate the economy for another 25 years until they pay down the mountain and have some free money left over? This off course assumes they make it through the 25 years, and don’t default once the cash rate starts to head north, requiring yet another bail out from the Government.

To me, this seems to be encouraging our old ways. Have we not learned anything since this crisis has started?

Then we have the $900 handouts. Of the money that is not going to overseas visitors, deceased estates or the dog and cat benefactors of deceased estates, it appear to be going straight into paying down debt. If this helps just one or two households avoid foreclosure, then I certainly wouldn’t mark the package unsuccessful. In fact, just to see the net savings ratio spike up, I think is a huge success.

But at the end of the day, we appear to have two policies – on one side of the rope we have the stripping large sums of money from retail and service sectors by encouraging young first home buyers into a life of excessive debt in a bid to keep the housing bubble afloat, while on the other side of the rope is trying to put money back into the economy with the aim to save jobs.

With news out today suggesting retail jobs which employ 15% of the workforce is under threat from the next stage of this crisis, It is time the government needs to decide what is important: High house asset prices or jobs?

The economy can’t sustain both.

The Sydney Morning Herald reports :

THE Australian housing market is facing the prospect of a “perfect storm” of financial pressures - including high mortgage debt, overvalued homes and rising unemployment - in which prices could eventually fall by as much as 30 per cent, investors have been warned.

» First-home buyers in the eye of a storm - The Sydney Morning Herald, 18th March 2009.

COMMONWEALTH Bank of Australia has cautioned that the Federal Government’s sweetener on the first home buyers grant should not become an open-ended offer because it could encourage some into the housing market who may not be able to afford home ownership.

» Subprime warning on first home grants - The Age, 18th march 2009

Real Estate agents are now expressing their fears that the housing market will collapse when the subprime frenzy caused by the FHOB ceases.

The Brisbane Times reports Real Estate agent Peter Secco’s office had 37 sales in January and only two were above $500,000.

“If that’s not enough evidence for you then I don’t know what is,” he said. “Every buyer we have now is a first-time buyer and I would say 90 per cent of them are doing it because of the government incentive.”

» Agents tip housing crash after grant glory - The Brisbane Times, 16th March 2009

Despite GDP figures released last week showing Australia is in recession and with unemployment rising, NSW Housing Minister David Borger, says it’s never a better time to load up with debt. “I strongly encourage anyone thinking about buying a new home to do so now - with lowering interest rates, a flat market and help from the state and federal Labor governments, Sydney is definitely a buyers’ market.”

Today’s comments come after the release of a NSW Government report on quarterly sales and rents showing that rents are rising while house prices are falling.

Mr Borger said “Our figures show that the sales price of homes in Sydney during 2008 dropped 8.1 per cent for homes and 5.6 per cent for units.”. With the medium house price in Sydney peaking around $575,000, a 8.1% fall or a “flat market” in his words, corresponds with approximately a $45,000 fall in value. As Australia enters a recession, there is no guarantee these falls will slow or reverse in the short term (3 to 5 years) meaning new home owners entering the market on Mr Borger’s advice could be losing $45,000 a year or $865 per week while having to make mortgage repayments. That’s a lot of money that could be used to pay rent.

Only on Wednesday this week, Mr Borger was telling News Limited that the number of homeless families in NSW had increased 51 per cent and that staff were finding shelter for an extra 643 people a month. “We are seeing people who are economic victims who have lost jobs and can no longer pay bills. They have racked up their credit cards,” he said. “There is a new category of economic refugee.”

Lets just hope Mr Borger’s comments today strongly encouraging new buyers into the housing market doesn’t end with a new set of economic refugee’s as job losses and negative equity starts to settle in.

» Cheaper to buy than rent - The Sydney Morning Herald, 8th March 2009.
» Families lose their jobs and homes - News Limited, 4th March 2009.

Last year Deputy Governor of the Reserve Bank of Australia, Mr Ric Battellino addressed the 7th ITSA Bankruptcy Congress with an update on household finances. In his speech, he raised differences between the Australia and U.S. housing markets :

“A third important difference between Australia and the US is in the groups that the lenders targeted, and in the loan terms on offer. In Australia, the lending boom was concentrated on existing home owners who traded up to bigger and better houses and bought investment properties. Many of these were people in their 40s and 50s who previously had low levels of debt. “ said Mr Battellino.

But how things have changed.

It all started last year on the 14th of October when the Australian Government announced increased grants to encourage people to take on more excessive debt. Under the First Home Owner’s Boost program, the Government gave an extra $7,000 to first home buyers purchasing existing dwellings and an extra $14,000 to first home owners wanting to build a new dwelling.

A couple of weeks later the NSW State Government got in on the action : NSW Government to join Federal in encouraging young first home owners to take on large debts. They are offering $3,000 of cream on top of the boost.

We are now starting to see examples of where all these incentives are going. Valentina Popovska appeared in the Sun Herald on the 1st of March, “thrilled” with her new home. It means that they now work 7 days a week and are paying a mortgage almost double their rent, but they were able to purchase their first home without needing a deposit.

Then emerged the story of teenager’s Matthew Tregent and Sarah Zajac who has brought a block of land and using $26,000 in government grants and $5000 of their own savings to build their first home.

The daily telegraph reports that Western Sydney is in the grip of a property mini-boom “with more than 50 per cent of all sales being first home purchases - with most sold for less than $500,000.”

However Australian Financial Group’s (AFG) general manager of sales and operations Mark Hewitt said “with more first home buyers entering the market, the loan-to-value ratio (LVRs) has risen steadily to a record high of 72.5 per cent in January” Many First Home Buyers enter the market with little to no deposit, relying solely on grants.

There are even reports in some area’s that the surge of first home owners are bidding up prices in excess of value of the grant, in order to secure the grant before it expires at the end of June 2009.

With the boom fueling more applications for home loans, lenders want the grant extended beyond the June 30th deadline. News Limited reports “Loan Market Group executive director John Kolenda said there has been a 300 per cent increase in inquiries from first home buyers since October. “Extending (the grant) will have a positive flow-on effect for the entire housing market and that will be beneficial to the whole economy,” Mr Kolenda said.”

But the driving force behind the latest boom cannot be all attributed to the First Home Owners Boost. The RBA has aggressively cut interest rates to a 45 year low of 3.25%, however the likelihood of rates remaining this low for the duration of a 25 to 30 year loan is next to none.

The other prospect facing new home owners is the possibly of either losing their job or the reduction in wages. To reduce the number of jobs to be slashed, many employers are opting for wage cuts or a move to a four day week with a 20% reduction in wages.

Only time will tell what the effect’s of Rudd’s subprime frenzy will be.

» Young families defying recession to lead revival - The Daily Telegraph, 7th March 2009.
» Grants help teens into a house of their own - The Sydney Morning Herald, 6th March 2009.
» Home loan lenders want FHOG extended - News Limited, 5th March 2009

Today’s release of the December ‘08 National Accounts came as a surprise. Not the fact that Australia’s GDP has recorded its first quarter decline since 1991 - it was only a mater of time for Australia to join the ranks of countries in recession. But while GDP has started to sink, technical we won’t be in a recession until two quarter’s of negative growth is recorded - that will come in three months.

The surprise was in the Household Net Savings Ratio.

It appears Australians, probably assisted by Kevin Rudd’s stimulus war chest is starting to turn into a nation of savers again. For those that have followed this site since we began in 2006, one area of focus has been household savings. In 2003, Australia households started spending more than they earned - clearly something not sustainable. In 2006 our poor record started to rub off on our friends in the U.S. Up to 2006, the U.S. had only ever recorded two years of negative savings, both years during the Great Depression when households dug into their savings to help purchase essential items such as food.

December 2008’s Net Savings Ratio has hit 6.6 per cent in trend terms and 8.5, seasonally adjusted. The seasonally adjusted figure is the highest it’s been since September 1990.

The realisation that unemployment will trend upwards has no doubt sent fear into Australian households and lead to the recovery of savings (and the reduction of consumption). Households are trying to de-leverage as quick as they can, and you certainly can’t forgive them granted the size of household debt we carry today.

Unfortunately Jobs, none more so than retail, was supported by the fact Australian’s were spending more than they earned. Now that this unsustainable habit has abruptly stopped, less disposable income is flowing into the economy to help support these jobs.

» 5206.0 - Australian National Accounts: National Income, Expenditure and Product, Dec 2008 - The ABS, 4th March 2009.

In an interview with TechTicker, Professor Robert Shiller author of Irrational Exuberance and co-producer of the Case/Shiller Home Price Index said U.S. house prices are still way to high.

Shiller said this is the biggest housing bubble in world history and &qout;we are entering a new era in some sense".

The graph above shows how far U.S. house prices have fallen to date.

"[U.S.] Home prices nationally are maybe a little past half way down to trend. The big question if they were coming back to trend we would expect to see them slow down and level off, but they are still overshooting"

This absence of a slow down coupled with the fact the world economy is entering a severe recession, if not a depression suggests house prices are likely to over correct and head down to levels seen during the great depression. If this is the case, then for the US the housing correction is less than half over. When asked if we could over correct, Shiller said "We haven’t seen big bubbles like this"

“The high home prices we saw in the early 2000’s were, I believe a result of a bubble, so the idea we will be back there is not supported by any good economics that I see, and I believe these events are inherently sociological.”

Rents in Shiller’s opinion was another indicator of the bubble.

"Amazing thing is rents didn’t really do much over this cycle, nothing at all like the home prices. So that’s another piece of evidence to suggest it really was a bubble. It was the evaluation of assets, rather than the earnings stream."

As the following graph shows, this was also a phenomenon witnessed in Australia. House prices bubbled, while rents didn’t really do much but tracked inflation.

» Shiller: House Prices Still Way Too High - The Business Insider, 23rd February 2009.