Tag Archives: financial crisis

Shadow Banking

The Financial Services Authority (FSA) is the banking and financial services regulator in the UK. For now at least.

Back in 2010, the Chancellor of the Exchequer (the equivalent of the Treasury in Australian terms) announced plans to scrap the FSA in response to a failure during the financial crisis of the 10 year old “tri-partite system”. This tri-partite system split responsibility for national financial stability management between the Treasury, the Bank of England and the FSA. The government is now working on shifting  responsibility back from the FSA to the Bank of England, a process which will establish three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). More three-letter initialisations and, dare I say it, a new tri-partite system?

Until this process is complete, the FSA continues about its business. The chairman of the FSA is Lord Adair Turner, Baron of Ecchinswell. Turner is also a member of the steering committee of the G20 Financial Stability Board (FSB). In March this year, he spoke at the London CASS business school on the topic of “shadow banking” and its role in the financial crisis.

Shadow banking, a term coined by Paul McCulley in the early days of the crisis, refers to a diverse range of entities such as “structured investment vehicles” (SIVs), hedge funds and money-market funds which have evolved to provide some very similar functions to banks, while not being subject to the same regulatory controls. A nightmare scenario for any bank is a “run”, when too many people try to withdraw their deposits at the same time. Shadow banks can also fall victim to runs. These runs may not be very obvious outside the financial markets, there are no queues of angry depositors on the streets, but they can be just as dangerous and runs on shadow banks were in fact a major factor underlying the global financial crisis. For this reason, regulators like Turner and the FSB are not only focused on strengthening controls on banks, but on better understanding shadow banks and, if possible, subjecting them to regulation to reduce the chances of future financial crises.

So what is it that shadow banks do? To answer that, I’ll first go back to the basics of banking. Although banks have evolved to provide many other products and services, the essence of banking is taking deposits and providing loans. The diagram below illustrates the flow of capital from an investor to a bank and from a bank to a borrower. Having given the bank some money, the investor now has a financial asset in the form of a deposit (and the deposit is a liability from the bank’s point of view). Likewise, the loan now represents a financial asset for the bank (and a liability from the borrower’s point of view). So the bank acts as intermediary between savers and borrowers. In doing so, however, banks act as more than a simple broker matching borrowers and lenders. Most bank lending also involves maturity transformation. More colloquially, this is known as lending long and borrowing short.

Bank Capital Flows

The typical depositor wants their money to be readily available in an at call transaction account. Some may be tempted by higher interest rates to put money in term deposits, usually no longer than 6 months to maturity. On the other hand, most borrowers do not want their loans due and payable too quickly. Home buyers borrow in the expectation that their earnings over coming years will allow them to pay interest and principal on their loans. Likewise, companies making capital expenditure, building factories, buying equipment or acquiring other businesses borrow in the expectation that the revenue generated by their expanded business capability will allow them to repay their loans. In both cases, the term of the loans must match the timeframes over which earnings are generated.

Some lenders will be prepared to make longer term investments, some borrowers may be able to repay more quickly, but overall there is a mismatch in maturity preferences of lenders and borrowers. Banks are in the business of bridging this gap in preferences. In the ordinary course of events, they can allow depositors to withdraw funds before loans are due to be repaid, making use of funds from other depositors, borrowing from other banks or, in need, borrowing from the central bank. But if too many borrowers withdraw at the same time and the bank is unable to meet those demands, then the bank can fail. This is known as liquidity risk, and has become an enormous focus of regulators, risk managers and rating agencies around the world in the wake of the global financial crisis.

While the financial crisis certainly highlighted the dangers of liquidity risk for commercial and investment banks such as Northern Rock and Lehman Brothers, it was outside the traditional banking sector that the greatest liquidity problems arose, particularly as a result of securitisation.

Securitisation is a form of structured finance that predates the financial crisis by many years. Essentially it involves setting up a trust (or similar legal entity) which provides loans that become the assets of the trust (often referred to as a “pool” of loans). The funds to provide these loans are obtained by selling a special kind of bond to investors, known as asset-backed securities (ABS). Principal and interest flowing from the loan pool is collected by the trust and periodically passed through to investors.

ABS capital flows

The most common form of securities bundles up pools of home loans, in which case they are referred to as residential mortgage-backed securities (RMBS).

Unlike bank-lending, there is essentially no maturity transformation involved in financing by means of ABS. Investors cannot withdraw their money early from the trust, they have to wait until it is repaid by borrowers. The only other option for an investor wanting to “liquidate” their investment (i.e. turn it back into cash) is to find another investor to sell their securities to.
The problem with ABS is the overall mismatch of maturity preferences between borrowers and lenders. Without getting into the business of maturity transformation, there was always going to be a limit on how large the market for ABS could become. Faced with a problem like this, it was only a matter of time before innovative financiers came up with a solution. One such solution was asset-backed commercial paper (ABCP). This involves adding another step in the chain, often referred to as a “conduit”. The conduit was simply another legal entity which would buy ABS, funding the purchase by issuing short-dated securities known as asset-backed commercial paper.
ABCP capital flow

Just like a bank, the conduit is exposed to liquidity risk. Before the crisis, this risk was considered fairly low. After all, the assets of the conduit were readily trade-able securities. Most of the time the conduit could repay investors simply by issuing new ABCP to other investors but, in the unlikely event that no such investors could be found, it could simply sell the ABS. In some cases, investors were provided with additional assurance of repayment in the form of “liquidity backstops” provided by banks, essentially a guarantee that the bank would step in to repay investors in need (although these commitments were not always very clearly disclosed to bank shareholders). This whole arrangement was considered highly satisfactory and conduits typically received the highest possible rating from credit rating agencies.

Unfortunately, liquidity risk is a real risk as the world eventually discovered. Once the US mortgage market started to get into trouble in 2007, investors around the world began, quite reasonably, to be rather reluctant to invest in RMBS and other ABS. Prices on these securities began to fall. Managers of large-scale cash investment funds, until then enthusiastic buyers of ABCP, decided that more traditional cash investments were more attractive. The conduits were forced to sell ABS at precisely the time when prices were falling. Their selling pushed prices down further in a vicious cycle, a perfect illustration of the close relationship between funding liquidity risk (the risk of not being able to repay obligations) and market liquidity risk (the risk of being unable to sell financial assets at anything other than a painfully low price). As a result, some conduits were rescued by the banks backing them (“taking them back on balance sheet”), while others collapsed.

The problems of ABCP were just one example of non-bank liquidity failures during the financial crisis. Others include the venerable US money market fund, the Reserve Fund “breaking the buck” or Australian non-bank lender RAMS finding itself unable to continue funding itself by means of “extendible commercial paper” (ECP).

ABCP conduits, money-market funds, non-bank mortgage lenders along with many other non-bank financiers that make up the shadow banking sector had well and truly entered the business of maturity transformation and are all exposed to significant liquidity risk as a result. There are many linkages between banks and these shadow banks, whether through commitments such as liquidity backstops, direct lending or even partial or complete ownership. Regulators are concerned that too much risk in the shadow banking sector means too much risk for banks and too much risk for the financial system as a whole.

One strategy for regulators is to enforce a cordon sanitaire around banks, protecting them from shadow banks. But many, including Lord Turner, worry that is not enough to protect our global financial system with its complex interconnections from damage when shadow banks fail. Ideally they would like to regulate shadow banks as well, preventing them from running too much liquidity risk. But this is not an easy task. As the name suggests, it is not easy to see what is going on in the world of shadow banks, even for well-informed financial regulators.

How Money Works

Notes of the WorldOver the last couple of years as the global financial crisis unfolded, a subject I have spent a lot of time thinking about is the nature of money. I have been planning a blog post on the topic and the time has finally come.

The catalyst for finally writing this post was attending last week’s 16th national conference on unemployment at the University of Newcastle, hosted by the Centre of Full Employment and Equity (CofFEE). I found myself there because the centre’s director, Professor Bill Mitchell, is the author of billy blog, which I read regularly. Bill’s research and advocacy in the area of unemployment and underemployment is firmly rooted in a detailed understanding of how money works in a modern economy (hence the appeal for me) and the implications these mechanics have for government spending policy. This theme also underpinned many of the talks at the conference and the program included a panel discussion on the subject of “Modern Monetary Theory”. The panel comprised Bill Mitchell, Randy Wray and Warren Mosler, all strong advocates of what is sometimes referred to as “chartalism”. Along with another billy blog regular, Ramanan, I was invited to participate by providing a brief wrap-up at the end of the discussion.

But how hard can it really be to understand how money works? You earn it and you spend it or save it. Or, as the textbooks would have it, money serves as both a medium of exchange and a store of wealth. Is there anything more to say?

In fact there is. Most people and, indeed, many economists have not given very much thought to the mechanics of money and this leads to a number of misconceptions, all of which have made frequent appearances in the press and in political debate around the world over the course of the financial crisis. One example is the suggestion that the UK government could run out of money, an idea given further credence by the decision of rating agency Standard & Poor’s to put the UK’s rating on “negative outlook”. Even Barack Obama seems to be saying that the US is running out of money. The fact is, governments in many developed countries simply cannot run out of money. China could (but it is very unlikely) and so could member states of the European Monetary Union, but the US, UK, Japan and Australia could not. I will explain why here. In later posts I will continue the theme of the mechanics of money and will look at other misconceptions such as the idea that banks can “hoard” their reserves at central banks or that government deficits inexorably lead to high interest rates (the short answer to this one is: look at Japan).

In this post I will start with the basics of how money works and cover the following points:

  • how lending can “create” money
  • the limits to money creation
  • the difference between “fiat” money and money that is convertible on demand

A useful parallel to money in a real economy can be found in gaming chips in a casino. So, imagine a fairly standard sort of casino. You walk in, James Bond-style, hand over a thousand dollars to the cashier and get a pile of chips in return. The chips are marked with various denominations and total one thousand. This is an old-fashioned sort of casino: every game is played on a green felt table, there is not a poker machine in sight and, of course, you need your chips to play. To make your stay easy, you can also use your chips to buy drinks and snacks. When you have finished your evening’s play, you can redeem any chips you have not gambled away for cash.

There might be hundreds of thousands of dollars worth of chips circulating around the casino, but so far behind every chip is a corresponding amount of money sitting in the cashier’s safe. If we call this money the casino’s “reserves”, then the chip supply in circulation around the tables is equal to the casino’s dollar reserves. Of course, there might be a few cases of chips in the croupier’s office and even a chip-pressing machine in the basement, but these chips are not yet in circulation. They are just waiting to be handed over to the next patron who walks in the door with a full wallet. Under this regime, every gambler can be completely certain that they will be able to redeem their winnings at the end of the night.

While your thousand dollar stake might seem like a lot, there are a few high-rollers who frequent the place who like to play with much larger sums. Rather than producing chips with very high denominations, this casino has introduced convenient “smart chip cards”. High rollers can pay the cashier as much money as they like and the cashier will add it to the virtual chip balance on their smart cards. At every gaming table, the croupier has a card reader which can be used to debit the balance on the card in return for actual chips. This means that the total chip supply in circulation is the sum of actual chips and virtual chip balances on the smart cards. But still, this chip supply is matched by money in the cashier’s safe.

Now suppose you are a trusted regular at the casino and one night you turn up short of cash. No problem, the casino is happy to advance you your thousand dollars in return for a quickly scribbled IOU with your signature. Your credit is good. You take your $1,000-worth of chips and walk to the Blackjack table. But now something has changed. The total chip supply in the casino is $1,000 higher than the money in the cashier’s safe. In theory this could be a problem. You could immediately lose the $1,000 in chips and walk out. Then if everyone in the casino wanted to redeem their chips, there would not be enough money to go around. But, it isn’t likely to be a problem in practice. The casino operates 24 hours a day and so there are always far more than $1,000 in chips in circulation. On top of that, the house takes a decent cut on the tables, so it would not take very long for the casino to win back over $1,000-worth of chips and then $1,000 can be held back from the profits that the cashier regularly sends up to the manager’s office. In fact, the credit seems so safe, the casino decides to offer credit more widely. While they are at it, they introduce a few other innovations, like offering lucky door prizes in chips, which also adds to the supply of chips in circulation without a corresponding increase in money in the cashier’s safe.

These loans that the casino has introduced give it the ability to “create” an additional supply of chips. But not all lending creates new chips. If instead of borrowing from the house, you had offered your IOU to a high-rolling friend you would still get your $1,000 in chips for the evening, but you got them from your friend so the chip supply does not change.

The new lending arrangements are working well, but the system is limited by the fact that the cashier does not know all of the patrons very well, and is naturally being very cautious about who to lend chips to. To manage this bottleneck, the casino decides to allow senior croupiers to provide loans to gamblers they know well as long as they take responsibility for the credit-worthiness of the borrower. So now getting credit is simply a matter of providing an IOU to the senior croupier who knows you best and he or she will charge up your smart chip card. If you need actual chips, that is not a problem either as the senior croupier has a stash under the table borrowed from the cashier. Of course, the croupier is taking a bit of a risk providing you with this advance since the house expects him or her to make good any amounts you do not repay. So to make it worth their while, you give the croupier a few chips for their trouble each time you need an advance. This works so well that the cashier no longer offers loans directly to anyone other than the senior croupiers.

As successful as the new arrangements are, the casino does have to be very careful about putting strict limits on the number of chips that the senior croupiers can create through lending. Otherwise, the day may come when there are simply too many chips and not enough money in the safe and a successful gambler may walk up to the cashier to cash in their chips only to find that the cashier does not have enough money in the safe. Word will spread and everyone will want their money back, but the casino will be unable to oblige. It would be bankrupt. So while there may be no limit to the number of chips that the casino could physically manufacture (and of course it has complete control of smart chip card balances), there is a constraint on the number it can put into circulation. This constraint is a direct consequence of the fact that chips are redeemable for cash.

The analogy to the real economy should be clear here. The cashier operates like a central bank and government treasury combined. The senior croupiers are the banks. Chips are money and smart chip card balances correspond to bank account balances. In the same way that senior croupier lending effectively creates new chips, so bank lending adds to the money supply in an economy. But what is the analogy to the money in the cashier’s safe? While central banks around the world do maintain reserves of gold and foreign currencies (think of all the US dollars that the central bank of China has), for many countries the analogy breaks down in one important respect.

The casino made a commitment to redeem your chips for cash. Some central banks do make similar commitments. In the days of the gold standard, central banks in Australia, the US, the UK and elsewhere would exchange currency for gold. Of course there were times, as in war, when this convertibility was suspended, but in those days having something backing money was seen as just as important as having money backing chips in a casino. The gold standard system was abandoned after the second world war and instead, under the Bretton Woods system, domestic currencies could be exchanged at the central bank for a fixed number of US dollars. This system collapsed in turn in the 1970s. Today, some countries such as China do maintain currencies pegged to the US dollar (or some other currency) and so still make a commitment of convertibility. However, most countries have adopted so-called “fiat” money. The word fiat is Latin for “let it be” and fiat money does not derive its value from any form of backing. It is declared to be money, and so it is. Many people still assume that Australian dollars are in fact backed by something, but if you tried to take a $10 note to the Reserve Bank of Australia, you would be lucky to get two $5 notes in return. You could certainly not be assured of getting any particular amount of gold or US dollars.

Some people find the entire concept of fiat money deeply disturbing and pine for a return to the “real” money days of the gold standard. But fiat money is in fact an extremely powerful innovation. In the casino analogy, the cashier must always be careful about how many chips are put into circulation to avoid the crisis of being unable to convert chips back to cash. However, in a country with fiat money, the central bank makes no convertibility commitments, so this risk simply does not exist. It has monopoly power in the creation of currency. So, the government simply cannot run out of money. There may be very good reasons for a government to curb its spending. For example, it may not want to add too much to demand in the economy because it is concerned about inflation. But running out of money is not one of those reasons, whatever the president of the United States may think.

I will leave it there for now, as this post is long enough already. But, stay tuned for more on the macroeconomic implications of a modern fiat money system.

Deleveraging and Australian Property Prices

car-smallA few weeks ago, I had a preliminary look at Australian property prices. That post focused on rental yields and argued that the fact that property prices have consisently outpaced inflation over the last 10-15 years can be associated with a steady decline in rental yields which has been matched by a decline in real yields in other asset classes. What I did not address was the argument that debt deleveraging will lead to a collapse in property prices just as it has done in the US. That is the subject of today’s post.

The Bubble

The bubble argument is a compelling one. The chart below shows the growth in Sydney property prices over the last 24 years. Prices rose fairly consistently over this period at an annualised rate of almost 7%. Over this period, inflation averaged around 3% per annum, so property prices grew at a rate of approximately 4%. This means since 1985, the cost of a typical house has risen by a disconcerting 123% over and above inflation. Little wonder that many people see the property market as a bubble waiting to burst.


Sydney Property Prices (1985-2009)*

The fuel driving the property market has been the rapid growth in household debt, most of which has been in the form of mortgage debt.  The next chart is taken from Park the Debt Truck!, a post which looks at trends in Government and household debt in Australia. The highlighted regions show the periods of Labor federal governments. Household debt began its upward trajectory during the Hawke and Keating years, but really gathered pace during the Howard years. With the help of continually extended first-time home-buyer grants, growth is yet to slow now that Rudd has come to power.

Govt and Household Debt

Government and Household Debt in Australia

This expansion of debt has been a key factor driving up property prices. Without the easy access to money, the pool of potential home-buyers would be far smaller and with less demand pressure, prices would not have risen so fast. A very similar pattern was evident in the US, but in late 2006 the process began to lose steam. Property prices faltered, debt became harder to obtain, borrowers began to default on their loans leading to foreclosure sales which put further downward pressure on prices. The bubble was bursting.

So far I am in agreement with the property bubble school of thought. Where I part ways is concluding that Australia will inevitably experience the same fate, resuting in a collapse in property prices, possibly in the range of 30 to 40%.


Words can be powerful. Once you use the word “bubble” to describe price rises, it seems almost inevitable that the bubble must burst. Similarly, “reducing debt” sounds like a good thing, while “deleveraging” sounds like a far more ominous destructive process. But all deleveraging really means is debt reduction and it can happen in a number of ways:

  • borrowers use savings to gradually pay down debt
  • borrowers sell assets to pay down debt
  • borrowers default on their loan

When it comes to borrowers selling assets, in some cases this may be voluntary. But it may be that they are forced to sell. A good example is in the case of margin loans to purchase shares. If the share price falls, the lender will make “margin call”, requiring the borrower to repay some of the loan. Selling some or all of the shares may be the only way to raise the money required. When borrowers default on a secured loan (such as a mortgage), the lender will usually sell the asset securing the loan in an attempt to recover some of the money lent. In this situation the emphasis is usually on ensuring a speedy sale rather than maximising the sale price.

Forced sales are the ideal conditions for a price collapse, particularly if lenders have become reluctant to finance new borrowers. If debt reduction takes the form of gradual repayment, the pressure on prices is far less. There will certainly be less demand for assets than during a period of rapid debt increase, but this can simply result in neglible growth in asset prices for an extended period of time rather than a price collapse.

To understand what form debt reduction will take, it is not enough to consider the amount of debt. The form of the debt is very important. Some of the key characteristics that will influence the outcome include:

  • the term of the loan (the length of time before it must be repaid)
  • repayment triggers (such as margin calls)
  • interest rates

Short-term loans can be very dangerous. In 2007, the non-bank lender RAMS learned this the hard way. It had relied heavily on very short-term funding (known as “extendible asset-backed commercial”) and back when the global financial crisis was simply known as a liquidity crisis, RAMS found itself unable to refinance this debt. It’s business collapsed and it was purchased by Westpac for a fraction of the price at which the company had been listed only months before.

The most common type of loan with repayment trigger is a margin loan. There is no doubt that a significant factor in the dramatic falls in the Australian sharemarket over 2008 was forced selling by investors who had used margin loans to purchase their shares. There are also other sorts of loan features than can be problematic for borrowers. Another one of the corporate victims of the financial crisis was Allco Finance. It turned out that they had a “market capitalisation clause” attached to their bank debt. This was like a margin call on the value of their own company and was an important factor in the collapse of the company.

Even if borrowers have long-term loans and are not forced to repay early, if they are unable to meet interest payments, they will be in trouble. A common feature of the US “sub-prime” mortgages at the root of the financial crisis was that interest rates were initially low but then “stepped up” a couple of years after the mortgage was originated. While the market was strong, this was not a problem due to the popular practice of “flipping” the property: selling it for a higher price before the interest rate increased. Once prices began to fall, the step-ups became a problem and mortgage delinquencies (falling behind in payments) and defaults began to rise. In some states, the phenomenon was exacerbated by laws that allowed borrowers to simply walk away from their property, leaving it to the lender, who had no further recourse to pursue the borrower for losses. On top of all this, rapidly rising unemployment put further stress on borrowers’ ability to service their mortgages.

So, how do Australian mortgages look on these criteria? The standard Australian mortgage is a 25-30 year mortgage with no repayment triggers. Most mortgages are variable rate and, despite the banks not passing through all the central bank rate cuts, mortgage rates are at historically low levels. In part due to the regulatory framework of the Uniform Consumer Credit Code (UCCC), lending standards in Australia have been fairly conservative compared to the US and elsewhere. The Australian equivalent of the sub-prime mortgages, so-called “low doc” or “non-conforming” mortgages, represent a much smaller proportion of the market. Many lenders cap loan-to-value ratios (LVR) at 95% and require the borrower to pay mortgage insurance for LVRs over 80%, which encourages many borrowers to keep their loans below 80% of the value of the property. Interest step-ups are rare. Mortgages are all full recourse.

The result is that while US mortgage foreclosure and delinquency rates have accelerated rapidly, they have only drifted up slightly in Australia. It is not easy to obtain consistent, comparable statistics. For example, deliquency data may be reported in terms of payments that are 30 days or more past due, 60 days or more or 90 days or more. Of course, figures for 30 days or more will always be higher than 90 days or more. Nevertheless, the difference in trends is clear in the chart below which shows recent delinquency rates for a variety of Australian and US mortgages both prime and otherwise. The highest delinquency rates for Australia are for the CBA 30 days+ low doc mortgages. Even so, delinquencies are lower even than for US prime agency mortgages 60 days+ past due.

Delinquency Rates (III)Delinquency Rates in Australia and the US**

All of this means that the foreclosure rate remains far lower in Australia than in the US. Combined with the fact that mortgage finance is still increasing, due largely to the ongoing first-time home-buyers grant, there has still been little pressure on Australian property prices. In fact, reports from RP Data-Rismark suggest prices are on the rise once more (although I will give more credence to the data from the Australian Bureau of Statistics which is to be released in August).

Once the support of the first-time home-buyers grant is removed, I do expect the property market to weaken. Prices are even likely to fall once more with the resulting reduction in demand. However, without a sustained rise in mortgage default rates, I expect deleveraging to take the form of an extended lacklustre period for the property market. Turnover is likely to be low as home-owners are reluctant to crystallise losses, in many cases convincing themselves that their house is “really” worth more. Even investors may content themselves reducing the size of their debt, continuing to earn rent and claim tax deductions on their interest payments.

The biggest risk that I see to the Australian property market is a sharp increase in unemployment which could trigger an increase in mortgage defaults. To date, forecasters have continued to be confounded by the slow increases in unemployment and now the Reserve Bank is even showing signs of optimism for the Australian economy.

Australian property prices have certainly grown rapidly over recent years. Driven by rapid debt expansion, prices have probably risen too far too fast. But, calling it a bubble does not mean it will burst, nor does using the term “deleveraging” mean that prices will inevitably follow the same pattern as the US. In the early 1990s, Australia fell into recession and the commercial property market almost brought down one of our major banks. Meanwhile, house prices in the United Kingdom collapsed. Despite all of this, in Australia, residential prices simply slowed their growth for a number of years. I strongly suspect we will see the same thing happen over the next few years.

* Source: Stapledon

** Source: Westpac, CBA, Fannie Mae, Bloomberg.

By the way, notice anything unusual in the picture at the top?

UPDATE: Thanks to Damien and mobastik for drawing my attention to this paper by Glenn Stevens of the Reserve Bank of Australia. It includes a chart comparing delinquency data for the US, UK, Canada and Australia. The data is attributed to APRA, the Canadian Bankers’ Association, Council of Mortgage Lenders (UK) and the FDIC. Since these bodies do not appear to make the data readily available, I have pinched the data from the chart and uploaded it to Swivel. It paints a very similar picture to the chart above.

Delinquency: US, UK, Canada and AustraliaMortgage Delinquency Rates

Australian Property Prices

Property prices have always been a popular topic of conversation in Sydney, but the subject has become more contentious since the onslaught of the Global Financial Crisis. Views on prospects for Australian property prices range from the bleakly pessimistic to the wildly optimistic. Iconoclastic economist Dr Steve Keen is one of the more prominent pessimists and expects a fall in property prices of as much as 40%. At the other extreme, research firm BIS Shrapnel recently released forecasts that prices in capital cities will rise by almost 20% over the next three years. Of course, both sides have their critics. Macquarie Bank economist Rory Robertson is so convinced that Keen is wrong that he has offered a wager in which the loser will have to walk to the top of Mount Kosciusko wearing a t-shirt saying “I was hopelessly wrong on home prices! Ask me how”. Meanwhile, many dismiss the optimists as mere shills intent on talking up the market in the interests of their clients.

Faced with a debate like this, the only recourse for the Stubborn Mule is to look at the data. Fortunately, I have been able to get my hands on a rich set of data (and ideas) from University of New South Wales economist Dr Nigel Stapledon*. Stapledon has painstakingly assembled data on Australian property prices back to the 1880s and rental data back to the 1960s. This data underpins a detailed comparison of the Australian and US property markets in Stapledon’s forthcoming paper  “Housing and the Global Financial Crisis: US versus Australia” in The Economic and Labour Relations Review, Sydney. By comparison, the House Price Indexes published by Australian Bureau of Statistics (ABS) commence in 1989.

A first glance at Stapledon’s index of Sydney property prices does indeed appear to show a meteoric trajectory that would inflame the passions of the pessimists.

Sydney House Price Index

Sydney House Price Index

Of course, asset prices tend to exhibit exponential growth, so it is far better to look at historical prices on a logarithmic scale. This reveals a striking trend. The growth of Sydney property prices has been remarkably consistent at around 9% per annum over the last 50 years.

Sydney House Price Index (log scale)

Sydney Property Prices (log scale)

Prices for Australia overall show a similar trend, with average prices over the six major capital cities growing at an average of 8.6% per annum since 1955.

Six Capital Cities

Australian Property Prices

What these charts do not take into account is the effect of inflation. Indeed, inflation varied significantly over the last 50 years, so adjusting for the effect of inflation shows that the trend in Sydney house prices has not been so stable. Booms such as those from 1987-1989 and 1997-2003 are made very clear in the chart below. But it is also evident that  prices have failed to keep up with inflation over the last few years. Nevertheless, over the last 50 years, Sydney house prices have appreciated an average of 3.1% over inflation and that is before taking rental income into account.

Sydney House Price Index (inflation adjusted)

Sydney Prices (inflation adjusted)

One difficulty with long-run property price data is that fact that observations are typically based on median house prices, which does not take into account changes in the quality of houses. The median house in 2009 may be “better” than the median house in 1955 and changes in price may reflect this change in quality as well as price appreciation. Stapledon has attempted to take this into account by constructing an index for Australian house prices (six capital cities) that is adjusted for both inflation and standardised to “constant quality”. The trend in real prices, adjusted for quality over the period 1955-2009 has been an increase of 2.1% per annum over inflation. This compares to an increase of 2.7% per annum over inflation without adjusting for quality. So, at a national level, quality changes overstate the trend growth rate by 0.7%. While Stapledon has not constructed a quality-adjusted index for Sydney, assuming that the national trend applied would lead to the conclusion that Sydney house prices have a trend growth rate of 2.4% over inflation.

Six Capital Cities (quality adjusted)Australian Prices (quality and inflation adjusted)

Interesting though this historical exploration may be, the question we would like answered is where prices may head in the future.

One approach to the problem is to assume that growth in property values in real terms may change in the short term, but over the long term will revert to a long term trend. Enthusiasts of trend following may see some significance in the fact that Australian prices still appear to be above the longer run trend, while Sydney prices have already fallen below trend. Of course, depending on the time period used to determine the trend, very different conclusions may be reached. If I were to base the trend on the full history from the 1880s, the last 50 years would appear to be well above trend.

Another popular approach is to consider housing affordability. This approach either looks at ratios of house prices to income or ratios of housing servicing costs (whether interest or rent) to income. The assumption is that these ratios should be stable over time and if increases in house prices result in reduced affordability this indicates the prices can be expected to fall in the future. Stapledon is critical of this approach, arguing that:

while income is expected to be a major influence on prices, there is no theoretical reason for any fixed relationship between prices and income or between rents and income

Over time, people may change their priorities and place a greater or lesser importance on housing and, as a result, be prepared to spend a larger or smaller proportion of their income on housing. Stapledon argues that a better approach is to examine rental yield, which is the ratio of rents to prices. Since the property prices can be expected to keep pace with inflation (and, in fact, outpace inflation), rental yields should be comparable to real yields (i.e. yields over and above inflation) on other asset classes. The easiest real yields to observe are those of inflation-linked Government bonds.  The Reserve Bank of Australia publishes historical data for inflation-linked real yields back to the late 1980s. The chart below compares these Government bond real yields to Stapledon’s history of rental yields. While the correlation is not perfect, both rental yields and real yields show a downward trend from the late 1980s/early 1990s which has only recently begun to reverse. Since rents have not fallen over this period, this provides an explanation for the strong growth in property prices over that period.

Rental Yields

Australian Rents and Inflation-Linked Bonds

So what could this approach tell us about property prices? Rental yields have already risen further than bond real yields, but certainly could go higher. What this means for prices does also depend on where rents themselves may be headed. The chart below shows the contribution of rents to consumer price inflation as published by the ABS. While the rate of growth in rents has slowed, history would suggest that rents are unlikely to go backwards. A cautious, but not overly pessimistic forecast could see rental increases falling to an annualised rate of 1% while rental yields could climb back to 4%. The combined effect would be a fall of 12%. Since prices have already fallen by 7% over the year to the end of March 2009, this would amount to a fall of almost 20%.

Rent CPI

Rent Inflation (Quarterly)

This is certainly a significant drop, but still half the fall that Keen expects to see.  For prices to fall by 40%, even assuming rents remain unchanged rather than growing by 1%, it would be necessary for real yields to rise to 5.8%, which exceeds the record level since 1960 of 5.4%. On this basis, I find it hard to be as pessimistic as Keen. Indeed, the latest data from RP Data-Rismark International suggests that prices are once again on the rise. The next ABS release is a little over a month away, so it will be interesting to see whether they see the same recovery.

The relationship between rental yields and real yields is an interesting one, but ultimately does not provide definitive predictions, but rather an indication of a range of outcomes that would be precedented historically. Of course, as Nassim Taleb has emphasised, unprecedented “black swans” can occur so history does not allow us to rule out more extreme events. Furthermore, nothing here addresses the question why prices in the US have fallen so dramatically and yet Australian prices could suffer far milder falls. That is the primary focus of Stapledon’s paper and is a topic I may return to in a future post, but this one is long enough already!

UPDATE: In this post I noted that the historical data shows a marked shift in behaviour from the mid-1950s without providing any explanation as to the cause of this shift. Needless to say this is a subject Stapledon has given some serious consideration, and I will quote from his doctorate, “Long term housing prices in Australia and some economic perspectives”:

From a longer term view, a key observation is the clear shift in direction in house prices and rents from circa the mid 1950s. House prices, in particular, jumped significantly, best illustrated by the rise in the price to income ratio from about one: one to about 4:1 in the 2000s. Looking at demand and supply variables…indicates that this shift in direction cannot be adequately explained in terms of the demand variables of income and household growth. Supply side factors appear to be more crucial and there is a substantial literature emerging in the US emphasising the importance of supply side variables and specifically the propensity to regulate to constrain supply. The evidence presented in this thesis of the lift in the cost of fringe land in the major urban areas provides prima facie evidence that supply factors have been a significant factor explaining the upward trajectory in house prices in Australia since the mid 1950s.

* I would like to thank Dr Stapledon for generously making his data available to me.

UPDATE: finally, I have published the post on why I don’t think Australia’s property market will experience the same fate as the US market.