The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, March 1, 2010

Getting the facts right

Today I am going to discuss the January house price index results and Andrew Cornell’s feature in the Weekend AFR.

Based on the RP Data-Rismark Hedonic Home Value Index, Australia’s housing market began 2010 with a resilient showing, registering a solid 1.8 per cent capital gain in the month of January based on the ‘indicative’ index results. This, however, employed a small sample of sales due to the seasonal summer slowdown. The indicative December 2009 month estimate, which was -0.3 per cent, has revised only very slightly to -0.4 per cent.

On a year-on-year basis, Australian home values expanded by 11.8 per cent following on from their 2-3 per cent calendar year fall in 2008 (see chart). Looking through both December and January, the average monthly growth rate was 0.7 per cent. On a seasonally-adjusted basis, the monthly rate of increase was around 1 per cent. As such, we have yet to detect any cooling in market conditions. This should nevertheless transpire as mortgage rates normalise. (Note also that RP Data-Rismark’s hedonic index has provided considerably more conservative estimates of the capital gains in 2009 compared with the ABS and APM stratified median price indices.)

Last week the interbank futures market was pricing another 90 basis points worth of rate hikes over the course of 2010 with a forecast cash rate of around 4.65 per cent by the end of the year (see chart below). This would result in the headline variable mortgage rate rising to 7.55 per cent. The discounted variable mortgage rate would be 65 basis points lower at 6.90 per cent (see second chart). Based on Governor Stevens’ testimony, this would put mortgage rates back at their historically ‘normal’ levels.

In his bi-annual testimony to Parliament, the Governor of the RBA, Glenn Stevens, pointed out that notwithstanding the sprightly house price growth recorded in 2009, lending standards have been tightening while credit growth has not been overly strong:

“The rate of growth of housing credit…is about 8 per cent…I would not regard that as grossly excessive—it used to be 18…What we have is pretty strong growth in house prices over the past year…but credit growth is not too bad; it is moderate. Lending standards for households are actually increasing, not falling. Banks are tending to reduce loan-to-value ratios—you have got to have a bigger deposit and so on, and I do not think you can get a no deposit loan now et cetera…So we do not see incredibly fast growth in credit at the moment—we might, but at the present time we do not—and we do not see lending standards falling, we see them rising”

That is to say, we do not see any evidence of a credit-fuelled asset price boom. On this note, one of the best financial services commentators going around, Andrew Cornell, had a reasonably good feature on Australia’s housing market in the Weekend AFR. I was quoted in regard to our analysis of the myths surrounding the productivity of investments in new and established housing, which you can read here. All sensible economists agree that housing plays a highly productive role in our economy.

While Cornell is a banking specialist and no housing expert, he made a solid and fairly even-handed fist of dealing with some undeniably some complex content. I have only a few quibbles.

The first relates to his claim the Australia’s ratio of house prices to income is over 6 times. This is just wrong, and illustrated by the fact that the diagram accompanying his article shows that Australia’s house price-to-income ratio between 1985 and 2008 has never exceeded 6 (ie, Cornell’s own chart contradicts his claims)! I suspect Cornell is quoting the widely discredited Demographia survey. Yet one only has to refer to a speech given by Glenn Stevens last year that presented a chart illustrating the RBA’s best estimate of Australia’s dwelling price-to-income ratio. I have republished this below, and one can see that the RBA put Australia’s ratio at 4.8 times in mid 2009. This is materially lower than the 6 times ratio quoted by Cornell.

There is, however, a problem with the RBA’s analysis as well: it is comparing capital city dwelling prices to all areas household incomes (incomes in capital cities are higher than those in non-capital city regions). A more correct analysis would be of ‘all areas’ dwelling prices with ‘all areas’ incomes. The second chart below presents exactly this comparison through to September 2009. Here we have included both ‘average’ prices and ‘median’ prices and use the same disposable income data from the ABS National Accounts that the RBA employs. Based on this measure, Australia’s mean or median dwelling price-to-income ratio is between 4.1 and 4.3 times. (As an aside, another mistake punters make here is taking ABS income data from 2007 and comparing it to house prices in 2010.)

The next issue I had with Cornell’s article is the quote from NAB CFO, Mark Joiner, that “they had a supply shortage in the UK too and prices there fell.” This is absolutely true. Yet, as I have highlighted before, the key point is that the UK banking system suffered a complete collapse that led to extreme credit rationing, which only then precipitated house price falls. More specifically, the UK experienced the first ‘run’ on a bank since 1866, while most UK banking institutions have been wholly or partially nationalised (UK taxpayers today own 84 per cent of RBS).

In contrast to the US, where poorly constructed home loan products combined with weak lending standards to trigger high default rates, distressed sales, significant price falls, credit rationing, and ultimately institutional failures, the chain of events in the UK worked the other way around. The collapse of global funding markets as a result of the US sub-prime crisis meant that institutions like Northern Rock could no longer finance themselves, which propagated extreme credit rationing, plummeting individual and institutional confidence, outright bank failures, house price falls (since credit was no longer freely available), and then rising default rates.

Finally, Cornell references Steve Keen as a credible voice in the housing market debate. You can read my thoughts on that in the post below.