Housing: “The Ultimate Ponzi Scheme”

Lindsay David, from LF Economics, looks at the challenges that first home buyers face to own property

Introduction: Australian Housing Market – the ultimate Ponzi Scheme

Ross Greenwood: Welcome back to money news right around Australia. Now, this is something that I might get a few calls from you, and that is about that forecast we told you about last night with John Edwards. Now, that was all about interest rates rising. Pretty much every consecutive caller over the next two years, 2018, 2019 that would take into straights up 2 percentage points on where they’re right now. That’s the Reserve Bank doing that, 1.5%, let’s call it, to 3.5%.

At the same time what you’ve also got is banks right now, and we saw the Commonwealth Bank earlier this week do this, they raised interest rates on their interest-only loans for investors and even homeowners who have got interest-only loans. As a result those interest rates have risen by more than 0.6% in the past three months since March. Some of those rates are getting out towards the high-five now.

Now, at the same time they’re also cutting principal and interest loans, so those people who are willing and prepared to actually pay-off a part of their home loan each and every month, even though that costs more in actual repayment terms, they’re doing so. In order to try and get more people to pay-off more of their home loan, the banks and they’re cutting the principal and interest loans, but raising the cost of the interest-only loans.

There are some people out there who believe that interest-only loans in Australia have got out of control that they are really, if you like, the straw that will break the camel’s back. If you can see that, that if interest rates do raise as John Edwards, the former Reserve Bank Directors says, that it will only exacerbate significantly the problem for many of those investors and homeowners who have used interest-only loans. More particularly, for those investors who have retched it up one property to another to another to ultimately get a portfolio of properties. If they’ve acquired those properties more recently, then there could be potential problems and even then for the banks as well.

One of those people who has been raising awareness about this for a long time, and in many cases people have looked at him and gone, “No, you’re on the wrong trend,” but as time goes on people go, “Actually maybe you’re a bit close to the mark,” is Lindsay David. He is the founder of LF Economics and he’s online right now. Many thanks for your time, Lindsay.

Interview: Lindsay David, Founder, LF Economics

Lindsay David: Good evening, Ross.

Ross Greenwood: Just explain the problem of interest only loans.

Lindsay David: Well, the problem with interest-only loans is the fact that you’re not paying down any principal. Let’s say, after five years and you’ve just being paying an interest-only loan, all you’re doing is just paying the bank interest to purchase an asset. What you’re not doing is actually paying down the principal that you owe back to the bank.

Now, here in Australia, the way our banks lend to homebuyers is, by any global standards, remarkably excessive. I’ve just gotten back from a global research trip and I can tell you right now it’s easiest country in the world to get a home loan six times your income or greater and indeed get a home loan six times your income or greater for an interest-only loan which is remarkably concerning.

For one reason or another, our banks have had for a long time very little hesitation in issuing these very large, jumbo-sized interest-only loans.

Ross Greenwood: Just explain to people, if we’re going to pick up there, the six times your income. Why is it concerning if a person takes out a loan on six times their income with an interest-only loan?

Lindsay David: Well, let’s say you earn an income of $100,000 a year and you take on a $600,000 loan and if it’s an interest-only loan, well, you still have to, inevitably, one way or another pay back that $600,000. If you were to take on a $600,000 loan principal and interest, you would be sucking up a very significant chunk of your net income let alone your income.

The big problem is when you allow society to take on these big loans you’re increasing the risk profile of the mortgage market and the Australian housing market and you’re providing the borrowers very very little room to navigate if they have to trade through some pretty rough waters.

Ross Greenwood: The question is what would create those rough waters? Obviously, it would be interest rates rising would be one, unemployment would be another. Unemployment rates have been relatively low. We know that people are underemployed right now. Do you believe there are already pressures being seen in the Australian economy?

Lindsay David: Well, I do see the pressure more coming from oversees where the Australian banking system is seemingly starting to get put under pressure from the American Federal Reserve because the Americans are now starting to raise their interest rates. As the Americans raise their interest rates, it becomes more attractive for international wholesale lenders to lend to American financial institutions versus our financial institutions.

That’s something I don’t think a lot of people have been really discussing here is the fact that what the Reserve Bank of Australia has essentially done over the six or 12 months by doing nothing has had less of an impact on interest rates. Particularly, those interest-only loans and the cost of funding for banks relative to what the American Federal Reserve is doing.

When I look at what’s going to be happening to interest rates at the moment, I’ll actually have a closer eye on what’s the Fed’s doing to impact the Australian mortgage market than what the Reserve Bank of Australia is doing to impact the mortgage market. Because, I would say our Reserve bankers would be very scared to raise the interest rates because they know that they would have to throw a sledge hammer into the Australian housing market.

Ross Greenwood: What you’re basically saying is that if there are really very high levels of indebtedness of Australian households and we have some of the most indebtedness households in the world. If that starts to spook the investors who put money into the Australian banks to allow our mortgages to be funded, if they get spooked and they either want a higher price for those mortgages or that they want to stop putting their money in altogether, then what ultimately happens? Is Australians will pay sharply higher prices for their mortgages?

Lindsay David: Well, exactly Russ. Well, there’s no doubt that here in Australia the cost of money one way or another is slowly on the rise and is probably going to continue to do so progressively.

Now, when you combine that and the dangerous cocktail there just by under any mathematical account has to be a significant chunk of those interest-only loans that have been issued to very speculative property investors. A lot of these loans, by any mathematical account, are just simply never going to be fully repaid unless that speculative borrower is able to sell that speculative investment for a high price than what they paid for it. What that speculative property buyer needs is someone else to go to the bank and be able to get a bigger loan than they did to be able to pay a higher price for the house that they’re trying to sell.

Now, that’s not an easy thing as the cost of money starts to rise and the flow of money starts to get a little bit tied up. That’s where I would say, in my opinion, that’s where we’re going to, inevitably, see a very serious problem in our Australian housing market. Because you’re going to end up with all these people holding an interest-only loan and they’re going really be restricted on both their ability to rollover those interest-only loans for another interest-only loan.

They’re inevitably going to have to be asked to start paying back some principal. I would say that in that moment you’re going to get, unfortunately, see a lot of good hardworking people who are probably maybe have invested into the Australian housing market that’s a bit too good to be true get caught with their pants down.

Ross Greenwood: You’ve also described that arrangement whereby loans are being passed around by the banks from one borrower to the next with higher prices. You’ve described that as a Ponzi scheme. Can you explain why did on that?

Lindsay David: Well, this is a big problem, especially in Sydney and Melbourne now where house prices are just so far off the norm or the rental returns that you can get there. If there was a legitimate issue on the housing shortage here, there would simply be a negative property investors because they won’t be making a fortune on rent.

Because rent have, in real terms, remained relatively flat that the cost of housing keeps on increasing. Basically, the whole housing market is just simply dependent on banks being able to keep on giving people bigger loans to essentially bail out those borrowers who are in a financial pickle. That’s essentially Ponzi financing. You just keep on giving everyone a bigger loan and you keep on stimulating demand. Well, you’re always going to have someone take those loans in the pit of a rational exuberance and then pay more for a dwelling.

Once again, once that access to easy money dries up like I think it inevitably will be, that’s going to be a very very serious problem for our housing market. Now, I would probably say Melbourne is going to be the city in Australia that’s probably going to see the biggest problem out of all that.

Ross Greenwood: There you go. Lindsay David, as I say, from LF Economics. He’s the founder there and done a lot of research both here and oversees into the Australian housing market. That is his prognosis of what happens in the Australian housing market in certainly a worst case scenario. Now, do bury more what a lot of what he says about ratcheting up of the prices is absolutely true because normally prices rise because income levels rise. If you actually have a look income levels are going very flat now. The most rents are very very flat but you’ve actually seen prices rise quite randomly during that period of time. Lindsay David, always great to have you in the program. We appreciate your time this evening.

Lindsay David: Thanks, Ross.

Ross Greenwood: Yes we’ll take your calls on this one, 131873. You’ve heard from Lindsay, but I want to know is he on the mark here? Do you think he is right? Of course, if you’ve got a lot of properties, you will not be a bit concerned by that prognosis as well. Give us a call on 131873.

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