Does house price crash follow unemployment or is it the other way?

June 8th, 2011

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One of the most common idea floating around in Australia is that as long as unemployment rate does not spike, mortgage defaults will not rise and consequently house prices will not crash from mass foreclosure selling.

That idea, taken in isolation, is self-evidently true. But is it logically correct to leap from this idea and jump to the idea that as long as the tide of unemployment holds low, there wouldn’t be a housing crash in Australia?

To answer this question, let’s take a read at this interesting article from MacroBusiness,

Australian banks pretty much only know how to lend against property. From time to time they rabbit on about lending against cash flow, but the truth is they do not have the skills. They vanished in the 1990s when merchant banks started disappearing. ?Investment banks are just financial tricksters fiddling with assets. As we see with Macquarie?s fate, they do not know how to invest in real businesses that achieve steady growth from serving customers.

There has been a sharp rise in business credit for SMEs since the mid 1990s, which pretty much tracks the property asset bubble.?In 1996 it was about $13 billion, two thirds of which was secured against property. By 2008 it was $63 billion, 75% of which was secured against property. In 2010, it fell to $56 billion. Again, about 75% is secured against property. About two thirds is secured against residential property.

This level is high by developed world standards. According to the World Bank,the average for developed economies is to have 56% of SME loans secured against property.

Banks are still lending, but mostly only where the loan is fully secured by tangible assets and personal guarantees (and, in some cases, key man insurance). Where there is an existing loan, banks are requiring additional security. Members stated that lenders were no longer prepared t provide finance on ?soft? security ? such as cash flow or good will (unsecured finance) ? as had been available pre-GFC.

In Australia, residential properties underpin much of the collateral for SME loans. The implication of a decline in house prices is the reduction in the value of the loan collateral. That will result in a tightening of credit. A precipitous decline in house prices will result in a credit crunch for SME. A credit crunch for SME will result in cash-flow problems, which in turn will result in mass layoffs (i.e. higher unemployment). A decline in house prices will also sap away consumer confidence via thewealth effects, which in turn will drain consumer spending out of the economy, which in turn will result in high unemployment in the retail sector.

So, the first round of impact from falling house prices will be rising unemployment. That will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Also, falling house prices can happen at the margins. You don’t need a mass selling panic to trigger a fall in house price. As we wrote inSpectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.

To put it simply, credit drives house prices, which in turn drives credit. Falling house prices will drain credit, which in turn pushes down house prices.

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  • Great article ? one of your best! It?s about time the banks were exposed for what they are, sellers of debt enslavement. I mean look at the ridiculous price of housing and the spruikers tell us its going to double again from here but Steve Keen is spot on when he says prices are already going down. How are we supposed to pay for more house price inflation? More debt from the banks? The market is in big trouble and Auction Results are collapsing. The banks will never admit housing is in a bubble for as soon as they admit it they know the whole ponzi comes crashing down. Oh well, I guess we just wait. The insanity can?t go on for much longer and soon we?ll see the market collapse under its own weight. We’ve seen a rapid fall in consumer spending in the recent data, and that’s is a classic tell tale sign of an economic bubble that’s about to pop.

    Tom Kline
    Australians for Affordable Housing

  • John

    Guys did you see this article in the morning papers http://www.smh.com.au/business/australia-big-on-debt-small-on-worries-20110609-1fu1n.html

    The stench of sub prime is overpowering.

  • Matt

    Bank’s capitalisation ratios normally allow the highest ratios against residential mortgages. I think under Basel 1 the EU banks are allowed 100% capitalisation on residential mortgages which is 8% in assets underpinning the loans, on commercial property its 50% so they can only extend half the credit off the same assets, on business loans its less again, you get the idea (that’s approximate figures off the top of my head). So the system is designed to micro manage the banks ability to extend credit and I don’t think the banks really care too much about their loans so long as they are at or near maximum allowable credit creation (particularly on the way up!). If there was greater scope to extend against commercial property than no doubt that would have boomed more, if it was business loans with the highest allowable ratios we’d all own a mid sized enterprise and be wathcing shows on how to climb the entrepreneurship ladder ‘Cashflow Cashflow Cashflow,, tonight at 6’.

  • Anon

    Interesting CIJ. Great article!

    “So, the first round of impact from falling house prices will be rising unemployment. That will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.”

    Thats brilliant.?