## Monday, February 1, 2010

### The Australian property market debt gamble

Investing and gambling are often mistaken for each another.  In one, you take risks based on known probabilities, in the other, unknown probabilities.  In one, you will probably win in the long run, in the other, you are bound to lose out.  In both pursuits we are psychologically predisposed to scams.

I find it interesting that prudent advice for gamblers is to risk only your own money, while for investors it's a different story - the more leverage the better.  But there must be an optimal level of leverage, otherwise we would all simply continue to borrow and destroy the value of the currency through money creation.

Given the realities of our world, one would expect that leverage below this optimal level would not persist for an extended period, as people would begin to notice the advantages of more leverage, nor would leverage or debt beyond this optimal level be able to persist.   It is therefore interesting to ask how would we know if we are above this optimal level?

One could easily spend some time on Steve Keen's blog and be convinced we are far beyond that optimal level, and that downwards adjustment in debt (debt deflation) will take place, which will result in a destruction of asset values, particularly property, which is usually purchase with high levels of debt.

The path I want to take is to first look at Australian historical data to paint of picture of where our debt situation is relative to assets and incomes, then compare household debt levels internationally to see whether a correlation can be drawn between high debt levels and a property market crash.

Below is data from the RBA B21 time series on household ratios.  It demonstrates a number of interesting points for the investor gambling with more than their money.

The first critical point to note is the rapid destruction of asset values from mid 2007 to mid 2009 - asset value on paper is always at risk until the asset is sold.

The second point to note is that during the value destruction, the debt to asset ratio shot up dramatically (as you would expect).  The lesson - debts are fixed while asset values are not.

The third point to note is the effectiveness of monetary policy in decreasing the burden of debt.  When interest rates where reduced during 2008, the interest costs dropped almost 50%.  However the downside to low interest rates is that it enables people to borrow more and makes raising rates again more painful (although the RBA seems to have no problems with that, unlike their American and UK counterparts).

Can we tell from this information whether we are above the optimal level of debt?  The only worrying thing I see is that the housing interest to disposable income ratio is still far above any level experienced before the recent property boom.  I suspect that even though the RBA appears to be in a tightening phase, by year's end we will see lower interest rates than at present.

The second graph below (from here) shows a fairly recent international comparison of household debt levels as a ratio of disposable household incomes.  What we note is that all countries with debt levels above 150% of disposable income have seen property market crashes (of differing severity) since this time.  The Dutch may yet be in the midst of a property market correction.  Prices in major Dutch cities are between 1,900 and 3,360euro/sqm which, quite unbelievably, are much the same as the apartment prices in Brisbane at the moment ($3,000-$5,000/sqm).  Further, as I have mentioned before, interest rates on home loans in Holland are around 4.5%, and the interest own your own home is tax deductible.

A second interesting feature is the flatness of Japan's debt ratio since the late 1980s.  Japan never saw debt levels as high as those currently observed in Australia and yet the central bank decreased interest rates to near zero since the time of their property market peak in 1990, decreasing the burden from this debt, but failing to significantly reduce it.

The take away message from these two sets of data must be that some form of property market correction will occur.  Whether it takes the form of static prices for some years, or some sharp drops, price increases such as those seen since 2001 will not be a feature of the coming decade.  At the moment, Australian households appear to be ignoring the advice given to gamblers, and are using high levels of debt to invest at a market with plenty of unknowns, and plenty of risk.

UPDATE
More here on Australian household debt, although I disagree with the prediction on interest rates.  I see interest rates lower by the end of the 2010.

1. Cameron, I do not agree entirely with your opening paragraph. which are you referring to regarding "known" and "unknown" probabilities? The probabilities in gambling are quite clear and known. For investment, the probabilities are also known, however, it is more likely to find a positive risk/return opportunity in investment than gambling.

At the end of the day, the assumptions and forecasts used in investment decisions are not known and although variance is often factored in, I don;t think the distinction between investing and gambling is quite as clear as you make out.

A closing thought - is it really a massive gamble on house prices when there is the implicit guarantee of government support (or in the case of the USA - explicit support - http://ftalphaville.ft.com/blog/2010/02/01/138151/us-housing-bubble-v2-0/ )? It seems to me to be a win/win situation for residential property investors when the risk of a property price fall is so politically sensitive due to such a high level of personal mortgage indebtedness, that ultimately the government would be forced to step in.

2. I agree about governments needing to prop up prices to stay in power, however I suspect we also agree about the probabilities in gambling and investment.

Also, I'm not sure if you mean that investing and gambling are more similar or more dissimilar to each other "the distinction is not as clear as I make out"?

Underlying my introduction is the point that In common gambling games, the probabilities of future events in the game are known. In investment decisions, only past outcomes can be observed, the probabilities can be derived from these events, however there is no reason to believe that past performance, variance, and subsequent quantifiable risk is a reflection of future probabilities. The statistical regress fallacy, made famous by Nassim Taleb, explains this problem, which is separate from other obvious problems such as changing geo-political context over time.

In either case, gamblers are told not to risk other people's money, while investors make an art for out of it.

3. The question is whether governments can really support private markets as large as the Australia property market for any length of time. After all, government is dwarfed by tis market. The federal and state governments are propping up the market by buying mortgage-backed securities, and by providing first home owners grants. However, if we see significant declines, there will be no more first-home buyers whose purchase can be brought forward, so larger grants will need to be offered, or other silly schemes that cost even more. Will the governments be able to afford this indefinitely? It seems unlikely, even in the unlikely case that we are really in a recovery.

Tim

4. I believe investing and gambling can quite often be more similar than it seems.

For example is an intraday trade of shares truly an investment? or merely a punt on the price?

However, long term a purchase of the same shares for >5 yrs could be considered an investment which returns a profit over time for a financial risk.

Gambling - the wagering of money on an event with an uncertain oucome with the primary intent of winning (basic definition for wikipedia)

One thing is for sure - all these activities are regulated completely differently and definitely attract the scammers.

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1. The second point to note is that during the value destruction, the debt to asset ratio shot up dramatically (as you would expect). The lesson - debts are fixed while asset values are not.

Ben Cass ,
Benjamin Cass