The new normal for housing not economic Armageddon: Christopher Joye

Today I can reveal an update to some important housing “valuation” analysis that we published here late last year. The revisions leverage off the ABS’s latest National Accounts, which form the basis of the quarterly economic growth (or “GDP”) data.

This analysis asks a simple question: if one took the median Australian house price way back in 1985, and indexed it to (1) the change in disposable incomes per household over time, and (2) any changes in borrowing capacity resulting from variations in mortgage rates, how would this “new” 1985 price compare to actual median prices in 2011?

Put another way, we want to know what percentage of the increase in Aussie house prices since 1985 can be explained by changes in disposable incomes and mortgage rates.

As a crucial part of this analysis, we hold constant the amount households spend on meeting their mortgage repayments as a share of their total disposable income at the original 1985-86 levels.

In particular, Rismark worked out the average mortgage repayments-to-disposable income ratio between 1985 and 1986, and then assume that this is the ratio future households apply to their repayments. The exact ratio used in the analysis is 25%; i.e., one-quarter of disposable income is available to service principal and interest repayments on a home loan.

One can then work out the maximum amount the household can borrow given a level of income and a specific mortgage rate.

The chart below shows the results of this analysis, which replicates a framework first developed by an ANZ economist, Paul Braddick.

Rismark finds that growth in disposable incomes on a per household basis explains about 60% of the increase in Australian house costs since 1985. Changes in borrowing capacity account for another 33% of the rise in Aussie house prices. Taken together, Rismark can explain nearly 93% of the total change in house prices over the last 26 years by simply using incomes and interest rates.

Regular readers will recall that I have belaboured here the quite radical adjustments in actual mortgage rates that took place over the past three decades. Specifically, the average variable mortgage rate in Australia between 1980 and 1995 was about 12.6%. Since 1995 the average home loan rate has fallen by more than 40% to about 7.3%. This is around where lending rates sit today.

The enormous reduction in the cost of housing debt has enabled households to increase their total amount of debt without necessarily boosting the amount of money they spend servicing that debt (although the evidence implies that there has also been a substitution towards additional housing consumption).

In this context, it is instructive to observe that Australia’s housing debt-to-income ratio rose from circa 40% in the early 1990s to a little over 130% by 2006. Since that time the debt-to-income ratio has flat-lined (see the second chart below). This tells us that housing credit is tracking incomes, which is what we should expect, all else being equal.

Some analysts like to thump the table about credit growth being at “35-year lows”. This is misleading and assumes that historical rates of credit growth were somehow normal. They were not. The surge in household debt during the 1990s was a function of the equally striking reduction in the long-term cost of that debt.

Going forward, we should expect to see housing credit shadow household purchasing power. That is exactly what is happening today. I would, therefore, characterise current credit growth rates as the “new normal” as opposed to a harbinger of economic Armageddon.

One word of warning. There is an important downside to the far higher housing debt-to-income ratio. The sensitivity of household spending and saving decisions to changes in mortgage rates is now greater than it used to be. That is to say, a sudden and large increase in mortgage rates is likely to have more of an impact on household decision-making than it might have had back in the early 1990s. The converse is also true.

Christopher Joye is a leading financial economist and a director of Rismark International and Yellow Brick Road Funds Management. The above article is not investment advice.