Definition of a bubble (part 3)

In Definition of bubble (part 2), I ended with the question: 
 
“So if higher prices leads to more demand, which feeds into higher prices, what’s to say this cycle can’t continue indefinitely?”
 
Well, the cycle of rising prices can, and did, continue longer than most of us (including myself) imagined.  But for the housing market to keep rising beyond wages and rental growth, there needs to be ever-increasing debt and a never-ending stream of new buyers. Both of these have limits. 

At some point, everyone who is going to get on-board the boom will have done so. And those who are buying multiple properties will, at some stage, reach their limit of risk.  

And when these limits are reached, prices plateau.  But after a boom, prices can’t plateau for long because when they do, the feedback loop starts to works in reverse.  Here's how:
 
Fear
For speculators, greed turns to fear when prices stop rising.  Investors who are getting a sub-5% rental return (a loss after expenses) are relying on capital growth to make the investment worthwhile. So when prices plateau, fewer investors are tempted to buy, and many start to sell.  

During the boom, first-home buyers are driven by the fear of being priced out of the market if they delay.  However, when prices flat-line or start to fall slightly, this pressure is taken off.  Many will take the opportunity to save a larger deposit in order to reduce the interest bill and avoid paying Lender’s Mortgage Insurance.  This reduces demand and has the effect of further reducing house prices.

Incorrect forecasts
While prices are going up, it’s very hard to imagine them ever falling.  Then, when they flat-line, people assume they will remain flat for a while.  But as I explained in Will property prices plateau, this expectation of flat prices is itself enough to reduce demand. As prices start falling in earnest, despair grows and people start to believe (again incorrectly) that house prices will never recover.

Falling equity
As the value of property goes down, people have less (or no) equity to borrow against in order to fund the purchase of a holiday home or an investment property.  

Weaker economy
As home-owners’ equity is eroded, they feel poorer and the wealth effect starts to work in reverse.  People spend less and focus their efforts on paying down debt in order to avoid going into negative equity – the uncomfortable situation where you owe the bank more than your house is worth.

Here in Australia, we can’t simply walk away from our mortgages, like they could in many US states.  Property bulls often cite this as a reason why our prices will not crash.  And I agree this might support house prices in initially.  However, by definition, it means we will be stuck paying off our super-sized mortgages for years.  As a result, the economy will suffer and jobs will be lost, resulting in forced sellers and more risk-adverse buyers.

Banks
During the boom, banks continually reduce their deposit requirements to ensure a steady stream of new buyers.  However, when falling prices become more obvious, banks will need to increase their  deposit requirements for fear of being unable to recover their money in case of default (mortgage insurance only covers them for a loss of up to 20%). As deposit requirements rise, the amount someone has available to bid on a house comes down – exponentially.

Other vested interests
Even real-estate agents contribute to falling prices while the bubble is bursting.  For real-estate agents, a sale is more important that getting a good price.  So, when buyers are scarce, real-estate agents subtly lower the expectations of their clients, encouraging them to “meet the market” if they want to make a sale.  

Of course, the media also do their bit on the way down – this time selling papers with headlines of doom and gloom.  

* * *

With falling auction clearance rates, rising stock on the market, record low growth of housing credit and flat or falling house prices, it seems as though Australia’s debt-fuelled binge has come to an end. If this is true, the process outlined above is just getting started.  

Many other countries took their cue that the party was over during the GFC and started the process of deleveraging.  Australians, however, kept partying into the early hours of the morning.  But we won’t be exempt from the bursting of the biggest global asset bubble in history. We didn’t avoid the GFC; we delayed it.  And the resulting hangover will be even worse as a result. 

www.debtdeflation.com/blogs

As shown in the above chart, our property bubble dwarfs the America one. I predict the bursting of the bubble – falls of at least 40% over around 7–8 years – will be painful, especially for those who have based their decision to buy on the flawed assumption that house prices always go up.  

Taxpayers will also be on the hook, funding bailouts of the institutions that are considered “too big to fail”.  The crash will be accompanied by a deep recession as households focus on paying back debt for many years to come. Businesses will close and many people will lose their jobs.

But this is the unpleasant-tasting medicine that we must take in order to get our economy on a more sustainable footing, an economy where money and effort is directed towards production rather than speculation, and an economy that does not thrive on the ridiculous habit of paying each other more and more for the same thing and celebrating the fact.

Comments welcome. 

Cheers, 

Andy.