In The Long Term, What Goes Up, Must Come Down, Right? / by Adam Howard

In the last Update I made a comment regarding a bank exercising it's mortgage, selling a property and retaining surplus funds after the property is sold.

There were a couple of queries and I need to clarify how this process actually works.

Firstly, in WA there is no statutory requirement for surplus funds from a mortgagee sale to be returned to the borrower.  The Federal Government's Financial Ombudsman's Service (FOS) advises that it is "industry best practice" for surplus funds to be returned to a borrower, but it doesn't HAVE to be happen.

WA's Transfer of Land Act states that funds from a mortgagee sale must be applied as follows:

  • First, in payment of the expenses occasioned by such sale.
  • Secondly, in payment of the money owing under the mortgage – the principal sum (or any balance of the principal sum) together with the interest reserved in the mortgage.
  • Thirdly, in payment of money owing on subsequent mortgages or charges in order of their respective priorities. This does not include caveators. If a priority agreement has been registered, this should be adhered to for the purpose of repayment.

Sadly, no mention of returning funds to the hapless borrower.

Common law does, however, play a significant role in how surplus funds are used.  

It is common and acceptable for banks to apply surplus funds from the sale of one property to reducing a defaulting customer's other loan balances.

But what happens to the surplus?  Well, you need to work out if there is even going to be a surplus to begin with.

On that topic, one of the tools a bank does have at it's disposal when dealing with high risk loans is a default rate of interest, which is much higher than a bank's standard variable rate.

Let's say that if the current standard variable rate is what it is now: about 5.4%.  Then a default rate of interest could be double that, or close to 11%.

If your loan of $500k goes into default, it has done so because you have failed to make the appropriate payment.  And the assumption is this has occurred because you don't have enough money to make the payments.

Once the bank decides the loan is in default, they can elect to apply the default rate of interest.

Lets say it took 3 years from default to settlement of the sale of your house, and the sale price was $800k and the bank's other costs were $100k.

3 years interest on $500k at 11%, or $55k pa comes to $155k, which is "capitalised", or added to the top of the loan.

So, at the end of the 3 years your loan is actually at $655k, plus the bank's costs of $100k, which totals $755k.

If the property sold for $800k, and the real estate agent was paid 2%, or $16k, net sale proceeds would be $784k.

So, in this scenario you might be lucky if there was a surplus of $30k after the sale.  And THAT'S how your equity, or the surplus gets eaten up.

Banks will not act inequitably, or unfairly, but I need to reiterate that a lender has significant power, so you need to keep it clean.

Now, onto this week's topic of the looming bloodbath in Australia's property market.

Oh, you didn't know that was on the way??  Surprising as it has been plastered all over newspapers and bulletins for the past few months.

For those interested, here is the link to the full report:

Housing Market Crash Paper

The theory is that the West (western, industrialised nations) has built up huge amounts of household debt over the past 40 years, mainly through home and investment loans.

Here is a nice graph of Global household debt levels in Trillions of dollars from  1952 onwards that illustrates this:

I like this graph as it shows movement over a longer term, and the longer term allows a trend to become more clear.

It shows a fairly steep upward trend and the writing on the graph inevitably draws the eyes and attention to the doubling of household debt between 2000 and 2008.  Not surprising, and in addition most media outlets do focus on 1996 as the year Australia's sharp uplift in housing values began.

But really, the steeper trend seems to have begun around the mid 1970s, doesn't it?  Maybe, to be cautious, we could say it began steepening in 1980.

It then makes sense that if debt is going up, it is doing so as demand for it is rising as it is needed to fund the purchase of increasingly more expensive houses.  Right?  Looks to be the case, as is shown by the following graph:

And this graph, which I like even more because as it is over an even longer period, confirms that since 1960 house prices in Australia have skyrocketed.  For the 70 years from 1880 to 1950, real property prices actually declined, but over the 60 years from 1950 to 2010 they appreciated by 300%. 

And to show you we weren't alone, here is a graph showing the movement in the US housing market over a similarly long period:

The issues identified by the economists behind the report are to do with that last dip in the US housing index.

Most other western nations had their bubbles burst by the Global Financial Crisis (GFC), but Australia didn't.  Thanks to China and it's appetite for iron ore, and the world's thirst for Liquified Natural Gas (LNG) and hunger for coal, Australia escaped almost unscathed.

Here is another graph showing the comparative performances of the Australian, US and UK property markets over the past 20 years.

The core argument is we didn't have our correction.  Our market hasn't dropped significantly.  In fact, the Sydney property market has exploded over the past 12 months, with Sydney's median house price now up around $900,000.

In addition, goes the argument, economic conditions are not strong enough to support the kinds of property values being reported in some, but not all, capital cities.

Here is another graph illustrating movements in median property prices in all our capital cities from 2006 to 2014:

A minor blip in 2009 and 2010 as the GFC bit, but then back to business as usual.  Very strong movements upwards for all capital cities except Hobart from 2006 to 2011, and then a leveling off.

Except Sydney, which has steamed ahead...much to the RBA's chagrin.  I think our respected Guvna, Glenn Stevens, actually called what was happening in Sydney crazy in the past few weeks.

Very strong words for someone as conservative and mindful of public utterings as Stevo. 

So, is it a bubble?  Not just Sydney, but Melbourne, Perth, Brisbane and Darwin?

Well, I have to say, I don't know...

I know, I know.  Pretty weak, right?

What I mean is, when you call it a bubble the implication is it will burst, and that's not always the case.

For those interested souls, here is a link to a discussion/definition of a housing market bubble:

Housing Market Bubbles Explained

This is where our long, long term graph displaying the Australian property index from 1880 onwards becomes useful.  It shows a long term trend, and I already said above that the value of Australian property began moving upwards in or around 1950.  Not a spectacular movement, but a long, steady upward trend.

If you drew a line that marked this trend it would look as follows:

I DO think different parts of the Australian and West Australian property markets are over valued and one way an overvalued market can correct is for it to cease appreciating over a long period...to just move sideways.

This is what you would call the soft landing.

And a soft landing relies on market participants all seeing the error of their ways and slowly unwinding their positions.

But, that's generally not how markets, particularly over valued markets operate.  Here is another graph that maps out how a bubble works:

This obviously relates to the share market, but can be applied to the property market.

If I were to have a shot at where Sydneysiders are right now, it would be somewhere in the "Mania phase" between enthusiasm and greed.

But our market here is far more subdued and hasn't attracted much attention lately, except for comments about over supply and falling rents.

And this leads onto the stages a property bubble...sorry, over valued market, goes through and how it slows.

First, debt has allowed speculators (investors) to push up values.  This is because interest rates and other costs are so low and demand for rental accommodation is so high that it makes it a profitable investment, even though residential property is typically low yielding.

Then something happens to affect the demand for rental accommodation.  Generally this "something" is an economic event.

In our case this has been the slow down in the mining sector that has seen people leave Perth, vacating their rental premises.

This means a lot of rental properties become vacant at about the same time.  Those ol' boys supply and demand have a get together and force rents down, as landlords try to get a tenant.

After all, they need one as they borrowed to invest, and that interest hurts.

Some landlords get a tenant, but at a lower rent than hoped.

Others don't and try to sell, but as with tenants there aren't many buyers, and asking prices drop...sometimes a lot.

So, prices drop and rents drop until they get to such a level that buyers return to the market and buy up the surplus stock.

And THAT'S a property bust.  

Loyal readers will recall I have spoken about the relative safety of a home loan...that they don't go into default very often.  It takes something fairly severe for an entire market to fail, as happened in the US in 2006 and 2007.

Here is a graph showing some comparable national home loan default rates over the past decade or so:

Like I have said in the past, home loan default rates OVER THE LONG TERM are below 1%, but during the GFC US default rates jumped up to 8-10%; in some cities and counties it reached almost 40%.

So, if our market is to suffer the same fate as the US, as shown in the graph above tracking the US property market index, then our mortgage default rate would need to jump up to the rates shown above in the US and Spain.

It's not impossible, but it is unlikely.

The questions for Australian markets are the following:

1. Is this slowdown the economic event that will result in a sharp market downturn?

2. If it's not, what is a potential event big enough to cause a downturn?

I DON'T think it is the event.  For a long while when I have been as growth asked what direction the property market is headed I have replied, sideways.

I know I can't just say "I don't think so" and leave it at that.  The reasons I don't think so are:

- our economy is still growing at about 2.5%.  Small number but way ahead of the negative numbers shown by the US, Spain and UK from 2008 onwards;

- there seems to be some data indicating better growth in New South Wales and Victoria balancing the slowdown in WA and Queensland;

- we are connected, both geographically and financially, to Asia which is the fastest growing economic region in the world.

Once again, not saying bad stuff is impossible, just not likely.

My opinion is wages need to catch up to asset values, and that level of wages growth usually takes a long while.

And I have also said that property markets are actually thousands of fractured markets.  I think it is futile to look at even the Perth metro market and make predictions about what it means for an individual household based on what the median metro house price has done.

A final point that needs to be made, and this might seem a little light given we are talking about serious economic stuff here, but Australia is a nice place...seriously.

The view from outside is Australia is a beautiful place with a warm, benign climate, a healthy economy and stable, inclusive politics.  If you want to know why thousands of boat people are heading our way, that's the message the people smugglers are putting out there.

Australia is also seen as having ample resources and space, being a large country with a population of only 23 million, and still offering the opportunity to make your fortune, as well as being a lot safer than almost anywhere else;  no wars and a low crime rate.

This attracts people, and people, or rather a growing population, is the single most important factor when considering whether an economy grows or shrinks, and then whether a property market rises or falls.

And that's food for thought...