New homes in Australia cost more than they should, and banks have concentrated too much on home loans at the expense of business lending, argues former ANZ director John Dahlsen.
The overheated housing market is a deep-seated problem that has existed for some time and unlikely to be solved without fundamental changes. This is a problem for politicians. Any solution will be enhanced by a well-articulated definition of the problem. The better the problem is defined, the easier to find a solution. What is the definition of the problem and what are the component parts?
The Australian Housing and Business Credit chart (below) makes clear that the four trading banks’ mix of lending between the mortgage market and the business sector has been widening for some time, with the volume of lending into the former being at the expense of the latter. The analysis, prepared by Dr Wilson Sy, formerly Principal Researcher at APRA, shows an extraordinary transformation across the 45 years from 1976 to 2021, Only in the year 2001 were mortgage and business lending in equilibrium. Many—such as National Australia Bank Limited (NAB) former CEO Don Argus—argue the business market has suffered as a consequence of banks becoming de facto building societies.
Banks have used technology such as digitisation to strip costs out of home lending. In the business market, the banks have removed a huge number of relationship managers and are now much more reliant on technology, rules, and box ticking. It is trite to say business banking is way more complex than home lending and needs the intervention of relationship managers to understand the business model, the people, and the sector risks. The banks have nevertheless standardised business lending practices with a narrow product range. But products should fit the customer, and not the other way round. Why has this happened?
BANKS’ CAPITAL ALLOCATION RULES
One reason for the growth in home lending is APRA’s capital allocation rules. APRA deems home loans to be far less risky than business bank products, so the capital required to fund these loans is substantially less. The banks are able to leverage the lower capital required to significantly improve return on equity.
The volume of money available for home lending has pushed the growth in the value of homes and other properties, thereby inflating the values of this asset class. It is not just low interest but also the volume of money available, but when combined it is inevitable that home asset prices will inflate and without change will continue to do so.
TRADING, RESERVE, AND CENTRAL BANKS
This is a structural defect in the portfolio of our trading banks’ home-lending assets. It has been shown that small changes in this ratio can make lenders (and borrowers) incredibly vulnerable when there are changes in income levels and/or interest rates. This means the Reserve Bank is in an extraordinarily difficult position. Many would argue the Reserve Bank’s policies are fundamentally flawed and the bank must accept some responsibility for the current mess. Australia’s Reserve Bank and APRA have been way too slow in acting and could have prevented much of the stress many homebuyers are now suffering. Labor wants to change the Reserve Bank Act and amend their charter. If it allows interest rates to rise too much in order to dampen inflation, it could cause severe problems for low-income borrowers and the banks. The Reserve Bank has led the market to believe that interest rates will stay low for some time. Many borrowers have relied upon this so if interest rates rise too much, borrowers will feel misled and this will impact the Reserve Bank’s credibility.
Many would argue the Reserve Bank’s policies are fundamentally flawed.
That 40 per cent of Australia’s borrowings are from overseas makes us captive to international interest rates. US rates increasing markedly because of inflation will affect international rates and those payable by Australia as a borrower. The banks are increasing and will continue to increase interest rates. If they do not, interest paid to interest received—the interest yield—will deteriorate. This has a dramatic effect on profits. It is similar to an ordinary business concept of gross profit. Given the banks borrow heavily internationally, they cannot resist the trend of the increase in international rates around the world as the various countries increase rates in an attempt to deal with rising inflation.
James Eyers in the Australian Financial Review provided an interesting table showing a comparison of the weighting of residential mortgages on bank balance sheets in different countries (above right). It shows Australia has by far the largest proportion of residential mortgages as a proportion of bank assets.
It is not surprising that housing affordability is a great black hole in Australia. APRA and the RBA deny that housing affordability is part of their mandate, and so (implausibly) are denying they are in any way responsible for the black hole. The RBA has said, moreover, that it sees no problem with the number of houses being built as it pretty much equal to the population growth in recent decades. This misses the point. The more house-and-land packages and more choices available to buyers, the more we can expect prices to be stable or even fall, rather than increase.
Similarly, the RBA is strangely comforted by the fact the most developed countries have—in line with Australia—experienced a doubling or even trebling of house prices since the mid-1990s.
The McKinsey Global Institute in November 2021 issued an outstanding report The rise and rise of the global balance sheet. Amongst many interesting findings in its international comparison are that:
- real estate as a proportion of net worth in Australia, at 61%, is the highest in the world
- Australia’s increase in land values from 2000-2020 was the fourth highest
This is no excuse for not taking excessive and unnecessary costs out of our house-and-land packages. It seems that nothing has changed in that there are clearly pockets of considerable mortgage stress, where interest repayments are running at a high level.
Government charges amount to more than 42 per cent of a house-and-land package.
The reality is that we have a structural defect in our economy with too much residential mortgages on bank balance sheets, and the RBA and APRA must share some responsibility for that. It is self-evident that with historically low interest rates, it is natural for people to increase the amount of their mortgages and as a consequence put pressure on the ratio of wages income to mortgage debt.
HOUSE COST INFLATION
Coupled with the inflation in the value of homes is the cost of house-and-land packages. This has increased dramatically. It is an issue of imbalance between supply and demand. State and local governments make it more and more difficult to rezone land, and require an incredible range of approvals such as environment and fire protection. The multiple government agencies—which are silos, as most act independently of the others—have become very intrusive in land development.
These agencies are very powerful, often do not work together, and sometimes are even in conflict with each other. This requires developers to spend a massive amount on consultants and experts. There is a lack of proportionality and some small issues are exaggerated in their importance. Such relatively small issues can involve extraordinarily amounts of expert time and cost to the developer, with little value to the community.
The development approval process has become an industry in its own way and the bureaucrats have become very powerful, making it more complex and demanding for the developer, with a proliferation of more and more experts—including solicitors and barristers—which make it a farce.
The consequences are large increases in the cost of land and long delays, which means less land is available. Developers take advantage of this by staging their sales program to maximise returns by delays and feeding into the market packages of land and houses which cost the homeowner more. State governments and local councils are therefore mainly responsible for creating the demand/supply imbalance.
If more land packages were for sale—giving the prospective homeowners more choice—developers would be forced to bring packages onto the market faster and at lower cost. It is not just inflation in value but dramatic increase in the cost of new homes. Government charges amount to more than 42 per cent of a house-and-land package.
It is noteworthy that median house prices in Melbourne rose $120,000 last year, while average weekly wages rose by two per cent or $1,600. This has been a major cause of the increase in the cost, quite apart from the dramatic slowdown in the process, the cost of holding stock, and the large amount of time companies spend developing land for sale. Despite this trend, the Victorian government has proposed taxing the realisation value of subdivisions.
The RBA table, below, says it all:
When you relate it back to individual wages, it is even more alarming. Housing prices represent about 10 per cent of the average Australian wage.
With little wage growth, this ratio is likely to deteriorate further (see below the table from PropTrack/ABS, originally published in The Weekend Australian).
Australia has one of the highest ratios in the world. One of the serious social consequences of the inflated value of housing is the effect on rent for low-income earners, where the rent becomes an extraordinarily high percentage of their income.
INTER-GENERATION VALUE TRANSFER
The other structural defect is the inter-generational transfer of wealth between younger and older generations. The widening of the wealth gap and the inequality of income is damaging our young, who are often at the front of job losses. It is much tougher for the current generation than the older generation.
Cheap debt has unquestionably fuelled house inflation. It is like too much money chasing too few goods; simply supply and demand being out of balance. It is now taking the youth of today much, much longer to fund deposits.
Without intervention, the bubble will burst.
This is causing a fundamental divide in the community and has, over the long term, adverse social implications. It is consistent with the view that the Australian middle class is shrinking as the upper middle class are joining the wealthy and at the other end many are dropping out to the working class. It will be interesting to see how this issue plays out at elections and how the parties devise policies to deal with this.
More and more parents and grandparents are paying or contributing to the cost of their children and grandchildren’s housing deposits, education, and cars. The percentage contribution in this area has been increasing considerably. Who will argue on behalf of the young?
WILL THE BUBBLE BURST?
Without any material intervention, it is inevitable the bubble will burst. History says it will. The combination of inflation, low wages, high financial leverage of borrowers, high house prices, and large amounts lent by the banks gives rise to a dangerous asset bubble. Some would include a share market bubble where there may be some interdependency. Invariably these bubbles burst as has happened in the past, because they are structurally unsound. With an election coming up it is difficult to see any serious policy changes taking place, so maybe the bubble will not burst for at least another 12 months. In the meantime, we have boiling frog syndrome.
With the Reserve Bank now saying the cash rate should be around 2.5 per cent, it is inevitable that the banks will take advantage of this and further increase their rates.
COMPLICATED GOVERNMENT DECISION MAKING
Government decision making will be substantially restricted by the large impact of COVID-19 adding more than A$800 billion to our national debt.
While inflation over time can reduce the effective cost of borrowings, the problem is the interest rate burden. Increases in international interest rates for Australia, as a significant international borrower, means small interest rate changes can be very detrimental to our national income.
It is only growth by productivity, innovation, and efficiency, rather than higher taxes and expanding deficits, that will keep governments in power.
We are becoming a divided community with incomes of the rich in contrast to the real wages of those with less income. There is a cost-of-living crisis for low-income earners who are not only facing little wage growth but also material inflation in essentials such as petrol. In some sectors, people losing their jobs due to technology are finding it difficult to find another job.
Is the middle class shrinking? It is difficult to get a realignment of wages between those of higher income and those, for instance, backed by unions where the wages are excessive—such as maritime, fire fighters, and train drivers—in contrast to nurses, school teachers, and police officers, for example. Even within the current slow wages’ growth, there could be wage realignment that is not only good for the economy but a fairer realignment of the wage increases.
The lever of pushing wage growth for the sake of it just to make the economy look better without any increase in the productivity of the economy is dumb.
Social pressure is also being placed upon younger home buyers. House-block sizes are shrinking, as is the house-to-block ratio. Subdivisions are being created in cheap outer metropolitan areas lacking appropriate infrastructure and amenities. Mortgage pressure will arise in these areas and there is a danger of a concentration of failed borrowers, which leads to pockets of problems such as unemployment, crime, drugs, alcohol, and abuse.
THE CHALLENGES OF REFORM
Professor Bradley Bowden, a professor at Griffith University and an Adjunct Fellow at the IPA, wrote an excellent article, ‘The Rise and Rise of the Modern State’ (IPA Review, Summer 2021/22). Bowden is deeply concerned about growing government intrusion. His analysis is based upon the ratio of government expenditure as a percentage of GDP, which has increased over the years to a large extent in Australia, USA, UK, and elsewhere, and was led by the UK.
Dr Wilson Sy, quoted earlier, has similarly found that government total expenditure above 25 percent of GDP usually leads to budget deficits which depress rather than stimulate economic growth, resulting eventually in economic stagnation and potentially collapse.
This growing intrusion reflects significant behavioural change in a sustained attack on “individualism, self-reliance, individual choice and liberty”. This reduces the room for individual choice, action, and liberty. It inhibits entrepreneurship in people wanting to aspire and have a go. Bowden claims that it is the protagonists that are claiming the high, moral ground, and it is a negative to be a proponent. Laissez-faire has become a dirty word.
The behavioural consequences of intervention cuts across Adam Smith’s view of capitalism. Self-interest is a concept of mutuality, as opposed to selfishness where there is no mutual benefit. Since the days of Adam Smith, self-interest delivered the Industrial Revolution and a huge improvement in our way of life.
Our social security depends upon a vibrant and successful economy.
You only need to read Geoffrey Blainey’s outstanding book, Black Kettle and Full Moon (Penguin, 2003), to understand the massive improvement in almost all dimensions of our lives since Australia was settled. This is fading as governments increase regulation and intrude on our lives.
French economist Professor Thomas Piketty (who wrote Capital in the Twenty-First Century) misses this in his analysis of the growing number of super-wealthy, super managers, inherited wealth, and those exiting the middle class to become wealthy, and those dropping out at the other end with low incomes and little wages growth.
According to Blainey, our way of life has improved dramatically and the issue of redistribution of wealth is another debate. It is pleasing to see some of the super-wealthy undertaking significant philanthropic efforts. Is it better for them to do that, or for the government to take this in taxes and distribute it to more welfare benefits? It will take a bold government to deal with this structural problem but if we do not tackle it, we are causing long-term problems not only for a healthy structure of our economy but creating a deep and unnecessary divide within our community.
A simple list of things we could consider will help cut through the large group of decision makers, influencers, and the fog. Agenda setting is important, otherwise one or more of the silos will capture the agenda and distort the conversation in its own interest. My suggestions for what should happen as a basis of a conversation is as follows:
- raise interest rates, but modestly
- change capital allocation rules to shift lending into the business market rather than the housing market
- curtail grants to first home owners
- boost supply of new house and land packages by making the development process more efficient
- resume immigration, but on a more intelligent basis
- encourage wages growth for those who need it, not those already excessively paid; and
- focus on productivity and efficiency, and increasing the private sector percentage of GDP.
Our social security—which is well over a third of our expenditure—depends upon a vibrant and successful economy, with full employment so plenty of individual tax is paid to the Treasury. Government expenditure as a percentage of GDP is now 31.6 per cent, whereas in 2007-08 it was 23.1 per cent. What about the role played by the states? It is alarming, if you look at Victoria. According to John Dagge, in the Herald Sun, the number of executives in the Victorian public service almost tripled from 647 in 2014 to 1,742 in 2021.
In terms of the public service, Victoria is by far Australia’s most expensive State or territory. This trend was well in place before the pandemic, but the pandemic has been used by the Victorian Labor Government as an excuse for this exuberance.
We have an existing and growing deficiency, which is being covered by increased borrowings.
We, therefore, need to nurture corporates and encourage the aspirations of employees wanting to get ahead, earn more income, and accordingly pay more tax to support our welfare system. Rates of tax are crucial: too high will dampen aspiration, too low will not be enough to fund the public sector.
Without the exercise of the critical element of leadership, we will continue to have a stagnant and distorted economy.
John Dahlsen is a former company director and solicitor. As well as his roles on the boards of major listed companies he was cofounder of Growth Factor Pty Ltd, a fintech company, and remains co-chairman of the family company, JC Dahlsen Pty Ltd, which was founded in 1877.
In the IPA Review of August 2018 he looked at the regulatory institutions of the finance sector – particularly APRA – and concluded that overregulation and red tape in banking had destroyed competition to the detriment of consumers.