Affinity Insights – Issue 3, December 2017

For a start, when house prices collapse there’s more of a chance that the banks, which have lent the money, end up in trouble, while any fallout leads to far more destruction than a sharemarket crash.

If there is an upside to a sharemarket crash, it is that they usually end very quickly.

These are a few of the findings of Maitland MacFarlan, a contractor to the RBNZ , who has had a forensic look at a range of house price collapses around the world since the late 1980s.

In addition to housing and the global financial crisis, MacFarlan has also taken a look at the Nordic financial crises that kicked off in the late 1980s and the Asian financial crisis that played out a decade later.

Amid all the talk of a booming property market in Sydney and Melbourne over the past few years, and what risks have built up around that bubble, neighbouring New Zealand has had a similar problem with booming house prices in Auckland.

It’s a major reason why the RBNZ got MacFarlan to take a look at all the risks around the housing market and some of his findings are very interesting.

V-shaped event

One reason why investors should be worried about a collapse in house prices is that more than likely there will be a bust.

It doesn’t always follow but the odds are it will happen.

He notes ” the cycle of booms followed by busts appears stronger with house prices than with equities”.

According to the report, almost half of all housing booms end in a bust while only 25 per cent, or less, of sharemarket booms end in tears.

And when there is a sharemarket crash it goes for two years and then a couple of years later all the losses have been recouped.

Call it a V-shaped event.

But when house prices collapse it tends to be a long, drawn-out affair, even if they don’t fall as far as shares do when they crash.

“House price collapses last significantly longer than equity busts” says MacFarlan.

“While house prices may fall by less than equities in a bust, they show a more protracted, U-shaped pattern of downturn and recovery, with downturns lasting around four to six years,” he adds.

Soft landings rare

Unfortunately, local investors get the worst of both worlds in that situation, given the big four banks account for 25 per cent of the S&P ASX 200 index.

If house prices collapse and the banks end up with a few problems, it makes it tough for the sharemarket and also to navigate any slowdown in the economy.

Another worrying discovery is that “soft landings” in the housing market are rare.

They just don’t happen very often.

Indeed, one study of 49 boom and busts showed there were no examples of a “mild’ or “gradual” fall in residential investments.

For all those reasons, a fallout in the housing market is a very good indicator of tough times ahead in any economy and can have twice the negative impact that a sharemarket crash has.

“In particular, the impact of housing busts on output, wealth, credit growth and other macroeconomic measures tends to be greater than with equity price collapses, a result in part of deeper imbalances that need to be unwound” notes MacFarlan.

There are several lessons for central banks in all of this.

Slashing interest rates and government spending can help ease the pain of any economic downturn when house prices fall but they don’t help so much with any recovery.

Furthermore, any time a central bank uses “unconventional monetary measures” to fix up the mess, it usually leads to other problems.

Finally, with a pointer to the big banks and their offshore funding, any “unhedged foreign currency borrowing, often driven by the (mis)perception of exchange rate stability, can quickly lead to severe economic and financial difficulties if external funding dries up and the exchange rate falls following a crash”.