Why “everyone wins” when housing is more expensive.

The perceived creditworthiness of a nation is largely dependent on market sentiment of that nation insofar as that the volume and indeed the acceleration of capital flow from that nation towards traditionally hedge instruments is indicative of their realisation of mania and is often known as the Minsky moment. Human nature inherently creates inefficiencies in markets as the incentives for those involved continue to grow, and it is that immutable fact that creates opportunities for those that see the market as being overwhelmingly influenced by self interest. The housing market is a fantastic example of this incentivised self interest.

There are layers of self interest that largely go ignored as driving factors for housing price growth and poor risk modelling. On the lowest level, buyers see property as a safe investment, and most of the time they seek to either make a return on their investment either through rental that exceeds the cost of the mortgage repayments (positive gearing) or to make money by a perceived increase in market value of the property that they can realise once they resell the property, or in many cases a combination of both. There are also people who seek to reduce their tax payment by charging less for rent than they pay in mortgage repayments, however these losses are eventually passed on to tax payers as the government thinks this is a suitable method for reducing rental costs for low income earners and that it reduces overall rental costs.

The next level up from this is a combination of brokers, people employed to undertake property valuations and real estate agents, all of whom receive commission as a percentage of the sale price of the property. There exists such a thing as home equity loans wherein banks and borrowers agree upon a valuation of the property which allows mortgagees or property owners to take on debt based on the perceived value of the property, which extends further credit than the initial loan. This feature of home equity lends itself to false market valuations by appraisers, real estate agents and brokers, in particular because it means that they are incentivised to originate additional loans that then pay commissions based on the appreciation of the previous property investment. Even if the current broker, appraiser or real estate agent is not used by the borrower for financing further property purchases, the industry wide practice almost certainly means that these people will continue to receive additional income as a direct result of the availability of credit in the form of home equity for property purchases.

Perceived property price appreciation is also handy for the tier of people in the finance, insurance and real estate (FIRE) sector above agents, brokers and valuers – bankers, insurers and regulators, as means tests for creditworthiness are conducted based on the difference between liabilities and assets values. When the perceived value of property rises quickly, the risk assessment teams who use this metric are quick to lend more money, as the loan to valuation ratio (LVR) of the property reduces, regardless of whether or not the borrower is making repayments on the property that include principal payments (i.e. a borrower could be making interest only repayments while their perceived debts are decreasing as the perceived property price on the market goes up). You could in theory make interest-only repayments on the property for as long as the bank is willing to take this as payment, wait for its perceived value to go up significantly, sell and take any additional profit from the sale of that property without ever having paid the principal price of the property. If the property is occupied by a rent paying tenant, you are making the debt accrual process even easier and faster as it means that the principal is decreasing whilst the perceived price is going up, allowing for additional home equity to be accessed to repeat the process, in the meantime giving the borrower what looks like a really good credit rating, and much smaller liabilities than if the line of credit provided by home equity for property purchasing is removed from the means testing process. The reason this is perceived to be good for banks and regulators is that the bank liabilities seem low, as the loan to value ratios are low on average which makes it seem like borrowers are not having problems meeting their repayments. The logical additional measure to eliminate appreciation bias and in fact a contradiction to the argument that risks are low when lvr numbers are low would be to assess the number of mortgage defaults over time, and to see whether this perceived lowering in risk by low lvrs is correlated to default data. This metric assumes that lvr values have almost nothing to do with risk in comparison to the nominal debt that borrowers have in comparison to their incomes and those of potential renters of the property. This is primarily due to the fact that a mortgage can be seen as negative wealth, an amount that does not decrease unless it is paid down by the borrower, while prices of houses are not guaranteed to go up, meaning that the risk modelling is beholden to the volatility of the property market and not the ability of the borrower to reduce their nominal debt in comparison to their incomes.

Banks primarily make a profit in this day and age by arbitrage, i.e. the buying and selling of money and other assets/financial products. For a bank to borrow money or what is known as a “line of credit” from a foreign institution rather than the government of the country they operate in (similar to how Bankwest borrowed from Halifax Bank of Scotland [HBOS] rather than the RBA), they have to prove themselves “creditworthy”: likely to pay back the loan given to them. This need to be creditworthy creates a dilemma for banks who seek continuous profit growth: how do they get people to borrow from them when the potential borrowers do not make enough money to service the loans? The brutally honest yet unpalatable answer is fraud, but the official line is that these types of loans are not originated in the first place, and to assume so would be preposterous. When fraud is committed, the borrower on the surface is perceived to be very likely to repay their loan, which then in turn means that the borrower may be eligible for future loans or that the banks are good at modelling risk. Ratings agencies love to hear this, as it means that banks are likely to create higher numbers of securities such as mortgage bonds that sell this debt to people who are willing to lend to the bank to facilitate these loans; the more of these bonds that are created, the more the ratings agencies are paid to rate the bonds based solely on the volume of bonds originated.

On the highest level, when property is sold and/ or owned, governments reap taxation benefits in the form of capital gains tax, land tax, stamp duty and a raft of other supposed tax revenue, which in turn makes the government in charge seem like good economic managers, as they skim supposed wealth out of the property market. On the same level, large scale property developers and lobbyists form a close relationship with politicians as their best interests overlap, these are in the form of laws such as negative gearing, capital gains tax concessions for investors, the first homebuyers grant, net rental loss taxation claims, lenders mortgage insurance taxation rebates and a raft of other laws that subsidise money going into property markets, making it seem like a safe investment. The effect that this has on the whole economy is that ratings agencies see the government as being good economic managers and as such they are given a high credit rating (in Australia’s case a AAA rating, the highest possible).

As mentioned in the beginning of this article, perceived creditworthiness takes a slippery slope down to people who are, at the end of the day, at the mercy of the rest of the market, as are the many cogs in the machine that is property speculation.