On today’s show we’re looking at why prices for real estate in Australia fell by 8.4% in the past two years and we’re answering the question as to whether what happened in Australia could happen elsewhere in the near future.

Australia’s median house price dropped 8.4% between July 2017 and May 2019. With only a handful of larger price dips during the late 1800s, the slump surpassed the recession of the 1990s and 2008 financial crisis, making it the worst ever recorded in recent decades.

markets in Sydney and Melbourne were hit the hardest during the downturn, which lasted from mid 2017 until earlier this year, with an average price drop of 22.5% in Sydney and 32.1% in Melbourne.

Following a boom that peaked in mid-2017, prices began to fall due to tighter lending conditions, low buyer confidence and changes to Chinese investor loan limits.

The government launched a Banking Royal Commission inquiry into lending practices, which commenced in late 2017 and concluded earlier this year, resulting in a crackdown on lending practices by big banks in Australia.

This government-led inquiry, triggered by reports of misconduct by certain Australian banks, was a major reason house prices began to fall. 

Much like the 2008 crisis, the downturn in Australia was the result of significantly reduced availability of credit in the market.

At the same time, demand from Chinese buyers, Australia’s largest offshore property investors, also slowed in 2017 and 2018. We’ve seen the same dynamic in the US and Canada. China’s government has imposed tighter capital controls, making it harder for residents to move money out of their own economy. There is still money coming into the market from China, but the numbers are down significantly. Chinese buyers have a cap of A$50,000 (US$33,903) they can take outside the country.

Much like the 2008 downturn in the US, the availability of credit is more important than the interest rate. When financing is hard to come by, the balance between buyers and sellers changes dramatically. If the only buyers are cash buyers, sellers will drop their price in order to sell.

Proof that the problem is a credit problem rather than a real estate problem is the fact that since May, lending has opened up and prices in Sydney and Melbourne have risen almost 6% in both those markets since May.

It’s fair to say that the issues in Australia were unique to that country. But it goes to show that something as simple as an investigation into banking practices can, at least temporarily crater the real estate values in an entire nation.

So the question is, could we see a credit crunch again in the US, in Europe, or in Canada? If so, what could be the cause?

We often think about the levels of sovereign debt that so many countries around the world have signed up to. This includes every major economy in the world. We’re talking about the US, China, Japan, the UK, Canada, Italy, and yes, even Switzerland.

So far the problem in Australia was limited to a regulatory issue. There was no domino effect. There was limited counter party risk. You might be wondering, what is counter party risk again? Well, I’m glad you asked.

Counter Party risk happens when an asset on my balance sheet appears as a liability on your balance sheet. If you fail to pay me, then I’m at risk of defaulting on my obligations to the liabilities on my balance sheet and the dominos start to fall.

Clearly the political will does not exist for any one country to trigger the next financial crisis.

The point is that this time the problem was localized to Australia. No dominos fell, except in Australia. Once the dominos start to fall, there is almost no stopping it from happening.