Telling the RBA like it is

The apathy of economists about the costs and burdens imposed upon modest citizens is staggering, as though this is their natural lot and there is nothing to be done. Housing is a perfect example. We see young adults rejecting home-ownership because without future price appreciation, taking on debt-slavery is futile. Existing owners cannot trade up or out unless first home buyers step up. This happened in Japan, to their great cost.

A key paper by Dr Luci Ellis, head of the Reserve Bank of Australia's financial stability department (Property Market Cycles as Paths to Financial Distress; Ellis, Kulish and Wallace, 2012) shows our central bank is relaxed about Australia's land bubble, and thinks the finance industry is safe.

The paper asserts the "distribution of debt is far more important in creating financial distress than its aggregate value." However, both measures are now at extreme levels – many borrowers supporting very heavy debt loads, betting asset prices will inflate away their inability to fund principal and interest on the cash flow from the investment (for owner occupied housing, the imputed rent).

The National Centre for Social and Economic Modelling at the University of Canberra has estimated that nearly 10 per cent of mortgage holders were paying more than 50 per cent of their income toward loan repayment in 2011.

This is Hyman Minsky's classic definition of 'Ponzi Finance'.

Ellis observes that the expectation property will hold or increase its value may induce both borrowers and lenders to treat the collateral as the primary guarantee of repayment, rather than as a second line of defence should the borrower's cash flow prove insufficient to service the loan.

While this lets banks create financial assets (loans), it doesn't help people buy a house – it risks trapping them in debt beyond their earnings and work-life.

Evidence before a recent Senate inquiry by Denise Brailey of the Banking and Finance Consumers Support Association is damning. She asserts widespread fraud in 100,000 low-doc and no-doc loan applications, inflating borrower incomes without their knowledge so applications appear reasonable and repayments manageable.

Australian banks have developed a loan application process involving brokers, bank business development managers and loan officers that mis-states borrower finances yet is deniable by all. It seems the whole machine is designed so brokers take the fall, then simply close up shop and vanish.

Here is the damaging fracture consistently denied by banks, regulators, commentators and spruikers.

Fraudulent practice has a nasty habit of metastasizing. We cannot be certain deceit has entered the mainstream mortgage market, but perverse incentives are evident right next door.

Ellis approvingly cites a Massachusetts study (Foote 2008) of the early 1990's downturn where 10 per cent of borrowers went into negative equity in Q41991 and 'healed' naturally and quickly in the later land price boom. A mere handful defaulted. Only problem is, that downturn was a mere blip compared to the land price crunch of 2008-12 which has put 30.9 per cent of all US households with mortgages underwater a full five years later.