Property Bubble: NAB has developed a new property bubble test...

Is the property bubble about to burst? The sceptics are wearing their A-frames and gathering on the streets shouting the end is neigh…So what’s new?

They’ve been doing this for as long as I can remember. Yes, the market has seen corrections over the decades but in most cases this has been due to external influences such as the 17% interest rates of the late 1980’s and the Keating recession we had to have in 1989 to 93 or the GFC of the late 2000’s.

In most cases the rapid rises in property activity usually follows extended periods of low mortgage interest rates which accompanies external forces such as share market crashes or changes in government policy.

The NAB bank has stepped away from the traditional economic model to develop an in house formula to assess the underlying state of the property market. As a result they believe that the bubble is a long way off from bursting.

This formula is called the Oster Algorithm named after the NAB chief economist Alan Oster. Based on his formula, Oster concludes that if borrowers today were to gear up like their predecessors in the early 1980s, before the peak of that boom in mid-1989, then the current jump in house prices has a long way to go.

All other factors being equal, prices across the nation could surge another 12 per cent, or 20 per cent in Sydney. Sydney is a prospective market because house prices were relatively flat before the recent spike, at the same time as the average income was rising.

In Oster's view, traditional indicators of irrational exuberance in the housing market, such as housing-debt-to income ratios, are unreliable. They might show big changes in gearing but they give us no guidance on what ratio is unsustainable.

Should it be a concern, for example, if our ratio is near 160 per cent, particularly if employment is strong and there's an ongoing income flow, when countries such as The Netherlands have survived at about 300 per cent?

Also, while it's true that households are more geared and increasingly sensitive to interest rate movements and loss of income, that does not necessarily equate to financial stress. Lower rates have improved serviceability, and data is skewed by the rich taking on big licks of housing debt, which they are better able to manage with their holdings of other assets. Average ratios, therefore, are not much use when you're looking for signs of imminent financial stress. This is where the Oster Algorithm comes in.

Its purpose is to measure a standard household's average ability to borrow against their property holding, or hypothetically borrowing ability (HBA).

HBA equals = annual earnings x bank Income test x (1/standard home loan interest rate) x loan to value ratio.

The following chart shows the HBA against house prices, illustrating the extent to which prices have been driven by increased borrowing ability.

house_price_ vs_borrowing_ability.jpg 

A reading significantly above 100 on the chart would suggest rising prices are stretching serviceability, which would point to a problem unless something else has fundamentally changed, such as a shift in population growth or in Perth’s case, the mining boom in 2005 to 2009.

Source: NAB, The Australian