The Ultimate Reason Real Estate is So Expensive
Greece was recently granted its third bailout since 2010. But the political and civil unrest that has ensued is bringing more questions about whether the European Union’s (EU) economic problems have really been solved or not.
Greece owes Europe more than €300 billion that it will never be able to repay. Even if the Greek people relax and parliament accepts the EU’s offer, little more has been done than kicking the proverbial can a little farther down the road. At best, this latest deal may buy Greece an additional three years, but then what?
The Greek people themselves know that Greece is ultimately screwed. Their rejection of the EU’s original deal reveals that what they really want is to hit the reset button, default, take their economic beating now, and then begin their recovery. But of course, that is not in the interest of their European creditors.
So, what is ultimately at the root of Greece’s dramas? Why did they declare “bank holidays,” and limit people to an ATM withdrawal allowance of €60 per day?
The problem in Greece is not simply that there’s not enough money. The ultimate problem is that the money the Greek people thought they had never actually existed in the first place. And ultimately, this is the very same reason why real estate is so expensive in Australia.
The Fractional-Reserve Banking System
For at least a hundred years, governments around the world have been attempting to grow their economies by encouraging debt. Not only are governments borrowing big, our current world banking system has also enabled average people to seek prosperity – or at least the appearance thereof – through debt. As you can see in the chart below, personal debt in Australia has risen dramatically over the past 30 years.
HOUSEHOLD DEBT PER PERSON IN AUSTRALIA
Source: Australian Bureau of Statistics
This growth in our culture’s love for debt has meant huge profits for banks. Banks primarily make money by receiving deposits, then loaning that money out to individuals and companies for a fee, called interest. What’s interesting, however, no pun intended, is that governments allow banks to loan out more than they take in through deposits; a whole lot more.
This system originally began in Europe hundreds of year ago. It’s called fractional-reserve banking, because the cash the bank keeps on hand is only a fraction of what it loans out. Banks are only required to maintain whatever amount they need to manage daily transactions by depositors.
It’s then up to the government regulators to act as the moral compass of the banking industry and enforce the reserve requirement, a limit on what fraction of a bank’s assets must be kept in cash. APRA regulates this requirement in Australia and uses it as a tool to either increase or decrease the money supply.
Large banks may be expected to maintain 10 percent reserves. Smaller banks may be given greater latitude at three percent or less. At present, required reserve ratios in most countries are no more than five percent.
In Australia, the liquid reserves to bank assets ratio was last measured in 2013 by the World Bank at 1.22 percent. That means the typical bank in Australia only holds about 1 percent of your deposits in cash. The other 99 percent has been loaned out to homeowners, investors, and businesses. Just in case you’re unsure how to feel about that, let me help. It should scare you.
The fractional reserve system works most of the time because rarely do all depositors demand their cash at the same time. But if depositors lose faith in the system, and all at once come to get their cash out of the bank, the house of cards would collapse.
Then, if the bank’s debtors are ultimately unable to repay their loans, depositors may lose some or all of their savings. The challenge is that until depositors know that the loans won’t be repaid, they don’t know that it’s time to withdraw their savings. By that time, it’s too late. We saw this happen in Cyprus several years ago, and it has happened many times over throughout the world. In fact, it happened here in Australia in 1893 and 1931.
Our banking system today is becoming increasingly more electronic. When a bank lends to a consumer, rather than handing over bags of cash, it simply processes a credit into the borrower’s account. This digitalisation of the system has enabled banks to ramp up their lending all the more.
If a bank holds $100 million in deposits, it could conceivably offer $1 billion or even $10 billion in loans. This new money does not actually exist, except as 1’s and 0’s on a hard drive.
Herein lies the root of the problem in Greece. The money that the Greek people think is sitting in their bank accounts never actually existed in the first place, except as numbers on a computer screen. The same is true for you and your savings deposits.
How Does Fractional-Reserve Banking Impact Real Estate Values?
The ultimate reason why real estate is so expensive is because of our fractional-reserve banking system. Without it, there would be much less money available for lending. With less money to lend, fewer people would be able to afford homes. Less demand would mean lower prices. History illustrates this fact.
Several years ago, a Deakin University Masters student wrote a research paper on the history of Australian property values. His study goes back 150 years by comparing house prices and land values to a number of fundamental metrics. The following are just a few of his many findings.
This first chart shows us that between 1880 and 1960, home prices remained relatively constant. Since that time, the cost of a home has increased by a multiple of five. This data only goes up to 2012, and we know prices have increased significantly since then.
This next chart shows the increase in the median house price to median income ratio dating back to 1960.
What we can see here is that until the 1960’s, median home prices in Australia were less than double the median annual income. In other words, the typical family could live on 75 percent of its income and use the remaining 25 percent to pay off a home in full within eight years or so.
Today, the national median house price to income ratio is about five to one. Melbourne is about 10 to one and Sydney is pushing 12 to one. The same family today in Sydney allocating 25 percent of their income to mortgage reduction would take not eight years, but 48 years to pay off their home.
That’s insane.
Never mind Sydney and Melbourne investors, nothing to see here. Just keep on borrowing and spending.
So, what happened in the 1960’s that caused home prices to start moving up? If we can answer that question, we’ll know the ultimate reason why real estate has become so expensive today.
Until the mid-1960’s, the Australian financial system was much more highly regulated. Banks were required to hold more cash in relation to lending and there were tight requirements on who could qualify to borrow. In short, it was much harder to get a loan back then.
As a result of these tight regulations, banks only loaned money to build houses, not buy land. The land had to be paid for either in cash or purchased from the developer through vendor finance. Click on the image to the right to see the terms this Melbourne developer was offering in 1906.
This inability to borrow required a much different mindset than today, one that promoted savings rather than debt. The number of people who were able to buy houses was therefore limited.
Then the Commonwealth Government changed its regulations, opening the door for banks to more readily lend for housing. Once banks started lending money to also buy land, then savings wasn’t as crucial to home ownership. This meant that many new buyers could enter the market, and property values began to rise.
But even then, it was not like today. Throughout the 1970’s and the early 1980’s, before a borrower could qualify for a mortgage, they would need to show 12 months of savings history and have enough cash to cover a 25 percent deposit. A 75 percent LVR was the maximum risk banks could accept. This was due to the government’s tighter reserve requirements back then.
Then in the mid-1980’s, the government, under Treasurer Paul Keating, loosened up even more, further deregulating the financial industry. This opened the door for foreign banks to enter the housing finance market, bringing increased competition and further relaxing lending policies. Banks were able to further reduce the security they required and to lower mortgage interest rates.
You’ll notice that the timing of the gradual loosening of the banks’ required reserve ratios perfectly matches the historical increases in the prices of real estate. Lower reserve ratios make more money available for lending, thereby increasing the supply of money into the economy in the form of debt. This new money creation has flowed primarily into our housing industry, bringing significant inflation.
Conclusion
The ultimate reason real estate is so expensive in Australia, and throughout the world, is the fractional-reserve banking system that creates money out of nothing.
At the end of the day, our property values have little to do with proximity to a CBD, an influx of skilled migrants or billions of dollars of foreign investment.
If local buyers could not freely borrow, the property market would collapse. If and when lending tightens up, either through government regulation or market forces, asset values must decline. This is just as true in Australia as it is in Greece.
What do you think?
- How is Australia different than Greece? Do you think we could ever experience a banking crisis here?
- How does it make you feel to know that virtually all of your deposits are invested in housing and businesses?
- What would it take for Australians to lose faith in the banking system and show up all at once to withdraw their savings?
- Should our banks be forced to maintain a higher capital reserve than 1 or 2 percent?
- APRA this week tightened the capital requirements of the big banks by about 80 basis points (.8 percent). Do you think this will have an impact on property values?
I’d love to hear your thoughts on this.
EDIT: I originally stated that APRA is tightening the capital requirements of the big banks by about 20 basis points or .2 percent. The accurate figure is about 80 basis points or .8 percent.
Comments
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Hi Jason,
Your Capital Reserve requirements seem to be different to others. My understanding is the banks will need to maintain 25% or more net equity value in mortgage portfolio as of July 2016. How does this differ from the Capital Reserve requirement of 1.22%.
Which is of more importance? If banks hold 10% in cash reserve that is still not going to help if people lose confidence and run on the banks.
Great question.
From July 1, 2016, APRA is increasing the average mortgage risk weight requirement of the big five banks to 25 per cent on residential mortgages. Currently it’s around 16 percent. All other lenders must keep a standard 35 percent.
Because residential mortgages are perceived to be less risky than other types of loans, the requirement is “weighted” against the risk of the asset. As I understand it, this means that the big banks only need to hold enough capital to cover losses on 25 percent of their loan book. That does not necessarily mean that they have to have cash that equals 25 percent of their total residential mortgage loans, but only enough cash to cover expected losses on that 25 percent. I have no idea what that exact figure is.
When it comes to the overall amount of liquid assets that banks must hold against all lending, that will be a much lower percentage (currently 1.22 percent). APRA said they want to increase that by about 2 percent. The current change in regulation would raise the big banks total capital requirements by about .8 percent (not .2 percent which I quoted originally in the article, sorry).
Brilliant Article, Jason. In NSW, even the government is adding to price rise by releasing new land in South West Sydney(size- approx 500 sq meter) priced around $400-500k . How do we explain that? For a government owned developer,it certainly does not cost 500k to develop 500 sq meter of land. Does it …
Thanks Dips. I guess the lesson in your example is that the government is not a charity, but has a profit motive. If only that meant we could pay less tax!
Seriously great pieces. I have been watching heaps of youtube docos on the fractional money system.. Worth checking out if anyone is interested.
Just type economic docos
So many people do not know about how money is made. It is scary!
The problem is not in the fractional banking as such. The main issue is supply, this is the reason why day to day goods where supply is unlimited have not risen in value even with fractional banking. Think about the cost of computer, it is hard to argue that the price is inflated as it is kept in check by the readily available supply and competition. Price of computer is composed of the price of parts, labour to put them together and the seller’s profit margin.
The property, by far, is no different with price consisting of the cost of land plus cost of labour and materials to erect a building. The main issue driving prices up is unavailability of land, just check property prices in any of regional cities where there is an unlimited supply of land – prices are hardly in a bubble and in most cases determined by what it actually cost to connect water, sewer and to build a house.
The real reasons for ridiculously high prices in Australia are the government policies that restrict supply of land, introduce an enormously complex and expensive red tape, concentrate high paying jobs in CBD’s and prevent developers from importing cheap labour, remove these restrictions and see what will happen to property prices even with the current lax lending policies and low interest rates. Increasing capital adequacy requirements for residential mortgages is not a solution, it will cool market down but won’t resolve the fundamental issues.
As an example in a $450k house and land package which is common in regional Australia around $150k is government fees and taxes, materials make up around $80k and the rest is labour and developer’s profit margin.
Fractional banking is not bad in itself it acts as a money supply mechanism allowing banks to issue cheap credit that bolsters economic growth.
I agree with Dmity.
What do you say in reply to that Jason?
See below :-)
Agree to a point that supply and demand are a factor, but I agree more with Jason on this one.
The experience of the U.S. last decade is instructional here. The sunbelt states (FL, GA, AZ, NV), which were by far the worst hit during the property market collapse, have no shortage of land. Even at the height of the market land was mind bogglingly cheap relative to Australia.
That did not prevent a massive housing bubble from forming. The chief culprit – excessive access to bank credit.
When bank mortgage lending essentially vanished in 2008 prices, which had already been declining as lending tightened a year earlier in the subprime sector, totally collapsed. 50% or more in some areas.
Supply and demand are certainly a factor, but once you’ve witnessed the credit rug being pulled out entirely it becomes evident that it is the dominant driver of prices relative to incomes.
I feel the computer analogy is flawed, as computers are not as consistently or aggressively financed by banks as housing is.
Dmitry, I agree that scarcity of land in proximity to jobs plays a significant part in capital growth. This is clearly seen as you say by comparing regional markets to capital cities. But my argument is that your examples are secondary factors. How else can we explain why even in regional areas median house price to income ratios are significantly higher than they were fifty years ago (after being stable for 100 years prior to that)? As @adunlop said, take away the people’s accessibility to cheap credit made possible by fractional reserve banking and the entire property market collapses.
great article, but since banks like all companies, exist to make money. They must as a consequence take my $100 deposit pay me $2 interest pa, they have now lost $2 unless they can on sell/loan the $100 to someone else for $4 so they now have made $2- . without this the flow of money would stop, less innovation and industry the economy would collapse.
However it is all predicated on depositors not wanting their money back at once (as Jason explained). What worries me and i am not sure whether this is the case, whether they loan money than they actually don’t have in deposits by simply sending money digitally to borrowers?
Are banks actually audited to ensure that do not loan more than they have ?
cheers vic
Vic, That’s the exact problem. The banks ARE allowed to loan out money they do not have. That is the crux of this whole article. Once upon a time a bank may have needed to have 25% of deposits on hand, whereas as regulation has lifted, that number has reduced drastically.
As you said Vic, banks accept deposits and only keep a fraction of those deposits on hand at any time. Here in Australia, nearly 100 percent of those deposits are loaned out in some way.
These loaned funds are then re-deposited and then re-loaned up to the limit of that or the next bank’s reserve requirements, thus compounding the effect in the economy as this happens over and over. This is how our banking system creates money out of nothing.
So no, an individual bank can not loan out more than it has taken in through deposits, but those deposits were loaned from another bank, and on and on, which means money is essentially being created out of nothing. When you start diving into this, you realise how dependent our entire economy is on debt.
Banks are held accountable by APRA, but you could make the argument that they are quite permissive parents. If banks were any other business, they would be insolvent. The only reason the system works is because people either don’t know or don’t care because the government guarantees deposits (http://www.guaranteescheme.gov.au/qa/deposits.html), promising to bailout banks if they go bust.
This of course brings some level of moral hazard leading banks to take on a higher level of risk than they perhaps would if they were held accountable by the markets trust in their viability. And if banks do go bust, where will the government get the money? They would create it out of nothing with the help of the RBA.
Jason, I think you miss Economics 101 – the Law of Supply and Demand!
and you missed the whole idea behind the article :) … did you even understand it, or read it at least? in a nutshell, it is still tied down to the law of supply and demand… but the reason why there is high demand of houses (which jacks up the prices) is that people can easily borrow money from the banks (at least for people who dont have any credit issues)… and the reason why the banks are easily able to lend money to people is… you guessed it this time, because of this thing called fractional-reserve banking system… let me stop here, and ask you, do you know what fractional-reserve banking system is? nope? then go back read the article above! :)
Jenny, I think you miss Econ 201 – accessibility to cheap credit!
The RB wants to devalue Australian currency… Um… When your dollar doesn’t buy as much today as it did yesterday, isn’t that what occurs in a recession or DEPRESSION? So the RB is deliberately inducing conditions that CAUSE a financial system crash.
It’s obviously worked SO WELL too: “Let’s lower interest rates. Hm… That didn’t do what we expected. Let’s try that again. Gee, that didn’t work either, must do it again…” What’s that definition for someone that keeps making the same mistake over and over again? Oh that’s right – INSANITY.
BTW, it’s no use us discussing what ‘should’ government do… Because any one crowd is only in power a few years. All ‘government’ is really interested in, is pushing the problem down the line a few years… “Let the next lot take care of that messy problem.”
And… The government guarantee on deposits is, basically, just for show. If banks did collapse at once, where exactly do people think the government will get the $ to hand over to depositors – and – where will depositors BANK it!?
First, gov. won’t sell assets to provide such a huge amount of money to Australian depositors (if they have any assets left after selling them off continually to the private sector).
Second, the banks are now wiped out – so who is going to provide the loans, to buy any gov. liquated assets.
Third who is going to buy those assets, since they will continue to plummet in value. No-one will have the money on hand to buy those assets anyway, because the banks are closed.
Finally, if a run on the banks actually happens, people are fooling themselves if they think gov. will honour their promise to reimburse savings. Gov. won’t liquidate the countrys assets – what they will do is just WIPE THE SLATE CLEAN. In other words, all debt erased, all savings erased – the old system didn’t work, we blame govs. of the past – let’s start a new era and get it ‘right’ this time. They MAY give everyone a digital credit or debt based on your previous position – but I doubt it.
PS. Those folks storing gold & silver (or worse, cash) under the bed… Those will be worthless too. History shows when such things occur (ie. whenever the government feels like it), the use of such currency is simply outlawed, and/or gov. require it all be handed over to the treasury, to back-up their next ponzi banking scheme. If it’s stored on the gold-trader’s premises (as many people do), such businesses will be legally required to surrender it to gov. If it’s in your own hand, it’s now illegal to trade with – so other people will dob you in, to get the reward gov. will promise for informing on ‘unpatriotic traitors’.
It’s true that governments are seeking to profit from land sales, but they wouldn’t be able to do so if there were not plenty of willing buyers at ridiculously high prices, no matter how much land is released. An added point is that up until the 1980’s, women had to have a man able to countersign a loan document from a bank. By allowing women to be borrowers in their own right the number of potential borrowers effectively doubled. Add that to almost unlimited money supply for mortgage lending and it is clear that skyrocketing property prices are demand not supply-driven.
Great point Sonni. I didn’t realise this. It seems this was also the case in the US – a woman’s income was not counted toward income calculations when applying for a mortgage.
What’s your thoughts on this?
http://m.smh.com.au/business/banking-and-finance/amp-bank-stops-lending-to-housing-investors-jacks-up-rates-20150729-gimqjt.html
This trend certainly doesn’t bode well for the property perma-bulls.
Enjoyed your article Jason, as I normally do.
How is Australia different than Greece? Do you think we could ever experience a banking crisis here?
no different, the same rules apply and yes a similar crisis is a real possibility.
How does it make you feel to know that virtually all of your deposits are invested in housing and businesses?
How I or anyone feel does not change the situation. Also I cant foresee a way to backtrack out of either. It would mean a complete restructure of the system as a whole.
What would it take for Australians to lose faith in the banking system and show up all at once to withdraw their savings?
mass media telling them such, large increase in unemployment etc.
Should our banks be forced to maintain a higher capital reserve than 1 or 2 percent?
Not really but there should be system that protects the Australian masses and banks should have to provide collateral the same way a home buyer does.
APRA this week tightened the capital requirements of the big banks by about 80 basis points (.8 percent). Do you think this will have an impact on property values?
Not enough to affect positively or neg if an issue arose.
In my opinion the bottom line is education, if the ins and out of the way the government/Financial sector and so on where understood in low level schooling (and so on) it could in turn benefit the country (e.g. Richest man in Babylon theory)
Fractional reserve is such a powerful tool of our economy. Ultimately I think it is good but can be very dangerous due to the leverage it created.