How Australia's banks could trigger a property crash

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If you're a dyed-in-the-wool property bull who hates seeing a negative thought written about property prices, stop reading now; what follows will only upset you. But if you're open to considering alternative views, please read on.

First, let me make it clear that I'm not making a prediction about a setback in the Australian property market. To insist that prices must fall seems as foolish to me as ignoring the possibility of a fall altogether. What follows is simply an observation about a potential risk, alluded to in a speech given by Phil Coffey, Westpac's chief financial officer.

In a presentation to the Australian Banking & Finance Capital Markets Forum last week, Coffey touched on the risks:
''Notwithstanding our strong credit ratings and our healthy relationship with global investors, at some point, institutional investor appetite or concentration risk may become a constraint. It is unusual and untested for an ongoing current account deficit to be funded so much by the majors of a banking system.''

These candid comments point to an inversion of the argument frequently advanced by banking bears: that falling property prices could cause enormous problems for the banks. There's certainly truth to that position but what Coffey is alluding to implies the opposite. Risk also lies in the exposure of our banks to offshore funding; that it may, in fact, be this reliance on offshore funding that triggers a property market meltdown.

Traditionally, banks use depositor funds to finance their lending. Yet that's no longer the case in this country (see Bank headlines you won't want to see). Australian banks now finance much of their lending from offshore because our national thirst for credit outstrips our collective ability to fund it. And, in exhausting our domestic savings pool, our banks have headed offshore to fill the breach, rather than curtail their lending.

Coffey, perhaps unwittingly, is inviting us to consider what might happen to the costs of servicing our mortgages and other loans if our foreign benefactors lose the will to extend further credit at some point. He politely described this disaster scenario as a ''constraint''.

We saw how our banks reacted to the reduced availability and increased cost of wholesale funding during the credit crisis of 2007, the forerunner to the global financial crisis. Credit was rationed and higher funding costs were passed on to borrowers. That provided a small dress rehearsal for what might happen if the cost of the banks' funding were to rise sharply, or dry up altogether, as a result of ''Coffey's constraint''.

A$ risks

Any such loss of confidence or appetite for Australian credit by international investors would most likely be accompanied by a loss of confidence in our currency. Again, we've had a fairly recent preview of this in late 2008 when the Aussie dollar plunged from more than 90 US cents to just 60 US cents in three short months. It's not popular to say, but several key parts of the Australian economy are dependent on the continued confidence of foreign investors.

The nightmare scenario goes something like this: International investors refuse to extend our banks credit at a reasonable price. This forces the banks to pass on additional costs to their customers and, in some cases, refuse credit.
These tight credit conditions could squeeze property developers and highly-geared property investors alike. Many developers would be forced to offload housing stock quickly- by reducing sale prices - to raise cash to repay their loans as they fell due and/or cover the increasing costs of their debt.

Ordinary property investors would face a similar squeeze; seeing prices fall and facing growing debt-servicing costs. Some would be forced to sell into a falling market, pushing prices even lower.

In effect, we'd witness the reverse of the positive feedback loop we've seen in the property market for many years. Instead of positive sentiment driving prices higher, negative sentiment, a lack of available credit and higher interest costs would push prices lower.

Again, this disaster scenario is not a prediction -it isn't even likely. The chances of this playing out as described are remote indeed. Our Reserve Bank, for one, has a few shots in its locker. But you only have to look at the US or Japanese housing markets to realise that once people's confidence is broken, low interest rates can only do so much.

The events of the past few years have shown that most of us are prone to underestimating our exposure to low probability/high impact events (see Nassim Taleb's book The Black Swan for more on this topic). Australian banks' reliance on foreign funding may well be one of those factors that seems all too obvious a risk in hindsight but nobody bothers to raise beforehand. With thanks to Phil Coffey, consider it raised.

This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor

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