This one sentence explains how Australia's property boom could end devastatingly badly

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Australian property prices, especially Sydney and Melbourne, have been rising strongly. That’s prompted the head of the Treasury Department, John Fraser, to tell a parliamentary committee that there is unequivocal evidence of a bubble in Sydney.

That implies that like all bubbles, a day of reckoning will come when it pops and we’re all left to deal with the fallout.

So, it’s worth highlighting analysis released by fund manager PIMCO on the Australian housing market which has a chilling conclusion that if the music stops abruptly, things could quickly deteriorate into a spiraling negative feedback loop.

Portfolio manager Aaditya Thakur and quantitative research analyst Dr Laura Ryan have found that Australian home buyers are most influenced by “the cost of debt (the mortgage rate) and recent asset price appreciation”.

They also found that borrowers react quickly to these two stimuli “needing only two-quarters of favourable changes in asset prices and mortgage rates to increase leverage”.

So it’s not hard to understand why the rise in Sydney property prices, which have accompanied the series of RBA rate cuts, has fed on itself and may be not done yet.

But because Australian property prices remain elevated on a global basis, Thakur and Ryan say that “with this starting point, it seems questionable to embed expectations of continued high price growth”.

Channeling their inner Alan Greenspan, they added that:

Households are exhibiting irrational exuberance because they are placing little weight on broader fundamentals like unemployment that may be more representative of future incomes or asset price returns, increasing the likelihood of asset price bubbles.

That’s where the warning of a devastating downward spiral comes in.

Because of the importance in the recent trend in values of housing in driving the decision to borrow and buy, “Australian households will react faster and more vigorously to a shock in asset prices or mortgage rates”.

Which suggests this current run-up in Australian housing could end very badly.

Thakur and Ryan conclude means-based on their model of leverage:

…if an exogenous shock sparked a deleveraging cycle in Australia, it would be expected to be quite severe given the larger co-efficient for asset prices and the quicker household response.

That means if rates have to rise or we see an external shock to the economy, or perhaps even to markets, we could end up with a buyers’ strike. Prices would then adjust downward based on the model and falling prices would then feed on falling prices, according to Thakur and Ryan.

Their message?

Don’t expect the good times to last forever and don’t buy property just because prices have been rising. The starting point means much of the good times is behind prices.

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