*2.1.1. Some aspects of the residential finance system in the U.S. and Australia*

In the US, the residential finance system played a significant role in the housing bubble of 2008. The regulation, residential finance institutional arrangements, and mortgage characteristics aided the excessive demand for housing finance. Housing finance was available and offered to borrowers with poor borrowing capacities. Consequently, excessive borrowing led to the housing bubble and the collapse of the financial system in the U.S in 2008. There are some fundamental differences in the lending practice in Australia when compared to the US [21].

In Australia the lending process is highly regulated by the institutional arrangement. The lending practices enforce the regulatory provisions on financial institutions forcing them to avoid excessive risk taking behavior. Table 2 outlines the characteristics of housing loans both in the U.S and in Australia. The table highlights the systemic susceptibility to riskier mortgages in the US and that availability of such funds to finance the mortgages were more common than in Australia.


Source: RBA [21]

370 Risk Management – Current Issues and Challenges

locations, if chosen.

**1.5. Risk and reward** 

Australian real estate market are investigated next.

**2. Real estate scenario in Australia** 

**Natural disasters:** In the real real-estate market, location plays an important factor in the investment decision. A property purchased at an appropriate location is expected to provide a good return on the investment. One of the main factors affecting location is the potential exposure to natural calamities such as bushfires, floods, sea level raise and erosion to name a few. If the location has a history or is likely to be exposed to a natural disaster it can be expected that the property prices will eventually be exposed to the risk. Therefore, it is wise to not be enticed into such toxic locations. Other factors that need to be accounted for are the costs of maintenance of properties and the nature and level of insurance required for risky

The nature of risk definition and management process is such that it should be integrated into "the philosophies, practices and business plans" of any individual investor or large organization's culture (Hillson [5], p.240). It is certain that there are many risks involved in real-estate market as mentioned. While real-estate provides variety of investment options every investor has to find their comfort level upon taking risks involved. It is not easy to decide if a selected property for investment is appropriate, but the decision should be made based on the consideration of all the factors discussed earlier. In the end however, the willingness to take risks largely depends upon individual preferences and circumstances.

The elements that usually determine the scale of risk or reward are the amount of money that is invested, length of time investment, rate of return or property appreciation, depreciation, fees, taxes, inflation etc. While it is natural for the individual and organizations to invest and expect returns it is important the investors make the informed choice to reduce the odds of losing the principle invested. The potential risks and rewards in investing in the

The speculation about Australian housing market has been intense since 2003. First it was the international monitory fund (IMF) which warned of the housing bubble in Australia "would bust" [15]. In mid-2008, IMF stated that the Australian property market was overvalued by about 25% [16]. In more recent times (April 2010), "The Economist" house price indicators estimated Australian house prices were the most overpriced in the world (56.1% overpriced against long-run average of price to rents ratio) [17]. The US based analysts Jeremy Grantham (Boston-based hedge fund GMO analysts co-founder) and Heather Hagerty (Fidelity Investments), were also speculating whether or not the Australian residential market is experienced a housing bubble, after the US housing crisis. According to Edward Chancellor [18], a US-based investment strategist and financial author, Australia was "in the midst of an unsustainable housing bubble that could burst at any time" and the "house prices are more than 50% above their fair value - a once in 40-year event." (p.1). In 2011 Morgan Stanley's global strategist Gerard Minack said that "we've had 20 years where the Australian consumers have been willing to borrow more to buy an asset that they believe always goes up in value. The classic sign of an asset bubble." and that "home prices are 30 to 40% above fair value [p.1, 19].

**Table 2.** Mortgage characteristics of Australia as compared to US

In the US, the non-conforming housing loans represent 13% compared to 1% in Australia [21]. Negative amortization loans are common in the US but no such loans existed in Australia at the time of the crisis. In Australia the mortgages are "full recourse" lenders and hence the incentive that is offered to households to take out loans they cannot repay is reduced. This is also deters financial institutions from offering risky loans. These primary differences stand out to support and contribute to a relatively strong performance of the housing loans in Australia when compared to the US. It is important to note that the share of non-performing loans in Australia were less than 1.5% even during the financial crisis.

Importance of Risk Analysis and Management –The Case of Australian Real Estate Market 373

than the purchase price, which often surprise first-time borrowers. Typically, the amount that lenders have been prepared to lend for housing has been restricted by one or both of the

scheduled repayments should not exceed some fixed share of the borrower's income –

the loan should not exceed a certain proportion, most commonly 80% [21] of the

The analysis presented in the previous section shows that Australia is fundamentally different to the US when it comes to the residential housing market. But, how does Australia compare to the other countries in the world? New research conducted by Lloyds TSB [27] - International Global Housing Market Review, shows that Australia just made it into the top 10 list of countries with the highest house price increases over the past decade (Table 3). Four of the six top performing housing markets since 2001 were in the emerging economies of the world. India with a booming real estate market tops the list - house prices rise by 284% over the last decade; Russia coming second - house price increase of 209% over the same period. China faired only marginally when compared to other major economies -

> **Real house price change % 10 year**

**Real house price change % 10 year per annum** 

the repayment-to-income, or serviceability, constraint; and

**2.2. Australian real estate market compared to the rest of the world** 

property's purchase price – the LVR constraint.

ranked 14th with a 47% growth rate since 2001.

**change % 1 year** 

**India** 8.7 284 14.4 **Russia** -24.3 209 12 **South Africa** -1.1 161 10.1 **Lithuania** -1.3 143 9.3 **Hong Kong** 13.6 125 8.4 **Bulgaria** -10 106 7.5 **France** 4.3 82 6.2 **New Zealand** -2.1 79 6 *Australia -5.7 76 5.8*  **Norway** 6.9 72 5.5 **Belgium** 0.4 69 5.4

According to the findings of the report Australian house prices increased by 76% and had the ninth fastest growing house prices during 2001-2011. During the same period house price declines were seen in the world's largest economies such as Germany, Japan and the

**Country Real house price** 

Source: Lloyds TSB International [27]

**Table 3.** Real house price changes – A global comparison.

following:

Another fundamental difference is that there is no government sponsored enterprise (GSE) in Australia while they exist in the US. The GSE in the US holds a guarantee of the loans that are offered. This potentially provides an impression that bad loans offered to borrowers with poor repayment capacity would be covered by the Federal Government [23]. This is not so in Australia where commercial banks provide 90% of all housing loans. The commercial banks are mainly funded by the bank deposits, short term and long-term wholesale debt [24]. The absence of the so called Federal guarantee restricts Australian banks from any excessive risk taking behavior. In 2007, at the beginning of the financial crisis, GSE's possessed 90% of these securities. The shadow banking system in which the financial institutions have a greater participation and the GSE's can be said to have led the excessive risk taking behavior and practices in the US [21]. In addition, according to the RBA [21], the regulation level of financial institutions in Australia is about 80% while in the US only 50% of all the financial institutions are regulated [21].

**Figure 7.** Non-performing housing loans Source: Real estate Institute of Housing America

The Loan to Value Ratio (LVR) refers to the amount of money borrowed against the total value of the property in a home equity loan. For example, a \$50,000 loan against a home worth \$200,000 has a Loan to Value Ratio of 25%. In Australia, loans with an LVR exceeding 80% require mortgage insurance - the risk of the borrower defaulting is far too great for the lender. The value of the property is determined by the lender and is often significantly less than the purchase price, which often surprise first-time borrowers. Typically, the amount that lenders have been prepared to lend for housing has been restricted by one or both of the following:

