House prices in Australia’s most expensive markets have risen to dizzying heights over the past five years. Many Aussies have taken out more debt to be part of this party.

However, the current housing boom might be coming to an end. It is now up to regulators and federal government to respond to a fall in house prices.

Markets are cooling

House price growth is beginning to slow in Sydney and Melbourne—the two epicentres of the most recent housing boom, according to CoreLogic. Mortgage lending volumes have also dropped, following APRA’s clampdown on interest-only loans. In Brisbane and Melbourne, oversupply is a problem as apartment prices could plummet due to falling values.

It is impossible for anyone to predict the future of house prices. However, past booms do provide some clues.

Australia’s past booms in property have seen prices drop modestly, or even flatlining for a long time. Prices did not plummet completely during these booms. Sharper falls are possible as demonstrated by the subprime crisis in the USA. However, such a scenario is highly unlikely in Australia, with regulators keeping such a tight rein on bank lending practices—though an economic downturn unrelated to housing could push the housing market over the edge.

Regulators place less importance on banks than on households.

Since the subprime crisis in the USA, commentators have been focusing on the dangers that property markets booms and busts pose to the banking sector. If there is more debt, lenders could run for their lives.

The banking system is not at high risk of being instabilized. according to the Reserve Bank, due to the fact that relatively few households have high loans-to-total-assets ratios. International standards also show that Australian banks are well capitalized and make strong profits.  

Regulators are more concerned about rising household debt, which could lead to a rapid drop in household spending. The Reserve Bank states that households with higher debt levels are more likely to cut their spending than those who have lower incomes.

The slowing Chinese economy or the slowing recovery in the USA could lead to an increase in unemployment. Many households would be forced to save more and spend less.

Small increases in interest rates could result in households spending less. If interest rates rose by just two percentage points, mortgage payments on a new home would cost more of a household’s income than at any time in the past two decades, according to the Grattan Institute.

While the Reserve Bank will only lift interest rates cautiously, another major disruption to international financial markets, similar to the global financial crisis, could see banks’ funding costs rise sharply, which in turn would raise mortgage rates.

What can policymakers do to deal with such risks?

Brendan Coates from Grattan Institute, Australian Perspective Fellow at Grattan Institute, believes that the Reserve Bank needs to be more prudent if it feels the need for higher interest rates in the future.

“Higher debt levels mean household spending is likely to fall more when interest rates rise than it did in the past. Perhaps the RBA should make smaller shifts in the cash rate – such as 10 basis points – to cushion the impact of future rate rises,” Coates said.

Second, the nation’s financial regulators (APRA and ASIC) need to be ready to clamp down on banks making risky loans if there are signs that lending practices are declining. However, lending shouldn’t be restricted just to bring down house prices, Coates said.

“Third, the Commonwealth Government needs get its fiscal house in order. Australia urgently needs a better budget position so we have more room to manoeuvre,” Coates said. “The Australian economy is particularly exposed: with interest rates at historical lows, there are limits to what the RBA can do to stimulate growth, so fiscal stimulus will be an important part of any response to a future economic shock.”