How might a housing bubble burst?

There’s been quite a bit of speculation over whether Australia has a property market bubble - where house prices are over-inflated compared to a benchmark - and when it might burst.
Associate Professor Harry Scheule of UTS Business School examined one scenario where this could happen, if lending rules were tightened and interest rates raised ...

Following concerns of the housing bubble, bank regulator APRA increases bank lending standards, it also increases the risk weight on Australian mortgages resulting in lower loan supply and higher loan costs. Banks are encouraged to reduce interest-only loans, hold a greater amount of costly capital (making home loans more expensive) and reduce the loan amounts offered to applicants due to higher future interest scenarios.

Following increases in interest rates in the US and Europe, as those markets recover, the Australian dollar begins to decline – forcing the Reserve Bank of Australia (RBA) to increase interest rates.

Higher interest rates lead to higher monthly repayments, as most of Australia’s home loans are adjustable. Interest only loans are the most exposed. Higher interest rates also lead to more mortgage delinquencies.

The banks tighten bank lending standards in response to the increase in delinquencies. This further constrains interest-only borrowers seeking to refinance after the end of the interest-only terms. This means more mortgage stress, as many had expected to roll over the interest-only period indefinitely, but now they are forced to make principal repayments next to interest payments.

The cycle between delinquencies and tightening bank lending standards continues and as a result there’s a noticeable drop in loan supply and a fall in house prices.

Illustrations by The Conversation, CC BY-ND.
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