How the great money market crash of 2007 changed the rules for property investment.

There’s no doubt that the financial world has changed significantly over the last 5 years. This has affected all of us and especially so if you have an interest in property investment.

So today I set myself the tricky task for summarising the money market crash and why it affected some overseas markets so differently to Australia.

Interbank lending

A little while ago I blogged about the LIBOR scandal, which considering the size and impact of the related fraud is attracting surprisingly light press coverage.

The LIBOR is an example of an interbank lending rate which banks and other institutions use as a benchmark when lending funds to each other. Trillion of dollars of other financial instruments are benchmarked to the rate.

In today’s banking environment, where banks do not always hold sufficient liquid funds to meet their needs, short-term interbank lending is part of the lifeblood of the financial system.

Although we often hear that sub-prime lending ‘caused’ the financial crisis, the actual trigger-point was a seizure in the money markets.

In days gone by banks simply took deposits and then used these to lend to other customers, but this naturally inhibited banks’ opportunities to lend funds and grow. Today ‘fractional reserve banking’ sees far greater volumes of funding being granted to customers as mortgages – and this needed a different method of managing the risk.


As the name suggests, securitization was the process by which banks managed to package up debt and sell it as securities (i.e. as shares, bonds and options).

The idea was simple enough: that being for banks to spread their risks among other investors and funds by selling them some of the risk.

While the idea is sound in theory, in practice the movement away from a direct relationship between the lender and the debt holder (a process known as disintermediation) gradually introduced more complexity and risk into the process.

In particular, it was the ‘bundling’ of mortgages and the so-called “slicing and dicing” – re-packaging debt into ever more complex instruments known as CDO’s (collateralized debt obligations) – which led to investors having very little transparency into what they were buying into.

D-Day arrives in 2007

With banks lending out more in mortgages than could reasonably be justified by their deposit levels, they had become highly reliant upon short-term funding from the wholesale markets.

While housing markets were rising all seemed well but when investors gradually began to realise that the US housing market could be falling, panic ensued and the demand for securities dried up.

With the great benefit of hindsight the onset of the great panic is traced back to 9 August 2007.

With banks increasingly both unwilling and unable to lend to each other the system seized up and this ultimately led to the failure of financial institutions both in the US (Fannie Mae, Freddie Mac and others) and in the UK (where Northern Rock was the victim of a modern day ‘bank run’ and had to be bailed out by the Bank of England as the lender of last resort).

Lending standards

It is now well documented that lending standards had declined appallingly in the US. Did something similar happen in Australia? Certainly debt had become easier to source and 100% mortgages were available up in the period preceding the money market crash.

It has long been recognised (including in the famous ‘economic clock’) that the ease of obtaining credit does tend to move in cycles and Australian credit was noticeably looser at that time. However, it is widely agreed that lending standards never fell to the same degree was seen in the US.

Property bubble?

The arguments in favour of a property bubble in Australia have long highlighted, with some justification, the increase in household debt over the last 25 years which saw house price to income ratios move up sharply from 3 times to around 5.5 times.

How the great money market crash of 2007 changed the rules for property investment.

Prices crashed in some parts of the US from 2007 where population and demand was falling. Indeed some remote markets crashed in value to almost zero. As inhabitants of the world’s sixth largest country, any Australian should intuitively know that land and property for which there is no demand is ultimately worthless (which, incidentally, is why I tend to only buy in supply-constrained suburbs of capital cities).

Yet in our highly urbanised country (where more than 50% of us live in just four cities) while prices in some speculative regions or remote markets fell sharply in value, there has been no such wider housing crash and Australia did not see such high profile failures of financial institutions.Increased regulation and tighter restrictions on Australia banking practices in the future would be a welcome and prudent move.

The arguments against a bubble

It is clear that debt cannot continue to increase at the same pace as it did from the mid-1990s but the argument of an unsustainable credit bubble overlooks a range of counter-factors.

Firstly, the above graph is effectively an inversion of a chart showing the movement in interest rates, although the correlation is obviously far from precise.

Debt ratios may be higher a quarter of a century on, but the cash rate has plummeted from a terrifying 17% in 1990 to just 3.00% today. Much of the increased exposure was a rational response by home-buyers to the structural shift to lower inflation and lower interest rates.

What else? Well, although debt levels have increased for many new homeowners, close to half of Australian homes have no mortgage debt at all against them.

If we had remained in an unsustainable property bubble for years one might expect to see increased levels of mortgage default in this country, instead of what we have seen, which is non-performing loans crawling along at a minimal percentage.

How the great money market crash of 2007 changed the rules for property investment.