We may sound a little like a broken record on Australia’s residential housing market. Based on metrics like disposable income-median property price or relative debt levels, Australian house prices appear extraordinarily expensive. Housing price data is thumbing its nose at our claims, continuing to rise (significantly in the most recent quarter), even as GDP remains stagnant or falls and unemployment edges higher.

Data released by the ABS earlier this week indicated that financing commitments for owner-occupied and investor housing grew by a further 1.8% in June (0.3% on a seasonally adjusted basis).

There have been many ‘reasonable’ explanations provided for ever increasing residential property prices (the median house price in Sydney is now $547,000 — almost ten times median income levels). Most common is the ‘supply’ argument: that hundreds of thousands of people are moving to Australia and they need to live somewhere. Or that Australia is a highly urbanized country and this vindicates a median house price which is more than double that of the United States.

Those reasons appear to make sense. But then again, during a bubble lots of things appear to make sense which in hindsight, are ludicrous. Remember the dot.com boom, when it was commonly thought that business over the internet would take over from bricks and mortar? This meant that at one point the loss-making pets.com was worth more than US$100 million before collapsing into liquation after 268 days.

There are two major causes for the recent residential property bubble — first, government meddling (specifically through the first owner’s grant, but also bank funding guarantees). This is providing house buyers with more cash (which is then leveraged up substantially) to purchase their dream home.

The second reason for the bubble is the Big Four banks’ continued willingness to lend money to home buyers on exceedingly generous terms, upwards of 90 percent loan-to-valuation ratios. If banks took a more prudent approach and cut LVRs to say 70 percent, we would witness a rapid, almighty slump in property prices (most notably at the lower end). Banks of course don’t want this, the collateral (security) underpinning the loans they have already made are other houses. Banks don’t usually like to destroy the value of their collateral — it isn’t good for business (or more pertinently, for bankers’ salaries).

The supply argument is not actually incorrect. Supply issues are clearly having a short-run effect on prices. However, eventually (and it may take years for these structural changes to transpire) the supply curve will adjust. If property prices become too expensive, immigrants will opt to relocate to other countries, where the cost of living is more bearable. People will also move further away from expensive cities. Japan is a far more urbanized country than Australia yet since 1991 Japanese city property prices have suffered a remarkable downturn, falling for 15 consecutive years.

It took a decade for Japan’s property boom to finally burst but eventually, supply readjusted and prices plummeted, even in Tokyo, which has a population of more than twelve million but is far smaller in geographical size to Melbourne which has a population of less than four million.

The slow moving supply curve was well explained by Nobel prize winning economist, Robert Shiller in The New York Times recently when he noted:

Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers think that home prices are in decline, most have no reason to hurry because they are not really leaving the market.

Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. First, many owners don’t have a speculator’s sense of urgency. And they don’t like shifting from being owners to renters, a process entailing lifestyle changes that can take years to effect.

Among couples sharing a house, for example, any decision to sell and switch to a rental requires the assent of both partners. Even growing children, who may resent being shifted to another school district and placed in a rental apartment, are likely to have some veto power.

Business Spectator and Crikey contributor, Chris Joye, was correct last week when he noted residential property isn’t the only asset bubble — witness the dramatic collapse in commercial property prices in Australia (and rapidly increasing vacancy rates) or sharp loss in equity values last year.

However, simply because there are other asset price bubbles which are more obvious and more reactive to economic conditions doesn’t mean that the price of much of Australia’s urban residential property has not far exceeded its intrinsic value.

As long as Australia’s banks have an interest in propping up residential property, the bubble will be tentatively kept alive. However, the risks of this path are significant. As Dan Denning in the Daily Reckoning noted presciently yesterday:

The bigger risk … is that Australia’s banks will become increasingly reliant on rising house prices to spur demand for new mortgages. That’s the process that contributes to earnings and keeps the balance sheet ticking along. The loans made to mortgagees go on the balance sheet as assets. They are funded from money borrowed abroad, which goes on the balance sheet as a liability.

The trouble here is that assets can change in value while liabilities do not. The debt has to be repaid, even if house prices fall. Australia’s banks are gambling with the capital structure of the entire nation, sinking more and more borrowed money into residential housing. It’s the biggest and riskiest bet yet.

Yes. Big, risky and very stupid. As no doubt Japanese banks can attest.