MICHAEL SCHNEIDER: There's a key point to draw from that, and that is that bubbles and the aftermath of bubbles are completely to do with credit phenomenon-- or phenomena I should say. So credit conditions drive the bubble up, so to speak, and credit conditions bring it back down.

JOE WALKER: Hi, I'm Joe Walker, host of the "Jolly Swagman Podcast." And I'm joined today by Michael Schneider. Michael, thanks for coming.

MICHAEL SCHNEIDER: Good to see you, Joe.

JOE WALKER: Great to meet you finally, after we were connected by Grant Williams, the man himself. I've had an opportunity to listen to your Real Vision interview with Grant from 2016. It was a great conversation, and a lot has changed in the intervening three years. I want to talk to you about that.

But the first thing I wanted to ask you about was just the virulence and degree of ferocity involved in the Australian housing debate. Is this something you've remarked upon before? I find it almost ridiculously tribal, and not just in the cesspit that is Twitter, but also even in the mainstream media. Bulls and bears-- it's a very emotionally charged debate.

MICHAEL SCHNEIDER: It sure is. And you only have to go to an auction to see exactly how emotional the housing market is. Yeah, it's interesting in the sense that it hasn't been a linear set of experiences in the last couple of years. We've had, obviously, the Royal Commission that certainly restrained and identified some malfeasance that was going on and misincentivization that was going on in the lending side of things.

So that was obviously a key component to sort of turbocharged that downward movement in the property market. But equally, we've had the withdrawal of mainland Chinese investors, by and large. So that was sort of a convergence at the same time. And then you had APRA that decreed that interest-only lending must revert back to 30% of all lending. So you had really a confluence of events that certainly all of a sudden converged into a serious retraction in house prices in the latter part of last year.

JOE WALKER: What's your sense of the role that foreign buyers played in the Australian housing market? Recently I went on Martin North's show for digital finance analytics, and I drew a contrast between two different sources. On the one hand, the treasury-- Chris Walker, an analyst at the treasury, published a study where he showed that the contribution of foreign investors to price rises in Sydney and Melbourne during the last cycle, 2012 to 2017, was very limited. I think they were responsible for about $80 to $122 of the price rises per quarter, when the overall price rises per quarter were in the range of $12 to $13,000-- so a very small impact.

And then when you juxtapose that-- if you talk to the average Australian and you ask them what they think is influencing house prices, typically the first thing anyone says is it's the Chinese buyers. So there seems to be kind of a perception and reality gap here-- if we assume that the treasury analysis is on point. But what do you think the actual role of foreign buyers has been in the market?

MICHAEL SCHNEIDER: I mean, I think that's a good point. Firstly, I think that it was fairly idiosyncratic in terms of where the Chinese buying was. In Melbourne, for example, you had fairly Chinese-centric suburbs that had disproportionate price increases as a result of that. Other places, like inner eastern suburbs as well, had a disproportionate amount of price increases on the back of that. But other areas like the Western suburbs, south eastern suburbs, I think were largely untouched.

But I can see an argument, though, for a scenario where that causes a ripple effect. So if the more affluent suburbs are having a disproportionate amount of Chinese buying, that should filter through to some of the more middle class suburbs.

JOE WALKER: Let's go back to circa 2017 just before the downturn, which we've just recently escaped. There's a sense in which you can kind of read Charles Kindleberger and then see signs of mania everywhere in your own times. And no one in a bubble or otherwise ever thought he was crazy, but it's very fashionable to kind of tut tut at manias of the past and to sort of look for signs of mania where they might not exist.

Were there any incontrovertible signs of irrational exuberance in your mind in the Australian housing market around 2017?

MICHAEL SCHNEIDER: I can think of one in particular. A colleague of mine, his grandmother-in-law passed away around that time. And so her house was being auctioned in a suburb called Toorak. And the agent, the realtor, was just about to knock down the price for sale. And literally a black Mercedes pulled up and a Chinese guy got out and offered $500,000 more than the price was about to be knocked down for-- and wrote a check accordingly for that. So that's probably one anecdote that stands out, but there's a million others in terms of valuations and particularly how much a lot of properties were going above the reserve price.

JOE WALKER: Yeah, it strikes me that as much as the foreign buyers were there during the last cycle, it's really a domestically driven story, isn't it?

MICHAEL SCHNEIDER: Yeah, and I think to your point about Kindleberger as well, I think there's a key point to draw from that, and that is that bubbles and the aftermath of bubbles are completely to do with credit phenomena. So credit conditions drive the bubble up, so to speak, and credit conditions bring it back down again. So to your point I would agree with that.

JOE WALKER: So riffing on that for a moment, do you think the credit supply shock that was the Banking Royal Commission is still the credit supply shock that it was? Have we kind of escaped that now? What are credit conditions like at the moment?

MICHAEL SCHNEIDER: I think you can divide that into two parts. The verification process has clearly tightened up, although I've seen reports recently that suggest that it hasn't tightened up in terms of full disclosure on loan applications. So I think maybe I'm a bit more circumspect about how tighter the verification processes have been since pretty much always September last year.

And equally, you have to look at the availability and the demand for credit. So the thing that I would certainly draw attention to there is private sector credit is going backwards at an increasing rate. So if you're looking at a backdrop of credit conditions, certainly demand for private sector credit is shrinking. And that suggests that the consumer is tapped out. The mortgage is really at some kind of leverage ceiling.

So again, whilst we've had a bounce in the last six months or so-- or even less than the last six months-- I think that's been certainly quite idiosyncratic. But it's also been against a backdrop of broader downturn in microeconomic conditions as well, such as retail sales. Vehicle sales are down 8% year on year. Even SUV vehicle sales finally turned negative in June of this year. So the microeconomic backdrop, I think, is very noteworthy in that sense.

JOE WALKER: Should we expect consumers to start spending again as household balance sheets repair with this house price recovery?

MICHAEL SCHNEIDER: You would think so, prima facie. But again, you're not seeing that in the credit numbers. You're not seeing that in private sector credit. So it either suggests that if credit demand on the private sector is decreasing and again at an increasing rate, then that suggests either demand is not there or supply is not there-- or a combination of both. I tend to think it's more demand is not there.

JOE WALKER: So we've spoken before by email and you've shared with me a really insightful kind of sequence to a housing blast and how it flows through to the consumer balance sheets, to the economy, indicators that we can identify along the way in that sequence. Can you just give us an outline of that, and then talk about where Australia stands on this trajectory at this moment?

MICHAEL SCHNEIDER: Yes, I'll start with another anecdote, which I think might be useful. In about, I think it was February, last year or so, almost two years ago, I was driving my daughter back from a sporting event, and there's a bunch of people gathering around the corner for an auction. And my daughter said, what's that dad? I said, well, come with me and I'll show you. And so I explained to her what an auction is.

And to the uninitiated, it's almost like a religious cult in Melbourne or Sydney. But what struck me at the time was I would have typically for that part of the neighborhood, I would have expected four or five times as many people at the front of the auction, and I would certainly have expected a far greater number of offshore buyers to be present at the auction as well. So that was just a kind of a reference point that I put in the back of my mind.

And then I went to a few other auctions, and there was a pattern emerging as well. So then to me, getting back to your point about credit conditions, clearly there was some impact in credit availability such as interest-only lending being withdrawn or reduced at the decree of APRA. And that pattern was pronounced more by, obviously, the Royal Commission and the findings of the Royal Commission.

So that, to me, was very much a severe retardant to credit availability around the middle of last year, or at least in the first six months of last year. And so that followed through subsequent to the conclusion of the Royal Commission. And then you saw a scenario where the lagging indicators have started catching up, such as GDP. I mean obviously, retail sales and vehicle sales in particular were very much either flat-lining or in significant decline. But then the lagging indicators towards the end of last year caught up. And so you're seeing a scenario now where GDP, for example, is barely above stall speed.

JOE WALKER: Which is precisely what we'd expect in this kind of environment with house prices falling.

MICHAEL SCHNEIDER: And then you layer that with a couple of other points on the structure of the Australian economy-- or at least Australian labor force-- something like 40% of the Australian labor force is either part time or contract. So if you keep getting-- and back to your other point about full recourse lending-- if you keep getting belt tightening because the consumer is either tapped out or is struggling with mortgage repayments and delinquencies-- and provisioning is suggesting that that is the case, that the consumer or the mortgagee is becoming squeezed.

So the structure is that if you start seeing any downturn in the economy from here, in my view-- and last, I think, two weeks ago, we got a glimpse of that. We had the worst unemployment result in something like 17 months. So if the employment market is at the effect of declining GDP rates, then that has to, again, have a ripple effect on the labor force. And you've got something like 11 or 12% the labor force is tied up with construction, particularly pertaining to residential housing.

So again, the structural backdrop to the Australian housing market is far more worrying than what, I guess, front page attention seems to be giving to it. Auction results are typically around 40% below the levels of the peak of the market in 2016-2017. The price rises are very idiosyncratic in terms of the suburbs that they're particularly occurring in. They're not occurring in the Western suburbs of Sydney, and they're not occurring in the southeastern suburbs of Melbourne.

So whilst there has been quite a pronounced recovery in some suburbs, it's most definitely not unilateral. And to use Martin's data as well, which I use quite vigorously, his metric is that lending conditions tightened post-August last year by something like 40% since the incoming government turned that around, or at least loosened some of the lending requirements and lending ratios. In May June this year, you've certainly had a turnaround where, in Martin's view, 15% of that 40% of restraint has certainly mitigated the credit availability. But again, I look at the kind of logic tests on these, and there's two things that really spring to mind.

One is that if this recovery in property prices is as sustainable as we're seeing in the broader media, then the Reserve Bank should be tightening interest rates, not lowering interest rates. So that's something that's very key in terms of how I look at things. And equally, if there is a recovery that is sustainable, then we're seeing that against the backdrop of rising delinquencies, rising foreclosures, benign retail sales, negative vehicle sales. So you're seeing it against a backdrop which doesn't suggest that a sustainable housing recovery is in place.

JOE WALKER: So the damage done by the price falls between 2017 and 2019 could feed back into house prices again under these conditions of macroeconomic weakness?

MICHAEL SCHNEIDER: Well, the other logic test that I apply to this is that at the peak of the property boom, for want of a better word, the median debt to income ratio in Sydney was eight times. In Melbourne, that was seven times. So my view is unless we go back to that, which I find difficult to believe will occur-- unless we go back to those types of leverage and credit availability, then I just don't see how a sustainable recovery is in place. And particularly again, referring back to private credit, I think that's really, really important.

JOE WALKER: So last year, a looming threat many people were pointing to in the Australian residential housing market was the $120 billion of interest-only loans that would be rolling over per year from 2018 to 2021. Is that shaping up to be the screw-tightening threat that it looked like it was going to be?

MICHAEL SCHNEIDER: You could argue that it hasn't been. And I think to be fair in defensive that argument, the median or average interest-only lending ratio at the moment is around 37%, 38% that I've seen-- the most recent data that I've seen. So you could argue that going from 30% to 37%, 38% of total loan books certainly takes some of the sting out of the impact of those interest-only rollovers.

However, the average at the peak of the market was around 45%. So again, to kind of look at the data that's out there and forget for a moment the euphoria that is beginning to appear in mainstream media, I think it's really important to pay attention that we haven't gone back by any metric. We haven't gone back to the kind of euphoria in terms of lending and credit availability that we saw in 2016, in particular.

Another thing that's worth paying attention to as well, back on the provisioning and on the logic test of all this, 2.4% of National Australia Bank's lending book is currently at loan to valuation in excess of 100%. Now, their provisioning is a fraction of 2.4%. So I still ask the question, if this were such a strong recovery, why isn't the Reserve Bank tightening interest rates?

JOE WALKER: Another vulnerability in the Australian banking system has historically been the banks' reliance on offshore wholesale funding. Back in 2006, a team of IMF economists actually came down under, and the key conclusion from their report was that this was the Achilles heel in the Australian banking system. That reliance on offshore wholesale funding, was that ever properly addressed by governments and regulators in the aftermath of 2008? To what extent is that still a vulnerability?

MICHAEL SCHNEIDER: Certainly the amount of deposits that were taken post-2008 have alleviated some of that pressure, as you describe it. But again, I look at this from a second derivative perspective. And what I mean by that is that no matter what the government or the regulators or the central bank does in terms of arresting or seeking to arrest any further downturn in housing, you're going to run up against a weaker currency. So it becomes a negative feedback loop in terms of the banks seeking funding from offshore. And pound for pound, we're one of the biggest importers of banking capital in the world.

So you have that problem where should there be any disturbances in offshore funding markets, and you've got a central bank that is more than happy to use the currency as a risk shock absorber for implementation of policy, then it does put more pressure on the banks going forward-- all other things being equal.

JOE WALKER: How do you see the next 12 months playing out?

MICHAEL SCHNEIDER: Yeah, I think at least from my perspective, I think the most important piece of data to look at is whether or not the recent downturn in the unemployment rate, or at least the downturn in the employment market, I should say, is the start of another trend. So when you've had GDP growth slowing for something like the last two, three quarters-- three, four quarters-- then if that starts permeating through the labor market, then we're going to see further arrears, further delinquencies, and further foreclosures.

So again, not a lot has to go wrong, at least from here out for another 12 months. And I think it's very, very difficult to expect a nice muddle-through scenario if there's any hint of a sustainable increase in the unemployment rate.

JOE WALKER: Hypothetically, what would the Australian regulators, central bank, governments need to do to ensure that we don't see that start to arise?

MICHAEL SCHNEIDER: Yeah, I think a different way of saying the same thing is what would be the lag time of any policy responses? So remembering that unemployment is a lagging indicator and GDP growth is a lagging indicator, if you start seeing policy responses at a point where, again, it's quite paradoxical when we're talking about a housing recovery, and yet we're also talking about policy responses and declining interest rates that suggest that this housing recovery isn't really sustainable. So there's an implicit message in there, I think.

But I think the key question to ask is of any policy responses, what is the lead time before the economy benefits from any of those? So for example, you might say we might have a fiscal response, which might mean directing a lot of resources towards infrastructure to get those projects-- to get major projects up and running is not going to happen in a month or three months or four months. Those things take 18 months, two years at least.

So if the economy is going to be impaired and without a quick lead time for any policy responses-- and the quick lead time responses are typically interest rates and maybe some regulatory looseness around the edges-- but they've pretty much played those cards.

JOE WALKER: I've often said that predicting Australia's housing cycles is as much a matter of political economy as it is of economics, because there's this ironclad consensus on the part of governments and the central bank that high home prices are important. It's very hard to predict cycles when there is that sort of political environment. Not many people saw the removal of the minimum serviceability buffer by APRA, not many people saw that coming. And yet that's proved pretty crucial in this recovery.

I've just wondered if you could riff with me-- some of the different levers and tools available to pump the housing market again