Are Australian house prices set to crash?

I recently saw a movie called The Big Short.

In case you haven't see it, in 2005 an eccentric hedge fund manager Michael Burry (Christian Bale) discovers that the U.S. housing market is extremely unstable, being based on subprime loans that are high risk and providing fewer and fewer returns.

Predicting that the market will collapse sometime in the second quarter of 2007, he realizes that he can profit from this situation by creating a credit default swap market, allowing him to bet against the housing market. The market eventually does collapse in 2007/2008 and he produces a 489% profit from the plan.

So I couldn't help but see the similarities, when a hedge-fund manager and an economist who posed as a gay couple on a combined income of $125,000 recently toured Sydney's western suburbs viewing housing developments and meeting mortgage brokers to determine if there's a housing bubble.

Their conclusions are even worse than I thought.

The two were, John Hempton, Bronte Capital's chief investment officer, and economist Jonathon Tepper, founder of Variant Perception. They toured suburbs across north-west and south-west Sydney and met 20 mortgage brokers three weeks ago.

Hempton, has short positions on there being a correction in the Australian housing market, and warned of a housing correction after witnessing first hand an oversupply of houses and apartments in western Sydney and poor underwriting practices by the big banks.

Tepper in his report bluntly warns: "Australia now has one of the biggest housing bubbles in history," noting the country's real estate value to GDP is 3.8 times, compared with Ireland and Japan which were both at multiples of 3.5 times before they experienced a housing market crash.

He's predicting falls in the Australian housing market of up to 50% in Sydney and Melbourne and of about 80% in mining towns.

"Australia now has the highest level of household debt to GDP in the entire world" added Tepper. Who is also warning of a sharp fall in the share price of Australian banks.

If this is the case, it means more bad news for our four major banks National Australia Bank Ltd. (ASX: NAB), Australia and New Zealand Banking Group (ASX: ANZ), Commonwealth Bank of Australia (ASX: CBA), and Westpac Banking Corp (ASX: WBC).

As the chart below illustrates, the Big 4 have had a dreadful start to the year. All four are down considerably this year. Falls have been led by ANZ, with the highest at 20%, NAB with 18%, Commonwealth Bank with 16%, and Westpac with 14%.

So what if John Hempton and Jonathon Tepper are on to something.

It's unimaginable to think that the same thing could happen in Australia, but we should never make the mistake of thinking that it can't. After all, that was exactly the sentiment which created the US housing bust.

There are however, a couple of signs of trouble ahead.

The National Australia Bank's latest residential property survey, predicts a decline in property investment and foreign buyer activity which is expected to reduce house price growth to just 1% over the next two years.

And, we shouldn't forget that when China's credit boom turns into a bust (which it seems likely to do), it might have a significant impact on the Australian housing market.

China has already started to tighten its cash controls over the amount of money leaving the country. Individuals are restricted to moving the equivalent of US$50,000 out of the country each year. Clearly this crackdown will spill over into the Australian property market, which has seen strong price gains over the last five years as Chinese buyers moved aggressively into the market.