Across the world, onlookers have looked with a glowing sense of schadenfreude and bemusement at the Ponzi scheme run by former Nasdaq chairman, Bernie Madoff. Upwards of $US50 billion was invested and ultimately lost by some of the world’s allegedly shrewdest investors, from Connecticut hedge funds to European banks. It eventually came to light that Madoff was paying earlier investors with new capital, the same strategy employed by the eponymous Charles Ponzi, way back in 1920.

However, before scoffing at Madoff’s investors’ misfortune, millions of Australians are participating in a Ponzi scheme of sorts – known as the property market. While not an exact replica of Ponzi or Madoff’s frauds, many investments which ignore income and hope for a subsequent capital return are, in a sense, the same thing, requiring money from new investors to provide satisfactory returns.

In the case of property, many investments are producing yields of three percent (or less in more exclusive suburbs). Why would investors purchase an asset which provides a return significantly below the risk-free rate? Only because they are hoping for a ‘capital gain’ – in other words, the hope that a bigger fool will pay even more for the same property in a few years. Even more concerning is that Australia’s property Ponzi scheme has been largely fueled by debt obtained during a period of full employment.

Property prices have already started to adjust, most noticeably, in the highest priced suburbs. The Age reported that the median price in Malvern fell by 32.5% in the past year. In neighbouring Armadale, the drop was 39.5%. Suburbs like Malvern (the home of former Prime Minister, Robert Menzies) were major beneficiaries of the property boom. In the year ending 30 June 2005, Malvern prices rose 57%. At the time, REIV boss, Enzo Raimondo, claimed that the “market was stable”.

Of course, in the eyes of the Real Estate Agents union, property prices rising in an unsustainable ‘bubble’ represent stability, while property prices falling by five percent is an irrational panic. Back in 2005, the median house price in Melbourne was $363,000 – most recently the REIV reported that the median property price was $435,000 – an increase of 20% over three years. During the same period, the All Ordinaries Index dropped by 17.5%.

In some parts, however, the Ponzi Scheme is still going strong. In the year ending September 2008, prices in North-Western suburbs like Broadmeadows and Oak Park rose by approximately 24%. These suburbs, located near Melbourne’s industrial heartland will be significantly affected by rising unemployment. Despite the ominous signs, Broadmeadows properties still yield around 4%.

Like any bubble, there are always those keen to perpetuate the myth. In an article appearing in Business Spectator, Christopher Joye, managing director of property data company Rismark, claimed that he was “amazed at the number of times individuals have expressed disbelief at the remarkable resilience displayed by the median Australian house price during the last 12 months.” Joye later noted that it is “highly misleading to presume that the experience of upper income households can be applied to the average Australian home owner as is the media’s wont. While rising unemployment will inevitably put further pressure on prices, this will be counterbalanced by 30-50% reductions in mortgage rates.” Like many living in a bubble, Joye is using historical data as a reliable indicator of future returns and significantly understates the effect of higher unemployment on property prices (the benefit of slightly lower mortgage repayments is more than offset by one’s income falling by 80% when they lose their job).

That is not to say property will never provide capital returns. Inflation alone will lead to higher property values, but ultimately, capital growth is a function of economic expansion. Since 1992, property prices have grown at a far higher rate than economic growth, largely due to increased use of debt. Instead of paying three times income for a property, Australians have been paying upwards of ten times’ income courtesy of banks’ lax lending standards and full employment.

However, like shares last year, the property bubble is starting to wobble. Property purchasers are starting to realise the game is up. Melbourne clearance rates have slipped from more than 80% to join Sydney and Brisbane at less than 50% as vendors fail to adequately lower prices to meet the market as the perfect storm approaches. Negative growth, low inflation, high unemployment and tougher lending standards mean that Australia’s residential property Ponzi scheme is about to collapse, just like Bernie’s.