Friday, December 31, 2010

Australia's unhealthy dependence on China

Debate is raging over whether China's massive boom in construction and real estate -- which is fueling Australia's commodity exports -- is a bubble waiting to burst. This is a critical question, because Australia's economy has become increasingly dependent on China for growth in its mining exports. In the chart below you can see that Japan, our biggest export market for much of the postwar period, is in a slow and steady decline. In contrast, China's share of our exports is growing exponentially.


Like it or not, our economic future is now inextricably linked to that of China. China now accounts for an astounding two-thirds of world iron ore demand, around one-third of aluminium ore demand and more than 45% of global demand for coal, according to this recent paper by the RBA.  Thanks to this voracious demand, our terms of trade -- or the ratio of our export prices to import prices -- is the highest it has been since the 1950s.


But is this enormous growth in demand from China sustainable? Many economists think not. My favorite China watcher, Michael Pettis of Peking University, has been arguing for some time that China is running up against the limits of it's investment and export-led growth model, and that the days of double digit growth rates will soon be a thing of the past. In a recent blog post, he says:
By the end of next year, I suspect that the consensus will be that for the rest of the decade we should expect growth rates in the 6-7% range for China.
Pettis describes even this forecast as being "optimistic", and dependent upon China being able to maintain consumption growth of 8-9% a year. 
If GDP growth slows so substantially, it seems to me that consumption growth of 8-9% will be very hard to maintain, so I would argue that we should be prepared for even lower average growth numbers, perhaps in the 3-5% range... Non-food commodity exporters will be badly hurt.
What would the implications be of such a drop in China's growth rate? Fitch Ratings recently performed a "stress test" of what would happen if Chinese growth slowed to 5% in 2011. Their conclusions are very interesting, so I am going to quote at length from the report. Firstly, as you can see below, Fitch expects that such a growth slowdown would cause a major crash in Asian stockmarkets, and a 20% fall in commodities prices.


And which countries are most vulnerable to such a slowdown? The chart below confirms that Australia's economy is one of the most commodity-dependent in the world.


Not surprisingly, Fitch identifies iron ore exporters as amongst the biggest potential losers:
Iron ore – used as a key raw material in the steel industry – would be the commodity most affected by a slowdown, with Australian commodity producers in particular being impacted...
But perhaps the most interesting section of the report is Fitch's expectations of what would happen to banking systems and financial markets in the event of a sharp slowdown in Chinese growth. Again, I will quote at length, because some very interesting points are raised.  
It is also worth noting that the domestic banks in those overseas countries that provide financing to corporate exporters to China could face potential deterioration in the credit quality of their loan books in the event that demand for their customers’ products declined. This could affect banks in countries such as Hong Kong SAR, Taiwan, Japan, Korea and Australia.
Investor risk appetite would likely reduce, increasing volatility in financial markets and resulting in capital flight from perceived riskier assets... Certain types of asset with high levels of correlation to the China growth story could be particularly badly hit, given investors’ ongoing initiatives to gain exposure to China through indirect routes such as commodities (especially copper), correlated currencies (the Australian dollar) and equities of multinational companies with global brands and a China presence...
Fitch anticipates that a material slowdown in the Chinese economy would have a negative effect on the willingness of global banking systems to continue providing credit... Those countries with the heaviest reliance on China as a destination for exports (Hong Kong SAR, Taiwan, Japan, Korea, Singapore, Malaysia, Australia, Brazil, Chile, Peru and Russia) could potentially see a retrenchment of their banking systems, with credit availability reducing...
This impact could be exacerbated by negative developments in the real estate markets of those countries with strong trade links to China, particularly those where property prices have risen strongly over the past 12–18 months, such as Singapore, Hong Kong, Taiwan and Australia.
So let's summarize the implications for Australia of a sharp growth slowdown in China. Firstly, our miners will be heavily hit as Chinese demand contracts and commodity prices drop significantly. The Australian dollar will probably fall sharply. International investors will become risk averse, and may be unwilling to refinance the massive external liabilities of Australian banks without demanding a large risk premium. As credit dries up, Australian property prices will inevitably fall. This is an ugly scenario all round.

China's massive boost to our terms of trade has undoubtedly been a huge boon. Along with the government's massive stimulus, it helped us dodge the worst of the global financial crisis in 2008. But this once in a generation boost to our trade is not going to last forever. We could have spent the last decade prudently running large budget surpluses to create a buffer for when the boom ends. We could have invested more in infrastructure and tried to boost the productivity of the non-mining sector through economic reforms. We could have introduced a sensibly designed tax on the mining sector and invested the proceeds in a fund for Australia's future. But instead, in a decade of what economist Ross Garnaut calls "The Great Complacency", we have inflated a massive housing bubble based on an unsustainable rise in household debt, partly financed by foreign investors who will bail at the first sign of trouble.

Now, even Fitch says it doesn't expect it's "stress case" of 5% growth in China to eventuate in 2011. China's economy is still in the relatively early stages of industrialisation and it's obvious that there is still a lot of growth to come. But there are clearly limits to the pace of this growth, and the growth to come is definitely not going to be in a straight line. The question is: are we prepared for when China inevitably hits a speed bump?

Wednesday, December 29, 2010

Australian house prices are "the best"

Our cricket team might be hopeless, but when it comes to house prices, Australia is the "best in the world" The Australian says today, restoring a bit of Aussie pride. This is a curious headline, since most of us who don't already own 12 investment properties would think that having the most unaffordable housing in the world is not exactly cause for celebration. But never underestimate the ability of Australian newspaper editors to put a positive spin on anything property related. In any case, house prices rose 9.4% in 2010, the article says, citing a report from Canada's Scotiabank. Here's what Scotiabank had to say:
"Australia is the clear front-runner in 2010. Housing demand is being supported by low unemployment, while tight supply is adding to the upward pressure on prices. Nonetheless, consecutive interest rate increases by the Reserve Bank of Australia (RBA), totaling 175 basis points since October 2009, alongside the expiry of the enhanced First Home Owners Grant in January 2010, have succeeded in cooling its red-hot property market to some degree...
We anticipate a further slowing in sales and price appreciation in 2011. While Australia’s close trade ties with Asia and resource wealth will continue to underpin a solid pace of domestic activity, higher interest rates will worsen already strained affordability. The RBA has recently taken pause, but we expect the resumption of a gradual policy tightening path in 2011, with short-term rates rising an additional 75 basis points by year-end."
So here's the problem. Let's say you're an optimist about the economy and you expect that China keeps growing at 10-11% a year. Australia keeps digging stuff out of the ground and the mining boom continues. In this case, the RBA will almost certainly be forced to raise interest rates further to control inflation. Scotiabank is not alone in forecasting multiple interest rate rises next year. But higher interest rates will force already tapped out consumers to devote a greater share of their disposable income to mortgage repayments, making housing even more unaffordable.

Remember that a huge volume of first homebuyers took out their mortgages in late 2008 and early 2009 (see chart below), when interest rates were more than 1.5% lower than today. In addition to the impact on recent homebuyers, higher rates are bad for the retail sector, which is reporting the worst Christmas sales since the early 1990s. Further rate rises could also push the Australian dollar even higher, strangling tourism and other industries that are becoming increasingly uncompetitive because of Australia's high costs.

On the other hand, if the bears are right about China and the commodity boom goes bust, the biggest impetus to economic growth in Australia in recent years would suddenly disappear, sharply slowing the economy. Unemployment would rise, and many homeowners could default on their mortgages. This is an ugly scenario for the economy and the housing market.

Source: RP Data


In other words, we are walking on a tightrope with respect to the housing market, and it's very hard to envision a scenario in 2011 that's good for house prices. And with personal debt at record levels, Australian households are very vulnerable to any economic turmoil. As the RBA's Ric Battelino warned in a speech in late 2007:
...the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. This balance sheet structure is very effective in generating wealth during good economic times, but households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise. 
Meanwhile, there are troubling reports that foreign investors are growing cautious about holding the debt of Australian banks, which are reliant on offshore markets for nearly a third of their funds. Since Australian house prices continue to outpace growth in incomes, the only way they can rise further is for households to assume more and more debt. And until recently, overseas investors have been willing to indirectly fund much of this housing credit, having been sold the line that "Australia is different". But what happens when the music stops?

Put simply, despite The Australian's rosy headline, there is nothing good about rising house prices driven by massive increases in household debt. We are now in a very precarious situation, as Morgan Stanley's Gerard Minack said last August.
It was a major error by policy-makers to let this bubble inflate, in my view.  There is no value to society from rising house prices.  It is simply a wealth transfer to existing owners from potential buyers.  Pumping up house prices creates no more wealth than the RBA printing an extra six zeros on every piece of currency.  Worse, by increasing the leverage in the household sector and financial system, it increases the financial risks in the economy, as the last two years have demonstrated elsewhere.
You would think our political leaders would be urgently addressing these risks: the increasing debt levels of households, the chronic unaffordability of housing, and the dangerous reliance of our banks on overseas funding. Unfortunately, at present we have "two parties led by two political pygmies" -- as Laurie Oaks recently put it -- who continue to ignore the real issues facing our economy. And that puts us all at risk.

Monday, December 27, 2010

The cult of property

When a cult is under siege, its members tend to cling to their fanatical beliefs even more strongly than ever.  This phenomenon is in full force at the end of the year as the property spruikers that dominate Australia's media come out en masse to tell us the recent softening of the market is a huge "buying opportunity" (as I noted in my last post). Now, I don't want to waste too much more time examining these claims, but sometimes an article comes along that is just too good to pass on.

The Australian Property Investor's Michael Yardney is feeling very smug and self satisfied this Christmas season, because The Economist, Steve Keen, Jeremy Grantham, and other so called experts like the IMF told us that Australian property prices were overvalued, but "awkwardly" for these know-alls, we don't have a bubble and there hasn't been a crash! "Oops!" he celebrates in the magazine's blog.

Mr Yardney concedes that prices could fall a teeny bit in some areas, but then recites the standard mantra of population growth and housing shortages -- the same one that was popular in California in the years up to the 30% crash there -- before revealing the secret weapon in his logical arsenal.
Sure, some Australians currently have issues with housing affordability and are putting off their home buying decisions. But people still need a roof over their heads. People are still getting married and people are still getting divorced, some are having babies and others have to move house for their jobs.
So there you have it. Australian house prices must continue to grow exponentially because some people are getting married, some are getting divorced, and some are having babies. Because people don't get married, divorced, or have babies in other countries like the USA, Spain, Ireland or Japan. I'm glad he's cleared that up.

In any case, he tellingly concludes the article as follows:
Our property markets have changed – don’t expect the type of capital growth in 2011 that many of us enjoyed in the past year or two. The Reserve Bank has deliberately put speed bumps on the road. They have increased interest rates to slow our booming property markets, and to an extent the general economy, on purpose. What this means is that buying any property and hoping it will make a good investment just won’t work in this new era in property. Now is the time to buy well in areas that will outperform the averages and buy properties to which you can add value.
This is the "new paradigm" talk that Delusional Economics wrote about this week, and which we are starting to see quite frequently. When faced with evidence that prices are starting to fall in certain areas, the property spruikers are trying to reassure us that "as long as you buy in the right areas, you'll be protected from any falls, and you have nothing to worry about." Go right ahead and take out that big mortgage.

Needless to say, I think this is pretty bad advice for the average punter. How do you identify areas "that will outperform the averages"? Australian Property Investor tells us in another article that it's as simple as "concentrating on suburbs with limited supply and choosing properties that will stand up in soft and hot markets".

But if you do believe that prices are going to fall, this is not likely to give you much shelter. Evidence from other housing markets around the world suggests that in areas with "limited supply", prices tend to appreciate much faster during bubbles, and crash much more violently when housing bubbles burst (this follows from basic economic theory; see here for example). Still, Australian Property Investor is apparently preaching to the converted.

For pure entertainment value, I recommend you check out the comments from some of the property bulls on API's blog posts, in particular, this one about the attractiveness of property versus shares. API tells us that it's better to buy property than shares, because you can leverage property more aggressively, and, as we all know, it only goes up. One reader who is well and truly drinking the API kool aid even claims that property prices have doubled every 7-10 years "in the past several hundred years just about everywhere in the western world."

Because I am a masochist, I just did the calculation, and worked out that a doubling every 7 years for 300 years would mean that house prices increase by a factor of 2.6 trillion times. That sounds like an excellent long-term investment, especially if you add leverage! Speak to your accountant, because you could probably negatively gear it too.

But back on a more serious note. Luckily for us, the IMF has a fascinating chart (from this article) based on the longest study ever done of housing prices. It's a house price index for the Herengracht neighborhood of Amsterdam, and it goes all the way back to 1628. Interestingly, it shows that despite huge booms and huge busts, in the 200 year period from 1628-1828, house prices basically went nowhere. And in the 380 years since the beginning of this survey, house prices in Herengracht have only risen by a factor of 3.5. This is a much smaller number than 2.6 trillion.


Source: IMF
But this is just a small suburb of Amsterdam. Surely it's different elsewhere, isn't it? Well, funnily enough, Robert Shiller (the author of "Irrational Exuberance") has compiled a house price index for the United States that shows a similar result when looking at price trends from 1890 to today. See below.


You can see that real house prices -- or house prices after taking inflation into account -- have risen only around 30% in the US since 1890, roughly in line with building costs, which have risen not much faster than inflation. This gives you an annual real return of about 0.23% over the 120 year period. Again, you can see huge booms and busts over the years, but in the long term,  the evidence suggests that house prices generally don't rise much faster than inflation.

It's important to keep this kind of long-term evidence in mind, because it puts things in perspective. If your only experience of property investing is the past two decades in Australia, you could be forgiven for believing, that, yes, prices double every 7 years. But the past two decades was an extraordinary period that we may never see again in our lifetimes. Note that in both the series above, there are also long periods of several decades where prices are stagnant or even falling, despite strong population growth.

I'm tempted to post this on the Australian Property Magazine blog, but I'd probably be excommunicated for life. Such is the nature of cults.
----------------
UPDATE: Who Crashed the Economy has some great long-term charts for Australia too.

Thursday, December 23, 2010

RP Data: Don't worry, be happy

"It is difficult to get a man to understand something when his salary depends upon his not understanding it." So said Upton Sinclair in 1935, but the words could equally be applied to the Australian property lobby today. As the housing market starts to slowly deflate (and in some areas like the Gold Coast shows signs of serious distress), we are being reassured it's now "a buyer's market", that any price declines will be very modest, and that fundamentals such as population growth and tight supply will continue to provide support.

RP Data's "Property Outlook" for 2011 is a classic example of this "move right along, nothing to worry about, she'll be right, don't worry be happy" attitude:
A variety of indicators are now suggesting that market conditions will continue to transition in favour of buyers... Despite the fact that the Australian housing market has moved out of the growth phase, this down turn is not likely to result in any material declines in home values. 

The good news is that Australia continues to record strong population growth.  Overseas migration to Australia appears to have peaked, however total population growth remains well above average...  Such a high rate of population growth will continue to create a high level of demand for Australian housing.  Coupled with the fact that, as a nation, Australia is building too few dwellings, the undersupply of housing is not likely to be corrected any time soon...
Now, I have argued before (see this post, for example) that population growth, supply constraints, etc are -- while worthy of examination -- largely a distraction from the broader issue, which is actually very simple: Australian house prices have grown much faster than household incomes for far too long, which means that the amount of mortgage debt required by the average household to buy an average Australian house today has simply reached unsupportable levels. The logical conclusion from this is that prices have to fall -- perhaps by quite a lot -- to restore affordability.

This is the same conclusion that a lot of overseas analysts come to after a quick glance at the relationship between Australian house prices and incomes. See p. 16 of this piece, from the well respected fund manager Jeremy Grantham, for example:
The key question to ask is: Can a new cohort of young buyers afford to buy starter houses in your city at normal mortgage rates and normal down payment conditions? If not, the game is over and we are just waiting for the ref to blow the whistle. In Australia’s case, the timing and speed of the decline is very uncertain, but the outcome is inevitable. For example, the average buyer in Sydney has to pay at least 7.5 times income for the average house... With current mortgage rates at 7.5%, this means that the average buyer would have to chew up 56% of total income (7.5 x 7.5), and the new buyer even more. Good luck to them!
Grantham notes that the sheer vitriol he faces when making such arguments, is, in itself, a sign that something is probably deeply wrong:
Australia ... does pass one bubble test spectacularly: we have always found that pointing out a bubble – particularly a housing bubble – is very upsetting. After all, almost everyone has a house and, not surprisingly, likes the idea that its recent doubling in value accurately reflects its doubling in service provided, e.g., it keeps the rain out better than it used to, etc. Just kidding... In any case, Australians violently object to the idea that their houses, which have doubled in value in 8 years and quadrupled in 21, are in a bubble.
Indeed, in response to such "simplistic" arguments, the RP Datas of the world invitably become indignant and roll out the "supply shortage" cannon. This is probably the single largest enduring myth surrounding the Australian property market, and it is repeated so often that many Australians have simply accepted it as fact. For this reason, it is important to examine the merits of the argument. I am not going to go into great detail on this, because The Unconventional Economist has already done an excellent job in debunking the "housing shortage" argument here.

But a couple of quick points are in order about RP Data's claims above. Firstly, Australia's rate of population growth has slowed considerably. The political appetite for the high levels of immigration seen in recent years seems to be waning, while the number of international students entering Australia is declining sharply, partly due to the strong Australian dollar.  In fact, the number of permanent and long-term migrants coming to Australia over the year to July was down by a record 32.5 per cent (see display below).

Source: RP Data

If you believe in the argument that strong population growth supports house prices (see the chart below from the IMF) then this development should trouble you.


Secondly, while it is true that we have an undersupply of affordable housing, the argument that we are not building enough to keep up with population growth is highly suspect. The display below, from the RBA's Ric Battelino, shows that overall, the number of dwellings in Australia has easily outpaced the growth in the number of households since the mid 1980s.

Here's what Battelino had to say in a November 2009 speech accompanying this chart:
Census data show that the number of dwellings built has exceeded the increase in the number of households by a large margin. As a result, the ratio of the number of dwellings to the number of households has been rising over time; as at 2006, there were 8 per cent more dwellings in Australia than there were households. Presumably, most of this surplus reflects holiday houses and second houses.
Presumably, many of these holiday houses and second homes are also held by the baby boomer generation, which is currently entering retirement. The question is, if prices fall sharply, how many baby boomers will decide to cash in on these investments, accelerating the downturn?

When you are in the midst of a speculative boom, it always looks like there is a lack of supply. The same argument was made in many parts of the United States, Spain, Ireland, etc.  What subsequently became obvious in many of these markets was that it wasn't so much a lack of supply that was the problem; it was an oversupply of demand from speculators, or "investors".

When the good times eventually end, holiday houses and second homes will be sold, children in their 20s will move back in with their parents, foreign investors will sell their property investments as the Australian dollar falls, and the apparent "supply shortage" will suddenly turn into a glut of properties that cannot be sold.

Just don't expect RP Data to tell you this first.

Wednesday, December 22, 2010

Rent vs Buy -- (Updated with new figures)

As auction clearance rates plummet around Australia and the inventory of unsold properties continues to rise, in 2011 we are no doubt going to be told by the spruikers that it is an "excellent time to buy". So let's revisit the question of whether it makes financial sense to buy at today's prices versus renting an equivalent property.

For today's experiment, I have randomly chosen a $685,000 property in inner Sydney that is listed on realestate.com.au. "Perfect for a single person or couple looking to live the life of luxury and convenience", the unit below is currently being rented out at $750 a week.
Let's compare buying the property with a 20% deposit, and renting, in which case I will assume you invest any savings you make relative to buying and earn a rate of return of 5% (I think this is reasonable for a portfolio of cash, bonds and diversified shares, including overseas exposure).

Now fortunately, the New York Times website has an excellent tool which gives us a graphical representation of the rent vs buy scenarios over time. (you have to tweak the Advanced Settings to account for tax differences in the US and Australia. Contact me if you are interested). Let's say you're a housing bull, and you think prices are going to rise at 6% annually for the term of your 25 year loan. Here's what you can expect below:


You can see that I've plugged in the current standard variable mortgage rate of 7.8%. Now, you might argue that you can get a better deal than this today, and you probably can. But remember that for the purposes of this calculation we are trying to guess what the average mortgage rate is going to be over the 25 year life of the loan. I don't have the data at hand, but the historical average is much higher than the current 7.8%, so I am actually being very generous to buyers in the calculation here.

You can see that in the case above, the buyer will break even with the renter after 6 years, and after 30 years, be around $55,000 better off. So it looks like a pretty good investment.

But how realistic is 6% annual growth over the coming two decades? I would argue that this projection is a total fantasy (see my previous post for more on this). So what if we get 4% annual appreciation, which would bring the long-term appreciation in house prices down to a similar growth rate as household incomes. Let's take a look:


It now takes 19 years just to break even with the equivalent renter. And 4% annual growth for the next 25 years is in my view, still rather bullish. What would happen in a scenario where prices appreciate at a modest 2% pace over the next 25 years, slowly restoring affordability relative to incomes?

It now takes almost three decades for the buyer to break even with an equivalent renter. Finally, let's take a look at the bear case of 0% appreciation.






Obviously, this final case is a total disaster for the buyer.

Now, a few final observations are in order:
  • These calculations assume that if you rent, you actually have the discipline to invest any savings you have made relative to buying. If you are the kind of person that is likely to spend all these savings at the pokies, it might still be better to buy.
  • The outcome of these calculations is highly sensitive to the assumptions for the rate of capital appreciation, rate of annual rent increases, rate of return you can earn on your savings, etc. Plug your own numbers in if you don't agree with my assumptions. This is just a rough reality check -- one that in my observation not enough home buyers perform.
  • This is not financial advice and the decision on whether or not to buy depends on your individual circumstances. There are good reasons to own a house, particularly if you have a family and want the stability that a permanent dwelling provides; this, however, is a separate question from whether or not this is likely to prove a good investment at today's prices.
Cheers and Merry Christmas!
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Note: The figures in this post have been updated. I have had a couple of questions from readers about whether or not the calculations assume a FHB grant. I didn't assume that initially, but it is now included. I also corrected the monthly rental figure and have assumed a long-term inflation rate of 2.5%, the midpoint of the RBA's target range. Strata fees of $2000 p/q are also included, as well as utilities, maintenance costs, etc.

Monday, December 20, 2010

Heart attacks and housing bubbles

I was rereading Malcom Gladwell's "Blink" this week, and it occurred to me that his theory of "thin slicing" is an interesting way of looking at Australia's housing bubble. For those that haven't read the book, Gladwell's main argument is that in a wide range of fields -- from psychology to police work -- we can often make better judgments by training our minds to instantly focus on the most relevant facts—and that less input (as long as it's the right input) is often better than more.

One of Gladwell's examples is a cardiologist named Lee Goldman, who has developed a decision tree that, using only four factors, evaluates the likelihood of heart attacks much better than most trained cardiologists in emergency rooms. When a patient walks into an emergency room complaining of heart trouble, the typical cardiologist, says Gladwell, will logically and systematically find out as much about the patient as he can in order to make a quick diagnosis. Is the patient under stress? Does he smoke? Does he exercise? Is he overweight? Does he have a history of heart trouble? But interestingly, Goldman's research suggests that most of this information is next to useless.
All you need is the evidence of the ECG, blood pressure, fluid in the lungs, and unstable angina....that extra information is more than useless. It’s harmful. It confuses the issues. What screws up doctors when they are trying to predict heart attacks is that they take too much information into account.

There are many more interesting examples in the book about how experts can often go badly wrong by trying to take too much information into account, thereby losing the forest for the trees. Now, before you wonder where the hell I am going with this, the IMF's recent report on the Australian housing market strikes me as a classic example of the exact phenomenon Gladwell is taking about. Confronted with overwhelming evidence that Australia is in the midst of a massive speculative housing bubble -- and an army of property lobbyists and government officials in denial about this patently obvious reality -- after taking all the evidence into account, the IMF has concluded that the massive rise in Australian house prices is mostly explained by fundamentals.

Like the clueless emergency room doctor, the IMF has ignored the patient's vital signs -- in this case, simple metrics like the amount of mortgage debt to GDP or the price of housing relative to median incomes -- and instead devoted all its time to examining a number of extraneous factors such as interest rates, the terms of trade, and population growth. Meanwhile, the patient is having a coronary.

So, in the spirit of Gladwell, let's forget about Australia's population growth, supply constraints, the mining boom, low interest rates, platypuses, and Kevin Rudd's hair, and focus on what's REALLY important in determining whether the current level of house prices is justified. The key determinant of affordability in housing is the relationship between prices, rents, and incomes. In fact, you could go so far as to argue that nothing else really matters all that much.

Why? Because houses are financed primarily by borrowing, and these mortgage loans have to be serviced out of people's income. If house prices grow faster than incomes for an extended period of time, then eventually, the amount of debt required to finance the purchase of a home becomes unsupportable. Simple as that. The result of this is that prices inevitably crash. Similarly, if house prices are growing faster than rents for an extended period, as they have been in Australia, buying will become increasingly unattractive relative to renting over time, until we reach a tipping point, and, again, the market crashes.

Now, as Keynes once said, the market can stay irrational longer than you can remain solvent. But it is clear that over the long-term, the relationship between incomes, house prices and rents inevitably reverts towards an equilibrium. Like the price-to-earnings ratio in the stock market, the median house price-to-income ratio, and the price-to-rent ratio will not tell you when a bubble is going to burst. But in the long term, they act as a pretty reliable anchor for prices.

See the chart below from this article by the IMF's Prakash Loungani.


So how far out of whack are prices in Australia? In the chart below, again from the IMF's Prakash Loungani, you'll notice that at the end of 2009 Australian house prices were more than 70% overvalued according to the long-term price-to-rent ratio, and almost 50% too expensive according to the price-to-income ratio.



Interestingly, according to the price/income metric, US housing is now "fairly valued" -- which is consistent with anecdotal evidence that prices in many US cities appear to be finally bottoming.

Source: Calculated Risk

Now, in response to such a simple argument, the property spruikers will no doubt try to bamboozle us with reams of statistics about supply shortages, population growth, and so on and so on. But again, none of those "fundamentals" really matter if households are already tapped out with too much debt to force prices any higher.

If you really don't think price-to-income ratios are important, and that there is still room for growth in Australian house prices, lets perform a quick reality check with the chart below.

This chart forecasts the future path of the price-to-income ratio in Sydney (currently the world silver medalist at 9.1) for various scenarios of capital appreciation over the coming two decades. You can see that if house prices were to continue growing at 8%, by 2030 the median house would cost almost 20 times the median income. Just for perspective, this is equivalent to having to pay $2 million for a house if you make $100,000 today. Clearly a financial impossibility.

If we assume annual wage growth of 4%, then 4% annual price appreciation over the coming two decades -- which many investors would probably regard as a poor result -- would merely preserve the current state of hyper unaffordability. In fact, to get the price-income ratio back down below a reasonable level of 3 would require average annual price declines of 2% for the next two decades. How many negatively geared investors are prepared for this type of scenario?



Yes, I think the patient is having a heart attack.

 

Saturday, December 18, 2010

From IMF lunacy to the Wall St whitewash

There have been a number of interesting articles and papers on the web over the past week that I've been meaning to comment on, but don't have time to go into detail on. Here's a selection below. 

What Drives House Prices in Australia (IMF)
Some of you may recall that the IMF's Prakash Loungani warned back in March that Australian housing prices were massively out of line with fundamentals (when measured by historical price/income and price/rent metrics). This mild statement provoked a storm of indignation from the Australian property lobby -- and consternation from Treasury and the RBA -- who argued the IMF wasn't taking into account that "Australia is Different". Low and behold, Loungani has apparently been banished to the Siberia bureau and after some "valuable suggestions" from Australian Treasury officials the IMF has come out with a new study that says Australian house prices are only overvalued by 5-10%. The IMF cites a number of fundamental factors such as the terms of trade boost from China, population growth, and "permanently lower nominal interest rates since 2000", but curiously, devotes little space at all to the possibility that some, if not all, of these conditions could be reversed.

Citizens awake and cast ye off the chains of home ownership
Somehow I missed this one, but it is currently the most commented story in The Age. In a refreshing departure from the kind of garbage that is served up on a daily basis by Australia's newspapers on the property market, economics writer Jessica Irvine writes:
I have a confession to make, one I fear will exclude me from every dinner party conversation in Sydney and forever mark me as deeply un-Australian. Here it is: I don't desire to own property... it's time to stop treating houses like a casino, throwing money in on the bet that house prices will go up. Investing in property serves no real productive purpose, in the sense of creating income and improving living standards. It just transfers wealth from young purchasers to older sellers....
Society would be better served if we invested our savings in shares - which companies use to invest and expand jobs and incomes. Or if we just invested them in the bank, earning a modest return of 5 per cent a year or so, and the bank could lend that finance to a entrepreneur to invest in new ideas and technology.
Predictably, Jessica's story touched off a firestorm of intergenerational warfare in the comments section, with many young folk in complete agreement, and older property owners making moronic statements such as: renters are suffering from a "typical victim mentality", are destined to become "impoverished pensioners", and are unable to save enough to buy because "the price in self discipline is just too high". Highly amusing stuff.

Newly Built Ghost Towns Haunt Banks in Spain 
An interesting story in the New York Times about the implosion of Spain's real estate market, especially in light of this recent report in Business Insider on China's empty ghost cities.

Wall Street Whitewash by Paul Krugman
An angry piece from Paul Krugman in the New York Times about the pitiful state of financial reform in the USA.
The bipartisan Financial Crisis Inquiry Commission was established by law to “examine the causes, domestic and global, of the current financial and economic crisis in the United States.” The hope was that it would be a modern version of the Pecora investigation of the 1930s, which documented Wall Street abuses and helped pave the way for financial reform... Last week, reports Shahien Nasiripour of The Huffington Post, all four Republicans on the commission voted to exclude the following terms from the report: “deregulation,” “shadow banking,” “interconnection,” and, yes, “Wall Street.”
Unbelievable. You can't make this stuff up. 

Wednesday, December 15, 2010

The Perils of Interest-Only Morgages

A quick follow up to my previous post. Via The Economist, the Federal Reserve Bank of Chicago has an interesting new paper suggesting that interest-only mortgages were the key means through which participants in US housing markets speculated on rising prices. Do not attempt to read the whole thing unless you are a total masochist; it's very dense and full of equations. But here's a bit from the abstract:
We describe a rational expectations model in which speculative bubbles in house prices can emerge. Within this model both speculators and their lenders use interest-only mortgages (IOs) rather than traditional mortgages when there is a bubble. Absent a bubble, there is no tendency for IOs to be used. These insights are used to assess the extent to which house prices in US cities were driven by speculative bubbles over the period 2000-2008.
We find that IOs were used sparingly in cities where elastic housing supply precludes speculation from arising. In cities with inelastic supply, where speculation is possible, there was heavy use of IOs, but only in cities that had boom-bust cycles. Peak IO usage predicts rapid appreciations that cannot be explained by standard correlates and this variable is more robustly correlated with rapid appreciations than other mortgage characteristics, including sub-prime, securitization and leverage.
So what does this mean in simple English? Essentially the researchers are saying that the prevalence of interest-only mortgages is THE key predictor of rapid price appreciation in housing markets, and is fact is an even stronger predictor than other factors such as the amount of subprime loans or measures of leverage such as LVRs. 

Needless to say, this is a pretty interesting result in light of the popularity of this type of loan in Australia. Again, here's the chart from Westpac that I displayed in my last post:

Source: Westpac




As you can see, around 30% of owner occupier and 50% of investor loans in Australia are interest only. If this isn't evidence of a speculative bubble, I'm not sure what is...

More from the paper on interest only loans:
Lenders prefer these contracts because they preclude the borrowers from gambling at their expense for too long, given that speculators will be forced to sell the asset once payments rise (or else refinance with another borrower if possible). At the same time, borrowers prefer these contracts because they can defer building up equity in what they know is a risky asset, leaving them with the option to default on all of the principal they borrowed should the prices collapse early. 
As I said in my last post, this is essentially a giant ponzi scheme, where borrowers are relying on the notion that prices can only go up, and that when the loan resets, they will easily be able to refinance. Not surprisingly, the researchers at the Chicago Fed found that the prevalence of interest-only loans was not only highly correlated with big price volatility on the way up, it was also correlated with volatility on the way down when prices started to decline and everything went pear shaped.
So far, our results show that the use of IOs appears to be strongly associated with rapid house price appreciation before house prices peak. However, the model would suggest that the use of these mortgages would also be associated with rapid declines in house prices if and when house prices collapse... we find a similarly strong correlation between the share of IOs and the decline in house prices following the peak to the one we found for house price appreciation. 

As The Economist says:
...the question for the peanut gallery is this: if IO mortgages are most commonly associated with bubble markets, and correlated with rapid price increases, are a means to bet on the continuation of those increases, and are therefore more likely to end in default, should they be allowed? Should users of interest-only loans be able to receive the same homeowner subsidies as other kinds of borrowers (assuming the subsidies aren't scrapped entirely, as they should be)?
Hear hear.

Our "Responsible" Lending Standards

How many times have you heard the robotic mantra that Australian banks are the model of probity and have not engaged in any of the risky practices seen in the USA and other countries where housing bubbles have burst? An article by Tim Colebatch in The Age nicely encapsulates this standard narrative of the Australian housing market, which is accepted as gospel by almost the entire mainstream media.
...unlike most in the West, Australia's banking system did not collapse in the global financial crisis. That's partly because the Australian Prudential Regulation Authority did an outstanding job as our watchdog before the crisis. It's partly because the government moved in the heart of the crisis to guarantee the banks' debts and deposits. But it's also because our banks were prudent and sensible lenders, when their overseas counterparts were not.
The global financial crisis began when this market was poisoned by American banks filling their securitised bundles with bad mortgages. As they went bad, the market for securitisation collapsed - even for Australian lenders, whose bundles remain good. And as it collapsed, so did the new lenders...
Is this indeed the case? Or is it just that the chickens haven't yet come home to roost? From a macro viewpoint, the amount of mortgage debt in the Australian economy is at unprecedented levels. In fact, it is higher than the USA, as the chart below from Steven Keen shows.

Source: http://www.debtdeflation.com/blogs/


Is it really plausible that all of this lending has been responsible? And is there an Australian version of the Mexican strawberry picker in California on a $14,000 salary who was given a $724,000 mortgage? (see The Big Short by Michael Lewis).

Maybe not, but let's take a peek inside a recent large RMBS deal. Last week Bendigo and Adelaide Bank priced a $1 billion issue, in which our very own AOFM invested more than $400 million of taxpayer money. The deal structure is below. Now, I don't intend to do a full primer on how RMBS works here, but a little explanation is in order.
 
Class A1 AAA $250m
Class A2 AAA $150m
Class A3 AAA $130m
Class A5 AAA $395m
Class AB AAA $45m
Class B1 AA- $20m
Class B2 n/a $10m

Essentially what Bendigo and Adelaide Bank have done is bundle together around 4,000 mortgage loans and slice and dice them into several classes of residential mortgage-backed securities (RMBS), which are collateralised by the loan assets. The interest and principal payments on the underlying bonds flow through to the investors in the securities. You can see that the top 5 classes of bonds are rated AAA by the ratings agencies, indicating that they are the very safest of investments. But in fact, these five classes all have very different risk profiles.

The top rated AAA note, class A1, has first priority on any cashflows -- therefore it is the safest investment and carries the lowest yield. The cashflows flow down the structure in a typical "waterfall" fashion, next to the A2, then the A3, etc etc. If there are any defaults in the pool, then losses are absorbed by the LOWEST noteholders first. In this case, just $10m of loan losses -- or 1% of the total mortgage pool -- would be enough to wipe out the entire investment of the B2 noteholders.

Now, the AOFM invested $395m in the Class A5 Notes and $20m in the Class AB Notes. As you can see, these are the two lowest rated AAA tranches. In fact, the AB notes have just $30 million in notes beneath them in the capital structure, meaning that a 3% loss in the pool and they are starting to suffer losses. So how the hell are these lower tranches still rated AAA? And why the hell is the AOFM investing taxpayer money in them?

Ratings agency S&P, which has an impeccable record and has never been wrong about anything, says its ratings on these notes are based on the following:
-- Our view of the credit risk of the underlying collateral portfolio;
-- Our view that the credit support for each class of notes, which comprises both note subordination and mortgage insurance covering 100% of face value of all loans, accrued interest, and reasonable costs of enforcement, is sufficient to withstand the stresses we apply;
So there are two parts to this. Firstly, S&P is judging that the underlying portfolio of loans is of very low risk. According to this source, the average "seasoning" of the loans is 43 months and the LVR of the pool is 64.9%.  So far so good. However, it should be noted that low LVRs tend to give a false sense of comfort during property booms, since the denominator in the calculation is inflated due to overvalued house prices. If prices were to collapse, LVRs will shoot through the roof.

Nevertheless, the most interesting thing here is that an astonishing 27.4% of this portfolio is concentrated in interest-only loans of up to 10 years (ie are not repaying any principal at all). For an excellent account of the kind of disaster that likely awaits many of these borrowers when house prices fall, read this article in the New York Times. And if you think this Bendigo/Adelaide Bank deal is an anomaly, see the chart below from Westpac. It shows that close to 40% of owner occupier loans in Australia are interest only, low-doc or nonconforming. Amazingly, half of investor loans are interest only. As many others have noted, this is nothing more than a giant ponzi scheme based on the notion that prices can only go in one direction -- up.


Source: Westpac

But I digress. Let's return to S&P's view of the Bendigo/Adelaide Bank mortgage pool. The key here is the statement in bold. Essentially, S&P (and Moody's) is comfortable rating these bonds AAA because the principal and interest payments on the loans are 100% insured -- in this case, by Genworth Financial and QBE.

Now this is very curious, because some of you may recall an American company called AMBAC. Or another one called MBIA. But more on that and the dark art of bond insurance in my next post some time soon...

Sunday, December 12, 2010

My Name is Bond. Covered Bond.

So, Wayne Swan's blueprint for "A Competitive and Sustainable Banking System" is out.  There is much to discuss in the plan -- which I regard as mostly a misguided distraction from the real issues -- but today I would like to focus on one element in particular: the government's plan to allow banks, credit unions and building societies to issue "covered bonds".

Now, this development was well flagged in advance and has already generated much consternation amongst some bloggers, see here for example.  But in order to examine whether or not letting Australian banks issue covered bonds is a good idea or not, a bit of background is first in order.

So what the hell is a covered bond? Firstly, it is not some newfangled instrument of financial destruction like a SIV, a CDO, or, god forbid, a "synthetic CDO squared". Covered bonds were first issued in 18th century Prussia, and today, are the main source of housing finance in Europe, with some 2.4 trillion euros of outstanding issuance as of 2008.

In essence, they are corporate bonds that are secured, or "collateralized", by a pool of assets -- usually mortgages. Covered bonds have become very popular with investors because of their perceived safety. Unlike the "originate and distribute" model of mortgage-backed securities, in the case of covered bonds, banks must keep the mortgage loans on their balance sheet and hold capital against potential losses. If the bank goes under, the pool of loans is "ring fenced" from the issuer's other assets, and reserved exclusively for paying any obligations owed to the covered bondholders.

To protect the interests of investors, the pool of mortgage loans is typically "overcollateralized" -- ie in many cases, the pool value is required to be 105% of the outstanding bond liabilities. Furthermore, the LTV of the pool (in Europe, usually a maximum of 80%) must be maintained by the issuer. This means that the underlying properties must be regularly revalued, and the pool has to be updated to maintain its credit quality: ie any nonperforming loans must be quickly replaced with sound ones.

Because of the on-balance-sheet nature of the mortgage pool backing covered bonds, in theory banks have a greater incentive to lend prudently as they are not simply slicing and dicing their loans into RMBS and flogging them to the next greater fool as under the failed securitization model. In short, there is a lot of built in protection for the investors of these bonds.

So let's look at the positives and negatives as this all applies to Australian banks. From the issuer's perspective, the ability to issue covered bonds opens up a new source of relatively low cost funding in a variety of maturities. To the extent that this reduces the unhealthy dependence of Australian banks on overseas funding, it is a positive.

But there are some major problems. When a bank becomes insolvent, depositors are supposed to have first claim on a bank's assets. But if an institution has issued covered bonds, the size of the pool available to bail out depositors and other creditors is reduced. The bondholders have to be paid out in full, even if that means there isn't enough left over to cover all the depositors. Now, as in most countries, in Australia the government insures deposits to help prevent bank panics.

What this means is that effectively, covered bonds shift risk to the deposit insurer -- and ultimately the taxpayer -- in order to protect the interests of the covered bondholders.

In most countries, there are regulations to ensure that taxpayers are protected from this risk. For example, to make sure that all the high-quality assets are not promised to covered bondholders -- with only the poorest-quality assets left to pay off the depositors -- the US deposit insurer, the FDIC, has recently mandated that the share of covered bonds in an institution’s total liabilities cannot exceed 4%. Furthermore, the LTV of loans in the pool is capped at 80%.

In the draft of its plan, the Australian Treasury attempts to reassure us with the following words:
Australian depositors will continue to have absolute certainty over their deposits under the Financial Claims Scheme, which is a permanent feature of Australia's banking landscape.
The Financial Claims Scheme also allows the Government to levy the banking industry to recover any taxpayer money used to pay depositor claims in the very unlikely event an institution fails and selling its assets does not recover taxpayer funds in full. This means Australian taxpayers will continue to be fully protected.
The Treasury will also consult on the appropriate level of cap to be placed on covered bond issuance for individual institutions, for example five percent of an issuer's total Australian assets. This will ensure a substantial buffer of assets to cover depositor claims, making it extremely unlikely that a levy under the Financial Claims Scheme would ever be needed.
The first thing that worries me about this text is that I see nothing about the required credit quality of the pools. Will they be limited to an LTV of 80% or below, as is the practice in Europe and now the US? If the eligibility criteria for the Australian Office of Financial Management's RMBS purchases (95% LVR; $750,000 loan size) is anything to go by, we could be in very big trouble indeed. Secondly, this Business Week article about the newfound popularity of covered bonds in the US identifies another major risk.
FDIC Chairman Sheila C. Bair is aware of the threat of covered bonds to her insurance fund, so she has decided that the FDIC won't allow covered bonds to exceed 4% of bank liabilities at first. Trouble is, that low ceiling prevents covered bonds from making a meaningful contribution to mortgage availability. So count on it: If covered bonds catch on, there will be political pressure to increase that ratio, allowing more bank assets to be encumbered, and thus beyond the FDIC's reach. 
No doubt covered bonds will prove popular with both banks and investors in Australia, too. Will policymakers be able to resist calls for a relaxing of any ceiling on their issuance?

And finally, if you are a foreign investor holding existing Australian bank debt today, wouldn't you suddenly be demanding a higher risk premium, since any surge in covered bond issuance effectively subordinates your claims?

In summary, compared to the old "originate and distribute" model of securitization, covered bonds have some attractive properties, both for banks and end investors. They could also increase the stability of our banking system by diversifying the banks' funding sources. But there are some serious questions to be asked about the risks involved. If the eligibility criteria and ceiling on issuance are not conservative enough, we are creating a major risk for taxpayers.

Can we really expect the government to get these details right? I for one am very sceptical. 

Saturday, December 11, 2010

Strategies for the Property Plunge (Dumb and Dumber version)

If you are looking for some incredibly stupid investment advice, you probably can't do much better than this recent article in The Australian. It's a perfect example of how 99% of the property market coverage in Australian newspapers is utterly useless, deluded, and in fact, quite dangerous.

The title, "Strategies for the Property Plunge", is at least promising, and makes one think the author might go out on a limb and suggest that maybe, just maybe, the forces of gravity have not been suspended down under. But of course, you would be wrong. Instead, we are treated with a deluge of advice from four property "experts" that verges from the sublime to the ridiculous.

This advice purports to cater to a range of investor types including "risk averse", "adventurous" or "patient" -- and mysteriously recommends buy, buy, and buy for all these cases respectively. The first strategist, who shall remain unnamed (and has written a book titled something like "How to Grow a Bazillion Dollar Property Portfolio in Your Spare Time Without Even Trying") says the investor has to "get his foot into the market". He then offers the following sublime piece of advice.
I suggest our investor use $40,000 to $45,000 of their money to put down as a deposit and borrow the balance of their investment purchase, using a loan-to-value ratio [LVR] of 90 per cent. They can do this by using lenders mortgage insurance [LMI] —a one-off premium that allows you to leverage money better.
If there is in fact a "property plunge" coming -- which the article suggests in its headline -- then how could it possibly be sensible advice to leverage oneself up to the hilt to buy an overvalued illiquid asset? With a 90% LVR, just a 10% price decline and you've wiped out your entire equity in the property.  In any case, the article continues with some even more ludicrous advice from the "experts"...
Karin Mackay of Australian Property Buyers advises our investor to buy into suburbs with an average of 10 per cent capital growth over the past 10 years... ‘‘When we look at the growth Melbourne has experienced, the suburbs that haven’t [achieved] an average of 10 per cent per year for the past 10 years will probably never achieve an average of 10 per cent,’’ she says. ‘‘Capital growth grows the wealth, not the rental income"
I'm not even sure where to start with this one. It's a bit like if someone had told you at the height of the tech bubble "only buy internet stocks that have grown 100% a year for the past three years. Forget about all those boring companies, that, you know, actually make stuff. They've never grown as fast as the dot com companies and they never will."

In other words, Karin Mackay is advising people to buy into the most overheated and overvalued areas, because, by jolly, if house prices in these areas have grown at 10% a year for the past 10 years, then why can't they continue growing at that rate for another few millenia? The sheer stupidity of this advice is mind boggling.

The article ends, almost sheepishly, with something that at least approaches sanity -- advice to save up more for a larger deposit and "wait like a tiger in the grass" for prices to fall further. However, this piece of advice still doesn't get to the real issue, which is not surprising since the authors of these articles only talk to "experts" who are hell bent on lining their pockets by flogging us more property.

The problem, of course, is that the entire premise of this article and most of the property investment advice in Australia is completely wrong. The question is not WHAT and WHERE to buy. It is WHETHER OR NOT to buy. As I have argued before, at current prices in Australia, it is very difficult to envision a scenario in which you will be better off buying than renting, even over periods of a decade of more.

Have you ever read a financial expert in The Australian advise people to rent instead of buying, and park their savings in a term deposit that gets you close to 7% entirely risk free? No. Instead, the "orthodoxy" is to tell people to spend years scrounging up enough money for a meagre deposit, and then leveraging this amount up to the moon in a single, highly illiquid asset that is overvalued by 30-50%.

Take anything you read about property in an Australian newspaper with a grain of salt. Read this, this, or this instead.

Monday, December 6, 2010

Property for Pensioners

Another day, another ludicrous article about property in a major Australian newspaper.
Today, the Australian's Jackie Hayes tells us how "cash-laden self-managed superannuation fund investors are taking advantage of streamlined borrowing laws and clever gearing strategies to invest in property."
"We have a lot of clients who want to borrow [within super] and specifically borrow to buy real estate," says Bryce Figot, a senior associate at SMSF specialist law firm DBA Lawyers. Figot says demand for the service has grown rapidly since 2007 when laws were first introduced allowing gearing to be used in superannuation to buy standard assets such as property and shares, but also possibly art and collectables.
The latest Australian Taxation Office figures illustrate how quickly property investments within SMSFs have risen, with $58.4 billion invested in domestic real property at June 30 compared with just more than $30bn in the sector only two years ago.
Very interesting. Now, at this point Ms Hayes could perhaps have enlightened us as to what Mr Figot's views are on the appropriateness of investing one's retirement savings in property just as the market appears to be on the verge of a major collapse. Or perhaps she could explore the appropriateness of a government policy that encourages Australians to leverage up their retirement savings in a massive gamble on an overvalued and illiquid asset class. Or, god forbid, she could actually talk to an academic or somebody without a vested interest in selling us property.

But no. Instead, she breathlessly rushes on, quoting Mr Figot further.
Australians have always felt comfortable borrowing to own property, and "that great Australian love of real estate definitely continues in the SMSF environment", Figot says.

The vast majority of his firm's clients - about 95 per cent - are choosing to leverage into property in preference to shares.

"Property has produced great returns over the years while the share market has had mixed results, to say the least," Figot says.
One wonders if Mr Figot has heard of the saying "Past performance does not guarantee future results." This is the classic mistake made by novice investors, who have rushed in to buy at the peak of every bubble in financial history -- from tulip mania to the tech bubble -- based on the idea that XX asset class has "produced great returns over the years" and so will continue to do so for perpetuity. But there's no time to explore this. The Australian's Ms Hayes is wheeling out another expert to enlighten us on the wisdom of highly leveraged property speculation with one's retirement savings.
...we continue to be more comfortable leveraging into bricks and mortar than into shares or other sorts of investment, financial planning advisory group Strategy Steps director Louise Biti says.

"So people will go out and borrow $100,000 to buy an investment property but they won't go out to borrow $100,000 to invest in shares," Biti says.
Finally, in a warning that is about as forceful as being smacked across the head with a dandelion, Ms Hayes concludes the piece with a reminder that gambling your retirement savings on leveraged property is possibly, just maybe, not necessarily always the best idea.

Are you still feeling relaxed and comfortable?

It's even worse than I thought.




Thursday, December 2, 2010

Can the government stop the bubble from bursting?

Houses and Holes has another excellent post today on Wayne Swan's new plan to create a "fifth pillar" of the banking system. I'd urge you to read it in full, and am in agreement that this latest salvo from Captain Swan amounts to nothing but kicking the can down the road without addressing the real issues, which include the banks' unhealthy reliance on offshore wholesale funding. But what struck me was this insightful comment on the post by "rht":
I would agree that it is a victory for the banks and equally so for Black Swan and the Government. The last thing they want is a significant drop in house prices whilst they are in power as it would certainly cause them to lose the next election.

They know that policies such as this only " kick the can down the road" and indeed will make the eventual collapse in house prices that much worse. However they hope that they will have had a good few years in government by then and that it will then be someone else's problem. I have for some time thought that house prices will only significantly decline here in Australia when the Government and the banks no longer have any say in the matter due to external factors /events such as a significant China slow down.

In the meantime they still have plenty of ammunition in their locker in addition to the policy announced today: lower interest rates (why not ZIRP for Australia ?), covered bonds, renewed and increased grants for first time buyers, more tax breaks for investors, abolishing stamp duty and capital gains tax (causing lower govt revenues yes but who cares about balancing the budget when the property ponzi needs to be propped up for as long as possible) and they are no doubt thinking up other policies at this very moment. 
Now I have a lot of sympathy for these views and am in full agreement that the Australian government may THINK it can continue to kick the can down the road, but the question is whether or not this will be possible. Contrary to popular belief, most investment bubbles eventually collapse under their own weight, and do not need an external trigger. This is an issue I would like to write about some time soon.

In any case, let's take a quick look at the experience of the US, where an extraordinary raft of measures have been taken in a desperate attempt to reflate the economy and housing bubble, all with little success:
  • The Fed slashed interest rates from 4.5% to zero 
  • Government takeover of Fannie Mae and Freddie Mac, the country's two biggest mortgage lenders
  • Two rounds of quantitative easing, including the Fed's direct purchase of $1.25 trillion (yes you read that figure correctly - almost 1.5 times Australia's GDP) in agency MBS
  • Introduction of a new $6,500 tax credit for home buyers purchasing a principal residence (recently expired)
  • The introduction of HAMP, a loan modification program designed to reduce delinquent and at-risk borrowers' monthly mortgage payments. 
I'm sure this is not an exhaustive list. But let's take a look below at what US house prices have done in the meantime. At the very least, this should make you think twice about the Australian government's capacity to dig us out of the hole we are in.

Tuesday, November 30, 2010

When the facts change, I change my mind. What do you do, sir?

It's fascinating to observe the slow but steady deterioration in sentiment amongst Australian property bulls in recent weeks, as the evidence mounts that we are headed for serious trouble.

However, not all the property bulls are finding it easy to let go. Which brings me to this highly amusing article in Domain's "Investor Centre" blog titled "Bubble Trouble - How Certain Are You?". In a truly rambling 1,100 word missive, "property journalist" Chris Vedelago says that he's "not convinced" that we are in a property bubble, or that the bubble is bursting.

In a stunning display of logical jujistu, the author argues:
  • Most of those predicting trouble today are the same people who predicted the property market would crash during the GFC. 
  • The property market didn't crash during the GFC. 
  • Therefore we should take a close look at the "motives" of anybody who thinks we are in the midst of a property market bubble today. 
  • Oh, I'm open to being convinced I'm wrong but don't tell me what a hedge fund operator has to say.
I'm not even sure where to start with this one. I don't think I need to repeat that the Australian housing market only survived the GFC thanks to massive government intervention. It's truly difficult to contend with this sort of contorted logic. Vedelago's argument is like saying that if a Qantas A380 with an exploding engine manages to land safely, the plane must be airworthy, so no further investigations are necessary.  Anybody who predicted that the plane might crash has suspect motives and should not be listened to.

I also find it highly amusing and ironic that Mr Vedelago impugns the motives of property bears, who truly have nothing to gain from a crash, while ignoring the massive vested interests of the spruikers who continue to insist that we are not in a bubble.

And finally, the author's silly swipe at hedge funds is totally misplaced. Contrary to popular belief, hedge funds are actually in the business of making money. If you read Michael Lewis's excellent account of the US subprime crisis, The Big Short, you will see that it was hedge funds, not real estate agents or "property journalists", who were among the few to correctly forecast the US housing collapse.


After another weekend of dismal auction results around Australia, the probability is growing that we are entering a prolonged slowdown in the property market, if not a crash. To paraphrase John Maynard Keynes, I would like to say to Mr Veledago, "When the facts change, I change my mind. What do you do, sir?"

Thursday, November 25, 2010

Sheltering your investments from the storm

In an earlier post, I examined the "rent vs buy" conundrum and came to the conclusion that -- after making conservative assumptions about the future path of house prices in Australia -- it makes little financial sense for most people to buy property at current valuations. 

As I said back then, many people forget that there is a huge opportunity cost involved in buying property. If you have $100,000 for a deposit, you could invest that money elsewhere for a potentially higher rate of return and lower level of risk. But there's a problem here. If you do expect the housing bubble to burst, you have to expect that there will be significant "collateral damage" in the economy and other asset markets.

So where should you park your money?

Burton Malkiel, the Princeton professor and author of "A Random Walk on Wall Street" has an interesting opinion piece in the Wall Street Journal about the benefits of diversification and "staying the course" in times of market volatility. Consider the chart below:


Now this article is written from the perspective of a US investor, but Malkiel shows how in one of the worst decades for stocks in memory, if a US investor had been well diversified and owned a well balanced index-fund portfolio of bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities, he or she would have actually done quite well.

Now I have no particular disagreement with the point that Malkiel makes. But I have to wonder if such a simple approach to diversification is going to work in Australia if the property bubble bursts.

Let's take a look at what might happen in the nightmare (but not altogether improbable) double whammy scenario of an Australian property crash and a sharp slowdown in China.
  • Australian property prices fall 30-40%
  • Australian stockmarket gets hit by a double whammy as resource stocks are clobbered by the China shock and bank stocks collapse thanks to their massive exposure to the property bust
  • China leads a massive selloff in emerging market stocks (no diversification here)
  • Australian dollar collapses to 50-60c
  • Unemployment rises sharply and many are unable to keep paying their mortgage
So again, what to do? First of all, if you do own a house or apartment, it would seem sensible to make sure you have a decent amount of equity in it (say 20% at least) and a buffer of savings so that you can continue to make mortgage payments even if you were to lose your job. Secondly, if all of your wealth is tied up in investment properties, just remember that if there is any kind of crisis, liquidity is suddenly going to vanish and it's going to be very difficult to sell in a hurry. Sadly, this is the position that hundreds of thousands of Australians could find themselves in. And if you do have some savings spare and want to do something to hedge against the risk of a property collapse, you could think about:
  • Term deposits. A quick google search shows you can currently get 6.8% on a two-year term deposit. This is a risk free investment, and it's hard to imagine many asset classes doing better than this if things go wrong. Of course, unfortunately under Australia's ludicrous tax system, you will be taxed at your marginal rate for this sensible investment, the proceeds of which will probably go towards bailing out irresponsible banks and overleveraged property investors
  • Own foreign currency via unhedged foreign stock/bond ETFs or index funds. (although I would be wary of too much stock market risk)
  • If you are are overexposed to Australian resource companies or banks, reduce your share positions or hedge by buying out of the money put options (definitely not for the average punter)
This is just a quick brainstorm, but now is probably a good time to start thinking about these issues. Once the storm starts, it's usually too late to find shelter.
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Note: This does not constitute financial advice and you should talk to a qualified financial planner about your individual circumstances before making investment decisions.