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?"

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.

Europe: It's even worse than it looks

Michael Pettis says it's almost certain now that Spain and Portugal will have to be bailed out. How do we know?

In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.

And he has a point. Consider these statements in an FT story today:

"Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”

 And now from Portugal:

“Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems.  “Portugal doesn’t need anyone’s help and will solve its own problems,” he said.

I can't help but note that these statements are also reminiscent of the flood of reassurances by American bank CEOs in September 2008 that their banks were "well capitalized." And we all know what happened right after that.

In any case, here are Pettis's main points:

1. Greece will be forced to default and restructure its debt, and the restructuring will come with a significant amount of debt forgiveness.  The idea that it can grow its way out of the current debt burden is a fantasy.

2. Greece will not be the only defaulter.  Spain, Portugal, Ireland, Italy, Belgium and much of Eastern Europe will also face severe financial distress and possible default.

3. Political radicalism in these countries will rise inexorably as a consequence of rising class conflict.

4. Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro.  They will almost certainly choose the third option.

I can't help but think we are coming to a very dangerous period in the global economy heading into 2011. As we have examined above, Europe is a mess and it is delusional to think there is a solution without some countries defaulting and/or leaving the euro. Meanwhile in the US, unemployment remains near 10% and the Fed is under fire from both the left and the right, undermining any positive impact that QE2 might have had. With the current anti government sentiment and the rise of the Tea Party Republicans, the prospect of passing any further monetary or fiscal measures should the economy take another turn for the worse is extremely limited. So we are out of bullets.

Meanwhile, China is on a crusade against inflation and is desperately trying to rein in it's unbalanced economy and chronic misallocation of resources. Against this highly uncertain global backdrop, Australia's economy is motoring along nicely, but our massive housing bubble is showing signs of collapsing under its own weight.

The property spruikers are already looking out for the best interests of the Aussie battlers, telling us that the modest falls in prices we have seen so far are an "excellent buying opportunity." But when Wayne Swan and the RBA come out with straight faces and start telling us that Australia's banks are well capitalised and there is nothing to worry about, be very afraid.

Nonsensical Property Shill Quote of the Day

Just when you thought you wouldn't see anything stupider than Robert Gottliebsen's latest column for a while, here's a wonderfully nonsensical quote from Australian Property Monitors chief economist Dr Andrew Wilson in the Australian today.

"What we are seeing in Melbourne is a pause in the market, mostly caused by a fall off in the bottom end of the market, but it's not a bubble," Dr Wilson said.
"The market was unsustainable because it couldn't be sustained by incomes, but now we are starting to see wages growth that will again fire up demand."

So the market was "unsustainable" and couldn't be sustained by incomes, but no, we are not in a bubble. According to the latest data from Demographia, Melbourne is currently the 7th most unaffordable housing market in the world, with a median price/income ratio of 8.0. Let's assume that a ratio of 5 (roughly the level of Toronto) is more reasonable. Now, through the amazing powers of arithmetic, I calculate that we could either get there with a 37.5% fall in prices, or a 60% rise in incomes, or some combination of the two. 

Dr Wilson has categorically stated that we are not in a bubble, but he doesn't seem to expect prices to fall. Instead, he expects affordability to be restored by wages catching up. Now admittedly I have plucked the price/income ratio of 5 out of thin air, but how on earth does he expect wages to rise by 60%, or even half that, any time soon? WTF??

To end this post I would like to dedicate this clip to Dr Wilson.

A double whammy from The Australian

Just a day after its revelation that there is dissent within the Australian Treasury about the government and RBA's view that Australia does not have a property bubble, we have an article today claiming that the Reserve Bank "deliberately intervened in the political debate over the property boom to stop governments releasing more land."

The bank feared the release of land would cause traffic gridlock, environmental problems and potentially a US-style housing slump. The move, detailed by a senior RBA official in documents obtained under Freedom of Information laws, is a rare example of how Australia's independent central bank is prepared to act to protect its monetary policy decisions.

Now, there are several interesting revelations in this article, but I was perhaps most struck by this passage:

Even if Australia had lifted supply-side restrictions, she said, and "became Phoenix or Las Vegas", there would still be significant price cycles... Ms Ellis, who, like Mr Stevens and Wayne Swan, has pointed to the more recent contribution of supply-side issues to higher prices, believes government restraint on housing supply helped avoid a US-style slump.

I find this interesting because it is, to put it mildly, totally at variance with the facts. There is very strong evidence that the US states that had the most "government restraint on housing supply" -- such as California and Florida -- had the biggest price rises when the market was booming, and are now suffering from the biggest crashes. It's hard to believe the RBA is not aware of this evidence. See the chart below.

Source: Carpe Diem

Important to note is that Texas, the second largest US state, has managed to almost entirely escape the housing crash. This article has a nice summary of the arguments. 

Throughout the past decade, Texas has experienced far smaller house price increases than in California, Florida and many other states. During the bubble, California house prices increased at a rate 16 times those of Texas, while Florida house prices increased 7 times those of Texas. As a result, after the bubble burst, subsequent house price declines were far less severe or even non-existent in Texas... Unlike Texas, all of the markets with steep house price escalation had more restrictive land use regulations. 

So back in the real world, the evidence suggests that supply side restrictions do nothing but intensify the boom-bust cycle and worsen the fallout when the music stops. Am I the only one disturbed that even the RBA is utterly unable to face up to reality?

All bubbles end in tears

Via the FT's Alphaville blog, Societe Generale's Dylan Grice has some great quotes on what he sees as a major credit bubble developing in China and other emerging market economies at present:

...a bubble is not a bullish scenario. It’s not bullish for the EM economies themselves, their citizens or for the world as a whole. The fact is all bubbles end in tears. The innocent bystanders who go to work not realising that their jobs derive from unsustainable demand suddenly find they’re out of work, through no fault of their own. The investors who believe the hype – generally but not exclusively naïve retail investors – get completely wiped out, or worse find themselves in debt after leveraging into the story. Those who are sceptical, but play along thinking they’ll exit before everyone else are rarely successful... Go to Ireland and ask them how they feel about bubbles. They’ll tell you a bubble is a curse, not a blessing.

Meanwhile, back in Australia the obsession with creating more "competition" in the banking sector continues. Let's take a look at Wayne Swan's latest economic note:

We have been working to build up more competition in the banking sector since we first came to office. Even during the crisis, we made a solid start on injecting more competition into the mortgage market, even while we were taking decisive action to secure our financial system. We are working hard to support the smaller lenders by investing $16 billion in Triple-A rated RMBS, which is helping to make this a more competitive source of funding again. The RMBS market was one of the key drivers of banking competition in the decade before the crisis, helping smaller lenders to drive a significant reduction in the net interest margins of the major banks, which you can see in this Reserve Bank chart.

All of this may be true, but to borrow a phrase currently in vogue, it is kind of ignoring the elephant in the room. As Steve Keen has pointed out, in the decade before the crisis, banks responded to this reduction in their net interest margins by massively increasing the volume of credit extended to households (and reducing lending standards). In fact, they kept up their frenzy of lending right through the GFC, when the Australian government decided it would be a good idea to reinflate the bubble.

The fact is that a "lack of competition" in the Australian banking sector is a secondary issue. Introducing more "competition" so that we can sucker another generation of young Australians into borrowing six or seven times their annual income to buy an illiquid and overvalued asset is not a good idea. How about we address the real problem of TOO MUCH DEBT?

As Dylan Grice says, all bubbles end in tears. And the more we try to kick the can down the road without addressing the real problem, the worse the fallout is going to be.

Elephants in rooms

So, the story of the week is that the Australian Treasury is becoming concerned about the bubblicious runup in Australian property prices over the past several years:

A SENIOR Treasury official has sounded the alarm over Australia's property market. He has warned that the prospect of a sudden and dramatic drop in prices is "the elephant in the room" and should not be ignored by the federal government.

 
It's nice that somebody in Canberra has finally cottoned on, but I don't expect this to change the head in the sand attitude of the current government and the RBA. We can only hope that the bubble deflates while Australia still has the cushion of strong commodities export growth to China. But on this front, too, there is reason to worry. From Bloomberg today:

China’s reserve-ratio increases for banks and threats of price controls on essential goods are likely to prove insufficient to tame inflation, and the central bank will have to raise interest rates further, economists said. 

All of which is likely to dampen China's growth.  China expert Michael Pettis has been arguing for some time that China's economy is set to slow down sharply in the next few years as the country rebalances it's overly export and investment-led economy. 

Over the next five years or more Chinese economic growth will necessarily be lower than growth in Chinese consumption. The massive but unsustainable investment in infrastructure and new production facilities that characterises the Chinese fiscal stimulus package will not be able to change this fact. From its dizzying heights during the past two decades, the world needs to prepare itself for a decade during which, if all goes well, China grows at a still respectable but much lower rate of 5-7 per cent.

Of course this type of view has been largely ignored by the mainstream press, which continues to assume that like Australian housing prices, China can keep growing at 10% a year until the year infinity. What would the implications be for Australia if China was to slow to 5-7% growth?

Keep in mind that according to this RBA paper, 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. Thanks to this voracious demand, China's importance to the Australian economy has risen exponentially over the past decade. See the chart below from Business Insider, which shows that Australia now exports almost SIX times as much to China as to the United States, although as recently as 2004 both export markets were roughly of equal importance.

Which brings us back to our heroic Treasury official.

"The elephant in the room is house prices or more specifically the risk of a precipitous drop in them, perhaps from an external shock or perhaps from their own internal dynamics when affordability constraints or capacity debt levels see prices and expectations of house prices start to move in the opposite direction," Mr Morling wrote on June 15.

Now, there are several signs that the bubble is simply starting to deflate under it's own weight, but an external shock such as a sharp slowdown in China would severely hamper Australia's ability to deal with the fallout of a real estate crash. It was only dumb luck that we escaped the worst of the GFC, and we have allowed the imbalances in our economy to grow even larger since.

2011/12 could be very messy indeed.

Not all Governments are Stupid

Today I was struck by this Bloomberg story about Hong Kong's forthright efforts to cool down it's overheating property market.

Hong Kong imposed additional taxes and raised down payments on residential properties, stepping up a battle against surging prices after the International Monetary Fund warned that asset inflation may derail the city’s economy. 

Let's look at some of the details:

Homes sold within six months of purchase will incur a 15 percent stamp duty from tomorrow, Financial Secretary John Tsang said in a briefing today. Down payments for homes costing HK$12 million ($1.5 million) or more will rise to 50 percent, from 40 percent. Down payments for homes costing between HK$8 million and HK$12 million will be increased to 40 percent from 30 percent, Hong Kong Monetary Authority Chief Executive Norman Chan said...The maximum loan to value for all non-owner occupied residential properties and those held by companies will be lowered to 50 percent, Chan said.

I'd like to repeat that last sentence.  If you want to buy an investment property, be prepared to put down at least 50% in a deposit. Meanwhile in Australia, a quick look at the home loan section of several Aussie bank's websites shows me that I can still buy an investment property at a 100% LTV, pay interest only for 5 years, and then refinance when my property is presumably worth 50% more. What could possibly go wrong??

Meanwhile, the Victorian coalition opposition is vowing to abolish stamp duty, our Federal government appears to be concocting a hairbrained scheme to backstop the RMBS market, and the RBA continues to deny that we have a housing bubble in Australia.

Good times.

On rent vs buy and ludicrous house price assumptions...

Today I would also like to tackle the commonly held idea (in Australia) that renting is “throwing money out the window” and that buying a house is always the best way to build long term wealth. It is very difficult to disabuse people of this notion, but I am going to try my best.

First of all, let’s try a little thought experiment. What would you say to a friend who told you that she had $100,000 in savings, and had decided to take that money to a broker, borrow $400,000 and then invest half a million dollars in the stock market? In the middle of a stock market bubble. You would probably tell her she is completely nuts. This is a highly leveraged investment. If the market falls 20%, then she loses ALL HER MONEY.

So why do young Australians think it is sensible to do exactly the same thing in the housing market? This is a decision to invest your life savings in a single, highly illiquid asset which is quite likely overvalued by 20% to 50%. The thing people forget is that there is an opportunity cost in buying a house. You could choose instead to rent, and invest that $100,000 in a term deposit and get 6-7% entirely risk free. You could invest it in a diversified portfolio of shares or bonds, perhaps earning an even higher rate of return. You could put that money towards starting your own business.

Houses are an asset. And like any other financial asset, whether or not it is sensible to buy comes down to the valuation. 

So let’s start crunching some numbers. I like this Rent vs Buy calculator on the New York Times website. Let’s compare buying a $500,000 apartment in Sydney with renting the same property for $500 a week. You’ll need to click on the “Advanced Settings” tab and correct for some of the US quirks such as tax deductibility of mortgage interest payments.

Let’s assume a 25-year mortgage and plug in the current variable mortgage rate of 7.8%. Now, the most important assumptions here are the expected annual home price change, the expect annual change in rents, and the expected annual rate of return you can make on alternative investments.

Let’s be really conservative, and assume that if we rent we’ll make 5% annually on our savings. And we’ll assume that rents grow 3% annually, a little faster than inflation. Now comes the most important assumption. At what annual rate can we expect house prices to appreciate over the coming 25 years? I have a feeling if you asked the average Australian property investor this question, you would get a lot of answers in the 6-10% range. So let’s take a look at how realistic this would be.

As in my last post, lets assume that household incomes grow at around 4% in the long term. And let's then calculate what would happen to Sydney's ridiculously high price/income ratio of 9.1 for various assumptions of housing price growth over the next 25 years. 

Capital Appreciation (%)	Implied Price/Income Ratio
0	3.41
2	5.60
4	9.10
6	14.65
8	23.38
10	36.98

 

These calculations show you that if you are expecting house prices to grow at even 6% annually in the coming decades, you are smoking something. Clearly somewhere in the region of 0-4% is more realistic, and I would argue for the lower end of that range. 

Let's plug those numbers into the NY Times calculator. Under the relatively optimistic scenario of 4% capital growth, you need to hold the property for 15 years until you come out ahead of renting. At 3% growth, it takes 25 years. Anything less than that is a total unmitigated financial disaster. 

Now, these are very rough calculations and they are very sensitive to the underlying assumptions. They do not suggest that renting is always the better option. But my point is that the standard mantra that buying is ALWAYS better than renting is absolute bollocks. This is only the case if your expectations for long term growth in housing prices are grounded in FantasyLand. 

Unfortunately, a whole generation of Australians has been brainwashed with the idea that owning property is a shortcut to long-term wealth. 

And this can only end in tears...

Have You Ever Seen Sydney From an A380 at Night?

Not another boring housing blog, you say. Believe me, I would rather be discussing Collingwood’s chances of going back to back in 2011, but it’s a practical matter. See, I have been living in the US for the past 5 years and am contemplating a return to Australia early next year. I’m coming up against the “rent vs buy” conundrum, and the more research I do on the Australian housing market, the more horrified I am. I have seen the carnage unfolding from California to Nevada to New York, and it ain’t pretty.

I first started to get worried on a recent flight back to Melbourne in a brand spanking new A380 with perfectly functioning engines. I was having a great chat with an Australian woman from Sydney sitting next to me… until the topic turned to housing. Here’s a snippet of our conversation.

Her: We just bought a place. It’s crazy. You can’t find anything nice for under a million.

Me: Wow. Weren’t you tempted to just rent?

Her: It’s only going to get more expensive if we wait. Anyway, housing prices in Australia double every 7 years so we think it’s a good investment.

Me: Some people in California said that and prices have fallen 40%.

Her: That would never happen in Australia. There’s a shortage of houses.

Me: They said that in California too.

Her: Are you getting the chicken or the beef?

This was followed by an awkward silence that persisted the rest of the 14 hour flight. And when I got to Australia, it was even worse. When it came to the topic of house prices everybody I spoke to seemed to be living in some kind of delusional fantasyland.

“We’ve got a fast growing population…”

“The banks have been much more responsible with their lending here...”

“There’s a massive shortage of housing supply…”

“The government wouldn’t let that happen here…”

And so on and so on.

Australians like to think Australia is different. But here’s the thing. Holding a belief that “house prices double every 7 years” as if it’s a gospel truth is a little bit like denying the existence of gravity or insisting that Sarah Palin is well educated because she went to four different universities over 5 years to get her bachelor degree.

Let’s step back for a minute and look at the big picture. Most studies show that in the very long term, house prices basically don’t grow much faster than inflation. For example, Robert Shiller has shown that in the US, real house prices (prices after accounting for inflation) grew at an average of just 0.4% a year between 1890 and 2004. 

Now you may argue that Australia is different. But one thing is for certain: in the long term, housing prices are constrained by the growth rate of household incomes. They MUST be. If housing prices are consistently rising at a faster rate than incomes (as we have seen in Australia for two decades now), this implies that households are taking on more and more debt. The only way that prices can continue to rise in such a situation is for banks to extend more and more credit and borrowers to become more and more indebted.

Logically, since there are limits to the amount of mortgage debt that it is prudent or possible to take on relative to one's income, this situation is totally unsustainable. At some point—as we have seen in countless housing crashes around the world over the past century—housing prices will either have to fall sharply, or remain stagnant for a long period while incomes catch up. This is an insight that is so basic most people seem to have forgotten it. And in my view, we are very close to a tipping point. Just look at all the kafuffle over the recent RBA rise and subsequent mortgage rate hikes.

According to Demographia, Australia’s median house price to income ratio is currently 6.8, by far the highest in the developed world. In Sydney, this ratio is 9.1, making it the second most unaffordable city in the world. Let’s take a brief trip to FantasyLand and assume that prices will continue to grow at 8% a year over the next decade. If we assume an average annual growth of 4% in household incomes over the same period, this implies that the price/income ratio in Sydney would rise to 13 by 2020. In other words, if you put every cent of your salary into mortgage repayments, it would still take you 13 years to pay back the principal. In fact, it would be much longer than that because we haven't even taken into account the interest payments.

Extrapolate out another decade at the same growth rates and you’ll get a price/income ratio for Sydney of 19. This would be equivalent to a person on a $60,000 salary today buying a $1.14 million house. Clearly these figures are ludicrous. With apologies to the author of this excellent blog, I would even say “delusional”. And yet there are still seemingly intelligent people out there saying things like “housing prices in Australia double every 7 years” as if it’s the most uncontroversial statement in the world.  I don’t know whether to laugh or cry.

Now, let’s take a look what would have to happen for the price/income ratio to merely get back to 5, which Demographia still sees as the borderline between “seriously unaffordable” and “severely unaffordable”. This would require a 44% price decline. Think that can’t happen? Look at the USA, Japan, Ireland, Spain, and countless other examples throughout financial history.

But let’s assume again that Australia is part of a different galaxy where it is impossible for prices to fall, and that we somehow manage to engineer a “soft landing”. If we again assume that incomes continue to grow at 4%, housing prices would have to stay flat (ie ZERO capital gains) for 13 years in order to get back to this level of (un)affordability.

Still think it’s a better decision to buy than rent? Let’s explore that one next time. 

In the meantime…

It’s the end of the world as we know it, and I feel fine…