tag:blogger.com,1999:blog-75824842408057592712024-03-14T14:49:06.750-04:00Financial FolliesDeflating the housing bubble: A critical look at the Australian economy from afarFinancial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.comBlogger33125tag:blogger.com,1999:blog-7582484240805759271.post-43174798070922255522011-01-24T22:47:00.000-05:002011-01-24T22:47:05.023-05:00The times they are a changin'Hi guys. This is just a quick note to let you know I'll be joining the folks at <a href="http://macrobusiness.com.au/">Macro Business</a>. If you haven't seen the site yet, it's a "superblog" with some of Australia's best bloggers covering the economics and finance world in Australia and beyond.<br />
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Since the team already has several very talented people writing about Australia, and since I'm currently based in New York, I'm going to change my focus a bit and give my perspective on what's going on in the US. The main focus will be the economy and financial markets, but I will also delve into politics and possibly other important issues like who wore the best outfit to the Oscars. In any case, you can read my first post <a href="http://macrobusiness.com.au/2011/01/market-for-palin-collapses/">here</a>.<br />
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As for this humble blog, I will keep it alive for now, and may post occasionally if I have anything to say about Australia. Since I have a day job, it's likely to be sporadic at best though. Thanks to all the readers and commenters so far, and please hop over to <a href="http://macrobusiness.com.au/">Macro Business</a> and check it out.<br />
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CheersFinancial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com11tag:blogger.com,1999:blog-7582484240805759271.post-81547510372183569832011-01-23T16:36:00.001-05:002011-01-23T17:05:23.733-05:00Disaster myopia: floods and financial crisesApart from the tragic loss of life, one of the saddest outcomes of the Queensland floods is the financial ruin that hundreds if not thousands of families are now facing having had their properties destroyed. Many do not have flood insurance. This recent <a href="http://www.theage.com.au/environment/weather/brisbane-landlords-face-further-disaster-20110117-19ssd.html">article</a> in The Age tells one typical story. <br />
<blockquote>Landlords across Queensland are likely to go bankrupt in the next few months, an industry expert has warned... <br />
<br />
Paul and Sarah Smith had been renting Sarah’s mother’s rental property at Goodna when the floods hit. Their home was inundated to the second story and the damage is enormous.<br />
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Ms Smith said her mother owned five other properties in Goodna which she rented out – all of them had gone under in the flood last week.<br />
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“My mum has six rental houses and they’re all ruined,” Ms Smith said.<br />
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“You might say ‘oh she’s got six rental properties, she must be rich’, but she’s not – she has mortgages on all of them and relies on the rent to help pay.<br />
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“How will she pay for them now? She’s devastated. She doesn’t have insurance for this...”</blockquote>Now, I have nothing but sympathy for the people involved. But you do have to ask the question. How sensible is it to have your entire net wealth tied up in six rental properties that are all geographically concentrated in a single flood prone area? And on top of that, to not bother getting flood insurance?<br />
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<b>Disaster Myopia </b><br />
This is a classic example of what economists and psychologists call "disaster myopia" -- the tendency of people to greatly underestimate the chance of catastrophic events. Here's how it works. You get a big disaster, say the 1974 floods in Queensland. This serves as a wake up call for people that bad things can and do happen. For a while, they start to behave more prudently: more people take out flood insurance, builders become wary of building in vulnerable areas, and banks start to take into account the flood vulnerability of houses before they issue mortgages. But sooner or later, memories of the disaster start to fade. As the years pass, fewer and fewer people bother getting flood insurance. Developments start cropping up closer and closer to river banks. Banks stop worrying about flood risk and issue loans to whoever is willing. We all get a bit complacent. And then another disaster strikes...<br />
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On a broader scale, this phenomenon is exactly what has got much of the global economy in such a big mess since 2008. In fact, the risky behaviour by banks that was at the heart of the recent global financial crisis can basically be seen as the result of disaster myopia, <a href="http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf">Andrew Haldane</a> of the Bank of England has argued. After a "golden decade" of high economic growth, rising house prices and low inflation around most of the world in the 2000s, banks started lowering their lending standards, based on the idea that the world had entered a new phase of economic stability. After all, there hadn't been a major global financial shock for about a decade, the period of time that seems to mark the limits of the attention span of risk managers in banks, Haldane notes:<br />
<blockquote>As time passes, convincing the crowds that you are not naked becomes progressively easier. It is perhaps no coincidence that the last three truly systemic crises – October 1987, August 1998, and the credit crunch which commenced in 2007 – were roughly separated by a decade.</blockquote>The problem is, the "golden decade" that banks were basing their decision making on, was a highly unusual one compared to history, as the two displays of UK unemployment and corporate earnings growth show below.<br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRk96A6RqNXpGEXcdTKd9iMKlMx2JXY3RerCsE4rtdLvaGtOycrrotN5-2GvsOedP0WKibsRlWeuCIKcAyaKd6Y25IQTAQyaLlXTWCW5pEGPbNxKsEvPYpAUr1pKH4TbL8Pu8XjFcXtRQ/s1600/UK_probability+density.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="217" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRk96A6RqNXpGEXcdTKd9iMKlMx2JXY3RerCsE4rtdLvaGtOycrrotN5-2GvsOedP0WKibsRlWeuCIKcAyaKd6Y25IQTAQyaLlXTWCW5pEGPbNxKsEvPYpAUr1pKH4TbL8Pu8XjFcXtRQ/s400/UK_probability+density.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: Bank of England</td></tr>
</tbody></table>Apologies if this is bringing back nightmares of Statistics 101, but you can see here that the probability distributions for both of these indicators looked very different in the "golden decade" to the longer-term history: in statistical terms, there was not a lot of variance around the mean. What did this lead to in practice?<br />
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If you were a banker with a short memory and only looked at the yellow curve, you might have concluded that property lending was very safe, because unemployment was "permanently" low and therefore the risk of borrowers defaulting on their loans was negligible. And bankers have an incentive to have short memories. After all, if everything blows up in 10 years because of all the stupid loans you made, who cares, because you still get to keep all the big bonuses you've made in the meantime. <br />
<br />
And if you were an investor looking at the yellow curves above, you might have concluded that stocks were a very safe investment, because corporate earnings were growing steadily with very little volatility. This illusion of stability led to an underpricing of risk: people took on a lot of debt and pushed asset prices higher and higher. And then the US subprime crisis hit and markets all over the world came crashing down. <br />
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<b>ANZ's Gold Medal</b><br />
It's time to return this discussion to Australia, where disaster myopia is almost an art form in some circles. A wonderful example of this came from a report by ANZ last week, which was their latest attempt to justify the sky high level of Australian property prices. I'm not going to examine it in detail, because other bloggers have already done an excellent job at ripping their arguments to shreds (see <a href="http://www.unconventionaleconomist.com/2011/01/never-trust-bank-economist.html">here</a> for example). However, I do want to pick up on the paragraph below from this <a href="http://www.smartcompany.com.au/property/20110117-australian-houses-are-not-overvalued-prices-should-rise-over-next-12-18-months-anz.html">summary</a> of ANZ's view.<br />
<blockquote>A new report from ANZ claims residential properties aren't overvalued and has taken aim at traditional methods of evaluating affordability, including price-to-income ratios, saying they don't take into account more complicated and less-quantifiable factors including historic declines in interest rates... More importantly, (ANZ economist) Montalti says, is how the market is performing now and where those prices are actually moving. He points out the country has quite a low delinquency rate, which is evidence of a largely affordable market that is valued correctly.</blockquote>In this single paragraph, ANZ gives us two classic examples of disaster myopia. <br />
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Let's deal with ANZ's second point first. Montalti points to the low level of delinquencies in Australia and says that this is <i>evidence</i> that the market is valued correctly. With all due respect to Mr Montalti, this is one of the dumbest arguments I have heard in a long time. It's a bit like if a meteorologist had told you at the end of 2010 that there hasn't been a major flood in Queensland for 30 years, so there was "evidence" to prove that nobody ever needs to worry about the risk of floods anymore. <br />
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In any case, back to ANZ's first point, which is almost as silly. What they're telling us here is that the very high level of house prices in Australia is justified because the historical decline in interest rates (in one <a href="http://www.anz.com/resources/5/5/5517ce804331090793ff9f5b4fbd8721/Australian-Housing-Update-20102705.pdf?CACHEID=5517ce804331090793ff9f5b4fbd8721">previous report</a> they described this decline as "<i>permanent</i>") allows people to service a much higher amount of debt than in the past. And they're not the only ones making this argument. The IMF recently cited "<i>permanently</i> lower nominal interest rates that have occurred since 2000" in its <a href="http://www.imf.org/external/pubs/cat/longres.cfm?sk=24507.0">analysis</a> of Australian house prices.<br />
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But what if the low level of interest rates we've seen in Australia over the past decade isn't permanent? In fact, it would be very surprising if it was anything more than <i>temporary</i>. Below, you can see that I've charted the probability distribution of Australian interest rates along the lines of the Bank of England charts above. (I picked the 90-day rate because the RBA provides data for this one all the way back to 1969)<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPruXlTZIlxwLgsLy0FyHG6dF-KPzTWe7PVatpPOETkmQGxZcL59neMEQ4l5u7iUMq3yBuaBI2ci-2tpF56FrY_b3NaAszKRqz19E5SjcHmRTUhFR8BxecDQUGo_lA1CQ_lqevaxhbDoo/s1600/aussie+rates+histogram.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="327" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhPruXlTZIlxwLgsLy0FyHG6dF-KPzTWe7PVatpPOETkmQGxZcL59neMEQ4l5u7iUMq3yBuaBI2ci-2tpF56FrY_b3NaAszKRqz19E5SjcHmRTUhFR8BxecDQUGo_lA1CQ_lqevaxhbDoo/s400/aussie+rates+histogram.png" width="400" /></a></div><br />
<br />
The result is quite interesting. If you only looked at the past decade, represented by the grey bars, you would see a nice bell-shaped looking distribution with interest rates generally clustered in the 5-7% range. But the red line, which shows the distribution of interest rates from 1969 to today, shows you that the past decade has been a bit of an anomaly in historical terms. The distribution is heavily skewed to the right.<br />
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Does this mean that interest rates are going to go back to 15% like we had in the 1970s? No it doesn't. But what it does suggest is that if you think the relatively stable level of interest rates we've had in the past decade is some kind of "new normal", you're probably in for a rude shock at some point in the future. And that's a bit of a problem, because Australian house prices today are so high that many borrowers are already forced to devote an uncomfortably high portion of their disposable incomes to mortgage payments even with rates at current levels.<br />
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How many people could deal with a rise in mortgage rates to 10%? Again, not to say that this is likely, simply that it wouldn't be all that out of the ordinary in historical terms. <br />
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<div class="separator" style="clear: both; text-align: center;"></div><b>A margin of safety</b><br />
It might sound like the tone of this post is overly pessimistic. After all, if we became totally paranoid about all the possible disasters that could happen none of us would even leave the house every day. And we wouldn't take any kind of financial risks at all. But that's not really the point. The point is that when making financial decisions, we should allow for the fact that some of the assumptions we have about the world could quite possibly turn out to be wrong. For example, ideas like:<br />
<ul><li>Property prices in Australia double every seven years</li>
<li> Unemployment under 5% is the norm for Australia</li>
<li>The terms of trade boost from China will last for decades</li>
<li>Interest rates will never go as high as 10% again</li>
</ul>And so on and so on. Now, we can't possibly predict which of these risks we need to worry about (and we certainly can't rely on the likes of ANZ to tell us), but that doesn't have to matter so much if we incorporate a margin of safety into our decision making. Do you have enough of a buffer in savings so that you could keep paying your mortgage even if you were to lose your job and be unemployed for a few months? Could you keep paying your mortgage even if your mortgage rate went up to 9 or even 10%? If the answer to these questions is no, then perhaps you are living a little too close to the edge. <br />
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Oh, by the way, I didn't mention the risk that the earth might get hit by a massive <a href="http://space.about.com/cs/asteroids/a/2003qq47impacta.htm">asteroid</a> in 2014, but I can assure you there's nothing to worry about there.<br />
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Until next time.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com5tag:blogger.com,1999:blog-7582484240805759271.post-12871074921794224452011-01-19T20:47:00.003-05:002011-01-20T08:08:28.614-05:00Iron ore and Australian house pricesIn my <a href="http://financialfollies.blogspot.com/2011/01/is-australia-living-on-borrowed-time.html">previous post</a>, we started to examine the million dollar question for Australia's economy today. How long will China's rapid growth and the commodity price boom last? We noted that while the arguments for continued growth in commodity demand from China appear fairly plausible, there are significant risks in the near term. And in actual fact, we've greatly understated the risks to Australia's terms of trade so far in this discussion, because we haven't even looked at what is happening on the supply side of commodities. <br />
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<b>Commodity Supply 101</b><br />
The supply of commodities like iron ore or coal tends to be fairly "inelastic" -- or unresponsive -- to rising demand in the short run. This is because there are massive capital costs involved in expanding mining operations or exploiting new reserves. Unlike agricultural commodities like potatoes, the average punter can't just start digging up iron ore in the back yard and selling it on international markets.<br />
<br />
What this means is that when you get a surge of demand in commodities, supply doesn't rise by much in the short term, so prices shoot through the roof and the miners make boatloads of money. But what history shows is that commodity prices repeat long cycles of boom and bust. When prices get high enough, miners eventually find it more economical to add new capacity and expand supply. There's generally a lag until this new supply hits the market, but when it does, prices inevitably cool down again. And that's exactly what we are likely to see over the next few years. <br />
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The chart below from <a href="http://www.globalmining.com.au/">Global Mining Investments</a> illustrates the economics of this very well. This is the cost curve for various iron ore producers around the world. I'm focusing on iron ore because, along with coal, it's Australia's biggest export.<br />
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You can see that the big three of Rio Tinto, Vale and BHP Billiton can make money as long as prices stay above $30-40 a tonne, around $100 below the current market price. This is because the big three, who control around two thirds of the market, have access to some of the world's highest grade iron ore deposits -- places like the Pilbara in Western Australia and Carajas in Brazil. So it's no wonder they're making a killing. But as the price of iron ore keeps rising, it becomes economical for higher cost producers in places like India and China to start tapping their lower grade iron ore deposits. <br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9JCQDsfdlnsHiL5U4Z0ATPLJGrBu6fzJEoo6pXjb0YVsfMqlarW8djU5QoQ9IKaK0QrQ6TLYxdztcSLPF-Ta2SSM4s5DdmJ6qdzTv-cuYHmZsfKBWrOOjjWpRl0U6TTvjFnbSKcGwJ5w/s1600/iron+ore+supply+curve.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="340" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9JCQDsfdlnsHiL5U4Z0ATPLJGrBu6fzJEoo6pXjb0YVsfMqlarW8djU5QoQ9IKaK0QrQ6TLYxdztcSLPF-Ta2SSM4s5DdmJ6qdzTv-cuYHmZsfKBWrOOjjWpRl0U6TTvjFnbSKcGwJ5w/s400/iron+ore+supply+curve.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: GMI</td></tr>
</tbody></table><br />
<b>A Coming Iron-Ore Glut? </b><br />
In fact, one recent <a href="http://au.ibtimes.com/articles/20100806/iron-ore-watch-the-emerging-glut.htm">report</a> says there could be an enormous 685 million tonnes of new iron ore production capacity coming on stream between 2010 and 2012, which is roughly equal to what Australia and Brazil (the worlds two biggest producers) produced together in 2009. For a list of some of these projects, see <a href="http://www.foxbusiness.com/markets/2010/10/06/factbox-vale-rio-bhp-iron-ore-expansion-plans/">here</a>. Furthermore, China has been speeding up the exploitation of domestic deposits and buying up mines all over the world to help ease their dependence on the big three. From a <a href="http://www.businessspectator.com.au/bs.nsf/Article/Rio-Tinto-BHP-Billiton-steel-iron-ore-China-GDP-pd20100902-8W4JL?OpenDocument">recent article</a> by Stephen Bartholomeusz in Business Spectator:<br />
<blockquote>The notion of a prolonged ‘mother of all booms’ is ... not one that the big miners necessarily subscribe to. They are aware that the mid-sized and smaller iron ore and coal producers, after something of a hiatus during the crisis, are now scrambling to bring their production into the market. There will be big and continuing increases in supply to discipline the prices... Goldman Sachs’ resource analysts suggested earlier this week that the iron ore market could move into balance in 2013 and over-supply as early as 2014. Even if steel production in China continues to grow at current rates the market would still be in an over-supplied position by 2015, they said.</blockquote>Meanwhile, iron ore spot prices continue to grind higher, and are currently approaching $180 a tonne. But a growing number of analysts are warning that this rise is unsustainable, and that a fall back well below $100 is inevitable in coming years. From another recent report in <a href="http://online.barrons.com/article/SB50001424052970204076004575616762872918550.html">Barrons</a>:<br />
<blockquote>The fading outlook for iron ore is being driven by miners' investments in new projects and mine expansions around the world. But it is also being driven by China itself, whose flourishing steel industry, currently the world's largest iron-ore consumer, may soon be producing more steel scrap, thus reducing the need to import the ore. <br />
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"From 2015, we believe an additional industry dynamic will enter the fray: the increase in Chinese domestic scrap supplies," Credit Suisse analysts say. China's new construction and its growing consumption of metal-intensive products will provide additional fodder for domestic scrap. Worn-out cars, household appliances, construction beams and old railroad tracks—all can be melted down and put it into a furnace to produce new steel products. <br />
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"We expect prices to begin falling well below $100 a ton..." Credit Suisse says, referring to the period beyond 2015. </blockquote>Let's quickly summarize. We can probably expect at least another decade or so of strong growth in commodity demand from China. China isn't going away in a hurry. But the miners all know this, and have been investing accordingly. Which means there is a huge amount of new commodity supply set to come on line in the next few years. Even if everything goes right and the very strong growth in Chinese metals demand continues, this additional supply is likely to send prices lower. <br />
<br />
And this new supply will also be hitting the market at a time when some economists (read <a href="http://mpettis.com/">Michael Pettis</a>, for example) believe China is running into some serious constraints in its growth model. If China was to hit a speedbump some time in the coming few years and fall into recession, there is a chance that commodity prices could collapse, with disastrous consequences for Australia. This is not necessarily a <i>likely</i> scenario, but it is a risk that we need to be mindful of, because Australia's economy is extremely vulnerable to such a potential shock, as we will examine a bit further below. <br />
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<b>Australia: Living on Borrowed Time</b><br />
Let's go full circle back to the terms of trade. Some of you might have read reports of a <a href="http://www.imf.org/external/pubs/cat/longres.cfm?sk=24507.0">recent study</a> by the IMF, which surprisingly concluded that Australian house prices were only mildly overvalued. The IMF argued that there were solid <i>fundamental</i> reasons for Australia having the most expensive property prices in the world. And one of the key reasons they cited is the massive rise in Australia's terms of trade. <br />
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You can see from the chart below that, indeed, inflation-adjusted house prices have basically increased in line with Australia's terms of trade over the past two decades.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTdgMHAlXayL5shmA4T-dzVgQpK2MUOOxmi5DHG3-JI5XMX3ZQr8t6iIfVJRQe4n6AHYVL5xYgGv2hhjyjCyxSAjZFjhSRbrqWb89T9CU3sAp-e2ezwodBum5xE30MboFKnnfjnzF-hgE/s1600/IMF_house+prices+and+ToT.png" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="306" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhTdgMHAlXayL5shmA4T-dzVgQpK2MUOOxmi5DHG3-JI5XMX3ZQr8t6iIfVJRQe4n6AHYVL5xYgGv2hhjyjCyxSAjZFjhSRbrqWb89T9CU3sAp-e2ezwodBum5xE30MboFKnnfjnzF-hgE/s400/IMF_house+prices+and+ToT.png" width="400" /></a></div><br />
This raises an obvious question. If you agree with the IMF's logic, doesn't this imply that house prices have to fall when the once in a generation boost to the terms of trade reverses? <br />
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Now, Australia's terms of trade has gone through long rises and falls over history without huge problems. And a decline in the terms of trade wouldn't necessarily have to be a big problem if Australia had invested the proceeds of the current boom productively. But instead, Australians have turbocharged the boom by taking on record levels of personal debt (see below), mainly to purchase houses. And the Australian banks are financing a good part of this mortgage debt not through deposits, but through a potentially unstable source of funding: the international bond markets.<br />
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So we are now left very highly leveraged, and the valuation of the biggest asset that most Australians own (their houses and investment properties) as well as their ability to service this debt (and the banks' willingness to keep extending credit) is dependent on the continuation of the commodity boom. The enormous level of personal debt means that many Australians today are highly vulnerable to potential shocks in the economy, whether from a slowdown in China, or from higher interest rates. <br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHVSOyTGECk4ARejGgsyyKppoTgBzjy9kDuQcRQJram-aiRL4vfMDLPgGHwxFi5Sa4Ya05fMzvntk9nOmBJgEz6tjeGCr2vusdFoG13Xy-KQAN4C6MB4C8TG72e0nPS1IN8jtlfrtAt84/s1600/debttogdp_png.png" style="margin-left: auto; margin-right: auto;"><img border="0" height="322" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHVSOyTGECk4ARejGgsyyKppoTgBzjy9kDuQcRQJram-aiRL4vfMDLPgGHwxFi5Sa4Ya05fMzvntk9nOmBJgEz6tjeGCr2vusdFoG13Xy-KQAN4C6MB4C8TG72e0nPS1IN8jtlfrtAt84/s400/debttogdp_png.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: Steve Keen</td></tr>
</tbody></table><br />
The chart below, from an excellent post at <a href="http://deflationite.com/">deflationite.com</a>, shows just how unbalanced the Australian economy has become over the past two decades. You can see that in 1990, the majority of Australian bank lending was being channeled into business investment, or investment in Australia's future productive capacity. But over the past two decades, the portion of bank credit allocated to business investment has steadily shrunk. In place of this, we have seen massive growth in property-related lending, to the point where one in seven Australians today owns one or more investment properties. <br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_C_4FuibmFXRzR2bqUW14_rjxG6lt3yekw_2Bcirw6RSfkwxTK6g7amNZisr_5__U68IMvRKIHLp1enAhW4X6V-fTBJ5WUiBsFX7t9RMaR13MXd_oaIKGJ-JYor8Mfjsx9_d-q3-mpvg/s1600/share+of+credit+australia.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="246" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh_C_4FuibmFXRzR2bqUW14_rjxG6lt3yekw_2Bcirw6RSfkwxTK6g7amNZisr_5__U68IMvRKIHLp1enAhW4X6V-fTBJ5WUiBsFX7t9RMaR13MXd_oaIKGJ-JYor8Mfjsx9_d-q3-mpvg/s400/share+of+credit+australia.jpg" width="400" /></a></div><br />
In essence, Australians have been behaving as if the commodity boom and the days of easy credit will last forever. Nobody can predict the timing, but they won't. Now, that doesn't have to mean disaster, but we're kidding ourselves if we think the adjustment is going to be easy.<br />
<br />
As Warren Buffet once said, "It's only when the tide goes out that you learn who's been swimming naked."Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com22tag:blogger.com,1999:blog-7582484240805759271.post-72885150009628985352011-01-17T08:11:00.012-05:002011-01-19T20:52:20.961-05:00Is Australia living on borrowed time?Credit Suisse this week <a href="http://www.theage.com.au/business/credit-suisse-tips-sharp-gdp-fall-in-2011-20110110-19kw4.html">predicted</a> a sharp slowdown in Australia's GDP growth for 2011 and recommended selling shares in resource companies, based on their view that the Chinese economy is headed for a slowdown. It remains to be seen if they're right, but one thing is for sure; Australia's economic fortunes are more closely tied to China and its demand for commodities than ever before.<br />
<br />
In this <a href="http://financialfollies.blogspot.com/2010/12/australias-unhealthy-dependence-on.html">recent post</a>, I argued that Australia is extremely vulnerable to a slowdown in China because of our highly leveraged households and a banking system that is overly dependent on overseas funding. Today, I would like to take things a step further and examine what is driving China's demand for commodities and for how long we can expect the commodity boom to continue. This is a complicated question, so I'm going to break it up into two posts. Today we'll look at the demand for commodities, and in a follow up post, I'll examine the supply side. <br />
<br />
You might ask the question of what there is to worry about, since commodity prices continue to shoot through the roof. Indeed, the Queensland floods have only exacerbated this upward pressure on prices, with many coal mines flooded and supply looking like it could be restricted for some time. The chart below shows the CRB commodity price index, which has been on a very steady climb for the past six months now. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisnTVWSzsrr0UZj8Mtg7RS0V1CaXRQr41LjzCsLetJAWRicFsruB_OPHad2UuB-3zT6Tif1wU51NWvfB0_i0xiCd9cTRskxb-uK1UPVn-pdBfLgPqda5V_hVK9GPv8Ki71onIHd1vJZcg/s1600/CRBQ.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="262" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEisnTVWSzsrr0UZj8Mtg7RS0V1CaXRQr41LjzCsLetJAWRicFsruB_OPHad2UuB-3zT6Tif1wU51NWvfB0_i0xiCd9cTRskxb-uK1UPVn-pdBfLgPqda5V_hVK9GPv8Ki71onIHd1vJZcg/s400/CRBQ.jpg" width="400" /></a></div><br />
This continued rise in commodity prices is likely to push Australia's soaring terms of trade even higher still. As you can see from the chart below, we are currently enjoying the biggest boom in our terms of trade since the early postwar years. But how long can this extraordinary situation last?<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuPyKKdc6otItR2MWt_BPql7BgKEzn8gERRxtLlOePRQbx84ALj44uxL61l-Q9Ail8cMO8dxoP6ly5TFER6sBxcXk56GTptUlQ5M1k2FHzZGpukgJYnEBtCEdpBgfy7ClXZMDdmnb0ABU/s1600/tot_rba.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="328" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuPyKKdc6otItR2MWt_BPql7BgKEzn8gERRxtLlOePRQbx84ALj44uxL61l-Q9Ail8cMO8dxoP6ly5TFER6sBxcXk56GTptUlQ5M1k2FHzZGpukgJYnEBtCEdpBgfy7ClXZMDdmnb0ABU/s400/tot_rba.png" width="400" /></a></div><br />
<b>Our Terms of Trade</b><br />
First, some definitions are in order. What does the explosion of the terms of trade mean in English? It means that the price of the stuff we export (commodities like iron ore, coal, etc) has been rising much faster than the price of the stuff we import (finished goods like cars, flat screen TVs, etc). All other things equal, a higher terms of trade means more purchasing power for Australians, and therefore a higher standard of living.<br />
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Let's now take a look at what drives the terms of trade and try to get a handle of whether its massive rise in the past decade is sustainable. Like any other good, the price of commodities is determined by supply and demand. The demand side of the equation is what usually gets the most attention, so we'll examine that first. <br />
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<b>China and the Demand for Commodities</b><br />
The first important thing to understand here is that there has been a massive shift in the composition of demand for commodities in the past couple of decades. While industrialized economies used to be the biggest consumers of non-food commodities, that is no longer the case, as the charts below from the Brazilian miner Vale show. You can see that emerging market economies now make up more than 80% of global demand for iron ore, and two thirds of demand for nickel and copper. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFp_1eiysaKigyZZa6o9vCeVKnOjYh19KvV8HSzMgMVAzXRQFc6CT4EOtjY7_3Q0Ls-pbNAdpeI26U1x7ddfow-RgypjR6uKgn8tbnBdFXzIQKfC2EYp_9nm8pti43HifmMDlP5yfBUI4/s1600/Vale_metals+consumption_png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFp_1eiysaKigyZZa6o9vCeVKnOjYh19KvV8HSzMgMVAzXRQFc6CT4EOtjY7_3Q0Ls-pbNAdpeI26U1x7ddfow-RgypjR6uKgn8tbnBdFXzIQKfC2EYp_9nm8pti43HifmMDlP5yfBUI4/s400/Vale_metals+consumption_png.png" width="400" /></a></div><br />
To simplify the analysis, let's just look at China, because it's pretty safe to ignore everybody else. Why? Take iron ore for example, which is the raw material used to make steel. World steel production has risen by two thirds in the last decade, but 90% of this growth has come from China, according to <a href="http://blogs.ft.com/beyond-brics/2010/10/13/after-peak-oil-peak-steel/">this article</a>.<br />
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How much longer can we expect this enormous growth to continue? Well, that's a very difficult question, because it depends on factors like the rate of urbanization in China, and the timing of when China shifts its economy from the current investment and export-led model to a more consumer-driven one. In any case, the consensus seems to be that we can expect the high growth period of China's demand for commodities to last at least another decade, since the country still has a lot of infrastructure to build to support its huge population. See more forecasts from Vale below. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3SjAPtbVlTQSNx2pZzWsa5Wbf_RR7Avm7Xa8xowozl9b4RSJBXc32FbJI1fXkw_qjbZuuXV05rK4Qg15AxbOG8SAb98NH8vuTkQvbwC2_FHKq6lpt96l8B3VLK9FvFoemnErx0d58gpc/s1600/vale_china+infrastructure+spending_png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="301" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3SjAPtbVlTQSNx2pZzWsa5Wbf_RR7Avm7Xa8xowozl9b4RSJBXc32FbJI1fXkw_qjbZuuXV05rK4Qg15AxbOG8SAb98NH8vuTkQvbwC2_FHKq6lpt96l8B3VLK9FvFoemnErx0d58gpc/s400/vale_china+infrastructure+spending_png.png" width="400" /></a></div><br />
One <a href="http://www.google.com/url?sa=t&source=web&cd=3&ved=0CCgQFjAC&url=http%3A%2F%2Fepress.anu.edu.au%2Fchina_update2010%2Fpdf%2Fch05.pdf&rct=j&q=china%20peak%20steel%20intensity&ei=A3omTY-2GIO88gaj16imAQ&usg=AFQjCNEXURPOVVZ0Rsp2xiTndj2jlJcJZQ&sig2=ja9VnhDLasjr4ICepQSkKg&cad=rja">recent study from academics at ANU</a> forecast that China would reach "peak steel intensity" -- or the peak consumption of steel per capita -- by 2024. The chart below from the <a href="http://www.rba.gov.au/speeches/2010/sp-dg-181110.html">RBA </a>illustrates the similar point that China is still in an early stage of economic development that tends to be very intensive in the use of raw materials. If we assume a similar path of development to that of Japan, then China still has some way to go along the path of industrialization before its demand for steel peaks.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhx7frlEsVjxM1HYtfuBiJJZRfwqHwdUJwjGzqOW7P2niMTZpn22zBXL9EtpFqL7Lrg0b9ssFKZFU_TiW97Fr-Kep_LS8N_4lDu1_BzKQk3bzcN6lzsCvpm0rQ29lyYU0s6rlehwWoJ66w/s1600/RBA+steel+intensity.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhx7frlEsVjxM1HYtfuBiJJZRfwqHwdUJwjGzqOW7P2niMTZpn22zBXL9EtpFqL7Lrg0b9ssFKZFU_TiW97Fr-Kep_LS8N_4lDu1_BzKQk3bzcN6lzsCvpm0rQ29lyYU0s6rlehwWoJ66w/s400/RBA+steel+intensity.png" width="400" /></a></div><br />
And this is broadly consistent with what the miners and other analysts say. As the investment bank Barclays put it in one recent report:<br />
<blockquote>The shift from metals-intensive, investment-driven growth to consumer-driven growth is likely to be gradual in China. Chinese steel consumption of about 480kg per capita for 2010 is still significantly below peak levels of 600kg-1000kg per capita seen historically in other developing economies. In addition, Indian steel consumption is growing at close to 10% per year but is still estimated to be just 60kg per capita for 2010. We see significant upside in demand for steel, steelmaking raw materials, and other metals in China and India over the next 5-10 years. </blockquote>So there are good reasons to expect the strong growth in Chinese demand for commodities will continue for some time yet. But there are a couple of important caveats here.<br />
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<b>What Are the Risks? </b><br />
Firstly, long-term economic forecasts for metals demand -- or anything else for that matter -- are little more than educated guesswork. As I noted <a href="http://financialfollies.blogspot.com/2011/01/economists-what-are-they-good-for.html">here</a>, economists don't exactly have a great track record at getting these things right. And this may be even more relevant in the case of China; the world has never seen such a large economy industrialize so rapidly, so we have no prior experience to base the forecasts on. So no matter how plausible these estimates sound, we should treat them with a healthy degree of scepticism, allowing for the possibility that they could turn out to be completely wrong.<br />
<br />
Secondly, even if the bullish long-term forecasts for Chinese metals demand are correct, that doesn't mean we won't hit any speed bumps along the way. There are plenty of signs that some of the infrastructure spending going on recently in China is unproductive at best, and at worst, reflective of a speculative bubble waiting to burst.<br />
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See the chart below, for example, which shows that China is set to build 44% of the world's skyscrapers in the coming six years. One <a href="http://www.hurriyetdailynews.com/n.php?n=china-skyscraper-boom-signals-8216misallocation8217-2011-01-06">analyst</a> calls this rush to build higher and higher skyscrapers a classic "sign of economic over-expansion and a misallocation of capital." Eerie footage of entire vacant cities, and reports of up to 64 million unoccupied houses in China (recently highlighted by the <a href="http://www.unconventionaleconomist.com/2010/12/chinas-empty-cities.html">Unconventional Economist</a>) also raise questions about the sustainability of China's boom, and have <a href="http://www.telegraph.co.uk/finance/economics/8261740/Hedge-funds-bet-China-is-a-bubble-close-to-bursting.html">reportedly prompted</a> some hedge funds to start betting on a crash. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOg7tBZVe-H5IFL-J4qMvCim5r3p4L0S3AAtwHE67SmzzPRAmx5laN402pvUziOjJFNjEESe0QgjUoNdsl47oRXpYFJ3F7P9f4h9NfDqPtLvdaCBWbKAxsx4oU65ZDRmGAwxSZeuBFR8k/s1600/skyscraper+chart.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOg7tBZVe-H5IFL-J4qMvCim5r3p4L0S3AAtwHE67SmzzPRAmx5laN402pvUziOjJFNjEESe0QgjUoNdsl47oRXpYFJ3F7P9f4h9NfDqPtLvdaCBWbKAxsx4oU65ZDRmGAwxSZeuBFR8k/s400/skyscraper+chart.png" width="400" /></a></div><br />
So there are some big question marks on the demand side for commodities, even if we do agree with the bullish long-term picture. And a temporary collapse in demand from China could cause a lot of damage to other economies and financial markets, because very few people are prepared for it. As Albert Edwards, an investment strategist at the French bank Societe Generale <a href="http://www.guardian.co.uk/business/2011/jan/03/albert-edwards-socgen-bear">puts it</a>:<br />
<blockquote>"In reality, China is a much more potentially volatile economy than people think. The Chinese situation is the one that could come out of nowhere because people are not considering it as a serious possibility." <br />
<br />
In Edwards' view, China is a "freak economy"; its investment-to-GDP ratio is off the scale in terms of size and endurance. "In development history, Korea is the only one that got close. It then collapsed. China is basing a growth model on the most unstable part of GDP. The Chinese authorities have recognised this and are trying to steer the economy over to consumption – which is fine, but it will take a long time. <br />
<br />
The danger, he suggests, is that China has produced such strong growth for such a long time that investors assume the process will last indefinitely. "There is too much confidence in the lack of volatility. If you get a zero or a small minus for Chinese GDP, in the great scheme of long-term development it's not a great problem. But it's a bit like <a href="http://www.guardian.co.uk/business/investing" title="More from guardian.co.uk on Investing">investing</a> in Nasdaq stocks in 2000 – there would be a big adjustment in price. There is an investment edifice built on the idea that China is the new growth engine of the world." </blockquote>This sense of complacency that Edwards talks about seems particularly relevant to Australia, which -- with the help of China and some massive government stimulus -- largely avoided the global financial crisis of 2008 and has not experienced a recession for two decades.<br />
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In any case, to summarize, we can be cautiously optimistic that China's demand for commodities will continue to grow for another decade or more, but there could be some very painful adjustments along the way. Having said that, we've still only looked at half the story, because it's the interaction of commodity demand with <i>supply</i> that determines prices and ultimately, Australia's terms of trade. What about the supply side?<br />
<br />
This is where the story starts to get interesting. And that will be the subject of my <a href="http://financialfollies.blogspot.com/2011/01/iron-ore-and-australian-house-prices.html">next post</a>.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com11tag:blogger.com,1999:blog-7582484240805759271.post-42980040772035506172011-01-14T19:56:00.002-05:002011-01-14T23:36:02.344-05:00Waiting for a sucker from OzMy <a href="http://financialfollies.blogspot.com/2011/01/on-australians-buying-us-property.html">recent post </a>on the wisdom of Australians buying up $600 million of US foreclosed properties has provoked a few interesting comments and questions by email from readers, so I thought it warranted a quick follow up. Firstly, here is what one concerned Californian reader had to say:<br />
<blockquote>Aussies planning to be millionaires by buying anything in California should think about this. There are literally hundreds of thousands of knowledgeable CASH buyers who are NOT buying. What do we know, that Aussies don't know? First if ANY house is going to be sold, at least 5-6 insiders will get a first shot at the deal..and they will buy in hours. Any property that you see on a list...is OLD, and probably a bad deal.... <br />
<br />
There is a small house across the street from me. In 2005 it cost USD $380,000...today it is for sale for $120,000. They have an auction every day. NO BUYERS! Why aren't people buying? The prices are TOO high! If you buy and rent out...what is to stop your tenant from giving notice and moving next door to the next empty house for LOWER rent? Nothing! So how many months can you handle no tenants---no rent money? Tenants are not stupid...<br />
<br />
I look outside my window and see five For Sale signs ---all "good deals", but why haven't they sold? They were from $750-899,000 only 4 years ago. One of them wants $450k....and has been for sale for 2 years. The asking price drops every month. Why buy TODAY...when the house will be cheaper next week? I have seen some houses go through 4 buyers and sellers in 5 years. All the buyers thought they would be rich. Now you tell me why they sold? Rents are dropping every month...and my county has 22% unemployment. More than one in five adults has NO JOB! <br />
<br />
You want to be rich? DO YOUR HOMEWORK. NO ONE wants to live near gangs. Gangs are attracted to low rents and vacant houses to squat in. Gangs move in and all house prices drop in the area. I saw an ad for the <a href="http://www.888usrealestate.com.au/">888 company</a> showing a newer house near Atlanta Georgia to sell to Aussies. I called a friend who lived nearby the house. There was a gang murder - two people shot one block from the house. Police have no suspects. People in gang areas will not talk...or they will be killed next. <br />
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You can see the listing on the 888 website. It's on a corner lot, in a suburb of Atlanta, Georgia....waiting for a sucker in OZ land. </blockquote>I think this comment speaks for itself about some of the risks involved in buying US foreclosed properties. In <a href="http://financialfollies.blogspot.com/2011/01/why-foreclosure-gate-matters.html">another recent post</a>, I discussed an additional risk that any Australian buying US foreclosed properties needs to be mindful of: the possibility of lawsuits from previous owners of the property claiming that they have been wrongfully evicted. In response to this, one reader asked if it is possible to protect yourself from such risk through <a href="http://en.wikipedia.org/wiki/Title_insurance_in_the_United_States">title insurance</a>. <br />
<br />
I'm far from an expert on these matters, but the answer to the question seems to be: "Yes, but...". The problem here is that some insurance companies have started to shy away from insuring foreclosed properties. And even with those that are willing to insure properties, you can't entirely rule out the risk of getting caught up in a complicated legal mess if the foreclosure is challenged in court. From one recent article in the <a href="http://www.washingtonpost.com/wp-dyn/content/article/2010/10/22/AR2010102206525.html">Washington Post</a>:<br />
<blockquote>The title insurance industry is maneuvering to protect itself from losses if courts rule that banks have played fast and loose with the foreclosure process. But people who buy foreclosed properties from banks may face some degree of loss despite having a title policy.<br />
<br />
Fidelity National Financial, the largest title insurance company, is leading the industry in demanding that lenders warrant that they have followed all legal procedures in the handling of foreclosures and indemnify the title insurers if a court decides otherwise.<br />
<br />
"They are putting on record that it is absolutely the bank's responsibility," said Susan Wachter, professor of real estate at the Wharton School of the University of Pennsylvania.<br />
<br />
But Wachter said buyers of these properties risk getting caught up in litigation among title companies, banks and possibly other entities if the foreclosure is overturned by a court. "There is still uncertainty," she said. "It's a question of litigation; it's a question of transaction costs." </blockquote>In other words, title insurance should protect you, but there is so much legal uncertainty surrounding foreclosures right now that basically nobody really has a clue what is going to happen. And this is my point. Is the average Australian investor that is buying US properties sufficiently educated about these risks? <br />
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To conclude, yesterday's <a href="http://online.wsj.com/article/SB10001424052748704723104576061740571955116.html">Wall Street Journal</a> had a truly bizarre story about how residents of Salem, Massachusetts are turning to witches to exorcise the demons from their foreclosed properties. If you are hellbent on buying a property in the US, maybe you'd better look into this.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzmF_ktgWcfn-S_Wm1ZawN0NCv3k0UUGe__nDfDS-JffZLzm8H87VAiYcsCKOCXsE41BAykvfaR8ZP4Q8fAUMaRP3ly6zpSqTVF3Ea0jhkigJbRavFFuGW_k2qDbIkmOZ6elr_yQ-TgX8/s1600/exorcism.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="241" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzmF_ktgWcfn-S_Wm1ZawN0NCv3k0UUGe__nDfDS-JffZLzm8H87VAiYcsCKOCXsE41BAykvfaR8ZP4Q8fAUMaRP3ly6zpSqTVF3Ea0jhkigJbRavFFuGW_k2qDbIkmOZ6elr_yQ-TgX8/s400/exorcism.png" width="400" /></a></div><br />
<blockquote>SALEM, Mass.—There's a certain look and feel to a foreclosed home, and 31 Arbella St. has it: fraying carpet, missing appliances, foam insulation poking through cracked walls.<br />
<br />
That doesn't faze buyer Tony Barletta since he plans a gut renovation anyway. It's the bad vibes that bother him.<br />
<br />
So two weeks before closing, Mr. Barletta followed witch Lori Bruno and warlock Christian Day through the three-story home. They clanged bells and sprayed holy water, poured kosher salt on doorways and raised iron swords at windows. <br />
<br />
"Residue, residue, residue is in this house. It has to come out," shouted Ms. Bruno, a 70-year-old who claims to be a descendant of 16th-century Italian witches. "Lord of fire, lord flame, blessed be thy holy name...All negativity must be gone!"<br />
<br />
The foreclosure crisis has helped resurrect an ancient tradition: the house cleansing. Buyers such as Mr. Barletta are turning to witches, psychics, priests and feng shui consultants, among others, to bless or exorcise dwellings. </blockquote>What can I say?Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com7tag:blogger.com,1999:blog-7582484240805759271.post-59686156958948262222011-01-12T18:27:00.007-05:002011-01-12T22:15:30.860-05:00Economists. What are they good for?The American economist Dean Baker has a nice article this week titled <a href="http://www.cepr.net/index.php/op-eds-&-columns/op-eds-&-columns/how-many-economists-does-it-take-to-see-a-housing-bubble">How Many Economists Does it Take to See a $8 Trillion Housing Bubble?</a><br />
<blockquote><span class="style23"><span class="style50">T</span></span><span class="style2">he answer to that question has to be many more economists than we have in the United States. Very few economists saw or understood the growth of the $8 trillion housing bubble whose collapse wrecked the economy. This involved a degree of inexcusable incompetence from the economists at the Treasury, the Fed and other regulatory institutions who had the responsibility for managing the economy and the financial system.</span> <br />
<br />
<div class="style2">There really was nothing mysterious about the bubble. Nationwide house prices in the United States had just kept even with the overall rate of inflation for 100 years from the mid 1890s to the mid 1990s. Suddenly house prices began to hugely outpace the overall rate of inflation. By their peak in 2006 house prices had risen by more than 70 percent after adjusting for inflation. Remarkably, virtually no U.S. economists paid any attention to this extraordinary movement in the largest market in the world. </div><br />
<div class="style2">Had they bothered, they would have quickly seen that there was no plausible<span style="font-family: Verdana,Arial,Helvetica,sans-serif;"></span> explanation for this jump in prices in either the supply or demand side of the market.</div></blockquote>Does any of this sound familiar? To some of us it is equally baffling that having watched what has happened in the United States and many other countries, economists at Treasury, the RBA and all the Australian banks continue to tell us that there is nothing at all to worry about in Australia.<br />
<br />
Maybe they're right. But wouldn't it be nice if they at least pointed out some of the risks? In any case, next time you read an economist's prediction in the newspaper, keep in mind that most of the time, at least when it comes to predictions about the future, the experts don't have a clue what they're talking about. And they are especially bad at predicting when things might go wrong. As James Montier of the fund manager GMO <a href="http://www.zerohedge.com/sites/default/files/Montier%2012.23.pdf">said recently</a>:<br />
<br />
<blockquote>Attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. <i><b>Economists are probably the one group who make astrologers look like professionals when it comes to telling the future. </b></i>Even a cursory glance at Exhibit 4 (see below) reveals that economists are simply useless when it comes to forecasting. They have missed every recession in the last four decades! And it isn’t just growth that economists can’t forecast: it’s also inflation, bond yields, and pretty much everything else.</blockquote><table cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEge84bWywXcphwiKJv3RAUsz1mkFlUULUIkYxFuAdlcHTltEXNtqAjOHLc6uD31akTFnSttmenrzgUQEburFK2ddn783qKajblOeq0CrfkSBs7XiGbi4JJl3bSckoR0fXS1OPHTiSE2jtA/s1600/gmo_economists+cant+forecast.png" imageanchor="1" style="clear: left; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" height="180" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEge84bWywXcphwiKJv3RAUsz1mkFlUULUIkYxFuAdlcHTltEXNtqAjOHLc6uD31akTFnSttmenrzgUQEburFK2ddn783qKajblOeq0CrfkSBs7XiGbi4JJl3bSckoR0fXS1OPHTiSE2jtA/s400/gmo_economists+cant+forecast.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: GMO </td></tr>
</tbody></table>Like any other profession, there are plenty of smart people in economics. So why are economists so incredibly useless when it comes to forecasting? As Dean Baker notes in the article above, if you were looking in the right place, it wasn't hard to see that there was a major housing bubble developing in the USA in the years of 2000 to 2007, but hardly anybody raised the alarm. Here are a few possible explanations that come to mind:<br />
<ul><li> Some events that impact the economy are impossible to predict; for example, the recent floods in Queensland or the 9/11 attacks. </li>
<li>In every single financial bubble in history, there has been an argument that "this time is different" -- from the Dutch tulip mania of the 1600s to the Japanese "miracle economy" of the 1980s to the recent US housing bubble. These arguments often sound plausible at the time, but are later shown to be rubbish. Even very smart economists get caught up in the euphoria. </li>
<li>It's not easy being a contrarian. If you forecast doom, and get it wrong, you look like a fool. If you forecast a continuation of the status quo and get it wrong, well, at least you can take comfort in the fact that you got it wrong along with everyone else. If you forecast doom and get it right, you may not get that much thanks because some people will want to "shoot the messenger". </li>
<li>The economists that are most prominent in the media (mostly from banks and real estate companies) are generally paid to be bullish in order to drum up business. Do you really think an economist at an Australian bank is ever going to forecast a crash in the housing market when their profits are so dependent on massive issuance of mortgage debt? (and if you think academic economists are completely free of conflicts of interest, go see <a href="http://www.sonyclassics.com/insidejob/">Inside Job</a>).</li>
</ul>Now, I'm not sure if any of the above apply here, but recently Craig James of CommSec <a href="http://www.news.com.au/money/property/brakes-put-on-2011-property-prices/story-e6frfmd0-1225977125672#ixzz1AUjcR4Li">got a bit testy</a> in response to the argument by some contrarians that Australian house prices might be a little overheated. (<a href="http://delusionaleconomics.blogspot.com/">Delusional Economics</a> wrote about this <a href="http://delusionaleconomics.blogspot.com/2010/12/desperately-spruiking-into-new-year.html">here</a>). <br />
<blockquote>"There hasn't been any evidence that there has been a housing bubble and none to suggest that one is likely," James says. "Some commentators make inaccurate and damaging comments about housing bubbles and affordability without facing consequences. While it may be an emotive story, inaccuracies can limit housing investment and prevent supply from adjusting to higher demand."</blockquote>It might just be my imagination, but Mr James sounds a little defensive.<br />
<br />
In any case, it's not easy going against the flow. David Rosenburg, a highly respected American economist who is now at the Canadian investment firm Gluskin Sheff, recently spoke about how lonely it was being one of the few pessimists during the market rally in 2003-2007, when he was chief economist at Merrill Lynch, whose corporate symbol was a bull. <br />
<blockquote>I recall all too well that 2003-07 bear market rally — yes, that is what it was... It was a classic bear market rally, and did last five years. I was forever skeptical because what drove that bear market rally was phony wealth generated by a non-productive asset called housing alongside widespread financial engineering, which triggered a wave of artificial paper profits. I knew it would end in tears … sadly, I didn’t know exactly when. I was constantly defensive in my investment recommendations at the time and there was a huge price to be paid for being bearish when there is a bull on your business card, trust me on that one. </blockquote>That's it for today. Next time, we'll take another look at China, the commodity price boom and Australian house prices. Just remember that I don't know what I'm talking about either...Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com13tag:blogger.com,1999:blog-7582484240805759271.post-87656560625704597242011-01-09T23:07:00.004-05:002011-01-11T08:46:23.472-05:00Why foreclosure-gate matters<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRB9vHKQqk7JSMYsgTId-YxAuGME5Bdzp-v40xMtbn2cdx-Ds39Segxj6VvXJhajO_5IX7PRIb771V5i4U_PGgW4KHLVmO6zb7r51x7wX0GZYGYGW0AR21OGvNn98q791pZsJn95XRk8k/s1600/foreclosure.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="265" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhRB9vHKQqk7JSMYsgTId-YxAuGME5Bdzp-v40xMtbn2cdx-Ds39Segxj6VvXJhajO_5IX7PRIb771V5i4U_PGgW4KHLVmO6zb7r51x7wX0GZYGYGW0AR21OGvNn98q791pZsJn95XRk8k/s400/foreclosure.jpg" width="400" /></a></div>In my <a href="http://financialfollies.blogspot.com/2011/01/on-australians-buying-us-property.html">last post</a> we took at look at Australia's latest investing fad: buying up foreclosed properties in US states like California, Nevada and Florida. We've already examined how anybody who thinks this is a good idea probably needs their head checked, but there is one additional risk that I didn't even mention: the risk of getting sued by the previous owner of a property that you've bought if he or she claims that they were wrongfully thrown out of their house. <br />
<br />
On this front, a Massachusetts court delivered a very important decision last week that could have huge implications for the US housing market and mortgage securitization. From the NY Times:<br />
<blockquote>The highest court in Massachusetts ruled Friday that U.S. Bancorp and Wells Fargo erred when they seized two troubled borrowers’ properties in 2007, putting the nation’s banks on notice that foreclosures cannot be based on improper or incomplete paperwork. Concluding that neither institution had proved it had the right to evict the borrowers, the Supreme Judicial Court voided the foreclosures, returning ownership of the properties to the borrowers and opening the door to other foreclosure do-overs in the state.</blockquote>To explain why this is important, we have to go right back to the root of the global financial crisis of 2008, which can be found in the securitization of US subprime mortgages.<br />
<br />
During the boom years leading up to 2008, American banks packed together millions of mortgage loans, and sliced and diced, or "securitized" these into thousands of securities called MBS. To create an MBS, the banks would first sell the loans to a trust, which then sold bonds backed by those mortgages to investors all over the world. But there was a minor problem. In their rush to issue as many of these securities as possible and pay themselves gargantuan bonuses, the bankers didn't bother to do the paperwork properly, and now it's unclear who actually holds the mortgage notes. Oops. <br />
<br />
Of course, at the time these loans were made nobody ever thought this would be a problem because, as we know well in Australia, house prices double every 7 years and borrowers never default on their mortgages. Now, a few years later, there are millions of Americans delinquent on their loans.<br />
<br />
"Foreclosure-gate" started brewing late last year when it became evident that having stuffed up the paperwork, many of the banks had hired thousands of "robo-signers" to write false affadavits claiming that they had reviewed the loan documents (which they hadn't even seen). These affadavits were then being used to evict people who had stopped paying their mortgages. <br />
<br />
So, the court case above puts an end to this kind of nonsense from the banks, at least in Massachussets. Until they get their paperwork in order (if that is even possible) they will have to stop turfing people out of their homes. The real estate experts cited <a href="http://www.nytimes.com/2011/01/09/business/09foreclosure.html?ref=business">here </a>here say that this delay in the processing of foreclosures would be a good thing for the housing market.<br />
<blockquote>If the slowdown continued through this month and into the spring, it could be a boost for the economy. Reducing foreclosures in a meaningful way would act to stabilize the housing market, real estate experts say, letting the administration patch up one of the economy’s most persistently troubled sectors. Fewer foreclosures means that buyers pay more for the ones that do come to market, which strengthens overall home prices and builds consumer confidence in housing. </blockquote>This is the optimistic view. If it becomes harder for lenders to foreclose, then they might become more willing to restructure loans instead (for example cutting the interest rate on the loan and/or reducing the principal that has to be repaid), which is probably the only eventual way out of this mess. At the end of the day, the banks are going to have to take a hit for making stupid loans that were never likely to be repaid.<br />
<br />
But loan restructurings are tricky, because if the lenders offer attractive loan modification terms to delinquent borrowers, then even people who are able to pay their mortgage will start "strategically" defaulting in order to become eligible for debt forgiveness. And this would probably make some lenders insolvent. On top of this, securitization makes the whole process even more complicated because there are so many parties involved. In an MBS deal, there are strict contractual limits on loan modifications, which usually can't be changed without the consent of 100% of the MBS holders, who could number in the thousands and are usually spread all over the world. Obviously getting all these parties to agree is pretty much impossible. <br />
<br />
In the meantime, there could be enormous potential for chaos, because the Massachusetts legal decision is going to be followed by waves of lawsuits in other states all over America. <a href="http://blogs.reuters.com/felix-salmon/2011/01/07/the-ibanez-case-and-housing-market-catastrophe-risk/">Felix Salmon</a> of Reuters has a great post addressing this issue which I will quote at length from:<br />
<blockquote>The legal craziness that this decision sets in motion is going to be huge, I’m sure. Anybody who was foreclosed on in Massachusetts should now be phoning up their lawyer and trying to find out if the foreclosure was illegal. If it was — if there was a break in the chain of title somewhere which meant that the bank didn’t own the mortgage in question — then the borrower should be able to get their deed, and their home, back from the bank. This decision <i>is</i> retroactive, and no one has a clue how many thousands of foreclosures it might cover. <br />
<br />
Similarly, if you bought a Massachusetts home out of foreclosure, you should be very worried. You might not have proper title to your home, and you risk losing it to the original owner. It might be worth dusting off your title insurance: you could need it. And if you ever need to <i>sell</i> your home, well, good luck with that. <br />
<br />
Going forwards, every homeowner being foreclosed upon will as a matter of course challenge the banks to prove that they own the mortgage in question. If the bank can’t do that, then the foreclosure proceeding will be tossed out of court. This is likely to slow down foreclosures enormously, as banks ensure that all their legal ducks are in a row before they try to foreclose. <br />
<br />
What’s more, courts in the other 49 states are likely to lean heavily on this decision when similar cases come before them. The precedent applies only in Massachusetts for now, but it’s likely to spread, like some kind of bank-eating cancer. <br />
<br />
If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain. <br />
<br />
The big losers here are the banks — of course — as well as investors in mortgage-backed securities, including of course Fannie and Freddie, a/k/a the US taxpayer. </blockquote> This could get very ugly.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com9tag:blogger.com,1999:blog-7582484240805759271.post-67793414636759085542011-01-08T15:20:00.011-05:002011-01-09T08:56:30.439-05:00On Australians buying US property...With Australian property prices looking very toppy and the Aussie dollar going through the roof, the latest delusional investing fad in Australia appears to be snapping up foreclosed US properties. I've been hearing stories about this a while now, so I thought I'd look into it a bit. Firstly, in case you missed the <a href="http://www.theage.com.au/national/australian-investors-could-lose-millions-on-us-rental-properties-20110101-19cm6.html">story</a> in The Age last week, here's a little extract to set the scene:<br />
<blockquote>AUSTRALIAN property investors risk losing hundreds of millions of dollars after snapping up thousands of US housing bargains at forced-sale prices, experts have warned.<br />
Emboldened by the soaring local dollar, Australians invested about $600 million on US residential property last year, according to the Washington-based National Association of Realtors, as overseas buying of US housing doubled. <br />
<br />
But consumer advocate Neil Jenman predicts that thousands of Australians will lose their money after unwittingly buying undesirable property.<br />
''It's going to be a calamity, for sure and certain,'' he says.</blockquote>Another <a href="http://www.theage.com.au/victoria/as-realty-bites-australians-taste-the-american-dream-20100305-powo.html">article</a> from The Age tells the story of the following couple:<br />
<blockquote>CLEANERS Ana and Miguel Canepa never imagined when they fled to Australia as refugees they would one day be landlords of four rental homes. But the residents of St Albans in Melbourne's outer north west are living the Australian dream, having last week signed contracts to buy their latest investment property. And it only cost them $A44,117.<br />
<br />
That is because the three-bedroom house is in the US city of Phoenix in Arizona.<br />
The couple, originally from El Salvador, have never been to Phoenix. But they already own two other homes purchased there this year for $A41,000 and $A52,100, as well as a fourth rental asset in Melbourne. <br />
<br />
Real estate specialist Kevin Walters, who arranged the Canepa's purchases, will next month lead a shopping tour for 10 Australians and a tax firm that advises self- managed superannuation holders. They will visit Phoenix and Las Vegas, the foreclosure capital of the US.<br />
<br />
''You can buy a house in the US for the cost of a deposit here,'' he says. ''Clients can purchase property in just two days, it's that easy. The only exception is that we don't have a lender for them at the moment, so they buy in cash.'' Mr Thomas says he gets rental returns of 16 per cent on his US assets, compared to about 3 per cent for his Australian properties. <i><b>''It doesn't seem a risk at all to me,'' he says.</b></i></blockquote><br />
What could possibly go wrong?<br />
<br />
The Age quotes a Byron-Bay based buyers agent called <a href="http://www.888usrealestate.com.au/">888 US Real Estate</a>, which according to its website charges a "committment fee" of $380 and then a commission of $3,420 for each property purchase it handles for the Aussie battlers trying to realise their dreams. But 888 US Real Estate is just one of a handful of organizations that are sprouting up like weeds to flog US property to unsuspecting Australian buyers. Here are just a few of the ridiculous sales pitches made on some of these websites. <br />
<ul><li>"It's no secret: USA property investment gives you a 10-20% net return... Even after your expenses are paid you will still make money with <a href="http://www.myusaproperty.com.au/">My USA Property"</a></li>
<li>"Once American banks start lending again, the USA market will recover. So you’d be wise to invest in an undervalued market now since every Australian dollar buys more" (My USA Property)</li>
<li> "When you say “Go!” you set the wheels in motion for an exhilarating ride as your property grows in value giving you the possibility to create enough cash to fund the rest of your life in a few short years. Call us now!" (888 USA Real Estate)</li>
</ul>Now, before you leave to throw up, I'd like to note that the statements above would be illegal if these guys were stockbrokers. But apparently in property land it's OK to promise fantastical rates of return without pointing out any of the risks involved in the investment strategy. Speaking of the risks, we'll get to that later.<br />
<br />
But for now, we should concede that some of the claims they make are accurate. It is indeed true that in many parts of the US today, you can buy a house for less than the price of a new car in Australia, or for less than the average deposit on a house in most Australian cities. Which raises another question. There are a lot of very smart American investors with a lot of money to burn. If properties in the US are such a bargain, why is it that many of these American investors still don't want to touch the property market with a ten foot pole? <br />
<br />
<b>Miami Vice </b><br />
I'm not going to go into detail about what an absolute debacle the US property market is today, but let's just take a look at an interesting graphic in a <a href="http://www.nabe.com/rt/real/documents/Chen_NABE_01212010.pdf">recent report</a> from the ratings agency Moodys. Moody's notes that there is still a massive surplus of housing inventory on the market, and that foreclosures and defaults are still skyrocketing in many parts of the country. You can see below that <b><i>there are significant parts of California, Nevada, Arizona and Florida, where Moody's doesn't expect the housing market to fully recover until 2030</i></b>. Yes, that's still two decades away. <br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNnz5-9Otan4ru6NbKMW30Pfjt54keWQrUXbCXyC6mx9DBCBjrDxUf2R0dC-GUfJN9IwL1k0ftvybeGFzEFzVwbIJG1m3uY1ZKCLy9Duf2G139UYg70O_Nyhp1IxtNTqSAry4HHLOzsE4/s1600/moodys_USA+house+prices.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="300" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhNnz5-9Otan4ru6NbKMW30Pfjt54keWQrUXbCXyC6mx9DBCBjrDxUf2R0dC-GUfJN9IwL1k0ftvybeGFzEFzVwbIJG1m3uY1ZKCLy9Duf2G139UYg70O_Nyhp1IxtNTqSAry4HHLOzsE4/s400/moodys_USA+house+prices.png" width="400" /></a></div><br />
And guess where the property spruikers are trying to talk Australians into buying investment properties? You're right. Places like California, Nevada, Arizona and Florida. Here's are a couple of <a href="http://www.myusaproperty.com.au/examples.php">listings</a> in Florida from My USA Property:<br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgST5a5vXAcNVGr-IKlW9EaqbXveu0jL0Pl6o1M2l3qfBryxdSM-2QhqsCcGmad-tv1EpKvV84yJo1X8hz1rD2mVSbQUPftZLeJ6DEYbxKvM65IDs9jciRsXH_kgZOcRib0IL1MseT9QCE/s1600/florida+properties+for+sale.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="227" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgST5a5vXAcNVGr-IKlW9EaqbXveu0jL0Pl6o1M2l3qfBryxdSM-2QhqsCcGmad-tv1EpKvV84yJo1X8hz1rD2mVSbQUPftZLeJ6DEYbxKvM65IDs9jciRsXH_kgZOcRib0IL1MseT9QCE/s400/florida+properties+for+sale.png" width="400" /></a></div><br />
Now, on the surface, property prices in Florida look like a real bargain, since they've already fallen around 45% in Miami and more than 40% in Tampa, as you can see below. <br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5jgiHVtoTkfAxcmdTDyhm1HbufvB_uGnKRTmac_55LYgorINwpNzANSesRpPFnbFPgXZqdq0fB9N-dg0SDtW32GuKvH5dQcxWe5-3E-ReApdQit5rnlX9K-_yk0GM7aoE-Hrt3oXBKr8/s1600/miami+tampa+house+price+index.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="180" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5jgiHVtoTkfAxcmdTDyhm1HbufvB_uGnKRTmac_55LYgorINwpNzANSesRpPFnbFPgXZqdq0fB9N-dg0SDtW32GuKvH5dQcxWe5-3E-ReApdQit5rnlX9K-_yk0GM7aoE-Hrt3oXBKr8/s400/miami+tampa+house+price+index.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: www.data360.org</td></tr>
</tbody></table><br />
<div class="separator" style="clear: both; text-align: center;"></div><b>Unsuspecting Suckers </b><br />
But there's no guarantee that prices are ever going to return to these peaks again, at least for a very long time in some of these areas. In fact, one <a href="http://www.housingamerica.org/RIHA/RIHA/Publications/75154_10296_Research_RIHA_ShrinkingCities_Report.pdf">recent study</a> (which I might examine in more detail when I get the chance) argues that the housing bust may have created new types of "declining cities" across the USA -- certain cities which grew rapidly in the boom, attracting huge population inflows and investment -- but which are now facing the prospect of decades of stagnation thanks to a vicious circle of falling house prices, declining populations, rising vacancies, and increasing crime rates.<br />
<br />
Some Australian investors are already finding this out the hard way. From the above story in The Age:<br />
<blockquote>Sydney woman Kathy Graffiti bought three properties in upstate New York in 2005 and estimates she has lost between $300,000 and $400,000 on her investment. She bought two properties in Rochester and one in Buffalo for a total of $250,000, expecting rental yields of between 22-23 per cent. <br />
The rental income stopped in 2007 and Ms Graffiti was forced to sell two of the properties at a significant loss. She has been offered $10,000 for the third property. </blockquote><a href="http://www.smartcompany.com.au/property/20101123-six-traps-of-buying-property-outside-your-home-market.html">According to Neil Jenman</a>, the consumer advocate quoted in The Age above, Buffalo, NY is one of the many areas where American "flippers" are buying up properties at fire-sale prices and then selling them on to "unsuspecting Australian suckers" at much higher prices.<br />
<blockquote>Typically, the American promoters work in tandem with Australian property spruikers who Jenman says are the "same rogues" who used highly questionable tactics when selling residential property on the Gold Coast and in the outer Melbourne suburbs.<br />
<br />
Jenman says some Australians paid $50,000 for US houses with expectations of extraordinary rental yields and now can't sell the properties for $25,000. And he knows of an Australian who paid $80,000 for a house and now is unable to sell it for $40,000 – the best offer has been $10,000.</blockquote><br />
<b>Dumb Things </b><br />
Without a doubt, there are going to be some good investment opportunities in some parts of the US. But how the hell are you going to identify them from Australia, and can you really trust the clowns at places like 888 US Real Estate to pick the winners for you?<br />
<br />
And that's not to mention the myriad of other problems involved with buying property in the US, which the property spruikers gloss over, but include:<br />
<ul><li>Significant foreign exchange risk</li>
<li>Major tax complications including the necessity to pay income tax in the US on any rental income</li>
<li>Stronger legal protections for tenants in the USA and a greater likelihood of lawsuits which can significantly raise costs for landlords compared to in Australia (see <a href="http://news.yahoo.com/s/prweb/20101213/bs_prweb/prweb8021733">here</a> for example)</li>
</ul>Finally, you may have wondered how Australian investors have been financing these purchases. The answer is that American banks generally refuse to grant loans to overseas property investors (they're having enough trouble dealing with all the dumb subprime loans they made to Americans), so the majority of purchases are being made in cash. And where is this cash coming from? Usually, one of two things. Either a line of credit based on the equity in their Australian property holdings, or cash from their self managed super funds. Does this sound like a smart idea to you?<br />
<br />
It's time to wrap this up. Let's end with an appropriate Aussie classic from Paul Kelly.<br />
<br />
<object height="385" width="480"><param name="movie" value="http://www.youtube.com/v/pWhj4sVeVD0?fs=1&hl=en_US"></param><param name="allowFullScreen" value="true"></param><param name="allowscriptaccess" value="always"></param><embed src="http://www.youtube.com/v/pWhj4sVeVD0?fs=1&hl=en_US" type="application/x-shockwave-flash" allowscriptaccess="always" allowfullscreen="true" width="480" height="385"></embed></object>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com277tag:blogger.com,1999:blog-7582484240805759271.post-61182499907135906882011-01-04T18:56:00.000-05:002011-01-04T22:19:13.249-05:00An investment property for the new year?Some of you may remember that I was a bit harsh on our friends at <a href="http://www.apimagazine.com.au/">Australian Property Investor</a> in this <a href="http://financialfollies.blogspot.com/2010/12/cult-of-property.html">recent post</a>. I was planning to go easy on them for a while, but I just happened to come across their new issue online and it's so compelling that I can't resist. According to API, 2011 is the year of "RED HOT BUYING OPPORTUNITIES". Yes, you too can become a millionare.<br />
<br />
Now, unfortunately you need the print version to get the full details, which apparently includes the story of a 24 year old role model for all young Australians who has racked up $1 million in property debt, but is "still in front"! Anyway, for those of us that don't have a subscription they have a nice little piece online titled <a href="http://www.apimagazine.com.au/api-online/web-specials/2011/january-cover-story-housing-construction-and-7-reasons-to-buy-now">7 Reasons to Buy an Investment Property Now</a>. It's a Pulitzer worthy example of the property spruiking genre, so I will quote all 7 reasons below, sprinkled with a bit of commentary in between:<b> </b><br />
<blockquote>1. It's a buyers' market - most buyers don't buy in a buyers' market; investors buy in a buyers' market, so we should call it an investors' market. So what should investors do? Get out there and buy. </blockquote>My first question here is, what the hell does this mean? I'm not really sure what they're talking about, but I think they're trying to tell us to just drop whatever the hell we're doing and go out there and buy some investment properties right now before they all disappear. <br />
<blockquote>2. Prices for some materials are dropping so now is the best time to do some renovations or building. </blockquote>What materials? Don't they say below that commodity prices are going up?<br />
<blockquote>3. There's the emergence of a major commodity demand coming out of China and India. The Reserve Bank is forecasting a resources boom, so investors need to get ready for that.</blockquote>The commodity boom is a double edged sword for Australia, as I argued <a href="http://financialfollies.blogspot.com/2010/12/australias-unhealthy-dependence-on.html">here</a>. If the boom continues, the RBA is probably going to keep raising interest rates, and the banks will follow by lifting mortgage rates. At the very least, this would reduce the returns on rental properties (which are already negative without capital gains). At the worst, higher rates will choke the rest of the economy and trigger a crash. On the other hand, if <a href="http://www.unconventionaleconomist.com/search/label/China%20Bubble">the bears</a> are right about China and the boom busts, our economy is in big trouble.<br />
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So yes, API is right that "investors need to get ready for that". They need to get ready by not making dumb financial decisions that leave them overburdened with debt when things go bad. Dumb decisions like collectively <a href="http://www.theage.com.au/national/australian-investors-could-lose-millions-on-us-rental-properties-20110101-19cm6.html">buying $600 million of residential US property</a> over the past year without a proper understanding of the <a href="http://www.businessinsider.com/gary-shilling-house-prices#">risks</a> involved, for example. (In case you're wondering, API has <a href="http://www.apimagazine.com.au/api-online/web-specials/2010/buying-cheap-us-properties">that covered </a>too) <br />
<blockquote>4. There's going to be an influx of workers, who will need somewhere to live and they'll most likely be renting properties. </blockquote><blockquote>5. A rental boom is just around the corner - as those workers come in there'll be increased demand for property and with a shortage of houses already rents are sure to increase. </blockquote>Where is this influx of workers going to come from? Immigration is falling from its peak levels of earlier this decade and international student numbers are falling sharply. See the chart below.<br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivrBFLUth35IUijZ88MUrWcMcJRHmYglrfkJBGVOEfVjbegyfTCBG_Y2ySzogitvIPP8IhtRSmBZxaR4ClbpBerIDqAIM4nwDWe5y4BpK6oC9IqSzg5nhB_nfznQNHPpponiroQp5OBuI/s1600/Overseas-arrivals-SMALL_png.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="165" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivrBFLUth35IUijZ88MUrWcMcJRHmYglrfkJBGVOEfVjbegyfTCBG_Y2ySzogitvIPP8IhtRSmBZxaR4ClbpBerIDqAIM4nwDWe5y4BpK6oC9IqSzg5nhB_nfznQNHPpponiroQp5OBuI/s400/Overseas-arrivals-SMALL_png.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: RP Data</td></tr>
</tbody></table><br />
<blockquote>6. Other markets - such as the sharemarket - are volatile but property is stable. </blockquote>This is one of the biggest myths surrounding property investing. While it's true that property has historically been less volatile than shares, it's a different story if you're highly leveraged, which is the case for virtually everybody buying property. If you buy $50,000 of BHP Billiton shares with cash and the market falls 20%, you lose $10,000, or 20% of your investment. Bad news, but not a total disaster.<br />
<br />
On the other hand, lets say you put this money in a $500,000 investment property. You put $50,000 down and borrow the rest at an LTV of 90%. In this case, if the market drops 20%, you have not only lost your entire investment, but you owe MORE money to the bank than the property is even worth. <i>Negative</i> equity. Another point to make is that unlike shares, property is highly illiquid. If you do need to offload that investment property in a hurry, it's quite possible there won't be any buyers.<br />
<br />
Highly leveraged investments are great when markets are going up, which is what we've seen in Australia for most of the past two decades. They make a lot of ordinary people look very smart. But they also contain the potential for financial disaster when things go wrong, as we have seen recently in the USA, Iceland, Ireland and Spain. And just how leveraged is the average property investor in Australia? Very. According to Westpac around half of investor loans in Australia are interest only, meaning that they haven't even paid down any of the principal and are basically gambling on capital gains. <br />
<blockquote>7. Growth in prices is coming - the cycle will soon turn. There'll be a rental boom and a shortage of housing will drive up prices. Investors should be getting ready for the next capital gain boom. Don't miss the boat. </blockquote>So don't miss the boat. There's a massive capital boom coming because... well, you know, it's just <a href="http://www.youtube.com/watch?v=lXxyTLbZNgw">"the vibe"</a>. <br />
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That's enough about the property spruikers for now, because there are more interesting things that I'd rather write about. But there's a serious point behind making fun of these guys, which is that Australians are getting a lot of very bad advice on property investing -- the risks involved are rarely properly explained. On a related note I would like to draw your attention to an interesting <a href="http://delusionaleconomics.blogspot.com/2011/01/is-this-legal-and-if-so-why.html">post by Delusional Economics</a> earlier this week. Citing a particularly egregious example of <a href="http://www.heraldsun.com.au/ipad-application/climb-the-ladder-to-your-dreams/story-fn6bn9st-1225980011917">property spruiking in the Herald Sun</a>, they ask the excellent question of whether or not advice on property investment is subject to regulation by the Australian Securities and Investments Commission (ASIC).<br />
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Well, apparently not, according to this comment posted by Delusional Economics reader PETER_W.<br />
<blockquote>The Real Estate industry is exempt from the Financial Services Reforms (Financial Advice) Act... The real estate industry lobbied very hard to ensure the dumbest of the very dumb... i.e. their own members the real estate agents were exempt from being licenced under the AFSL... Australian Financial Services Licencing Act. So long as their advice is only constrained to real estate they can tell the public that house prices will grow at 20% compound for the next 40 years with no legal constraints. </blockquote>Since a house is by far the most important investment most people make, shouldn't there be some sort of regulation here?Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com17tag:blogger.com,1999:blog-7582484240805759271.post-74226802151651194622011-01-02T14:22:00.004-05:002011-01-02T14:52:45.249-05:00The lunacy of US health careA quick departure from the usual themes of this blog today, as I have an interesting anecdote illustrating the financial folly of the US healthcare system. A couple of months ago I went to see a doctor in Manhattan about a minor skin problem. She spent about 10 seconds examining me, immediately identified the problem, wrote me an illegible prescription, and sent me packing. At the most I was in her office for 2 minutes.<br />
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Two months later I get a strange letter in the mail from the clinic, telling me that my insurance company is refusing to pay them the $160 they charged me for that 2 minute appointment. Here is what it says.<br />
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<blockquote>To date, we have been unable to secure payment for the services rendered to you. We appreciate any assistance you can provide, including calling your insurance company, to help get these claims paid. We appreciate your assistance in resolving your outstanding insurance balance. </blockquote>This is a perfect illustration of how completely nuts the US healthcare system is. Firstly, $160 for a two minute office visit. Enough said.<br />
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Secondly, it appears to be routine business practice of a lot of the health insurers here to deny a certain percentage of claims, whether or not they have a genuine reason for doing so. Patients are then forced into an endless bureaucratic nightmare of paperwork, fine print and phone calls and have to waste hours negotiating with their insurance provider to get them to pay the bill. Some people just give up eventually and end up paying the bill themselves, which is probably what the insurance company was hoping for in the first place. There appears to be no government regulation to put a stop to this kind of stupidity. <br />
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Now, my example is nothing more than an annoyance. But there are legions of stories here of cancer victims, etc, being denied coverage for totally arbitrary reasons and then being stuck with enormous bills for services which they thought they were covered for. If you think I'm exaggerating, see <a href="http://www.health.com/health/gallery/0,,20315060,00.html">here</a> for some heartbreaking stories. In fact, the inability to pay medical bills is the leading cause of personal bankruptcy in the United States.<br />
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As the entertaining <a href="http://www.rollingstone.com/politics/news/sick-and-wrong-20100405">Matt Taibbi</a> of Rolling Stone puts it: <br />
<blockquote>The system doesn't work for anyone. It cheats patients and leaves them to die, denies insurance to 47 million Americans, forces hospitals to spend billions haggling over claims, and systematically bleeds and harasses doctors with the specter of catastrophic litigation. </blockquote><blockquote>There are currently more than 1,300 private insurers in this country, forcing doctors to fill out different forms and follow different reimbursement procedures for each and every one. This drowns medical facilities in idiotic paperwork and jacks up prices: Nearly <i>a third</i> of all health care costs in America are associated with wasteful administration. Fully $350 billion a year could be saved on paperwork alone if the U.S. went to a single-payer system...</blockquote>President Obama passed a modest reform package last year that attempts to deal with some of these issues, but would still fall well short of the kind of comprehensive health care systems that most other western countries have in place. For this, he has been derided as a "socialist" and a "nazi" by the crazed tea party types currently gaining prominence in the Republican party, who assert that health care is "not a right, it's a privilege". <br />
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Anyway, my rant on US health care is over.<br />
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Happy new year to everybody reading. If you're new, the aim of this blog is to debate some of the big issues facing Australia's economy today, many of which are getting very short thrift in the Australian media.<br />
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To date, I have focused largely on what I think is the biggest vulnerability we face today: the huge rise in Australian property prices over the past decade and the unsustainable growth in household debt that has accompanied it. I will probably continue to go on about this like a broken record, because it is the single issue where I think mainstream Australian opinion (reflected in the media) is the most utterly divorced from reality. But I would also like to broaden the themes of this blog a bit this year. <br />
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Some interesting topics that I will probably explore:<br />
<ul><li>Is China's boom and the massive rise in commodity prices sustainable? </li>
<li>Is it sensible to tax the miners with a resources tax? </li>
<li>Are we going to see sovereign defaults in Europe? And what would trouble in the international debt markets mean for Australia's banks and our property market?</li>
<li>Why were the Henry review's recommendations on property taxes completely ignored? </li>
<li>How overvalued is the Australian dollar?</li>
<li>What is going on inside the head of Brendan Fevola?</li>
</ul><br />
Feel free to suggest related topics or weigh in with your own opinion in the comments section below the posts. Time permitting (I do have a full time job!), I will try to reply. I don't expect everybody to agree with me. If you work in real estate, you will probably think I'm an idiot. That's fine. In my opinion, the mark of a good blog is the quality of the comments section.<br />
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Until next time.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com2tag:blogger.com,1999:blog-7582484240805759271.post-79299897331465783032010-12-31T19:27:00.003-05:002011-01-01T00:07:05.845-05:00Australia's unhealthy dependence on ChinaDebate 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. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcJD28bKHh6OnSwg-UCW3fNpMbW4tLiKJAYfkqgRaFhnUbWi72V5zNzWh09u4O7qbiQak_uszwedIOLJex1ABbGBR-xRt36rLCNWRirqmbtl4BuHN9cToTNl89H-R4ScqZM3W1K0kmdSM/s1600/australianexports.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="293" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjcJD28bKHh6OnSwg-UCW3fNpMbW4tLiKJAYfkqgRaFhnUbWi72V5zNzWh09u4O7qbiQak_uszwedIOLJex1ABbGBR-xRt36rLCNWRirqmbtl4BuHN9cToTNl89H-R4ScqZM3W1K0kmdSM/s400/australianexports.png" width="400" /> </a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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 <a href="http://www.rba.gov.au/publications/rdp/2010/2010-08.html">paper</a> 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.</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuPyKKdc6otItR2MWt_BPql7BgKEzn8gERRxtLlOePRQbx84ALj44uxL61l-Q9Ail8cMO8dxoP6ly5TFER6sBxcXk56GTptUlQ5M1k2FHzZGpukgJYnEBtCEdpBgfy7ClXZMDdmnb0ABU/s1600/tot_rba.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="328" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuPyKKdc6otItR2MWt_BPql7BgKEzn8gERRxtLlOePRQbx84ALj44uxL61l-Q9Ail8cMO8dxoP6ly5TFER6sBxcXk56GTptUlQ5M1k2FHzZGpukgJYnEBtCEdpBgfy7ClXZMDdmnb0ABU/s400/tot_rba.png" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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 <a href="http://mpettis.com/2010/12/chinese-growth-in-2011/">post</a>, he says:</div><blockquote><div class="separator" style="clear: both; text-align: left;">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.</div></blockquote><div class="separator" style="clear: both; text-align: left;">Pettis describes even this forecast as being "optimistic", and dependent upon China being able to maintain consumption growth of 8-9% a year. </div><blockquote><div class="separator" style="clear: both; text-align: left;">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... <i><b>Non-food commodity exporters will be badly hurt</b></i>.</div></blockquote><div class="separator" style="clear: both; text-align: left;">What would the implications be of such a drop in China's growth rate? Fitch Ratings recently performed a "<a href="http://asianbondsonline.adb.org/publications/external/2010/The_Impact_of_a_China_Slowdown_on_Global_Credit_Quality_FR_30_Nov2010.pdf">stress test</a>" 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. </div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhlKpUTokS0y6-PNFA0fxUvH8-5nQ0uucKqtdWjWgqUpUqtu7ShpGf3zYngOHFt9S30-XSw0sm_qcTkpIlACzAXx5sKy-dWbYqBDR5C5g7LJ7giXmjRl1t-Jy1H_ggTfljFhaMOXm90YqU/s1600/china+stress+test_fitch_png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="261" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhlKpUTokS0y6-PNFA0fxUvH8-5nQ0uucKqtdWjWgqUpUqtu7ShpGf3zYngOHFt9S30-XSw0sm_qcTkpIlACzAXx5sKy-dWbYqBDR5C5g7LJ7giXmjRl1t-Jy1H_ggTfljFhaMOXm90YqU/s400/china+stress+test_fitch_png.png" width="400" /></a></div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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.</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLjgsjN9mrAlWJacXo4W0IPlhxUFNaBETbmqyRwwG3VGJbfV4jQA2r-jjlIMJlxCdCas9u5AtDQMNzQSW097Xy5GAtufFL4aD8J-fXoy1DOPvRRmsC4xRX3CqJkyXdd7U9RfKnf55FM8o/s1600/commodity+dependence_fitch.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="325" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjLjgsjN9mrAlWJacXo4W0IPlhxUFNaBETbmqyRwwG3VGJbfV4jQA2r-jjlIMJlxCdCas9u5AtDQMNzQSW097Xy5GAtufFL4aD8J-fXoy1DOPvRRmsC4xRX3CqJkyXdd7U9RfKnf55FM8o/s400/commodity+dependence_fitch.png" width="400" /></a> </div><br />
Not surprisingly, Fitch identifies iron ore exporters as amongst the biggest potential losers: <br />
<blockquote><div class="separator" style="clear: both; text-align: left;"><i><b>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</b></i>...</div></blockquote>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. <br />
<blockquote><i><b>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</b></i> 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. </blockquote><blockquote>Investor risk appetite would likely reduce, increasing volatility in financial markets and resulting in capital flight from perceived riskier assets... <i><b>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</b></i>...</blockquote><blockquote>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... <i><b>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</b></i>, with credit availability reducing... </blockquote><blockquote><i><b>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.</b></i> </blockquote>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.<br />
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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 <a href="http://www.rossgarnaut.com.au/">Ross Garnaut</a> 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.<br />
<br />
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?Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com5tag:blogger.com,1999:blog-7582484240805759271.post-7065985547393157572010-12-29T22:36:00.000-05:002011-01-02T12:19:02.066-05:00Australian 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 <a href="http://www.theaustralian.com.au/business/markets/australian-home-prices-best-in-the-world/story-e6frg926-1225977779184">says today</a>, 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 <a href="http://www.google.com/url?sa=t&source=web&cd=3&ved=0CCwQFjAC&url=http%3A%2F%2Fwww.scotiacapital.com%2FEnglish%2Fbns_econ%2Fretrends.pdf&rct=j&q=scotiabank%20housing%20markets&ei=v4waTZPrCoG78gb8yKiSDg&usg=AFQjCNEEXpWcGq17p2N-VA94OtfqGSYaOg&sig2=2TMuX_bbCsAsVLEQaa84Wg&cad=rja">had to say</a>: <br />
<div style="text-align: justify;"><blockquote>"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...</blockquote><blockquote>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."</blockquote></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2XHm1H1lwX0YDqlv8oQC7D_SCk9QUFQIeHsWc52lQkLdd0i2G0X1JCa-Sf3UuUYKGjbVs_9UgB1ixPX1oGhFNSzTw2xSNi3bmTUurx7coI7a42IcLjiIQAd4GuelxQCnZLUibuUn6Mko/s1600/real+house+prices+scotia.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2XHm1H1lwX0YDqlv8oQC7D_SCk9QUFQIeHsWc52lQkLdd0i2G0X1JCa-Sf3UuUYKGjbVs_9UgB1ixPX1oGhFNSzTw2xSNi3bmTUurx7coI7a42IcLjiIQAd4GuelxQCnZLUibuUn6Mko/s320/real+house+prices+scotia.png" width="211" /></a></div>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. <br />
<br />
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 <a href="http://www.heraldsun.com.au/business/traders-crying-out-for-help/story-e6frfh4f-1225975247935">worst Christmas sales</a> 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. <br />
<br />
On the other hand, if <a href="http://www.unconventionaleconomist.com/search/label/China%20Bubble">the bears</a> 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.<br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="float: left; margin-right: 1em; text-align: left;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCXqDWCkAJMK1flvjdsoCSEK2cuuaQfQiBJdyuERhKppxdT8KSPz7MErLgVEwBAiPTGGtJtFgVnr0gqVNRj_asI_B7NoLal-YhXRyBhdl74t7R6ykuVojzEcspKqkSxLZzS9-YgCPa8Tw/s1600/volumefirsthomebuyers.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="248" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCXqDWCkAJMK1flvjdsoCSEK2cuuaQfQiBJdyuERhKppxdT8KSPz7MErLgVEwBAiPTGGtJtFgVnr0gqVNRj_asI_B7NoLal-YhXRyBhdl74t7R6ykuVojzEcspKqkSxLZzS9-YgCPa8Tw/s640/volumefirsthomebuyers.png" width="640" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: RP Data</td></tr>
</tbody></table><br />
<br />
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 <a href="http://www.rba.gov.au/speeches/2007/sp-dg-250907.html">speech</a> in late 2007:<br />
<blockquote>...the household sector is running a highly mismatched balance sheet, with assets consisting mainly of property and equities, and liabilities comprised by debt. <i><b>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. </b></i></blockquote>Meanwhile, there are <a href="http://www.heraldsun.com.au/ipad-application/foreign-lenders-get-the-property-jitters/story-fn6bn9st-1225976177345">troubling reports</a> 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?<br />
<br />
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 <a href="http://www.morganstanley.com/views/gef/archive/2010/20100817-Tue.html#anchor25c64a02-aa03-11df-8410-d952cf7db8be">Gerard Minack</a> said last August.<br />
<blockquote>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. </blockquote>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 <a href="http://www.heraldsun.com.au/news/national/prime-minister-julia-gillard-a-political-pygmy-laurie-oakes/story-e6frf7l6-1225968802138">political pygmies</a>" -- as Laurie Oaks recently put it -- who continue to ignore the real issues facing our economy. And that puts us all at risk.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com6tag:blogger.com,1999:blog-7582484240805759271.post-56847201664120332922010-12-27T07:50:00.009-05:002011-01-02T01:31:31.482-05:00The cult of propertyWhen 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 <a href="http://financialfollies.blogspot.com/2010/12/dont-worry-be-happy.html">last post</a>). 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. <br />
<br />
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 <a href="http://www.apimagazine.com.au/blog/2010/12/the-biggest-property-myth-of-2010/#more-1031">blog</a>. <br />
<br />
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. <br />
<blockquote>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. </blockquote>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.<br />
<br />
In any case, he tellingly concludes the article as follows:<br />
<blockquote>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. <i><b>Now is the time to buy well in areas that will outperform the averages and buy properties to which you can add value.</b></i></blockquote>This is the "new paradigm" talk that <a href="http://delusionaleconomics.blogspot.com/2010/12/beware-wolf-in-sheeps-clothing.html">Delusional Economics</a> 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 <i>right areas</i>, you'll be protected from any falls, and you have nothing to worry about." Go right ahead and take out that big mortgage. <br />
<br />
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 <a href="http://www.apimagazine.com.au/blog/2010/09/will-our-property-market-crash/">article</a> that it's as simple as "concentrating on suburbs with limited supply and choosing properties that will stand up in soft and hot markets".<br />
<br />
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 <a href="http://www.unconventionaleconomist.com/2010/06/macroeconomic-examination-of-housing.html">here</a> for example). Still, Australian Property Investor is apparently preaching to the converted. <br />
<br />
For pure entertainment value, I recommend you check out the comments from some of the property bulls on API's blog posts, in particular, <a href="http://www.apimagazine.com.au/blog/2010/06/property-vs-shares-battle-of-the-assets/">this one</a> 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."<br />
<br />
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.<br />
<br />
But back on a more serious note. Luckily for us, the IMF has a fascinating chart (from this <a href="http://www.google.com/url?sa=t&source=web&cd=2&ved=0CCAQFjAB&url=http%3A%2F%2Fwww.imf.org%2Fexternal%2Fpubs%2Fft%2Ffandd%2F2010%2F03%2Fpdf%2Floungani.pdf&rct=j&q=Prakash%20Loungani%20house%20prices&ei=G5kOTbKnB4H58AaY8LybDg&usg=AFQjCNHuT85H1fWwxpDS3TqtVLeJ4Y2aCA&sig2=JAaL-WHJRbl534TRJo42Rg&cad=rja">article</a>) 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. <br />
<br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRU8c7IupAnXfkXb-I4Si-qmlacpZ0mcfIQFzxlQCETMXg5f_TwAsgSMSAzn3gUoKY7qxa7o0wnV-o32PBUZgZ4ByQUftwuiiKSDgDLwd6KUymK7fiiedn7pc7yZ4qyGVhdh1XFbiXpPk/s1600/herengracht+price+series.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="372" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgRU8c7IupAnXfkXb-I4Si-qmlacpZ0mcfIQFzxlQCETMXg5f_TwAsgSMSAzn3gUoKY7qxa7o0wnV-o32PBUZgZ4ByQUftwuiiKSDgDLwd6KUymK7fiiedn7pc7yZ4qyGVhdh1XFbiXpPk/s400/herengracht+price+series.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: IMF</td></tr>
</tbody></table>But this is just a small suburb of Amsterdam. Surely it's different elsewhere, isn't it? Well, funnily enough, <a href="http://www.econ.yale.edu/%7Eshiller/data.htm">Robert Shiller</a> (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. <br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhil3ysXMCOnmCWtaPZ1RyvqZp5rQQa5MbOQJP2-U1neC0LYDu_od6itRC5lIDaNT6KKa1bcCWccVr723_fMy9SKWKCWzrUt6kmgCGSfq8y8_0Rj2q_yTzdxNdFbI4y730-VaOEgDE5aZI/s1600/shiller+house+prices+long+term.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="392" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhil3ysXMCOnmCWtaPZ1RyvqZp5rQQa5MbOQJP2-U1neC0LYDu_od6itRC5lIDaNT6KKa1bcCWccVr723_fMy9SKWKCWzrUt6kmgCGSfq8y8_0Rj2q_yTzdxNdFbI4y730-VaOEgDE5aZI/s400/shiller+house+prices+long+term.png" width="400" /></a></div><br />
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.<br />
<br />
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. <br />
<br />
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.<br />
----------------<br />
UPDATE: <a href="http://www.whocrashedtheeconomy.com/">Who Crashed the Economy</a> has some great <a href="http://www.whocrashedtheeconomy.com/?page_id=365">long-term charts</a> for Australia too. <br />
<br />
<blockquote></blockquote>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com8tag:blogger.com,1999:blog-7582484240805759271.post-25667227207487356912010-12-23T00:28:00.000-05:002011-01-02T16:43:15.399-05:00RP 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 <a href="http://delusionaleconomics.http//delusionaleconomics.blogspot.com/2010/12/gc-moves-to-next-level.html">serious distress</a>), 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. <br />
<br />
RP Data's "<a href="http://www.myrp.com.au/showNews.do?id=439">Property Outlook</a>" 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: <br />
<blockquote>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. <br />
<br />
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... </blockquote>Now, I have argued before (see <a href="http://financialfollies.blogspot.com/2010/12/heart-attacks-and-housing-bubbles.html">this post</a>, 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. <br />
<br />
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 <a href="http://www.gmo.com/websitecontent/JGLetter_NightofLivingFed_3Q10.pdf">this piece</a>, from the well respected fund manager Jeremy Grantham, for example:<br />
<blockquote><i><b>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.</b></i> 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! </blockquote>Grantham notes that the sheer vitriol he faces when making such arguments, is, in itself, a sign that something is probably deeply wrong:<br />
<blockquote><i><b>Australia ... does pass one bubble test spectacularly: we have always found that pointing out a bubble – particularly a housing bubble – is very upsetting.</b></i> 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. </blockquote><blockquote></blockquote>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 <a href="http://www.unconventionaleconomist.com/">The Unconventional Economist</a> has already done an excellent job in debunking the "housing shortage" argument <a href="http://www.unconventionaleconomist.com/2010/05/debunking-australian-housing-shortage.html#comments">here</a>. <br />
<br />
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). <br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivrBFLUth35IUijZ88MUrWcMcJRHmYglrfkJBGVOEfVjbegyfTCBG_Y2ySzogitvIPP8IhtRSmBZxaR4ClbpBerIDqAIM4nwDWe5y4BpK6oC9IqSzg5nhB_nfznQNHPpponiroQp5OBuI/s1600/Overseas-arrivals-SMALL_png.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivrBFLUth35IUijZ88MUrWcMcJRHmYglrfkJBGVOEfVjbegyfTCBG_Y2ySzogitvIPP8IhtRSmBZxaR4ClbpBerIDqAIM4nwDWe5y4BpK6oC9IqSzg5nhB_nfznQNHPpponiroQp5OBuI/s1600/Overseas-arrivals-SMALL_png.png" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: RP Data</td></tr>
</tbody></table><br />
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.<br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjduUBkobY2fqChamXWgZ_g8Opm7XSxOcuDLIT3xrqMcJTzxf6bKP963HBu8MOToAHwazQ1ZcJDoHA85kfPWF5gxC8RiZVdItO8D2ZPBMw9maYmPyJoMKRWxCyQwqy5P4Cn-3O2JmmWfjE/s1600/IMF_housepricesandmigration_png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjduUBkobY2fqChamXWgZ_g8Opm7XSxOcuDLIT3xrqMcJTzxf6bKP963HBu8MOToAHwazQ1ZcJDoHA85kfPWF5gxC8RiZVdItO8D2ZPBMw9maYmPyJoMKRWxCyQwqy5P4Cn-3O2JmmWfjE/s400/IMF_housepricesandmigration_png.png" width="400" /></a></div><br />
Secondly, while it is true that we have an undersupply of <i>affordable</i> 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.<br />
<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEituraVLVBBul-kwMXVpU3NHDp_mrwmeMn_zNxrHuBu2RemVIMMExQt0ug9p269bijJmNP1UIZbXbWdsP9J5SAxkQmErPtocZoGr4MWgH4kqdqZ9JXDYMaWAVfqx26kT6V3BkKvB8ahXaM/s1600/sp-dg-251109-graph6.gif" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEituraVLVBBul-kwMXVpU3NHDp_mrwmeMn_zNxrHuBu2RemVIMMExQt0ug9p269bijJmNP1UIZbXbWdsP9J5SAxkQmErPtocZoGr4MWgH4kqdqZ9JXDYMaWAVfqx26kT6V3BkKvB8ahXaM/s400/sp-dg-251109-graph6.gif" width="400" /></a></div>Here's what Battelino had to say in a <a href="http://www.rba.gov.au/speeches/2009/sp-dg-251109.html">November 2009 speech</a> accompanying this chart:<br />
<blockquote>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.<i><b> Presumably, most of this surplus reflects holiday houses and second houses.</b></i> </blockquote>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?<br />
<br />
When you are in the midst of a speculative boom, it <i>always</i> 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".<br />
<br />
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.<br />
<br />
Just don't expect RP Data to tell you this first.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0tag:blogger.com,1999:blog-7582484240805759271.post-44609604074882646782010-12-22T18:52:00.008-05:002011-01-01T10:35:20.584-05:00Rent 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.<br />
<br />
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.<br />
<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg23SNwndx-LtXSsAtkJ_pcwGW9nuaXJgcsrTzB5KuSknbAcd1N-KVSzv60KW5Tzb-RzUNWpO9dpxPFcfYcS8ALpzHtUVoRyB6HnLFd46zvH0XkAUX3GAmdpYDQfrAuMxECZQEODu8q5x4/s1600/20101214122931.jpg" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg23SNwndx-LtXSsAtkJ_pcwGW9nuaXJgcsrTzB5KuSknbAcd1N-KVSzv60KW5Tzb-RzUNWpO9dpxPFcfYcS8ALpzHtUVoRyB6HnLFd46zvH0XkAUX3GAmdpYDQfrAuMxECZQEODu8q5x4/s320/20101214122931.jpg" width="320" /></a></div>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).<br />
<br />
Now fortunately, the New York Times website has an excellent <a href="http://www.nytimes.com/interactive/business/buy-rent-calculator.html">tool</a> 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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgL2VVUy4pe18s-9-Lrq-IETVZP4D2GqM9trLhlDfqfgsN_39SB8IL1i6y2EKTvvZvcdVfzsPW2pkP8T3tLYjtoHBu4f6Su6yitoziI9DrRvrVH5NqERTgtPQEsSToZ5aLVlVz1vnHz6EQ/s1600/buyvsrent6pct.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgL2VVUy4pe18s-9-Lrq-IETVZP4D2GqM9trLhlDfqfgsN_39SB8IL1i6y2EKTvvZvcdVfzsPW2pkP8T3tLYjtoHBu4f6Su6yitoziI9DrRvrVH5NqERTgtPQEsSToZ5aLVlVz1vnHz6EQ/s640/buyvsrent6pct.png" width="640" /></a></div><br />
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. <br />
<br />
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.<br />
<br />
But how realistic is 6% annual growth over the coming two decades? I would argue that this projection is a total fantasy (see my <a href="http://financialfollies.blogspot.com/2010/12/heart-attacks-and-housing-bubbles.html">previous post</a> 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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpAI9xNTdNLIH8n4NAVLSN4k1OIHchGxiELmrNiWNBZy-zxRtr0mxta5YqyYVsepnOp9vCmhTUiY0TRi9pDITD4HEdw_JS4NgyV2feMxFkvV5T3BnNrn0aqQx_UR4ILGweBbR306Q4gr0/s1600/buyvsrent4pct.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpAI9xNTdNLIH8n4NAVLSN4k1OIHchGxiELmrNiWNBZy-zxRtr0mxta5YqyYVsepnOp9vCmhTUiY0TRi9pDITD4HEdw_JS4NgyV2feMxFkvV5T3BnNrn0aqQx_UR4ILGweBbR306Q4gr0/s640/buyvsrent4pct.png" width="640" /></a></div><br />
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?<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOG_Ww97AMuYH4KerSFt9NEs-CvMw7lMgPG8WwPtJDVF7N0MBi0JQmHcBB2WG1AvFDhYUQrNOE1-KLH18heVqFRvmsfqobSC68XTqdqdJolekmqG-M4ACZkjJgMuZraWhmZZw5dIBDTcg/s1600/rentvsbuy2pct.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="288" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOG_Ww97AMuYH4KerSFt9NEs-CvMw7lMgPG8WwPtJDVF7N0MBi0JQmHcBB2WG1AvFDhYUQrNOE1-KLH18heVqFRvmsfqobSC68XTqdqdJolekmqG-M4ACZkjJgMuZraWhmZZw5dIBDTcg/s640/rentvsbuy2pct.png" width="640" /></a></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpgG6ESVWIbsR9idWkUVioZH7BMTEZhHatFIPULgwh8J69vPtGv-E91S03jasSAfYSj9JYHTl6h3fUIFItxfgAI7czWp90ZsHBAHAGXgXWHR027gW689jTPqTmoksq2kCKHLIjrnlv5S8/s1600/Untitled1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"> </a></div>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.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUcX4KIhJfuwdaOLgAd6W6_fTk7JzoQJ9YTPCUG93x5280TI2sit28ZDkLNCrlZ5dUMfGBoCQWf4zWzR3r0msUogJyhO7sp5FlbUGolc3vMZ9P_L11MvKOqOJCeyj-k30GaAPtHlNEpFc/s1600/rentvsbuy0pct.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" height="286" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhUcX4KIhJfuwdaOLgAd6W6_fTk7JzoQJ9YTPCUG93x5280TI2sit28ZDkLNCrlZ5dUMfGBoCQWf4zWzR3r0msUogJyhO7sp5FlbUGolc3vMZ9P_L11MvKOqOJCeyj-k30GaAPtHlNEpFc/s640/rentvsbuy0pct.png" width="640" /></a></div><br />
<br />
<br />
<br />
<br />
Obviously, this final case is a total disaster for the buyer.<br />
<br />
Now, a few final observations are in order:<br />
<ul><li>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.</li>
<li> 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.</li>
<li>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<i> investment </i>at today's prices<i>.<br />
</i></li>
</ul>Cheers and Merry Christmas!<br />
--------------------------------------- <br />
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.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com6tag:blogger.com,1999:blog-7582484240805759271.post-86733924792037726372010-12-20T22:03:00.002-05:002010-12-26T01:52:06.118-05:00Heart attacks and housing bubblesI was rereading Malcom Gladwell's <a href="http://www.amazon.com/Blink-Power-Thinking-Without/dp/0316172324">"Blink"</a> 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. <br />
<br />
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.<br />
<blockquote>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 <i>too much</i> information into account. </blockquote><br />
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 <a href="http://www.google.com/url?sa=t&source=web&cd=3&ved=0CDAQFjAC&url=http%3A%2F%2Fwww.imf.org%2Fexternal%2Fpubs%2Fft%2Fwp%2F2010%2Fwp10291.pdf&rct=j&q=imf%20australian%20house&ei=hg8QTdbaPMKC8ga18NGSDg&usg=AFQjCNEteKY1_kYFHaHUh6-ygXi5pqeoYA&sig2=ZbS5QdDm7NP3o4HKCLx3JQ&cad=rja">report</a> 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 <i>all the evidence</i> into account, the IMF has concluded that the massive rise in Australian house prices is mostly explained by fundamentals. <br />
<br />
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.<br />
<br />
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.<br />
<br />
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.<br />
<br />
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. <br />
<br />
See the chart below from this <a href="http://www.google.com/url?sa=t&source=web&cd=2&ved=0CCAQFjAB&url=http%3A%2F%2Fwww.imf.org%2Fexternal%2Fpubs%2Fft%2Ffandd%2F2010%2F03%2Fpdf%2Floungani.pdf&rct=j&q=Prakash%20Loungani%20house%20prices&ei=G5kOTbKnB4H58AaY8LybDg&usg=AFQjCNHuT85H1fWwxpDS3TqtVLeJ4Y2aCA&sig2=JAaL-WHJRbl534TRJo42Rg&cad=rja">article</a> by the IMF's Prakash Loungani.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh3DritZ8bt0_zWXWvv-lax7FnFFF_DKPvSm_NQnAtpAVOrnSaz3l6HdfwAWa-kCi5ZPvYaQfWM1uHPAosOsAph6pzoN1nzNctYNW_qYZA6CNic0dgnsTxmV5nEHqmImnaTsBhri0bjYLU/s1600/loungani1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="265" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh3DritZ8bt0_zWXWvv-lax7FnFFF_DKPvSm_NQnAtpAVOrnSaz3l6HdfwAWa-kCi5ZPvYaQfWM1uHPAosOsAph6pzoN1nzNctYNW_qYZA6CNic0dgnsTxmV5nEHqmImnaTsBhri0bjYLU/s400/loungani1.png" width="400" /></a></div><br />
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. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHh7ciLLMLxhLG29ZHp-MqZiQsjKHW1pfaciWIyvoxY4tucVsxloOy1kZJyHeaMmllAdp-hHu6Q8EdMJ8mcJajeU1Jffz46EkcjqM7WJExMXtmvztoWhI_mLaT70LNLlYqU48QfHZ_CC0/s1600/loungani2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="295" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHh7ciLLMLxhLG29ZHp-MqZiQsjKHW1pfaciWIyvoxY4tucVsxloOy1kZJyHeaMmllAdp-hHu6Q8EdMJ8mcJajeU1Jffz46EkcjqM7WJExMXtmvztoWhI_mLaT70LNLlYqU48QfHZ_CC0/s400/loungani2.png" width="400" /></a></div><br />
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.<br />
<br />
<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHCP00926Ji4hY8a429d_-yhs5jxscGPEeo2vtXzQK90gZKobglvMxikETqYT9RYl9lmuAM-QLHu-M9JVBGEpNo3NrHpzsgKebG0MJ_exWUD-V25DYMhJ9vK2wg47nEooVRrZIMId_ZMg/s1600/PricetoIncomeQ12009.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="275" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgHCP00926Ji4hY8a429d_-yhs5jxscGPEeo2vtXzQK90gZKobglvMxikETqYT9RYl9lmuAM-QLHu-M9JVBGEpNo3NrHpzsgKebG0MJ_exWUD-V25DYMhJ9vK2wg47nEooVRrZIMId_ZMg/s400/PricetoIncomeQ12009.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: Calculated Risk</td></tr>
</tbody></table><br />
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.<br />
<br />
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. <br />
<br />
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. <br />
<br />
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? <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpgG6ESVWIbsR9idWkUVioZH7BMTEZhHatFIPULgwh8J69vPtGv-E91S03jasSAfYSj9JYHTl6h3fUIFItxfgAI7czWp90ZsHBAHAGXgXWHR027gW689jTPqTmoksq2kCKHLIjrnlv5S8/s1600/Untitled1.png" imageanchor="1"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgpgG6ESVWIbsR9idWkUVioZH7BMTEZhHatFIPULgwh8J69vPtGv-E91S03jasSAfYSj9JYHTl6h3fUIFItxfgAI7czWp90ZsHBAHAGXgXWHR027gW689jTPqTmoksq2kCKHLIjrnlv5S8/s1600/Untitled1.png" width="400" /> </a></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">Yes, I think the patient is having a heart attack. </div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: center;"> </div>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com5tag:blogger.com,1999:blog-7582484240805759271.post-85998693895640112672010-12-18T15:50:00.000-05:002010-12-18T15:50:15.712-05:00From IMF lunacy to the Wall St whitewashThere 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. <br />
<br />
<a href="http://www.google.com/url?sa=t&source=web&cd=2&ved=0CCYQFjAB&url=http%3A%2F%2Fwww.imf.org%2Fexternal%2Fpubs%2Fft%2Fwp%2F2010%2Fwp10291.pdf&rct=j&q=imf%20australian%20house&ei=bhANTbaLD4K88gauluG_Dg&usg=AFQjCNEteKY1_kYFHaHUh6-ygXi5pqeoYA&sig2=uTm0FTiZTBEtLVrPklAOAA&cad=rja">What Drives House Prices in Australia (IMF)</a><br />
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 "<a href="http://www.unconventionaleconomist.com/2010/12/now-i-understand.html">Australia is Different</a>". 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.<br />
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<a href="http://www.theage.com.au/opinion/politics/citizens-awake-and-cast-ye-off-the-chains-of-home-ownership-20101212-18tvj.html">Citizens awake and cast ye off the chains of home ownership</a><br />
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:<br />
<div style="text-align: justify;"><blockquote>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.... </blockquote></div><blockquote><div style="text-align: justify;">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.</div></blockquote>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. <br />
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<a href="http://www.nytimes.com/2010/12/18/world/europe/18spain.html?_r=1&hp">Newly Built Ghost Towns Haunt Banks in Spain </a><br />
An interesting story in the New York Times about the implosion of Spain's real estate market, especially in light of this <a href="http://www.businessinsider.com/pictures-chinese-ghost-cities-2010-12?slop=1#slideshow-start">recent report in Business Insider </a>on China's empty ghost cities. <br />
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<a href="http://www.nytimes.com/2010/12/17/opinion/17krugman.html?partner=rssnyt&emc=rss">Wall Street Whitewash by Paul Krugman</a><br />
An angry piece from Paul Krugman in the New York Times about the pitiful state of financial reform in the USA. <br />
<div style="text-align: justify;"><blockquote>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.” </blockquote></div>Unbelievable. You can't make this stuff up. Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0tag:blogger.com,1999:blog-7582484240805759271.post-16573573648808342542010-12-15T16:08:00.001-05:002010-12-25T23:45:24.087-05:00The Perils of Interest-Only MorgagesA quick follow up to my <a href="http://financialfollies.blogspot.com/2010/12/our-responsible-lending-standards.html">previous post</a>. Via <a href="http://www.economist.com/blogs/freeexchange/2010/12/housing_markets">The Economist</a>, the Federal Reserve Bank of Chicago has an interesting <a href="http://www.chicagofed.org/webpages/publications/working_papers/2010/wp_12.cfm">new paper</a> 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:<br />
<blockquote>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. </blockquote><blockquote>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. </blockquote>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. <br />
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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:<br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZueystU4MYNiRs47dPYC8Ah8CPAwoMAFqkkYBlWzgK17t7C3tS5gF5tQYdVGaO0PXgOgVnXg1YkOHHimPILx7B8PcaYLtJym5-pPnomqEGIcZRiIklCuBl8HGpF1WsjTBmQHDW6dyr94/s1600/westpac_loan+characteristics_png.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="278" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZueystU4MYNiRs47dPYC8Ah8CPAwoMAFqkkYBlWzgK17t7C3tS5gF5tQYdVGaO0PXgOgVnXg1YkOHHimPILx7B8PcaYLtJym5-pPnomqEGIcZRiIklCuBl8HGpF1WsjTBmQHDW6dyr94/s400/westpac_loan+characteristics_png.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: Westpac</td><td class="tr-caption" style="text-align: center;"></td><td class="tr-caption" style="text-align: center;"></td><td class="tr-caption" style="text-align: center;"><br />
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</tbody></table><br />
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...<br />
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More from the paper on interest only loans:<br />
<blockquote>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. </blockquote>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.<br />
<blockquote>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. </blockquote><br />
As The Economist says:<br />
<blockquote>...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)? </blockquote>Hear hear.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0tag:blogger.com,1999:blog-7582484240805759271.post-64853545594751098652010-12-15T14:09:00.002-05:002010-12-26T09:51:13.774-05:00Our "Responsible" Lending StandardsHow 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 <a href="http://www.theage.com.au/opinion/politics/battling-the-big-banks-20101213-18veb.html">article</a> 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. <br />
<blockquote>...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. <i><b>But it's also because our banks were prudent and sensible lenders, when their overseas counterparts were not. </b></i></blockquote><blockquote>The global financial crisis began when this market was poisoned by American banks filling their securitised bundles with bad mortgages. <i><b>As they went bad, the market for securitisation collapsed - even for Australian lenders, whose bundles remain good.</b></i> And as it collapsed, so did the new lenders...</blockquote><blockquote></blockquote>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. <br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHVSOyTGECk4ARejGgsyyKppoTgBzjy9kDuQcRQJram-aiRL4vfMDLPgGHwxFi5Sa4Ya05fMzvntk9nOmBJgEz6tjeGCr2vusdFoG13Xy-KQAN4C6MB4C8TG72e0nPS1IN8jtlfrtAt84/s1600/debttogdp_png.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="322" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhHVSOyTGECk4ARejGgsyyKppoTgBzjy9kDuQcRQJram-aiRL4vfMDLPgGHwxFi5Sa4Ya05fMzvntk9nOmBJgEz6tjeGCr2vusdFoG13Xy-KQAN4C6MB4C8TG72e0nPS1IN8jtlfrtAt84/s400/debttogdp_png.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: http://www.debtdeflation.com/blogs/</td></tr>
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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).<br />
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Maybe not, but let's take a peek inside a <a href="http://member.afraccess.com/media?id=CMN://3A347298&filename=20101210/BEN_01131358.pdf">recent large RMBS deal</a>. 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.<br />
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<table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse; width: 225px;"><col span="3" width="75"></col> <tbody>
<tr height="13"> <td height="13" width="75">Class A1</td> <td width="75">AAA</td> <td width="75">$250m</td> </tr>
<tr height="13"> <td height="13">Class A2</td> <td>AAA</td> <td>$150m</td> </tr>
<tr height="13"> <td height="13">Class A3</td> <td>AAA</td> <td>$130m</td> </tr>
<tr height="13"> <td height="13">Class A5</td> <td>AAA</td> <td>$395m</td> </tr>
<tr height="13"> <td height="13">Class AB</td> <td>AAA</td> <td>$45m</td> </tr>
<tr height="13"> <td height="13">Class B1</td> <td>AA-</td> <td>$20m</td> </tr>
<tr height="13"> <td height="13">Class B2</td> <td>n/a</td> <td>$10m</td> </tr>
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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. <br />
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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. <br />
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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?<br />
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Ratings agency S&P, which has an impeccable record and has never been wrong about anything, <a href="http://www.xe.com/news/2010/12/06/1568105.htm?utm_source=RSS&utm_medium=TL&utm_content=NOGEO&utm_campaign=News_RSS_Art4">says</a> its ratings on these notes are based on the following: <br />
<blockquote>-- Our view of the credit risk of the underlying collateral portfolio;<br />
-- Our view that the credit support for each class of notes, which comprises both note subordination and <b>mortgage insurance covering 100% of face value of all loans</b>, accrued interest, and reasonable costs of enforcement, is sufficient to withstand the stresses we apply;</blockquote>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 <a href="http://www.talkfinance.net/f33/bullet-rmbs-latest-twist-australian-bubble-saga-7911/">source</a>, 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. <br />
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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 <a href="http://www.nytimes.com/2009/09/09/business/09loans.html">article</a> 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.<br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZueystU4MYNiRs47dPYC8Ah8CPAwoMAFqkkYBlWzgK17t7C3tS5gF5tQYdVGaO0PXgOgVnXg1YkOHHimPILx7B8PcaYLtJym5-pPnomqEGIcZRiIklCuBl8HGpF1WsjTBmQHDW6dyr94/s1600/westpac_loan+characteristics_png.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" height="277" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZueystU4MYNiRs47dPYC8Ah8CPAwoMAFqkkYBlWzgK17t7C3tS5gF5tQYdVGaO0PXgOgVnXg1YkOHHimPILx7B8PcaYLtJym5-pPnomqEGIcZRiIklCuBl8HGpF1WsjTBmQHDW6dyr94/s400/westpac_loan+characteristics_png.png" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Source: Westpac</td></tr>
</tbody></table><br />
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. <br />
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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 <strike>in my next post</strike> some time soon...Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com2tag:blogger.com,1999:blog-7582484240805759271.post-45455162718279423402010-12-12T15:42:00.001-05:002010-12-25T23:50:58.386-05:00My Name is Bond. Covered Bond.So, Wayne Swan's blueprint for "<a href="http://ministers.treasury.gov.au/DisplayDocs.aspx?doc=pressreleases/2010/091.htm&pageID=003&min=wms&Year=&DocType=">A Competitive and Sustainable Banking System</a>" 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".<br />
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Now, this development was well flagged in advance and has already generated much consternation amongst some bloggers, see <a href="http://delusionaleconomics.blogspot.com/2010/11/here-comes-intervention.html">here</a> 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. <br />
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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.<br />
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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.<br />
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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.<br />
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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. <br />
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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.<br />
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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.<br />
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<i><b>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.</b></i><br />
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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%.<br />
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In the draft of its plan, the Australian Treasury attempts to reassure us with the following words:<br />
<blockquote>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.<br />
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. </blockquote><blockquote>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.</blockquote>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 <a href="http://www.businessweek.com/magazine/content/08_32/b4095000911375.htm">article</a> about the newfound popularity of covered bonds in the US identifies another major risk. <br />
<blockquote>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. </blockquote>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?<br />
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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?<br />
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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.<br />
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Can we really expect the government to get these details right? I for one am very sceptical. <br />
<blockquote></blockquote>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com3tag:blogger.com,1999:blog-7582484240805759271.post-75181990838602046632010-12-11T00:03:00.000-05:002010-12-11T00:03:18.601-05:00Strategies 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 <a href="http://smh.domain.com.au/home-investor-centre/strategies-for-the-property-plunge-20101210-18rzb.html">article</a> 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.<br />
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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.<br />
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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.<br />
<blockquote>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.</blockquote>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"...<br />
<blockquote>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" </blockquote>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."<br />
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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.<br />
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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. <br />
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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 <a href="http://financialfollies.blogspot.com/2010/11/on-rent-vs-buy-and-ludicrous-house.html">before</a>, 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. <br />
<br />
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%. <br />
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Take anything you read about property in an Australian newspaper with a grain of salt. Read <a href="http://delusionaleconomics.blogspot.com/">this</a>, <a href="http://www.unconventionaleconomist.com/">this</a>, or <a href="http://housesandholes.blogspot.com/">this</a> instead.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com1tag:blogger.com,1999:blog-7582484240805759271.post-63739849970807286802010-12-06T18:24:00.001-05:002010-12-25T23:58:15.895-05:00Property for PensionersAnother day, another <a href="http://www.theaustralian.com.au/business/property/super-rush-to-invest/story-e6frg9gx-1225964457598">ludicrous article</a> about property in a major Australian newspaper.<br />
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."<br />
<blockquote>"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. </blockquote><blockquote>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.</blockquote>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. <br />
<br />
But no. Instead, she breathlessly rushes on, quoting Mr Figot further.<br />
<blockquote>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.<br />
<br />
The vast majority of his firm's clients - about 95 per cent - are choosing to leverage into property in preference to shares.<br />
<br />
"Property has produced great returns over the years while the share market has had mixed results, to say the least," Figot says.</blockquote>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.<br />
<blockquote>...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.<br />
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"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. </blockquote>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. <br />
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Are you still feeling relaxed and comfortable?<br />
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It's even worse than I thought. <br />
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<blockquote></blockquote>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com1tag:blogger.com,1999:blog-7582484240805759271.post-36411732181178027242010-12-02T08:40:00.001-05:002010-12-25T23:53:20.959-05:00Can the government stop the bubble from bursting?Houses and Holes has another excellent <a href="http://housesandholes.blogspot.com/2010/12/fifth-pillar.html">post</a> today on Wayne Swan's new <a href="http://www.smh.com.au/business/bankers-beware-fifth-pillar-on-its-way-20101201-18gp2.html">plan</a> 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":<br />
<blockquote>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. <br />
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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.<br />
<br />
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. </blockquote>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. <br />
<br />
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:<br />
<ul><li>The Fed slashed interest rates from 4.5% to zero </li>
<li>Government takeover of Fannie Mae and Freddie Mac, the country's two biggest mortgage lenders </li>
<li> 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</li>
<li>Introduction of a new $6,500 tax credit for home buyers purchasing a principal residence (recently expired)</li>
<li>The introduction of HAMP, a loan modification program designed to reduce delinquent and at-risk borrowers' monthly mortgage payments. </li>
</ul>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. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBeqsM3_D-NeqhcEg0S_Z6zNO6AkF1GlWpxOncjDduGXHCqjkSfpVrxdRfyZS0T7JV5_8IBBt8FuHzXFA7fQiL2TfYoXJ7h1ceIeqO9h1nnsTFGHvJFuM-RQ56e-W1v0eNSfpfQRLx2zg/s1600/CSSept2010.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="277" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBeqsM3_D-NeqhcEg0S_Z6zNO6AkF1GlWpxOncjDduGXHCqjkSfpVrxdRfyZS0T7JV5_8IBBt8FuHzXFA7fQiL2TfYoXJ7h1ceIeqO9h1nnsTFGHvJFuM-RQ56e-W1v0eNSfpfQRLx2zg/s400/CSSept2010.jpg" width="400" /></a></div>Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0tag:blogger.com,1999:blog-7582484240805759271.post-80500680892019710352010-11-30T18:30:00.001-05:002010-12-26T00:10:06.431-05:00When 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.<br />
<br />
However, not all the property bulls are finding it easy to let go. Which brings me to this highly amusing <a href="http://theage.domain.com.au/home-investor-centre/blogs/domain-investor-centre-blog/bubble-troublehow-certain-are-you/20101130-18eqh.html">article</a> 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.<br />
<br />
In a stunning display of logical jujistu, the author argues:<br />
<ul><li>Most of those predicting trouble today are the same people who predicted the property market would crash during the GFC. </li>
<li>The property market didn't crash during the GFC. </li>
<li>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. </li>
<li>Oh, I'm open to being convinced I'm wrong but don't tell me what a hedge fund operator has to say.</li>
</ul>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.<br />
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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. <br />
<br />
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, <a href="http://www.amazon.com/Big-Short-Inside-Doomsday-Machine/dp/0393072231">The Big Short</a>, 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. <br />
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After another weekend of dismal <a href="http://www.homepriceguide.com.au/">auction results</a> 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?"Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0tag:blogger.com,1999:blog-7582484240805759271.post-47013403594263222282010-11-25T12:07:00.002-05:002011-01-02T16:32:57.957-05:00Sheltering your investments from the stormIn an earlier <a href="http://financialfollies.blogspot.com/2010/11/on-rent-vs-buy-and-ludicrous-house.html">post</a>, 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 <i>financial</i> sense for most people to buy property at current valuations. <br />
<br />
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.<br />
<br />
So where should you park your money?<br />
<br />
Burton Malkiel, the Princeton professor and author of "A Random Walk on Wall Street" has an interesting <a href="http://online.wsj.com/article/SB10001424052748703848204575608623469465624.html">opinion piece</a> in the Wall Street Journal about the benefits of diversification and "staying the course" in times of market volatility. Consider the chart below:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg50F7A92gJ7KIc3q84YyfDjldUv18vnYi45duhkf-a_yx8qmp5DsFxEOWLNpuCV0IGXkH5PmGu0ZFJkI9ITiMjR-Ttea4MqIRx9RCeIeP23IyNFxwR84oRHA-VBQ9scNo5bmQ5bspsc64/s1600/malkielinwsj.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="233" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg50F7A92gJ7KIc3q84YyfDjldUv18vnYi45duhkf-a_yx8qmp5DsFxEOWLNpuCV0IGXkH5PmGu0ZFJkI9ITiMjR-Ttea4MqIRx9RCeIeP23IyNFxwR84oRHA-VBQ9scNo5bmQ5bspsc64/s400/malkielinwsj.jpg" width="400" /></a></div><br />
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. <br />
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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.<br />
<br />
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.<br />
<ul><li>Australian property prices fall 30-40%</li>
<li>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</li>
<li>China leads a massive selloff in emerging market stocks (no diversification here)</li>
<li> Australian dollar collapses to 50-60c</li>
<li>Unemployment rises sharply and many are unable to keep paying their mortgage </li>
</ul>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:<br />
<ul><li> <i><b>Term deposits</b></i>. 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 </li>
<li>Own <i><b>foreign currency</b></i> via unhedged foreign stock/bond ETFs or index funds. (although I would be wary of too much stock market risk)</li>
<li>If you are are overexposed to Australian resource companies or banks, <i><b>reduce your share positions</b></i> or hedge by buying out of the money put options (definitely not for the average punter)</li>
</ul>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.<br />
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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.Financial Follieshttp://www.blogger.com/profile/18074060737860512595noreply@blogger.com0