The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, July 19, 2010

The case for an Aussie housing bubble

Having presented Rory's arguments (long-time readers will have been bludgeoned by mine), this is the other side of the debate. As discussed earlier, if you are an institutional investor that wants to short the market, get in contact with me. The following is a summary from analyst Brian Johnson of CLSA. For the record, some of his numbers are wrong (that is, based on the wrong housing data: peak-to-trough falls were only 3% and Aussie mortgage rates today are not low at all--they are 7.4% and in line with the average since the mid 1990s (and higher than almost all other developed economies):

"In recent days we are spending our days on conference calls with international investors concerned over the prospect of a collapse of Australian housing prices. “The Economist” of 10 July specifically highlights that based on comparing the current house prices to rents ratio with its long term average “Australian property is the most overvalued of any of the 20 countries we track” (page 73). More to the point this link to The Economist global housing data sets highlights how Australian house prices have diverged from other countries over the course of the Global Financial Crisis (refer As detailed in our May 2010 “Losing Altitude” report we believe there is a housing bubble in Australia, however the catalyst for a meaningful correction is rising interest rates, not unemployment as is often cited.

The argument for an Australian housing bubble

* Asset bubbles are often only observable in hindsight. Periods of imprudent highly geared lending on ever declining credit underwriting standards are masked by rising asset values, which themselves are fuelled by easily available credit. This only becomes apparent after banks curtail lending (Fig 2). The Aus bank “deposit deficiency” (Fig 4) sees a reliance on offshore term funding with the Global Financial Crisis presenting a potential adverse “liquidity trigger”.

* However Aus home loans are less risky than those in the USA given Aus housing lending is (i) initially more lowly geared, (ii) not tax deductible, (iii) full recourse and (iv) variable rate (Fig 3). USA housing lending is more risky given the implied property value “put option”, the interest rate “put option” and the tax incentive to maximise borrowings. Australian housing lending is less risky than in the USA, but that is not to say it is riskless!

* An initial bout of credit rationing by the Aus banks triggered a ~11% decline in house prices between Dec 07 and Mar 09 before unprecedented Government / RBA intervention (ie cash rate cut from 7.25% to 3.00%, Govt guarantee funding, First Home Buyers Grant increased from A$7,000 to A$21,000, RBA increased repo flexibility) triggered a rebound of 22% to an national av price of A$500K (Fig 5).

* On any measure the dramatic rise in Australian house prices has been fuelled by a dramatic increase in household gearing tolerance on a variable interest rate product in a low interest rate environment, and Aus housing prices look irrational on most metrics (Fig 7 to 10). Similarly Aus corporate and business borrowers increased leverage (Fig 11). This structural increase in household gearing coincides with a slump in “savings” (Fig 12) which are likely increasingly channelled into “riskier growth assets” via compulsory superannuation at the expense of deposit products.

* The combination of “negative credit reporting” and readily available “zero rate balance transfer credit card products” sees Aus households still enjoying “cheap” incremental debt funding with the thus far unexplained massive surge to ~A$47bn of credit card debt not explained by credit card purchases but increased “revolver rates” (Fig 13 and 14). ~A$47bn of credit card debt equates to ~A$6,300 of potentially expensive credit card debt per household.

* Prevailing low interest rates still see Aus housing affordability reasonable but stretched relative to other countries (Fig 15 and 16), however the prospect of rising interest rates could prima facie increase the interest burden to an intolerable level (Fig 17 & 18), particularly for the ~30% of housing lending done at the 3% interest rate trough by First Home Buyers (Fig 19) apparently leveraging up the increased First Home Buyers Grant.

* Notwithstanding persistent signs of inflation the risk of potentially “pricking the Australian first home buyers housing bubble” must be a major consideration in the RBA setting monetary policy. We suspect the trick is to some how gradually deflate housing prices without increasing interest rates too much higher! Ultimately this interest rate constraint could impact the A$.

* The Aus banks home loan stress testing models suggest loan losses would be manageable under extreme circumstances (Fig 21) however the earnings leverage is significant. A 1% rise in loan loss defaults and a 10% loss on default would trigger 3% to 4% profit declines (Fig 22)."