Bonds

RBA should expect a dead cat bounce from the rate cut

The RBA has cut rates to a record low 1.25%. The irony here is people and businesses invest because they see a cycle, not because interest rates are low. Lowering rates will do little to spur investment, especially as the global economy cools.

Post the Hayne Royal Commission, the banks will likely pass on the full amount which will only impact margins and weaken them given the high reliance on wholesale funding.

The other problem the RBA faces is that banks have become so reluctant to lend post the RC that the net impacts of the rate cut will be negated by the unwillingness to lend at levels we have seen in the past given the penalties associated with it.

CM still contends that the Aussie banks tread a perilous path given their leveraged balance sheets. CM thinks part nationalization or worse is a real prospect if the slowdown is severe enough. The equity buffers are tiny relative to the real estate portfolio. All contained in the above link.

The rate cut is unlikely to boost confidence other than loosen the noose around stretched borrowers’ necks.

Cate Faehrmann plays investor for a day

Investment managers have difficult jobs. They have to forecast a whole plethora of variables from global economic growth, currencies, commodity prices and micro level corporate industries. If governments can provide ironclad policy certainty, investment choices become relatively easier. Unfortunately, perfect information detracts from performance because things get priced almost instantaneously.

It might be nice that 415 funds all call for a ratification of Paris Climate Accord (which means nothing in practice as the US isn’t a signatory and its emissions have fallen while China is a signatory and emissions continue to rise) but truth be told,  it sounds what is commonly termed in financial circles as “talking one’s book.” NSW Greens MLC Cate Faehrmann pretends to understand finance in her latest piece.

While these 415 firms might represent $32 trillion in assets under management (AUM), the truth is not all of those funds are spoken for in terms of climate-related investments. Investment advisors by their very nature have very diverse client bases. They cover basic low-risk pension (i.e. stable income) funds all the way to riskier return profiles for clients that want more exposure to certain themes or countries. If clients aren’t interested in buying climate funds, the asset managers don’t gather fees. Pretty simple.

Much of the fund industry has focused on ESG (environment, social responsibility & governance) since its inception in 2005. ESG represents around $20 trillion of global AUM, or 25% of total professionally managed funds. Therefore the other 75% of monies are deployed without this in mind. In reality, this is done because investment managers must hunt for the best returns, not those which sacrifice profitability for virtue. If NAB offered you a 10% 1-yr deposit and no solar panels on the HQ roof and Westpac offered a 1% 1-yr deposit because it did, would you invest in the latter based on its ecomentalism?

Let’s take the world’s largest public pension fund (2 million members), California Public Employees’ Retirement System (CalPERS) which is a cosignatory to this demand for climate action. Apart from the fact that this $380bn fund has been so poorly managed (marked to market unfunded liabilities are c.US$1 trillion), its portfolio consists of widespread ownership of met coal, petroleum and other mining assets. It owns bonds in fossil-fuel producing nations such as Abu Dhabi, Qatar and Saudi Arabia as well as highly environmentally unfriendly aluminium smelters in the world’s biggest polluter, China. So there goes the rhetoric of “demanding” Paris is ratified, that we shift to a low carbon economy and we force companies to report their carbon commitments.

It is frightening that some members of our political class believe that investment managers which collaborate in groupthink are worthy of listening to. On the contrary, the performance of many must be sub par. It is a sad reality that 80% of large-cap fund managers fail to outperform the index on a regular basis. So praying for governments to backstop investments they deployed capital into shows more desperation than innovation.

Maybe we should think of Adani as a classic example of investment at work. While Annastacia Palaszczuk’s government is backflipping on the Adani Carmichael coal mine after the electoral drubbing handed out to federal colleagues, the voluntary infrastructure tax is a cynical way to try to make the project less financially viable. After 8 years of ridiculous and onerous environmental approvals, Adani probably think it only needs to wait til October 2020 when an election will wipe out Queensland Labor from government and the infrastructure tax will be repealed soon after.

CM has long held that the non-ESG names are the place to invest. Most of the auto-pilot, brain dead, virtue signalling group think money has been poured into ESG. All non-ESG companies care about is profitability, not focusing on all the soft cuddly things they do displayed on the corporate lobby TV screens on a loop. Sadly when markets inevitably implode, investors always seek safe havens to limit the damage. As so much money is collectively invested together, so the bigger the stampede to the relatively attractive values provided by the stocks that have been cast aside by “woke” investors.

Actually, vote on the political emergency

No surprise to see The Guardian parrot on about a climate emergency. The editorial completely misses out on the political emergency we face. The economic climate is a massive issue facing Australia. When Bill Shorten tells us that he “will change the nation forever” we shouldn’t view that positively. It is probably the honest thing he has said. Labor’s policy suite is the worst possible collection one could assemble to tackle what economic headwinds lie ahead. Our complacency is deeply disconcerting.

First let’s debunk the climate noise in The Guardian.

The math on the climate emergency is simple. Australia contributes 0.0000156% of global carbon emissions. No matter what we do our impact is zip. If we sell it as 560 million tonnes it sounds huge but the percentage term is all that is relevant. Even Dr Finkel, our climate science guru, agrees. What that number means is that Australia could emit 65,000x what it does now in order to get to a 1% global impact. So even if our emissions rise at a diminishing rate with the population, they remain minuscule.

Bill Shorten often tells us the cost of doing nothing on climate change is immeasurable. He’s right, only in that “it is too insignificant” should be the words he’s searching for.

Perhaps the saddest part of the Guardian editorial was to say that the Green New Deal proposed by Alexandria Ocasio Cortez was gaining traction in the US. It has been such a catastrophic failure that she lost an unsolicited vote on the Senate floor 57-0 because Democrats were too embarrassed to show up and support it. Nancy Pelosi dismissed it as a “green dream.” At $97 trillion to implement, no wonder AOC says feelings are more important than facts.

With the 12-year time limit to act before we reach the moving feast known as the tipping point, it gets confusing for climate sceptics. Extinction Rebellion wants things done in only 6 years. The UK House of Commons still can’t get a Brexit deal done inside 3 years but can act instantaneously to call a “climate emergency” after meeting a brainwashed teenager from Sweden. It speaks volumes of the desperation and lack of execution to have to search for political distractions like this.

The ultimate irony in the recent celebration of no coal-fired power in the UK for one week was fossil fuel power substituted all of it – 93% to be exact. Despite the energy market operator telling Brits that zero carbon emissions were possible by 2025 (40% of the current generation capacity is fossil fuel), it forgot that 85% of British homes heat with gas. Presumably, they’d need to pop on down to Dixon’s or Curry’s to buy new electric heaters which would then rely on a grid which will junk 40% of its reliable power…good luck sorting that out without sending prices sky high. Why become beholden to other countries to provide the back-up? It is irrational.

Are people aware that the German electricity regulator noted that 330,000 households (not people) were living in energy poverty? At 2 people per household, that is 1% of the population having their electricity supply cut off because they can’t afford to pay it. That’s what expensive renewables do. If the 330,000 could elect cheap electricity to warm their homes or go without for the sake of the climate, which would they choose? 100% cheap, reliable power. Yet Shorten’s plan can only push more into climate poverty which currently stands at 42,000 homes. This is before the economy has started to tank!

If one looks across Europe, it is no surprise to see the countries with the highest level of fossil fuel power generation (Hungary, Lithuania & Bulgaria) have the lowest electricity prices. Those with more renewables (Denmark, Germany & Belgium), the highest. That is Australia’s experience too. South Australia and Victoria have already revealed their awful track record with going renewable. Why did Coca-Cola and other industries move out of SA after decades? They couldn’t make money with such an unreliable

Ahh, but we must protect our children and grandchildren’s futures. So low have the left’s tactics sunk that using kids as human shields in the fight for climate change wards off conservatives calling out the truth because it is not cool to bully brainwashed kids. We should close all our universities. As the father of two teenagers, CM knows they know everything already so there is little requirement for tertiary education!

The Guardian mentioned, “But in Australia, the Coalition appears deaf to the rising clamour from the electorate [on climate change].” Really?

CM has often held that human consumption patterns dictate true feelings about climate change. Climate alarmist Independent candidate Zali Steggall drives a large SUV and has no solar panels on her roof! Her battleground in the wealthy seat of Warringah is probably 70%+ SUV so slapping a Zali bumper sticker does nothing but add to the hypocrisy.

Why do we ignore IATA forecasts that project air travel will double by 2030? Qantas has the largest carbon offset program in the world yet only 2% elect to pay the self-imposed tax. Isn’t that telling? That is the problem. So many climate alarmists expect others to do the heavy lifting.

SUVs make up 43% of all new car sales in Australia. In 2007 it was 19%. Hardly the activity of a population fretting about rising sea levels. In Warringah, waterfront property sales remain buoyant and any bank that feared waves lapping the rooves of Burran Avenue would not take such portfolio risk, much less an insurance company.

Shorten’s EV plan is such a dud that there is a reason he can’t cost it. Following Norway is great in theory but the costs of installing EV infrastructure is prohibitively expensive. It will be NBN Mark II. Will we spend millions to trench 480V connectors along the Stuart Highway?

Norway state enterprise, Enova, said it would install fast chargers every 50km of 7,500km worth of main road/highway. Australia has 234,820km of highways/main roads. Fast chargers at every 50km like the Norwegians would require a minimum of 4,700 charging stations across Australia. Norway commits to a minimum of 2 fast chargers and 2 standard chargers per station.

The problem is our plan for 570,000 cars per annum is 10x the number of EVs sold in Norway, requiring 10x the infrastructure. That would cost closer to $14bn, or the equivalent of half the education budget.

The Guardian griped that “Scott Morrison’s dismissive response to a UN report finding that the world is sleepwalking towards an extinction crisis, and his parliamentary stunt of fondling a lump of coal”

Well, he might doubt the UN which has been embroiled in more scandals related to climate change than can be counted. Most won’t be aware that an internal UN survey revealed the dismay of unqualified people being asked for input for the sake of diversity and inclusion as opposed to choosing those with proper scientific qualifications. The UN has climbed down from most of its alarmist predictions, often citing no or little confidence of the original scare.

Yet this election is truly about the cost of living, not climate or immigration. The biggest emergency is to prepare for the numbers we can properly set policy against.

We have household debt at a record 180% of GDP. We have had 27 years of untrammelled economic growth. Unfortunately, we have traded ourselves into a position of too much complacency. Our major 4 banks are headed for a lot of trouble. Forget meaningless stress tests. APRA is too busy twiddling its thumbs over climate change compliance. While the Royal Commission may reign in loose lending, a slowing global economy with multiple asset bubbles including houses will come crumbling down. These banks rely 40% on wholesale markets to fund growth. A sharp slowdown will mean a weaker dollar which will only exacerbate the problem.

We have yet to see bond markets price risk correctly. Our banks are horribly exposed. They have too little equity and a mortgage debt problem that dwarfs Japan in the late 1980s. Part/whole nationalization is a reality. The leverage is worse than US banks at the time of the Lehman collapse.

We have yet to see 10% unemployment rates. We managed to escape GFC with a peak of 6% but this time we don’t have a buoyant China to rescue us. Consumers are tapped out and any upward pressure on rates (to account for risk) will pop the housing bubble. Not to worry, Shadow Treasurer Chris Bowen assures people not to panic if their home falls into negative equity! This is the level of economic nous on the catastrophe that awaits. It is insanely out of touch.

Are our politicians aware that the US has to refinance US$8.4 trillion in US Treasuries in the next 3 years? That amount of money will crowd out a corporate bond market which has more than 50% of companies rated BBB or less. This will be compounded by the sharp rise in inventories we are witnessing on top of the sharp slowdown in trade (that isn’t just related to the trade war) which is at GFC lows. The 3.2% US economic growth last quarter was dominated by “intellectual property”, not consumption or durable goods.

China car sales have been on a steep double-digit decline trajectory for the last 9 months. China smartphone shipments dwindle at 6 year lows. In just the first four months of 2019, Chinese companies defaulted on $5.8 billion of domestic bonds, c.3.4x the total for the same period of 2018. The pace is over triple that of 2016.

Europe is in the dumps. Germany has had some of the worst industrial production numbers since 2008. German GDP is set to hit 0.5% for 2019. France 1.25% and Italy 0.25%. Note that in 2007, there were 78mn Europeans living in poverty. In the following decade, it hit 118mn or 23.5% of the population.

Global bellwether Parker Hannifin, which is one of the best lead indicators of global industrial growth, reported weaker orders and a soft outlook which suggests the outlook for global growth is not promising.

This election on Saturday is a choice between the lesser of two evils. The LNP has hardly made a strong case for reelection given the shambolic leadership changes. Take it to the bank that neither will be able to achieve surpluses with the backdrop we are headed into. Yet when it comes to economic stewardship, it is clear Labor are out of their depth in this election. Costings are wildly inaccurate but they are based on optimistic growth scenarios that simply don’t exist. We cannot tax our way to prosperity when global growth dives.

Hiking taxes, robbing self-managed super fund retirees and slamming the property market might play well with the classes of envy but they will be the biggest victims of any slowdown. Australia has run out of runway to keep economic growth on a positive footing.

We will do well to learn from our arrogance which has spurned foreign investment like Adani. We miscalculate the damage done to the national brand. Adani has been 8 years in the making. We have tied the deal up in so much onerous red tape, that we have done nothing more than treating our foreign investors with contempt. Those memories will not be forgotten.

There will come a point in years to come where we end up begging for foreigners to invest at home but we will only have ourselves to blame.

The editorial closes with,

However you choose to exercise your democratic decision-making on Saturday, please consider your candidate’s position on climate and the rapidly shrinking timeframe for action. We have endured mindless scare campaigns and half-baked policy for too many decades. We don’t have three more years to waste.

This is the only sensible quote in the entire article. The time for action is rapidly shrinking. However, that only applies to the political and economic climate. One can be absolutely sure that when the slowdown hits, saving the planet will be furthest removed from Aussie voters’ minds.

Drinking the UnKool-Aid

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It appears President Trump has been bullying the US Federal Reserve to drop rates by 1% and get them to reopen the spigots on QE. What he is failing to grasp is that businesses invest because they see a cycle, not because interest rates fall.

Trump tweeted,

China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go…up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!

This is a frightening proposal. Rates are at 2.25~2.50%. Although it masks a more important reality. Can Trump avoid a market calamity ahead of the next election? The real engine of the economy is slowing.

Despite the headline US GDP print of 3.2%, consumer spending and business investment slumped to the lowest levels under his presidency. Business investment spending was dominated by “intellectual capital” (soft) which is a pretty hard metric to put a reliable number next to. Equipment and structures (hard) contribution to business investment was near as makes no difference zero. Personal consumption of durable goods slumped to their lowest reading since 2011. Wholesale inventories (ex-autos/petroleum) surged ahead of sales.

Trump might argue China is adding stimulus. He is right. China’s Aggregate Financing (approximately system Credit growth less government borrowings) jumped 2.860 billion yuan, or $427 billion – during the 31 days of March ($13.8bn/day or $5.0 Trillion annualised (a Japanese GDP)). This was 55% above estimates and a full 80% ahead of March 2018. This pump priming added 8% to the Chinese stock indices but since then the market has been rolling off.

The world does not need more debt to be inflated away to get us out of the current mess we are in. A recession is inevitable. To put it into context, the world, since GFC, has added $140 trillion in debt for a grand total of $20 trillion in global GDP growth. That is right. $7 of debt only got us $1 of GDP. So if the Fed acquiesces President Trump he will probably get even worse metrics.

Then again perhaps we can take the words of a venture capitalist, Chamath Palihapitiya, who said on CNBC that “central banks have created an environment where major downturns and expansions are almost impossible.” It is statements like this that almost guarantee that central banks have lost control. Central banks have one role – ensure that markets maintain “confidence”. Powell’s latest move to cut rates after such a shallow peak tells us that “confidence” is waning. 

Greatest Corporate Showman on Earth

Tesla’s 1Q 2019 results were dreadful. CM has long held that Tesla is a basket case. The ever charismatic Elon Musk is trying to fan the flames of his company with dying embers. The question is where do we start on this diabolical 1Q report?

1. Musk started off with cash to speak to solvency. Tesla talks to $2.2bn in cash and equivalents. Down $1.5b, partly due to a $920m convertible repayment. Don’t forget Tesla has $6.5bn in recourse debt and $3.5bn in non-recourse debt. It has payables and accrued liabilities of another $5.5bn offset with receivables of just over $1bn.

2. Model S/X deliveries fell from 21,067 in 1Q 2018 to 12,091 in 1Q 2019. That’s -56% at the high margin premium car end. Musk claimed it was due to demand pull forward with a reduction in tax credits. Well he just proved that without credits, demand suffers appreciably.

Model 3 production was 3% higher on the quarter but deliveries were 20% lower. Note customer deposits total $768m, marginally down on the previous quarter. If Tesla starts to implode, customers have a right to get those credits back. Residual values aren’t holding as we discuss in pt.5.

3. Solar deployed -38% year on year

4. (Battery) Storage deployed -39%YoY

5. CM made it clear in point 11 of the 30 reasons why Tesla will be a bug on a windshield report,

The Tesla Residual Value Guarantee, while well intentioned carried risks that crucified the leasing arms of the Big 3. After the tech bubble collapsed at the turn of the century, do you remember the ‘Keep America Rolling’ programme, which was all about free financing for five years? While sales were helped along nicely, the reality was it stored up pain…Goldberg & Hegde’s Residual Value Risk and Insurance study in 2009 suggested on average 92% of cars returned to leasing companies recorded losses on return of up to 12%. Any company can guarantee the price of its used product in theory, the question is whether used car buyers will be willing to pay for it. Sadly Tesla does not get a say in what the consumer will be willing to pay.”

In the 1Q 2019 result, Musk admits that Tesla suffered $121m impairment on residual value guarantees (RVG). Is it any wonder they stopped this scheme. Now it’s payback time. There are $480mn worth of RVGs still on the balance sheet that are unlikely to have been marked to market values.

6. Level 5 autonomous driving is a pipe dream in the near term. 20+ years away. A fleet of Tesla taxis is an even bigger thought bubble. Regulation will put that on the back burner. The current level 2 systems have already shown significant short comings given the numerous beta testing deaths at the wheel of the Tesla auto pilot.

7. Musk is doing a stealth cash raise by putting a time limit on auto pilot upgrades. The question is when will the next cap raise come. His noise around Tesla taxis, Level 5 autonomous systems, Model Y all speak to the snake oil promises that he needs to distract investors from what is clearly going on.

8. His public spat with his biggest supplier, Panasonic, will not end well. Suppliers have to be on board with production expansion. Panasonic is cooling off its relationship. Musk publicly slapped the Japanese battery maker. It doesn’t augur well for the rest of the supply chain either to see these ructions

Peter DeLorenzo wrote the following with respect to Musk,

That this latest charade from Musk is yet another desperate act in an attempt at saving his floundering company is obvious. Where it differs from other Muskian braggadocio is the fact that he is insisting that his AV technology is safe for mass application and consumption. Sorry to disappoint all of the St. Elon acolytes out there, but this is the insane part…

…Unleashing a fleet of zombie Teslas on the streets of America curated by a notorious nanosecond-attention-span personality such as Musk is the quintessential definition of flat-out crazy. You can’t even squint hard enough to suggest that this is, in some way, shape, or form, rational thought. It’s a case of an intermittently brilliant mind that has wandered over the line into the Abyss of Darkness. A dangerous mind that is so obsessed with pushing his perpetually sinking car company into some sort of elevated stratosphere that he is willing to treat real people as so much collateral damage...

This country is 25 years away – at least – from widespread adoption of autonomous vehicles. Yes, there will be scaled deployment in limited, commercial applications primarily in urban centers over the next two decades, but driverless Teslas careening around less than two years from now? It is a recipe for disaster the likes of which simply defies calculation.”

All the reasons CM has disliked Tesla remain. It is so chronically overvalued. This stock will be lucky to be $100 by year end. Sadly the economy is slowing meaning it will be tougher to compete with more competition launching this year. China may give cause for some future hope but don’t bet on it.

The more Musk talks, the more desperate he is. Don’t forget he is not learning from SEC requests to lay off Twitter. His guidance in 1Q is lower than recent tweets suggesting appreciably higher targets. Tesla is a time bomb.

Almost half of Canadians on verge of bankruptcy-Ipsos

An Ipsos poll for bankruptcy specialist MNP Ltd has shown that 48% of Canadians have $200 or less of going bankrupt each month after meeting all obligations. The poll also revealed,

“35% of Canadians say an interest rate increase would move them towards bankruptcy, while 54% said they worry about their ability to repay debts.”

This is consistent with a ME Bank survey in Australia which found only 46% of households were able to save each month. Just 32% could raise $3000 in an emergency and 50% aren’t confident of meeting their obligations if unemployed for three months.

According to Digital Finance Analytics, “there are around 650,000 households in Australia experiencing some form of mortgage stress. If rates were to rise 150 basis points the number of Australians in mortgage stress would rise to approximately 930,000 and if rates rose 300 basis points the number would rise to 1.1 million – or more than a third of all mortgages. A 300 basis point rise would take the cash rate to 4.5 per cent, still lower than the 4.75 per cent for most of 2011.”

Do you know how many homes NAB has under repossession on its books at the latest filing? Around 277. Yes, Two hundred and seventy seven. Out of 100,000s of loans.

But we needn’t worry because we have to trust our central banks will keep rates low to avoid any economic shock. Remember the current and previous US Fed Chairmen have all but guaranteed there will be no more financial crises in their life time. Either they don’t hold much prospect for their longevity or they are clutching at straws.

Complacency kills – the ticking time bomb for Aussie banks

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In the late 1980s at the peak of the property bubble, the Imperial Palace in Tokyo was worth the equivalent to the entire state of California. Greater Tokyo was worth more than the whole United States. The Japanese used to joke that they had bought up so much of Hawaii that it had effectively become the 48th prefecture of Japan. Japanese nationwide property prices quadrupled in the space of a decade. At the height of the frenzy, Japanese real estate related lending comprised around 41.2% (A$2.5 trillion) of all loans outstanding. N.B. Australian bank mortgage loan books have swelled to 63% (A$1.7 trillion) of total loans.

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Sensing the bubble was getting out of control, the Bank of Japan went into a tightening rate cycle (from 2.5% to 6%) to contain it. Unfortunately it led to an implosion in asset markets, most notably housing. From the peak in 1991/2 prices over the next two decades fell 75-80%. Banks were decimated.

In the following two decades, 181 Japanese banks, trust banks and credit unions went bust and the rest were either injected with public funds, forced into mergers or nationalized. The unravelling of asset prices was swift and sudden but the process to deal with it took decades because banks were reluctant to repossess properties for fear of having to mark the other properties (assets) on their balance sheets to current market values. Paying mere fractions of the loan were enough to justify not calling the debt bad. If banks were forced to reflect the truth of their financial health rather than use accounting trickery to keep the loans valued at the inflated levels the loans were made against they would quickly become insolvent. By the end of the crisis, disposal of non-performing loans (NPLs) among all financial institutions exceeded 90 trillion yen (A$1.1 trillion), or 17% of Japanese GDP at the time.

The lessons are no less disturbing for Australia. Don’t be surprised to hear the authorities and local banks champion stress tests as validity that we are safe from any conceivable external shock. The November 2018 Reserve Bank of Australia minutes revealed that the next rate move is likely up but the board is happy to sit on its hands because housing is slowing even at 1.5% cash rates.

With US rates heading higher, our banks are already facing higher funding costs because of our reliance on overseas wholesale markets to fund mortgage lending. Japanese banks have 90%+ funding from domestic deposits. Australia is around 60-70%. Our banks need to go shopping in global markets to get access to capital. Conditions for that can change on a dime. External shocks can see funding costs hit nose bleed levels which are passed onto consumers. When you see the press get into a frenzy over banks passing on more than the rate rises doled out by the RBA, they aren’t just being greedy – a large part is absorbing these higher wholesale funding costs.

What about America? Who could forget former Goldman Sachs CEO and US Treasury Secretary Hank Paulson tell us how robust US financial institutions were right before plugging $700 billion to rescue the crumbling system? US banks such as Wells Fargo, Citi and Bank of America (BoA) have been reducing mortgage exposure relative to total loans outstanding. Yet each received $10s of billions in TARP (bail out funds) courtesy of the US taxpayer.

By 2009 the Global Financial Crisis (GFC) had turned over 16% of Bank of America’s residential mortgage portfolio into either NPLs, mortgage payments over 90-day in arrears or impaired (largely from the shonky lending practices of Countrywide (which BoA bought in 2008). Countrywide’s $2.5bn acquisition price turned out to cost BoA shareholders a further $50bn by the end of the clean-up. Who is counting?

Oh no, but Australia is different. Residential property prices in Australia have had a far steadier rise over a longer period – a 5-fold jump over 25 years – meaning our local banks should be less vulnerable to external shocks. There is an element of truth to that, although it breeds complacency.

Property loans in Australia as at September 2018 total A$1.653 trillion. 82% of those loans are made by the Big 4 banks. Interest only loans are around $500 billion of that. As a percentage of total loans outstanding in Australia, mortgages make up 65%. The next is daylight, followed by Norway at around 40%. US banks have cut overall property exposures and Japanese banks are now in the early teens. Post GFC, US banks have ratcheted back mortgage exposure. They have diversified their earnings through investment banking and other areas. You can see this below.

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The advent of interest only loans has helped pushed property prices higher. NAB notes in its latest filing that 29% of its mortgage loan book is in interest-only form. The RBA expects $120 billion of interest only loans resetting to principal & interest (P&I) each year to 2020 which will hike monthly mortgage repayments to jump 30-40%. If investors were up to the gills in interest only mortgage repayments, adding one third to the bill will not be helpful. This is before we have even faced a bump in wholesale finance rates due to market instability. Look at the way that GE – once the world’s largest company in 2000 – is being trashed by the credit markets as they seek to reprice the risk attached to the $111bn in debt after a credit downgrade. This is a canary in the coalmine issue.

We also need to consider what constitutes a bubble in property. Sensibly, affordability makes the strongest argument. At the height of the bubble, the average central Tokyo property value was around 18.2x income. Broadening this out to greater Tokyo metropolitan area this was around 15x. This figure today is around 5x. Making arguments that ever higher levels of migration will keep property buoyant is not a sound argument as affordability affects them too.

Back in 2007, Sydney house prices were 8x income. In 2017 Demographia stated average housing (excluding apartment) prices are in the 13-14x range. The Australian Bureau of Statistics notes that 80% of people live in houses and 20% on apartments. Only Hong Kong at 19x beats Sydney for dizzy property prices.

In 2018, Australia’s GDP is likely to be around A$1.75 trillion. Our total lending by the banks is approximately $2.64 trillion which is 150% of GDP. At the height of the Japanese bubble, total bank lending as a whole only reached 106%. Mortgages alone in Australia are near as makes no difference 100% of GDP.

Balance sheets are but snapshots in time. If we look at our current bank exposure to mortgages, it is easy for analysts to paint rosy pictures. Banks’ shareholder equity has quadrupled in the past 16 years. Prosperity and record bank profits should give us comfort. Or should it? We need to understand that the underlying tenets of the Australian economy are completely different to that of a decade ago.

At the time of Global Financial Crisis (GFC) Australia’s economy was lucky to get away broadly unscathed. We carried no national government debt and were able to use a $50 billion surplus to prime the economy through that period of turmoil. Many countries were not so lucky. Our fiscal stewardship leading up to the crisis allowed economic growth to remain in positive territory soon after. Now we have $600 billion debt and charging the national credit card with all of the promises so aggressively that we should expect $1 trillion of debt in the not too distant future.

Australian banks are highly leveraged to the mortgage market. It should come as no surprise. In Westpac’s full year 2018 balance sheet, the company claims around A$710 billion in assets as “loans”. Of that amount, according to the latest APRA data, A$411 billion of lending is ‘real estate’ related. Total equity for the bank is A$64.6 billion. So equity as a percentage of property loans is just shy of 16%. If Australia had a nationwide property collapse (we have not had one for three decades) then it is possible that the banks would face significant headwinds.

What that basically says is if Westpac suffered a 16% decline in the value of its entire property loan book then it would at least on paper appear in negative equity, or liabilities would be larger than assets. Recall in 2009 that BoA had over 16% of its residential loan portfolio which went bad. It can happen. CommBank is at a similar level. ANZ and NAB are in the 20% range before such a hypothetical situation would be triggered. See the chart below. Note how the US banks stung by the GFC have bolstered balance sheets

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Of course the scenario of a housing collapse would imply that a growing number of borrowers would have to find themselves under mortgage stress and default on payments. It also depends on the portfolio of the properties and when those loans were written. If the majority of loans were made 10 years ago at 40% lower theoretical prices than today then there is lower risk to solvency for the bank if it foreclosed and dumped the property.

Although if we look at the growth in loans since 2009, the Australian banks have been making hay while the sun shines. As it stands, the likes of Westpac and CommBank each have extended mortgage loans to Aussies to nearly as much as BoA has to Americans. That said the American banks, so stung by the GFC, have become far more prudent in managing their affairs.

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It goes without saying that keeping one’s job is helpful in paying the mortgage. If you were a two income family and one of you lost your job, it is likely that dining out, taking fancy overseas holidays, buying new cars (which have been awful this year) and so on will go on the backburner. Should those actions swell to a wider number of mortgage holders, the economic slowdown will exacerbate in a downward spiral. Even your local coffee store may be forced to close because $4 is just cash you and others might not be able to spend. Boarded up High Streets were everywhere in America and Europe post GFC.

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The following chart shows the negative correlation between housing prices and unemployment rates. US unemployment doubled to 10% when Lehman collapsed. Housing prices took heavy hits as defaults jumped. It is not rocket science.

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On the other hand, Australia’s unemployment curve remained below 6% for around two decades. Even with GFC, jobless numbers never got out of hand. Our housing prices only suffered a mild dip.

We can argue that a sub-prime style mortgage crisis is highly unlikely. But it does not rule the risk out completely. To have that, mortgage holders would need to be in arrears on monthly payments, their houses would need to be in negative equity and banks would be required to take asset devaluations.

An ME Bank survey in Australia found only 46% of households were able to save each month. Just 32 per cent could raise $3000 in an emergency and 50 per cent aren’t confident of meeting their obligations if unemployed for three months.

According to Digital Finance Analytics, “there are around 650,000 households in Australia experiencing some form of mortgage stress. If rates were to rise 150 basis points the number of Australians in mortgage stress would rise to approximately 930,000 and if rates rose 300 basis points the number would rise to 1.1 million – or more than a third of all mortgages. A 300 basis point rise would take the cash rate to 4.5 per cent, still lower than the 4.75 per cent for most of 2011.”

Do you know how many homes NAB has under repossession on its books at the latest filing? Around 277. Yes, Two hundred and seventy seven. Out of 100,000s. Recall BoA had 16% of its loan portfolio go bang in 2008?

If we think about it logically, examining the ratio of total assets to shareholder equity (i.e. leverage), the Aussie banks maintain higher levels than the US banks listed below did in 2008. Were total asset values to suddenly drop 7% or more ceteris paribus, Aussie banks would slide into a negative equity position and require injection.

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Human nature is conditioned to panic when crisis hits. Sadly many of our middle management class have never experienced recession. They are in for a rude shock. As for depositors note that you should be focused on the return “of” your money, not the return “on” it.

As Mark Twain once said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so!