Financial Markets

Brexit – Jonathan Pie does it again

Whether you’re a Remainer or Leaver, Jonathan Pie explains in his trademark profanity-laced way why the Brexit deal of UK PM Theresa May is such a dud. What is the point of having a referendum which garners the highest ever voter turn out only to throw it back in the faces of both sides? In what world would a collective constituency want their parliamentarians to vote for a deal that makes everyone worse off? Why did May fold to every EU demand? She should have channeled the leader across the pond as to how to negotiate with Brussels.

Last week the Bank of England (BoE) ditched its independence charter to aid-and-abet the PM by producing a document stating a “No Deal” Brexit would hit UK economic growth by 8%.  What a joke. Would the EU seriously try to stitch up the economy of the second largest car market for German auto makers? It is preposterous in the extreme. Obama threatened in 2016 that the 5th largest economy would be at the back the queue when it came to trade deals. Trump would happily move it to the front. Canada and Australia too…can the BoE honestly come up with credible reasons why the ROW would spurn the UK in unison to get to an 8% slump?

Why only now has the BoE discovered this potential economic apocalypse? After all, the scare stories leading into the referendum about how the UK would plunge into the abyss should “Leave” succeed have simply not manifested. None of it. Why believe it now when its forecasts have been so off reservation? After all it did not advise the HM Treasury not to dump all of its gold at the very bottom.

Yet the Brits aren’t so stupid to see the deal being offered is the only one going. They have heard Minister for European Parliament (MEP) Guy Verhofstadt demand that member states hand over more sovereign powers to the EU. They saw EC President Juncker stagger blind drunk across a NATO stage BEFORE the dinner. There was little doubt in their minds when they checked the ballot square as to what was at stake. A No Deal Brexit is the one that should be pursued. The EU has so many disaffected member states that it is the one that needs to play nice with the UK, not the other way around.

 

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Take this chart, which shows the level of apathy member states have to show up and vote at European Parliamentary elections. Were the Brits so gung-ho to stay in the EU, why have only one-third of Brits ever shown up to express their love and affection for federalism? Is it any surprise that Italy, Spain, France & Greece have shown similar disdain over time as the EU fails to deliver for them? Surely the trend since 1979 has shown the underlying mood of member state constituents about how they value EU membership.

Perhaps Verhofstadt put the Brexit discussion into perspective (from 6:20) – after member states ratified the May plan in 38 minutes (a sure sign it is a great deal for the EU) – when he stated the hope that in the not too distant future, “a new generation of British…decide to come back into the great political European family

Tells us all we need to know. This week will show beyond a doubt about whether the island nation will have the very democracy it has shed so much blood to defend will be protected.

As Baroness Margaret Thatcher said of Europe,

 “During my lifetime most of the problems the world has faced have come, in one fashion or other, from mainland Europe, and the solutions from outside it.”

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!

 

 

When the supervisor can’t follow the rules

Japan Exchange Group’s (owner of the Tokyo Stock Exchange) CEO Akira Kiyota has agreed to take a 30% pay cut for 3 months after admitting he’d broken internal rules on prohibited investment.

Surely as the supervisor of one of the largest stock exchanges in the world there would be sufficient systems in place to prevent such embarrassing events. A bit hypocritical to come down hard on listed corporates when the headmaster can’t follow his own rules.

As a former stockbroker, it was a sackable offense to make stock and bond investments without sign off from compliance and a manager to mitigate any risk of insider trading. It is a bit rich to suggest the JPX boss wasn’t aware of his internal rules and had he any doubt whatsoever it would have been an easy discussion had with the relevant department.

Corporate governance in Japan remains woefully inadequate. The JPX board has approved the ¥20mn (US$180k) profit made by the CEO on the initial ¥150mn (US$1.3mn) investment be given to the Japanese Red Cross. Will that be pre or post any capital gains tax? Why isn’t the board calling for him to resign? Why isn’t Kiyota resigning on principle to save the organization’s stained reputation as the vanguard of best practice?

Then again we should not be surprised. It took months for the JPX to remove/suspend Toshiba from the best in class corporate governance index (JPX Nikkei 400) after its accounting scandal became outed and there has been no investigation of Kobe Steel when blatant insider trading was visible to a novice. It leaked information about its fraudulent product specifications to customers three weeks before announcing to the market. All the tell-tale signs of heavy short selling positions on many multiples of average daily volume traded on the day of informing clients was evident. Yet nothing was even suspected, investigated or referred to the regulator.

Then take a look at the saga of Nissan. Documents have revealed former CEO Carlos Ghosn supposedly washed his multi-million dollar personal investment losses through the company as well as using Nissan money to buy several private properties in his name. That would still require the board to be willfully blind to sign off on such big ticket items or point to woeful internal controls. What governance structures could be in place when there is no board accountability over Ghosn’s actions? Being bullied by a dominant CEO is no excuse. The board should have tendered their resignations en masse.

Indeed there have been countless corporate governance lapses overseas – Parmalat, GSK, Stanford, Enron, Tyco etc- but in Japan there is little or no punishment for most executives who break laws (internal or external). Throwing the book at Ghosn will be an exception. Most C-level managers in Japan escape with little more than wounded pride.

Cutting salary for misdemeanors is woeful governance too. The biggest way to force compliance is to threaten a Japanese boss’ company car privileges. The highest status for a CEO is to be whisked around in a personal Toyota Century. Stripping it would literally force corporate leaders to do the walk of shame.

Brexit – the EU explained by bridges

Many may not be aware of this folly of the EU but it starts with the euro currency itself. All of the bridges that are printed on euro notes do not exist in Europe. The debate was had to put existing bridges on the notes but was rejected for fear of causing offence to EU nations who ‘missed out’ or were on lower denomination bills. Surely if a matter as trivial as this cannot be bridged (no pun intended) what hope has real integration got?

Good to see the English stuck the old war-horse Sir Winston Churchill on their new machine washable GBP5 note with the quote “I have nothing to offer but blood, toil, tears and sweat” . PM Theresa May would do well to heed this.

Begs the question why Baroness Thatcher isn’t due on a note. Perhaps they couldn’t fit

“(A unified) ‘Europe’ is the result of plans. It is, in fact, a classic utopian project, a monument to the vanity of intellectuals, a programme whose inevitable destiny is failure: only the scale of the final damage done is in doubt.”

“What we should grasp, however, from the lessons of European history is that, first, there is nothing necessarily benevolent about programmes of European integration; second, the desire to achieve grand utopian plans often poses a grave threat to freedom; and third, European unity has been tried before, and the outcome was far from happy.”

Not even this was short enough but boy was she so right!

“During my lifetime most of the problems the world has faced have come, in one fashion or other, from mainland Europe, and the solutions from outside it.”

We shouldn’t forget the EU’s Brexit bully Guy Verhofstadt openly said that the problem with member states is they are reluctant to yield sovereign power to the EU. His view was the only way out of the crisis is to cede more power and control to the EU. What a great idea. Give unelected bureaucrats more power to dictate to sovereign nations.

PM Theresa May might do well to build bridges with her own constituents rather than sign a deal which forces one way tolls. At the moment she sings to Verhofstadt’s tune. No doubt if she got her way then she would have a cushy job in Brussels.

Nothing to see here

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Aussie bank mortgage lending continues to reach ever dizzier heights. What is probably lost on many is that Westpac & CommBank have outstanding mortgage loans extended to as many Aussies as the colossal Bank of America (BoA) is lending to Americans.

Shareholder equity as a % of real estate loans looks like this. Note how post GFC  the US banks have shored up the balance sheet to avoid a repeat of the disastrous contagion when Lehmans collapsed. Note Citi, BoA and Wells Fargo each took $20-45 billion in TARP to prevent a collapse.

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Westpac & CommBank have shareholder equity vs R/E loans of 16%. That means if the aggregate loan value get smacked  by 16% or more via defaults or a sharp slowdown then these banks would be in negative equity. Extreme?

In 2009 the Global Financial Crisis (GFC) had turned over 16% of BoA’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?

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.

Japan ended up wiping out Y90 trillion ($A1.1 trillion) or 17% of its GDP at the time. The only thing that springs to mind with the Aussie banks is complacency and the RBA minutes today only reinforced that view. At least 3 years behind the curve. Yes of course people will lob stress tests as a reason not to worry (we were told in 2007 that everything would be fine until the whole edifice collapsed) but CM doesn’t buy it for a second.

Aussie banks are still beholden to global wholesale markets. In a world where rates are rising overseas and companies like GE are facing a massive wall of higher funding costs due to credit downgrades, risk is about to be priced properly. The Aussie dollar is likely to be hit too.

A recent ME Bank survey in Australia found only 46 per cent 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.

The Weekend AFR reported that 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 300.

Carlos Ghosn facing arrest

The Asahi Shimbun says Nissan group President Carlos Ghosn is expected to face arrest by prosecutors for underreporting salary. Noone should be above the law but to think of the number of jobs at Nissan he saved plus the return to record profitability makes CM think the tax man is well ahead on the trade.