#ANZ

Debunking Modern Monetary Theory (MMT)

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While the Dow & S&P500 indices grind back higher thanks to the US Fed chickening out on a rate rise in because the economy can’t handle it, many people still overlook the fact that core US profitability has tracked sideways since 2012. 6 years of next to nada. Sure one can boost profits by adding back unrealistic  “inventory adjustments” but the reality is plain and simple. If you search for inventory adjusted earnings they’re still marginally growing but there in lies the point. Real profits aren’t.

Record buybacks fueled by cheap debt is the cause for ‘flattered’ earnings. No growth in E  just falls in S.  EPS growth can look spectacular if you ignore 50% of US corporates have BBB credit ratings or worse.

The latest lexicon is “modern monetary theory” (MMT). The idea that the central banks just manipulate markets in perpetuity. Austerity is no longer needed. Central banks print money and extinguish debts the same way. Seriously why bother with taxation? The question is if it is meant to be a sure winner, why aren’t we all living in 5 bedroom mansions with a Mercedes Benz and a Porsche in the driveway? Why not a helicopter?

Logically if central banks can buy our way out of this debt ridden hellhole, why is growth so anemic? Why is European GDP being cut back? Why is German industrial production at its worst level since 2009? Why does Salvini want to jail the Italian central bankers? Why does the Yellow Vest movement in France carry on for its 15th consecutive week? If MMT works why would the EU care if the UK leaves with No Deal? MMT can solve everything for unelected bureaucrats in theory. Even £39bn can be printed

Last year the US Fed announced it had stopped reporting its balance sheet activity. In 2006 it stopped reporting M3 money supply. Curious timing when inside 2 years the world was flung into the worst recession since 1929. Transparency is now a danger for authorities.

The question boils down to one of basic sanity. All assets are priced relative to others. It’s why an identical house with a view in a nice neighborhood trades at a relatively higher price than one in a outer suburban back lot. The market attributes extra value even if the actual dwelling is a carbon copy. It is why currencies in banana republics trade by appointment and inflation remains astronomical. Investors don’t trust their ability to repay debts unless given extremely favorable terms. Market forces at work.

To put the shoe on the other foot, if all countries adopted MMT why bother buying bonds for retirement? The interest is merely backed by a printing press. Best consume 100% and save zero. The government has moved beyond moral hazard and hopes no one will notice

Take a look at Japan. It has $10 trillion in outstanding debt which is 2x its economy. The Bank of Japan owns 60% of that paper bought through a printing press. The market for JGBs is so manipulated that several Japanese mega banks have handed back their trading licenses because it has become worthless to be on that exchange. The BoJ thinks it can make whatever prices it chooses. The ultimate aim is to convert all of the outstanding debt into a zero coupon perpetual bond with a minor ‘administration’ fee in order to assign some value to it. To the layman, a zero coupon perpetual means you get no interest on the money you lend and the borrower is technically never required to pay the borrowed amount back. Such loans are made by parents to their children, not central banks to politicians (although one could be forgiven to think their behaviour is child like).

Yet the backdrop remains the same. Consumers are tapped out in many countries. Lulled by a low interest rates forever mentality, even minute rises to stem inflation (real is different to reported) hurt. My credit card company constantly sends emails to offer to transfer balances at 9% as opposed to the 20% they can charge if I don’t pay in full.

APRA recently relented on interest only mortgages after demanding it be tightened to prevent a housing bubble getting bigger. Now mortgage holders hope the RBA cuts rates to ease their pain.

Like most new fads, MMT can’t remove the ultimate dilemma that Milton Friedman told us half a century ago. Inflation is always and everywhere a monetary phenomenon. One can’t hope that putting money in the hands of everyone can be sustainable.

The one lesson that we should have learnt from GFC was that living at the expense of the future has rapidly diminishing returns. All we did was double down on that stupidity.

Do we think it normal that Sydney house prices  trade at levels the Japanese property bubble did in the late 1980s? Do we realize that we hold as much mortgage debt than Japanese banks did for a population 5x our size? Do we think that our banks are adequately stress tested? When an economy like ours has avoided recession for a quarter century, it builds complacency.

MMT is nothing more than a figment of the imagination. It preys on the idea that we won’t notice if we can’t see it. Unfortunately behind the scenes, the real economy can’t sustain the distortions. The French make the best modern day example of  a growing number of Main Streeters struggling  to make ends meet.

Central banks monkeying around with MMT smacks of all the same hubris of the past. It is experimental at best and reckless at worst. Markets can be manipulated for as long as confidence can be sustained. Lose the market’s trust and all of a sudden no amount of modern day jargon  can overcome what economists have known for millennia.

If you flood a global economy with cash at 5x the rate the economy can feasibly grow then it will ultimately require bigger and bigger hits to get the same bang before the jig is up. It’s a Ponzi scheme. Bernie Madoff got 120 years jail. Why not the central bankers?

So what is the best asset out there? Gold. It can’t be printed. It requires effort to discover it and dig it out of the ground. Of course the barbouros relic deserves to be consigned to the dustbin of history. If that were so Fort Knox might as well leave the gate open. The more it is hated only makes this contrarian investor want it more.

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!

 

 

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.