|Shares Out. (in M):||4,184||P/E||0.0x||0.0x|
|Market Cap (in M):||69,421||P/FCF||0.0x||0.0x|
|Net Debt (in M):||0||EBIT||0||0|
How many times in investing are we given the opportunity to capitalize on a theme that has just played out in fantastic fashion?
Shorting Australian real estate is just that opportunity. Given the recent experiences in the US, Ireland, Spain, the UK (& soon to be Canada), Australia is on course to match, or even exceed, most of those housing declines.
We spent one week last summer in Australia where we met representatives of the RBA, notable housing bulls and bears, as well as real estate agents from Melbourne to the Gold Coast. We even posed as potential home buyers and witnessed an (unsuccessful) auction.
We came away more confident that the average Australian homeowner was way over-levered and in denial of the pending doom. There was a certain kind of arrogance from many of the bulls (Christopher Joye being the most arrogant of the bunch). The bulls claimed to be keenly aware of the American experience and did their best to sell us their version of “it’s different over here”.
In our opinion, house prices are a function of credit growth and psychology. When both are positive, prices go up. When price growth outpaces income growth, you have a problem. When homeownership becomes a national obsession, you have a problem. To get a better understanding of the roll of credit and housing, go to Professor Steve Keen’s blog, http://www.debtdeflation.com/blogs/
One of the main papers (The Financial Review) came out with an article a week or two ago titled, “The Slow Death of Housing”. Plenty of interesting stuff in the article but one quote caught my attention. “Conversation at the dinner table has turned from ‘how big is your home to how small your mortgage is’”. The psychology has finally turned bearish. Up until late last year, 8 out of 10 articles or news programs was bullish on housing, now 8 out of 10 are bearish.
Primer on Australian Housing:
Another great resource, other than Professor Keen, are the guys over at http://www.macrobusiness.com.au/. They’re sharp guys. It seems that the bears always do better homework.
Two arrows in the quiver:
There are really only two ways the government can deal with a housing correction. One is via monetary policy (the RBA has an inflation target range of 2 to 3%. Inflation is believed to be running well below 2% currently, leaving them plenty of wiggle room to reduce rates). Also, see http://www.macrobusiness.com.au/2012/04/here-come-the-rate-cuts/
The other is fiscal policy. Australia is in control of their own currency and they have a total Debt to GDP of under 30% (don’t quote me exactly here). They have plenty of room bail out the banks and drop interest rates. You can short interest rates by buying a receiver swaption (tie it to the 5 year or 10 year Australian Gov’ Bond).
You can short the banks (or buy CDSs on them). We have avoided CDS due to the government’s ability (and high likelihood) to save the banks. The big 4 are ANZ, Commonwealth, Westpac, and NAB. Collectively, they are 80% of the mortgage market and 50% to 60% of their assets are tied to residential mortgages. At more than 2 x tangible book, the odds of the banks going up another turn of book is possible, but unlikely. They pay dividends, so your carry is negative.
In the face of the global financial crisis (they all refer to it down there as the “GFC”) the RBA dropped the OCR to 3% and the government initiated the first of two first time home buyers credit programs that stopped the house price declines. As the world began to recover from the depths of 2009, Australian housing resumed its trajectory. If you look at the price trends, supply of homes, velocity of sales, loan approvals etc. now versus 2009, one could argue that it’s finally the end game. Home sales are back to 1996 levels. Rates will likely go much lower than 3%. Owning receiver swaptions with a strike of 3.5% and having the OCR go to 1% would be an absolute home run. It is difficult to give you an exact quote on them given they vary significantly between banks. Ideally, one would shop among the big dealers.
Valuing these swaptions on a monthly basis can be aggravating. It’s driven by the demand for hedging. Lower vol = lower values when out of the money. If rates don’t come down fast enough, the duration of your trade becomes very important.
Many of the ratios look great now. For example, Westpac’s impairment charges on loans written off to average loans (%) are still low (.38) but they are more than double 2007. Westpac’s total housing related loans as a percentage of total loans are 50% (351 billion AUD) and loan loss reserves are less than 5 billion. Equity as a percentage of total assets are 6.5% and as a percentage of housing related loans it is less than 12%. A real correction can play havoc with their loan loss provisions, delinquency rates etc as well as their earnings power.
The banks are also more reliant now on offshore funding than ever before. Offshore funding stands at more than 30% of total deposits, more than double the level in 2000. Household deposits as a percentage of total bank deposits are almost 50% lower than 2000 (down to 22% or so from 35 to 40%).
Net margins have also been marching lower. They’re around 2.2%, down from north of 3%, despite a rising housing market and mining boom. Offshore funding is inherently more expensive and likely a little more ephemeral than domestic savings.
The bulls made a point of showing us charts comparing the housing related ratios of US banks to the Australian banks. In our opinion, the comparison is flawed because it assumes both countries are in the exact same house cycle (or secular trend). When the correction begins in earnest, we will be able to compare the housing cycles and we’ll likely find an eerily similar relationship between the US and Australia.
We think the main risk is time. We’re convinced housing will crash but they always take longer than you initially think. We remember thinking housing was getting crazy in the US in 2002. It took another 4 years to crack, and even after the initial crack, it took another couple of years for the banks to collapse. In the case of Australia, house prices cracked during the GFC. They rebounded when the RBA dropped rates and the Government initiated the First Time Home Buyers Tax Credit. Those were only temporary stop gaps, on what we think is a secular retreat.
The banks have the implicit backing of the government. Yes, the banks could survive, but given what happened here, the banks would be trading at a fraction of book value.
Biggest risk is that China will continue to purchase Australian commodities in substantial quantities and the secular commodity bull market will continue and Australia’s mining riches prop up the faltering retail and housing industries. Even with that the housing bubble could collapse of its own weight.
|Entry||04/30/2012 02:15 PM|
Much to many people's surprise, many states in the US are full recourse. The "jingle mail" is overstated in our opinion. It also comes down to capacity and willingness to pay. Yes, if you believe that your bank will come at you for the remaining debt you may hang on for as long as you can. However, if you don't have the capacity to pay, you can't pay.
That also leads you to a second tier issue relating to banks and mortgages. If you default and can't pay the balance for years to come, you likely are taken out of the home-buying market, which would decrease demand for housing and loans. This causes further home price declines and exacerbates credit contraction, which is what drives bank's earnings. It just gets worse.
There are many first time home buyers, via the tax credits employed by the government, that brought forward a lot of demand. You have a void in demand, declining prices and over-leveraged first time homebuyers.
Again, since most mortgages are floating rate, so droping rates drastically will allow homeowners to hang on to their homes, but your interest bet will work out beautifully as the government does all it can to keep people in their homes.
If you're upside down on your mortgage, you won't likely be selling and moving into another home either. Again, credit growth contracts. It's Koo's "balance sheet recession".
|Subject||RE: RE: Question|
|Entry||04/30/2012 02:26 PM|
Great writeup. How would you suggest taking advantage of this through non-ISDA requirement trades? Would you short the banks? Buy puts on the ASX-100 index? Are there overpriced Aussie homebuilders?
I'm currently short AUT, which I think will pop if the ASX trades down more than 20%, but am interested in evaluating more direct exposure.
|Subject||RE: RE: Question|
|Entry||04/30/2012 02:58 PM|
You say the 'two-speed' economy is a myth. Why? We've looked at this in particular detail and find that in fact, the mining sector is indeed preventing incomes from collapsing into oblivion. At some point this may change, but considering the tight labor supply and the incremental jobs coming from the mining industry, it's not clear how you get a major correction in prices until then.
As a data point, there are approximately 2% fewer jobs available than there were last year according to the SEEK website. Ex mining, resources and energy jobs, there are 4% fewer jobs available, but MRE jobs available increased 32% year-over-year. We also find similar result in every major sectoral data series.
The result of this is that incomes have yet to roll over. And because of that, there's no immediate need to sell the house. So really what you need is a Chinese slowdown. Of course, if you believe this is happening now, then you'll be very, very right. But in that light, one wonders if Australia is the best way to play a collapsing China (vs, say, Japan).
|Subject||RE: RE: RE: Question|
|Entry||04/30/2012 03:38 PM|
from what we've read, employment is slowing dramatically. Your analysis of employment data is likely more granular than ours. You can have employment lag housing, as it has done time and again in other housing corrections.
We believe that we have a major credit contraction coming. Housing is the number one asset (& its tethered mortgage which is the number one liability) for almost all Australians. As it falls on its own weight, it will drag everything with it.
I wish there was a John Paulson in Australia to create a CDS market for housing loans. That would be sweet. One can dream.....
|Subject||RE: RE: RE: RE: RE: Question|
|Entry||05/01/2012 08:59 AM|
supply has been steadily increasing as the velocity of home sales is imploding. In fact, it's back to 1996 levels. Because of this, we don't think the banks's assets reflact fair value. Most homes cannot be sold for their asking price. The bid ask spread is wide. Plenty of data on this from SQM Research, RP Data, Residex, and even the guys at macrobusiness.com.au. If you know housing is expensive and you think it'll be cheaper next month you'll wait another month. The psychology of the housing dream has turned.
One of our other short positions is a bet that interest rates have to decrease. It's the gov's most powerful tool to control a housing decline. A 50 basis point cut in rates signals how worried they are about housing (in our opinion). I'm sure many will view this is a long term positive for the banks because conventional wisdom says that dropping rates in directly affects mortgage rates (since most are floating). We would argue that the rate cuts are a weak response to a secular credit contraction. To get housing to affordable levels, they would need to fall by 50% in many areas. We think Australia is entering a Balance Sheet Recession.
|Entry||05/01/2012 11:22 AM|
but do you know what % of big banks mortgage books are insured? and if that insurance is worth anything?
|Entry||05/02/2012 09:57 AM|
don't know the %s but WBC for example required Lenders Mortgage Insurance ("LMI") for > 90% LTVs.
The bulls will argue that this transfer of risk from the banks to the LMI co's insulates the banks. We disagree on a few fronts. Incidentally, Genworth Australia, one of the largest mortgage insurers pulled their IPO recently due to "elevated losses".
Given the LMI's losses, you can bet they'll fight hard to avoid paying claims. There'll be some greater scrutiny on the disclosure provided by the banks on the insured mortgages.
From the unconventional economist at macrobusiness.com, "the banks' internal Basel capital adequacy models are a huge risk, as they require greater capital to be held as house prices fall and 'probability of default' and 'loss given default' rises. This will put an automatic clamp on credit availability, the banks' profitability, etc and could lead to further house price falls as credit is rationed".
This gets us back to our theme re: credit contraction. As prices fall, mortgages that were considered "unrisky" (ie -- LTVs < 90%) eventually become risky.
Banks rely on credit growth to grow earnings.
NAB just reported "record" 1st half profits, but beneath the surface you can see the structural issues emerging. net margins continue to slip. Because of this, they are resistant to pass along the full RBA 50 bp cut yesterday. NAB announced a cut of 32 bp, to 6.99%. There are cries from the real estate industry saying that the cut is a joke.
On floating rate mortgages, the bulls believe that this is an embedded hedge. lower rates translate into lower mortgage payments which should in turn lead to a stabilizing of house prices, defaults etc..
If this is the case, why did so many low rate ARMs in the US default? In a Balance Sheet recession, lower rates won't drive credit growth. It may keep some in their homes longer, but it won't stop the mean reverting process.
As is happening in the US, the mean reverting process involves overshooting on the downside, much like it did to the upside.
Banks trade at a premium to book because they are expected to earn a return in excess of their required return. When credit begins to contract, net margins compress and the justification for trading at a multiple of book value dissappears.
If you follow the headlines, there's been a dramatic shift in sentiment. Austalia's gone from being a country with a housing obsession to a bunch of "pundits" pointing figners and calling for drastic changes to help a broken system.
|Subject||RE: For What it's worth|
|Entry||05/03/2012 05:23 PM|
|Subject||Rate predictions. one arrow in the quiver|
|Entry||06/04/2012 09:22 AM|
|Subject||RE: Revisiting the Thesis|
|Entry||08/08/2014 08:33 AM|
the "delayed thesis" is a nice way of saying we've been wrong, as least as of today. We have taken down the bank shorts over time as the correction in housing prices didn't materialize. We still think it will, it's just a matter of time.
The leverage in the system has only gotten worse. betting on a drop in interest rates worked but the banks have benefited from this as well, as historic low mortgage rates have driven a new wave of buyers into the market. The RBA, in our opinion, has painted themselves into a corner. The last time housing ripped, they increased rates to temper the move. In a meeting with an RBA exec back in 2010 said, "we methodically pricked the bubble". It seemed to have worked back then. This time however, there is a lot more leverage out there. They're going to have to keep rates low for a long time in order to keep housing "stable". That will just exacerbate the problem and make the correction longer and deeper than it should have been. For now we are sitting, for the most part, on the sidelines. We are still a little short but are waiting for the crack. Shorting macro themes can be very tough.
|Subject||Re: RE: RE: Revisiting the Thesis|
|Entry||11/19/2014 10:05 AM|
The article below argues that improved bank capitalization ratios are more a product of changing standards than actual economic improvement. Would those following this situation agree or is the author missing something?