A Loss is Not a Loss if You Turn Debt into Equity

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In today’s episode of the Daily Reckoning, some important questions about banking – especially the loan books of Australia’s big banks – are asked. You’ll also read why small Australian resource explorers are headed to Africa instead of WA. And more evidence that Chinese real estate speculation has lost its blob.

But first, we’re going to take the 18-month highs on U.S. indexes as a sign that everything is stuffed. The reflation strategy of the Fed has pumped up stocks. But we’re going to take the opposite side of the trade and proceed under the impression that the rally is bogus and rigged. If want the official line, pick up a newspaper.

The first big issue today is property. Residential housing is still doing its best impression of a slow-motion implosion in the U.S. Existing home sales fell for the third straight month, according to government data. Median prices fell to a tidy US$165,000. The sales level was at its lowest since last July, with 8.6 months of supply (3.59 million units) overhanging at current sales rates.

It’s hard to see how that’s going to get any better with high unemployment, tougher lending standards, and higher 10-year Treasury rates and 30-year mortgage rates as the Fed exits from its Quantitative Easing Program. But maybe Congress can pass a new law.

Of course none of this matters to Aussie property bulls, right? There is no inventory overhang here. There is, so it’s claimed, a structural shortage of supply. And in psychological terms, it’s possible the national infatuation with housing (exhibiting all the signs of a mania) is just no reaching its ridiculous phase.

You can tell by the amount of property and credit porn that is beginning to show up on television. Last night we say an advertisement for a new show that promised to show investors how to turn beaten-down properties into rivers of gold. A new coat of paint, some feng shui, and a well manicured hedge were all featured suggestions.

This is exactly the sort of garbage we saw on air in the UK and the US at the height of the boom. But they’re really just tricks and gimmicks to convince people that cosmetic changes to a property would translate into tens of thousands of dollars of pure, low-taxed, capital gains. You’d be an idiot not to tune in.

While the mood of the property market turns deeply bubbly, the guts of finances are increasingly mushy and constipated. Just two lenders – Westpac and Commonwealth Bank – hold 50% of all outstanding mortgages in Australia, according to CoreData’s Q1 Australian Mortgage Report. Like in the rest of the world’s financial system, risk is being concentrated in fewer and fewer large institutions.

CBA owns 25.9% of the national market. And as we mentioned in February, it took advantage of the GFC to grow its property loan book massively. Westpac – with 24% of the market in 2009 – did the same thing.

But the banks have a problem now. And Westpac’s leadership knows it. Yesterday’s Australian Financial Review has a front page story with the headline “Westpac tips five years of rate rises.” In that article, Westpac’s Ted Evans says that the main drive of interest rates in Australia my no longer be the RBA cash rate but the cost of borrowing money on the wholesale international markets.

Uh oh.

Why would it be true that the domestic price of money has less influence on bank interest rates than the cost of wholesale funding? Well, because Australia is a capital importer. The banks borrow internationally to lend locally. That’s what’s powered the housing boom here in Australia.

The loan books of Australian banks are growing faster than deposits. Bank loans outstanding total $1.6 trillion and are growing at 8% per year while deposits of $960 billion are growing at 5% a year, according to John Durie and Martin Collins in the Australian. If Aussie banks want to keep lending, they’ll have to keep borrowing abroad.

The trouble with that is that foreign borrowing costs are on the rise. Between 2011 and 2014, Durie reckons over $650 billion in leveraged loans will have to be refinance by Aussie banks. With so many governments borrowing money right now, Aussie banks are surely going to have to pay more to borrow from abroad. They’ll be able to refinance, but probably a higher price.

That higher price of refinancing old loans and getting new ones is why Westpac reckons it’s going to have to raise interest rates independent of what the RBA does. If the banks can’t loan from deposits (since loans are growing faster than deposits) they’ll have to squeeze existing borrowers with higher rates. And you know who we’re talking about.

Homeowners. Or, to be precise, mortgage owners. Because of the reliance on foreign funding at a time when the global cost of capital is headed up, Aussie banks are going to put the screws to all those newbies who got into the market with the First Home Buyer’s Grant.

The yoke of debt may have felt light until now. But the lash of higher rates on the back will definitely be noticeable. Let’s just hope it doesn’t break the financial back of a whole generation of home buyers, although this is what we fear “bringing forward demand” will do. It brought premature buyers into the market that will not be able to survive in a world of higher interest rates.

A quick note about yesterday’s conversation of converting debt into equity. It’s not new, as we mentioned. But what is really going on both structurally and conceptually?

Well, structurally, converting debt into equity turns a secured or unsecured creditor into a shareholder. Instead of having a claim on the company’s actual assets in the event of liquidation – what secured creditors are entitled to – equity investors get nothing. So why would you agree to restructure your ownership claim if it disadvantages you?

The answer, we think, is that it’s better to get a little of something than all of nothing. A loss is not a loss if you turn debt into equity. In other words, the alchemy of converting debt to equity is acknowledgement that the value of the asset is bogus. Instead of taking a total loss on your capital, you instead restructure your claim so that you get a piece of any future cash-flows or earnings the company or asset may generate. You also get to vote as a shareholder.

So, in a way, accepting equity rather than demanding repayment of a debt is a fundamental restructuring of your investment expectations. You are partially admitting you didn’t get what you paid for and that you may not be made whole on your original capital investment. In other words, it’s a nod to reality and a beginning of the liquidation of mal-investments made in the boom.

The sham, though, is taking debt and forcing the taxpayer to become an equity investor through some government designed Franken-corporation. This is what we expect to happen in the U.S. It’s not impossible that it could happen in Australia too, someday. The AOFM is buying billions of mortgages originated by second-tier lenders. If those debts go bad, they could someday become public equity too.

And while we’re on the subject of red ink and red tape, did you see Monday’s AFR piece on Aussie firms who are moving to Africa to do their exploration? “The difficulty of getting projects up and running in Australia now is immense compared with Africa, where they have more the attitude that Australia had in the 1960’s and 1970’s,” says Paladin Energy managing director John Borshoff.

Nicole Hollows, the CEO of Macarthur Coal, says “For equity markets, why would you want to invest in Australia? Queensland has already increased its royalties and so has NSW, and now [with the Henry review] no one knows what the royalty structure will be…We developed Copabella [coal mine] in 15 months in 1998. You couldn’t do the same project in less than five years now.”

Incidentally, the long-lead time in getting new mines up and running is one reason why sudden spikes in demand can lead to a supply shortage in key commodities, despite big projects in the works. This is something Alex Cowie has been looking at in Diggers and Drillers. With some commodities (like uranium) you only get a share that’s sensitive to price movements in the underlying commodity if the company is actually going to be producing in five years.

But back to the development time and the “green tape” of environmental regulations. Maybe it’s progress (confusion at a higher level, according to aviation genius John Boyd). That is, it is probably easier to take less heed of the environment by doing business in Africa, where governments might not protect it as much.

Even so, Australia’s growing jungle of policy requirements and hazy transparency on royalty taxation are making it a less desirable and easy place to do business. That’s despite some world class ore bodies and abundant supplies of key commodities the developing world needs, like coal and iron ore.

So are the policy wonks at the State and Federal level going to blow it? Are they going to take Australia’s resource endowment for granted because they believe that no matter how difficult and costly it is to extract out of the earth, foreign investors will keep on queuing up because they have no other choice?

As Bill has pointed out, Great Empires and large institutions invariably find a way to seek their own destruction. From Rome to Tiger Woods, nature seems to abhor a hyper-power. So a word to the wise wonks of Australia: don’t squander the boom!

In the meantime, Alex has stocked up the list of recommended stocks in D&D with Aussie-listed companies who have found great resources in Africa. It doesn’t hurt that their capital and operating costs are usually done in U.S. dollars. His latest research came across my desk last night and should be published to D&D readers tomorrow.

Finally, imagine a quaint British village with little replica steam engines, statues of Winston Churchill, Marry Poppins, and Harry Potter…faithfully reconstructed on the other side of the world in China. That’s what this article about Thames Town in Shanghai describes. The only detailed touch missing? People!

If there was ever proof that China’s productive boom is the largest off-shoot of the global credit bubble, it’s this. Of course that makes the demand for Australian resources itself – this great commodity boom since 1999 – derivative of the credit bubble too. Hmmn.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Thames Town is only a minor example of the China bubble. There are entire cities that have been built and remain empty.

    Put Ordos into your search engine for a good example.

    Reply
  2. Greg, some that came up on internet search have been quoting density figures based on a prefecture level area. “The city has an administrative area of 86,752 km² and covers the bigger part of the Ordos Desert”. Hohot has 17K at this level but only 149 km² urban area. Wiki is screwed up. Grant you that it is a Brasilia sort of place but at least it has an industrial base attracting hotshots. I am interested in learning more about those industries.

    Reply
  3. Fine words from Nicole Hollows. Maybe she should taken on a tour of all those mines that were fast tracked during the late 80’s-90’s. Those once large companies names are now forgotten, but their legacy is now being paid for by the greater community. Acid Mine drainage, soil erosion and polluted ground water are all like trying to put the Genie back in the bottle or get fall-out out of a victims lungs! The damage these fly by nighters did will be paid for long after the royalties and wages have been spent.

    Those minerals have been there for millions of years…from now on they can wait just a little longer till all the checks and balances are examined. And by more level headed individuals than Mining executives or greedy politicians I might add.

    Mining Companies are like Governments, their motivators are not in the community’s interests.

    Reply
  4. …china’s emperors would build entire cities way back “ming” as safe places to reside, complete with actors/people in the lanes and alleys…now, modern china could open the doors of these new empity city to western tourists staffed by loyal communist eavesdroppers…making money,friends and learning more nice secrets…

    Reply
  5. sorry, if you can’t aford the blossming new hampshire real estate up-tick, try wymoging, or el canada.

    hey! larry kudlow, me buddy from high school, is going to tear you a new asshole…..

    Reply
  6. Two for DD in case he missed them.

    First is the unmasking of underlying belief that should be challenged in an unexpected corner. Prudent Bear’s Martin Hutchinson shows his Brittania banking form here : http://www.prudentbear.com/index.php/thebearslairview?art_id=10357
    I am with Denninger on this matter, they must be declared illegal, if not by a similar use of existing provision back by natural justice in “when in 1989 the High Court declared all the swap contracts with local authorities to be ultra vires” then alternatively by legislating that the holding of such agreements (existing and future) as unenforceable by law. Stuff the paternal empire’s relationship bankstering!

    Next and more in tune with the above (debt-equity trickery to bank on inflation to come), here is the first sign of the US major’s cutting mortgage principal. And of coarse it is as crook as Rookwood. It is off AAP but I won’t post another link because it will send it into moderation so I will just post the preamble text.

    quote

    By THE ASSOCIATED PRESS
    Published: March 24, 2010

    Filed at 3:13 p.m. ET

    CHARLOTTE, N.C. (AP) — Bank of America Corp. is giving some of its most troubled mortgage borrowers relief from the threat of foreclosure.

    The bank, the largest mortgage servicer in the country, said Wednesday it will forgive up to 30 percent of some customers’ total mortgage balance. The homeowners must be at least 60 days delinquent on their loans and owe more than 120 percent of their homes’ value.

    unquote

    What it doesn’t say is that these will be non recourse loans subject to almost certain jingle mail or otherwise foreclosure outcomes. For BOA the 30% cut on the mortgage balance can be compared with a jingle mail outcome of a usual loss of over 90% of the compound interest already booked as bank profit and then a +40% cut on the collateral. They can’t afford the 30% haircut on their balance sheet let alone the likely alternative. As an underwater non recourse borrower, you would take the free rent as long as it lasts and then start fresh in most muni’s, even those around DC. Who is going to sign onto buying past asset deflation and future slavery when you have a non recourse contract?

    Reply
  7. There was a piece on “Thames Town” on TV a few weeks back – possibly ABC’s “Foreign Correspondent”. Talk about a speculative bubble. The reporter found only one residence that was occupied, by a family who said that the Chinese – presumably meaning rich Chinese – don’t like living in second hand houses, so the speculators who bought into the estate won’t put tenants in.

    Reply
  8. “The loan books of Australian banks are growing faster than deposits. Bank loans outstanding total $1.6 trillion and are growing at 8% per year while deposits of $960 billion are growing at 5% a year, according to John Durie and Martin Collins in the Australian. If Aussie banks want to keep lending, they’ll have to keep borrowing abroad”

    The above statement sounds like the largest load of garbage to me. Banks all use what’s called “fractional reserve banking” to loan from 8x (conservative banks, lets say ozzie banks fall into this category) through to 50x (Wall Street banks such as CitiGroup) of the collateral they have on there books.

    This statement also suggests that our banks do not loan money at all, they borrow all of it from overseas markets and they act more like brokers rather than banks. I find it hard to believe that an organization that has a license to manufacture money (using fractional reserve banking) would not be leveraging off it. Banks and there spokes people are only there to misinform those who do not know how the system works.

    Is this correct or am I missing something? Let me know what you think…..thanks!

    Reply
  9. No Shaf, fractional reserve system still means there must be a 1$ deposit for each 1$ of loan. “Fractional” allows them to retain only a portion of deposit in “reserve” and lend out the rest.
    You put $100 to your savings account in a bank, now bank has assets of $100 in your cash and $100 liability to you – the balance is maintained. Under fractional reserve, it then can lend say $90 to me. So it will have $10 in reserve, $90 as my loan (bank’s asset) and $100 liability to you – the balance still maintained.
    Problem is, where previously we only had $100, we now have $190 – cause you still consider your deposit “yours”, and reclaim it any time. Of course, if too many people reclaim their deposits, the bank can’t pay.

    Reply
  10. Ahh, but what you’re missing SV is what constitutes a deposit. The banking system is able to monetise debt, effectively, they can create deposits collateralised with (bad) debt.

    These deposits are redeemable in physical dollars, yet the commercial banks cannot create physical dollars, they can as you say, only borrow them. The solution?

    A central bank that issues legal tender, i.e. ‘money’ you have to accept in payment of debt whether you like it or not, collateralised with (bad) debt, in the form of deposits which the commercial banks can draw from….

    Reply
  11. Would be if it actually was ‘in sight’, Lachlan!~ :)

    Http/1.1 Service Unavailable

    Biker Pete
    March 25, 2010
    Reply
  12. Biker every link Ive ever posted has flopped. My aswell go to the garage now and hang with Shoes’ clammy mates :(

    Reply
  13. “My aswell” arrrrgh the carnage continues…

    Reply
  14. Don’t give up, mate. Persistence rocks, OK?!~

    Biker Pete
    March 25, 2010
    Reply

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