Binge Housing, Australia-style

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“We are a puny and fickle folk,” wrote the Yankee Romantic Ralph Waldo Emerson. “Avarice, hesitation, and following are our diseases.” It is in that spirit that today’s Daily Reckoning looks at the stock market’s fickle reaction to the Geithner plan, and the avarice of bankers and mortgage lenders.

The volume figures suggested Monday’s rally was broad but not deep. On Tuesday, that was confirmed. In Australia, the All Ords finished up but couldn’t match the 7% surge on the S&P 500. Financials like Macquarie Group (ASX:MQG) and Westpac (ASX:WBC) were the big winners on the day.

Today is another story. Stocks in New York were down. And investors now have to figure out just what this Geithner plan means for the banking system. That is a question we’ll deal with today, too. It’s a big one.

But first, there’s more news on the housing front to report and argue about. Remember, all we’re saying is that rising Australian housing prices had a lot more to do with the credit boom than any critical shortage of housing stock.

This alleged shortage is often alluded to but never proven, so far as we can see. If someone does have proof, we’re happy to publish it. But if there were really a shortage of housing units, wouldn’t there be a lot more people living in the streets or in their cars?

The main reason we’re harping on the topic is that Australia is showing the same social and psychological symptoms of housing infatuation that we saw in America in 2004. It’s a love affair. Or a disease. Or both. But the point is that turning to property as an antidote to the share market poison may not be your best bet.

While the great youth Binge on Housing unfolds, one statistic to watch is how many new housing loans are going to first home buyers. Before the U.S. housing boom went manic in 2004, subprime loans accounted for about nine percent of all new mortgage originations in the U.S. Then-after the Fed lowered short-term interest rates to one percent and kept them there for a year-non-bank lenders went down the credit ladder looking for new marks.

At the height of the boom, subprime loans as a percentage of all new mortgages rose to 25%. In certain states like California, subprime loans started to account for an even larger percentage of all new loans made. The low rates even induced a lot of borrowers with fixed rate 30-year mortgages to refinance into a subprime or adjustable rate mortgage.

Getting the marginal buyer into the housing market keeps the bubble going. But it’s also the last phase before the bubble pops. So keeping an eye on an influx of marginal buyers into the market is one way of alerting yourself to potential falling house prices.

Earlier this month the Australian Bureau of Statistics reported that, “The number of first home buyer commitments as a percentage of total owner occupied housing finance commitments increased from 25.7% in December 2008 to 26.5% in January 2009. This is the highest level recorded since the series commenced in 1991.”

These would be the First Home Buyers (FHB) taking advantage of the Kevin Rudd’s enlarged first home buyer grant ($14k for existing properties and $21k for new homes). And if you dig a little deeper, you find that more of these new borrowers are borrowing more with ‘honeymoon’ introductory interest rates that later reset to standard variable rates (exposing them to rising rates, probably in 2010 or 2011, more on that below).

So the first problem we have is that marginal buyers are becoming a larger percentage of the market. The second problem is that they are borrowing more. According to the Australian Finance Group, loan-to-value ratios were 66% in September of 2007. They’re now at a new high of 72.7% nationally (75% in Victoria and 76.6% in New South Wales).

What’s more, the number of new buyers choosing the low introductory ‘honeymoon rates’ has grown from 5.3% of new lending to 21.8%a 311% increase. And according to industry outfit Mortgage Choice, 92% of new mortgage loans in Australia are variable rate.

We provide this litany of statistics to make a simple point: the marginal buyer at the most risk of losing his job and with the fewest assets and facing the highest mortgage stress is borrowing ever larger amounts of money at variable rates at the low phase of the interest rate cycle. He has maximum exposure to falling house prices and rising rates.

Of course, you could argue that interest rates have reached a permanently low plateau. You’d be a moron if you did so, but you’re welcome to it. It’s much more likely that interest rates will begin to rise in 2010 or 2011. Why?

Well, by then you will either have inflation as a result of more stimulus packages, deficit spending, and an expanded money supply. Or if you prefer a positive scenario, a recovery will taken hold by then and the RBA will be forced to raise rates to “cool things off.”

Another scenario we won’t go into in massive detail is that China may be blamed for inflation by then. This came to us via a reader but it makes sense so we’ll mention it briefly. The theory goes that massive multiple government stimuli will have worked their way into the economy as bank lending by later this year or early next.

This will lead to inflation, which naturally will shock (simply shock) policy makers. So they will blame China. You know, the China that’s been busy stockpiling resources and tangible assets, while getting rid as many of its dollar reserves as possible, as quickly as possible.

That’s largely a geopolitical issue, and could lead to some intriguing fireworks next year. But economically speaking, it means about a year from now, FHB’s are going to find out that interest rates rise as well as fall. Kevin Rudd better hold the election before then. If he doesn’t, no amount of love from Barack Obama may save him from a mob of angry, disillusioned, and heavily indebted Gen Yers.

While we still have China on the brain, did you see the speech by Zhou Xiaochuan of the People’s Bank of China on the need for a new international reserve currency that is not the U.S. dollar? It was a Jim Dandy of a speech.

He said a lot of provocative things in the speech without ever mentioning the U.S. dollar by name. But the key line for us was the realization that money not backed by a real asset or real collateral is not real money.

Zhou said, “The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history. The crisis again calls for creative reform of the existing international monetary system towards an international reserve currency with a stable value, rule-based issuance and manageable supply, so as to achieve the objective of safeguarding global economic and financial stability.”

The speech mentions a few possibilities for replacing the dollar, some of which include using a basket of other currencies and commodities. But don’t expect anything to happen soon. As troublesome as the dollar standard has become to everyone, it’s not the sort of thing you swap out like a bad light bulb.

What’s more, an international reserve currency would have to be managed by someone or some organisation other than individual national governments. That’s pretty unlikely. Why?

National governments would be extremely reluctant to give up the ability to devalue their own currencies in order to support exports (see Asia). Also, the strategy of deliberate inflation is a time-tested government method of delivering phony prosperity by expanding the money supply. To give up that ability is to give up the power to create illusions of wealth. Incumbent governments would get the boot from voters for not magically creating more money and giving it away. Avarice.

Also, do you sense a little bit of whinging on the part of the Chinese now? They are worried about the value of their dollar holdings. But the Chinese also deliberately kept the Yuan from appreciating versus the USD over the last ten years. They are every bit the currency manipulators that the U.S. government has become.

China’s artificially cheap yuan perpetuated its low-cost labour advantage across the globe. It kept Chinese goods cheap overseas and allowed Americans (flush with credit and in high spirits over the housing boom) to go an epic spending spree.

Now China has all its foreign currency reserves in the dollar basket. And that basket is on fire, so its leaders are belly aching (albeit it dignified fashion). If anything, yesterday’s announcement could have been targeted at the rest of the G20 nations as a plea NOT to sell the dollar. China saying, “Yes, this sucks. We’re aware of it. We need something different. But not just yet.”

One other note regarding China. How suicidal have American policy makers become? By devaluing the dollar they accomplish two things: they cheapen the dollar’s purchasing power on international markets and lessen the appeal of U.S. financial assets to foreign buyers.

This makes it harder for the U.S. to finance its massive deficits AND it means Americans are competing for scarce tangible assets on the international markets with an increasingly weak currency. Nice work boys!

Okay. Finally. The Geithner plan. What more can we say about it that hasn’t already been said?

Rather than going into the details of the plan we’ll just tell you what we think: it’s a big cop-out by the Feds and a big power grab by the money centre banks to avoid their day of reckoning for making a massively bad bet on U.S. housing prices.

The upside for the banks is that the plan may just help them avoid insolvency. For investors, there is no risk to participating in the scheme designed by Geithner. Because the FDIC provides financing and the Treasury the Equity, private capital interested in the deal has to pony up only a little capital to be exposed to any upside in the toxic assets.

And the downside? That belongs to the FDIC and by extension, the U.S. taxpayer. So with that kind of deal, it’s no wonder Bill Gross and others are excited to have a punt. Why wouldn’t they?

The flaw in the plan, as others are beginning to point out, is that its basic assumptions are wrong. It is trying to fix a fictitious problem. In Geithner’s world, the U.S. banking system is basically sound. But these prodigal assets, these mortgage backed securities are impairing the ability of banks to loan.

The Geithner plan assumes that the problem with the assets is not the collateral that underlies them (subprime loans made to delinquents), but with the pricing of the assets. So he’s invented a scheme that creates an artificially high price for the assets that brings together an unwilling seller (the bank, who must not take too large a loss on the assets or it will see its equity destroyed) and an unwilling buyer (private equity and hedge funds).

Will it work? Well, it may clear the assets off bank balance sheets. That itself doesn’t guarantee banks will resume lending. Lending to whom? To all those people wanting to buy a house? To all those Americans terrified of losing their jobs? And let’s not forget, the whole plan assumes there will be no further deterioration in still other securitised assets held by banks. That’s a big assumption.

In any event, the plan reveals part of the spirit of our age: the belief that there are no real or lasting consequences for being wrong or for moral mis-behaviour. It’s as if once the assets are gone, the same bank managers and risk takers who made a huge directional bet on U.S. housing can get right back to business as usual, forcing U.S. tax payers to pay (for years) for their mistakes.

The truth is the U.S. money centre banks have a huge amount of political power. They donate and contribute to the campaigns of the clowns in Congress who pretend to regulate them. The stockholders and bondholders in these institutions should be forced to realise their losses as punishment for the bad investment they made in U.S. housing. That’s how markets ought to work (and that’s what makes them fair).

But the whole thrust of the Obama/Geithner team is to protect bondholders and stockholders and punish taxpayers. It also punishes the many regional banks that did not make bad sub-prime bets and did not receive billions in unaccounted for TARP money.

The alternative is to place the big banks in receivership. It allows them to stay in business while the assets are liquidated, new capital adequacy ratios are instituted, and new regulations put in place on the amount of leverage depository institutions can use in their proprietary trading.

But none of that looks like it’s going to happen. It’s as if nobody did anything wrong and the assets themselves are to blame for being wayward and underperforming. The Washington/Wall Street axis refuses to acknowledge and take the loss for a huge misallocation of capital. And so the rest of the country and the rest of the world will pay the price by way of higher inflation and later, nationalisation.

As Matt Taibbi wrote in this month’s Rolling Stone, “In essence, the bailout accelerated the decline of regional community lenders by boosting the political power of their giant national competitors. Which, when you think about it, is insane.

” What had brought us to the brink of collapse in the first place was this relentless instinct for building ever-larger megacompanies, passing deregulatory measures to gradually feed all the little fish in the sea to an ever-shrinking pool of Bigger Fish. To fix this problem, the government should have slowly liquidated these monster, too-big-to-fail firms and broken them down to smaller, more manageable companies. Instead, federal regulators closed ranks and used an almost completely secret bailout process to double down on the same faulty, merger-happy thinking that got us here in the first place, creating a constellation of megafirms under government control that are even bigger, more unwieldy and more crammed to the gills with systemic risk.

“As complex as all the finances are, the politics aren’t hard to follow. By creating an urgent crisis that can only be solved by those fluent in a language too complex for ordinary people to understand, the Wall Street crowd has turned the vast majority of Americans into non-participants in their own political future.

“There is a reason it used to be a crime in the Confederate states to teach a slave to read: Literacy is power. In the age of the CDS and CDO, most of us are financial illiterates. By making an already too-complex economy even more complex, Wall Street has used the crisis to effect a historic, revolutionary change in our political system – transforming a democracy into a two-tiered state, one with plugged-in financial bureaucrats above and clueless customers below.

We’ll leave the last word today to investor John Hussman: “Make no mistake – we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own.

“All our policy makers have done to date has been to squander public funds to protect the full interests of corporate bondholders. Even Bear Stearns’ bondholders can expect to get 100% of their money back, thanks to the generosity of Bernanke, Geithner and other bureaucrats eager to hand out the money of ordinary Americans.

To be continued…

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. Dan, You write “The number of first home buyer commitments as a percentage of total owner occupied housing finance commitments increased from 25.7% in December 2008 to 26.5% in January 2009. This is the highest level recorded since the series commenced in 1991” – but you omit to state what the annual levels or average level has been since 1991. If it has always been around the 20-30% mark then it would look like you are sensationalising. If however the figure has risen substantially in recent years from a much lower average then that would be something.

    Matt Taibbis thoughts about breaking up institutions so that they don’t get too big to fail is an interesting one. Perhaps another good analogy is to think of the huge cables holding up the Golden gate bridge: Those cables are made up of thousands of small strands (i.e. banks). The fine strand structure means that load & stress (loans to deposits) can be distribute more evenly and the failure of one, two, or several strands do not put the whole bridge (i.e global finacial system) into jeopardy. If on the other hand, if the bridge is supported mostly by a few massive support members (eg; Lehman, AIG, etc) then internal (hidden) cracking or erosion, leading to increased (hidden) stress and ultimately to visible failure of just one large member can bring the whole thing down, even if the others parts are still in good condition. Just like that bridge in Minnasota.

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  2. Great article Dan, still not sure why more Australians cant see the Aussie housing bubble, although I have noticed an increase in this realization from the number of comments made on various sites when housing is mentioned. Could it be that more people are actually seeing this self evident truth about housing and its just slower than I would have expected in a highly educated population. Psychology is a funny thing in economics, thats why I consider behavioural economics to be far superior, than the current neo classical line of thinking. After all its people who drive markets and we are all heavily influenced by our beliefs – psychology.

    DrewRiskManager
    March 25, 2009
    Reply
  3. Slightly disappointing article as Fred says. In addition, house buyers have known about the world wide credit problem for 6 months at least in Australia. Purchasers who are trading up are therefore fewer, waiting to see what happens to their current investment before attempting to take the multiplier. Note the falls in interest rates have made housing much more affordable, but there is still reluctance to buy up. Buying in may make sense…..and may not. There are very few no doc and low doc loans now. Property prices are not increasing generally as with the example. Those who are buying can afford to rent but prefer not to. The commissions to salesmen in the USA meant that they would sell to anyone. Interest rates on mortgages here are 5% or above. On the other hand income/price ratios are worse here than in the states. Possibly taxes on property were larger in the states? I am surprized that the market is so resilient but if I were trying to sell a property that was once said to be worth $1M, I might have a different view of the market?

    Pat Donnelly
    March 25, 2009
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  4. Dan, you rudely ignored my email to you where I explained how there can be both a shortage of housing AND a bubble in house prices.
    You are clueless if you expect the first sign of a housing shortage to be that a rich person like you notices people living on the street or in their cars. You do not visit the areas where this happens.
    Take a place like Sydney where I believe there is a severe housing shortage. Rather than expect to see homeless people on the street, I would expect the shortage to show itself in these ways:
    * high prices to buy or rent housing
    * young adults staying longer with mum and dad
    * young families pooling resources to share one house instead of buying one house per family.
    * excessive travel time and costs as people move too far out
    * poor immigrants and students living in overcrowded units and houses
    * caravan parks filled with long-term residents
    * increase in homeless numbers noted by charities
    * large numbers of poorer and younger people leave for other states
    * large numbers of poorer and younger people leave for other countries
    In Sydney we have all these indicators present. I call a shortage. I also call a price bubble.

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  5. Regarding the worlds banking sector, Nicholas Taleb said something very much the same. This is an interview with Teleb and my personal hero Beniot Mandelbrot as the current crisis started to unfold.

    http://www.youtube.com/watch?v=DLFkQdiXPbo&feature=related

    DrewRiskManager
    March 25, 2009
    Reply
  6. Dan – It’s the very point you make about governments wanting to retain the ability to devalue their currencies that give credence to a new International Reserve Currency…

    Reply
  7. very good article. well structured and well argued. you certainly can see far into the future. the unfortunate thing to most ordinary people is that you are not in power and you are the tiny tiny minority.

    Robert King
    March 26, 2009
    Reply
  8. Housing ‘shortage’ is a myth. Watch it unravel when house prices crash.

    The only shortage is in cheap housing in prime inner locations. That’s a no brainer. Everyone wants that, and it doesnt exist. Some of us clearly wanted it so bad we forgot about the ‘price’ component. Welcome to the subprime crisis.

    Ever heard of speculators who buy houses and don’t rent them? Buy land or houses and just leave them empty, waiting for capital appreciation? Watch all the rats scurry when the flood of homes hits the market. If you think they don’t exist, think again.

    There are entire apartment blocks out Paramatta way with only 3 of 30 units occupied. Again, it is not a housing shortage, it is a ‘desired housing’ shortage. All the pretty houses we ‘want’ are taken, and we’re too fussy to take the rest. Watch that attitude change soon enough when easy credit and employment levels drop.

    Pat: I think you might have been suckered in to seeing signs of things that aren’t actually there. You can probably thank the media for that one.

    David V: There is a difference between a ‘house shortage’ and an ‘affordable housing shortage’. Both would have similar signs to the ones you mentioned, but the forces affecting them are completely different. One is a product of overpopulation, the other is a product of economic forces. Guess which one we have? (Hint: Economic)

    Incidentally, I think where Dan is coming from is that people in the US are living on the street and in cars. I think he may be pointing out the difference between overpopulation vs. overpricing.

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  9. The bottom line is that housing cannot increase beyond the ability of new home buyers to purchase based on wage growth and interest costs. We can assume that a couple is the largest economic unit and maybe 100% of the after tax income of one partner can pay mortgage and the rest living expenses. However the banks would be crazy to lend to this level, as ability to repay is too risky.
    I think it is going to hit the fan here, after China buys up everything they can first.

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  10. Robert, the banks are maybe not that crazy.

    The more banks lend, the more they will have to swoop on in the coming ‘foreclosure season’. Increasing interest rates or decreasing interest rates plus tightening lending standards, either way, read a loan contract, and the property belongs to bank until further notice. If they can take down a group of FHB and their parents who put up their principal home as collateral, all well and good.

    As to China, you are right. They have a mantra: Use their resources before we use our own. They have a 200 year plan, Aus govt has a 2-3 year plan.

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  11. Bob: You said “If they can take down a group of FHB and their parents who put up their principal home as collateral, all well and good.”

    I think the proportion of FHB’s that have used their parents home as collatoral is surprisingly low, NOT the norm at all.

    When the vicious cycle of foreclosures begins, the banks will lose out big-time, as the assets are worth only a portion of the defaulting loan.

    The foreclosure cycle works something like this:
    1) Home is foreclosed upon.
    2) Banks try to sell home. Banks have to sell at a low price.
    3) The volume of foreclosures forces ALL house prices down by a margin.
    4) Buyers hold out, thinking house prices will go lower once the trend starts.
    5) Bank drops house price again (Banks aren’t home owners…they will liquidate a house at whatever price they can get and won’t wait for prices to rise to sell in 5 years like an investor)
    6) Banks start losing money. Raise rates. Tighten lending.
    7) Even lower home prices forces others to get out of the market, drawing house prices even lower.
    8) Buyers hold out again, waiting for lower sales.
    9) Goto step 2.

    The key points are 2, 3 and 4.

    It’s something along those lines. A feedback-loop I think it is called. Nasty. Consider Japan’s 90% home price drop in the 80’s that most Japanese thought couldn’t happen at the time (you know the “we’re overpopulated and don’t have enough housing” talk you got from people in Japanese cities much more dense that ours).

    I totally agree with you Bob on China’s longterm plans though. Whilst us western countries have become such short-termists, China is happy to sit back and work on things several generations ahead.
    They’ll probably have Taiwan back in 50 years.

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  12. How is this for an idea on the ‘real’ intent of the public/private purchase of toxic assets, aka the Geithner plan… Tax payers feed billions to the banks, at a real profit to the banks, ridding the banks of toxic assets and moving said ‘assets’ to the public.

    As posted on http://www.oftwominds.com/blogmar09/comments03-09.html

    “RE: Mr. Geithner’s new bailout plan:
    This plan is sheer genius. The bank executives have earned their bonuses again. Here is what I would be doing if I were Citi.

    Step 1: I would set up a new entity, say a Structured Investment Vehicel (SIV) and call it $chiti. I doubt the banking regulators will think there is anything strange with this name.

    Step 2: I would place 10 billion dollars of TARP funds into $chiti. This money, which the government gave Citi, comes in handy for setting up these off balance sheet companies.

    Step 3: I would instruct my lackey at $chiti to bid on $250 billion dollars of bad assets in Citi. These assets are not worth $250 billion, that is their face value. That means, that Citi paid $250 billion dollars to buy these assets. The problem is they are only worth between 7 and 10 billion dollars. $chiti would not bid $250 billion dollars for these gems. No, anyone could tell these mis- understood assets must be worth at least $300 billion dollars. So $chiti places a bid for $300 billion dollars.

    Now at this stage, one of two possibilities can occur. Some fool may bid more than $300 billion for the bad assets at Citi, or option 2, $chiti wins the bid and gets the assets.

    Let’s go with option 2 first. $chiti wins the bid, and now needs to come up with $290 billion dollars (remember it only has $10 billion in it right now) to buy Citi’s bad assets. This is where the government comes in. Tim’s plan lends and “invests” the other $290 billion.

    So, now at Citi, I make $50 billion dollars of profit as I get $300 billion for assets that were originally worth $250 billion.

    $chiti does not fair quite so well, as the assets it bought are worth no more than $10 billion dollars. So over time the loan the government gave me through Mr. Geithner goes bad, and $chiti goes bankrupt. Unfortunately Citi loses its $10 billion investment in $chiti.

    So to recap. I get to shift $250 billion dollars of stuff that is probably worth only $10 billion dollars, to you the tax payer. Citi gets a $50 billion dollar profit from the sale, and $chiti gives Citi a $10 billion dollar loss. As a result I (Citi) make $40 billion dollars. Not bad, and definitely worth a $1 billion dollar bonus for engineering that plan.

    Now let’s look at that first option. Someone else bids more than $300 billion for Citi’s assets. I know it is unlikely, but you never know. Assume they bid $310 billion. Well then, Citi makes $60 billion in profit and it quietly shuts down $chiti and takes back the $10 billion in it. So overall I make $60 billion in money (the $10 billion coming back from $chiti does not count as profit it is really just moving an asset).

    So either way, Wall street can now engineer enormous profits for this year. Bonuses will be back with a vengeance. Everyone is happy. Until that tax bill comes due.

    In reality Citi probably won’t be so blatant as to buy their own assets. They will collude with Bank Of America and JP Morgan and other banks, with the help of Geithner, to buy each others’ assets. This way it all appear kosher, while the taxpayer is fleeced for vast sums of money.”

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  13. Stewart: How many of these “$chiti’s” would the US need? It seems like they would need many…

    Do you think they could get away with it unnoticed?

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  14. I think it may also be illegal somewhere? Not exactly sure where, it just seems like it might be

    Reply
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    Stephen Witherspoon
    March 30, 2010
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