The $5 Trillion Debt Tsunami

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Bubbles, bubbles everywhere. And not a stock to buy. Even emerging economy stocks are expensive, according to Nouriel Roubini, the New York University professor who is famous for calling the U.S. housing bubble and the global financial crisis. Roubini is now warning that even in the places of the world where things grow, you should be on your guard.

“In Brazil, like in many other emerging market economies,” he told Bloomberg, “there is now evidence of overheating of the economy…Expected and actual inflation is starting to rise, and that implies that over the next few quarters there has to be a tightening of monetary policy, gradually but progressively, in order to make sure that inflation expectations remain anchored.”

This is the monetary tightening we expect to pop the Chinese real estate bubble. That is our proposition, anyway. It could be wrong. Chinese GDP grew by 11.9% in the first quarter. “China is struggling to contain the threat of an overheating economy in the face of rising house prices, inflationary wage increases and a continuing surge in money supply,” reports the U.K.’s Telegraph.

The rest of the world is trying to figure out how to get rid of rotting bank collateral without destroying the banks in the process. Meanwhile, Chinese banks continue their lending boom on real estate assets. Money supply (M1) grew up by 31% from last year, according to Guo Shuqing, the chairman of China Construction Bank.

Remember, in 2009, Chinese banks lent out nearly US$1.5 trillion into the economy. The regulators in China have raised capital adequacy ratios at banks and introduced measures to try and drive speculators out of the real estate market. But it’s not like bank lending is drying up. Total loans outstanding in the Chinese economy are on pace to grow by 18% this year, with another US$1 trillion in loans to hit the books.

Yes. $1 trillion is less than $1.5 trillion. But it’s more than half a trillion, which is about the amount of yuan loans made out in 2008 – before China’s lending bubble went Nasdaq. As inflation is always and everywhere a monetary phenomenon, you don’t increase the money supply that much without unleashing inflation. And inflation is afoot in China.

Not in the stock market, though. The Shanghai Index is down 27% year-to-date. That may foreshadow the slowdown in the real economy to come. But in the meantime, Mr. Guo says that property prices have risen by 40% this year in some Chinese cities. “Property prices are definitely seeing something of a bubble,” but it differs from city to city.

Ah yes. All real estate is local. But all mortgage bubbles are national. This is true especially in markets – and we won’t name names – where most of the lending is concentrated in just a few issues. This tells you where lending risk resides in a financial system. In the U.S. subprime bubble, that risk was transferred from the loan originator to investors, via Wall Street’s securitisation machine.

Lately, the risk has migrated back on to the public balance sheet via the nationalisation of the U.S. mortgage market by Fannie Mae, Freddie Mac, and the FHA. The ultimate repository of U.S. housing risk is now the United States government. How’s that credit rating boys?

In Europe, the risk of bad loans made during the boom now calls the euro home. That is, the euro stands the most to lose from Europe’s version of a bad debt epidemic. But spare a thought for many of Europe’s banks. Overnight, the European Central Bank warned that euro-zone banks may have to write off as much as $238 billion in bad loans over the next eighteen months. In this case, for the most part, the bad collateral has nothing to do with mortgages. Instead, its deadbeat sovereign debt that will be rescheduled, marked down, or defaulted on.

But as bad as that loss figure is, and as much pressure as it would put on bank balance sheets, take a look at the chart below from International Monetary Fund’s Global Financial Stability Report published in April. It shows that global banks have nearly $5 trillion of debt maturing in the next 36 months. Can you see what this means?

Bank Debt Rollover by Maturity Date

The problem for the banks – and for sovereign governments – is that there borrowing needs exceed the capacity of global savers to fund. The alternatives are deleveraging for the private sector and debt monetisation for the public sector. In other words, the banks will have to reduce the amount of debt and new credit issued in the economy (which leads to lower real growth rates) and central banks will have to buy debt issued by governments who cannot fund their deficits in public bond markets.

We’ll get to the consequences of that in just one minute. But you can see the problem of borrowing short-term when interest rates are low. The maturity schedule of bank debt and public sector debt is biased toward very short terms, when rates are low. This creates big problems when you have long-term assets (like mortgages) at fixed interest rate, but you borrow short term at variable rates (which are rising).

Sure, it’s also an interesting case study in how centrally rigged interest rates – which distort the cost of capital – create huge misallocations of capital in the real economy that ruin plans and lives. But you can see what’s coming: a global contest for scarce capital.

In that fight, we’d expect smaller regional banks that are not politically connected to either fail or be swallowed up by larger ones that enjoy government backing (including loan guarantees). But the general trend is not good. It is the continued concentration of risk in a smaller number of large and complex organisations whose chief assets are someone else’s liabilities.

Now you may be thinking that in a world of fiat money, there can be no capital crisis. The central bank can print more money to buy government debt. How can there ever be scarcity when you own a printing press. Or a helicopter?

It’s a fair point. But it prompts this rejoinder: do you think the supply of gold and other precious metals will grow as fast as the supply of paper money and government debt in the coming years? Do you?

Australia’s banking sector will have to weather the storm like all the rest. But it too, borrows short term and must roll over a lot of debt. You can see now that Australian institutions are competing with other global banks and governments for savings and capital. That should push up the cost of capital for Aussie banks, even if the Reserve Bank of Australia sits pat and does nothing.

A higher cost of global capital probably wouldn’t be such a good thing for the Aussie market, we reckon. Housing finance fell last month, according to data from the Reserve Bank of Australia. And house prices have finally stopped rising on the ocean of credit, according to the RP Data Rismark Hedonic National Home Value Index.

Right then. Over the last 16 months national home prices have risen by an average of 12%. Late last week an IMF economist named Prakash Loungani said that house prices were still “well above historical values” in some places in the world, on a price-to-income basis. He included Australia in a list of those countries where prices are “misaligned” with incomes.

Naturally, his analysis was rubbished by Australian property analysts who say that property remains affordable here because interest rates are low. ANZ property analyst Paul Braddick said the price-to-income ratio is fundamentally flawed because it, “explicitly ignore a key component of the housing affordability equation – interest rates.”

Well. Hmm. It’s true that the amount of debt you can service is the key component of affordability. And the amount of debt to be serviced is a function of the interest rate. That’s true. But the total amount of debt required to get into a house is a function of prices. And relative to incomes, Australian house prices are nuts.

Besides, would you say that a drug addict is not an addict if he doesn’t have access to smack? Are Australian houses affordable because credit is accessible, for now? Determining the affordability of something based on your ability to borrow money seems a little dubious. This makes the Mona Lisa and Ferraris affordable too, provided you can find a banker to lend to you.

But obviously that’s rubbish. At an intuitive level, most people understand that affordability is not based on whether you can get the loan from the bank. It’s based on whether you can carry the loan without breaking the back of your financial plan. Obviously the banks and the real estate industry are keen to put you into debt. It’s good for their business. But it might not be good for your life…at least when prices are this high.

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. We want to go long taxes and interest rates! Commodities won’t soar until after the leverage comes out of them and both the inflated purchasing power of the USD collapses and the shrunken capital pool is recreated made of savings rather than of leverage. Deflation first, inflation second.

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  2. DD: “This is the monetary tightening we expect to pop the Chinese real estate bubble. That is our proposition, anyway. It could be wrong.”

    That would be a first, Dan. Can’t believe it’s possible, in fact.

    Reading Bill’s perceptions of China, I’d been impressed with his new vision of this economic powerhouse… and wondered how DRA could integrate Bill’s unusually buoyant optimism with the ‘Oz-property-on-the-Highway-to-Hell-when-China-falls’ vision… . :)

    Still trying to come to terms with Japan as the Trade of the Decayed. ;)

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  3. DD is a “Black Swan” reporter Biker – Yunno, he chats about things that could happen but really most likely won’t. But if they should, will hurt a lot. ‘Course what’s a Black Swan to the likes of us ‘n DD, is probably just common knowledge to the likes of GS who told the Greeks how to cheat their way into the EU; And have been waiting happily since to short all the appropriate stuff.

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  4. Real estate is a very emotional topic. Owners (or, at least, borrowers) are deeply committed pyschologically to rising prices. Those trying to buy are caught between the refusal to drink the Kool-Aid and the terror of being forever priced out. Real estate professionals (be they agents, bankers, mortgage arrangers, etc.) all have a vested interest in rising prices. Generally, the worst vitriol comes from the first and third groups; when one dares suggest that real estate is overvalued, the epithets fly thick and furious.

    One of the big problems is the persistent belief that real estate is great investment. Once this is accepted, there is almost no way to break down the bull mind-set. If an owner can at least be forced to accept that it is not a good financial investment, he will inevitably fall back on intangibles like the pride or security of “owning” a house. Renters’s intangibles like freedom to move and lack of worry over the condition of the housing are dismissed entirely.

    I pointed out the bubble to friends and family five years ago and was berated, insulted and treated with contempt. Some asked me why I wanted them to lose money. Most simply told me I was wrong without justifying why they were right.

    It is all about affordability. Multiples of income over the long term. Interest rates are fickle creatures of politics. Sure, a million dollar home is a breeze to finance at 4%, but where will your resale price be in ten years with interest rates at 10% or higher. Oh, I forgot…you are NEVER going to sell. Well, um, then how the heck is that any kind of investment?

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  5. “…there is almost no way to break down the bull mind-set.”
    Yet you state that: “_Real estate_ is a very emotional topic.”
    Why is it necessary to _break down_ the bull mind-set?
    If property is going to crash, why the necessity to break it down, vocally?
    Sounds pretty emotive to me!~ :)

    I suspect it’s because a.) property is a tangible; b.) gold is a tangible; c.) ownership of gold _is_ also a very emotional matter; d.) and, in this fanciful competition between two tangibles, hopes get a little (a)frayed.
    Realistically, of course, putting all your eggs in any one basket is a little unwise, especially if you can’t afford to lose them.

    Perhaps most telling here is the oft-repeated hope of goldbuggers once gold reaches amazing new heights: the desired home in a top location, or the sweet little rural hideaway they’ll buy. Nothing wrong with that of course… they’re two of the many rewards of successful investment.

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  6. BP..
    and a bunker, and a place to grow food. noting Miller is working on a new Mad Max movie. are the Amish into gold that much? black swannies, how I love ya, how I love ya…that’s it, too silly!

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  7. Working on my own silly film strip ‘Ratbiker’ at present, Peter. Ratbiking is a genre all its own. Met a couple of ratbikers way up north; and one in southern Mexico. The theme would appeal to Max… .

    Once crossed the Nullabor (sideways)*; retracing some of the route crossed by Gelignite Jack back in the fifties. Some of the gnamma holes we found hundreds of kilometres north of the Bight reverbrated with surf pounding the cliffs south… but the water in the caverns was pure and clean, if a little calcified…

    * In the 70s, one of the dirtbike mags paid me well for the ride story… and even better for the photos.

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  8. “…are the Amish into gold that much? black swannies…”

    White geese, I think. I know they have hearts of gold, mate!!

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  9. What’s got me beat, is if a useful commodity like sugar can go down 50% over 6 months, why a useless commodity like gold can’t? :)

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  10. Got me beet, too!

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  11. Having said same, I bought a few mangey nuggets a while back on the off chance I ever should need to revert to being an 1860s type digger/modern day Zimbabwean, I’ll know how to recognise same and won’t throw my fortune away! (Wouldn’t like to be as ignorant as I was when I first went chasing sapphire!!!) What can a bloke say? … Nuggets are pretty little things perhaps??? … :)

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  12. BP,
    wow, you go waayyy back… I can imagine you getting together with malcom Frazer nowadaze and doing a road movie…. go left, go left, no its the nullabore , straight ahead or back…or off the road altogether.

    abagail as airbags?

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  13. Road? What is ‘road’?

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