The Cash Flows Are Coming


The cash flows are coming! The cash flows are coming!

Big Aussie blue chips like Commonwealth Bank, Telstra, and BHP Billiton report their annual results this week. It is a contention of this version of the Daily Reckoning that corporate cash flows have been unusually high for the last fifty years – a combination of an explosion in credit and debt markets and the real economic activity the credit boom kicked off in the industrialised world and, lately, emerging nations like Brazil, China, and India.

The emergence of those economies as producers of capital goods and consumer goods puts pressure on prices for Western manufacturers. Meanwhile, legacy costs for Western firms (taxes, pension, healthcare etc) rise. All of this eats into cash flows, forcing them to revert to the mean (lower).

And let’s not forget the credit boom has ended. Sure, global capital markets are not as broken down and frozen as they were last year. But trillions of dollars in capital has been wasted in speculation or sunk into bad investments (residential American real estate).

National governments are demanding a larger portion of global savings. Government welfare transfer schemes and bailouts have to be funded from borrowing (unless from money printing), which also makes capital harder for private companies to get. Corporate cash flows will revert to the mean in the absence of huge infusions of credit to finance the growth of the balance sheet.

So yes, the cash flows are coming, and in some cases, going. They will reveal which companies emerged from the last eighteen months of chaos with sound capital structures…and which are still vulnerable (not enough equity, too many dodgy assets not valued correctly). It may sound kind of boring. But for investors, taking a microscope to the balance sheet and income statement has never been more important.

Housing finance data for June is out tomorrow. That will be worth a look. Remember that the Reserve Bank has cut the cash rate by 425 basis points since last October. They remain at a 49-year low. By the way, what do you get when you cut rates by that much that fast? You get yourself a bit of a bubble in the housing market.

“Are we agreed that the proposal is crack-brained, absurd, could prove incalculably expensive, and violates every dictate of financial prudence?” writes Robertson Davies in “The Lyre of Orpheus.” We picked up a copy in Fitzroy Street and ran into that line. It could apply to a great many things.

Speaking of crack-brained schemes, the Australian is reporting that credit unions are looking to the superannuation industry has a source of liquidity for making home loans. “If the fund gets the green light, it will give credit unions an important alternative source of funding to expand their market share in home lending, now at 7per cent,” reports Adele Ferguson.

It’s another example of forced speculation. The Big Four banks source their home loan funding from capital raisings (guaranteed by the government) both domestically and overseas. The borrowed money goes into commercial and residential property. Banks make a mint, and the liquidity drives prices up which drives more people into property, keeping up demand for more bank loans (and keeping stamp duty coffers full for state governments).

The credit unions want a piece of that action. And why wouldn’t they? If the government, the banks, and the regulators rig the housing market so that it’s the preferred destination for foreign capital, smaller competitors can’t be blamed for wanting to get in the game. It’s where the easy money is made.

Of course this could be the mother of all bad capital allocation decisions for Australia. You’ll have a larger share of superannuation money going into the housing market. An increasingly large share of the nation’s income will be tied up in residential housing. This confirms what Dr. Steve Keen said recently at our Debt Summit. “Americans traditionally speculate on stock prices. Australians speculate on houses,” he said. (By the way, the transcript of the Summit should be available this week).

What made the housing boom so unusual in America, he pointed out, is that it was one of the first time’s Americans speculated so wildly on houses. Prior to the last twenty years, house prices never went up much faster than the rate of inflation. They were consumption assets. Not financial assets.

The lowering of interest rates by the Fed and the explosion of non-traditional mortgage lenders changed the financial incentives just enough for Americans to abandon prudence and start gambling with houses. It ended – is still ending in fact – in what we once called the total destruction of the U.S. housing market.

As we told a Diggers and Drillers reader last week, “A report from Deutsche Bank reckons that by 2011, nearly half of all U.S. mortgages could be underwater with negative equity. Further price falls, the Bank reckons, will wipe out the little equity that large swathes of the market currently have. Once the equity in the house is gone, there’s no reason for the borrower to hang on. In the States mortgages are non-recourse loans, which means the lender cannot chase up the borrower if the borrower decides to walk away.”

“Why does this matter to junior resource stocks? It was the original fall in U.S. house prices that kicked of the credit crisis. The fall in home values wiped out bank collateral and rendered into junk a lot of the securities that were made up of subprime U.S. home loans. That episode brought the global financial system to the brink of ruin.”

“The market is telling us that the system has recovered from its near-death experience. In fact the market is obviously pricing – in a robust recovery in earnings, which itself implies a return to normal economic life. No one, apparently, is considering the possibility that further losses in U.S. real estate could again trigger a capital collapse in global financial institutions. But it’s a real threat!

“Australia’s banks appear to have minimized their exposure to losses from U.S. real estate. But what did happen in the last year is that the capital crunch led Aussie banks to be a lot more conservative in their lending to the mining sector. The mining sector responded by tapping the equity markets directly and bypassing the banks. But some companies were left exposed an unable to fund their projects or roll over loans.”

“That’s exactly the situation that could happen again. At least it’s something you have to consider. The supply of capital to the mining sector looks stronger. But Australia is a net importer of capital. Its strategic weakness has been exposed and not fully repaired.”

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.


  1. From ‘Business Spectator’ today;

    Bendigo and Adelaide Bank posts 24% drop in cash earnings, launches $300m capital raising. Regional lender says credit quality sound, well positioned for sustainable growth.

    Its credit quality is sound but it needs $300 million? What a load of bulls**t. They probably invested in mortgage paper.

  2. So yes, the cash flows are coming, and in some cases, going. They will reveal which companies emerged from the last eighteen months of chaos with sound capital structures…and which are still vulnerable (not enough equity, too many dodgy assets not valued correctly).

    Since mark to market requirement has been dropped (If you don’t like the stories in the news, don’t watch it) because we didn’t like the action required to address the corporate valuation deficiencies, how on Earth are we to view their results. What’s on the books as an asset at an unjustifiable price just laggards future earnings.

    Sooner or later the value of the asset has to be realised, or if without loss, the asset value laggards until re-inflated to its cost. Since you won’t realise the timely loss on an asset, you cannot claim a positive revaluation until its value exceeds cost. Money sat doing nothing.

    Surely it is criminal to not make true statements as to a companies worth. And this position has been sanctioned by the regulators.

  3. “Banks make a mint, and the liquidity drives prices up”

    And the town planners make sure the land prices don’t drop to meet the demand by keeping land for rezoning to residential in short supply.
    Wasn’t there a story a while ago of a Councillor sleeping with two land developers?

  4. So the housing market in Australia (in keeping with popular opinion) was a good idea after all? I still think that housing in Australia, whilst it won’t crash spectacularly, will grind itself away and under-perform when compared with inflation and wages growth, so that over several years we will have had our housing correction.

  5. Dan, I contend that it was Basel combined and topped off with the off balance sheet vehicle that had Americans do what only Ozzies and Brits and Japs had done before them (if we discount the Dutch and tuplis or every other banker driven bubble in history). NULAB started here in Australia with Chairman Keating as treasurer, spread to the UK where it picked up the handle and went over to Bubba’s fraternity who were in awe of what the Japanese did before them.

    Your point on capital and cashflow for the viable companies in the medium term is similar to mine on inventory. If they can’t finance their inventory (or other infrastructure input costs in service based industries) they will be stuffed.

    I was reading the SEC filings on one of the most conservative and lower geared A rated US companies today and in the notes it said that a single interval move from low A down to highest B on their debt rating would double their cost of borrowings as signed off in their covenants.

  6. Dan, as Greg has correctly reminded us several times, there is not one ‘property market’ in Australia. Some sectors will rise… some will remain flat… and some will fall. Reducing the complexity of this asset class to the generalisations we often read here is simplistic… . :) Location isn’t the only factor, but it’s still the major indicator. Right now I’m sitting in a simply beautiful two-storey home, on seven sculpted-lawn acres, its long deck overlooking a lovely river, with mountains stretching along the horizon. At the water’s edge, there’s a deep-water landing, capable of mooring several large craft. Long tree-lined driveway and beautiful gardens lead up to a double garage/shed all matching the sweet country decor of the house. There’s an impressive golf course within a kilometre. The retired owners, who travel the world continually, have just put this place on the market… for $350K…! It’s _all_ about location, we’re told. We tend to agree. Even the winter weather issue is a location issue.

    To quote Keen when discussing property anywhere, is always an amusing adventure back into the realms of fantasy. Good stuff to read to the kids at bedtime, but most adults are also nodding off as Keen’s GPC theories are rehashed… . Aussie homes haven’t crashed to 40% of their value, nor have rents. These wild imaginings from prophets of doom raise their status in the media (and academia briefly!) but the “I-sold-my-house; so-should-you parable” sounds kinda silly when his location then appreciates 7% despite the 60% loss prediction… . ;)

    Biker Pete, Fredricton, Canada
    August 10, 2009
  7. Nic, that councilor story you speak of was in Wollongong, NSW. It wasn’t a councilor but a woman working in the D.A. section of the council, giving ‘favours’ to developers in return for expensive jewellery etc, but I digress, Wollongong is I think a pretty obvious example of the housing bubble.

    I used to live in Wollongong, so remember what it was like in the early-mid ’90’s. Apart from being much nicer then, there was not anywhere near the extreme development as now. There’s no way anyone with half a brain could see the place and not conclude there’s been a serious bubble in housing. In fact, only a few weeks ago I saw an ad for an entire ‘almost complete’ apartment complex up for sale.

  8. I agree with Dan. I’ve been saying this for a while now – The “average” Australian house ($350k – $450k range, 3 Bed, 2 bath etc) won’t crash, there may be a 5-10% fluctuation, but overall prices will remain, on average, steady. The next 5 – 10 years will see relatively flat prices with only glimpses here and there of growth in prime markets. This way inflation and wage growth will see incomes rising against flat prices making RE more “affordable” over the next few years. I just read an article stating the “average” house price in the UK is now £191,423 ($380k AUD). Just an opinion, but; when you consider the market over there has fallen off a cliff to get to $380k AUD, it shows that our average price isn’t as “high” or “unaffordable” as we all claim it is as prices in the UK have started to stabilise around our average house price. And if I’m not mistaken, the average wage in the UK is no higher than here in Australia, in fact it may well be lower….

    Cyber Cynic
    August 12, 2009
  9. The ‘average UK house’ is far less of a residence, CC. We saw nothing we’d buy at those prices, given just that factor, let alone location. Opposed to that we have seen some delightful homes which represent brilliant value in Canada’s maritime provinces. We agree that the Australian market is plateaued for a while. How long that lasts is anybody’s guess. You can’t rely on past realty performance to predict what might happen this time, but we’ve continued to invest through three past ‘flat’ periods, all followed by very impressive ‘growth’. As the bears have reminded us for a very long time now, “Time will tell!” :)

    Biker Pete, Quebec City
    August 12, 2009
  10. Interesting about the UK situation, Cyber Cynic. A housing crash in Oz is still not out of the question, especially if a new phase of the economic crisis takes hold (a new unwinding of debt, or worse). But at the moment I can’t see how it will happen.

  11. So, given all the noise on the best investments, how to survive the crash – how do we keep our heads above inflation over the next decade on our surplus cash = is it simply products that provide an ‘guaranteed’ income stream above inflation = investment property, franked dividends in utilities, inflation indexed bonds – be satisifed with 2-3% above inflation and not worry about the capital gain and go fishing or do we copy the ‘black swan’ model and put 90% of assets in safe conservative investments where capital is protected and the remaining 10% in assets that can return big returns or nothing, even total capital loss

  12. rag..perhaps another alternative is to look at emerging markets, many of which will slip under the carbon emissions radar? As developed nations tax companies because the planet may be warming, many developed nations will keep pumping Co2 into the air and may enjoy a mini boom.

  13. Dan,

    Below is a link for you re your comments on banks and possibe seminal asset market turn events for Australia.

    Even though Battelino has his paws all over this BIS document it has given BIS sufficient insight that I believe they have in recent days highlighted the existence of the risk of a run on the AUD.

    But let’s start here with the context, that from hot money and its effect on exchange rates over the very long term including the original floating of the dollar, the capital flow risk, the spike and hence cliff we are falling off re terms of trade, the chart showing our bank’s third rise since 2000 in foreign liabilities at the same time as the third drop in domestic deposits.

    So going past Battelino and RBA spin and combining the certainty of a significant retreat in the trade terms (unless the USD collapses) with foreigners owning 27% of all our securities and the hot money, and then we get into the interesting part which is the countervailing startling and massive growth of the ownership by Australian private enterprise’s in foreign assets and equities in the funny money era that recycled/releveraged some of that hot money into expansive colonialising capital like little Goldman’s and hey presto balanced the capital accounts. And what did our funny money factories buy with their hot money? Well look no further than the MAQ and B&B infrastructure portfolios that paid over the odds for crappy secondary assets in far flung corners.

    So like BIS is now saying , Ponzi Australia’s risk is now sovereign and it is a run event that will turn our domestic asset world.

    Elsewhere in Asia bilateral exchange commentary BIS notes that our bilateral trade with China which was about even in 2005 rather than some huge surplus as recently as 2005, and our trade weighted exchange rate positively rather negatively balanced at that time. So import price inflation on a terms of trade collapse is right at our door. We may have got away with it at the Asian crisis but their is no guarantee this time. 27% of our equities with hot money leveraged investors and exchange rate risk is not a risk free cruising Australia.


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