Two More Reasons to Sell Treasury Bonds

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Two more reasons to sell US Treasury bonds: Fannie Mae and Freddie Mac.

These two giant mortgage lenders are poster children for the dangers of wrapping government guarantees around the credit markets. With help from the state-sponsored banking system, these two government-sponsored entities (GSEs) perverted the process of credit intermediation and artificially suppressed the cost of mortgage loans over many decades.

This perversion of mortgage finance explains why house prices grew faster than household incomes for roughly a decade ending in 2006. With the broad recognition that the GSEs were insolvent in late 2008, the artificial suppression of mortgage rates was about to come to an end. That is, until the Treasury and Federal Reserve doubled down on their commitments to throw good money after bad. Now, permanent manipulation of mortgage interest rates has become official government policy. The cost of this policy will be even higher federal deficits in the future.

Government guarantees temporarily hide risks, which results in foolish capital allocation throughout the economy. This game can last until the activity collapses under its own weight (like housing in 2007), or until the government itself runs out of financing options at affordable interest rates.

Just like Medicare policies influence the practices of health insurance companies, Fannie and Freddie mortgage-backed security (MBS) guaranty policies influenced the underwriting behavior at mortgage brokers. Therefore, no one should be surprised that mortgage brokers fudged numbers to shoehorn borrowers into “conforming” mortgages. These brokers generated huge profits by unloading massive amounts of underpriced credit risk into the Fannie and Freddie MBS pipeline.

Mortgage expert Mark Hanson described the triumph of automated mortgage underwriting over prudence in a December 2009 issue of the Mortgage Pages:

During the bubble years, the GSEs looked at [debt-to-income ratios] secondarily to credit score, [loan-to-value ratios], and cash reserves as measured by liquid cash and 70% of retirement [assets]… During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.

Many lenders, especially the big banks, had…underwriting “trainers” that would go around to the various mortgage branches and teach underwriters how to “trip” the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of…a borrower with a 100% [debt-to-income ratio] – with limited documentation required on the automated findings – was not uncommon.

The poorer-than-expected quality of the mortgages inside of the MBS that Fannie and Freddie guarantee will lead to hundreds of billions in credit losses. The frequency and severity of these credit losses over the next few years will take Wall Street by surprise.

These credit losses will blow huge holes into the GSEs’ balance sheets, overwhelming their thin slices of capital several times over. When this capital vanishes, the US Treasury Department will float more government debt and use the proceeds to refill the capital shortfalls.

On Christmas Eve, the Treasury delivered a lump of coal to US taxpayers: It eliminated caps on future equity injections into Fannie Mae and Freddie Mac. Let’s not kid ourselves. These capital injections are not “investments.” No rational investor would be injecting equity into the GSEs right now. Rather than demand a reasonable risk-adjusted return, these injections will just keep the GSEs’ loss-plagued balance sheets solvent.

Consider the situation by visualizing Fannie’s and Freddie’s balance sheets. Since the beginning of the financial crisis, the Treasury and Federal Reserve have teamed up to reinflate the assets and equity of these institutions. The Treasury pumped new equity (in the form of preferred stock) into them as needed, while the Fed used newly printed money to buy up the GSEs’ debt and the mortgage-backed securities that the GSEs guarantee. Thanks to these shenanigans, the market prices of the assets on the GSE balance sheets appear to be holding up. But make no mistake; despite the Fed’s actions, the real underlying value of these is being eaten away by credit losses.

On Jan. 12, Amherst Securities published a study on the estimated losses Fannie and Freddie will absorb as foreclosures flow through the credit loss pipeline in the coming years. Using a database of 29 million active prime mortgages from First American CoreLogic, Amherst estimates that the GSEs will ultimately suffer $448 billion in cumulative credit losses. Amherst explains the likely distribution of these losses:

These gross losses will be distributed across four categories – write- downs already taken by Fannie and Freddie and reflected in their loan loss provisions, future credit losses to be taken by Fannie and Freddie, losses absorbed by mortgage insurers, and losses absorbed by originators through put backs. Fannie’s loan loss reserves total $66 billion: $57 billion for MBS guaranty losses, $9 billion for loan losses. Freddie’s loan loss reserves total $30 billion: $29 billion for MBS guaranty losses, $1 billion for loan losses. The remaining $352 billion of losses will show up across the other three categories (Fannie and Freddie future losses, mortgage insurers, and originator put backs) over time.

If Amherst is accurate in its projections – which I expect, given the quality and independence of its research – then Fannie and Freddie have built allowances to cover a mere 21% ($96 billion divided by $448 billion) of the losses they’ll ultimately have to absorb from the housing bubble.

It’s no wonder the Treasury Department lifted the bailout caps on Christmas Eve; it’ll be the only entity willing to plug the GSEs’ deepening capital holes.

What does this mean for the markets? It translates into very bad news for complacent stock market bulls and junk bond junkies.

The lifting of the GSE bailout limits strengthens the case for rising Treasury yields in 2010. Rising Treasury yields are bearish for the stock market because higher yields offer better competition for investors’ dollars. Rising Treasury rates also increase the cost of capital for all companies.

The elimination of limits on Treasury’s capital infusion into Fannie and Freddie is a de facto nationalization. We’ll see a gradual transformation of these hollow zombies into new branches of government. They’ll implement the official agenda for housing, with little regard for prudent lending standards. This could severely degrade the creditworthiness of US Treasury securities.

The government will probably stick to its dishonest, Enron-style accounting; it won’t officially consolidate Fannie and Freddie assets and liabilities onto the federal balance sheet, but many foreign creditors will. These creditors will demand higher rates to compensate for the rising risks of investing in US Treasuries…and that means bond prices will fall…eventually.

Dan Amoss
for The Daily Reckoning Australia

Dan Amoss
Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.
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Comments

  1. This perversion of mortgage finance explains why house prices grew faster than household incomes for roughly a decade ending in 2006.

    I have to take exception to this statement. This does not account for the same feat being achieved in Euro land, Pound Land, and Australian dollar land.

    Perhaps what was more acreditted is the lie that is CPI. With wage inflation slightly above CPI it gives the impression the populous is becoming ever wealthier. CPI does not include housing costs and housing values. The single biggest purchase any individual makes in their life as a proportion of earnings is their first home. In the U.K 2000 – 2003 the average price of a home doubled. Yet CPI was (according to the government and Bank of England) between 2 & 3%. And this senario was replicated around the World because governments do not like the pain of dealing with inflation. So, better to hide it.

    Had the average price of a house contributed to the calculation of WorldWide inflation, causing rates to increase to moderate increases, then this situation could never have occurred.

    If inflation is ‘an expansion in the money supply’, then having such an asset base balloon 100% inside 3 years, must equally be expanding the money supply in order to support the transactions.

    The crash/recession we have had has been 100% politician managed from poor/insufficient regulation to fixing the markets for political appearances sake. None of this has changed and so will replicate in the near future. That is not a prediction, but a guarantee.

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  2. Agreed, except shorting Treasuries.

    Just read an article at ZeroHedge describing the ridiculous Eurodollar short position. And anyway, rising yields on Treasuries is not necessarily bearish for stocks, plus the recent uptrend in yields is already starting to flatten.

    I think it depends more on yield spreads across differently rated securities than the gov bond rate.

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  3. But sugar’s certainly doing well!

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  4. “If inflation is ‘an expansion in the money supply’, then having such an asset base balloon 100% inside 3 years, must equally be expanding the money supply in order to support the transactions.”

    Yes.

    In 2005, my Yorkshire mate pointed out to me that English housing prices were silly, that his fellow Brits were using their equity as an ATM; and that his neighbours were acquiring luxury cars and holiday homes, fully encouraged by the banks. We continually saw TV advertising encouraging second mortgages. Nick laughingly noted that his own home, on a few acres was now ‘worth’ over a million quid. He predicted it would all end in tears… and, as we know, it did.

    On our most recent UK trip, in 2009, we looked at realty closely, thinking it might be possible to pick up a nice home cheaply. We found no bargains. Nor did we see the modern home features most Aussies now take for granted. It’s our perception that the properties we saw for sale were all overpriced… .

    No doubt potential buyers in some large Australian cities have the same perception about desirable homes in good locations. While there are people prepared to buy for location, it’s likely that even these expensive properties will sell. We didn’t see anything selling in Britain and friends confirmed that the market was very, very slow. Australian property appears to be picking up, in terms of reduced days-on-the-market… and prices… .

    Nonetheless, I like the concept of a guarantee, particularly as most I’ve seen specify an exact date. How long is the near future, Joe?

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  5. Apparently the time frame between boom and bust is shortening.
    I can’t recall where I read this (recently in the last day or so).
    Apparently the last Bull run was only 6 and a bit years and those prior (in the normal cycle of these things) were ever larger the further back you looked.
    Seems the market makers are having a shortening affect on the Bull runs.
    So by near future, I would say within 5 years from the last crash. So 2007 takes us up to 2012 (ish!).
    I certainly do not believe that all the debt sloshing around the World has been accounted for. The new money printed to re-inflate the banks asset to liability ratios have only shored up the assets with piles of new money, which will (as it always does) make its’ way into the general economy.
    Inflation beyond what we have known for over a decade is unavoidable, as it is the saviour of bad political management. Your debts are deflated compared to your earnings, and then, whoopee, everyone can afford another turn on the roundabout. That is the only conclusion you can make of the current interventionism sweeping the Global World of commerce.

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  6. So Joe, You are saying that new money that has been printed will find its way into the general economy. I agree. It will inflate property and shares alike.
    In my opinion the money that has been printed wordwide has yet to inflate asset prices (I haven’t seen any evidence of it yet). So what do we do as investors knowing that the money supply base has been increased dramtically? I believe now is the time to buy assets before this flood of money hits the general economy and inflation goes through the roof.
    Perth property to me is the best value given it has dropped over recent years, did not rise in 2009 (like Melb & Syd) and as a state has huge prospects going forward for resource projects which will lead to a new flood of 457 visas and not enough houses to house everyone.
    We better try to profit because under a high inflation environment it is the elderly that are the real losers. Best to ensure that our parents hang onto their house instead of selling up and moving into a nursing home because once selling, their wealth (which took a lifetime to build) will quickly be eroded by inflation. This is the sad side of inflation unless you can hedge yourself with assets.

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  7. ..and how does all this printed money flow into the economy By giving it away? Excess reserves in banks are just that excess reserves. Money flows only if people are willing to take out loans.

    I am also amused at how property investment somehow skews what one aspires for ones own country. Its so easy to find a property investor but none to partner in a business (oh more risk ! less returns ! What is the risk of everyone thinking like this?) .

    I cant see why all this gas that is siphoned off to Japan and China cant be used productively within our country like replace all that coal fired power stations to gas fired?

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  8. Some great points raised above, in my view. Brian, we agree that Perth may be a very good buy, right now. We expect WA to take off in the next few years. We think key regional areas, close to the sea, may also fly.

    Inflation has its positives, but I’ll grant you the point about the effects on the elderly.

    Nirvan, my sons would agree that support for business is lacking. Both contract their expertise, but are considering start-ups. As you say, the risks are much higher, but the returns can outpace those in other investment areas. Surprised you find this amusing.

    Not sure (how) property investment ‘skews’ one’s aspirations. Brian’s points reinforce how essential it is to invest wisely, so that one can survive the downside of inflation in one’s retirement. Maybe there’s an opening for a good book: “100 Ways to Beat Inflation”… !

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  9. The liquidity in reserves was surely made to enter the economy at an appropriate time, in my opinion once new consumption taxes are in place. We cant have all that velocity now without maximum returns to governments and all their friends. Alas we’ll just bust again down the track (if killer inflation doent nip the boom in the bud first). I suppose if productivity were to be held up through nationalisations then things will limp on for longer. Maybe imploding sounds like more fun.

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  10. Pretty limitted knowledge here, but from the bit I’ve read it’s not until the money finds its way into wages and salaries that inflation really takes off? That was a big part of the stagflation deal in Oz in the 70’s and 80’s apparently – A government that wanted to keep the public service happy in the face of rising prices and upped their salaries. Although something has to trigger the rising prices – Oil would seem to be as reasonable a bet as any in that regard – As mentioned elsewhere by CA if I recall correctly? Although our busted arsed little state governments putting up their charges on everything presumably doesn’t help.

    Two other general thoughts:

    * Avoid saying stuff like must and will and has too I suspect – A lot of this stuff is more in the realm of hypothesis than theory even perhaps – As in economists think it might be how it works until the hypothesis gets tested.

    * If everyone protects themself against inflation, then governments using inflation to fix the problem mightn’t be very likely to work. So the central banks may well have a vested interest in talking down inflation concerns.

    But as I said, I’m a numpty – So really can’t argue if anyone says Ned you’re a numpty! But an explanation as to why you disagree could be helpful? :)

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  11. House prices are funny ones – My thoughts on same are about as loved as the proverbial dead swine at the bar mitzvah – So try this one on for size:

    If I was a deceptive little Oz pollie, I’d possibly let the thought creep into my mind that I’ve got lots of old people coming up to retirement who’ve invested in them. And lots of young people floating around who haven’t. And if the old buggers can keep collecting rent it will keep them off the pension. And if the young buggers keep paying rent it’s cheaper for them than buying – So they’ll have more disposable income to spend on ipods and lattes and stuff that keeps the economy poking along – ‘Cause I know that by and large those mean old buggers are gunna spend squat.

    Just a thought?

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  12. Money doesn’t look after old people. People do. Just a thought ;)

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  13. And nice thought too Dan – If you happen to be a member of a multigenerational family orientated society. But the great majority of Aussies aren’t?

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  14. Pete what I mean is Australia as a country should have a good mix all kinds of investments in different sectors or in niche areas for competitive advantage. Some people wouldn’t mind the FIRE sector grow to the detriment of other industries.

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  15. G’day Steve! I appreciate your scores as always – Ta.

    PS: If ya want to send me that $100k of yours in exchange for a promise to bequeath you 5% of one of my properties when I croak I’ll run it past my accountant. Doubt he’ll be keen though? As prices are going up a lot and I don’t expect to croak all that soon? :)

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  16. and Pete your sons are standouts!

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  17. Good on ya Nirvan for giving a bit of credit where it’s due – Way too many whingers on this site who reckon the only way life will be fair is if everyone else gets cut down to their level. That’s my impression anyway! And Yes, I’m also real glad sugar is going up Justin! And wouldn’t even lose any sleep if your GBP improved Pill Boy! :)

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  18. I got lucky, Nirvan… married into a deeper gene pool. Confess I used to worry (too much) about my sons; but in their mid-twenties they’ve achieved what I was still chasing at 40. (Ned, my ‘level’ at present is about 1.6 m… down… .)

    Dan… “Money doesn’t look after old people. People do…” I’m probably closer to that downsized state than most here. Still optimistic about that future, but I’ve recently seen a lot of examples of a.) money looking after the elderly; b.) people looking after the elderly; c.) no-one at all looking after the elderly. Not sure the government is really doing its job here (even tho’ my mother gets all the war service benefits and copes well.)

    But having seen a _non-means tested_ system operating across Canada, in which my in-laws get multiple pensions added to their investment income, I’m pretty awed by that. Not bitching about the fact that no-one in my family is likely to ever get a cent in pension money… we don’t need it… but that aspect of Canadian policy certainly creates a lifelong incentive to achieve! (Not really a downside that they’re still paying taxes in their mid-eighties, either.)

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  19. Don’t confuse “lucky” with “experienced” perhaps I think? And I’m not that sure that people with “experience” should be thought of as “lucky” – If ya get my drift? :)

    Damn difficult for me to accept any thought that Kev and Co or their replacements and those they represent might be overly predisposed to looking after me after 30 years of having been told quite specifically that isn’t how it’ll work! :)

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  20. Thanks for the offer Ned, but no thanks

    Did you read the good news today Ned and Pete???

    “Westpac requires higher deposit for first-home loans”

    I am sure the other banks will follow soon hahaha, this is just the start with rising interest rates this is just what the doctor ordered :D

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  21. And having hung around DRA and seeing just how much all and any PIs are despised. What can a bloke say? It’s bin a fascinating learning experience. A bit like being a curry muncher in Melbourne perhaps?

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  22. And Steve says “I am SURE” … You keep making the same mistake again and again and again hey mate? After you’ve been informed of the fundamental risks in thinking that way for a year or more. Suit yourself …

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  23. Ned it I knew what was going to happen as soon as our prime minister introduced that stupid policy.

    Fundamental risks?
    Wouldn’t lending 500k to a low income earner be a FUNDAMENTAL RISK??? HAHAHAHAHA

    Its good to see westpac is starting to get nervous about their stupid lending standards

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  24. So our banks are really stupid and you are really clever mate? Based on the US precedent that their banks were really stupid and their borrowers were even stupider … I understand the attractions of drawing that parrallel. But I wrote to Bargeass about it before. Based on 367K new loan and $85k pa Oz average household income after tax. Those numbers don’t stack up for a debt driven crash anytime soon. IMO. But think differently by all means if you wish?

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  25. Id actually argue that their banks were stupid and ours are even more stupider…
    the fact that our banks lend alot more than theirs ever did might have something to do with it!!!
    Now they are starting to realise this by requiring a higher deposit that will cut back demand, just as rising interest rates will cut back demand

    But think differently by all means if you wish?
    Don’t worry I sure do

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  26. Yes, good luck, Steve. Westpac pays my eldest 6.8% while ANZ _charges_ me 6%, tax-deductible. You must be right… beginning of the end. Think how well-placed you’ll be to get out of that bedroom you’ve been cooped-up-in for the last 24 years… ! You can put up 30% deposit, kiss the olds farewell, you’ll be flying… . So why the ongoing bitterness… and SHOUTING(?) You’ve got it made, Steve. Smile! :)

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  27. Ni nites to all from me – With an especially big smooch ta me Brit mate Pill Boy! And his really cultcharred Dutch daddy if he needs it? :) Blogging is SUCH hard work … I reckon I should be paid for it in my next reincarnation? :)

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  28. Yes Pete I know how much you want to ram it down me just how much better your son is than me and how much more money he has got than me by mentioning him in every second post, I bet he is a Liberal voter? Just like his old man?
    Ohh I am so bitter!!!

    But no that would be wrong of me to think that because I don’t make assumptions like you do.

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  29. Steve: “Ohh I am so bitter!!!”

    You needn’t be, Steve. You have loving parents (I’d have kicked you out at 20! :) ) ; a good job; a fair whack of cash in the bank; you live in the best country in the world… and apart from a ‘first-or-last -child chip’ you have everything going your way.

    You don’t make assumptions, but you know my politics? Mate, _I_ don’t know my politics! :)

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  30. HAHA come on Pete admit it your a Liberal :D

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  31. I sign every political post to any news story of interest “Swinging Voter”, Steve. Swinging Voters are the people who change governments. I’m not tied to any party. Your union ties are your business.

    As you mature, you’ll find that analysing the issues… and each party’s position… is worthwhile. If you vote Labor, I’m sure it’s because you perceive Labor is giving your needs and views the very highest priority. My wife and I have often voted for parties which don’t represent our needs, but those of the country. That’s _starting_ to change, as we age. We are starting to assert our needs before yours. We are starting to tire of _some_ of your generation expecting a free ride. We’re also realising that, as a voting force, we’re part of a cohort which may be able to drive changes which meet our needs for a couple of decades… as swinging voters… .

    I don’t expect any praise for this position… . Our loyalties are becoming more attuned to our own needs! :)

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  32. “We are starting to tire of _some_ of your generation expecting a free ride.”

    Ummm yeahhhh, your the one making the money on all your investment properties and doing nothing for it but wait, and someone else is paying twice as much as you payed for it in real terms and they are the ones who have to go out and work for it not you

    And you are saying they are the ones who want a free ride????

    Pffft get real mate

    Your the one who is getting the FREE RIDE not us.

    I will make the exact same quote you said in regards to your generation
    “We are starting to tire of _some_ of your generation expecting a free ride.”

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  33. You mean I’m digging soakwells while you’re waiting for the Great Property Crash, Steve?

    Workers and waiters. You’re (note that spelling, son) a waiter.

    Time’s on your side, Steve. Just don’t expect it all to be handed to you on a plate any time soon, son. ;)

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  34. When you say

    “We are starting to tire of _some_ of your generation expecting a free ride.”

    What do you mean by that???

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  35. Some? I mean there are a lot of your generation who get off their butts and get out there to take advantage of the opportunities Australia extends to anyone who wants to get ahead. Most young people _don’t_ continually bitch about the bad hand dealt them; the Bad Baby Boomer generation who got all the good stuff cheap; and the government being to blame for their own poor decisions.

    Now Steve, I really hate to think of you over there, well past midnight EST, sitting in your room, waiting for a comeback. I’ll be up at first light when it’s cooler, digging trenches and holes to finish our current project. Doubt it will sell for “…twice as much as you payed (sic) for it in real terms…”. Ten percent clear will suit us fine. If not, there’ll be a queue to rent it. That’s the nice thing about property. Options… . :)

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  36. Hmm I don’t think you really meant that, I think your just trying to spin it because you can’t come up with an answer to your own statement that you made now that I asked you what you meant by it.
    I work shift work thats why I am up late.

    I think its a bit rich of you to get on here and say “We are starting to tire of _some_ of your generation expecting a free ride.”
    When as I said YOU are the ones who got the free ride not US

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  37. Steve: “I work shift work thats why I am up late.”

    Good to see we’re getting value for our dollar, Steve. Sounds like a free ride to me… .
    Line manager know about it?

    Doubt you’ll get the free ride you expect from Aussie families losing their homes, so you can leave the nest, mate. As Ned says, I wouldn’t bank on it… . Off to dig, then to see the tax man, to recoup our expenditures.

    Good luck with your investments, Steve. (What _are_ your investments?!)

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  38. My investment is to wait now for the property market to correct,
    Just as there are “investors” investing in property now, expecting it to go up, my investment is to wait

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  39. Steve, mate i’m in the same boat…unfortunately as the saying goes, markets can remain irrational longer than you can remain solvent.

    Still, 8%pa term desposit rates must seem like mana from heaven for those outside australia. e.g japan/uk/usa…Something i think aussies, in our collective obsession with rising property prices, have forgotten.

    Think about it, “waiting” is a whole lot more feasible when your money can still grow at a decent speed in the safety of a bank deposit. In other countries, if house prices don’t have to rise by very much before you’r “holding back” strategy falls apart.

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  40. The statistical guestimations go along the lines that while there are 5 workers supporting every busted arsed broken down old bugger now, by 2050 there will only be 2.7 – And that includes all the highly motivated and skilled new migrants we’ll get.

    So the big picture, long term stuff that I see for Oz is more competition.

    Thus, for a home grown Oz Gen Y with no particular desire or skills to compete, the suggestion that “now” just could be as good as it’s gunna get in their working lifetime probably shouldn’t be scoffed at?

    Which doesn’t shake me up too much in hindsight when I consider the fact that I found it was easier to get ahead when I was 25 than now that I’m 50 odd. Suspect that’s just life in an increasingly competitive world?

    Hmmm … Wake me up after WWIII and the next great flu epidemic perhaps? :)

    PS: I’ve also been working on another hypothesis in me idle moments – I don’t think it’s a good idea to encourage the average Aussie to breed – We can get way higher quality full grown foreign imports that whinge way less way cheaper? :) :) :)

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  41. @Ned,

    If that is the case why are we still brining in English migrants.

    Once upon a time we’d bring in working class Pom’s, give them a shovel and say go for it.

    Now we bring in middle class Poms who want to give us the shovel while they work on making sure their horrible brats keep wearing EPL shirts and working on fake pommy accents.

    The latest arrivals are without doubt the least hardworking of any migrants since the first Australia Day.

    Fiscal Phil
    January 25, 2010
    Reply

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