Welcome to the House of Debt

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Hubble on Housing Bubble Trouble

Today I’m going to get deeper in thought about debt but before I do, let’s look at the Australian housing market…

‘End of the Property Dream’ – Business Review Weekly

‘In the ten months to October, seasonally adjusted home prices in Melbourne are down 5.8 per cent, second only to Brisbane’s 7.5 per cent fall in that period, according to RP Data.’ – The Age

‘Glut and doubt blow house prices down – The value of houses and apartments fell for the 10th consecutive month in October … a glut of unsold properties.’ – AFR 1st Dec

‘There’s still more than 300,000 homes for sale around Australia’ – Tim Lawless, RP Data

The housing bubble is striking closer to home for more Australians by the day.

Now that most of my cousins have left home, Auntie Julie and Uncle Ian mentioned they might sell up and downsize. But they’re worried they won’t get the same price they paid in 2004. And there’s been quite a few years of inflation since then.

Of course, the Robinson Rabble, as they are known, didn’t buy their house as an investment. And the house they choose to buy when they do downsize will have fallen in price about as much as their current house did. So they will be no better or worse off in the end.

But if you agree with that notion, you have to agree it applies to rising house prices too. It’s the irony of investing for house price growth. If the price of your house goes up, the price of the next house you buy will probably have gone up just as much. And, in real terms, you’re left no better off than when you started.

But here’s the problem with this kind of thinking: Don’t forget debt.

In fact, that’s probably the phrase that sums up everything you need to know about finance and economics in general. At least, we are becoming increasingly convinced of the idea that debt is what the real worlds of finance and economics boil down to. Houses, banks and governments have been the big economic stories of the decade. All are going through debt crises right now.

Surprise, surprise, then that academic economics doesn’t make a mention of debt. (There are a few exceptions of course.) The logic for overlooking debt goes something like this: Because one person’s debt is another person’s asset, the two cancel each other out. Debt doesn’t matter. Of course, this doesn’t quite square off with fractional reserve banking, but that’s not the point we want to make. The point is – mainstream economics ignores the most important factor driving the real world today – debt.

Surely the academics of finance do a better job? Nope.

Good old Wikipedia reminded us of the sort of delusions taught at University finance classes:

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt. It does not matter what the firm’s dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

Yes. Once again, debt doesn’t matter. If this defies your belief, a more complete explanation will fill in the gaps:

The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.

With a list of assumptions as long as Miller and Modigliani put together, we could prove just about anything. What’s even funnier than the list of assumptions is the following: ‘Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.’

Yes. If you invent an imaginary land where people are omniscient, not taxed, don’t need lawyers – and so on – and then prove something is the case in that imaginary land, it gets you a Nobel Prize in Economics.

And people forget about debt.

The hedge fund Long Term Capital Management illustrated nicely how these theories work in practice. In a keynote speech to the Financial Management Association, a Professor Stulz pointed out ‘LTCM was mostly engaged in transactions that would be close to the Modigliani-Miller arbitrage transactions if markets were perfect.’ After a couple of good years, it lost billions in just a few months (back when billions were a big deal). The firm had to be rescued under the supervision of the American central bank.

The academics-turned-traders at LTCM used leverage to make bets on bonds. They ignored the risks of the debt used to fund their investments and they ignored the risks of the debt they invested in. It ended very badly.

So now you know that mainstream economics and finance are blind to debt. And that this occasionally blows up in the face of mainstream followers. But how does all this apply to the Australian housing bubble?

Well, Aussies have bid up the price of houses to absurd levels using debt. The debt that the mainstream will tell you doesn’t matter. But it does.

We won’t get into just how bad our debt bubble is. Economist Steve Keen does a great job explaining the housing bubble and how it formed here. Instead, let’s try and find an optimistic future beyond the debt bubble. Is there an opportunity coming down the road? What happens after housing prices tumble?

Once an asset bubble truly pops, you can’t reflate it with more money and debt. It’s like trying to inflate a balloon with a hole in it – it just makes a rude noise. You will know it’s time to buy back into an asset class when discussing it is impolite. When people’s retirement has taken such a big hit they can’t talk about it. But buying property at that time won’t be a good idea if you’re buying to make a quick buck on capital growth. Capital gains don’t re-emerge for post-bubble assets for quite some time.

Instead, what you’d be looking for are cash flows in the rubble of asset bubbles. Here’s an example.

Your editor’s new desk buddy, named Woody because of his last name, owns a property in the UK. While the price of his house fell during the financial crisis, his mortgage payments fell more. The yield he gets in rent is now almost three times his mortgage payments!

Sounds like a snazzy investment. In cash flow terms. Of course, Woody took a hit when house prices fell. But he doesn’t plan to sell when the house is earning him so much cash.

Here is the really interesting part: Woody reckons wealthy people have little choice but to park their savings in a house investment. Owning a home is the replacement for a savings account because interest rates are so low.

In other words, post-bubble assets are great places to go hunting for ‘yield’ when central banks suppress interest rates.

The beauty of property investing after a bubble is that it is nicely hedged against inflation too. Property has a real value to it. So even if central bankers do manage to overcome deflation, you are well positioned.

Yes, believe it or not, one day you will read in the Daily Reckoning that it’s time to buy property. In the meantime, we’re sticking with what has been working very nicely for our subscribers – real assets like gold and silver. Dr Alex Cowie reckons he has found six red hot stocks that will turn steadily rising resource prices into far larger gains for investors. You can find out more here.

Until next week,

Nickolai Hubble.
The Daily Reckoning Weekend Edition

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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4 Comments on "Welcome to the House of Debt"

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Jeremy Greer
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A huge problem in society today is that the media and the blogosphere are dominated by the real estate industry vested interests and bubble deniers. They control everything, the news we read and watch, the “truth” that they drip fed to the unthinking masses, to the 99 percent. It was recently revealed that the real estate industry actually pays spruikers and shills to post positive spin on forums and blogs (yes even blogs like this one) to talk up the market, to post as if they’re just one of the 99 percent, a normal person, when in fact they are… Read more »
Wayno
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M&M tells you that if you increase leverage in a non dividend imputation environment, then leverage does affect the value of the firm/household.

i.e. Value(Leveraged) = Value(Unleveraged) + tax Rate * Debt(leverage)

However, it does state that the value of the firm will increase until the cost of bankruptcy costs (due to unsustainable leverage) exceeds the tax shield gained from having leverage.

Therefore, M&M starts off with 5 assumptions (all unrealistic) but you are supposed to relax them and NOT apply it blindly in the real life situation!!!

Nexus789
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Mainstream economics is a sham…..a complete fabrication as it fails to take into account the other factors in a society such as the political and societal dimensions that determine how ‘value’ is created and distributed (extracted/stolen is more apt) and consequently cannot adequately explain how asset bubbles are created and the impact they have. Individuals like Friedman created a dogma based on ‘instrumentalism’ and got a Nobel Prize. In effect he made up his own philosophy to fit the facts and the ‘philosophy’ then underpinned the wave privatisation, IMF and World Bank stealing of the ‘commons’. Mainstream philosophers have had… Read more »
belinda
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Here is how the media promote vested interests.

In here, it’s for the HIA.

http://theage.domain.com.au/real-estate-news/housing-shortage-bites-as-supply-fails-to-keep-up-20111221-1p55v.html

Is there a body who regulates journalism that promotes such or involves itself in conflict of interest claims ?

It should not continue.

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