A Stubborn Mule’s Perspective

Property prices have always been a popular topic of conversation in Sydney, but the subject has become more contentious since the onslaught of the Global Financial Crisis. Views on prospects for Australian property prices range from the bleakly pessimistic to the wildly optimistic. Iconoclastic economist Dr Steve Keen is one of the more prominent pessimists and expects a fall in property prices of as much as 40%. At the other extreme, research firm BIS Shrapnel recently released forecasts that prices in capital cities will rise by almost 20% over the next three years. Of course, both sides have their critics. Macquarie Bank economist Rory Robertson is so convinced that Keen is wrong that he has offered a wager in which the loser will have to walk to the top of Mount Kosciusko wearing a t-shirt saying “I was hopelessly wrong on home prices! Ask me how”. Meanwhile, many dismiss the optimists as mere shills intent on talking up the market in the interests of their clients.

Faced with a debate like this, the only recourse for the Stubborn Mule is to look at the data. Fortunately, I have been able to get my hands on a rich set of data (and ideas) from University of New South Wales economist Dr Nigel Stapledon*. Stapledon has painstakingly assembled data on Australian property prices back to the 1880s and rental data back to the 1960s. This data underpins a detailed comparison of the Australian and US property markets in Stapledon’s forthcoming paper  “Housing and the Global Financial Crisis: US versus Australia” in The Economic and Labour Relations Review, Sydney. By comparison, the House Price Indexes published by Australian Bureau of Statistics (ABS) commence in 1989.

A first glance at Stapledon’s index of Sydney property prices does indeed appear to show a meteoric trajectory that would inflame the passions of the pessimists.

Sydney House Price Index

Of course, asset prices tend to exhibit exponential growth, so it is far better to look at historical prices on a logarithmic scale. This reveals a striking trend. The growth of Sydney property prices has been remarkably consistent at around 9% per annum over the last 50 years.

Sydney Property Prices (log scale)

Prices for Australia overall show a similar trend, with average prices over the six major capital cities growing at an average of 8.6% per annum since 1955.

Australian Property Prices

What these charts do not take into account is the effect of inflation. Indeed, inflation varied significantly over the last 50 years, so adjusting for the effect of inflation shows that the trend in Sydney house prices has not been so stable. Booms such as those from 1987-1989 and 1997-2003 are made very clear in the chart below. But it is also evident that  prices have failed to keep up with inflation over the last few years. Nevertheless, over the last 50 years, Sydney house prices have appreciated an average of 3.1% over inflation and that is before taking rental income into account.

Sydney Prices (inflation adjusted)

One difficulty with long-run property price data is that fact that observations are typically based on median house prices, which does not take into account changes in the quality of houses. The median house in 2009 may be “better” than the median house in 1955 and changes in price may reflect this change in quality as well as price appreciation. Stapledon has attempted to take this into account by constructing an index for Australian house prices (six capital cities) that is adjusted for both inflation and standardised to “constant quality”. The trend in real prices, adjusted for quality over the period 1955-2009 has been an increase of 2.1% per annum over inflation. This compares to an increase of 2.7% per annum over inflation without adjusting for quality. So, at a national level, quality changes overstate the trend growth rate by 0.7%. While Stapledon has not constructed a quality-adjusted index for Sydney, assuming that the national trend applied would lead to the conclusion that Sydney house prices have a trend growth rate of 2.4% over inflation.

Australian Prices (quality and inflation adjusted)

Interesting though this historical exploration may be, the question we would like answered is where prices may head in the future.

One approach to the problem is to assume that growth in property values in real terms may change in the short term, but over the long term will revert to a long term trend. Enthusiasts of trend following may see some significance in the fact that Australian prices still appear to be above the longer run trend, while Sydney prices have already fallen below trend. Of course, depending on the time period used to determine the trend, very different conclusions may be reached. If I were to base the trend on the full history from the 1880s, the last 50 years would appear to be well above trend.

Another popular approach is to consider housing affordability. This approach either looks at ratios of house prices to income or ratios of housing servicing costs (whether interest or rent) to income. The assumption is that these ratios should be stable over time and if increases in house prices result in reduced affordability this indicates the prices can be expected to fall in the future. Stapledon is critical of this approach, arguing that:

while income is expected to be a major influence on prices, there is no theoretical reason for any fixed relationship between prices and income or between rents and income

Over time, people may change their priorities and place a greater or lesser importance on housing and, as a result, be prepared to spend a larger or smaller proportion of their income on housing. Stapledon argues that a better approach is to examine rental yield, which is the ratio of rents to prices. Since the property prices can be expected to keep pace with inflation (and, in fact, outpace inflation), rental yields should be comparable to real yields (i.e. yields over and above inflation) on other asset classes. The easiest real yields to observe are those of inflation-linked Government bonds.  The Reserve Bank of Australia publishes historical data for inflation-linked real yields back to the late 1980s. The chart below compares these Government bond real yields to Stapledon’s history of rental yields. While the correlation is not perfect, both rental yields and real yields show a downward trend from the late 1980s/early 1990s which has only recently begun to reverse. Since rents have not fallen over this period, this provides an explanation for the strong growth in property prices over that period.

Australian Rents and Inflation-Linked Bonds

So what could this approach tell us about property prices? Rental yields have already risen further than bond real yields, but certainly could go higher. What this means for prices does also depend on where rents themselves may be headed. The chart below shows the contribution of rents to consumer price inflation as published by the ABS. While the rate of growth in rents has slowed, history would suggest that rents are unlikely to go backwards. A cautious, but not overly pessimistic forecast could see rental increases falling to an annualised rate of 1% while rental yields could climb back to 4%. The combined effect would be a fall of 12%. Since prices have already fallen by 7% over the year to the end of March 2009, this would amount to a fall of almost 20%.

Rent Inflation (Quarterly)

This is certainly a significant drop, but still half the fall that Keen expects to see.  For prices to fall by 40%, even assuming rents remain unchanged rather than growing by 1%, it would be necessary for real yields to rise to 5.8%, which exceeds the record level since 1960 of 5.4%. On this basis, I find it hard to be as pessimistic as Keen. Indeed, the latest data from RP Data-Rismark International suggests that prices are once again on the rise. The next ABS release is a little over a month away, so it will be interesting to see whether they see the same recovery.

The relationship between rental yields and real yields is an interesting one, but ultimately does not provide definitive predictions, but rather an indication of a range of outcomes that would be precedented historically. Of course, as Nassim Taleb has emphasised, unprecedented “black swans” can occur so history does not allow us to rule out more extreme events. Furthermore, nothing here addresses the question why prices in the US have fallen so dramatically and yet Australian prices could suffer far milder falls. That is the primary focus of Stapledon’s paper and is a topic I may return to in a future post, but this one is long enough already!

UPDATE: In this post I noted that the historical data shows a marked shift in behaviour from the mid-1950s without providing any explanation as to the cause of this shift. Needless to say this is a subject Stapledon has given some serious consideration, and I will quote from his doctorate, “Long term housing prices in Australia and some economic perspectives”:

From a longer term view, a key observation is the clear shift in direction in house prices and rents from circa the mid 1950s. House prices, in particular, jumped significantly, best illustrated by the rise in the price to income ratio from about one: one to about 4:1 in the 2000s. Looking at demand and supply variables…indicates that this shift in direction cannot be adequately explained in terms of the demand variables of income and household growth. Supply side factors appear to be more crucial and there is a substantial literature emerging in the US emphasising the importance of supply side variables and specifically the propensity to regulate to constrain supply. The evidence presented in this thesis of the lift in the cost of fringe land in the major urban areas provides prima facie evidence that supply factors have been a significant factor explaining the upward trajectory in house prices in Australia since the mid 1950s.

* I would like to thank Dr Stapledon for generously making his data available to me.

The phrase de jour (or du mois in fact) in financial markets is “green shoots”. Optimists, world equity markets included, are seeing tentative signs of improvement in the world economy. Google trends saw a blip in searches for the phrase green shoots back in January when UK Government minister Baroness Vadera used the phrase and was lampooned for what was perceived as premature optimism. Moving forward a few months and searches have surged again, but this time consensus seems to be far more supportive of a positive outlook.

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To date, in their efforts to make the Global Financial Crisis (GFC) even more disastrous than it already is, the US Government has pumped an extraordinary $170 billion into the American International Group (AIG), the humbled and humiliated insurance giant. AIG’s biggest problems arose from entering into enormous credit default swap (CDS) transactions. The reason this creates systemic risk is that CDS are bilateral transactions between two counterparties and so if AIG is in trouble, so are the counterparties on the other side of the transaction. CDS are a little like insurance contracts (albeit with far less regulation), which is perhaps why AIG was attracted to the business, and with AIG selling protection, the buyers of protection are nervous.

Given the amount of money that the US Government has provided to AIG, it is reasonable for US taxpayers to expect some transparency from the recipient of their hard earned dollars. Today AIG has begun taking steps in that direction with the release of a number of documents under the heading “AIG Moving Forward”. Among these documents was a list of collateral postings made to AIG’s CDS counterparties. While this does not give the full picture of the vast CDS transactions volumes AIG built up over recent years, it gives an interesting glimpse of some of the larger participants in this dangerous game. The collateral postings are similar to margin payments made on margin loans when share prices fall: as AIG loses money on its CDS, it makes collateral payments to the counterparty to mitigate the risk that AIG may not be able to pay up in the future.

The counterparty list includes many of the usual suspects: Deutsche Bank, Goldman Sachs, UBS, etc. There are, however, a few interesting names. The one that struck me was DZ Bank,. Never having heard of DZ Bank, I had to look them up. It turns out, that Deutsche Zentral-Genossenschaftsbank is the fifth-largest bank in Germany and operates as a central bank for small German co-operative banks.  It is not a listed company as it is collectively owned by the 1,000 or so cooperative banks it serves. It seems that providing services to these banks was not enough for DZ and so they branched out into the exotic world of CDS. Based on AIG’s disclosure, DZ have received a total of $1.7 billion in collateral (split between direct payments from AIG up to December 2008, and payments from the Maiden Lane III vehicle established as part of the Government bail-out) and so they ventured into CDS in scale. I can’t help thinking that in doing so, they didn’t know much more about what they were taking on than Waverly Council. It also helps to explain how they managed to lose €1 billion in 2008.

One last point on the subject of AIG. Despite managing to destroy such large amounts of value, it seems that they still want to pay bonuses of $165 million to senior executives. Timothy Geithner, Obama’s new Treasury Secretary, described this as  “unacceptable”. I think he was politely trying to say “wake up and see what’s going on around you!”.

There is no doubt that the big four Australian banks have navigated the global financial crisis better than many banks around the world, particularly in the US and UK. However, there seems to be a pervasive tendency in Australia to overstate the success of the Australian banks.

A couple of weeks ago, Michael Duffy wrote in the Sydney Morning Herald that

There are only 15 banks in the world which now have a AAA credit rating. The four major Australian banks are among them.

It would be nice if it was true. However, no Australian bank has a AAA rating, they are all in the AA band.  There are a few Government-owned or guaranteed banks around the world with a AAA and the only privately-owned bank with a AAA rating these days is the Dutch Rabobank.

More recently, Kerry O’Brien was interviewing the astute Morgan Stanley analyst Gerard Minack when he made the comment

Given that the big four banks in Australia are now in the top 12 around the world, what risk still applies to Australian banks as this scenario that you’ve described unfolds?

Gerard blinked for a moment before moving on, so I suspect he knew that Kerry did not have his facts straight here. By my reckoning (with a bit of assistance from Bloomberg),now that Westpac has taken over St George, it just scrapes in at number 12. ANZ, however, is all the way down at number 33 and the other two are somewhere in between. If I have missed any of the major world banks in my calculations, that would only push Australian banks further down.

The chart below shows data I have uploaded to Swivel giving the market capitalization for 40 of the biggest banks in the world in billions of US dollars. Figures are in thousands of millions (i.e. billions) of US dollars. While management of the big four Australian banks should be pleased with how they are faring, there is no need to blow their trumpets to the point of ignoring the facts.

One final point: it is interesting to note that the three biggest banks in the world today are Chinese banks.

For those who read my earlier Amazing Shrinking Banks post, you may notice that I have added a few more banks, including the large Chinese banks.

Last year, I wrote quite a few posts on the subject of the credit crunch, aka the GFC (”Global Financial Crisis”) or GD2 (”Great Depression 2″). Whatever you want to call it, it has been unfolding for almost two years, and does not show any signs of letting up yet. The hardest hit to date have been banks. Many, including Northern Rock, Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual and every Icelandic bank have fallen along the way, via bankruptcy, merger or Government bailout. Others limp along with the odd adrenaline shot from Government to shake a little more life back into the patient.

Just one of these terminal patients is the Royal Bank of Scotland, whose market capitalization has fallen by 90% over the last two years, despite large injections of capital by the UK Government. The bank’s chief executive, Sir Fred Goodwin, has just resigned and was described by the Telegraph as “the most reviled man in Britain”. The once gargantuan Citigroup has shrunk even more and is now 92% smaller than it was in January 2007. In contrast, whether by good luck or good management, Australian banks have held up  well. Nab has been the worst affected, thanks in part to some pesky CDO write-downs, shrinking by 55%. Westpac has weathered the storm better than any major bank in the world, with a fall of only 17% in its market capitalisation. (Quick note to shareholders: your investment will have fallen by more than this since market capitalization equals share price times number of shares and like all banks, Westpac have raised additional capital during the course of the crisis and of course they have also bought St George).

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Yesterday’s quarterly inflation release, which showed prices falling by 0.3% over the December quarter across Australia, cemented expectations of a 1% cut in interest rates in February. How things have changed! My very first Stubborn Mule post back in May 2008 examined the inflationary pressures that had so concerned the Reserve Bank and led them to keep interest rates high well into the financial crisis. In that post I used a heatmap to dig down into the drivers of inflation, and a quick comparison of the latest December inflation rate with inflation six months earlier gives a very clear illustration of where prices are falling.

Austalian Quarterly Inflation – Dec 2008
(click to enlarge)

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One of the more peculiar stories of late in these times of turbulent financial markets is how, briefly, Volkswagen became the biggest company in the world. In the process, hedge funds around the world suffered losses estimated at over US$35 billion.

Over the last few years, Porsche has been building a stake in Volkswagen. By November 2007, the size of their stake had reached 31%, much of which was achieved by means of share options* rather than direct share purchases. Significant increases in the Volkwagen share price meant that these options delivered large profits for Porsche, prompting criticism that the company was acting more like a hedge fund than a car manufacturer.

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Over the last few months I have written a lot about the global financial crisis. My posts have focused on specific events as news has broken, ranging from a programming bug by Moody’s to the enormous US bailout plan and Government guarantees from Ireland to Australia. Here I will instead take a broader perspective and provide an overview of how the crisis has unfolded and, more specifically, how Australia came to be caught up in the mess.

A year ago, many commentators were extolling the idea that Australia’s economy had “de-coupled” from the United States and Europe, and would continue to be powered by the rapid growth of China and other developing nations. Concerns about inflation meant that interest rates were rising and many felt Australia would escape the incipient economic slowdown in the developing world. Events have instead unfolded differently. The Federal Government has taken the extraordinary step of guaranteeing deposits held in all Australian banks, building societies and credit unions and the Reserve Bank of Australia has delivered an unexpected 1% cut in interest rates, citing heightened instability in financial markets and deteriorating prospects for global growth. This was an extraordinary turnaround. It is, of course, the result of Australia becoming ensnared in the global financial crisis that began in mid-2007 and has intensified ever since. But how and why did Australia get caught up in a mess that started with falling property prices in the US?

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In a post earlier this week, I wrote

The Government was right to step in with the guarantee and it has doubtless provided some stability for a financial system that remains jittery, but the sooner the details are sorted out, the better.

The main outstanding question I was referring to was how the guarantee would apply to wholesale debt. Uncertainty on this point has been creating significant concern for investors in cash management trust and other managed funds. The amount of money moved from these funds to bank deposits may be over $1 billion.

Finally today, the Government announced the wholesale guarantee fee, which will also apply to retail deposits over $1 million. While there had been speculation that the fee would vary based on the time to maturity of each security, the Government has instead opted for a fixed fee. The fee varies with the credit rating of the bank taking up the guarantee.

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Following the shenanigans in parliament earlier this week, the Government has modified their original 12 October media release about the Government guarantee for banks. In the process they no longer list the local and foreign banks covered by the guarantee, so with the help of Google’s cache* I am republishing the original list here. The Government has also (finally) announced the terms of the wholesale guarantee, so stay tuned for another post on that subject. Update: here is that post.

Today the Government announced the fees payable for a guarantee on wholesale debt, which will also apply to retail deposits over $1 million. At the same time they announced that foreign bank branches will be able to access the deposit guarantee but only if they pay the fee, regardless of the size of the balance. The lowest possible fee is 0.70% (it varies with each bank’s credit rating) and the bank is sure to pass that on!

Note that foreign banks not in the list below are now also able to access the wholesale guarantee (for short-term debt only) and the deposit guarantee, but the wholesale guarantee fee will apply even on balances below $1 million.

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