Tag Archives: australia

RSPT – A Fair Valuation Based on True Value of New and Existing Mines

Following on from the interest generated by his last post, Mule Stable regular Zebra (James Glover) returns to the subject of the Resources Super Profits Tax in another guest post.

In a previous post I explained how the formula for the RSPT (Resource Super Profits Tax) was derived by considering the Government to be a 40% silent investor in any mining project. I showed that the correct deduction from the return on investments is indeed GBR (Government Bond Rate), as proposed, not a higher rate that includes a “price of risk”. One important thing I missed in this analysis, however, was whether the investment amount (I) was the correct basis for valuing the Government’s new 40% “investment”. I aim to show that the correct variable should actually be the Market Value of Assets (MVA) and as such the appropriate deduction from profits is several times (maybe as much as 4 times) higher for established mines.In the example given based on the mining industry “price to earnings ratio” of 14 the RSPT would only be 9% of earnings. I should emphasise this is not about having separate formulas for new and existing mines but correctly taking into account the fair, market based, price the Govt should pay for it’s 40% share of the earnings.

For new mines MVA = I (where all “=” signs should be taken to mean “approximately equal” to head off the pedants) so the proposed tax is correct in this case.

The Government says that in return for this tax take they are taking downside risk as well as upside benefit. One of the criticisms of the RSPT is that the Government is effectively nationalising 40% of ongoing mines and the GBR deduction is irrelevant as there is no serious downside risk. In the framework I propose the Government is not currently proposing to pay a fair price for this “nationalisation”. If the fair price of the Government’s stake is taken into account then the tax from existing mines is considerably lower than proposed. It may be as low as 9% of earnings. This does not require a backdown by either the miners or the Government, although the Government’s tax take might be less than forecast

If the Government is going to nationalise 40% of a mine – at a fair price – then it needs to effectively pay 40% of the Market Value of Assets (or MVA) for the mine. For new mines the Investment = Equity + Debt is pretty much set at this value. The Government RSPT tax is then:

Tax = 40% x (Earnings – GBR x MVA)

The first term is the Government’s 40% share of the earnings (here taken as Earnings before Tax). The second term is the deduction for the interest that recognizes that the funding of the Government’s share is undertaken by the mine at the Government Bond Rate or GBR. There is no good reason for the Government to pay less than the market value of this asset or MVA. For a new mine just starting up MVA = I, the investment amount, so

Tax = 40% x (Earnings – GBR x I)

If ROI = Return on Investment = Earnings/I then we can write this as:

Tax = 40% x (ROI – GBR) x I

which is the proposed RSPT formula.
For an ongoing mining operation with established operations and contracts, the market value will exceed the book value several times over. I am going to take the very simple assumption that MVA = Price ie the market value of the assets is the market value of the equity. This ignores leverage and is probably too simplistic. Price is based on share price and the number of outstanding shares. In terms of PE-ratio (the ratio of Price to Earnings as determined by the share price) we can write

Tax = 40% x Earnings x (1 – GBR x PE-ratio)

Compared to the original formula the deduction is  40% x GBR x PE-ratio x Earnings. Alternatively we can write this as 40% x GBR x I x MBR where MBR is the Market to Book ratio = MVA/I. So the original Govt funding deduction is just multiplied by MBR. The current formula assumes implicitly that MBR = 1. For existing businesses eg. banks MVA/BVA can be as high as 4 (which is BHPs current value). This gives a very simple deduction in terms of % of earnings, rather than Investment/I, of 40% x GBR x PE-ratio. Note that this is really the same formula for new and existing mines; it just makes proper allowance for the true value of established mines.

So what is the fair deduction for existing mines? It obviously varies with share price and hence market conditions. For mines which are privately held we need a proxy based on publicly traded stocks. The PE-ratio for traded mining stocks is currently about 14. So now, using GBR=5.5%, the  fair deduction for the Govt’s nationalised share for existing mines is not 5.5% (as many erroneously claim) or 22% (allowing for a 25% ROI) but 31%! Note this deduction is off the 40% so the total RSPT tax on earnings would be 9%.

So under a scheme based on a fair deduction for existing mining assets the tax should be:

RSPT = 40% x  Earnings x (1 – 5.5% x 14) = 9% x Earnings.

After 30% company tax this represent a total tax of 38%. Even if we don’t know what the PE-ratio would be for mines which aren’t publicly traded we can use an industry based proxy for the mines whose stocks are publicly traded. Currently this is in the range 13-14. If I was the miners I’d be pretty happy with that. Maybe they should have taken a closer look at the RSPT before opposing it. All the miners have to do is get the Govt to accept it should pay a fair value for its stake and the framework I propose makes that transparent.

Are Australia’s banks about to collapse?

Bank cracking photoUPDATE: In this post I repeated Business Insider’s mistake of attributing the presentation I criticise to Steve Keen. While Steve considers it an excellent presentation, he did not write it and I apologise for not confirming the source before publishing this post. I have now struck out the incorrect attributions. My criticisms of the presentation itself still hold, which is why I am leaving the post up in its edited form.

Steve Keen and his forecasts of a property market collapse have received plenty of local media coverage over the years. Now he has come to the attention of the international press as well.

In April, Keen hiked to the top of Mount Kosciuszko after losing a bet about the direction of property prices with Macquarie Bank strategist Rory Robertson. This event was enough to prompt an extensive review of Keen’s concerns in the New York Times. Curiously, Robertson himself did not receive a mention, despite winning the bet.

Now the US business site Business Insider, which has a penchant for drama, has published one of Keen’s presentations a presentation, incorrectly attributed to Keen, under the headline “Here’s What You Need To Know About The Major Property, Debt, And Banking Crisis Brewing In Australia”.

One of Keen’s central concerns is the size of private sector debt in Australia. This is a legitimate concern and should receive more focus than misguided fears about Australian government debt. However, I am far less pessimistic than Keen about the outlook for Australian property prices.

As for the Business Insider presentation, Keen takes his concerns it goes too far, to the point of unsupportable alarmism. The final slide of the presentation is evidence enough of this, not to mention being in extremely poor taste. This slide appears to have been added by Business Insider! If that is not enough to convince you, I will consider just one of the arguments offered by the anonymous author Keen.

On slide 22 of the presentation, he writes:1

Look at CBA 2009 annual report—Leverage ratio is almost 20 times (total assets of $620.4 billion against $31.4 billion of equity). Of $620.4 billion of assets, $473.7 billion are loan assets. If around 6.6% of CBA’s loans go bad (any loans not just mortgages), 100% of its shareholder equity will be wiped out!!

(the bold italics are not mine, they appear in the presentation). Here the implication is something like “6.6% is not very much. Wow! CBA could easily collapse!”. But, that line of thinking does not stand up to even moderate reflection.

Crucially, we must understand what “going bad” means for a loan. It does not mean losing everything, which is in fact very rare for most types of bank loans.

Over half of CBA’s are home loans and these are secured by the property that has been mortgaged. According to their half-year presentation2, based on current market valuations, the average loan-to-value ratio (LVR) for CBA’s portfolio is 42%. This means that, on average, the value of the property is more than twice the loan amount. This gives the bank an enormous buffer against falls in property prices. Of course, this average conceals a mix of high and very-low LVR loans. Even assuming that loan defaults occurred on a higher LVR section of the portfolio, say with an average LVR of 70%, and allowing for Keen’s oft-quoted figure of a 40% decline in house prices, CBA would still only lose 14% on their defaulting loans3. Even then, this does not take into account the fact that, like other lenders, CBA takes out mortgage insurance on loans with an LVR of more than 80%.

But we can be more conservative still. In their prudential standards, the banking regulator APRA considers a severely stressed loss rate on defaulting home loans to be 20%. To suffer actual losses of 6.6% in their mortgage portfolio, CBA would have to suffer a default rate of at least 33%! This would be astonishingly unprecedented. Currently, the number of CBA borrowers late on their mortgage payments by 90 days or more is running at around 1%. Most of these borrowers will end up getting their finances back in order, so for actual defaults to reach 33% is inconceivable. A default rate of a “mere” 2% would be extraordinary enough for CBA.

As for the rest of the $473.7 billion, it includes personal loans, credit card loans, business loans and corporate loans. The loss rates on some of these loans can be higher than for mortgage portfolios, but losing everything on every defaulting loan is still highly unlikely. So to suffer 6.6% in actual losses on these loans, defaults would have to run at a far higher rate. Furthermore, since the dire prognosis for the banks is rooted in the view that the property “bubble” is about to burst, presumably the argument would not simply be based on everything other than the home loan portfolio collapsing.

If property prices do fall sharply and our economy has another downturn, will bank earnings be affected? Of course. Are they teetering on the brink of collapse? Of course not.

1 While there is a footnote on the slide referencing this post, what is not made clear is that the whole paragraph is a direct quote rather than Keen’s own words. Presumably he agrees with it though!

2 Page 84.

3 If property prices fall to 60% of the original value, the loss on a 70% LVR loan would be (70% – 60%)/70% = 14.3%.

Who are the big carbon emitters?

Earlier this week, @pureandapplied brought to my attention the emissions data that has been published by the Department of Climate Change in Australia. Their report comprises data for the 2008-09 reporting year provided to the Greenhouse and Energy Data Officer by corporations whose greenhouse gas emissions exceeded 125 kilotonnes*. A few corporations are missing from the list for a number of reasons, including failure to provide their data in time for the report’s publication (a sorry excuse indeed). Nevertheless, the data makes for some interesting reading. As @pureandapplied remarked, for example, Qantas was responsible for more emissions than Shell: those air points are producing a lot of CO2-equivalent emissions!

The data is reported in two categories, “Scope 1” and “Scope 2” emissions. The definitions of the two scopes are as follows:

Scope 1 emissions are the release of greenhouse gases into the atmosphere because of activities at a facility that is controlled by the corporation. An example of this would be gases emitted by burning coal to generate electricity at an electricity production facility (i.e. a power station).

Scope 2 emissions in relation to a facility, are the release of greenhouse gases emitted at a second facility because of the electricity, heating, cooling or steam that is consumed at the facility. An example of this would be greenhouse gases emitted to generate electricity, which is then transmitted to a car factory and used there to power the car factory’s lighting. The greenhouse gas emissions are part of the factory’s scope 2 emissions. It is important to recognise that scope 2 emissions from one facility are part of the scope 1 emissions from another facility.

The report is very careful to note that these two scopes should be used warily. In fact, it warns that the two figures “should not be used individually, or added together” to estimate liabilities under any emissions abatement scheme. That is a red rag to a Mule, so I will indeed look at them individually and added together. The chart below shows the top 25 emitters in the Scope 1 category.

Top 25 Scope 1 Emitters

It should come as no surprise that the big Scope 1 emitters are primarily power generators, although there are a number of mining companies in there, along with Qantas thanks to its burning of jet fuel. Scope 2 tells a somewhat different story.

Top 25 Scope 2 Emitters

Here “poles and wires” make an appearance: Transgrid and the like, move energy from place to place that has been generated elsewhere. So, the Scope 1 emissions are counted by the generator, but the tranmission company wears the Scope 2 emissions. Woolworths manages an impressive fifth place, perhaps thanks to the lights in all of their supermarkets? Wesfarmers, the owners of the Coles supermarket chain, rank higher still.

Finally, here are the top 25 emitters by the combined total of Scope 1 and Scope 2 emissions. Not surprisingly, the generators dominate once more.

Top 25 Scope 1+2 Emitters

Also included in the data is the total amount of energy consumed by each corporation. It is in these numbers that I stumbled upon something of a puzzle. Envestra produced a reasonably sizeable 627,161 tonnes of Scope 2 CO2-equivalent, but had one of the lowest levels of total energy consumption at only 193 GJ. What have they been up to? Guesses are welcome!

* Also included are those corporations holding a reporting transfer certificate.

The Mule on Mortgages

My friend and prolific blogger, Neerav Bhatt (@neerav on twitter), asked me to write a guest post for his Rambling Thoughts blog about how much debt is too much when it comes to buying a house. In pulling the post together, @dlbsmith was very helpful, allowing me to tap into her knowledge of bank home-lending practices. Here is an extract of what I wrote.

So you’ve saved up a deposit for your first house, you want to take advantage of the government’s first home owner grant while you still can, and the bank is actually prepared to lend you money. But how much should you borrow?

While Australia has not had the same problems with “sub-prime” borrowers finding themselves too deep in debt for a house which has collapsed in value (house prices can and do go down as well as up), there are certainly still people who have borrowed too much and are struggling to make their mortgage payments.

Once upon a time, many banks had rules of thumb for the maximum size for a home loan. A common rule was to lend no more than three times the borrower’s annual income (before tax). These days, even in the wake of the “global financial crisis”, it is not uncommon to hear of people being offered loans or four or five times their annual income.

Just because a bank is prepared to lend you enough to buy the house of your dreams doesn’t mean that the loan they are offering you isn’t too big! Borrowers have to decide for themselves how much is a safe amount to borrow and how much is too much.

You can read the full post here.

Rethinking the basis for the Australia Day holiday

In anticipation of tomorrow’s Australia Day holiday here in Australia, this guest post by John Carmody examines whether or not 26 January is really the most appropriate date for Australia Day. John Carmody is a Sydney-based writer on medical and cultural history and (in the interests of full disclosure) is closely related to the Stubborn Mule.

January 26 is a nettlesome date for the official celebration of the Australian nation and as a commemoration of our colonial foundation.  Apart from the significant nuisance that it falls so close to the end of the holiday season when our minds and emotions are trying to deal with more pressing obligations, it really asks a serious philosophical and moral question.

For indigenous Australians, conscious of their fraught history since 1788, it is no cause for celebration at all.  Understandably, they consider that it was the beginning of an invasion and see no reason to rejoice in it.  White Australians and, indeed, all immigrants can only respect that attitude; but we must do that reflectively.  The fact is that there are several distinct reasons to discard 26 January as that festive occasion.

The first point is that the date is not when the founding fleet arrived in Terra Australis: that was, rather, at Botany Bay on 19-20 January, 1788.  It was only because the officers were so disillusioned by how little resemblance that coast bore to Joseph Banks’s glowing descriptions and because of an indifferent water supply, that Governor Arthur Phillip made a reconnaissance to Port Jackson (which Captain Cook had not entered) that the venture was transferred to Sydney Cove. Even then, in the afternoon of 26 January there was little time for formalities or any grander celebration than hoisting a flag and drinking the health of the King and the success of the colony with a few glasses of Porter, followed by the flourish provided by a round of rifle fire.

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Hot and Dry Days Ahead for Australia

Earlier this month, the Australian Bureau of Meteorology released the October figure for the Southern Oscillation Index (SOI). It showed a precipitous plunge of almost 20 points down to -14.6. Just how significant a drop this is can be seen in the chart below, which shows the distribution of monthly changes in the SOI going back to 1876 (-14.6 is at the lower 5% quantile, which means that a fall as big as this, or bigger, has only occurred 5% of the time).

SOI histogram

Distribution of SOI changes (Jan 1876-Oct 2009)

But what exactly is the SOI and what is the significance of this decline in the index? The index is the standardised anomaly of the monthly average difference in sea-level air pressure between Tahiti and Darwin. “Standardised anomaly”  means that the index measures the deviation of this pressure difference from the long-term average and is scaled by the standard deviation of the pressure difference and then multiplied by 10. The significance of the index lies in its relationship to the El Niño weather phenomenon. According to the Bureau of Meteorology:

Sustained negative values of the SOI often indicate El Niño episodes. These negative values are usually accompanied by sustained warming of the central and eastern tropical Pacific Ocean, a decrease in the strength of the Pacific Trade Winds, and a reduction in rainfall over eastern and northern Australia. The most recent strong El Niño was in 1997/98, although its effect on Australia was rather limited. Severe droughts resulted from the weak to moderate El Niño events of 2002/03 and 2006/07.

The chart below gives a historical perspective of the SOI over the last ten years. To get a better sense of the trends in the index, I have overlaid two different types of curve smoothing: a lowess (“locally-weighted scatterplot smoothing”) curve and a spline curve. The two give very similar results and make the 2002/03 and 2006/07 SOI downturns clearly visible. The timing of these downturns suggest that the corresponding droughts follow with something of a lag.

SOI 10 year historySouthern Oscillation Index (Jan 2000-Oct 2009)

Over the last couple of years, the SOI has been solidly in positive territory and, again with a lag, there has followed an improvement in drought conditions. Indeed, New South Wales recently replaced the tight water restrictions which had been in place for a number of years with the less onerous “Water Wise” rules. Unfortunately, this change may turn out to have been premature. If the downward trend in the index seen over the last few months persists, Australia may face a return to severe drought conditions.

For anyone who is interested in how these charts were created, here is the R code. It is also available from the Stubborn Mule files section.

UPDATE: at the request of singingfish, here is a chart showing the full recorded history of the SOI back to 1876. The blue line is a spline smoothed curve.

SOI - Full History

Southern Oscillation Index (1876-2009)

Petrol Price Update

Another five months on since my last petrol price update and oil prices have continued to rise, but so has the value of the Australian dollar. So while crude oil prices in US dollars are up around 75% since their lows in February, they are only up 29% in Australian dollar terms.

WTI Prices - USD and AUDWest Texas Intermediate Oil Prices

The Australian dollar has been rising steadily for the last six months, pushed along by the Reserve Bank of Australia which has started raising their target cash rate. Higher interest rates in Australia make it more attractive for offshore investors to buy Australian securities and they have to buy Australian dollars to do so. Australian investors holding foreign assets may do the same.

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Crime Around The Corner

Observant visitors to this blog may have noticed the recent appearance of a “wiki” button at the top of the page. This links to the recently established Stubborn Mule wiki, which I plan to use as a repository of information relevant in some way to the blog. Since so many of the posts here focus on data analysis, I have started with a collection of links to useful sources of data online, particularly economics and finance data.

The latest link I have added is to the New South Wales Bureau of Crime Statistics & Research (while I did not include it in the economics and finance section, maybe it does belong there). This site includes a research data set which provides monthly crime data going back to 1995 broken down by local government (council) area and offence type.  Needless to say, the first thing I was interested to learn was the level of criminality in my own local area, particularly as I moved here only very recently.

The chart below shows the total number of crimes in the various offence categories for 2008 in my local government area of Marrickville. While I was not surprised to see theft coming in at the top of the list, there were a few oddities further down. I was initially surprised to see driving offences at the bottom of the list. My driving is, of course, impeccable but I do not know if the same is true of all of my neighbours, not to mention visitors to the area. Digging further, I discovered that from 2003 onwards*, the figures for driving offences have been zero for all areas and transport regulatory offences have leapt up. So, presumably there has been a classification change. One mystery solved.

Crime in Marrickville (III)

Marrickville Crime Count (2008)

More intriguing is blackmail and extortion. Until 2008, the highest rate this crime had reached in Marrickville was four cases per year and in three years, the figure was zero. Yet, in 2008, there were nine cases of blackmail and extortion. What lies behind this wave of blackmail around the corner? Mystery not solved.

This led me to examine other trends through time. Starting with theft, I was gratified to learn that 2008 was the lowest year for theft since these records began. I am hoping 2009 will be lower still.

Theft in Marrickville (II)

Occurrences of Theft in Marrickille

A look at prostitution also suggests the area has become more law-abiding after a significant spike in offences in 2001.

Prostitution in Marrickville (II)

Occurrences of Prostitution Offences in Marrickville

As for serious crime, Marrickville experienced three homicides in 2008. The total number of homicides in the area since 1995 is 66, putting Marrickville in a somewhat disturbing 14th place out of 155 local government areas, although these two have been reducing over recent years. For those interested in the most murderous areas in New South Wales, here is a list of the top five areas in terms of total homicides since 1995. Any country readers will note that all of these local government areas are in Sydney (the area in the table labelled “Sydney” encompasses only the central business district and some inner-city suburbs).

Area Homicides
Fairfield 242
Sydney 327
Blacktown 136
Liverpool 102
Parramatta 82

* The historical data for Marrickville is in the “Files” section of the blog.

Malcolm Turnbull’s Word Cloud

My last post looked at the favourite words of Australia’s prime minister, Kevin Rudd. In the interests of balance, I will now turn the word cloud lens onto the opposition leader, Malcolm Turnbull. Turnbull’s speeches are conveniently assembled online and the graphic below illustrates the frequency of his words from speeches made in 2009. Unlike the analysis of Rudd’s speeches, this analysis does include some speeches given in parliament.

Turnbull Word Cloud

Just like Rudd, Turnbull’s favourite word is “Government”, and “Australia” is not far behind. But from there, differences appear. The word “billion” is far more prominent, reflecting the opposition leader’s obsession with growing public debt. The appearance of “Rudd”, “Labor” and “Coalition” clearly reflect the realities of life in opposition where so much time is taken attacking the other side.

Interestingly, the word “emissions” is clearly visible in the cloud, whereas nothing relating to climate change was visible in Rudd’s cloud.

“Now” is as prominent as Rudd’s “also”. Does this reflect a constant sense of urgency from a man of little patience?

Deleveraging and Australian Property Prices

car-smallA few weeks ago, I had a preliminary look at Australian property prices. That post focused on rental yields and argued that the fact that property prices have consisently outpaced inflation over the last 10-15 years can be associated with a steady decline in rental yields which has been matched by a decline in real yields in other asset classes. What I did not address was the argument that debt deleveraging will lead to a collapse in property prices just as it has done in the US. That is the subject of today’s post.

The Bubble

The bubble argument is a compelling one. The chart below shows the growth in Sydney property prices over the last 24 years. Prices rose fairly consistently over this period at an annualised rate of almost 7%. Over this period, inflation averaged around 3% per annum, so property prices grew at a rate of approximately 4%. This means since 1985, the cost of a typical house has risen by a disconcerting 123% over and above inflation. Little wonder that many people see the property market as a bubble waiting to burst.


Sydney Property Prices (1985-2009)*

The fuel driving the property market has been the rapid growth in household debt, most of which has been in the form of mortgage debt.  The next chart is taken from Park the Debt Truck!, a post which looks at trends in Government and household debt in Australia. The highlighted regions show the periods of Labor federal governments. Household debt began its upward trajectory during the Hawke and Keating years, but really gathered pace during the Howard years. With the help of continually extended first-time home-buyer grants, growth is yet to slow now that Rudd has come to power.

Govt and Household Debt

Government and Household Debt in Australia

This expansion of debt has been a key factor driving up property prices. Without the easy access to money, the pool of potential home-buyers would be far smaller and with less demand pressure, prices would not have risen so fast. A very similar pattern was evident in the US, but in late 2006 the process began to lose steam. Property prices faltered, debt became harder to obtain, borrowers began to default on their loans leading to foreclosure sales which put further downward pressure on prices. The bubble was bursting.

So far I am in agreement with the property bubble school of thought. Where I part ways is concluding that Australia will inevitably experience the same fate, resuting in a collapse in property prices, possibly in the range of 30 to 40%.


Words can be powerful. Once you use the word “bubble” to describe price rises, it seems almost inevitable that the bubble must burst. Similarly, “reducing debt” sounds like a good thing, while “deleveraging” sounds like a far more ominous destructive process. But all deleveraging really means is debt reduction and it can happen in a number of ways:

  • borrowers use savings to gradually pay down debt
  • borrowers sell assets to pay down debt
  • borrowers default on their loan

When it comes to borrowers selling assets, in some cases this may be voluntary. But it may be that they are forced to sell. A good example is in the case of margin loans to purchase shares. If the share price falls, the lender will make “margin call”, requiring the borrower to repay some of the loan. Selling some or all of the shares may be the only way to raise the money required. When borrowers default on a secured loan (such as a mortgage), the lender will usually sell the asset securing the loan in an attempt to recover some of the money lent. In this situation the emphasis is usually on ensuring a speedy sale rather than maximising the sale price.

Forced sales are the ideal conditions for a price collapse, particularly if lenders have become reluctant to finance new borrowers. If debt reduction takes the form of gradual repayment, the pressure on prices is far less. There will certainly be less demand for assets than during a period of rapid debt increase, but this can simply result in neglible growth in asset prices for an extended period of time rather than a price collapse.

To understand what form debt reduction will take, it is not enough to consider the amount of debt. The form of the debt is very important. Some of the key characteristics that will influence the outcome include:

  • the term of the loan (the length of time before it must be repaid)
  • repayment triggers (such as margin calls)
  • interest rates

Short-term loans can be very dangerous. In 2007, the non-bank lender RAMS learned this the hard way. It had relied heavily on very short-term funding (known as “extendible asset-backed commercial”) and back when the global financial crisis was simply known as a liquidity crisis, RAMS found itself unable to refinance this debt. It’s business collapsed and it was purchased by Westpac for a fraction of the price at which the company had been listed only months before.

The most common type of loan with repayment trigger is a margin loan. There is no doubt that a significant factor in the dramatic falls in the Australian sharemarket over 2008 was forced selling by investors who had used margin loans to purchase their shares. There are also other sorts of loan features than can be problematic for borrowers. Another one of the corporate victims of the financial crisis was Allco Finance. It turned out that they had a “market capitalisation clause” attached to their bank debt. This was like a margin call on the value of their own company and was an important factor in the collapse of the company.

Even if borrowers have long-term loans and are not forced to repay early, if they are unable to meet interest payments, they will be in trouble. A common feature of the US “sub-prime” mortgages at the root of the financial crisis was that interest rates were initially low but then “stepped up” a couple of years after the mortgage was originated. While the market was strong, this was not a problem due to the popular practice of “flipping” the property: selling it for a higher price before the interest rate increased. Once prices began to fall, the step-ups became a problem and mortgage delinquencies (falling behind in payments) and defaults began to rise. In some states, the phenomenon was exacerbated by laws that allowed borrowers to simply walk away from their property, leaving it to the lender, who had no further recourse to pursue the borrower for losses. On top of all this, rapidly rising unemployment put further stress on borrowers’ ability to service their mortgages.

So, how do Australian mortgages look on these criteria? The standard Australian mortgage is a 25-30 year mortgage with no repayment triggers. Most mortgages are variable rate and, despite the banks not passing through all the central bank rate cuts, mortgage rates are at historically low levels. In part due to the regulatory framework of the Uniform Consumer Credit Code (UCCC), lending standards in Australia have been fairly conservative compared to the US and elsewhere. The Australian equivalent of the sub-prime mortgages, so-called “low doc” or “non-conforming” mortgages, represent a much smaller proportion of the market. Many lenders cap loan-to-value ratios (LVR) at 95% and require the borrower to pay mortgage insurance for LVRs over 80%, which encourages many borrowers to keep their loans below 80% of the value of the property. Interest step-ups are rare. Mortgages are all full recourse.

The result is that while US mortgage foreclosure and delinquency rates have accelerated rapidly, they have only drifted up slightly in Australia. It is not easy to obtain consistent, comparable statistics. For example, deliquency data may be reported in terms of payments that are 30 days or more past due, 60 days or more or 90 days or more. Of course, figures for 30 days or more will always be higher than 90 days or more. Nevertheless, the difference in trends is clear in the chart below which shows recent delinquency rates for a variety of Australian and US mortgages both prime and otherwise. The highest delinquency rates for Australia are for the CBA 30 days+ low doc mortgages. Even so, delinquencies are lower even than for US prime agency mortgages 60 days+ past due.

Delinquency Rates (III)Delinquency Rates in Australia and the US**

All of this means that the foreclosure rate remains far lower in Australia than in the US. Combined with the fact that mortgage finance is still increasing, due largely to the ongoing first-time home-buyers grant, there has still been little pressure on Australian property prices. In fact, reports from RP Data-Rismark suggest prices are on the rise once more (although I will give more credence to the data from the Australian Bureau of Statistics which is to be released in August).

Once the support of the first-time home-buyers grant is removed, I do expect the property market to weaken. Prices are even likely to fall once more with the resulting reduction in demand. However, without a sustained rise in mortgage default rates, I expect deleveraging to take the form of an extended lacklustre period for the property market. Turnover is likely to be low as home-owners are reluctant to crystallise losses, in many cases convincing themselves that their house is “really” worth more. Even investors may content themselves reducing the size of their debt, continuing to earn rent and claim tax deductions on their interest payments.

The biggest risk that I see to the Australian property market is a sharp increase in unemployment which could trigger an increase in mortgage defaults. To date, forecasters have continued to be confounded by the slow increases in unemployment and now the Reserve Bank is even showing signs of optimism for the Australian economy.

Australian property prices have certainly grown rapidly over recent years. Driven by rapid debt expansion, prices have probably risen too far too fast. But, calling it a bubble does not mean it will burst, nor does using the term “deleveraging” mean that prices will inevitably follow the same pattern as the US. In the early 1990s, Australia fell into recession and the commercial property market almost brought down one of our major banks. Meanwhile, house prices in the United Kingdom collapsed. Despite all of this, in Australia, residential prices simply slowed their growth for a number of years. I strongly suspect we will see the same thing happen over the next few years.

* Source: Stapledon

** Source: Westpac, CBA, Fannie Mae, Bloomberg.

By the way, notice anything unusual in the picture at the top?

UPDATE: Thanks to Damien and mobastik for drawing my attention to this paper by Glenn Stevens of the Reserve Bank of Australia. It includes a chart comparing delinquency data for the US, UK, Canada and Australia. The data is attributed to APRA, the Canadian Bankers’ Association, Council of Mortgage Lenders (UK) and the FDIC. Since these bodies do not appear to make the data readily available, I have pinched the data from the chart and uploaded it to Swivel. It paints a very similar picture to the chart above.

Delinquency: US, UK, Canada and AustraliaMortgage Delinquency Rates