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Bankrupt hedge fund guru wishes he bought property

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If a bear dies in the woods, is anybody listening?

This week, the world lost a great bear. Hedge Fund guru Hugh Hendry is closing his fund.

Hugh Hendry is a bit of a legend in managed fund circles. With a name like Hugh Hendry, he was always destined for funds management, politics or porn. He chose the lesser of three evils.

In 2002 he launched Eclectica – a contrarian fund for people with more money than all of us combined. At the time, the fund attracted a lot of attention… and a lot of money.

And in the early years, it made good money. It made great money. And the contrarian strategy saw Hendry and co. well positioned to ride out the GFC.

But since the GFC, its returns have been disappointing to say the least. 2011 was its best year, but even then it only posted 8.6%, only slightly bettering the market.

Every other year, however, it underperformed the market substantially.

And 8 months into this year, already down 10%, Hendry decided to throw in the towel. The great bear howled its last howl, rolled over and died.

Essentially Hendry’s bet – that the radical money-printing experiment that followed the GFC was only going to end in tears – turned out to be wrong.

The theory was impeccable. The case was well argued. The mechanisms were obvious. It was just never true.

And ultimately, in his farewell letter, Hendry capitulates completely. The nightmare scenarios of the GFC just never came true, and right now, the economy looks pretty good.

Right now, Hendry “is not bearish on anything.”

In fact, the outlook is positively sunny.

“If anything we feel more convinced that our thesis of a healing global economy is understated: for the first time in an age all parts of the world are enjoying synchronised economic momentum and I can’t see it ending for some time…

… The implications of a sustained bout of economic growth are good for you. It’s good because it should continue to underwrite a continuation in the positive performance of global equities. I would stay long. It’s also good because I can’t see interest rates rising abruptly to interrupt the upward path of equities. And commodities have already acknowledged the upturn in the fortunes of the global economy and are likely to trend higher still. That’s a lot of good news.”

Oh, how the mighty have fallen.

For the record, Hendry still maintains that the markets are broken. Quantitative Easing created massive disruptions and misallocations of capital. However, the fallout from these misallocations has been largely contained, and the real economy is recovering and gathering steam.

And if the economy keeps doing well, time, ultimately, heals all wounds.

The GFC might still get a rehash at some point, but to Hendry, it doesn’t look like it will be soon.

I find this all fascinating because it still feels like the contrarian mindset is the dominant mindset.. (I know. Ironic)

Most people still don’t trust the economic recovery – we’re still calling it a recovery. It all feels fragile. The ghosts of the GFC still linger and are now rubbing shoulders with Trump and Kim Jong Un.

It can’t end well.

But how long does it take for confidence to take hold?

How many years of “recovery” do we have to see? How low does the unemployment rate have to go? How many contrarian hedge funds have to keel over and die?

More and more the tone of commentary is brightening. More and more people are saying, you know what, maybe things aren’t that bad. Maybe the economy has got legs.

Given this emerging shift in sentiment, I would actually say that the worst is probably behind us. The global economy is gearing up for a solid spell.

This is all great news for Australia – as a small open economy, our fortunes flow with the world. And if it’s true as Hendry thinks that, “commodities… are likely to trend higher still,” then it is fantastic news for Australia.

These past five years have been a bit of a battle for Australia, mostly because our major trading partners, apart from China, have been struggling.

But what happens if they all start finding form?

What happens to Australian growth rates – rates that are already the envy of the world? What happens to the unemployment rate? What happens to wages?

And what happens to property prices?

Just look at how well property has done with all the headwinds under the sun being thrown at it.

Now imagine what happens if it starts getting some tailwinds. Imagine what happens if incomes start gathering speed again.

In my mind, if Hendry’s thesis plays out and the global economy continues to go from strength to strength, it is very hard to see property prices decelerating.

In that scenario, the only way is up.

Mark my words.

The other point I’d make is that sentiment always flows this way. At first, there’s only a few dissenting voices, like Hendry. In time, the herd capitulates and the contrarian view becomes the dominant view.

And by then, your opportunity to make real money has passed you by.

There are no guarantees in this game, but my bet is that Hendry won’t be the last bear to cop it in the neck this cycle.

The mood is shifting.

Mark my words.

Where do you think we’re heading (globally speaking)? It’s it’s black clouds and storms ahead or bright skys and tailwinds?

“Boom has 40 years to run” – some boffin.

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What base case are our boffins using? 40 more years of boom.

So I’m putting the final touches on my masterpiece, my magnum opiate – “Why the boom has ten years to run”, and some boffin in Sydney comes out and calls 40 years.

C’arn mate. Let’s not get into a willy measuring contest about it.

Ok, so I’m talking about a professor of Economics at the University of Sydney, Prof Judith Yates. She’s probably never heard of me. I’ve never heard of her until someone forwarded me this report.

(Don’t bother opening it unless you’re super keen. It’s over 100 pages long.)

Anyway, it’s the Centre for Economic Development (CEDA)’s Housing Report. It’s huge. It’s mammoth. It makes my magnum opiate look like something scrawled in crayon you’d stick to the fridge.

But the good news (if you’re me) is that these boffins are pretty much bearing out all the things I’ve been talking about here in this blog.

But not only that, Prof Yates has upped the stakes and saying that the outlook for the next 40 years is pointing to further surges in property prices.

That’s not really Yates’ angle. She’s thinking about ‘affordability’, but they’re both sides of the same coin.

Anyway, what jumped out at me was this:

Looking forward, there can be little sense of optimism about future housing affordability outcomes:
• Demand pressures are likely to continue over the next 40 years. Economic growth per capita is (still) predicted to continue, although at a somewhat lower rate than experienced over the past 40 years.
• Australia’s population also is projected to continue to grow at only a slightly lower annual growth rate than over the past 40 years, with this growth being concentrated in Sydney and Melbourne.

Ok, I’d agree with this. I’m not sure that the picture is completely without optimism. But it does require a rethink of the way people enter the property market. But that’s a story for another day.

And demand pressures continuing over the next 40 years? Well, I think you’re mad if you’re going to forecast anything over a 40-year time horizon (but then, who’s going to hold you to it?) But I think what she’s saying is that if you look at all the projections and forecasts we’ve got, none of them have demand pressures easing.

The base-case scenario is for the economy to keep growing and for wages to keep rising with it. The base-case is also for population growth to continue at strong levels.

If that eventuates, and you’d have to think it is the most likely outcome, then property demand will grow. Unless something happens to supply, that means prices will keep rising.

So does she say anything about supply?

Actually, yes, she does.

Supply constraints are likely to remain. Urbanisation trends are expected to continue, with the proportion of people living in Australia’s capital cities projected to rise from a current 66 per cent to almost 74 per cent.  Jobs in the future are projected to grow in service and knowledge based industries with skilled labour being favoured over unskilled.

This will reinforce the steady growth in earnings inequality that Australia has experienced since the mid-1970s.

So supply is going to struggle to keep pace. It’s failed for pretty much the past twenty years and it looks like it will keep failing (again, based on pretty much all the projections out there).

But she hits the nail on the head when she points to urbanisation trends. It’s not exactly true to say that we have a supply problem. There’s a whole lot of cheap houses out the back of Cloncurry.

The problem is that we don’t have supply where we need it (mostly in Sydney and Melbourne.)

And that reflects how concentrated the Australian population is in our major centres. But get this. It’s going to get worse. Two-thirds of us live in the big cities now. Soon that will be three-quarters.

So the price pressures that come from poorly located supply are going to get worse before they get better.

And when you add in the tendency for new economy jobs (services) to be overly weighted to the big cities, the picture only gets worse.

So this is the base case scenario. Not just for property bulls like me, but everybody. These are the projections that everyone in academia and government are using.

Demand keeps going up. Supply keeps struggling.

But then you can add in some structural features as well. As Yates says:

Increasing population, increasing economic growth and increasing concentration of well-paid employment opportunities, therefore, are likely to continue to put pressures on well-located land in our metropolitan regions. Such pressure will be reinforced by:
• Increasing income and wealth inequality;
• A tax-transfer system that encourages established households to hold on to the growing equity in their owner-occupied housing and to increase their housing wealth by borrowing to invest in residential property; and
• A housing finance system that remains biased towards those most able to pay.

Pressures on the private rental market will continue as low and middle-income households are excluded from home ownership and higher income households choose to rent rather than own.

I don’t need to go into all of these but you get the idea. Demand and supply will remain unbalanced. On top of that, all relevant policy settings will remain tilted to favouring property owners, increasing the desirability of property, and pushing prices up.

And that folks is all your ducks in a row.

The result. 40 more years of house price gains.

A lot could happen a long the way, but on the whole, she’s right.

I’m certainly not betting against it.

What do you reckon? 40 more years?

The true source of inequality in one surprising chart

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Growing wealth inequality is driven by one of three things – business income, labour income or housing income. Guess which one it is.

Okay, I know we’ve been spinning round the outer-reaches of the academic universe these last few weeks, but do you want an edge or not?

Do you want to see the trends that the big players see? Or do you want to keep taking your financial play book from the Sun Herald? See how far that gets you.

The whole point of these blogs is about helping you see a bigger picture. The higher up the mountain you go, the more you can see.

If you want gags and ramblings… well, that’s what Friday’s for.

So bear with me a little longer here. I’m building to something. I need more than a few blogs to do it. Nothing worth having is easy. But trust me, it will all come together soon and you’re going to be amaa-aazed.

Ok, so last week, I showed you how falling wages are driving property prices higher. You never thought that sentence could even make sense, but I think you got the point I’m making.

The economy is a bunch of relativities. Everything in relation to everything else. The usefulness of labour is falling, so the relative price of labour must fall. That’s another way of saying that the price of housing, relative to labour must rise.

And that’s what we’re seeing.

But let’s slap a little more nuance on this picture. Let me pop a little swan made of meringue on top here.

Ok, so typically economist divide the factors of production – the stuff that makes stuff – into three groups – Land, labour and capital (machinery, factories etc).

Since land is fixed, economists just tend to put it to one side and focus on labour and capital.

(I know, you’ve got to wonder what they’re thinking.)

And so Marx said all history is the history of class struggle, between labour and capital.

A few years ago, Thomas Picketty, that French economist wrote “Capital” – which argued that wealth inequality was getting worse because capital owners were able to capture more of the surplus, at the expense of their workers.

And in all of this, land is just the place where they grow cheese.

And you can kind of get why. Land is just dirt to most people. It kind of has no character, no personality. It’s not able to rise up against its oppressive overlords.

The battle between labour and capital on the other hand – oh boy is that a story. It’s a theatre for all the hopes and dreams of the working class, all the aspirations of our entrepreneurs and captains of industry.

Land just doesn’t care about any of that. And it will still be there once all the workers and managers and capital owners are dead.

So it gets written out of the story.

And so then you see charts like this one:

This is the share of total income going to workers and to capital owners (in the way of profits).

The argument that people make – people like Picketty – is that labour’s share is falling and that’s a bad thing. That means workers have less power. Businesses have more. And that’s one of the factors driving inequality.

And that might all be true, but it is missing a huge piece of the puzzle.

Land.

Recently I did come across one economist who tried to put land back in the picture. This chart comes from a young grad student at MIT. It breaks capital income (from the chart above) into capital AND land (rather than just lumping profits and land income in together.

Look at what happens:

This is for the developed world since 1948. You can see that since 1980 in particular, capital’s total income share has been growing. That’s Picketty’s story.

But look at why. It’s not that regular business profits have been growing – the non-housing share of capital income has been pretty much flat.

All of the growth since 1980 can be explained by the increase in housing income.

Let that sink in for a second. If the rich are getting richer, if income and wealth inequality are getting worse then it’s got nothing to do with businesses, it’s got everything to with housing, and the way the rich uses property as the number one way, to build, protect and transfer wealth across generations.

I know as a business owner it may sound like I’m talking my own book here, but a careful and measured analysis of the above, highlights that the balance of evidence suggests that, taken together, all you pinko-lefties should take your redistributive business taxes and shove them up your bum!

(Nah, just kidding. You’re great. I love ya.)

But the central idea is that this hasn’t been a golden age for capital. Technology hasn’t made it easier to exploit workers and earn super profits.

If anything, technology has made the game harder. Technology depreciates in value and usefulness incredibly quickly (anyone want to by my Iphone3?), and the digital market place has meant that disruption is coming at you from every which way.

No sooner do you have a great idea, than a dozen firms in China are ripping you off.

Think about what AirBnB did to the hotel industry, what Uber did to taxis, what Amazon is doing to retail.

This is no capitalist utopia.

So labour income is falling. Capital income is falling, or it’s on the way down. The relative price of these two must decline.

Relative to what?

Land.

(Gee, it’s like you’re not even listening sometimes.)

As I’ve said before, in an economy where everything is getting less and less real, where more and more activity is moving into the unlimited infinity of unrealness, the relative scarcity of real things, commodities and real estate, increases.

As their relative scarcity increases, so does their price.

We’re still in the middle of a commodity boom that continues to surprise, and the real estate boom…

Well, we’ve put some great runs on the board…

But the game is nowhere near over.

Will capital’s share of income start to fall?

How falling wages are driving property prices higher

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Part three in ‘Ten Reasons Why the Boom has Ten Years to Run’ is something I don’t see anyone else talking about – how property became the new gold.

I don’t know if you caught this article a couple of weeks ago. The new Governor of the RBA, Phil Lowe, was urging workers to rise up and seize the factors of production.

Well, not quite. But he was urging them to demand higher wages.

The governor of the Reserve Bank has called on workers to start demanding large pay rises from their bosses. 

In a remarkable statement for a central bank chief, Philip Lowe said Australia’s economy was suffering a “crisis” in wage growth, and workers ought to realise the relatively low unemployment rate meant they could start asking for a larger share of the nation’s economic pie.

Lowe told a conference at the Australian National University on Monday the labour market was in better shape than some critics were suggesting.

 “The crisis is really in real wage growth,” he said.

He said despite the relative strength in the labour market, too many workers were putting job security ahead of pay rises, partly because they were worried about competition from “robots” and “foreigners”.

I don’t know if all of my readers are old enough to understand what a seismic shift this is.

Not that long ago, when central bankers used to worry about inflation, they would warn us about the dangers of a “wage-price spiral”. Where higher wages pushed up costs, which pushed up prices, which saw workers demand even more pay, and on and on it would go.

It used to happen.

But the last time it did Phil Lowe was in grad school.

And these day, central bankers aren’t worried about inflation. They’re worried about deflation. A lot.

As Phil points out, wages growth is now the lowest on record (which isn’t entirely as bad as it sounds since inflation is also around record lows).

And it is really hard to believe that this is because workers just don’t have enough balls these days.

This really feels like wishful thinking on Lowe’s part. It’s a central banker hoping for something, anything, to save the country from the horrors of deflation.

But this isn’t about the mental state of Australia’s workers.

This is about seismic shifts in the structure of the modern economy.

The de-physicalisation of the economy – where we spend more on apps than we do on furniture – has given us true globalisation. Our app developers can be living in any country on earth.

And the labour pool with access to a device and an internet connection is staggeringly huge, and expanding rapidly.

The price of labour is falling simply because the effective supply of labour is exploding. Every graphic designer in Australia is now competing with millions of other designers from every corner on earth.

That’s one.

Two is that technology has slipped the chain. At some point in the past 10 years we went from labour-augmenting technology (where technology helps workers be more productive, e.g a book-keeper using a lap-top to manage the company’s books), to labour replacing technology (We don’t need a book-keeper any more. There’s an app for that.)

This dynamic is churning through jobs faster than they can be replaced.

Humans are being made redundant. And so the price of humans is falling.

Lowe is wrong to suggest that people are irrational for “fearing jobs and robots”. It’s happening.

And this, is big new for property. It means property prices will go up.

But hang on Giaan. The conventional wisdom is that when people have more money, they can spend more on houses, and so prices go up.

And that’s true. Normally. But these aren’t normal times.

There are intense downward pressures mounting on wages.

But wages are sticky. They very rarely fall. Labour contracts, no disadvantage tests, unions and the public sector all help put a floor under wages.

We very very rarely see wages fall, even an incy bit.

Even at current growth rates – the lowest on record – they’re still growing.

But the economic adjustment must happen somewhere. The price of labour must adjust. It has to.

But where?

Well, the thing to remember is that prices are a relative concept. Prices help us understand the worth of one thing relative to another. Prices are meaningless in isolation. They only make sense in relativity.

Say, what if I told you that a widget is worth 4 wodgets (a currency I just made up.) What does that tell you? Nothing.

What if I said, a widget is worth 4 wodgets, and an apple is worth 2 wodgets.

Now you understand, roughly, what a widget is worth.

So if we understand that prices are a relative concept, and we know that the price of labour needs to fall, then we understand the price of labour, relative to other things, needs to fall.

Now, we can see that this can happen two ways. The nominal price of labour can fall, OR the nominal price of other things can go up, relative to labour.

And since the nominal price of labour is not allowed to fall, that means the adjustment is forced on to the price of other things.

What other things?

Well, theoretically, everything. But since globalisation is suppressing prices in the digital economy, expect to see the adjustment in the price of real things.

What real things?

Did some one say real estate?

So far, no one has created an app that manifests land and builds houses on it. Property is untouched by the digital revolution.

And so in a world where everything else is being swamped by gluts, the relative price of property must increase.

If it doesn’t happen through falling nominal prices – ie. Deflation, which central bankers will spend billions avoiding, then it will happen in nominal gains in property value.

And this, is what we’re seeing right now.

And this is what we’re going to keep on seeing, until the robots overthrow us and make us their slaves.

No, I don’t know what the end game is. But this dynamic is in full-effect right now, and it could take decades to play out.

So you want the big, big picture? You want the long, long-term view?

Property is the new store of value. Property is the new gold.

The sellers of labour (workers) will get poorer. The owners of property will get richer.

Which side are you going to be on?

Is it that bad? Are wage earners doomed?

We’re already in a rate hike cycle… so what?

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When people say they’re worried about rate hikes, I say rates are already rising, and it hasn’t hurt anyone yet…

Last week I gave you the first reason why I thought this bull run had at least another ten years to run. Read it here.

I haven’t had time to pull the other points together, but I just wanted to clear something up.

Some people thought it was strange that I was talking about structurally lower interest rates when their banked had just jacked UP their rates – especially on interest-only investor loans.

So I just wanted to explain what I mean.

First when I’m talking about duration and the bond market and so on, they’re not seeing the interest rates increases that we’re seeing.

As far as they’re concerned, rates are still at rock bottom.

All the rate hikes that we’ve seen and that people are talking about are what we call “out-of-cycle”. (Forgive me if I’m going over old ground here).

That is, they’ve got nothing to do with the RBA’s regular monthly cycle of official interest rates. (Monetary Policy: Now with Wings)

It’s got to do with other stuff.

Right now that other stuff has to do with two things. The first is a new set of standards in global banking, called Basel 5.0 or something like that. Basel is the city in Switzerland where the Bank of International Settlements is located. The Bank of International Settlements is the public relations wing of the Intergalactic Order of Templar Knights and Space Lizards.

(No, seriously. Google it.)

The short of it is that the new Basel rules mean that banks have to be a little less slap happy with their loan to equity ratios, and at the coal face, that means higher rates for people like you and me.

(Curse you space lizards!)

The other place this stuff is coming from is our own APRA. APRA – the Association of Performance and Recording Artists – has seen a steady mission creep in recent years towards oversight of the financial sector. Now they’re worried that banks are a little too exposed to the mortgage market – especially investors and interest-only loans.

To put a lid on things, they’ve introduced speed limits – restrictions on how quickly banks can grow their investor and interest-only mortgage books.

At the coal face, that means higher rates for people like you and me.

(Curse you Molly Meldrum!)

You can get a sense of the first effect here. This chart shows the growing disconnect between official interest rates and the standard variable rate.

The gap opened up in the GFC, and has since got steadily wider and wider. Today, we’re looking at a gap of around 3.5 percentage points.

This chart just tracks the difference:

That’s pretty substantial. I mean, imagine what your interest rates would be if there hadn’t been this decoupling.

Banks would be practically giving you money.

So that’s one.

To get a feel of the second, this chart here overlays rates for investor and interest-only mortgages on the chart above.

You can see that the recent pick up has been driven by the premium that interest-only investor mortgages are attracting…

… just as Molly Meldrum intended.

And if you compare current rate settings with where we were at a year ago, you can see that owner-occupiers have seen a pivot – P&I rates are cheaper, while IO are more expensive.

But there’s no dodging it for investors. Investor loan rates are up about 0.3 perceantage points for P&I, and up a whopping 0.8 pp for IO.

That’s a pretty thorough disincentive. Many mortgage brokers are saying there’s no point even going for IO loans any more.

Anyway, long story short, interest rates are up. Not in the general economy, just in the mortgage market.

That means two things to me.

The first is that since interest rates in the general economy haven’t budged, the duration effects I was talking about in my last blog are still in full effect.

The second thing is that when chicken-littles are freaking about Molly Meldrum’s do-youself-a-favour rate hikes, I’m a bit like, whatever.

We are 350 basis points – or 14 rate hikes – into the current rate hike cycle. The rate hike cycle is almost 10 years old. It hasn’t trashed the economy yet. It’s not about to do it soon.

The Australian property market is one tough nut. A slight upward drift in book rates facing investors isn’t about to derail the whole show. Not by a long shot.

And that’s because interest rates are just one part of the story. I can think of at least 9 other factors driving prices higher…

But I haven’t got time for it this week.

Maybe next week.

Anyone out there copping some over-sized rate hikes?

Banks vs. Perth Property (a clash to keep an eye on)

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The banks are quietly rotating their books. Who wins, who loses?

Let’s stop and think about the APRA restrictions again.

Now we know that APRA have gone hard on the banks about the pace of growth in investor loans, and in interest-only loans in particular.

So far it seems the banks are playing ball. We’ve seen all financial institutions increase mortgage rates, though there has been some pivoting away from investors and interest only toward owner-occupiers in the pricing.

Ask any mortgage broker and they’ll tell you it’s a much tougher credit environment, especially for investors.

Now let’s think about this from the bank’s perspective.

You’re in a competitive industry. Until recently the name of the game was market share – you were growing your mortgage book as fast as profit margins would allow.

But then along comes APRA and totally flips it on its head. You don’t get to say how fast your mortgage book is growing any more – at least to investors. APRA says investor loans can’t be growing at more than 10% a year.

They also put limits on investor only loans, saying they can’t be more than 30% of issuance.

Suddenly an industry that was spread out over a range of growth rates is pulled into a very tight pack. Every bank will want their investor mortgage book growing at 9.99%. They’ll all want 29.99% of their loans to be interest only.

Suddenly they’re marching in lock step.

So maybe you compete on price, but the pricing space was competitive already, so there’s not much you can do there, and you’re funding costs are largely determined overseas so it’s out of your hands.

So what do you focus on to get a competitive advantage? How can you separate yourself from the pack?

Loan quality.

Not all loans are the same. Some borrowers are riskier prospects than others.

So say you’re a bank growing very close to your 10% speed limit. You’ve got one more loan you can make before you’re maxed out. You have two choices in front of you. Which one do you go with?

The one that’s lower risk.

The aim of your game, if you’re growing as fast as you can already, is to start rotating your book into a higher quality portfolio.

That might mean choosing higher quality applicants over less quality ones.

But it may also mean going back through your book and weeding out lower quality ones to make room for higher quality ones.

And that might mean that interest-only investors, when it comes time to roll their loan over, might be facing a very tough time of it. The banks will be looking at them and saying, if I cut this borrower loose, will I be able to replace them with a better one?

I might be able to cut them loose and pick up a higher quality borrower, thereby saying under APRA’s speed limit, but improving the quality of my book.

Now that probably means passing a stricter eye over an individual borrowers circumstances, but knowing what we know about the banks’ business models, it probably also means differential preferencing for different geographies.

Banks might be saying, other things being equal, we’d like to replace Perth borrowers with Sydney borrowers…

… for example.

We are seeing some signs of this. Mortgage brokers in Perth are saying things are pretty tough right now, and APRA’s measures are a ‘sledgehammer’. From mortgage broker mag, The Adviser:

“The Australian Prudential Regulation Authority (APRA) has been castigated by brokers for its nationwide “sledgehammer” crackdown on interest-only loans, which have been labelled as “myopic” and “devastating” for regional Australia. 

Damian Collins, managing director of Momentum Wealth in Perth, told The Adviser that APRA’s moves to limit the flow of new interest-only loans were based on a “sledgehammer” approach that neglected to consider the impact on areas outside of Sydney and Melbourne.  

… Mr Collins said: “We got told in WA [in April], that for investor refinances, [lenders] are not doing them… so, you can tell APRA is definitely putting the pressure on the banks to manage their loan book growth, which is strange because in WA there aren’t a lot of investors doing anything at the moment.

“So, I guess [APRA] aren’t really looking at it state by state, they’re just looking at it as a global pull and finding any way they can to make changes.”

The Momentum Wealth MD went on to say that some of his clients in WA had previously been able to borrow around $2 million and, within a couple of months of the macroprudential measures being announced, that figure dropped down to $700,000.

Mr Collins lamented that the regulator had not taken a state-by-state approach.

“It’s like taking a sledgehammer to the problem and certainly has affected investors across the country… You’d think [APRA] would be able to do it better, but they haven’t,” he added.

Touching on the crackdown on interest-only loans in particular, Mr Collins said that the penalties now made this type of loan practically redundant for investors. According to the Momentum Wealth managing director, the repayments on some interest-only loans are the same now as P&I.

He said: “It’s at the stage now where, for a lot of our investor clients, we’re saying: ‘Get a P&I loan, it’s just not worth paying that premium for paying interest-only.’”


Looks like a pretty serious wind-back in Perth. But I actually reckon it’s worse than what this bloke is saying.

It is not that Perth is getting hit with the same stick as Sydney and Melbourne. It’s that APRA gave the banks the stick and the freedom to hit whoever they wanted.

For the sake of loan quality, they decided to hit Perth – hard.

That has the potential to create a self-fulfilling prophesy in some of these markets that are struggling.

I’m still watching Perth. I think there will be some bargains to be had. But I also don’t think its time to jump in just yet. Give it a few more months and see how the APRA restrictions and this loan-quality business play out.

Too soon for Perth?

Interest rates to go higher! (Here’s another reason why)

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S&P just downgraded the entire financial sector. The timing is suspicious, but I just can’t figure out who’s pulling the strings.

Ok, this is another story that really isn’t getting the air-time it deserves.

Effectively, S&P just downgraded the entire Australian financial sector. Yep. The entire Australian financial sector.

Effectively, they said that yes, actually, there is a property bubble. And that bubble is, in fact, dangerous. So much so that every Australian financial institution is more of a credit risk than they were before.

Yep. Every one.

Oh, but not the majors. No. The big four are too big too fail, the tax-payers have their back, so no worries there.

What’s more, the timing of this is really breath-taking. Just as the smaller banks were looking forward to a more even playing filed thanks to the big bank levy, bam, they’re hit with a ratings downgrade, making them even less competitive.

The Bank of Queensland CEO is pissed. Oh man.

And this almost certainly feeds through into the interest rates we’re looking at. For the 23 smaller banks affected, their cost of funds just got more expensive. What can they do? They’ve got to pass it on…

But the timing of all this really makes me think that there’s something going on behind the scenes that we just can’t see. I’m not sure what that is, but I have three theories.

But let’s recap in case you missed it because this story really isn’t getting the attention it deserves. So Standard and Poors (S&P) – a ratings agency which effectively tells people in the money market how credit-worthy other institutions are – has downgraded 23 financial intuitions in Australia.

They did it all in one go, effectively saying that an “increased risk of a sharp correction in property prices” was now a threat to the entire Australian financial system.

So we’re talking all our regional banks – BOQ, Bendigo, Adelaide Bank, BankWest…

The “big four” banks, however, managed to escape a downgrade because S&P believes they are likely to receive “timely financial support from the Australian Government” if something happens to the property market.

But then, after going on about the dangers of a “sharp correction in prices” and “economic imbalances” they do admit (so far towards the end of the press release that it’s practically a footnote), that actually, the “outlook for Australian banks remains relatively benign by global standards”.

So like, worry, but don’t worry too much.

It really is bizarre.

This isn’t about any institution in particular. Effectively they’re saying the entire Australian financial system is now a riskier prospect…

… because why?

What do we know now that we didn’t know at the beginning of the year?

They don’t point the finger at anything in particular. If something passed some sort of threshold to trigger a downgrade, they don’t say what it was.

And given everything else that’s going on in the past couple of weeks – with the bank levy and APRA’s second round of intervention, it just looks a little suspicious to me.

But I don’t know where to point the finger…

I’ve got three theories.

Theory One: It was the Big Banks

This is the most seductive theory. Effectively the big banks are so annoyed that the government turned around and stabbed them in the back with the Bank Levy, that they went out and had a quiet word to their mates/puppets at S&P.

As I said last week, I expected the big banks to come up with something big, and quickly. They have to hit back. They need to send a strong message, otherwise the Bank Levy could just go up and up and up.

Getting the entire financial system downgraded is a pretty strong message. Especially, when you get off scott-free yourself.

How do you like those apples, Morrison?

Theory Two: It was the government

At the same time though, this whole fiasco just focuses everyone’s attention on the reality that there’s one set of rules for the Big Four, and another for everyone else.

One of the best rationales for the Bank Levy was to claw back some of the funding advantages the Big Four got from their implicit government guarantee.

I don’t think most people understand just what a free kick this is.

So perhaps the government had a word to their mates/puppets at S&P and said, look, we need something that shows just how sweet the Big Four have it. If you wanted to downgrade all the minors, we won’t get in your way.

And so far the government has been surprisingly quiet. It is the kind of thing you’d normally expect to generate a lot of outrage.

S&P also downgraded China last week and the government there said that S&P had no idea how the Chinese economy actually worked.

But there’s nothing but crickets in Canberra.

Theory Three: It was the RBA and APRA

Another theory that holds as much weight in my mind is that it was the RBA and APRA.

So far this year there’s been a real shift in the tone of our regulators’ public statements. When it comes to housing, they’re suddenly talking tough.

Effectively, the RBA and APRA seem keen to “talk their way out of the problem”.

This is a classic play for the RBA. Remember 2003 when they started fretting about the “Sydney bubble”. A few warnings and a couple or rate hikes successfully took the heat out of that market, and things settled down.

We’re seeing the same strategy in action now. Rates are on the rise through APRA restrictions, and there’s a lot of jaw-boning going on. They’re successfully reshaping expectations.

The S&P downgrade fits perfectly into the narrative they’re trying to create. Economic imbalances have built up, and things need to be unwound in an orderly way.

So maybe the RBA and APRA had a word to their mates/puppets at S&P and said, look guys, a downgrade would really help us out right now – just a little one, just a little shot across the bows.

But which is it?

All of these scenarios seem plausible to me. But really, there’s no way to know. What do you think?

But at the end of the day, the least likely scenario in my mind, is that an independent ratings agency just decided to downgrade the entire financial system of an advanced economy, right in the middle of one of the most electrically charged political and economic climates in recent memory.

I’m not buying that for a second.

What do you reckon?

What game theory says banks will do next…

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Are the banks going to blow the whole thing up? Do they even have a choice?

I was talking about this Bank Levy business with a good friend of mine. He’s a smart man – has a PhD in mathematics and game theory. His take on the whole bank levy thing has really got me thinking… and a little bit scared.

On the face of it, I like the levy. The too-big-to-fail banks enjoy an implicit government guarantee. That means that if sh!t hits, the fan, the government (i.e taxpayers) has their back.

The markets recognise this situation, and so are willing to lend them money more cheaply. As a result, Aussie banks are some of the most profitable in the world:

Killing it.

Christopher Joye at the AFR reckons the government guarantee saves them about 0.18bps on their funding costs. So a levy that slaps them with 0.06% on their liabilities, only claws about a third of it back.

So it’s only fair. And it many ways it helps level the playing field with smaller banks who don’t have a government guarantee.

But as my friend pointed out, the problem is that this isn’t directly tied to their funding guarantee. It’s just a levy. Just a tax. Just because ScoMo said so.

And this makes it dangerous. The UK introduced a bank levy a few years back, and guess what happened? Since then they’ve jacked it up 9 times.

9 times! And why wouldn’t they? It raises a lot of revenue, and everyone hates the banks. It’s like free money. Whee.

And since our Bank Levy isn’t tied to anything either, what do you think the chances are that it will stay at just 0.06bps?

Would sod-all be a fair estimate? (That’s what my mate reckons it is.)

So think about this from the bank’s perspective for a sec. This is not just a one off cost that they somehow have to manage. Who knows where it’s going to end up?

Letting the government tax you now is like letting Dracula set up a catheter in your jugular and trusting him to only take as much as he needs.

(Just a couple of drops to tide me over to pay day…)

So there’s a lot more at stake here than the initial estimate of $1.5bn a year. It’s a liability that could quickly grow to $3bn or $6bn or $12bn!

So the stakes are high – much higher than I thought.

The question now is how are than banks going to play it?

So far, their response has been fairly predictable. And that’s because somehow the government did a good job of keeping it secret. The banks genuinely seemed to be caught off-guard.

And so their response has been pretty lame. It’s “tax by stealth”. It’s going to be passed on to consumers, or maybe shareholders. Jobs are at risk. It’s “playing fast and loose”. It’s poorly thought out and light on detail.

The banks seemed to be throwing up a bunch of muck and seeing what stuck. But all it did was just create noise, and by the time the banks had figured out their story, the front pages had moved on.

The PR battle has been fought and won.

And this is what makes me nervous. If the PR battle is won, what happens next? If you back a grizzly bear into a corner, what happens next?

As my mate says, the banks can’t afford to roll over on this one. If they cop it sweet, and spread the cost out across their consumers, shareholders and staff, all it says to the government is that cookie jar is open.

Next time you need the money, just dip in here first.

My mate says that the banks have to go hard and they have to go now. They don’t have a choice. Even if they lose this particular battle, they have to leave the government with enough scars to make any future government think twice about tapping the Bank Levy cookie jar.

If they don’t it will cost them another $6bn… at least!

So how would they do that?

Well, what does a banking sector on the offensive look like?

I don’t know what you reckon (I’m genuinely curious, let me know your thoughts), but I think whatever counter-offensive we see, it’s going to involve rate hikes.

A lot of rate hikes.

My friend reckons the dominant strategy for the banks is to hike rates so hard that they almost put the economy on the floor. … almost.

And I think they could do that. They could say, we’ve got the bank levy to deal with. We’ve also got APRA on our backs about shoring up our capital bases. Fine. You want us to be “unquestionably strong”? Here it is.

100 bps.

Bam.

(I’m in a pretty sweet position but even I would notice a full extra percent on my interest payments.)

And if they really wanted to stick the knife in, they could focus hikes on investors (since negative gearing would mean the government would actually get less revenue) while giving first home-buyers a discount to try and sway public sentiment.

They could also go hard on foreigners purchasing apartments to try and push the (already-shaky) apartment segment over.

100bps, overnight, would hurt. A lot. It could be enough to break sentiment in the property market and in the broader economy altogether.

It could be enough to bring on a recession, which would be enough to ensure the government was turfed from office.

And that, maybe, would make any future government think twice about tapping the cookie jar.

And ScoMo says he’ll be watching the banks closely, but it doesn’t matter. Even if the ACCC forced them to reverse course at some point down the track, you only need high rates for a short time to snap the neck of sentiment. A month would probably do it.

If my mate is right, it’s a dangerous situation because the banks’ strongest play seems to be to take the economy to the brink of collapse, if not over it altogether.

It’s killing me imagining what’s going on behind the scenes right now. It’s going to make a fantastic book one day.

If we make it through.

What do you think? Is my friend making a mountain of a mole-hill?

NO B.S. FRIDAY: The deep fear in the Australian psyche

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There’s a deep fear in the Australian psyche that makes the Bank Levy a political knock-out.

The more I look at it, the more the Bank Levy looks like a significant turning point.

One of the things that surprised me during the Rudd / Gillard years was how easy it was for the mining industry to kill off the Super Profits tax.

A relatively cheap PR campaign, a few full-page ads, a couple of pollies in the pocket and bang, it was gone.

Their campaign was so effective (and so cost effective) it has now become the standard in resisting government regulation.

And so now everyone is wondering if the banks could pull off something similar with ScoMo’s Bank Levy. Are they going to try?

Even if they spent a billion dollars, which would be an epic media onslaught, if they ended up saving themselves $6 billion, it would still be a great return on investment.

So they’ve certainly got the means and the motivation.

And on the face of it, it should be easy. The mining industry employs relatively few people, and is something like 85% foreign-owned.

The banking industry employs twice as many people as mining, and is Australian-owned by law. On the economics of it, it is much easier to make the “killing our jobs” case for banking.

So it’s a done deal right? The banks will fight and the banks will win, right?

Hardly. In fact, I haven’t heard a single person who thinks the banks could fight this one back. Most wonder if they’ll even bother trying.

It is true that the political context matters here. With the mining tax, there was an brutally effective opposition at the ready to prosecute the case for the mining industry.

In contrast, Labor has already campaigned hard against the banks, and has said they won’t be fighting this one. (What choice do they have?)

So the banks are up against a rare bipartisanship. That doesn’t help.

And it is also true that banks are on the nose pretty badly these days. There’s been a string of scandals recently. And not just the ones that involve rigging obscure market rates and ripping each other off. They’ve been personal. Real people have been overcharged, denied valid insurance claims, received bad investment advice, or had they mortgages unfairly foreclosed.

The mining industry might not be the greenest, cleanest industry in town, but compared to the banks, they’re model citizens.

And you’ve also got to remember the battler-bludger polarity in Australian politics. The more you can cast yourself as a battler, or pro-battler, the more votes you’ll get.

For the mining industry, this was an easy call. Mining is hard yakka. It involves real work – hot, dirty work out in the middle of nowhere. It involves big trucks and work-boots and hard-hats.

In a digital age, it’s one of the most ‘real’ industries we have left. Total battler country.

Compare that with banking. Banking involves sitting in an air-conditioned office and pushing buttons on a computer.

Other than blogging about property and macro-economics, work doesn’t get much cushier than that.

And banking is not real work. In that, it doesn’t make real things.

Finance plays a unique role in our economy – it’s a facilitator. It connects people with money with the people who need it, to make economic activity happen.

But it is not economic activity itself (even though it’s counted that way). And I think what we have to realise is that if our finance sector is growing (which it has been), then that means our economy is becoming LESS efficient.

That is, if the finance share of the economy is growing, it means we need more finance for the same level of output.

That’s not a good thing.

And I think there’s a danger that our economies tilt towards shuffling money around rather than putting that money to work. Think about the ever-expanding markets in derivatives of derivatives of derivatives.

People make money, but no one is better off.

Such is the nature of banking.

And I think the ancients cottoned on to this. Usury (making money by holding debt over people) wasn’t just illegal, it was immoral.

If you made your living by doing nothing but holding debts over others, you weren’t really contributing to society.

What’s worse, combined with a tendency for power and money to accumulate, you had the potential to create a dangerous parasite.

I think finance in the modern world has reached parasitic proportions. That is, it draws more energy from the economy that it gives back in return – which is why we see it growing and growing.

And I think people are genuinely worried about this.

Don’t get me wrong. Finance is an essential service. We need it. But this need is what gives the finance sector its power.

When you combine it’s essential nature (up there with air, water and wifi), with a parasitic tendency and a concentration of power, and you have something that people are genuinely worried about.

… even if they haven’t been able to name it until now.

So I think this is not just about the recent scandals. Those scandals just make this fear tangible – the fear that we’re living with a monster that we can no longer control.

This is the fear that the Bank Levy plays to.

And it’s why it’s such a political winner.

That said, I’m not sure random taxes here and there really address the issue. But I think it is a very interesting change in the game.

This is about making people feel like their fears are justified after-all, and validating the belief that the people should be able to control the finance sector that serves them.

(What a dangerous idea!)

As far as the banks are concerned this is what will scare them. Money is just money. But if the public believes they have the right to control them? Oh boy, look out.

So they’ll fight it tooth and nail.

But if what I’m saying is true, expect to see a war for the ‘story’. They’ll need to reframe this in a way that is not about the public bringing them to heel – they just can’t allow us to take that power.

It will be interesting to see how the narrative evolves.

Watch this space.

If you were the banks, how would you play it? (Assume maximum evil.)

The fun and games behind rate hikes

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What’s really causing banks to hike up their investor loans?

So I’ve seen a lot of people make a bit of a deal of the recent out-of-cycle rate hikes – especially people in the media. (Haven’t you got anything better to do with your time?)

No, I get it. It’s important. In the last week all the big four have jacked rates at least a little.

But it is interesting how much of a hoo-ha it has caused this time around.

So let me make a couple of points.

#1 – This isn’t really new
We’ve been seeing a series of out-of-cycle hikes since Trump took office back in November. Little by little. And nothing’s changed. The story is still the same. Bond yields in America are rising. Funding costs are rising. Banks need to pass it on to their customers.

Lol. Soz.

#2 – It’s still chicken feed
We’re generally talking pretty small amounts still. A few basis points here or there. Even putting them all together we’re still well short of the 25 basis points that the RBA usually moves in.

That’s not to say that it’s not putting a dent in people’s pockets, but it’s hardly time for panic stations just yet.

#3 – Credit is still loose
Even if we see this go on for a few more months, we’re still living through some of the loosest credit conditions in modern history.

UBS put it together in their Financial Conditions Index, which mashes interest rates, bond curves, exchange rates and asset prices. On their reckoning, we’ve seen financial conditions tighten in recent months, but not all that much.

The financial conditions index is the blue line, and you can see that it’s edged down towards the tighter end of the spectrum.

But track it across from it’s current levels and what does it tell you? It says that these are some of the easiest credit conditions since 2006 – so it’s hardly a disaster.

What’s more, the way they track it against GDP growth, they still reckon that financial conditions are still very expansionary – that is we should see further solid growth on the back of current settings.

Again, that’s hardly disaster.

#4 – The funding costs story is B.S
That’s what I reckon. Everyone’s talking about how much funding costs are rising, but it’s hard to see in the data. This chart here looks at CDS spreads – a proxy for funding costs – for CBA and some internationally similar banks. CBA is the grey line.

What it shows is that funding costs have been falling since the end of 2015, and are still falling!

Maybe there’s some stuff that’s being driving costs that’s not being picked up here, but even if there is, it’s hard to imagine that funding costs are surging all that much.

Which raises the question, what is it really about?

#5 – This is mostly politics
If you look at where banks are raising rates, so far it’s mostly been focused on investors and interest-only loans.

Now if it really was all about funding costs, why focus on investors? Do investor loans cost the banks any more than owner-occupiers? Do their funds costs more depending on where they end up channelling their funds?

Do the forms for interest only loans cost more to process?

Of course not.

So there’s another game going on here. And that’s about the banks trying to get ahead of the curve of any regulatory intervention.

There’s a growing clamour for regulators to get a lid on the Sydney and Melbourne “bubbles”.

(Yeah, I know.)

The banks are also on the back foot right now. They only just fended off calls for a Royal Commission and they know there’s no political mileage in sticking up for them.

So they’re on notice.

They also want to avoid any regulatory limits because they like money. They’re making hay and they don’t want it to end. And any regulatory limits just limit their flexibility to run their business as they want to.

So they’d rather avoid it if they can.

So what I think they’re doing is throwing the regulators something.

“You don’t need to regulate us. Look, we’re already making it tougher for investors.”

I don’t think it’s going to be enough. I still think we’ll see APRA action in some form or another in the near future. But we’ll see.

#6 – It’s not the end of the world

Since this is still fairly small fry, and since this is mostly domestic politics rather than some fundamental seismic shift in the financial landscape, it’s not the end of the world.

There are always risks to the outlook for property. Always. But right now, this funding costs BS isn’t one that keeps me up at night.

Don’t let it get to you.

What do you think the risks are here?