Sydney property: Don’t believe the Aussie big short

Steve Keen said Aussie house prices would fall 40 per cent during the global financial crisis. They corrected 6 per cent. Demetrius Freeman

by Christopher Joye

 

Short the big short. First we had Dr Steve Keen telling us Aussie house prices would fall 40 per cent during the global financial crisis (they corrected 6 per cent and Dr Keen was forced by Westpac’s Rory Robertson to hike from Canberra to Mt Kosciuszko for his forecasting sins).

Then Jeremy Grantham, founder of the $100 billion fund manager, GMO, told us in late 2010 that Aussie housing was a "time bomb" that was overvalued by 42 per cent.

When I publicly offered Grantham the opportunity to put a $100 million, three-year short against RP Data’s house price index, there was silence. Grantham was unwilling to put his money where his mouth was, which was smart given house prices climbed 2 per cent over the next three years.

Now we have a hysterical promotional report (the words "crazy" and "mania" appear 11 times) from hedge fund researcher, Jonathan Tepper, aided by his client, Bronte Capital, which recommends shorting the banks, mortgage insurers, property trusts and the Aussie dollar, because house prices are going to "fall 50 per cent in many areas in coming years".

Australian housing valuations.

Channeling Ryan Gosling in The Big Short, Tepper says "the Australian property market is on the verge of blowing up on a spectacular scale, similar to Ireland and Spain after the crisis".

"The feed-through effects will be immense…bank shares will fall sharply [and] the economy will go into recession." This will be driven by default rates spiking to 20 per cent "in line with the Irish experience".

To put that in context, the current 90-day default rate on home loans across the Australian banking system is around 0.5 per cent (among the lowest in the world) despite our internationally high mortgage rates.

While system-wide residential defaults only lifted to circa 1 per cent during the GFC, Tepper forecasts they will jump 40 times higher than current marks, or to levels that are twice as bad as US lenders experienced in the crisis.

Jeremy Grantham, founder of the $100 billion fund manager, GMO, told us in late 2010 that Aussie housing was a "time bomb" that was overvalued by 42 per cent. Domino Postiglione

Bronte Capital told its investors it started shorting the Aussie banks in early February after Hempton’s road-trip with Tepper.

This has been an overcrowded trade for 12 months and Bronte would have missed the 18 per cent to 34 per cent declines in the major banks’ share prices between March 2015 and February 2016.

Tepper doubtless convinced other clients to jump aboard. I have been inundated with calls from overseas hedge funds in recent weeks.

One of Sydney’s top real estate agents, Alex Phillips, says "UBS in New York and another hedge fund research group are coming to see me in my office to figure out whether there’s value in shorting our housing".

Channeling Ryan Gosling in The Big Short, Tepper says "the Australian property market is on the verge of blowing up on a spectacular scale, similar to Ireland and Spain after the crisis". Supplied

With 9 per cent of personal incomes forced into superannuation, which has the highest weights to listed equities of any pension system in the world, and much of the downside risk already priced into bank stocks, the short is, however, tricky and has been a historical "widow-maker" for hedgies.

Tepper’s report was published on February 22, presumably to spruik his clients’ positions. He duly scored a 60 Minutes interview on Sunday followed by a front page story in The Australian Financial Review on Wednesday, which was reproduced as the lead article on the nation’s most popular news site, smh.com.au.

On the day this helped smoke the majors’ stocks, which plunged up to 4 per cent, wiping-out as much as $15 billion in shareholder value. The cost of the banks’ debt funding also increased.

Most of the concerns highlighted by Tepper – including record household debt-to-income and price-to-income ratios, a dilution in lending standards, an influx of foreign buyers, record interest-only loan shares, unprecedented investor participation, valuations that are seemingly stretched well beyond fundamentals, and other bubble-like features – have been repeatedly documented by this column since 2013.

Yet many have also since been addressed by Australia’s regulators.  After we highlighted that banks were flouting rules released by the Australian Prudential Regulation Authority in December 2014 to cool investor loan growth and improve serviceability standards, the regulator promptly initiated an aggressive public crack-down.

Deposit requirements and repayment tests were significantly strengthened while investment loan approvals fell off a cliff. Banks like AMP temporarily stopped lending to investors altogether.

Aside from colourful taxi-cab anecdotes and impressions from live auctions that would not look out of place in the Big Short’s script, which Tepper naturally references, his report presents little new empirical evidence other than recycling well-known research previously cited in these pages and published by government agencies and other third-parties.

Despite arguing that house prices were up to 25 per cent overvalued, we correctly forecast double-digit growth in 2013 and 2014, strong single-digit growth in 2015, and capital gains at 1 to 2 times the pace of wages in 2016.

House prices did fall modestly in the final quarter of last year following unilateral rate hikes by the banks to compensate for equity capital costs. Yet, as we expected, they have risen 1 per cent over the 3 months to February 24 and by 7.6 per cent over the last 12 months according to RP Data’s index.

What Tepper and Hempton have overlooked is that it is actually easy to rationale current price levels through fundamental analysis.

Bank of America Merrill Lynch’s Dr Alex Joiner has demonstrated that if you take the median house price in 1985 and adjust it only by disposable household income growth between 1985 and 2015 and the change in borrowing capacity over this period (via generally declining mortgage rates, not loan-to-value ratios), you find that the 1985-adjusted value is 1 per cent above current median prices.

So the change in incomes and interest rates since 1985 imply that Aussie housing is fairly valued (actually slightly cheap). This analysis is crucially predicted on interest rates staying at or below their present marks.

If you think, as I do, that rates are going to eventually normalise, Aussie housing looks very expensive.

Yet the bond market currently implies that over the next 10 years the cash rate will only climb by about half a percentage point. Many investors also subscribe to this view. On that basis, there is nothing wrong with contemporary valuations.

This column pioneered the rationale for the big short of major bank stocks back in 2013. Yet it had nothing to do with house prices or default rates.

We argued that the major banks were overvalued because they were carrying insufficient equity capital, which allowed them to use excessive leverage that produced unsustainably high returns on equity (RoEs). This in turn justified the extraordinary 2 to 3 times book value premium the major banks’ share prices commanded.

Westpac was required to hold just 1.3 percentage points of equity against its home loan book, which meant it levered these assets 77 times. This was the secret behind the world-beating RoEs.

The majors have since been forced by APRA to more than double the capital they hold against mortgages in what has become the biggest deleveraging in modern banking history.

After raising over $40 billion of tier one capital since June 2014, the majors’ RoEs have started converging back towards their 10 per cent to 11 per cent cost of equity, which is what you would expect in a competitive market.

A normalisation in cyclically low bad debts and heightened price-based competition from smaller rivals that will soon be able to use similar leverage will reinforce this process.

After 30 to 40 per cent share price falls since March 2015, ANZ and NAB look like they are close to fair value with multiples of 1.1 to 1.2 times book value. Yet CBA and Westpac remain expensive at 2.1 and 1.8 times book and vulnerable to shorts.

Today the majors rank among the best capitalised banks in the world and, even after the resources recession, their non-performing loan rates are still half and one quarter US and UK bank levels, respectively, and one-sixth European bank arrears.

While Tepper and Hempton have contrived to attract enormous media attention to push their positions, they are almost certain to join Steve Keen and Jeremy Grantham as sideshows in Aussie housing’s animated history.

Read more: http://www.afr.com/real-estate/residential/sydney-property-dont-believe-the-aussie-big-short-20160224-gn32hj?login_token=nGinxJwfgZudyDdjU2MlwiSrIphy5qkjiLN0uKDQxL95Xw_3rjIWZUsJ_1zTxn-Ji95rxAXm0l0xY3MdvDtkkA&expiry=1456393039&single_use_token=yDay1DXUE2Os91p5uvWftDTkirnfxtHL3OSjc-pry1xm04-a453rkjS6Oi4TUU4b7UAy2yhiCHbajnR4PAnx7Q#ixzz41Agv68nn 
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