2014 Sept ASFA Presentation

Your Economic Future: Bubbles, Bail-outs and Bail-ins?

Damian Lillicrap

September 2014

www.barenakedeconomist.com

Important information

This information is for general purposes only, without taking into account your financial objectives, situation, or needs, so it may not be appropriate for your circumstances.

These views are my views as an author, not my regular employer’s, whose views may or may not align on various subjects

www.barenakedeconomist.com

• Reflect on housing bubbles:

– China

– US

– Australia?

• Monetary policy & house price relationship

• Consider proposed “solutions”

– Increased bank capital

– Macro prudential – limit excessive loan to value ratios

– Risk sharing

Today

www.barenakedeconomist.com 3

Who thinks property returns over the next say 5 years will be:

a) 6% to 10% per annum or better

b) Better than cash returns up to 6% per annum

c) Cash like

d) Less than cash to slightly negative

e) Due for a significant fall

Poll the room

www.barenakedeconomist.com 4

• Easy reading but not dumbed down;

• The more you know the more you’ll find in it.

Some forecasts in the book - published Jan 2013:

• “it is also hard to see rates rising significantly above current levels for a number of years; that is, rising and staying much above 2.5 per cent in the United States.”

• “My sense is that...growth in China will slow”

About me & my book

5www.barenakedeconomist.com

Why an interest in housing

– 2006/2007 I was worried about share market prices (especially the US)

– Came to believe:

• While there wasn’t a PE bubble

• There was an earnings bubble

• Funded by credit bubble related to a housing bubble

• Influenced by low interest rates

China

Has a housing bubble:

– The government has told us:

‘There are structural problems in China's economy, which cause unsteady, unbalanced, uncoordinated and unsustainable development.’

Premier Wen Jiabao 2007

Chinese Premier Wen Jiabao said that home prices remain far from a reasonable level and relaxing curbs could cause “chaos” in the market, indicating no imminent relaxation of cooling measures.

“We must not slacken our efforts in regulating the housing sector,” Wen said at a press conference in Beijing Wednesday, according to an English translation. A bursting property bubble would hurt the entire economy, and the government wants “long-term steady and sound growth” in housing, he said. March 14, 2012, Financial Post

China’s housing bubble

But:

– Gearing is low

– High savings – lots of parental and grand-parental help

– Little or no sub-prime

– They have macro prudential measures in place

No subprime, NINJAs.

Are there a common, simple set of

factors that are sufficient to produce

housing bubbles?


It is a very populous country but:

– There are huge vacancy rates possible 30% to 40%

– People are happy to buy properties and leave them empty

Why? People have believed that housing will produce good (significantly better than cash) returns


Market just over a decade old:

– It has mainly gone up, with 5% to 10% most years

– Shares have gone badly in recent years

– “Everybody” has wanted to invest in property

– “Everybody” believed property was destined to go up


It has low credit but:

– Even 50% leverage is enough to double the price of housing (incrementally of course)

– Which would require a 50% fall to get back to fair value

Credit seems important for bubbles

but doesn’t have to be excessive.

Vested interests - Authorities

Provincial/State Governments:

– Measured on GDP (historically)

– Development of land good for GDP

– Infrastructure funded by lending funded by land sales

Governments prefer property prices to

go up, they aren’t a good control

Vested Interests - Lenders

Banks* really don’t care if you pay too much for your home:

– The risk is on you

– They have a buffer

– Then they have a claim on you.

Banks control the price of houses:

– Most of us use debt to buy a house

– It is often the amount that we can borrow that determines what we pay

– What if banks said “We won’t lend if you pay that much!”: Prices capped?

– Banks test a house against the market, not the market itself.

*I’ll generalise and use the term banks to cover all lenders, given their dominance

Banks control the price of housing but

have little vested interest

Recipe for house prices

So China suggests for a house price bubble you need:

– People believe house prices will go up

• The more this happens the more they believe!

– Credit – but even 50% Loan to Value ratios is more than enough credit

– A lack of alignment between those controlling prices and those taking the risk.

– A mis-alignment of interest with other potential controls

Let’s see if it works elsewhere?

The US story

Recipe for a house price bubble – learnings from China:


– Credit

– A lack of alignment between those controlling prices and those taking the risk.


Common causes blamed for the US house crisis

– Excess lending 100% loan to value ratios

– Financial engineeringI’d suggest that these commonly

blamed factors are symptoms of the

problem, not the cause.

Securitisation

Sub-prime loans

– Brokers made loans, sold off to banks so didn’t hold risk

– Investment Banks packaged up loans into “securitised products” and sold off so didn’t hold risk

– Ratings agencies rated risk but didn’t hold risk.

– Buyers often relied on ratings so didn’t assess risk themselves, but held risk themselves.

All care but no responsibility.

No alignment!

Securitisation vs traditional banking

Traditional Banking

– Bank manger assesses loan

– Bank manager responsible loan

Securitisation

Sub-prime a symptom of lack of

alignment

Loan originator Banks

Ratings Agency

E.g. Local Governments In

Australia

RiskRisk

Creator/ Risk Creator Risk Assessor Risk Taker

Short Term Incentive

Higher through-put

Higher through-put

Higher through-put

Higher prices good, buy more

Better alignment of interest:

The bank manager cared if he

wrote a bad loan!!

Monetary Policy – Central bank alignmentUS Debt to GDP

Since ~1987 pretty much the only measure of economic imbalances for the Fed has been inflation

Source: US Federal Reserve, BEA, ‘The Statistical History of the United States, FromColonial Times to the Present’, Ben Wattenberg, Morgan Stanley Research

No infla

tion no pro

blem???

Rates down, debt up – who’d have thought

How is the debt utilised?

In theory, people borrow to build productive assets:

– Economy slows

– Central bank lower rates

– Businesses borrow more to build productive assets (e.g. Car plants)

– More productive economy

– Boost to the economy

Central banks like to pretend

this is the primary mechanism,

but...

But the debt mainly goes to buy existing assets

http://www.positivemoney.org/2014/03/creating-money-purpose-adair-turners-latest-speech/

How very low rates is

stimulating the UK economy.

Sustainable??

How is the debt utilised?

In reality most debt goes to buy existing assets!! For example:

– Economy slows

– Central bank lower rates

– People can pay more for the same house on the same salary

– House prices up

– People selling (generally older) more cashed up (than they would have been)

– Funded by people buying (generally younger)

– Cashed up people spend – boost to the economy

Not quite houses as an ATM

but not far off

Problem

Using debt to buy existing assets may boost the economy:

– But if rates revert to previous levels

– This boost is reversed!!

Solution:

– Don’t move rates back to previous levels

– In fact keep moving rates lower (the chart earlier)

Impact:

– Record low rates

– Record high debt

– Record high asset prices

The central bank was just

doing its job, but their

incentive is to boost, not to

control house prices – when

push comes to shove!

What was sufficient in China was present in the US:

Our house price bubble recipe:


– Credit

– A lack of alignment between those controlling prices (banks) and those taking the risk (home buyers).


• Governments

• Central banksEveryone is one the same side

http://www.google.com.au/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=rja&uact=8&docid=09Qrp_HtHj8WoM&tbnid=hEaC-ciZ0gwdKM:&ved=0CAUQjRw&url=http://en.wikipedia.org/wiki/MV_Cougar_Ace&ei=-5cJVMX2JoHn8AXPpoCIDQ&bvm=bv.74649129,d.dGc&psig=AFQjCNFQVlWJJ76Wgbr4Ey_OfX8mZ_IadA&ust=1410001249799771

Over very long periods house prices match inflation:

– Logically this makes sense

– House prices really can’t go up faster than wages to support those prices for ever page 25

How much should house prices go up?

From http://baobab2050.org/2011/04/02/the-herengracht-canal-perspective/

Here are US house prices against this chart page 26

How much should house prices go up?From http://baobab2050.org/2011/04/02/the-herengracht-canal-perspective/

What the central bank said at the time

'We've never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilise, might slow consumption spending a bit. I don't think it's gonna drive the economy too far from its full employment path, though.‘

Ben Bernanke July 2005

'House prices have risen by nearly 25 per cent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals.’

Ben Bernanke Oct 2005

Great. No problem then!

‘It is difficult to get a man to understand something, when his salary depends on his not understanding it.’ Upton Sinclair 1935

You know what happened next!!

“Real estate” is a “real” asset.

Real returns (i.e. Inflation adjusted returns)

can’t be large over the long term.

http://www.all-the-news.com/world-news/how-did-canadas-middle-class-get-so-rich

But Australia is different?http://www.debtdeflation.com/blogs/2009/04/06/steve-keens-debtwatch-no-33-april-2009-lies-damned-lies-and-housing-statistics/

Sure is different!!

Let’s step through the list.

Do you think most Australians think

house prices should track inflation

nowadays??

Have we got credit?http://www.afr.com/p/business/property/house_prices_flash_red_record_debt_MPI3fve6eztNMyT62R4P1J

Yes we have credit!

Does anyone really limit the prices?

Buyers:

– most of us don’t have a long term view

Banks

– They could turn off the tap

– They haven’t had teams that look to understand the fair value of the housing market – it’s not their risk

The RBA

– Has pushed back a little against bubbles, but monetary policy is a blunt tool

– But when push comes to shove they want to prime the economy.

Governments:

– Benefit from growth, and taxes when the market goes up

Risk taker – not qualified

Price controller – not their risk

Authorities tend to favour managing short term over long term risks - in a pinch

What ruins the party?

Typically

– Higher interest rates; and/or especially

– Higher unemployment

Post the mining construction boom:

– Ironically RBA seems to be hoping for housing to support the economy (and in turn support the house prices) – i.e. home building providing jobs.

But more houses probably isn’t good

for supporting a housing bubble in the

long run!

What happens if house prices fall

The economy will tend to slow, then...

Interest rates will drop (even lower), which:

– Supports the price of assets at higher levels - so those that paid too much for assets are bailed out (too some degree).

– Means lower returns for those saving (e.g. for retirement) so they are bailed in – they are worse off so that some one else is better off.

There are no good outcomes at this point, which is

why it is best to prevent bubbles

Bail outs!!

Bail-ins!!!

What needs to happen to prevent bubbles?

Not:

– Macro prudential (e.g. Limits on loan to value ratios) – China shows these slow bubbles but doesn’t prevent

– Capital adequacy – Makes banks marginally safer doesn’t prevent house bubbles

– Supply and demand – arguably house prices do find equilibrium due to market forces, but they experience massive swings taking 50 years – the lesson from Amsterdam

What needs to happen to prevent bubbles?

Yes:

– Education – will help a bit: i.e. That housing (if not overvalued) is a store of wealth, not a high returning investment.

– Lending could be more targeted – want money to go to new productive assets – not existing assets – probably best achieved by taxes not monetary policy.

– Risk sharing by the lenders – e.g. Fines if a house or group of house prices falls more than 10% in the next X years.

Housing is just too important to the economy

to keeping doing things the same way

The summary

House price bubbles are the result of similar base causes from China to America.

The Australian market is subject to the same weaknesses.

This suggests a bubble is inevitable – when not if.

House prices, when compared to inflation and wages, look high.

What is high can always go higher – it may not all be over – yet!

Better to prevent than try to fix up.

Best prevention is risk sharing.

I don’t believe risk sharing will really happen unless

we have a property crash.

Risk sharing by lenders – a plea!

I don’t believe that this will happen in the near term – not enough people understand/believe the risks.

Most of the audience probably doesn’t think that we

will have a property crash in the next decade.

If there is a significant sell-off:

The thing we will have missed is the need for better

alignment by those that control the price of houses

and those that take the risk for house prices.

Please ensure there is alignment going forward, so

we don’t do the whole thing over.

Thanks

Questions

Back pocket slides

Lower rates boost prices but lower future returns

Consider if rates fall from 10% to 5%:

– A property that was collecting rent of 12% may now look attractive at 7%

– The price of the property then rises

– But the rent falls relative to the price from 12% to 7%

– If we look at history, we might expect higher returns (based on one off capital gains) but we should expect lower returns.

As a rule: Returns higher, future returns

lower... But it appears human to be sucked

into believing in last year’s winner.

2014 Sept ASFA Presentation

Economy & Finance

Transcript of 2014 Sept ASFA Presentation