How many times in investing are we given the opportunity to capitalize on a theme that has just played out in fantastic fashion?

Shorting Australian real estate is just that opportunity.  Given the recent experiences in the US, Ireland, Spain, the UK (& soon to be Canada), Australia is on course to match, or even exceed, most of those housing declines.

We spent one week last summer in Australia where we met representatives of the RBA, notable housing bulls and bears, as well as real estate agents from Melbourne to the Gold Coast.  We even posed as potential home buyers and witnessed an (unsuccessful) auction.

We came away more confident that the average Australian homeowner was way over-levered and in denial of the pending doom.  There was a certain kind of arrogance from many of the bulls (Christopher Joye being the most arrogant of the bunch).  The bulls claimed to be keenly aware of the American experience and did their best  to sell us their version of “it’s different over here”.

In our opinion, house prices are a function of credit growth and psychology.  When both are positive, prices go up.  When price growth outpaces income growth, you have a problem.  When homeownership becomes a national obsession, you have a problem.  To get a better understanding of the roll of credit and housing, go to Professor Steve Keen’s blog, http://www.debtdeflation.com/blogs/

One of the main papers (The Financial Review) came out with an article a week or two ago titled, “The Slow Death of Housing”. Plenty of interesting stuff in the article but one quote caught my attention.  “Conversation at the dinner table has turned from ‘how big is your home to how small your mortgage is’”.  The psychology has finally turned bearish.   Up until late last year, 8 out of 10 articles or news programs was bullish on housing, now 8 out of 10 are bearish.

Primer on Australian Housing:

• The majority of mortgages are floating rate and are based on whatever premium the large banks put on the overnight cash rate (“OCR”).  Currently, it stands at 4.25% (http://www.rba.gov.au/statistics/cash-rate.html) and mortgage rates are somewhere around 6.7%.
• Mortgage debt to GDP is around 90%, almost 20% higher than where the US peaked in 2006.
• Median house prices to median income (& these numbers are refuted by the bulls – yet I couldn’t get them to explain why median home prices to median income was the wrong way to look at it) peaked at over 6 times on a national average.
• Mortgage interest is not deductible but they have a nifty little tax clause for property investors called negative gearing.  **** Pay attention here – most properties do not produce positive cash flows.  It actually costs the investor to rent it out, yet they can claim the difference as an expense for tax purposes.  No + cash flow?  Make it all up on capital gains?  Hmm.. doesn’t sound like a good combination to us.
• Auctions and clearance rates.  Homes are sold literally on the front steps of a home.  When a homeowner decides to enlist an agent to sell the property, they market the property and provide all the due diligence necessary for any potential buyer to make an offer.  The agent then brings in an auctioneer to hold the auction.  When we attended one, the auctioneer literally stood on the front steps and talked like he was selling cattle.   The clearance rate is the % of homes that sell on auction day.  During the height of the bubble (back in 2005 or so), clearance rates were above 70%. Now they’re well below 60% …and sometimes below 50%.  So, when you walk by a Ray White branch office and see all those houses listed for sale on the window, it is because they failed at auction. 
• Loan approvals.  This, according to some real estate “experts” is a leading indicator.   Ex re-financings, it’s trending down (Louis Christopher of SQM Research tracks this on his site).

Myths:

• China’s demand for everything Australia digs out of the ground makes the secular growth in Australia the cushion that will absorb any price declines (by the way, this is a nice backdoor short on China.  As Dylan Grice of SocGen said recently, "What do you call a credit bubble built on a commodity bull market built on a much bigger Chinese bubble? Australia"). 
• Australia is a two speed economy.  The collective wealth from the mining industry has not been a boon for retail.  Retail is in the dumps. Their cost structures are out of whack, which is surprising given their proximity to China, Taiwan, etc.  We saw a pair of Nike sneakers at a Foot Locker in Sydney that was listed for 165 AUD, vs $69 at Dick’s here.  Coupled with a strong Aussie dollar, consumers are buying internationally. 
• Unemployment.  Still around 5%, but many have argued that there’s been a shift where many have taken part-time jobs or jobs that are well below previous income levels.
• Location. Coastal living is more expensive (I love this one) so housing should be more expensive, much like coastal living in the US vs the interior.  Where else are you going to live in Australia?  I’m sure you can grab a nice plot of land in the Outback.  You can only live on the coast (with the exception of their capital, Canberra).
• Banks are conservative lenders.  Nope. The average mortgage debt as a percentage of after tax income is north of 50%.  Per Residex’s President’s recent letter, it’s 60% for a Sydney resident.
• Any housing correction would be a measured move.  Really?  House prices trend to income growth and overall affordability.  At 450K AUD as a median house price in Australia (give or take), and 6.5x median income implies median income of approximately 70K AUD (after tax, dual income).  Assuming 20% down, and a stamp tax of approximately 20K, that means the home buyer would have to plunk down 110K AUD to get the keys.  Most loans are not 20% down. It’s just too much money.  Go on any mortgage site and plug in the mortgage criteria. I’ve come up with being approved for a loan that would have required 60% of my after tax wage, with a lot less than 20% down.
• Loan to Value Ratios are low.  That is misleading on two fronts.  One, the prices of homes are high by a factor of 2.  A normal housing market should see a ratio of median home price to median income of 2.5 to 3.5.  At 3 x 70K after tax income, you’re looking at 210K in median home prices, some 50% lower.  The other issue is that it includes the value of all homes and all mortgages.  The homeowner without a mortgage skews this number.

Another great resource, other than Professor Keen, are the guys over at http://www.macrobusiness.com.au/. They’re sharp guys.  It seems that the bears always do better homework.

Two arrows in the quiver:

There are really only two ways the government can deal with a housing correction.  One is via monetary policy (the RBA has an inflation target range of 2 to 3%. Inflation is believed to be running well below 2% currently, leaving them plenty of wiggle room to reduce rates).   Also, see http://www.macrobusiness.com.au/2012/04/here-come-the-rate-cuts/

The other is fiscal policy.  Australia is in control of their own currency and they have a total Debt to GDP of under 30% (don’t quote me exactly here).  They have plenty of room bail out the banks and drop interest rates.  You can short interest rates by buying a receiver swaption (tie it to the 5 year or 10 year Australian Gov’ Bond). 

You can short the banks (or buy CDSs on them).  We have avoided CDS due to the government’s ability (and high likelihood) to save the banks. The big 4 are ANZ, Commonwealth, Westpac, and NAB.  Collectively, they are 80% of the mortgage market and 50% to 60% of their assets are tied to residential mortgages.  At more than 2 x tangible book, the odds of the banks going up another turn of book is possible, but unlikely. They pay dividends, so your carry is negative. 

In the face of the global financial crisis (they all refer to it down there as the “GFC”) the RBA dropped the OCR to 3% and the government initiated the first of two first time home buyers credit programs that stopped the house price declines.  As the world began to recover from the depths of 2009, Australian housing resumed its trajectory.  If you look at the price trends, supply of homes, velocity of sales, loan approvals etc. now versus 2009, one could argue that it’s finally the end game.  Home sales are back to 1996 levels. Rates will likely go much lower than 3%.  Owning receiver swaptions with a strike of 3.5% and having the OCR go to 1% would be an absolute home run. It is difficult to give you an exact quote on them given they vary significantly between banks. Ideally, one would shop among the big dealers.

Valuing these swaptions on a monthly basis can be aggravating.  It’s driven by the demand for hedging.  Lower vol = lower values when out of the money.  If rates don’t come down fast enough, the duration of your trade becomes very important.

Many of the ratios look great now.  For example, Westpac’s impairment charges on loans written off to average loans (%) are still low (.38) but they are more than double 2007. Westpac’s total housing related loans as a percentage of total loans are 50% (351 billion AUD) and loan loss reserves are less than 5 billion.  Equity as a percentage of total assets are 6.5% and as a percentage of housing related loans it is less than 12%.  A real correction can play havoc with their loan loss provisions, delinquency rates etc as well as their earnings power.

The banks are also more reliant now on offshore funding than ever before.  Offshore funding stands at more than 30% of total deposits, more than double the level in 2000.  Household deposits as a percentage of total bank deposits are almost 50% lower than 2000 (down to 22% or so from 35 to 40%).

Net margins have also been marching lower.  They’re around 2.2%, down from north of 3%, despite a rising housing market and mining boom.  Offshore funding is inherently more expensive and likely a little more ephemeral than domestic savings.

The bulls made a point of showing us charts comparing the housing related ratios of US banks to the Australian banks.  In our opinion, the comparison is flawed because it assumes both countries are in the exact same house cycle (or secular trend).    When the correction begins in earnest, we will be able to compare the housing cycles and we’ll likely find an eerily similar relationship between the US and Australia.

Risks:

We think the main risk is time.  We’re convinced housing will crash but they always take longer than you initially think.  We remember thinking housing was getting crazy in the US in 2002.  It took another 4 years to crack, and even after the initial crack, it took another couple of years for the banks to collapse.  In the case of Australia, house prices cracked during the GFC.  They rebounded when the RBA dropped rates and the Government initiated the First Time Home Buyers Tax Credit.  Those were only temporary stop gaps, on what we think is a secular retreat. 

The banks have the implicit backing of the government.  Yes, the banks could survive, but given what happened here, the banks would be trading at a fraction of book value.

Biggest risk is that China will continue to purchase Australian commodities in substantial quantities and the secular commodity bull market will continue and Australia’s mining riches prop up the faltering retail and housing industries. Even with that the housing bubble could collapse of its own weight.