“Hey dude, I have a question for you.”
“Why so serious? I mean, all you do every day is write about the worst-case scenario. It’s depressing. Who died and made you the harbinger of financial doom? How about something positive for a change?”
“Is that code for, ‘buy me another beer?'”
“No, seriously. It’s not all bad all the time is it?”
We’ll tell you how we answered our friend’s question below. But first up, the markets. It was another red day in New York, with Dow stocks down over one percent. Tech stocks on the Nasdaq – the ones enjoying a bit of euphoria renaissance – were down 2.67%. September new home sales in the U.S. fell 3.6% from the month before. The Aussie dollar shed 1.44% against the greenback.
Is that all just noise? Or is there a melody building in the markets? The chorus chanted by Ken Henry, Wayne Swann, and most of the media is that the strong Aussie dollar, the strong market, and the strong(ish) economy are all factors of Australia’s great policymaking and unique relationship to the China boom.
But the alternative tune – the one which we’ve been humming – is that most of the rally in stocks since March and most of the 30% rise in the Aussie dollar is a result of the carry trade. Yes, Aussie assets are relatively more attractive when the cost of capital in the U.S. is zero. But this can change in a flash when foreign speculators change their trading minds.
That’s just what happened last year. Only then, it was both a dollar and yen carry trade that led to a rise in Aussie assets. Once the credit crisis set in, the yen carry got dropped and investors fled risk assets and piled right back into the greenback and U.S. Treasuries. Stocks fell, commodities fell, and the Aussie dollar plummeted to nearly 60 cents against the USD.
It doesn’t have to happen that way now just because it happened that way then. But since our main job here is to question conventional wisdom and offer you an alternative explanation, that’s the one we’re offering you. Beware carry trades promising false permanent prosperity!
But what about today’s earnings? ANZ followed up yesterday’s bad debts bonanza from NAB with one of its own. ANZ reported an 11% fall in net profits (to $2.94 billion) and a 46% rise in bad debts to $3 billion. But both banks hinted that the end of the “bad debt cycle” is over and that things can only get better.
Let’s take the other side of that trade. Again we’ll focus on two risks: access to foreign funding and asset values on the balance sheet. ANZ sourced more of its funding from domestic savers and less from short-term whole sale funding, according to its report. Aussie savers funded 55% of ANZ new loans for the year (up from 50%) while the company reduced its reliance on short-term whole sale funding by 17% (now just 17% of all funding).
What does that mean? It means the company is making plenty of new loans (you’d want to, especially to the housing market, to prop up the value of your real estate portfolio). But it means the company is relying a lot less on short-term borrowed money from overseas in order to boost lending to Aussie homes and businesses.
Whether it is doing this by necessity or by choice is big question. But all we want to point out is that if your economy relies on imported capital to finance investment (or consumer spending, or new mortgage lending) you’re vulnerable if that capital is not forthcoming. It’s great when the dollar is high and capital is flowing. But if those capital flows reverse, the banks may find themselves in a jam that even a government guarantee makes it hard to escape.
It’s not just us saying this, by the way. “We need to figure out how we can become less dependent on wholesale funding to finance our economic growth,” said Commonwealth Bank of Australia chairman John Schubert in last Friday’s Australian Financial Review. “It is not assured that we will get the funding into the future.”
No foreign funding, no continued housing boom. In fact, we’d be willing to say that a cut off from short-term wholesale foreign funding is just the sort of thing that could lead to a major correction in Aussie house values. Naturally, the government here would step into the mortgage finance market in a big way, and not just for non-bank lenders, as it’s done with the Australian Office of Financial Management buying securitised residential mortgage backed securities.
The U.S. government has done everything it can to keep the mortgage credit flowing and household net worth from imploding. Australia would do the same if it had to. But like in the U.S., this means more government borrowing to prop up the property market. More debt, higher interest payments, less capital available for lending to the rest of the economy.
But let’s assume for now the public sector does not enlarge again to Depression-era levels of debt. Let’s assume that Aussie banks have access to overseas credit. There is still the issue of asset values. ANZ says it is leveraged about 17 to 1. With $476 billion assets, that leaves it with about $28 billion in equity (according to how it calculates both assets and equity). And like yesterday, it’s fair to say that a few billion in loan losses and bad debts are hardly the sort of thing to wipe out that much equity.
That’s not where the real risk is, though. The real risk is to the asset portfolio. Twenty eight billion in equity capital is just under 6% of total assets. Or, put another way, a 6% loss in assets wipes out the equity.
A six percent loss in assets? Is that possible? The IMF and APRA have stress tested Aussie banks for scenarios in which large chunks of homeowners can’t pay their mortgages. They chuck in large corporate bond default rates just to make things more stressful. And after all that, they’ve concluded that most of the banks’ assets are solid and safe and unlikely to incur mammoth losses that would jeopardise the equity capital (solvency).
And maybe they are right. But we’re just saying…in a world dominated by massive credit write downs…where we have just seen six months of re-leveraging…and where house values here in Australia have managed (thus far) to escape massive deflation…is a six percent loss on assets totally unimaginable?
We can imagine it, although we don’t relish it. Either way, we wouldn’t buy the banks just now.
But if you’re looking for the most over-valued asset class in the world – the one worth a punt for going short – it has to be U.S. government bonds. Paolo Pelligrini, the man who helped John Paulson make a mint shorting the U.S. housing market, told Bloomberg that shorting long-term U.S. debt is the “only attractive bet” going at the moment.
“I always like to think about assets that are likely to experience a breakdown; the only thing I’m pretty comfortable with right now is U.S. Treasury securities and U.S. agency mortgage-backed securities…I think that those are overpriced so they are attractive shorts.”
If you’re not going to short the U.S. long-term bond market any time soon, the take away from this is to look for assets that go up when U.S. bond prices fall. If U.S. bond prices fall it means U.S. interest rates go up. That might, for a bit anyway, lead to a stronger USD and a weaker AUD.
For a trader – other than cash and gold – we’d look to see which of those Aussie stocks hammered by the stronger Aussie dollar have been beaten down the most. They might be due for a quick rebound – although they will be fighting the general trend in the market. We’ll ask Murray what he thinks and get back to you.
So what did we tell our drunk friend when he asked us why were so critical, sceptical, negative, and gloomy all the time?
“Relax dude. It’s my job to plan for the worst case scenario. It makes me happy to have a purpose in life. If you want the best case, turn the TV on and turn your brain off. And I object to your overly negative characterisation of my work.”
“My work isn’t negative. It only seems that way because we live in a period of wealth destruction. I wish it were a world of wealth creation. But in a world of wealth destruction, you have to focus on preserving your wealth and maybe, when you can, growing it if you’ve got the big picture sorted out correctly.”
“But you make it sound like the end of the world every day.”
“It is the end of the world every day. But it starts all over the next day. And it is just the end of the financial world as we know it. Not the end of the world world…Besides, it’s a lot less scary when you face up to what is really going on and make a plan for it. Uncertainty is scarier than risk because with uncertainty, you have no idea what to expect. Risk you can at least manage.”
“But how can you be so sure you’re right about the big picture? Everyone else I talk to says there’s no way the dollar is going down as a reserve currency and that only kooks believe that. Are you a kook?”
“Certified. But that doesn’t mean I’m wrong. You can’t keep adding debt forever to fund your way of life. Debts have to be repaid. And interest has to be paid on the money you’ve borrowed. The politicians in America keep making new promises they aim to keep with borrowed money. This borrowed money is massively interest rate sensitive. And it’s in addition to a huge amount of money they’ve already borrowed. It’s the end-game for the whole financial/fiscal/political model.”
“But so what? Isn’t everyone else doing the same thing?”
“Well yeah. All fiat money is a scam. It’s a way for the government to run perpetual debts and steal savings through inflation. It’s an immoral living arrangement in that respect. But more importantly, from a financial perspective, it’s a way of funding a political arrangement. And that way of funding it – borrowing more and raising taxes on a small productive class to pay for a larger public sector – is every bit as dead as the funding model for investment banks.”
“But the government bailed out the investment banks. Who is going to bail out the government?”
“No one. Nothing. It will try inflation. But that doesn’t work. Printing more money to pay off your debts just destroys wealth. That’s where we’re headed. That’s what you should plan for. Sooner, not later.”
“I would like to begin my plan with another beer, if it’s all the same to you.”
for Markets and Money