The Collapse of Complex Asset Values

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Now to the markets and the Australian government’s growing concern about the commercial property sector. The issue gained added urgency yesterday when Westfield Group said it would take a $3 billion write down and cut its dividend for 2009. It blamed U.S. property markets.

Access Economics economist Ian Harper told the Australian that the hip bone is connected to the leg bone. “If there is a major collapse in asset prices in the commercial property market, that could feed through into domestic housing,” he said. “Given the exposure of the domestic banks to housing…that is what we’re trying to avoid at all costs.”

He was referring to the plan announced over the weekend whereby the Australian government , in partnership with the Big Four banks, establish a slush fund to help commercial property owners roll over debt they cannot finance in the international capital markets. If they can’t do that, they’d be forced to sell assets to raise capital and equity levels. And when you sell assets in a distressed fashion, it tends to further accelerate the decline in asset prices.

Big subject. Very complicated. More on it below. In the meantime, let’s just remind question the basic assumption that the temporary provision of liquidity for borrowers addresses the larger issue of inflated asset values. It doesn’t. That means everyone here-from the government to the rate cutting RBA to the Banks-is trying to sustain the unsustainable (and they’re using your money to do it.)

Before we get to the collapse of complex asset values, more about gold and the dollar and the forecast for commodity stocks. Yesterday we mentioned that the expiration of the Central Bang Gold Agreement in late September this year may usher in a new phase for gold’s role as a reserve asset. Banks will start hoarding it rather than selling it.But what’s this? Yesterday’s Guardian reports that numbskull politicians in Germany want to sell the country’s gold in order to finance the stimulus package. This is a bit like junkie’s who sell their body for drug money. The addiction leads to debasement, while the high is fleeting. Coming down is even worse.

The Guardian reports that, “German Finance Minister Peer Steinbrueck warned on Wednesday against the central bank selling gold reserves, after a senior conservative said the Bundesbank could do so to help finance government stimulus measures.” See. The finance ministers understand the inherent value of gold as a reserve asset. Not only does Germany own 11% of the world’s gold reserves, but also, 64% of its monetary reserves are in gold, according the World Gold Council.

Why would the otherwise prudent Germans trade real gold for paper money? Well maybe they won’t, which is what we suggested earlier this week. “I don’t believe there is any chance of this being realised over the next year,” Eugen Weinberg told the Guardian.

Weinberg is a commodities analyst with Commerzbank. He added that, “Although the Bundesbank has a quota (for sales) under the Central Bank Gold Agreement, I don’t think any of it will be realised. Every time the gold price is rising, and every time the gold price is at some important level…(there is talk of this)…But I don’t think there is any chance of it happening. It is not in the interests of the central banks at the moment to sell this ultimate safe haven.”

Only a blockheaded bureaucrat with no understanding of monetary history would sell a nation’s gold at a moment like this. It’s a bad trade. But since when are politicians good traders?

If you’re looking for a good trade right now, by the way, Jeff Clark says you should sell the U.S. Dollar and look for a corresponding rise in commodity prices. In a note Jeff sent out to clients in the U.S. yesterday, he showed a chart like the one below.

The dollar index measures the U.S. dollar against a basket of other currencies. You can see that it rallied during the same period that investors flew into U.S. Treasury bonds and notes. It’s nice to invest alongside the Fed, isn’t it? But the very same week that the Bernie Madoff Ponzi scheme hit the papers, the greenback began to buckle, and whispers of a trillion dollar stimulus in Washington and Fed buying of Treasury bonds undermined the rally.

The trading action since then, Jeff suggests, is a deceased feline rebound. A dead cat bounce. This particular deceased feline may have run out of upward momentum. Yesterday’s close on the dollar index leaves it hovering just above its 50-day moving average. Look out below!

If the U.S. dollar gives ground, it may not be against the Australian dollar. But it could give ground against oversold commodities. The question is whether or not this will mean a rally in Australian commodity stocks?

You know our position based on the last two weeks. It will be hard for most sectors of the resource market to rally on stronger earnings this year for the simple fact that earnings aren’t going to improve a lot (energy, ag, and precious metals excepted). What’s more, you have the IMF reporting today that world trade collapsed by an annualised pace of 45% in the last three months!

Double Daloob! A 45% contraction in trade? Is that already factored into resource prices? Or does it suggest, as we believe, that there won’t be any recovery in industrial production this year, and thus no relief for industrial commodities and base metals (despite their oversold status?)

About the only good thing you could say is that the last few days indicate the amount of selling seems to have diminished in the resource sector. Leveraged funds and institutional players seem to finally have cashed out. That leaves room for a rebound, by virtue of their being so few sellers in the market.

But even if that’s correct, it only argues for a short-term rebound in most resource shares. This is not the Obama rally. But it is the rally you should sell into to liquidate base metals and bulk commodity positions, if our take on the situation is correct.

Now, back to commercial property and the “Bad Bank” idea in the States. A warning first, though. We’re thinking of moving this type of discussion to a weekly newsletter format, where we’d have time to edit it. It would be shorter, and perhaps not try your patience so much as we work through our thoughts here in raw format. Stay tuned.

In the meantime, consider the thought that Australia and America are headed down the same road to failure in their attempt to support asset prices, whether it be through a special fund for commercial property or a “Bad Bank” to buy toxic assets, as is currently being discussed in Washington.

Make no mistake, the idea of creating a new fund to finance commercial property is a mini-version of the “Bad Bank” idea in the States. You might say, charitably, that the Australian fund is designed to prevent the assets from going bad in the first place, whereas in the States they are ALREADY bad. In fact, that’s just what Wayne Swan is claiming.

“What Mr. Turnbull and Ms. Bishop don’t seem to understand,” Swan said in response to opposition criticism, “is that a collapse in commercial property prices would not only seriously impact on confidence, activity and jobs in the sector, but also risk undermining the stability of our financial system.” But why is that true? Why is a commercial property collapse such a trigger event?

Mr. Harper of Access economics said that the connection between residential property prices and commercial prices is “too close for comfort.” He’s partly referring to the fact that Australian banks own a lot of both. Falling asset values set in motion a now familiar and unpleasant cycle: deteriorating capital adequacy, the need to sell assets to raise cash, and the knock-on effect of forced asset sales leading to lower asset values. You can add to that rising unemployment as the business sector deleverages its balance sheet and both sells assets and cut costs (the biggest of which is labour.)But now we really come to the question that is probably keeping so many people up so late at night. Is there anything anyone can do to keep asset values where they are? There is $52 trillion in credit that went into driving those assets up. Take that credit away, and the value goes down. Incremental efforts to prop asset valued up simply won’t work.

There are two conceits or mistakes that lead policy makers to believe that they can prop up asset values. The first is that the lack of a price for distressed assets is what’s leading to the collapsing market value, not some fundamental trouble with the asset itself. This position-forcefully advocated by FDIC President Sheila Bair-is that assets values will “normalise” once the government helps establish a market and a “rational price.”

In an interview with the Wall Street Journal, Bair put it this way, “The idea here is that the aggregator bank [a bank set up to buy toxic assets] would buy the assets at fair value. Some are concerned that you’d have to mark the assets down to purchase them, but I think it could help provide some rational pricing, actually, for the market in some of these assets because we don’t have really any rational pricing right now for some of these asset categories.”

That’s not exactly true. How can the “fair value” price be rational while the market price is not? The assets aren’t trading because traders either don’t know what they’re worth or, alternatively, don’t think they are worth anywhere close to what the banks call “fair value.” Using government funds to establish the price is a loser of an idea for a simple reason: the government is not using its own money. It is not behaving rationally, out of self-interest, at all.

Other market participants (banks, hedge funds, private equity) ARE using their own (or shareholder money). So why on earth would those potential buyers concur with Bair-who’s spending tax payer money-that the price she’s willing pay for these assets is what they’re really worth? She’s got nothing to lose! It’s not her money! And therefore, it cannot possibly be a “rational price.”

Prices for financial assets ceased to be rational about the time Alan Greenspan ceased to have integrity as a central banker. But let’s give the man his due. He knew exactly what we were all getting ourselves into. In December of 1996 the then-Fed Chairman famously said:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

Here is an answer to Greenspan’s question: we know that asset values are due for an irrational escalation when the return on capital exceeds the cost of capital. And boy was that ever true over the last ten years!

The absurdly cheap cost of capital established by Greenspan and his central banking peers through interest rates-the cost of capital also being the price of money-did exactly what Mr. Magoo said it might: it grossly inflated asset values for ten years. As Dr. Kurt Richebacher so often explained in his letters, the only way to keep asset values high once the credit got into them (stocks and property) was ever larger amounts of credit creation.

But there is not a lot of credit being created now is there my Precious? No. There isn’t my love.

Perish the thought that cheap credit was responsible for the appreciation in asset prices. If that were true, it would mean we face much steeper falls in asset prices as the credit depression lengthens. It also means that if risk premia for stocks and bonds are to return to higher levels, then the cost of capital HAS to go up. After all, if money is cheap and easy to borrow, you wouldn’t expect to get much reward for taking borrowed money and buying common stocks. Yet that’s exactly what happened!

All of that is now unwinding. And there like a Paper Wall standing in front of the asset deflation and credit deflation are an army of paper mongers trying to print their way out of it. But further injections of taxpayer money, or even worse, public borrowing to subsidise commercial property values (or toxic bank assets) is worse than throwing good money after bad. It is the willing destruction of future capital and savings via borrowing and deficit spending. There is nothing “fair” about it. It’s unfair, unjust, and immoral.

The challenge for Bair and Obama is to get the market to want to pay something closer to fair value for the bad debt than the current market value. In other words, you have to turn the market for bad debt back into a marketplace where price tells you something about the value of the asset. If a reflexive fair-value bid from the Feds won’t do it, you need to rethink the plan.

Maybe there is no plan whereby investors are willing to buy the majority of debt securitised by U.S. houses. And that’s the deep dark secret no one wants to utter in public. These values have to fall by another 20-40% to begin looking reasonable. They cannot be supported these levels. The collapse of complex asset values built on credit is inevitable.

The notion that this is okay, that prices go in cycles and fall as well as rise, is somehow anathema to the modern mind. It’s the second reason that governments think they should and can prop up asset values. They believe, absurdly, that cycles are bad and can be avoided with proper policy and stimulus (Friedman-like monetary policy and Keynesian fiscal policy).

This position is both wrong and destructive. Not that policymakers are consciously trying to destroy value. It’s just what they naturally do.

When credit creation via global fiat currencies is unchecked (not restricted to available savings or tied to the value of a tangible good), then you get monumental resource misallocation. The decline in the cost of capital leads to a decline in investment discipline (risk assessment) and ethical discipline (Madoff et al). You also get a generation of home and property owners keenly interested in preserving asset values through government intervention just in time to finance a long-awaited retirement.

It’s perfectly natural that no one wants to see a lifetime of saving and investment wiped out by falling asset prices. It’s not fair. You play by the rules and you expect to get what you have coming. But the nature of fiat money systems is to inflate.

This is not a few fact. It’s been evident in previous growth cycles in which credit accelerated returns prior to going bust. It’s just the Boomers probably didn’t expect the bust to happen in their lifetimes. Yet here it is.

In fact, the sooner this cycle is allowed to operate naturally-destroyed the bogus value on bank balance sheets and liquidating the bad investments of the last ten years-the sooner we can move on to more organic growth. The new will replace the old. Institutions that fail to adapt will be replaced by healthier, better capitalised, and better run ones.

But in the name of “stimulus” and “recovery” and to supposedly correct the excesses of the market, none of the normal free market mechanisms to punish the excesses are being allowed to function. Instead of acknowledging that markets work in boom/bust cycles of progress, excess, and consolidation, today’s generation of policy leaders want to eliminate cycles to preserve their fictitious wealth and power!

It won’t work. But that won’t keep them from trying. More on the stifling effects of stimulus tomorrow. And we promise we’ll get to the question of whether economic growth is inherently limited by resource scarcity.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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7 Comments on "The Collapse of Complex Asset Values"

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Great article as usual. My question has always been why cant Aussies see that the big run up in house prices is nothing but crowding out caused by easy credit. They seem to all agree thats what happen in the US and UK housing markets but it couldnt have possibly happened in Australia. Next time you are read some flashy technical analysis (or simple clap trap from REI) for Australian house prices simply ask does their analytical methodology if used in markets we know had huge bubbles show them. You will get some reply like oh there is no bubble… Read more »

Does anyone else think it would be a good idea to use an analytical method which can indentify the bubbles that we know existed in other countries to look at the Australian market.? Maybe thats too revealing for the industry to consider. Believe it or not when you do, our housing bubble is far larger than anything the world has seen so far, except Japan in the early 90’s

BS&E: I think that ‘they’ would rip the method apart with the “it’s different here”(“IDH”) arguments :( You nailed most of the factors there, but I think another factor that contributes to the “IDH” arguments is that Australia’s economy has not been affected in parallel with other global economies. For instance, only now are we starting to see the housing correction take hold, but it is well established in the US and UK. Only now are we seeing the investment banks and highly leveraged companies complain, whereas this happened earlier in the other countries. I think we are seriously naive… Read more »

Thanks for the laugh Pete, I hadnt thought about “its different here” as IDH. Gee thats perfect for I’m D&^% Head for thinking its different here..

It will make me laugh everytime I here the spuikers use it.

Ah the old IDH excuse. :-)

Mate with 20 years of currency and Ag commodity trading and risk management experience. I cant believe the level of ignorance that exists amongst our so called Economists. Glad you said just some degrees I think mine has been put to good use over the years.

Yeah housing market in many parts of Australia is generally overpriced, and in some mining towns in particular was just ludicrous.There will be a downward trend, but the reserve did raise interest rates to slow down housing bubble some time ago and whilst difficult because of rising unemployment, the landing will be a bit softer in majority of australian housing markets, that parrot like following of other countries.There are a number of differences between countries and markets within those countries and you need a better analysis than talking down everything. Houses will fall and many with multiple leveraged investments will… Read more »
I can see where you are coming from Gerry, just remember that house prices ‘depreciate’ over time, it is only the land prices that ‘appreciate’. This is especially important for apartments. So that means 10 years of making no ground is actually losing ground on the housing/maintenance side, ignoring capital gains in land prices. Sorry, don’t take that as me disputing what you have said because what you have said is quite reasonable, especially disregarding housing as a pure investment. I guess I cannot dislodge my own thinking that housing will always be an investment of sorts, regardless of how… Read more »
Greg Atkinson
Pete, Gerry..the residential housing market in Oz looks great from where I am sitting here in Japan. Here I can only hope that the value of my apartment might hold some reasonable value in the future. By the way let’s not forget rental yields and interest rates. Many landlords in Sydney might not have done well in terms of capital gains, but rents in many areas have been rising and interest rates falling, so it isn’t all bad news. P.S. I posted some views about gold on the blog..if you get time have a look and please feel free… Read more »
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