The Geithner Plan

Right then. There’s no financial problem a little leverage can’t solve. So take a bow Tim Geithner. You’d better enjoy the glory while it lasts.

We’ll get to the details of the Geithner plan in a moment. And we also want to cover the thread that ties the Geithner plan to the Australian housing market. But first, let’s look at the market’s reaction to the plan and see where it takes us.

Investors appeared to absolutely love the U.S. Treasury Secretary’s plan to subsidise private sector purchases of toxic bank assets. The Dow closed up nearly 500 points, or 6.8%. The S&P closed up seven percent. The move gave stocks in New York their best two-week gain since 1938, according to Bloomberg.

The futures show the Aussie market opening up big, as well it should. BHP’s New York listing was up nearly eight percent. The financials should get a nice boost too. In fact, as we dissect the technicals and the performance of U.S. markets yesterday there are three things we need to mention here.

First, the Real Estate Investment Trusts (REIT) sector was by the far biggest winner yesterday. Of the five best performing sectors, four were REIT-related. And if you look at the top ten (see below) you can see all of them are finance related.

The Financial Economy Strikes Back!

Click to enlarge

Top-ten performing sectors on the U.S. market for March 23rd, 2009, source:

No one stands to benefit more from government-supported real-estate prices than real estate investment trusts. Well, no one except perhaps banks who cannot currently unload real-estate related assets without making themselves insolvent in the process. This explains why the money centre banks–JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) all rallied too.

The REIT performance struck us this morning because just yesterday we read a piece from Kris Sayce in which he tipped a REIT. We thought the man had gone truly mad. He is, after all, an Englishman.

But it turns out Kris is not mad at all. He’s added a regular feature to the Australian Small-Cap Investigator called “Radioactive Stocks.” Sounds dangerous doesn’t it?

That’s just the point. Kris takes a look each month at the most speculative punts on the market. And in March (the issue is due out later today) he reckoned REITs were one sector that would soar if the market rallied. We’ll see if he’s right today.

It makes sense that with both the Australian and U.S. governments effectively subsidising the real estate market (Australia more directly with Ruddbank than the U.S. with its new public/private plan), investors might place a higher valuation on the properties held by REITs. Not that it’s a sound economic policy. But it certainly may be a tradable move for punters.

That brings us to the second point about yesterday’s action. If Australia rallies in kind, how high could the rebound go? In an update sent out to members last week, Swarm Trader Gabriel Andre produced an ASX/200 chart and provided some analysis. First the chart below.

Swarm Trader Analyses ASX/200

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So what does it mean? On Friday Gabriel wrote that the chart, “Indicates a potential target for the current price action at 3,600 points. That’s 3.75% higher than the current level. The second objective (if the rally gains some momentum) is the second resistance oblique line that goes through the historical high of November 2007 (point A) and the lower highs of December 2007 and May 2008 (points B and C).”

“It would represent a further 30% upside move, with a potential objective at 4,500 points. However the immediate target is 3,600 points. It is more than likely that it will be hit next week.”

In fact the futures indicate 3,600 will be hit today. But will it hold? And if it does, is it possible the market could really all the way to 4,500?

Well yes. It IS possible. And it would certainly be the bear market rally nearly everyone expected at the beginning of the year (the Obama bounce). It also has the look and feel of a rally. It’s not so much the bears capitulating as the bulls being suckered back in.

This is what the bear does. He roughs you up. You play dead. He goes away. You think he’s gone. And you can’t help yourself. You get back in. That’s what investors are doing. But not all of them.

This is the final point we’ll make about yesterday’s market action. It was an unusually large up move on the Dow given the number of shares that actually traded hands. As you can see on the chart below, volume on the Dow yesterday was just over 500 million shares. First take a look at the chart and then we’ll tell you what we think it means.

You can see that most of the big volume days came on days the market closed lower (red columns). Even then, you haven’t seen large intra-day moves like yesterday’s on heavier volume. Last Friday saw heavier volume and a lower close, but not a big move in percentage terms. So what?

All of this is telling us that this is a paper thin rally that should be sold. The Swarm Trader concurs.

“Big moves on light volume are often tricky,” he responds to our query on the subject. “Moves like this on lighter than average volume are often generated by a few big orders that, because of the little liquidity, easily move the price.

“It is not significant if only a few ‘smart’ players take advantage of the spike, and typically days like this are not enough to create some momentum. Volume creates price. The price is only the ‘shadow’ of the volume that’s why it is so important to track the volume. If the volume soars, then the price will follow.

“You need some volume to push a trend up further. But when the volume stops…the momentum is over. I wouldn’t say the rebound is over yet at 3,641. But a bullish trend needs higher volume to be durable.”

Or maybe it needs more money. The last two weeks have been punctuated with big commitments by the Feds to inject money into credit markets and, indirectly, on to bank balance sheets. First Bernanke commits to buying $300 billion in U.S. Treasuries and $750 billion in mortgage backed securities and the market goes up.

Now, along comes a Geithner with as much as $1 trillion in tax payer funds to dole out to his private equity and hedge fund buddies and we get another rally. Really…who doesn’t like free money to you change your life? No wonder Wall Street is partying it up.

By the way, Bank of America’s Richard Bernstein rained on the parade at the end of the day, telling clients to sell bank stocks after their two-day, twelve percent rally. “The history of bubbles shows quite well that financial sector consolidation is inevitable,” Bernstein wrote. “Financial stocks will be attractive when the government tries to speed up that inevitable process. However, to the contrary, the government continues to attempt to stymie that inevitable consolidation.”

Not exactly a ringing endorsement of the rally from an insider working for one of the firms at the heart of the crisis. But the man has a point. And we’ll get to the Geithner plan in just one quick second.

First, we need to correct an error. Last week we wrote that the global economy would not recover this year because, in part, “You still have massive over capacity in global production (demand far in excess of supply).” A few alert readers pointed out that we meant “supply far in excess of demand.”

Sorry about that. We sit corrected. Incidentally, the outlook for the global economy hasn’t improved much for last week. The World Trade Organisation is predicting a nine percent contraction in global trade this year. Its report doesn’t come out tomorrow, but if global exports shrink by nine percent, it’s not going to be good for Aussie exports.

In fact, Dun and Bradstreet’s Global Economic Outlook released yesterday says Australian GDP will shrink by 0.2% in 2009 instead of expanding by 0.5% as it previously expected. “A collapse in world trade, particularly in the Asia-Pacific region, and a sharp drop in economic growth for China have significantly heightened the downside risk to Australia’s outlook.”

You can say that again. But please don’t.

The more frightening projection from the D&B report is that it reckons Chinese GDP will come at just 3.5% in 2009, a full six percent lower than the 2008 growth figures. “While there are a number of concerns for Australia, the most significant will be the decline in forecast economic growth for China, which has fuelled much of Australia’s growth over the last decade.”

Much lower Chinese growth will have social implications for china. But it also has budget implications for Australia. With Aussie exports to China falling, tax and royalty revenues decline further. Perhaps that’s why Treasurer Wayne Swan is already preparing the public for a $50 billion budget deficit and another stimulus package.

All of this adds up to a very contrarian idea: this rally may be your last best chance to sell stocks this year before the market tests new lows. Your risk, the bulls will tell you, is that the Geithner plan put a bottom under stocks and the recovery can now begin.

If the rally continues, it’s going to severely test the resolve of those who are paying attention to the economic trends that lead corporate earnings. But hey…that’s why they call them markets. There are always two sides to every trade. Someone is going to win and someone is going to lose.

Speaking of losses, how about another quick foray into the Australian housing market? Could it be we have been wrong in predicting a house price correction/crash for two years now? Is it possible that Australia’s bubbliest days are head? Is it possible that Australia is just now repeating the very same mistakes that led the U.S. into such a mess in 2004-2007?

Yes. It is possible.

“Australian housing market holds sub-prime danger,” write Glenn Milne and Nick Gardner in the Sunday Telegraph. “Australia is facing its own version of the US sub-prime housing crisis, with thousands for young homeowners risking bankruptcy as a result of Kevin Rudd’s stimulus package,” they write.

The article goes on to feature the work of Dr. Steve Keen, whose work we’ve published here before at the Old Hat Factory. The argument is simple to understand, too. The only way to keep house prices abnormally high is to suck ever larger numbers of borrowers into the market.

The government is doing just this with the first home buyers grant (FHB). It’s doing so under the guise of “affordability.” But in fact, it could turn out to be the worst financial decision many of these couples in their mid-twenties ever make. Why?

They will have borrowed a huge amount of money at just the moment when home prices in Australia are reaching their peak. What’s more, these are the most marginal borrowers left. They are the most vulnerable to losing their jobs. And because they’re just getting started in their careers, they are likely to be under the most mortgage stress of any borrower (paying the largest percentage of disposable income to the mortgage).

These new homebuyers face a dual risk. It’s hard to say which is more dangerous right now, unemployment or higher rates. Most of these new buyers are getting into the market at the low point in the interest rate cycle. Because Australians favour the adjustable rate mortgage, these new buyers will have maximum exposure to rising interest rates.

The more you look at it, the more it looks like the government is doing its best to saddle a generation of young Australians with a lifetime of debt they can never hope to repay. Sure, it’s good for the banks. They can grow their loan book. And because most home loans in Australia are “recourse” loans, the banks don’t have to worry about being saddled with a bad debt.

This is a key point. Many Aussie analysts highlight the “non recourse” nature of the U.S. market as one reason why house prices can’t crash in Australia. They say that in the U.S., the borrower can simply walk away from the loan if the market value falls below the mortgage. You get “jingle mail” where the borrower-who has no interest in continuing to pay on a property that’s worth less than the mortgage-sends the keys back to the lender and moves on.

You can’t do that in Australia. In Australia, the bank can do more than just seize the collateral (the home) put up for the loan. It can come after your personal assets too. The bank has “recourse,” the borrower does not.

Some have argued that in the 1990-91 recession, unemployment rose but house prices did not fall. They cite this as evidence that Australians “fight” to stay in their homes even during tough times and this puts a floor under house prices. But this is nonsense.

Whether you can afford your house is not a question of how bad you want to stay in it. It’s a question of whether you can really afford your mortgage payment. As the chart below from the Treasury shows, interest rates were already on the decline in 1991. This meant that those people who did lose their jobs in the recession at least found some relief in lower mortgage rates as the rate cycle headed lower.

The Interest Rate Cycle and Aussie Savings Rates


Today’s first home buyers get a big fat government check to help cover stamp duty. And they get one to two years of fixed interest rates on a massive loan. And after that? They are fully exposed to rising interest rates. They have little in the way of savings or other assets for the banks to chase after should house prices fall.

So yes. It’s true. Australia does not have a sup-prime problem. But by incentivizing the marginal buyer to come into the market just now, the government may be sowing the seeds for first a spike in home prices and then later, the inevitable correction. The credit boom made Australia’s houses some of the most expensive in the world. For now.

The other nasty side effect of the credit boom is the high household debt to income ratio. The boom suckered people into taking on big mortgages at ever greater multiples of income. Now, these borrowers face the prospect of losing their come in a recession.

Australia’s Household Debt to Income Ratio


But won’t this all be fine if the government sends another stimulus check to these households? And won’t it all be fine if the RBA cut rates at its next meeting? After all, it looks like rates are headed lower, not higher, and the government is there to hand out money to anyone who needs it.

Well, all of that is wishful thinking. A one-off payment of $900 is not enough to bail someone out of a $450,000 mortgage (the median home price in Australia), especially when the bank can come after your personal assets.

We meant to take a closer look at how to structure your assets for falling property prices. But we’ve run on long enough already. We’ll save that-and a fuller breakdown of the Geithner plan for tomorrow. For today, let’s consider the possibility that the first home buyers in Australia, at the encouragement of the Federal government, are walking into a lifelong financial nightmare from which their credit ratings might never recover.

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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8 Comments on "The Geithner Plan"

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Call the Geithner plan for what it is. A benevolent fund for Bill Gross and the bank managements. The loser is guess who the taxpayer. Give a bunch of cronies buckets of taxpayer money to which they add a nickel or too and tell the to “use it or lose it” and of coarse they will bid back toward phoney asset price levels. And the Bill Gross’s will take positions to make money on their nickels when the asset prices do collapse and those positions will take more money from the even lower asset price bottom as a result. The… Read more »
Here’s a serious question for the DR brains. If we’re headed into an inflationary period, wouldn’t investing in quality real estate work well? Of course, ‘quality’ is a loose concept, but real estate in locations which have traditionally performed well, popular suburbs, inner city areas, etc. If we assume that the Australian government will follow the UK and USA example and print money to hold up property values, then wouldn’t it follow that borrowing money in 2009 dollars and purchasing property work out well, because residential property has an intrinsic value to the owner (somewhere to live)? So, even if… Read more »
Mr T
Great question brc, I have been searching the net for more insight into this concept and would love to hear what the DR brains have to say! My concern with this investing strategy is the RBA’s reaction to high inflation, will they raise interests rates? And by how much and how quickly? As they sure came down quickly… It would be a sure way to burst this property bubble fueled by first home owners jumping into the market with rates at record lows. Would the property prices tumble? It would be suicide… to raise the rates in order to contain… Read more »
The Outback Oracle
brc My thinking is that inflation is not uniform. In the past we had inflation in house prices (and other assets) but not in consumables, mainly due to the Chinese factor. Most of the inflation we are about to see will be in goods we consume. Further it may well be mostly in goods we import (China will be exporting inflation instead of deflation). So petrol might be $3.00 per litre. This will result in a flow-on into food prices etc etc. Wages will not keep pace with inflation. Interest rates will rise, possibly dramatically, although interest rates will still… Read more »
brc: I partly agree with Outback Oracle here. I think I have commented on this topic in the ‘other’ article. Consider: Interest Rates:- why will your mortgage be eaten away by inflation? Do you really think that banks won’t raise rates to at very least equal the rate of inflation, if not exceed it? If you were a bank, isn’t that the minimum you would expect? I think a basic formula would be something like: Interest rate = inflation rate + risk premium + expected profit margin The Government – to bank (no pun intended) on the fact that our… Read more »
BRC, cool your heels. Wait for the asset deflationary cycle to hit and then buy the lowest of servicable low income housing (that occupied by those that will receive government assistance sufficient to cover the lowest of rents). Yes cost of living inflation will raise real estate prices to the point where your return determined by the rental income typical of that worked out by a public servant to cover the current interest bill on the then current property value but even the lesser inflation (less than the cost of living basket) that hits your low income house price will… Read more »
Greg Atkinson
I honestly do not think the central banks and politicians are thinking too far into the future and my fear is that central banks will overshoot the mark with interest rate cuts. That means at some point I am guessing the inflation genie will be out of the bottle again and in a high unemployment environment that could be very nasty. The question I keep pondering is this: has demand for good and services really dropped by so much globally or is it just that at the moment a lack of confidence and money slushing around has merely put a… Read more »

Greg, think about the ratio of discretionary vs non discretionary spending and the change in that ratio in the past 30 years in the services based economies. Look at Piers and examine the commodity mix and that discretionary traded goods sector’s volume growth from 1990 through to 2007 on the China-US (incl Hong Kong transhipment) trades. So now it is inflation that will hit the non discretionary and currency-commodity combo led inflation, equally the collapse and the countervailing deflation in the discretionary traded goods and services sectors.

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