The Broyhill Letter (Q2-10)

8/9/2019 The Broyhill Letter (Q2-10)

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T H E B R O Y H I L L L E T T E R

House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a nationallevel these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steadyrates of household formation, and factors that limit the expansion of housing supply in some areas.

Current Chairman of the Federal Reserve, Ben Bernanke, 2005

Executive Summary

While most investors today probably understand that Europe isnt exactly a poster-child for prudent government spend-

ing or budget planning, were not sure that the consensus is bearish enough on the spillover effects from a prolonged

European Debt Deflation. Exports are still the foundation of the China story, but with their largest customers still lying

in intensive care, we doubt appetites for cheap Chinese goods will be quite the same. At the same time, strategists today

are still debating whether or not the massive, credit-induced spike in Chinese real estate prices is in fact, a bubble. Well letinvestors answer that one for themselves, but consider that the ratio of residential real estate to GDP in China looks a lot

like California in 2006, while levels in Beijing and Shanghai match the Japanese peak in 1990.

Market participants around the world have obsessed over every blip in Chinese economic data for the better part of the

last decade; and rightly so, as China has been a rare source of strength in a fragile global economy. This year, the Shanghai

Composite is among the worlds worst performing equity markets, as the governments visible hand has taken measures to

curb speculation, dampen money growth, slow loan growth, and launch an aggressive attack on housing prices. Leading

indicators of Chinese growth have responded accordingly, and have been slowing along with the stock market since last

fall. We view this speed bump in the high-growth China story as an important leading indicator for global markets and

explore one such consequence Down Under, in this letter.

Who Can It Be Now

Leading up to Japans bursting real estate

bubble in 1990, we were told that this time

was different house prices simply reflected

the growing economic power of Japan Inc.

and there was a land shortage in overcrowded

Tokyo. Today, Japanese real estate prices are

still less than 50% of that peak value reached

more than two decades ago. During the UK

bubble, Brits blamed zoning requirements for

creating land shortages until prices crashed to

the lowest multiple of income on record in

1997. Similarly, builders in Northern Irelandpredicted severe housing shortages if plan-

ners did not release more land in 2003. And

before Americas bubble burst, there were

land shortages across the country, from Floridas undeveloped west coast to the deserts of Nevada. While prices at home

have already fallen 30% from their peak, theyd have to fall another 45% just to reach the long term trend, which according

to Robert Shiller, has been flat in real terms for three and a half centuries!!

The recurring theme in every case is that housing bubbles are almost always justified by new era thinking, land shortages,

and are considered unique right up until the moment they pop. Most bubbles around the world have at least partially de-

flated in the wake of the Great Contraction, yet the property market Down Under continues to chug along ignoring the

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Source: Steven Keens Debtwatch


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gravitational forces of mean reversion as Aussie consumers continue their American-inspired credit binge. US housing

prices nearly doubled in the decade leading to their ultimate peak as shown in the above chart. Australian real estate kept

pace with these gains until US home prices lost nearly a third of their value as US home owners deleveraged their balance

sheets. Since then, Australian households have watched their home prices appreciate by at least that much, while they con-

tinue to feast at the trough of easy credit.

Here We Go Again

Financial deregulation in Australia began slowly in the

1970s before accelerating more quickly in the 1980s. A

number of factors contributed to a shifting focus within

the banking system from business towards housing in the1990s, resulting in a doubling of the share of housing

loans to banks total lending in the past two decades. In

other words, Australias banks are very exposed to the

bubble in household real estate. Deregulation predictably

led to considerable product innovation in the Austra-

lian mortgage market. Homeowners in the US under-

stand that product innovation is a nice way of saying

weaker lending standards. Wholesale lenders competed

aggressively for market share by undercutting the banks

and creating sexy new mortgage products like home-eq-

uity, interest-only and low-documentation loans. Sound

familiar? These lenders, with no balance sheet and little

capital, quickly garnered 15% of housing loan approv-als (see chart below). Low-doc loans accounted for 10

percent of new housing loans in 2006, compared with

less than one half percent in 2000. This trend continued

unabated until the Credit Crisis sparked a near closure

of the RMBS market, and several large wholesale lenders

were acquired by major banks. As a result, the market

share of Australias major banks rose from 60 percent to

over 80 percent of the entire housing market!!

Granted, lending standards in Australia did not loosen as

much as some other markets. There was little sub-prime

lending of the kind we grew to love here in the states,

and non-performing housing loans have remained low,

for now. Yet, according to Guy Debelle, Assistant Gov-

ernor of the RBA, low-doc loans still account for almost

10 percent of new loans and almost half of all new home

owners are opting to not make any principal repayments.

We also find it curious that investors (i.e. speculators)

share of new home loans has risen almost uncontrolla-

bly, while first time buyers disappear from the market a

clear indication that affordability is declining, and a big

red flag, as first time buyers represent an important link

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in the residential food chain. Standard & Poors recently

warned that Australias record mortgage debt could expose

some borrowers to financial shock should interest rates or

joblessness rise, while flagging the danger associated with the

high levels of debt held by Australians.

Australian households currently hold more than $1 trillion in

debt, a record level. The ratio of household debt to dispos-

able income in Australia was 158 percent, at the end of the

first quarter. About one in seven Australian tax-payers has

an investment property other than the family home. Despite

all the talk about Australian lenders being more responsiblethan those in the USA, mortgage debt in Australia rose three

times faster since 1990, according to Steven Keen. Having

started with a mortgage debt to GDP ratio that was just 40%

of Americas, Australias ratio is now higher than ours and still increasing (see chart). No deleveraging here. More punch

please.

Whack A Banker

A survey by Australias Finance Sector Union shows that nearly one

third of Australian bank employees are worried about their customers

ability to repay loans, while nearly half say they are under pressure to

push more credit on customers even if customers dont ask and may

not be able to afford it. In the survey, nearly 60 percent of bank work-ers said selling debt to customers had become a much higher priority

and sales targets always go up. Acting FSU National Secretary, Wendy

Streets, said that bank workers uniformly reported being under con-

stant pressure to sell more products to customers and have concerns

about customers capacity to manage their debt. The survey found that

79% say Australia needs tougher regulations to stop personal debt get-

ting out of control.

Australian Bankers Association chief executive Steven Mnchenberg

claims, Banks undertake a detailed assessment of a customers ca-

pacity to pay before providing a home loan. Banks conservative risk

profiles and the rigorous assessment of the customers capacity to pay

are reflected in the low level of banks loan delinquencies. We thought

this was particularly interesting in light of comments by a lender in the

industry that explained, They cannot write the stuff quick enough,

and despite stories of prudent lending practices down under, Some-

times the bank just asks for a few bank or recent credit card statements

before approving multi-million dollar loans. Another customer wrote,

I maxed my $10,500 credit card limit during my travels offshore and upon my cards expiration I decided not to reactive

the new card so that I could easily repay this huge debt. When later talking with a call centre representative not only did she

offer to increase the limit on my maxed out card but also pressured me into reactivating the new card and creating further

debt. Wow. Conservative risk profiles indeed.

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Another Land Shortage

New homes starts hit a six-year high last quarter thanks

to stimulus spending on public housing. In all, home

starts were almost 35 percent higher than in the first

quarter of 2009, the fastest annual pace in eight years.

Approvals to build new homes surged 43 percent be-

tween May and December last year, leaving a big pipe-

line of construction still to come. Growth in approvals

has leveled off in the past few months but they still re-

main 37 percent above last years low. Yet analysts still

allege that far fewer homes are being built than neededto meet demand. We shall see.

Demand for new home loans fell to a nine-year low in April as rising interest rates dampen enthusiasm for housing. The

number of new home loans has fallen 26 percent since its recent peak in June 2009, a leading indicator for housing. With

a lag, you would expect these numbers to flow through to building approvals, housing starts and ultimately prices. Higher

interest rates are starting to bite with new home sales dropping by more than 6 percent in May 2010 and average loan prices

declining, according to Australias Housing Industry Association (HIA). Sydneys most recent auction clearance rate fell

below 50 percent and remained flat in Melbourne, with both posting their lowest rates since December 2008.

House prices in the major cities climbed 20 percent in the 12

months to March. But activity has cooled since the First Home

Owners Grant expired last year and interest rates began to rise.

Since last October, new home loans have fallen for seven months

straight. Pockets of stress have emerged in Western Sydney fol-

lowing a sharp run up in house prices. More recently there are

signs of increased housing stress in southeast Queensland and

Western Australia, again following sharp rises in house prices in

these areas.

Australia has gone two decades without a serious downturn,

leading most to believe that house prices move only in one di-

rection, despite historical data which clearly indicates that the

ratio of home prices to income has always fluctuated around a

stagnant long term average. The reason is that income acts as an

anchor limiting the price homeowners are able to pay, and hasalways pulled prices back to earth in every instance. It is only a

matter of time. In a recent speech, GMOs Jeremy Grantham

explained that the average family can afford a home about 3.5

times their income. In 2005-2006, new homes in the U.S. were

selling for well over 5 times median income while other real

estate bubbles have grown to 6 or 7.5 times. Australian real estate is at 7.5 times family income today - twice the price it

should be according to GMO data, and needs to decline by over 40 percent to return to trend. A more dire analysis by The

Economist estimates Australian property is more than 60% overvalued based on the ratio of house prices to rents, more

than any of the 20 countries the publication tracks. Six of the 10 most unaffordable cities are in Australia according to the

annual Demographia International Housing Affordability Survey. Its no wonder that manyfirst-time buyers are already

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Source: The Economist


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struggling to meet payments, with 40 percent of those who took advantage of government subsidies reporting some de-

gree offinancial stress. Initial mortgage payments for a home in Sydney or Melbourne absorb more than half of the aver-

age familys disposable income. Yet, the potential for even a pause in ascending real estate prices is seldom considered as

the local media often maintains that Australia completely dodged the Great Contraction. It appears that the great majority

of home owners in major cities discount the possibility of a bubble in their own backyard, despite warnings from Jeremy

Grantham, speaking in Sydney and Melbourne last month, that the housing market is a ticking time bomb.

Investment Implications

Despite the growing and increasingly obvious risks cited

above, Australian banks are still trading at extremely rich

multiples, particularly when compared to their US coun-terparts. The average price-to-tangible-book values of two

major lenders on our radar is roughly 3 times, double that

of their American peers. It would appear that the banks

are enjoying an undeserved premium, as investors are led

to believe that lower charge-off rates and delinquencies are

the result of more prudent management teams and more

conservative lending standards. More likely, it is simply an

issue of timing. Take a moment to review the chart below,

from the FDICs March 2008 Quarterly Banking Profile.

At the time, the report warned of high and increasing non-

current loan growth. The main point being that the growth

in reserves, while increasing, was not keeping up with the

rise in noncurrent loans, so the industrys coverage ratio

was deteriorating. We all know how this story ended.

Now tell me if you see any similarities between this chart,

from the FDIC in early 2008, and this chart, which is the

latest data from one of Australias largest home lenders.

From our perspective, it is increasingly likely that the

rate of loan-loss reserves is forced sharply higher just to

prevent further erosion in the coverage ratio. In order to

actually raise the coverage ratio, far more massive write-

downs would be required, as we have learned the hard

way in the states. While NPLs have inched higher Down

Under, any increase has largely been driven by commercialloans . . . so far. Not surprisingly, residential delinquencies

have remained subdued as home prices have continued

their ascent. But what happens if home prices dont go

up forever? The two banks with the largest exposure to

Australias housing market have aggressively increased housing loans in recent years, such that residential real estate expo-

sure now represents more than 11 times tangible equity. Not exactly what wed call a Margin of Safety.

Stress tests are all the rage in the wake of the Great Financial Crisis as central banks around the globe rush to assure inves-

tors that the balance sheets of their nations banks are sound. In early 2009 results in the U.S. sparked a monster rally in

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Source: Hussman Funds

Source: Company Presentation, Broyhill Asset Management estimates


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risk assets as market participants blindly accepted the promise of regulators. By the end of this month, we should also hear

similar promises out of Europe, although we would encourage prudent investors to view said strength with a healthy

dose of skepticism. This is simply a public relations program. Similarly, we find it a tad suspect that the industry-wide tests

conducted by the Australian Prudential Regulation Authority concluded that not a single bank would have breached their

minimum capital requirements under their severe but plausible scenario. Upon closer inspection, perhaps this shouldnt

come as a surprise considering the very banks that are being stress tested, applied their own models to the tests. One

particular management team even assured investors on a recent conference call that, Nothing is likely to have an impact

that would cause us to have to raise any capital. We are not as confident. Our analysis indicates the potential for severe

stress should housing prices revert to normal, let alone overshoot. We wonder how the currency would react should Aussie

officials be forced to recapitalize the banking system, given investors current optimism on the AUD as reflected by this

CSFB survey.

Bottom Line

A disorderly unwinding of Chinas credit and property bubble may well be the principal global macro risk today. While

all eyes are on Europe, it would certainly have the potential to catch investors by surprise. But such an unwinding is not

necessary to have a noticeable impact on its largest supplier. In macro, what happens at the margin matters most. Many

argue that a slowing of Chinese GDP growth from 12% toward 8% still represents an exceptional growth rate for the

worlds second largest economy. We suggest that investors focus instead on the 33% decline in the rate of growth, which

will have a comparable effect on Chinas demand for (Australian) commodities. Any significant reduction in said demand

could easily provide Australias property bubble with a Chinese Pin. Then again, bubbles of this magnitude often collapse

under their own weight as gravity pulls valuations back to earth over time.

One of the ways we seek to earn superior returns on our capital is by developing thoroughly researched macro themes that

are different than the markets general perception. We are often looking at the same information, but different conclusions

provide us with an opportunity to position accordingly - and wait for the market to play catch up. Mean reversion is always

a good bet, although timing is always uncertain. Today, the consensus remains whole-heartedly in the bullish commodity

camp based primarily on Chinas insatiable and uninterrupted appetite for resources. We have invested considerable time

exploring cheap hedges to profit from a speed bump in Chinese demand and another deflating property bubble (or two).

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While we remain constructive on the long term prospects for commodities and other real assets, buying a little insurance

in the face of near term cyclical risks seems like the prudent thing to do, particularly since market participants have again

forgotten that prices are capable of moving in a direction other then up. Since last October, the Reserve Bank has raised

interest rates 6 times. JPMorgan and others are forecasting Australian cash rates to move from the current level of 4.5%

to 6% by next year. We think this is highly unlikely in light of the risks noted above and especially while the rest of the

developed world hurdles towards deflation. The odds of at least one of these bubbles bursting increase with every central

bank tightening. This sequence of events would have interesting consequences for Australian interest rates, currency and

highly leveraged home lenders.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The authors opinions

are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice

or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of

any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not

guaranteed.

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The Broyhill Letter (Q2-10)

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