Thinking of shorting Australian house price?

May 10th, 2011

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Recently, we received an email from one of our readers:

Just wondering if you’d like to touch on possible investment ideas for hedging australian real estate?

I’ve had a look at puts on the banks before but the banks have mortgage insurance along with an implied guarentee from the gov so I was thinking that while their may be some correlation, it may not be as high as one would like when the chips are down.

As such any other possible hedging ideas would be appreciated, ideally it would have to be highly leveraged to act as a suitable hedge.

Looking at other places that suffered a debt/property collapse with a low housing supply may be a good place to start? (UK?)

Today, we will talk about this topic. We haven’t talked about Australian property for quite a long time. But you can read through our old archives and know where we stand on this topic. Also, please take note that nothing that is said in this blog should be construed as financial advice. Instead, we are just voicing out our ideas and suggestions for discussion and brainstorming. With that disclaimer, let’s dive into it.

It is no secret that Australian house price is heading for stagnation at best and a crash at worst. Even the most optimistic forecasts from the vested interests call for stagnation. Already, house prices in Perth have been falling for over a year already. There are reports of rising supply of homes for sale while at the same time, demand is weak and auction rates are weakening.

So, if you reckon Australia is heading for a house price bust, what are the ideas for shorting/hedging Australian house prices? Since there exists no financial instruments that can short Australian house prices directly, we can only do so indirectly through the side-effects of falling prices.

First, before we run off to take up short positions, it is helpful to envisage a few possible scenarios:

  1. Professor Steve Keen sees that we are facing a scenario whereby house prices fall 40 percent in nominal terms over a period of say, 15 years. That’s basically the Japanese scenario whereby the housing bubble deflate with a slow hiss. In this case, the fall in prices will be so slow (a few percent a year) that it becomes almost imperceptible.
  2. A rapid fall of say 10-15% followed by slow deflation.
  3. A big crash of say, 40-50% in a short period of time, say a couple of years.

In the first scenario, there is nothing much to short. The economy may be able to muddle through in stagnation for a very long time.

In the second scenario, the banks will suffer heavy losses but they will probably survive. The obvious idea is to short the bank shares. In this scenario, we can imagine consumer spendings will be depressed as well. Therefore, shorting retail related stocks is another idea. Property developers and builders will be shorting candidates as well. In this scenario, we imagine that the AUD will be weak as well, as the RBA will have to cut interest rates.

The third scenario will be the nightmare scenario. Such a precipitous fall in house prices will put the Australian banking system in serious trouble. For one, since property is the most popular collateral for lending in Australia, a house price crash will result in a credit crunch. As you can see what happened in the United States during the GFC, a credit crunch result will ultimately result in rising unemployment, which will in turn will feedback into a second round of effects into the economy through more mortgage debt defaults. If the entire banking and financial system falls into deep trouble, we will likely see an AUD currency crisis (see Will there be an AUD currency crisis?). In this scenario, we will not even bother to short Australian banking stocks. The financial and economic situation in Australia will be unpredictable and volatile. As we wrote in Protecting yourself against currency crisis.

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Even if the AUD is to survive, we may witness rising interest rates as the RBA sought to defend the AUD from speculative sell-off.

Now, some people may ask, what if the Commonwealth government bail out the banks? Will that avert a crisis?

The problem with this question is that the word “bail out” is too vague. Does that question ask whether the government will bail out depositors? We imagine the government will do that. But does it mean that the government will bail out depositors and bank bond holders? Or even better still, will the government bails out depositors, bank bond holders and bank stock holders? Obviously, the more stakeholders the government bail out, the more expensive it is going to be. Will the government be able or willing to fork out that much?

With that, we turn to our readers. What are your thoughts and ideas?

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  • Phil H

    “Even if the AUD is to survive, we may witness rising interest rates as the RBA sought to defend the AUD from speculative sell-off.”

    I read this, and despair.

    A floating currency is one of several stabilisers built into our economy, so if the AUD falls because the economy tanks, it will be viewed as a good thing, and the RBA will do precisely *nothing*. (Just as it’s doing nothing about the current high exchange rate against the USD.)

    There’s no doubt that a drop in the AUD against other currencies would produce a spike in inflation, and we might see a brief rise in rates until the exchange rate stabilises. But then again, the RBA might choose to “look through” the effects of the changing exchange rate, and take no action.

    Regarding housing: if house prices fall significantly, the economy will contract, and interest rates are far more likely to fall than rise. If that happens, 10-year bonds will do better than just about everything else. You could also take a punt on the AUD by putting cash into a bank that offers deposits in other currencies. Half in EUR and half in CHF, maybe.

    Far better, though, to do what you can to ensure you keep your job.

  • Tom

    “There’s no doubt that a drop in the AUD against other currencies would
    produce a spike in inflation, and we might see a brief rise in rates
    until the exchange rate stabilises. ”

    That’s the Iceland scenario! Rising interest rates, rising debt defaults, falling asset price.

    That’s scary!

  • Pete

    Short Westfields!

    Shops can’t pay exhorbitant rents, retailers suffer because people have no discretionary spending power after paying mortgages, credit cards are no longer available like candy…

    Great comments
    @34be319df306031fcf11f0777a4d5b08:disqus
    and
    @5100989158738837bf157ec8e3d937f1:disqus

  • A floating currency is one of several stabilisers built into our economy, so if the AUD falls because the economy tanks, it will be viewed as a good thing, and the RBA will do precisely *nothing*…

    But then again, the RBA might choose to “look through” the effects of the changing exchange rate, and take no action.

    That’s true in theory, if it is the garden variety type of downturn.

    But in a currency crisis, all bets are off. As we quoted Bank for International Settlements (BIS) in Why central banks are forced to raise interest rates in a currency crisis?

    External constraints could also bind for some countries. Particularly in smaller and more open economies [e.g. Australia], pressure on the currency could force central banks to follow a tighter policy than would be warranted by domestic economic conditions.

  • Shirleybates

    Just pass a law that all super funds must hold 30% bank bonds.These will be at low intrest rates as intrest rates rise and devalue them.Thus transfering super money to the banks.This would provide the 300,000,000 billion needed to help support the housing market.

  • Pete

    That’s true. And then we’d have a huge systemic risk whereby if any of the banks failed, people would lose 30% of their super.

    But as absurd as it seems to me, don’t be surprised if in the future super funds are required to hold a certain percentage of Govt. bonds.

  • Wasn’t Christopher Joye of RPData recently spruiking a ”
    residential property derivatives market” based on their so called hedonistic index. What ever happened to that – did it ever get off the ground? It’s clear the property market is entering terminal decline after decades of unsustainable growth. The derivatives index would allow us bears
    to profit from the future price falls. That’s if we can trust in the accuracy of Joye’s hedonistic index, which is not entirely certain!

    Tom Kline
    Aussie Property Bubble Chat Forum

  • Matt

    Great article and comments!

    I am interested in this topic for those who can’t get out of property but see things aren’t ‘smooth sailing ahead’

    Ideas – Short banks, short Westfields, long the 10year.?

    Of these I think I like the short Westfield idea the best. The banks could get all sorts of support in a housing collapse that ensure their share prices don’t reach their true bottom. There may also be too much ‘core’ inflationary pressure to drop interest rates as low as needed (does the RBA support the currency or the economy?) for existing bonds to soar. So it would seem that leveraged developers and property trusts would be the most vulnerable (reflecting the market problems themselves!) – much like centro properties at the beginning of the GFC.

    Does anyone know if there are exchange traded mortgage bond funds in Australia (mortgage backed securities)?

  • We believe there is still a case for shorting the banks. This is because bank bailouts may not necessarily benefit shareholders as the government may not want to help beyond say, bond holders. We believe at the very least, depositors will be protected. Perhaps the government has learned from Ireland, where its government went bust after bailing out its banks.

  • Anon

    I think AUD is probably going to go parabolic after some bear trap falls. Don’t be surprised to see 1.40 AUD.USD in the next 3-5 years.

    I agree with your assumption re: Interest rates. Will probably sky rocket in a few years – 10-15%? giving AUD.USD further strength. RBA won’t back down re: its fight against the evil inflation beast!

    DJIA is on the edge of a cliff and about to jump off with a paracheutte. Watchout below.
    Expect to see a serious, bear market fall Aug-Oct this year or next year. Retest 09 bottom possible sometime in the next 3-5 years.

    Silver looks like its bottoming out aswell. Theres a massive shortage on silver atm. Silver giving bear trap sell signals, which is usual in a euphoric parabolic trend — stay the course!
    Expect to see 48$ silver EOY, 58$ 2012, 150$+ 2013. Good longterm investment imo. Silver is the new tulips, ride that bubble!

    This is not advice, please see a licensed adviser for such things.

  • Anon

    I think the bank bust short is still too early. Some of the big 4 look like they’re about to breakout. These blowoff tops can take out so many shorts, and weak hands. Best to be late if you’re going to short, than be too early.

    Housing market has only just started to crack, takes years for that to flow into a full fledged bank bust — maybe something we see in 2014-2015.

    This does not constitute financial advice and should not be taken as such. Seek to obtain professional
    advice before proceeding with any financial decision.

  • This is by far one of the most constructive articles I’ve read on how to make money from a property crash.

    Thanks for the excellent ideas and suggestions.

    Shorting the banks with the most property exposure on their books seems to be the way to go. Timing it is another issue all together!

  • Tom

    It did not pass the ASIC requirements?

  • Matt

    Very good point, you can bailout the banks but that may not save the equity price.?

  • Matt

    Good point too – the US Subprime debacle began unfolding in early 2006 if I remember correctly and the market collapse wasn’t until 2008?

  • Matt

    The US Gov is raiding public pension assets right now as the debt ceiling has been reached and they need to keep their deficits running – I think Geithner said he’d make them whole once QEIII is passed…

    I believe the Irish Gov pledged the public pension assets as collateral to receive bail-out funds.?

    In the late 70’s/early 80’s private retirement funds had to have a certain % of Aust Gov bonds. ?

  • Matt

    Bearing in mind that the banks have mortgage insurance on all residential loans (WBC does self-insure).

    That doesn’t cover all other types of lending though, nor does it protect their future income streams.

  • Yoda

    Fun n games all round! Shame vested interests prevent the obvious trade. Foreign capital would return after values stabilise. Gold & silver seem to be doing well ATM . Fanks

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