Archive for May, 2008

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Economy in downsizing phase

Thursday, May 29th, 2008

Recently, we noticed a trend in some housing neighbourhoods. Large four bedroom houses are sprouting out “For Sale” signs. At the same time, the “For Sale” signs for smaller and cheaper three bedroom houses disappeared much quicker than their four bedroom counterparts. What is happening?

Our theory is that as the Australian economy slows down, people are downsizing. As interest rates rise, the mortgage debt burden for the more expensive four bedroom houses increases. In order to cope, some owners decide to sell them and downgrade to cheaper three-bedroom houses, which will lighten their mortgage repayment burden. Meanwhile, less and less people are able to afford the more expensive four bedroom houses and as a result, their sales slow down. It is also possible that people more from more expensive suburbs to cheaper suburbs. That explains why these three bedroom houses sell much faster then their four bedrooms ones due to competition from ‘outsiders.’

If you look around, you will find the same for cars. People are downsizing from the more expensive petrol guzzling fast cars to smaller and petrol-conserving cars.

When it comes to retailers, the same principle holds. As the economy slows, retailers in the upmarket and more luxurious end will suffer slowdown in their sales as consumers feel less wealthy (see the negative wealth effect on The Bubble Economy), cut costs and reduce their discretionary spending. At the same time, retailers in the bargain end (e.g. the Everything-$2 shops) may experience an initial upsurge in their sales as consumers who used to spend in the upper end downsize to the cheaper end.

So, what is the lesson here for investors?

In the initial stage of an economic slowdown, stock prices of upmarket retailers will decline as their sales fall. But stock prices of the bargain retailers may see their sales rise initially. If the economic situation remains in limbo, this may be a case for selling the stocks of upmarket retailers and switching to bargain retailers.

But there is a potential trap here. What if the economy deteriorates further into a severe recession (or touch wood, depression)? Then it will be very likely that even some bargain retailers will not be spared as consumers’ spending powers evaporate through rising unemployment.

In short, during the initial downsizing phase of the economy, there will be winners and losers. But if the economy worsens further, even the winners may still lose.

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Posted in Analysis - Business, Economics/Finance | 10 Comments »

How futures price affect market price

Wednesday, May 28th, 2008

In our previous article, Who is to blame for surging food and oil prices?, we mentioned that institutional investors,

… through the futures market, affecting futures price, which in turn affected the spot prices (i.e. the real world market price).

Now that we have explained the basics of futures in Introduction to futures and Pricing of futures, we can now explain how those Index Speculators can affect real world market price through the futures market.

What happens, if the Index Speculators push up the price of a commodity futures above its theoretical price? When that happens, there will be an arbitrage opportunity.

Let’s say the price of a July futures is $110 when its theoretical price is $105 (i.e. spot price  of $100 + carry cost of $5). In that case, you can sell the overpriced July futures at $110 and buy the underlying at $100. When the futures expires in July, you can then sell the underlying at $110. Your arbitrage profit will be $5 ($110 futures price – $100 spot price – $ carry cost).

What if the futures price is below its theoretical price? Let’s say, the futures price is now $103 instead. You can short sell the underlying at $100, earn the carry cost $5 (e.g. interests) by holding the proceeds of the sale as cash. When the time comes to close out your short position in the underlying, you can buy the underlying at $103 when the futures expires. Your arbitrage profit will be $2 ($100 short sell proceed + $5 carry cost – $103 close out short sell position).

All these are at least true in theory. In reality, for whatever reasons, futures price can veer out of its theoretical price. It can even fall below the spot price! That phenomenon is called “backwardation.”

And one last thing. Critics of Michael Masters’ theory that Index Speculators are behind the price inflation of commodity prices will point to the fact that inventory levels had not risen considerably as a result.

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Posted in Futures, Investor Education | 18 Comments »

Australian housing shortage myth

Tuesday, May 27th, 2008

When it comes to solving Australia’s housing problem, there is an entrenched superstition that makes many believe that there is a housing ‘shortage’ in Australia. This superstition has resulted in many proposed solutions to the housing affordability crisis that are completely useless, wasteful and counter-productive. For many vested interests, it may as well be that such a superstition be propagated. But for the sake of our nation, it is in everyone’s interest that this superstition be demolished.

Back in November 2007, we said before in Myths on the Australian housing/rental crisis & its implications, the numbers from the Australian Bureau of Statistics (ABS) shows that from 2001 to 2006,

The increase in the number of dwellings far exceeded the population growth and household formation. Furthermore, the increase in unoccupied dwellings is almost triple the increase in population growth.

Therefore, there cannot be a real shortage in housing. As this article in the Sydney Morning Herald (SMH), Empty dwellings in a city desperate for places to live reported yesterday,

The number of unoccupied residential dwellings in Sydney counted by census workers in 2006 was 122,211, with the highest number found in the inner city. That does not include the thousands of empty warehouses, pubs, churches and shops.

Below is the map of the unoccupied dwellings based on the 2006 census data:

Number of vacant dwellings (per local government area)

We can expect the numbers to be increasing from 2006, due to mortgage defaulters. If there is no housing shortage, then any solution to the housing affordability problem that involves building more houses (i.e. increasing the supply of housing) is a complete waste of resources. As that article quoted Mr James,

“You get the property development industry bleating about how they need to produce 1000 dwellings a week to meet housing demand,” he said. “I say to them, “Well, guys, there’s 120,000 houses out there you are not doing anything with.”

So, what is there such a superstition in the first place? In reality, the housing ‘shortage’ superstition is the result of an illusion. The illusion arises from the fact that there is a mismatch of housing demand and supply. In some parts of Sydney, there is an over-demand for housing, which gives rise to the housing ‘shortage’ illusion. In other parts of Sydney, there is an over-supply of housing (some of them brand new) that are unwanted.

Of course, we can expect vested interest to be in denial of this problem. As this article in the SMH, Empty homes now for all to see, reported today, NSW president of the Property Council, Ken Morrison said,

“Vacant properties tend to be very much third-tier-quality building held by private owners who have some sort of other objective for the property than income yield,” Mr Morrison said. “You just don’t get perfectly tenantable apartments which are vacant.”

Really? Fortunately, there is a web site, Bubblepedia, which “has a maps section and an image gallery so readers can send in pictures of the buildings they believe are going to waste.” An example of a block of brand new overpriced apartments (in Parramatta, Sydney) that had been mostly vacant for 18 months:

Apartments. Overpriced not many sold. Been available 18 months

 

The link to this photo at Bubblepedia web site can be found here.

The statistics from the ABS tells us that there is an overall glut of empty dwellings in Australia. Anecdotal evidence from the Bubblepedia shows us the real-life photos of vacant housing. Now that this web site has gained publicity in the mainstream media (it crashed today due to overwhelming traffic), we will get to see more pictures of empty dwellings that had gone to waste.

So, what is the implication of the housing ‘shortage’ being a myth? First, many of the so-called proposed ‘solutions’ to the housing affordability problem have to be abolished. As we said before in Myths on the Australian housing/rental crisis & its implications,

As a result, many of the conventional solutions to the housing/rental crisis will not work. Therefore, the only sustainable solution is to introduce/change policies that will encourage a sustained decline in property prices (e.g. remove Capital Gains Tax exemption, close negative gearing loophole)- we recognize that such solutions are politically costly (nobody wants to see the value of their property fall). If the government will not make such a move, then sustained interest/mortgage rates rise will have to step in to do the job.

In addition, land has to be more efficiently used. For example, in Sydney, if you drive along Parramatta Road towards city, you will find rows of old double-storey shop houses. These should be demolished to make way for high-rise buildings.

Furthermore, Sydney is under-developed and under-maintained in terms of infrastructure. For example, there are many brand new housing estates in outer suburbs of Sydney that remained unattractive for buyers because they are located in relatively remote locations that are under-serviced by infrastructures such as transport.

So, why does Australia have a housing affordability problem? Three words to sum it: mismanagement, speculation (see The Bubble Economy) and hoarding.

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Posted in Property | 41 Comments »

Pricing of futures

Monday, May 26th, 2008

After having introduced futures yesterday in Introduction to futures, we will explain the basics of futures pricing. It must be noted that the pricing of futures is a theoretical concept, which is what the price shoud be. In real life, the actual price could deviate from its theoretical prices for various reasons.

The pricing of futures is very simple:

Futures price = spot price + carry cost

The spot price is the prices fetched by the underlying in the market.

Next, what is the carry cost? The carry cost is basically the cost to hold the underlying. One of the components that makes the carry cost is the opportunity cost of interest foregone when holding the underlying till expiry of the futures. For example, let’s say you want to hold 1000 stocks of a company at $1 (which is the spot price or market price) each for 12 months. What is the carry cost for holding those 1000 stocks? At 10% interest rate, the carry cost is $100 (or $0.10 per stock) over 12 months. Therefore, if a futures contract expires in 12 months time, then the futures price for that stock as underlying is:

$1 (spot price) + $0.10 (carry cost, which is the interests foregone for holding that stock over 12 months) = $1.10

If the stock pays dividend within the 12 months, then this dividend plus the interests associated with that dividend itself will be adjusted in the carry cost to arrive at the theoretical value of the futures.

For stocks, since it is an intangible thing, the carry cost is basically the interest foregone (and the dividends plus the interest on dividends). But for physical commodities (e.g. oil, gold, copper), the carry cost involves warehousing, insurance and other costs associated for physically holding them.

So, what if in actuality, the futures price deviates from its theoretical price? Keep in tune!

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Posted in Futures, Investor Education | No Comments »

Introduction to futures

Sunday, May 25th, 2008

In our previous article, Who is to blame for surging food and oil prices?, we explained Michael Masters’ argument that the distortion of prices in the commodities futures market will affect the prices of commodities in the spot market (i.e. its real world market prices) and by extension, its inventory levels. If you can demolish that argument, you effectively demolish Michael Masters’ testimony.

We will not attempt to do that here. But today, we will introduce what futures is in order for you to have some understanding of the interaction between futures prices and spot prices.

First, what is a futures contract?

Basically, it is a contract to buy or sell something at a pre-determined price in the future. For example, if you buy a June futures contract for gold at $1000, it means you have entered a contract that obliges you to buy gold at $1000 in June. Conversely, if you sell a June futures contract for gold at $900, you are obliged to sell gold at $900 in June. In this example, gold is the “underlying” of the futures contract and June is the “expiry” of the futures contract. In the financial market, there are all sorts of “underlying” for futures, from stocks, bank bills, bonds, commodities and so on.

Thus, if you have an existing futures contract to obliges you to buy or sell an “underlying” in the future, you are said to have an open position. What if you want to absolve yourself from that future obligation? You need to enter an opposite futures position at the current market price to close out that position. For example, if you have already bought June futures for 100 ounce of gold, then you have to sell June futures for 100 ounce of gold at whatever the market price to close out your futures position. If you have already bought the futures at $950 per ounce and sold the futures (to close out your position) at $900 per ounce, then you have made a loss of $50 per ounce.

That’s all for the introduction to futures. For those who are un-initiated to futures, isn’t it surprisingly simple? Next, we will cover the basics of futures pricing.

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Posted in Futures, Investor Education | 4 Comments »

Who is to blame for surging food and oil prices?

Thursday, May 22nd, 2008

Imagine you are standing in a typical petrol station in 1974 on a typical day (there was an oil shock in 1973). This is what you may see back then:

Cars queued for hours to get petrol in 1974

Now, imagine you get sucked into a time warp and time-travelled to today on 2008. This is what you may see:

A typical petrol station in 2008

So, let’s say a passer-by told you that petrol price had doubled more than 2 ½ times over the past 2 years, would you laugh at the passer-by? “Yeah right!” you may say. “Where’s the queue and rationing?”

Indeed, this is what has happened. As we said before in The Problem that can throw us back into the age of horse-drawn carriages, there are good reasons why the oil price rose over the past decade. In fact, this is true for commodities in general (e.g. base metals, food). As we explained before in Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower, there are good reasons for this. Already, we are hearing of food riots in the Middle East and Asia.

Yet, strangely, these upward price movements seem unreal. Where’s the queues and rationing? How do we explain this?

Two days ago, in the U.S. Senate Committee on Homeland Security and Governmental Affairs hearing, this question was put forth: Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation? Here, we must give special thanks to one of our readers, Zoo for highlighting this piece of information at Picture of a fiat money.

Here, let us zoom into the testimony of Michael Masters, who is the Managing Member and Portfolio Manager, Masters Capital Management, LLC. As our reader Zoo said, “It seems it is the testimony of Michael Masters, a hedge fund manager, which made all the Senators sit up and take notice (sic).” This is Michael Masters’ introduction in his testimony:

Good morning and thank you, Mr. Chairman and Members of the Committee, for the invitation to speak to you today. This is a topic that I care deeply about, and I appreciate the chance to share what I have discovered.

I have been successfully managing a long-short equity hedge fund for over 12 years and I have extensive contacts on Wall Street and within the hedge fund community. It’s important that you know that I am not currently involved in trading the commodities futures markets. I am not representing any corporate, financial, or lobby organizations. I am speaking with you today as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy. While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.

You have asked the question ?Are Institutional Investors contributing to food and energy price inflation?? And my unequivocal answer is ?YES.?

That’s a strong categorical statement. Unlike many mainstream financial commentators, Michael Masters did not fluffed around with the “on-the-other-hand” and “having-said-that” types of answer. It is as clear as you can get, backed up by evidence, charts and numbers.

So, how do we explain such a spectacular rise in commodity prices without the queues and rationing? Michael Masters answered,

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets

Just who is this “new category” of market participants? Is it China and India? No! The rising demand of these two giant nations had been gradually brewing and simmering over the past decade and will continue to the next decade and beyond. Their demand are hardly a shock. Michael Masters pointed the finger at:

Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

To give you a sense of scale of their share on the commodities futures contracts, Michael Masters gave an example:

According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators’ [institutional investors’] demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

There are a few more examples given by Michael Masters in his testimony. What happened was that these institutional investors hoarded commodities through the futures market, affecting futures price, which in turn affected the spot prices (i.e. the real world market price). The spot prices are the prices that we all face in our daily life.

In additional, these institutional investors (which Michael Masters called “Index Speculators” are a completely different breed from the traditional speculators. The latter were relatively small fries who (1) had limited supply of money, (2) specialised in certain commodities and (3) price conscious (i.e. they are careful with what price they pay for). The Index Speculators are poles apart. They have vast amount of money (fiat money in US dollars) to be distributed among “key commodities futures according to the popular indices” and are not conscious about the price they pay. They think in terms of portfolio asset allocation, which means that if they decide to allocate, say 2% of their assets into a specific commodity, they will “buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been ‘put to work.’ ” Unlike the traditional speculators who buys and sells, Index Speculators never sell because they treat commodities as some kind of quasi-assets. You can expect such behaviour to have colossal impact on commodity prices.

How did all these Index Speculators came about? Michael Masters explained,

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new ?asset class? suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been ?uncorrelated,? meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could ?buy and hold? commodities futures, just like investors previously had done with stocks and bonds.

The value of assets devoted to commodities by these Index Speculators grew from just US$13 billion in 2003 to US$260 billion as of March 2008. Over these 5 years, the prices of commodities grew by an average of 183%. In 2003, they were small fries in the commodities futures market. Today, they are the largest force in the market.

Why is it that no one seems to know about this phenomenon? Michael Masters believes that (emphasis in the original testimony):

The huge growth in their demand has gone virtually undetected by classically-trained economists who almost never analyze demand in futures markets.

To compound the effect of Index Speculators on commodity prices, it must be noted that the commodity futures markets are much smaller than the capital markets. For example, it is 240 times smaller than the global equity market. Thus, every dollar on commodity futures has a much greater impact on prices than the same dollar on equities. To compound the problem even further, it was observed that their demand increases prices, which in turn increases demand even more. That is, hoarding begets more hoarding.

So, let’s return to the petrol problem. Let’s say OPEC increases production in an attempt to help bring down the price of oil. Or the world decides to to embark on an oil fast. Will that work? You can see that these Index Speculators can easily pour more money into the oil futures sink hole.

Sad to say, through a loophole, the US Commodities Futures Trading Commission (CFTC) allows such speculators “unlimited access to the commodities futures markets.” As Michael Masters explained,

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC?s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as ?Commercial? rather than ?Non-Commercial.? The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

So, whose fault is this? We can blame these Index Speculators. But as we said before in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

Is it surprising to see the arrival of the Index Speculators?

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Posted in Commodities, Economics/Finance, Food, Oil | 41 Comments »

The economics of inflation

Wednesday, May 21st, 2008

Today, we will introduce another great book- The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany by Costantino Bresciani – Turroni, an economist who lived through the German Hyperinflation of the 1920s. That book was first published in Italian in 1931 and the English edition was first published in 1937. The foreword of this book begins:

THE depreciation of the mark of 1914-23, which is the subject of this work, is one of the outstanding episodes in the history of the twentieth century. Not only by reason of its magnitude but also by reason of its effects, it looms large on our horizon. It was the most colossal thing of its kind in history: and, next probably to the Great War itself, it must bear responsibility for many of the political and economic difficulties of our generation. It destroyed the wealth of the more solid elements in German society: and it left behind a moral and economic disequilibrium, apt breeding ground for the disasters which have followed. Hitler is the foster-child of the inflation. The financial convulsions of the Great Depression were, in part at least, the product of the distortions of the system of international borrowing and lending to which its ravages had given rise. If we are to understand correctly the present position of Europe, we must not neglect the study of the great German inflation. If we are to plan for greater stability in the future, we must learn to avoid the mistakes from which it sprang.

This book was recommended by Marc Faber and serves an excellent example of what can go wrong even in a highly cultured and advanced nation. Although history never repeats itself exactly, it rhymes and provides a grave warning to us today. If you have not already, we recommend that you read out guide, What is inflation and deflation? first before reading the rest of this article.

Now, let us turn our clocks back to Germany after the end of the First World War. For a period of time, the German economy seemed to be prospering- it was the envy of others. As Costantino wrote in Chapter 5,

It was often affirmed that only the inflation made it possible for German industry to continue to produce, there being the exceptional and interesting spectacle of extraordinary activity and prosperity in Germany at a time of general crisis in business in other countries, and especially in some of those who were victorious in the Great War.

To this view others objected that it was a question only of an “apparent prosperity,” which concealed the real and continual loss of capital, the disintegration of productive apparatus, the increasing poverty of many classes of society, and the symptoms of a crisis, which, after having remained latent for a long time, burst forth with unparalleled violence in the last months of 1923.

After the First World War, Germany had to sign the Treaty of Versailles, which required her to pay punishing war reparations. Up till 1919, the German mark fell rapidly and remained stable till the second half of 1921. As Costantino wrote in Chapter 1,

Throughout this period the movement of the mark exchange was analogous to that of the other principal European exchanges, save for a greater amplitude of fluctuation.

But from the second half of 1921 onwards (till 1923), the German mark began a downward spiral and depreciated exponentially (so much so that a diagram of the mark exchange rate with the US dollar was best drawn on a logarithmic scale). It was under this backdrop of a depreciating currency that (Chapter 5):

To that was added the influence of an economic conception, which is widely held in countries with depreciated currencies, that is the myth of “real value” or “intrinsic value.” It was thought that even if for the time being the entirely new equipment was not utilized, it nevertheless always represented an “intrinsic value,” a “substance” as it was called in Germany.

In times of inflation, the Germans hoarded capital equipment in an attempt to preserve the purchasing power of their rapidly depreciating marks. Today, we have a similar parallel- under the depreciating US dollar, prices of oil, gold, silver and commodities (including food and base metals) in general soared due in part to hoarding (see Connecting monetary inflation with speculation) and growing demand from China and India.

The initial effects of inflation in Germany seemed to be prosperity. German engineering industries were greatly stimulated during the fall of the mark. Demands for these capital goods eventually converged on the market for iron and coal, which was a great boon for these industries. There was a continuous reallocation of resources from the consumer goods industries to the capital goods industries. As Costantino quoted Professor Hirsch,

… from 1919 to 1921 an industrial migration occurred with a rapidity which had no precedent in history; more than 200,000 new workers were employed in the mines.”* The highest number was reached towards the end of December 1922.

This expansion resulted in Germany not only reconstructing their industrial capacity after the war, but also greatly enlarge them.

Sadly speaking, monetary inflation always result in distortion that are harmful to society in the long run. In Germany, the distortionary outcome was:

In the acutest phase of the inflation Germany offered the grotesque, and at the same time tragic, spectacle of a people which, rather than produce food, clothes, shoes, and milk for its own babies, was exhausting its energies in the manufacture of machines or the building of factories.

Looking back at history, we find many eerie parallels with today.

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Posted in History | 10 Comments »

Picture of a fiat money

Tuesday, May 20th, 2008

Recently, we came into possession of 100 units of fiat paper currency. Physically, that fiat paper currency is not different from the US dollar- both of them are ink printed on paper. That money looks like this:

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At the latest exchange rate, this piece of paper is worth around 1.12 Aussie cents. Can you guess which country’s fiat money does that piece of paper belong to?

Posted in Economics/Finance | 14 Comments »

De-leveraging in the real economy- corporations

Monday, May 19th, 2008

Yesterday, in De-leveraging in the real economy- mortgages, we said that,

… de-leveraging of the household sector means that consumer spending has to cut back significantly. Given that more than 70% of the US economy is made up of consumer spending, there is no avoiding of a serious recession.

Nowadays, corporations and businesses are more highly leveraged too. At one point during the private equity boom, corporations with ‘lazy’ (i.e. ‘lack’ of debt) balance sheets felt vulnerable to takeover attempts. Those private equity funds uses vast amount of leverage to flip corporations, which is reminiscent of speculators flipping property in Florida and stocks on the NYSE.

For the high quality businesses, the cost of funding will increase. Those weaker ones will find it difficult to access funds. In total, it is estimated that there will be at least hundreds of billions of dollars of loans to be re-financed by businesses over the next few years. For many businesses, an environment whereby money is more expensive (see Rising price of money through the demise of ?shadow? banking system) may prove too much to handle. Such businesses will fail. As Satyajit Das said in Nuclear De-Leveraging,

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor?s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

In other words, those businesses who are weaker financially are the primary beneficiaries of the money obtained from the ‘shadow’ banking system. With the ‘shadow’ banking system now in shambles, a lot of these businesses will fail.

Guess what will happen when businesses fail?

Unemployment will rise. With households already so highly leveraged, even unemployment of a secondary job can spell the loss of a mortgaged home. This will result in even more bad debts for the banks, resulting in deteriorating bank assets, which in turn will make credit even scarcer (see Banking for dummies). Scarcer credit will deliver the second round of effects for businesses and households.

By now, it should be clear that the de-leveraging process is a vicious cycle.

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Posted in Economics/Finance, Looking Forward | 6 Comments »

De-leveraging in the real economy- mortgages

Sunday, May 18th, 2008

In our previous article, Is the credit crisis the end of the beginning?, we said that the de-leveraging of the financial sector will usher in a new phase whereby the real economy de-leverage. Today, we will show you how it will unfold by looking at mortgage de-leveraging.

First, we will explain the concept of de-leveraging. As Satyajit Das said in Nuclear De-Leveraging,

Assume a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage 5 times, then the hedge fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Assume the asset falls $10 (10%) in value. The hedge fund leverage increases to 9 times ($10 of equity (the original amount less the loss) and $80 of debt supporting $90 of assets). If the permitted leverage stays constant at 5 times then the hedge fund must sell $50 of assets – 50% of its holdings ($10 of equity and $40 of debt funding $50 of the asset). If lenders (more realistically) reduce permissible leverage, say, to 3 times, then the hedge fund must then sell $70 of assets – 70% of its holdings ($10 of equity and $20 of debt funding $30 of the asset).

That is why, as we said before in Why are fantastic stocks sold off in a bear market?, with so much leverage, even a tiny fall in value of assets will result in savage selling, which results in even more fall in value.

Now, look at Australia’s household sector. For a typical first-home buyer, it is possible to leverage 9 times (i.e. 10% deposit and 90% debt for a house). With house price at record un-affordability, debt-servicing burden for such buyers are stretched to the limit. With a leverage of 9 times, highest debt-servicing burden and a loan term of 30 years, first-home buyers are most vulnerable to any fall in value of their property. 30 years is a very long-term commitment. A lot can happen in 30 years. With a leverage of 9 times, there is very little margin for error for first home buyers.

For those who are thinking of buying their first home in such a time, note this: as you start of with your loan repayments, the vast majority of the payment comprise of interests. In other words, most of your initial years of loan repayments goes to making the bank rich and not to reduce the principal of your loan. For example, suppose you have a $300,000 loan for 30 years at 10% p.a. Your loan repayment will cost $2632.71 per month. The first month of payment will only reduce the principal of your loan by a miserly $132.71! At the end of 3 years, the principal reduction per month is only another miserly $177.44! In other words, after of 3 years of slaving after your mortgage, you still owe the bank $294,454.94! That is just only a 1.8% reduction of your total debt in exchange for 3 years of slavery!

Of course, if house prices go up forever and ever till infinity, this is not a problem for the banks. At worst, the banks can just foreclose the house and get back their money. The home ‘owners’ have to bear the consequences of losing their homes and go back to renting. A consolation is that they will at least get back their 10% deposit, plus whatever is above the original purchase of the house, minus fees, taxes and charges. But if house price goes down by more than 10%, then the home ‘owners’ will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

For property investors this is a tip: in any property downturn, newly built estates are most vulnerable because the first home buyers are the majority there.

Now, a first home buyer who can faithfully pay $2632.71 per month is doing okay (assuming they can still remain employed). But as Satyajit Das wrote,

Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of ?easy? credit will force de-leveraging.

In the US (and to a lesser degree in other countries), banks allow the consumers to ‘extract’ the equity of their house as cash, especially in the days of rising house prices. Here, we have to emphasise that the rising of house price is an illusion (see Spectre of deflation for the concept of imputed valuation) because debt is real but the ‘value’ of houses is not real. In the case of the first home buyer, consistent and faithful repayments hardly put a dent in the amount of his or her total debt initially. If equity were to be ‘extracted’ from the loan (on the assumption that house price will rise forever and ever till infinity), wouldn’t the total amount of debt increase further due to the compounding effect?

Now that the days of Chinese deflation are over, borrowers have another worry to fret (in addition to falling house price): rising price inflation. As Satyajit Das continues,

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt. Higher food and energy cost, especially over a sustained period, may affect the degree of de-leveraging if income levels do not adjust.

Imagine the situation of a household that is already highly leveraged with crippling mortgage debt. ‘Extracting’ equity from the house will result in an increase in the amount of total debt owed. Now, with price inflation added into the powder keg mix, wouldn’t this lead to the situation whereby the chances of debt default increases (because the margin for error is reduced to razor thin level)? As debt default increases, this means banks’ bad debts will increase. This will lead to the increase of bad bank assets, which means more write-downs, capital raising and de-leveraging in the financial sector.

The only short-term fix for the household is to resort to the plastic (credit card debt) to pay for the mounting cash-flow problem. That will further exacerbate the debt problem in the longer term. With the financial sector in the process of further de-leveraging, how realistic can we expect the tap of credit to flow further? That is why Ben Bernanke and company is doing everything to keep the credit tap flowing from the banks.

Given such a situation, de-leveraging of the household sector means that consumer spending has to cut back significantly. Given that more than 70% of the US economy is made up of consumer spending, there is no avoiding of a serious recession (in fact, the US is already in a recession).

Make no mistake- the real economy will be affected acutely.

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Posted in Economics/Finance, Looking Forward, Property | 8 Comments »

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