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?