More on the Com­mon­wealth Bank

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My last post on the Com­mon­wealth Bank’s “there’s no hous­ing bub­ble in Aus­tralia” doc­u­ment focused sim­ply on the use of two dif­fer­ent data sources for the House Price to Income ratio; I left the argu­ments the bank made untouched.

Not so David Llewellyn-Smith, who ran a logician’s eye over the bank’s doc­u­ment and found “logic” of Monty Python “if she weighs more than a duck, she’s a witch” cal­i­ble. David pub­lished this post in the Henry Thorn­ton blog, and he has kindly con­sented to me repro­duc­ing it here.

Determined to be difficult

Every­one has seen the ads. A sturdy and com­mon sense banker con­fronts a troupe of Amer­i­can adver­tis­ing hot shots. The banker responds with steady incredulity to their fast and loose attempts to mod­ernise his brand. He is the model of pru­dence, jux­ta­posed against fad­dish spin doc­tors.

In the real world, Com­mon­wealth Bank (CBA) exec­u­tives are cur­rently trav­el­ing inter­na­tion­ally (includ­ing to, pre­sum­ably, Amer­ica) to do more than dis­pense with a fic­ti­tious adver­tis­ing agency’s fool­ish ideas. They have, in the bank’s own words, gone “over­seas to meet with some of the Group’s off­shore share­hold­ers and other investors inter­ested in Aus­tralia and the Aus­tralian bank­ing sec­tor.”

Though the goals of the trip are no doubt myr­iad, last week’s press release herald­ing their depar­ture came com­plete with a 19 page pre­sen­ta­tion that will be used on the trip to reas­sure inter­na­tional investors that there is no Aus­tralian hous­ing bub­ble. It included directly refuted quotes from such notable hous­ing bears as Mor­gan Stanley’s Ger­ard Minack and GMO’s Jeremy Grantham. CBA man­age­ment has set sail on a bub­ble-bust­ing road­show.

Given the stake we Aus­tralians have in this lit­tle exer­cise, it is fit­ting that we assess how the fun­da­men­tals of our hous­ing mar­ket are being rep­re­sented around the world by our biggest bank. Is the pre­sen­ta­tion likely to reas­sure foot­loose global investors, now acutely aware of the dam­age a hous­ing bust can do to their cap­i­tal? Per­haps, but only if they are closely related to the dun­der­headed Amer­i­cans that CBA uses so cal­lously in its own ads.

The pre­sen­ta­tion begins with the argu­ment that “tak­ing into account geo­graphic dif­fer­ences, the ratio of house prices to income in Aus­tralia is not that much dif­fer­ent to most other com­pa­ra­ble coun­tries.” The doc­u­ment pro­vides some nice slides and graphs mak­ing the com­par­isons clear. And they look rea­son­able enough, except that the sta­tis­tics aren’t explained. We don’t know what income mea­sures are being used, nor what median prices.

Worse still, as Money Morn­ing uncov­ered Fri­day, the sta­tis­tics are cherry-picked from dif­fer­ent sources to ensure the most favor­able com­par­isons.

But the lack detail in the pre­sen­ta­tion is quickly for­got­ten as CBA’s argu­ments sink into a fal­la­cious morass. Accord­ing to the bank, “Aus­tralia is the 4th least densely set­tled coun­try in the world — 83% live within 50 kms of the coast. Coastal loca­tions demand a pre­mium – Australia?s pop­u­la­tion con­cen­tra­tion in capital/coastal cities dis­torts com­par­isons to other, more densely set­tled coun­tries.”

You’ll for­give this writer if he points out that if 83% of Aus­tralians live in coastal cities then that surely con­sti­tutes 83% of the hous­ing mar­ket. There is, there­fore, no greater mar­ket against which a pre­mium for coastal prop­erty can be justified–as opposed to other nations, where an even spread of pop­u­la­tion means there is ele­vated demand for coastal liv­ing as a reward for suc­cess. Nor has there has been a great Aus­tralian exo­dus to the coast from the bush in the past fif­teen years. We’ve always lived by the seashore.

The CBA argu­ment would still make sense if it were posi­tion­ing Aus­tralian cities in a con­text of global demand for coastal liv­ing but it is clearly not doing so. CBA’s logic is sim­ply that because coastal prop­erty every­where is expen­sive, and Aus­tralia has largely coastal prop­erty, then Aus­tralian prop­erty is jus­ti­fi­ably expen­sive.

Aris­to­tle would turn in his grave.

CBA’s sec­ond argu­ment begins: “pop­u­la­tion growth has been a key dri­ver of Aus­tralian house price appre­ci­a­tion” and offers a series of graphs show­ing that growth above his­toric aver­ages as well as falling hous­ing starts since 2005.

This ratio­nale does help account for the 50 per cent or so rise in median house prices from 2005 when the com­mod­ity boom prompted skills short­ages and immi­gra­tion rose strongly. I say helps explain it, because that is still not enough. It’s a ker­nel of truth around which an invest­ment fer­vor gath­ered pace.

What CBA doesn’t men­tion nor explain is the prior 8 year burst in prices of approx­i­mately 120 per cent, dri­ven largely through rock­et­ing demand for invest­ment mort­gages, up 308% over the period.

To under­stand that, CBA turns to its third argu­ment, that there are “other dri­vers of house price appre­ci­a­tion [that] are struc­tural, rather than cycli­cal in nature”. Accord­ing to the bank, “Australia?s low inflation/low inter­est rate envi­ron­ment has dra­mat­i­cally increased the demand for, and acces­si­bil­ity of credit.” CBA then con­cludes “On RBA esti­mates, the reduc­tion in mort­gage rates dur­ing the 1990’s expanded the poten­tial hous­ing mar­ket by 600,000 house­holds. Absent a dra­matic response from the sup­ply side, a large part of the lift in val­u­a­tion ratios is a per­ma­nent struc­tural shift.”

Those who inter­pret Aus­tralian house prices as a bub­ble would hardly dis­agree that a period of his­tor­i­cally easy credit is a major cause of asset-price growth. But for the pur­poses of CBA’s pre­sen­ta­tion, that is not the impor­tant point. The main claim is that this is a “per­ma­nent struc­tural shift” and it makes it with­out a jot of evi­dence. There is no analy­sis of infla­tion­ary dynam­ics in the Aus­tralian econ­omy. No men­tion of the effect of com­mod­ity prices. No break­down of labor mar­ket trends. Noth­ing about capac­ity util­i­sa­tion. Nor is there is any men­tion that the sup­posed same “per­ma­nent struc­tural shift” was thought to have occurred in the US, where it was dubbed the Great Mod­er­a­tion and cul­mi­nated in the mother of all cycli­cal busts.

The fail­ure to address this point with evi­dence is a key fail­ing in the report given Jeremy Grantham has stated that the Water­loo for the bub­ble will come with higher inter­est rates.

The same fail­ing is also espe­cially unfor­tu­nate given that this pre­sen­ta­tion is likely to be aimed in part at the global bond­hold­ers who deter­mine the inter­est rate at which CBA bor­rows its whole­sale dough and, there­fore, in part, Aus­tralian inter­est rates. For them, the bank isn’t argu­ing an objec­tive case for con­tin­u­ing low inter­est rates, it is assum­ing those rates will be forth­com­ing and argu­ing that that will sus­tain house prices. Need­less to say, this is dan­ger­ously cir­cu­lar.

Unde­terred, the CBA pre­sen­ta­tion ploughs on. Next it claims that “the house­hold debt ratio in Aus­tralia is sim­i­lar to many other devel­oped coun­tries”. Again it offers a pretty graph, this time of Australia’s house­hold debt as a per cent of house­hold dis­pos­able income as com­pared with the UK, NZ, Canada, US, Japan and Ger­many.

The prob­lem with this item is that Aus­tralia is sec­ond only to the UK, the other mar­ket iden­ti­fied by Jeremy Grantham as hav­ing the last of the great hous­ing bub­bles. More­over, it is clear in the graph that Aus­tralia is in a much worse sit­u­a­tion than US house­holds and almost twice as bad as the sit­u­a­tion in Ger­many. If any­thing, the graph makes it star­tlingly clear just how enor­mous Australia’s hous­ing bub­ble has become.

At this point, if I’m an inter­na­tional investor, I’m think­ing ‘we gotta short these chumps’.

The presentation’s next argu­ment is based upon the demo­graphic dis­tri­b­u­tion of mort­gage debt, in par­tic­u­lar its con­cen­tra­tion in those classes that can most afford it. It is fine as far as it goes.

The final two argu­ments are about strong eco­nomic fun­da­men­tals min­imis­ing “the down­side risk to house prices” and his­tor­i­cally low loan-loss rates for Aus­tralian banks through var­i­ous hous­ing cycles since 1988.

Both of these argu­ments are fair enough but again rely on hid­den assump­tions. Aus­tralian bank’s loan-loss rates are low but the same con­sis­tent returns and small losses can equally be explained by the work of Hyman Min­sky. Busi­nesses that bor­row to repay other debts dis­play just such a pat­tern, until investors cot­ton on and begin to with­draw funds. At that point the losses rocket.

Now, let’s get real. The point of this analy­sis is not to pre­dict an immi­nent hous­ing crash. In fact, con­di­tions are not yet ripe for the reck­on­ing of the great Aus­tralian hous­ing bub­ble. It would have hap­pened in 2008 when global mar­kets closed to whole­sale Aus­tralian bank debt, but was post­poned by a strong Fed­eral Bud­get that sup­ported both the asset and lia­bil­ity side of the banks’ bal­ance sheets. The will­ing­ness of the Fed­eral gov­ern­ment to sup­port the bub­ble means the reck­on­ing can only come when the Bud­get also finds itself under pres­sure from a more seri­ous and long-term cor­rec­tion in com­mod­ity prices or, as Grantham has hypoth­e­sised, from a burst of seri­ous infla­tion.

But in the mean time we might rightly ask: Is CBA’s rep­u­ta­tion in global mar­kets cur­rently so at risk that it need resort to the spin pil­lo­ried in its own adver­tis­ing?

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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    bb… re #125

    Mr Joye said there are risks of fur­ther house price declines in the year ahead.

    If the resources boom com­bined with frisky con­sumer spend­ing com­pel the RBA to lift the cash rate four (to) six times by end 2011, we would expect to see nom­i­nal dwelling val­ues decline mod­estly. This is not a bad thing,” he said.

    Indeed, the cool­ing of house prices will be wel­comed by those con­cerned the mar­ket place is over­priced.

    Fitch Rat­ings said yes­ter­day it will con­duct stress test­ing on the hous­ing mar­ket in com­ing months after being inun­dated with inquiries on the sus­tain­abil­ity of prices.

    Mr Joye said asset prices can­not always rise, not­ing that since 1993 there have been five instances when the RBA has lifted the cash rate sharply and on each occa­sion national cap­i­tal city dwelling prices have “flat-lined or declined”.

    If the RBA aggres­sively raises rates, there is no rea­son to expect 2010-11 to be any dif­fer­ent,” he added.

    Home bor­row­ers may also be sub­jected to addi­tional inter­est rate hikes by com­mer­cial banks in com­ing months as ris­ing fund­ing costs crimp profit mar­gins.


    bb (Cap­tain)

    If Chris Joye is roughly right, a poten­tial ‘investor’ who puts up a debt free pri­mary res­i­dence as secu­rity and bor­rows 100% for an invest­ment prop­erty (50% LVR), is presently look­ing for­ward to a 5% pur­chase cost and an after NG tax deduc­tions cash loss of 3% head­ing toward 4% to own an asset that “flat-lined or declined”… i.e. the investor is likely to be out of pocket 8 — 9% in cash cost at the end of year 1. 

    If the RBA aggres­sively raises rates, there is no rea­son to expect 2010-11 to be any dif­fer­ent,”

    Why would an ‘investor’ buy into this scene­rio?

    37 — 39% of all loans are ‘investor’ loans, and ~40% of all sales are to ‘investors’.

    Are ‘investors’ ratio­nal or gam­bling their house?


    bb (Cap­tain)

    Aus­tralian res­i­den­tial investors remind me of the Fitch risk model…

    Aus­tralian AAA low mort­gage debt house­holds presently pledg­ing (low > zero debt) pri­mary res­i­dences to buy ‘invest­ment’ prop­erty could be mes­mer­ized by the same Fitch logic…

    In March 2007, First Pacific Advi­sors
    dis­cov­ered that Fitch used a model that assumed con­stantly appre­ci­at­ing home prices, ignor­ing
    the pos­si­bil­ity that they could fall. Robert Rodriguez (2007), the chief exec­u­tive offi­cer of First
    Pacific Advi­sors, describes the dis­cov­ery
    We were on the March 22 call with Fitch regard­ing the sub-prime secu­ri­ti­za­tion market’s
    dif­fi­cul­ties. In their talk, they were highly con­fi­dent regard­ing their mod­els and their
    rat­ings. My asso­ciate asked sev­eral ques­tions.
    FPC: “What are the key dri­vers of your rat­ing model?”
    Fitch: “FICO scores and home price appre­ci­a­tion of low sin­gle digit or mid sin­gle digit,
    as home price appre­ci­a­tion has been for the past 50 years.”
    FPC: “What if home price appre­ci­a­tion was flat for an extended period of time?”
    Fitch: “Our model would start to break down.”
    FPC: “What if home prices were to decline 1% to 2% for an extended period of time?”
    Fitch: “The mod­els would break down com­pletely.”
    FPC: “With 2% depre­ci­a­tion, how far up the rating’s scale would it harm?”
    Fitch: “It might go as high as the AA or AAA tranches.”

  • CBA came out again today say­ing bank rate rises out­side the RBA move­ments are likely! Will they hold their nerve?