Editor's Note: Click the play button or read the excerpt below for insight from a new conversation between hedge fund manager and MacroVoices podcast host Erik Townsend and Hedgeye Housing analyst Josh Steiner.
Erik and Josh discuss the state of the Australian, Canadian and U.S. housing markets (Click here to get a special offer on Market Edges, our weekly macro newsletter.)
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Erik: You’ve got a whole bunch of fantastic slides on Canada. I want to encourage our listeners to check those out. But, in the interest of time, I want to make sure we leave room for the rest of this story.
Let’s move on to Australia. What’s the story there? How is it different from Canada? What are we looking at?
Josh: Australia, in a fair number of respects, is analogous to Canada. They, too, are perceived as this resource economy but, in reality, are as much if not more than Canada a one-cylinder finance-driven economy. Like Canada, where it’s this two-horse race between Toronto and Vancouver. Australia mimics that in being a Sydney-Melbourne–driven property market.
There are, however, some idiosyncratic factors in Australia that make it, at least in my mind, even more dangerous a housing market than what’s going on in Canada. And a few of the big callouts – one, I think, the construction phenomenon in Australia is even more robust.
For instance, we have a chart here. This deck is a little bit dated. We put our big Australia deck – like 150 pages – we put that together in the middle of 2016. So now it’s about a year and a half old. But just to give you an idea.
On Slide 26, these are the number of current residential construction cranes operating in the Australian market, in the big cities. We’ve got Sydney, Melbourne, Perth, and Brisbane here. This is updated, actually, through the third quarter of this year. But you can see that right now you’ve got 350 residential construction cranes operating just in the Sydney market alone.
To put that in perspective, on Slide 27, this is the RLB crane index for all of North America. So this includes the major metro markets of North America – NYC, DC, Boston, Toronto, Chicago, Denver, Phoenix, Austin, LA, San Fran, Portland, Seattle, and Calgary. And across all those markets combined you have – this is back in early ‘16 – you had about 190 total residential construction cranes as compared with 350 in just Sydney. And I went back and checked on this yesterday ahead of our talk here, and that number for North America has actually declined a bit. It’s now just under 175.
So you literally have more than twice as many cranes building residential towers in Sydney than you have across all of North America. Just to put that in perspective. On Slide 28 we just make that apples to apples to truly show the ridiculousness of it. So I think there’s a lot more construction.
The other thing that’s going on big time across Australia from a funding standpoint – and, again, for Canada I talked about this idea of how the hallmark of property bubbles is that you always see creativity on the financing side towards the twilight.
So in the US it was obviously the sub-prime loans, the liar loans, the ninja loans, the wrapping of the paper into the securitization structure, and the rewrapping into collateralized debt obligations, and so on and so forth.
In Australia they have IO loans, just like we had here in the US. The predominant term on their IOs is five years, but they have 58% payment shocks when those IOs come up for reset.
And, if you look back at Slide 31, really there’s two categories of paper in Australia. One is owner-occupiers, the other is investors. For investors, interest-only loans account for north of 70% of all loans – investors are using interest-only to fund their purchases.
And owner-occupiers have been steadily trending higher on the IO side as well. Again, this is what you would expect to see in a market where affordability is transitioning to increasing levels of unaffordability. People are basically reaching to be able to buy the house. They can’t qualify based on their income and a traditional mortgage, so instead they go with one that has no principle component to increase their affordability.
The problem is that these will all come up for reset. And that’s increasingly going to start to hit in 2019, next year. I think that’s one of the big factors.
To their credit, the Australian regulators, from APRA and the RBA, have begun cracking down on this, so they’ve put some limits around the allowable growth rates for the big four Australian banks around IO lending.
But, again, you talked about what’s the catalyst to undo all these markets, and I think that’s it. You get regulators who finally – usually at the twilight, which is like the worst possible time, they step in with these regulatory interventions intended to facilitate a soft landing, but really they catalyze the undoing.
Another idiosyncrasy to the Australian market is what they call negative gearing. This one is pretty wild. Basically, I showed earlier how about three quarters of investment purchases of Australian investment property are done with interest-only mortgages. Well, there is a provision in the Australian tax code that allows you to deduct losses from rental properties against your income.
What people do is they go out and they buy homes that produce losses, investment properties that produce losses. And they fund them with interest-only loans. So, think about this for a minute – they do it solely so they can deduct the losses against their income.
So you’ve got a house that you’re not actually building any equity in, because it’s an interest-only funding structure. It’s generating operating losses for you, and the only way that you ever realize any return on that is through capital appreciation. So you’ve got a huge swathe of the market set up this way. It’s fundamentally nonsensical. But, because Australian home prices have risen so much for so long, the idea that they could not keep going up is just this far-removed crazy risk thought that the average Australian doing this just doesn’t really think about.
When I was in Australia I interviewed numerous people from all walks of life – sophisticated, unsophisticated – this idea that negative gearing is a no-brainer is pervasive. So I think that sets the stage for a fair amount of risk.
The other thing that I found interesting and differentiated about the Australian market is that there’s a lot of home equity withdrawal. If you go to Slide 34, one of the hallmarks of the US going into its full bubble phase was that you saw the amount of home equity being taken out of homes to basically buy things like vacations, pay for college, buy a car, as well as home-enhancing things like home improvement – really rose pretty dramatically.
From basically the bulk of the 1990s, even into the early 2000s, home equity withdrawal in the US ran between 1% and 2% of GDP. And then as the bubble ramped up in 2004–2005–2006, those numbers essentially tripled, even quadrupled up to around 4%, 4.5% of GDP.
So we were curious whether Australia exhibited those same tendencies. And we found some pretty interesting data from some academic studies that allowed us to figure out what was the amount of equity being taken out of homes in Australia.
It’s a little bit dated – the dataset we were able to find covered the 2001–2008 period – but what we found was pretty amazing. In any given year over that period, Australians were withdrawing 13%–15% of the equivalent of their disposable income in home equity. And they were spending it on all manner of things from car repairs to home improvements to vacations to groceries to medicine.
And I think it’s pervasive, like this joke. In the US – although they don’t do it anymore – time was when you walked into McDonald’s they would ask you if you wanted fries with that. And the joke was largely based on reality: When you walk into an Australian bank branch to do a routine transaction, they will basically ask you at the end if you’d like some home equity with that.
So these are a few of the things about Australia that are interesting.
And then, more recently, if you go to Slide 37, the Australian property market works a little bit differently than either that of the US or Canada. For instance, in the US the only auctions for properties are done in distress i.e. in the event of foreclosure. The bank now has the REO and they’re looking to dispose of the property, so they do it through an auction-based process.
In Australia, auctions are actually one of the mainstays for selling non-distressed property. Whether it’s in Sydney or in Melbourne, there will be a notice that there’s going to be an auction for 18 Queen Street. People will show up on that given weekend, there will be anywhere from 50 to 100 people gathered around in a circle, there will be an auction barker there (basically like selling art) trying to get two or three people bidding against each other, create a carnival atmosphere of excitement and enthusiasm. The clearance rates are basically the percentage of these auctions that actually lead to a sale.
So what’s interesting about Sydney is that these clearance rates have been trending lower over the last year and a half, but then more recently have dropped off pretty sharply.
Now, I talked earlier about this hallmark sequencing of property bubbles and what happens. And, again, one of the first things – actually the first thing you see – is that volumes peak from a rate of change standpoint, then start to slow down.
And that’s when you know that prices are coming somewhere thereafter, typically on about a one-year lag. And then you start to see the delinquencies pile up and, obviously, the banking sector, from an equity standpoint, take its hit. So the fact that Sydney is beginning to roll over is definitely notable.
Erik: Now, in the United States, that was a securitized market. So if you wanted to play this as an investment trade you knew the trade was basically credit default swaps to take advantage of the ability to bet against that securitized paper. And the catalyst that people who were most successful looked for is they knew that what would probably break the back of this would be some kind of adjustable rate mortgage reset. And that was what they timed it around.
In these markets that are not securitized, both Australia and Canada, what’s the trade? Is it shorting the banks directly? Or are there other intermediaries? What’s the big short here? And how do you know when it’s time to put it on?
Josh: This has been one of the big challenges as an investor looking to try to capitalize on a falling property market in these other countries. Whether it be Australia or Canada, unlike in the US a decade ago where there were many different ways to do this, your option set is significantly more limited in both these markets.
So in Australia you've really got the “Big Four” banks. You’ve got CommBank (Commonwealth Bank) and Westpac and NAB and ANZ. You’ve got some smaller mortgage insurance companies. You’ve got a few property developers, Goodman, Mirvac, Lendlease.
And then, I think the one that comes up from a macro trade standpoint is the obvious one which is the currency. The Australian dollar, the Canadian dollar.
There are credit default swaps that trade on the big Australian banks, the “Big Four”, but my understanding is that they’re not terribly liquid, not terribly easy to take advantage of. And I think, to be fair, there is almost a national pride, pretty different – in both Australia and Canada – there’s like a national pride that sort of goes alongside. In Canada the “Big Six”, and in Australia the “Big Four” banks – in my mind there’s a tremendous amount of willingness on the part of the government to backstop these entities from anything overly catastrophic.
Whereas in the US, now, the big banks of course are regarded generally as villains. A decade ago that wasn’t the case, they were just sort of neither here nor there. People didn’t really feel especially proud of them, but didn’t think of them as this tyrannical industry. So I think that’s going to be a real factor, ultimately, that helps to prevent anything catastrophic happening in both these markets.
But that’s not to say you couldn’t generate some pretty asymmetric returns between here and the point where that backstop really comes into play on the credit default swap side.
So we look primarily at the equities, but anybody sort of combing around for more levered ways to think about it, that’s an option. In terms of timing, again, the only way I know how to do this is you watch the volumes of the property market. That gives way to price changes on a lag, and then those price changes give rise to delinquency rate inflections. And then, ultimately, the stocks finally catch on thereafter.
So it can be a long time. It can take a few years. In the US, for instance, property transaction volumes peaked in mid-’05, prices in mid-’06. But you didn’t have the XLF – which is sort of the financial ETF here in the US – peak until the first quarter of ‘07. So it can take quite a while.
