Leverage: The Silent Assassin

One of the greatest financial inventions is leverage: the ability to create an asset of value in excess of your original investment.

Simply put this is how you can buy a house with no deposit or a small one. Consider the reality of leverage:

You buy a house for $500,000 and put down a 10% deposit of $50,000.

In a few years (certainly recent times) you sell it for $600,000. You have just made $100,000 from an investment of $50,000…a 200% return. Of course you have to subtract your interest but that is what you would have paid in rent anyway or so the theory goes.

In recent years this has been the name of the game. Between 2000 and 2008 New Zealand house prices rose 169%……..!! Yes that’s an incredible number………21% per annum on average. No wonder people thought this was an easy game. No wonder leveraged investments in property became the biggest game in town. But hold on: we are talking about houses not tulips. How could such an unusual bout of asset inflation happen right under the noses of the inflation focused RBNZ.

Well house prices are not included in the CPI calculation. Call me old fashioned but that’s ridiculous.

The major problem with any bubble is that it ends. In this case NZ has not had the same end as the USA with its sub-prime mortgage induced property collapse though the NZ finance company sector did its best to compete.

But the leverage has not been washed out of the system yet. House prices have recovered from the 2008-9 fall and now are back up close to their historic highs. Why is this? Why hasn’t the NZ housing market fallen back to more realistic levels?

There’s no clear answer but I’d like to suggest one: It’s not in the interest of the banks for prices to fall heavily. Why? Because they are the ultimate owners of the housing stock. If they lend 90% to a borrower and the price of that house falls 10% then the borrower has lost their equity and the bank owns the rest. That’s how leverage works on the downside. If the price falls further than 10% the borrower is into negative equity. So far so normal. The bank will just hoover up any savings or other assets held by the borrower. But at some point the bank is left holding the security. Banks don’t like that very much so they seek to sell the asset and recover as much cash as possible. If the borrower cannot cover the loss then the bank has to write that off.

But in a bubble situation the banks have to be very careful not to knock down the price of all property. Otherwise their entire lending portfolio will take a hit not just the one loan which went bad. So banks have a vested interest in keeping prices from falling too far.

Back in 2008 I called for land prices to fall 30%. They haven’t yet but it’s simply a matter of time. In fact they only fell 8.5%…not much of a fall considering the enormity of the rise. Wages are not rising at a rate which can cover the compounding interest on the debt pile (see upcoming post on debt) so the strains of maintaining the illusion will continue to show through. Therefore the banks have a big part to play in making sure house prices do not rise or fall too much whilst they reorganise their lending practices.

What needs to happen? Well a reversion to traditional lending practices will come back into vogue: where you can borrow 2-3 times your salary. Imagine that. Median wage in Christchurch is somewhere between $30-40,000 depending where you look and the average house price is $360,000. Scary……so the banks who are operating on the interest/cash flow model (see upcoming post on definancialisation) will find switching back to the traditional model simply isn’t possible as house prices would fall by rather a lot. You couldn’t find a house for under $200,000 these days so we would have to see a severe correction, probably in excess of 30% though very low borrowing costs would help ease that.

It’s clear that the same financial practices that we have seen employed in the global bond markets have also been applied to residential lending. The valuation model shifted from the established practice of ability to repay the mortgage to the ability to cover the interest. Why? Because the price of the house would always go up. Really? Isn’t delusion fun. The fact is that prices did go up….and up…and up. As they say the market can be wrong a lot longer than you can be right.

All this creates a major dilemma for banks (who are probably aware, one hopes, of their position) and regulators who clearly are not (always happy to be surprised): How to withdraw leverage (which was a ponzi scheme) from the residential mortgage market without causing a crash? How to realise that we have been deluding ourselves as to the  ”value” of our houses. How can we explain that 169% rise? Did we suddenly become more wealthy? Er no our trade balance for the period March 2000-2008 was minus $30.7bln!!!!

No we simply revalued our property again and again for no reason other than the banks were happy to go with the valuations (also pushed it has to be said by overseas immigrants paying cash prices) which just kept going up. If house A in one street sold for 20% more then all the other houses must be worth 20% more. Housing became a commodity and so was able to enjoy the commodity style price action……….of course housing isn’t a commodity as people actually live in them. And that is what is keeping the market afloat…..but don’t look too hard at the numbers. They might make you wonder exactly what it all means.

More on that in the upcoming posts on debt and definancialisation.

3D View: Debt, Deleverage and Definancialisation

It’s taken me a long time to get round to this post. My eyes have been glued to the train wreck that is European fiscal management. Who could forget the financial gymnastics performed by many EU wanna-bees prior to EMU integration. 3% budget deficit….no problem said Greece….we have some very good accountants in Athens.

So the chickens have finally come home. And now the Euro project is in harms way. Or is this just the next stage in complete sovereign consilience? It’s fiscal consolidation or that’s the end of the road.

The real problem, if you look hard enough under the falling limbs of the EU forest, is simply debt and its modern bedfellow, leverage. The financial binge of the last decade, built upon market deregulation in the 80s, has simply finished. Apres le binge, le deluge as they might say in Paris. A bad hangover is one thing but watching bankers get on the big white telephone is no fun at all.

The debt binge primarily was brought about not so much by low interest rates (though that helped) but by the belief that capital gain was guaranteed. Stocks always go up in the long run, property always goes up in the long run…..don’t worry about income, just borrow as much as you can and buy an asset. These financial assets have become a magnet for all investors and, naturally, sellers of investment products. I wonder how many people are holding derivative products which allow them to catch the upside of the stock market with no risk unless the market falls 50%….oops. Certainly Mr Buffet has a few of those.

The return to a time when people invested in companies based on their fundamental performance and bought houses to live in is long overdue. That people cannot afford to buy a home is without doubt the result of excessive lending by banks over the last 30 years. This is the root cause of the problem. Banks have actually created the inflation we have seen in financial assets….unearned income to be exact. That asset price inflation has seen real wages fall heavily over the years consigning the average wage earner or those unable to access leveraged credit to a lifetime of renting and debt.

The maths of excessive leverage is the simple maths of compound interest….compounded.

As Paul Volcker noted in this recent piece,

“There was one great growth industry. Private debt relative to GDP nearly tripled in thirty years. Credit default swaps, invented little more than a decade ago, soared at their peak to a $60 trillion market, exceeding by a large multiple the amount of the underlying credits potentially hedged against default.”

The bottom line is very simple: we have spent our GDP already….for many years hence.

Now it’s payback time. The payback process could take many forms: bankruptcy, forced asset sales or a slow descent back to a normalized level of activity - actually living within our means. Stripping away the financial sector so it works for people and business rather than conspiring against them will be the first requirement: not so much regulation as reengineering.

Whichever route we take it will be a painful adjustment made worse by the fact that those who are in charge are actually responsible for perpetuating the current system or refusing to question and change it.

Coming soon: The ANZAC$

Surely the ultimate humiliation for New Zealand would not be losing the Bledisloe Cup nor even seeing the Wallabies win the Rugby World Cup in 2011 at Eden Park but the bone jarring crunch of monetary union with Australia.

Recently smoke signals have been wafting from the Beehive as John Key and Kevin Rudd white flagged the issue in recent talks. When politicians say it’s a good idea but unlikely you know that it’s on the table. In fact this is not a new story. It comes up whenever there has been a proper meltdown and New Zealand looks a bit lonely and downbeat.

It’s been raised by some local economic commentators and all the usual pros and cons have been mentioned. Don Brash laid these all out nicely in a speech back in May 2000 and it’s hard to see past his conclusion that it is primarily a political decision, given that the economic pay off is unclear.

It may be a political decision then but it may not be a comfortable one. As Bernard Hickey writes today “we may not have a choice if we continue to borrow heavily”. The “shotgun wedding” wouldn’t be the most favourable outcome but NZ is not well placed at the moment. To coin a phrase you can’t be a little bit pregnant.

And, as Brian Gaynor writes, according to a recent OECD study, New Zealand is perilously close to Iceland in a ranking of countries with exposure to “overseas debt……personal debt and financial leverage”.The numbers are eye watering and the piper will be most surely paid at some point in time.

But, for now, the Australian banks, which make up most of our banking system, have underwritten us by sending new capital across the ditch. We also had to follow Australia’s deposit guarantee scheme with no choice in the matter. To all extents and purposes we are heavily dependent on them. So as Bernard notes we may find ourselves at the altar of currency union by default and not by political will. And it may happen sooner than we think.

Is there an alternative? Yes. A fully sovereign domestic money supply. More on that another time.

Chimerica: $ Dis-Ease rumbles on

To the joy of conspiracy theorists everywhere, the new “United Future World Currency” coin was presented at the recent G8 summit in Italy. So far though its just a piece of alloy metal but hey value is in the eye of the holder.

As usual it was the Russian President, Dimitry Medvedev, giving the $ a good roasting and moving the debate forward to the minting process. But really how far advanced is this process and how serious are they? More to the point what would a global currency unit look like?

To answer the first question is simple: I have no idea. At the political level it is mere grandstanding usually for the domestic audience. Sometimes it’s easy to forget that most politicians have little understanding of how the global financial system works (no different from anyone else!) but back in the offices of Treasuries and Central Banks it may be a different story.Though I was struck by the recent bizarre questioning of Bernanke over the issue of $ currency swaps with central banks. It’s a classic.

I do think though that the Eurasian block are serious about making this move. Each step is a step closer to creating a multipolar currency whether its based on the Special Drawing Rights (SDRs), a Commodity Backed Currency (CBC) or an Energy Backed Currency (EBCU). Even the Amero could be a consideration.

But the key outcome will be whether we move from a Fiat based system to a hard currency system. That would make a major change in the structure to the global system perhaps taking us back to Keynes’s suggestion, the Bancor. If we stay with a Fiat system then we simply exchange one piece of paper for another.A hard backed system would certainly restore some much needed reality to the meaning and value.

What’s clear is that the US has become a fiscal disaster and holders of paper issued by the US have said enough is enough: your paper is not “as good as gold“.

Aussiebank? Aussies looking at their version of Kiwibank

3 months a campaign was launched in the UK for a Post Bank to compete with high street lenders and provide a more democratic platform for banking. And now the Aussies are getting behind the same proposition. Dubbed the People’s Bank, it would be run through the network of Australia Post just as Kiwibank has done in New Zealand.

Initial reaction has been interesting with the government saying everything is fine and no need for any competition new competition or inquiry into the financial system for that matter. Well that’s what governments always say. In 5 years of corresponding with officials here in NZ I’ve never had a response that ever differs even when pointing out the finance company sector was going to collapse.

There has also been some commentary about not needing a government owned bank given the disasters of earlier years when many state owned banks collapsed. I enjoyed this quote from the Liberal Senator, George Brandis:

“In principle the opposition philosophically does not support government-owned enterprises unless there is a very clear case, for example, cases of market failure.”

Er yes.

Mostly the commentary has been at the fluffy level. Kiwibank has demonstrated that it is possible and can work well. I certainly have enjoyed their internet platform and found it way better than the big 4 banks. I like that government is backing it in terms of capital though it should be noted it operates as a stand alone SOE. Sam Knowles was quick to comment on the workability of the Kiwibank model in Australia.

So this is the opener in a debate that could take some time and hopefully focus on the real issues within the banking system namely who creates the credit.

Stay tuned.

New Zealand: Small Business crying out for Microfinance

Following on from the news about Kiva moving into the US small business market, fleet footed Ben Kepes calls us to action in New Zealand.

Small businesses in NZ have seen no relief from high interest rates in the recent lowering of rates here. At the same time credit is hard to come by and many business owners have resorted to credit cards to keep their businesses going.

This is a troublesome state of affairs given its the productive economy that has to earn the dollars to pay back the humungous debt necklace hanging around the necks of Kiwis.

So what’s the state of play with microfinance at the moment? Well Kiva is going great guns. It’s really tapped into people’s desire to help and be generous in giving but created this new joy of creating and empowering change for people. It connects people together and that personal touch pulls the punters in.

The more tradtional p2p lending services are not finding life so easy. Charis Palmer reports here on recent developments citing problems for Prosper in the US and some success for Zopa in the UK. Locally Peermint has fallen by the wayside, Nexx hasn’t really got going and Lending Hub has joined a busy Australian market.

So there’s no shortage of platforms but it’s proving harder than expected to deliver the business. But there seems to be no platform for small businesses to secure funding. This is certainly an opportunity as there is certainly a strong and established market on the borrowing side with appropriate forms of due diligence available.

The major stumbling block for p2p start ups has been compliance with various regulatory authorities. However there may be ways around this and with politicians supportive of the small business sector the time may have come for a serious attempt to create what would be a mini-corporate bond market funded by the retail investement market direct.

Now that sounds like a major step forward in building a more productive economy.