Sub-prime debacle has knock-on effect Down Under

Posted on 5/05/2008  

Six months ago you would have been hard-pressed to find anyone other than people working in finance companies who had ever heard of the term "sub-prime mortgage". Now, after a $US1 trillion shock to the international banking system (caused by fast and loose lending practices and apparently flawed financial engineering), the term is in common use - even appearing on the front page of Sydney tabloids.

A "sub-prime" loan is money lent to someone with a limited capacity to pay it back. The lenders squeeze their own criteria and outsource the lending function to "low-doc" or "no-doc" finance companies who arrange for the borrowers to qualify, one way or another. Then there is the second stage - packaging all this dubious loan money into Collateralised Debt Obligations (CDOs), which are then sold to investors at an interest rate which, as it turns out, did not properly reflect risk. Think Michael Milkin, junk bonds, 1987, recession, pain and suffering, and you are somewhere close to it.

The whole sorry tale has slowly emerged over the last six months, almost bringing down one of the big US investment banks (Bear Stearns) along the way. The US Federal Reserve intervened, slashing interest rates and is now reported to be printing money in an effort to jump-start an economy which, if it is not in recession already, is certainly heading in that direction.

But what does it mean for Australia, and in particular, investors whose residential properties are mortgaged to the Big Four banks or any of the dozen or so big regionals and top building societies which should be expected to weather any such storm with aplomb?

Before we get into that, let's examine the exposure of Australian investors who might have been expected to know better - the local government authorities who eagerly invested in CDOs. In New South Wales, at least six councils have owned up to being $200 million to $400 million in the red as a result of investing ratepayers' money in what can now clearly be seen as sub-prime investments.

NSW Treasurer Michael Costa has warned that some essential services could be compromised and some councils face solvency issues as a result of being involved in the US-inspired melt-down. Local governments left with paper linked to CDOs are expected to face a total write-off on these investments. The only upside is that a review by NSW Treasury will tighten investment criteria for future occasions.

The sharp collapse in equities markets has caused its own set of problems, with the Australian listed finance sector taking a big hit. All four major banks have suffered paper losses in share value of 20% or more, but not all of it was logical. In one example, Queensland insurer and financier Suncorp took a double hit (this was a bad year for insurance risks), with its share price collapsing from a year-high of $21.91 to a low of $11.08. We use the Suncorp example to make a point that markets can and do over-react - Suncorp had little or no exposure to the sub-prime market and the re-rating may have more to do with internal factors (buying Promina at the top of the market and losing its entire investment team to a competitor).*

The drop in share values in many market sectors in Australia has resulted in a predictable series of collapses, near-misses, rescues and corporate manoeuvrings. The listed property trust sector took a big hit and there have been a couple of well-publicised fiascos (MFS and Centro). Listed property trust Record Realty has put its entire commercial property portfolio on the market - at a time when many investors in this sector are also looking to cash up.

And as the equities rout causes ructions inside specific businesses, the inevitable job shedding will flow through to the housing market. For example, whitegoods manufacturer Fisher & Paykel has closed its Brisbane factory and is relocating manufacturing offshore, with the loss of 300 local jobs.

But it is clearly misleading and mischief-making to compare what is happening in the US housing market with what is happening in Australia. Much of the sub-prime trouble in the US started in the so-called "rust belt" where home loans were provided to people living in the once-mighty US steel manufacturing cities like Detroit and Cleveland where unemployment is now widespread. There is also an oversupply of housing in the US, whereas in Australia one of the major drivers of our rising house market has been a shortage of land and housing.

Brisbane-based analyst Michael Matusik observed that housing prices rose about 13% across southeast Queensland in 2007, while in the US prices fell by 10% over the same period. Matusik explains: "There are two main differences between our housing market and the US. Firstly, we are undersupplied - we have a new stock deficiency of 32% across Australia and 46% in Queensland, compared to a 16-month over-supply of newly-completed homes sitting vacant across the US."

Matusik also explains the different financing methods. In Australia we commonly mortgage our house as security for the loan whereas in the US many mortgages are "non-recourse" - that is, in the case of default, the bank is left to rely on whatever it can sell the house for, while borrowers can simply walk away from their debt. In Australia, we owe the bank the mortgage amount regardless of what our house is worth.

Many American home buyers also obtained "no doc" loans where there is no requirement for independent/third party proof of income or capacity to pay. The low-doc/no-doc model has been used sparingly in Australia and now that the major lenders have been forced to look at their exposure, many are backing away from mortgage broker relationships and insisting on more conservative loan to valuation ratios.

And in Australia, the economy continues to grow strongly, thanks largely to China's seemingly insatiable appetite for our raw materials, as well as other expanding markets that need coal, iron ore and copper (not to mention wheat and cotton). However, domestic inflation remains a worry - some economists think the Reserve Bank will lift domestic interest rates again, which seems certain to take the prevailing mortgage rate to the psychologically painful double figures. Never mind that there is little difference in monthly repayment between servicing a loan at 9.85% and at 10.1%; there's something about double-digit interest rates that conjures up images of a Paul Keating hologram in the sky, warning about the recession we have to have!

There is a certain school of thought that says coping with inflation of 4% is better than risking the economy sliding into recession via an over-zealous use of monetary policy (as appears to be happening in New Zealand). And inflation of 4% may soon seem modest against China's inflation story. China's cost of living began spiralling last year as a result of too many factors to mention - for example, flooding in China's south and drought in the north (not to mention a pig ailment called blue ear disease), adding greatly to a 15.4% hike in food prices in the July 2007 quarter.

Although inflation in China dipped to 8.3% in March 2008 (it was 8.7% in February), price rises will continue to be triggered by increases in monthly wage rates and welfare benefits. The Economist reported that grain shortages could again push up food prices, as it has done elsewhere in Asia. However, China's manufacturing sector is keeping a lid on inflation, through intense competition and massive foreign investment. If this bullish scenario were to change and domestic consumption in China slowed, it could have all sorts of negative ramifications for Australia's resources sector and retailers (who have come to reply on cheap and plentiful consumer goods, clothing and food from China).

Despite the negative signals from the US, UK and some parts of Asia, Access Economics is not overly concerned about Australia in 2008. In its latest Business Outlook report, Access Economics says "2008 looks fine for China - and hence for Australia too." The theory is that as long as China continues to buy our coal and iron ore (at increasingly higher prices), we will sail through the rest of 2008. But if China stumbles and the US takes longer to emerge from recession, 2009 could be a different story. Let's not forget that the Shanghai market index is down 47% since October 2007.

Back home, as the US housing market continues to unwind and the credit squeeze continues, we can expect Australian lenders to insist on better security for loans - if only as a "better them than us" reaction.

Recent housing approval statistics suggest that rising interest rates are already causing investors to back off. And the HIA says any further contraction of investment in housing will cause further pain to those who already struggle to meet rising rental payments.

So what about the Australian housing market, recently identified in an IMF survey as one of the world's most over-valued markets? In the IMF terminology, there is a ‘house-price gap' when increases in house prices cannot be explained by the usual fundamental drivers of real estate prices, such as lower interest rates and higher incomes. According to the survey (published in The Economist), Australia's ‘house-price gap' widened to more than 20% between 1997 and 2007.

The real worry for investors in such unstable market conditions is what might happen to the 20% "premium" built into Australian house prices, as this premium is more to do with the bullishness of times now past than market fundamentals.

*The writer owns shares in Suncorp

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