Wednesday, September 22, 2010

Determined denial

Everyone has seen the ads. A sturdy and commonsense 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 executives are travelling internationally (including to, presumably, America) to do more than dispense with a fictitious advertising agency's foolish ideas. They have gone "overseas to meet with some of the group's offshore shareholders and other investors interested in Australia and the Australian banking sector".

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 housing bubble in Australia. It included quotes from such notable housing bears as Morgan Stanley's Gerard Minack and GMO's Jeremy Grantham that it aims to refute. CBA management has set sail on a bubble-busting roadshow.

Given the stake we Australians have in this little exercise, we should assess how the fundamentals of our housing market are being presented 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 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 graphs making the comparisons clear. And they look reasonable enough except the statistics aren't explained. We don't know what income measures are being used, nor what median prices. Worse still, the statistics are cherry-picked from different sources to ensure the most favourable comparisons.

The lack of detail in the presentation is quickly forgotten as CBA's arguments sink into a fallacious morass. According to the bank: "Australia is the fourth least densely settled country in the world - 83 per cent live within 50 kilometres 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 will forgive this writer if he points out that if 83 per cent of Australians live in coastal cities then that surely constitutes 83 per cent 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 been a great Australian exodus to the coast from the bush in the past 15 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.What CBA doesn't mention nor explain is the prior eight-year burst in prices of 120 per cent, driven largely through rocketing demand for investment mortgages, up 308 per cent 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 1990s 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 labour market trends. Nothing about capacity utilisation. Nor is there 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 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 unfortunate given that this presentation is likely to be aimed in part at the global bondholders who determine the interest rates at which CBA borrows its wholesale funds 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 percent of household disposable income'' as compared with Britain, New Zealand, Canada, US, Japan and Germany.

The problem with this item is that Australia is second only to Britain, the other market identified by 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 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 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 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 meantime 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?

This article was originally published at Henry Thornton and was reproduced by Debtwatch, and Business Day. It also got picked up in New York.

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