11 October 2017
Real estate bubbles are often the most insidious of all financial bubbles. We can choose not to participate in the stock market and bond market – but we don’t need a stock certificate to keep warm and dry.
When animal spirits and cheap credit combine in the housing market, it can only end badly because we all do need a place to call home –the social and economic cost of a housing bubble tends to be felt very broadly. Anyone who lived through the bust of US housing from 2007 onward has tales of woe to tell.
Somebody forgot to tell the Australians
The latest ‘Things That Make You Go Hmmm…’ from RVP favorite Grant Williams takes us on a fascinating journey Down Under to discover a rare creature indeed: an economy that hasn’t had a recession in 26 years. The recency bias for gains formed by strong employment trends, rising house prices, and a growing economy combine to create a ‘can’t lose’ bias on property purchases, driving some seriously bubbly valuations.
I won’t steal Grant’s thunder by repeating just how insanely leveraged Aussie households are – but one of the most interesting aspects of his deep dive is the exposure of the Aussie banks. Investors are always looking for ways to gain exposure on the long or the short side to a given macro trend… these banks are vulnerable to a housing correction:
Residential Property as % of Total Loan Book
Australian banks are packed full of mortgage loans. They make Canadian banks look well-diversified by comparison! This is a seriously exposed sector – and putting two and two together with the Tabbush report on Aussie banks, this should be the perfect short! As Daniel Tabbush demonstrates, these banks are also stuffed full of corporate business loans whose quality is souring rapidly:
Australian bank impaired loans and Australian corporate debt ( US$bn)
Source: Tabbush report
Yes, the fragility of this system makes it look like the perfect short – and yet the trade idea has burned a lot of fingers to date:
‘Shorting the Australian housing market has been a widow-maker trade.’ – Sujit Dey, JPMorgan
Short sellers who are looking for a repeat of the US housing bust have been short-changed by the surprising resilience of Australian housing. The macro setup is all there, but the catalyst is yet to arrive – and shorting businesses that are cyclically challenged but not fraudulent can be a terribly protracted waiting game.
The Canadian housing bubble is another popular point of contention. I wrote in The HackSept 8th about the ‘everything bubble’ that includes Canadian housing. There is ample anecdotal evidence of a huge bubble, driven in the first instance by foreign investment in Vancouver – I mean, really two million loonies?
Picking your short
The Canadian banks must be a short, then? Well, legendary short seller Marc Cohodes was all over the news a few months back as Canadian lender Home Capital Group looked set to collapse amid a run on deposits. Marc was short the company, which he reckoned was worth zero. Marc successfully identified the weakness of the company – it was effectively a subprime lender with lax standards. Whilst Marc was also short Equitable Group, another ‘specialist’ lender, he was not short the wider banks. Many championed him as being short Canadian real estate, but that’s not strictly true – he was short the weakest and most exposed players… until Warren Buffett stepped in and ruined his trade.
Why does everyone want to short real estate?
Being short Canadian or Australian real estate is a popular cause, especially amongst residents excluded from the housing market by prohibitively high prices. But be careful what you wish for: Busts precipitate wider economic crises, as the GFC showed.
Canadian housing is clearly overvalued; but when you pick a short trade, you pick the weakest stock in the pack. You don’t want to be short the big players because they are stronger, more diversified, and higher up the pecking order for a government bailout.
Who else has got a big bubble, then?
Source: The Economist
New Zealand is a real standout – it tends to follow Australia, and most of its bank lenders are Australian or dual-listed, like ANZ. Germany, on the other hand, looks quite restrained, as does the United States. Spain is instructive on what a big crash looks like after its mega boom into the mid-2000s, which is still killing off small banks and caixas like Banco Popular.
Britain is another bubbly market – after a mini-bust in the GFC it’s been on the rise again. It also has an interesting mix of housing-exposed stocks.
The Great British housing bubble
The UK banks have a good selection of mortgage loans on their books; but increased regulation, lower lending limits, and government guarantees have generally left them less exposed to a housing bust than they were during the GFC, when Northern Rock collapsed and any and every building society that demutualised in the 90s was taken over by bigger banks.
But the UK also has other housing-exposed stocks.
Homebuilders in the UK tend to make most of their profits from ‘land banking’ rather than home building due to highly restrictive planning laws. By developing large parcels of land into the maximum possible number of home units, homebuilders can realise exceptional profits. Throw in some juicy government subsidies and you have the ingredients for a huge boom – but look at what happened during the last bust:
UK Homebuilders Price Chart 2010–2017
Persimmon (Blue), Taylor Whimpey (Red), Redrow (Orange), Barratt (Yellow)
The sector took a major hit during the GFC, with Redrow and Taylor Whimpey nearly going bust – yet the recovery has been nothing short of meteoric.
Estate agents are exposed, too.
Estate agents’ share prices tell the other side of the UK housing story. Declining transaction volumes resulting from high prices and high frictional costs from transaction taxes have caused profits to collapse:
UK Estate Agents Price Chart 2014–2017
Foxtons (Blue), Countrywide (Red), Winkworth (Orange)
Therefore, homebuilders gain from high prices and low supply – meaning they can sell new units at a premium. Estate agents, on the other hand, are seeing falling commissions from increased competition for fewer sales and are signalling a broader downturn in activity.
UK house prices remain elevated today, but when will a wider bust hit that makes homebuilders and even banks an attractive short trade?
So that’s the micro; where’s the macro?
Housing in the Anglosphere has continued to outfox macro minds looking for a US-style bust. The UK saw a mini-dip and a further reflation; Australia never noticed; and Canada just decided to go crazy, especially out west.
When can we expect the macro to turn so that these short trades will make sense? The short answer is when rates rise.
The shock move by the Bank of Canada (The Hack Sept 8th) to raise rates another 25bps this month caught markets unawares. These rising rates have pushed the 10-year government yield over 2%; and as this rate increase transmits through to mortgage rates, we can expect those with large household debt loads to start to feel the squeeze – will this finally cause the Canadian banks to drop?
Tightening of regulations around real estate is also having an impact, and there are nascent signs that the bubble is beginning to pop. The cursed foreign buyers seem to be drying up, too, in the bubble’s centre, Vancouver:
These changes have cooled momentum (blue, below) even as the price index hits new highs (black line):
Vancouver Real Estate Index
The BOE is flirting with some tightening and regulation that is putting a lid on further house price appreciation:
The Bank is keen that lenders do not get lulled into a false sense of security by current low interest rates and offer increasingly risky loans. The report points out that mortgage debt has historically been a source of risk in terms of financial stability. – The Telegraph
There are nascent signs that extended British borrowers, already stuffed to the gills, just can’t find any more credit to throw at the housing market. The narrative in the press has changed from cheering house price growth to calling it house price ‘inflation’ as real incomes are squeezed and living standards are feeling the pinch. Borrowers are already seeing record prices relative to income:
UK house price to earnings ratio
Source: Nationwide Housing Index
This extended ratio is signalling that people just can’t put any more money into the market, and it shows in falling growth momentum:
Annual percentage change in UK house price
Source: Nationwide Housing Index
What happens when this momentum stalls and turns negative? Without free money from rising housing equity, many second homes and buy-to-rent properties will flood the market, potentially exacerbating a price collapse. Who then will buy all those new homes built by the UK homebuilders?
Momentum is the killer.
“How did you go bankrupt?” Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises
The tipping point occurs when expected growth in house prices fails to materialise. With such high leverage, a massive unwind could potentially precipitate a major financial crisis. Australia looks most exposed since its banks are so heavily exposed to mortgages in their loan books.
To date, the Aussie banks have held on, but a slight rise in rates or a slow grind in real wage growth could put an end to the party. Keep your eyes peeled on the macro signals.
This article was originally published at Real Vision Publications.