In this week’s MacroVoices podcast, host Erik Townsend interviews Josh Steiner, who heads up financials research at Hedgeye.
In recent months, Steiner has focused on vulnerabilities in global housing markets. Since covering the global market in its entirety (where bubbles in housing, just like stocks and bonds, are seemingly omnipresent) the two focused on the markets in two resource-rich countries: Australia and Canada.
As Steiner explains, the economies of these two countries have experienced dramatic shifts over the past two decades. Many investors think of these two economies as being primarily resource driven – and resource-rich economies are famously prone to bubbles.
However, in recent years, growth has been primarily driven by the FIRE – financials, insurance and real estate – which, coupled with the staggering home-price appreciation, is making the situation in both markets particularly precarious.
But our work has shown that really in the last ten plus years, especially in the last five years, these are largely FIRE-driven economies. We’ve looked at the contribution to both the economy at large – the share of growth in the economy from financing, insurance, real estate, construction, across both Australia and Canada. And we’ve sort of likened them to one-cylinder engines where, really, the bulk of growth is being derived from appreciation in collective property values, the financing of it, the insuring of it, the construction of it, and the wealth
effect created thereby.
So I think, definitely, looking back through time, there’s certainly a resource-driven component, and that’s still there. But when you really dissect the source of new growth for these countries over the last half decade or decade, it is pretty surprising just how much of it has come from the property markets.
As Townsend reminds us, the catalyst for the housing crash that precipitated the financial crisis first materialized during the first quarter of 2007. As was memorialized in “The Big Short”, a wave of adjustable-rate mortgage resets rocked homeowners, and all of a sudden, the market collectively realized that the trajectory of home-price appreciation was not only unsustainable, but was already unjustifiably overdone…
….And the rest, as they say, was history.
Circling back to the present day, the catalysts for the Canadian and Australian housing-market collapse are most likely going to vary in both numerically and qualitatively. For one, adjustable-rate mortgages aren’t nearly as popular today as they were back then. More pertinent perhaps are the many other risk factors that are hanging over the Australian and Canadian housing markets like the Sword of Damocles.
For example, both markets have been propped up with foreign capital – primarily from mainland China, where investors, worried about the consequences of another yuan devaluation, have sought to stash their capital in reasonably stable offshore markets. But Chinese authorities tightened capital controls a year ago to curb real-estate speculation. As a result, one crucial source of capital has been dramatically curtailed.
Steiner had a somewhat more complicated view. As he explained, the US housing collapse was purely a result of prices just running out of steam. This was expressed by a plunge in transaction volumes in 2005 that predated the inflection point in the housing market by just over one year. Crises, Steiner reminds us, don’t happen overnight: Even once housing prices started falling, more than a year would pass before the Lehman bankruptcy.
The way I think about housing bubbles is that housing sort of takes on one of two forms at any given point. And the curiously repeating phenomenon with housing bubbles is that housing undergoes, if you will, this phase transition from what’s called a basic good to what’s called a giffen good. A basic good being something you buy more of as the price goes down and a giffen good the exact opposite, something you buy more of as the price goes up. And why on earth would anybody buy more of something as the price goes up? The reason is because it transitions from something you consume, a consumption good, to an investment good.
And you saw this in the US. You’ve seen it in every property bubble globally, historically. People buy the most of these things, the most housing, when the prices are at their most extreme, i.e.
their most unaffordable. And then, conversely, when things are incredibly cheap, they buy the least. And that’s because people’s perception around what a house represents has undergone this phase transition from somewhere I live to an investment, back to somewhere I live.
That was the real catalyst. So you hit peak buyer in mid-’05 and then a couple of years later you hit all these problems in the sub-prime market. This whole cottage industry of sub-prime originators basically collapsed and went bankrupt over the course of the first half of ‘07. And then it was even a full year and a half after that before you had the full-blown, full-throttle financial crisis that took down Lehman Brothers and the general banking system.
Steiner expects a similar dynamic – what’s known as a “Minsky Moment” – will play out in Australia and Canada. Prices will hit a critical mass of affordability, and buyers will turn their backs. Eventually, sellers will be forced to either remove their inventory from the market, or lower prices. Many will inevitably choose the latter.
In both countries, housing authorities have adopted policies that will almost certainly accelerate the collapse. Local governments in Canada and Australia have imposed restrictions on foreign buyers. In Canada, these restrictions are particularly egregious.
And what Canada is doing right now, between these foreign buyer tax disincentives, the B-20 guidelines making it much harder for people (first-time buyers especially) to qualify – all of this is sort of feeding that, fueling that fire that’s really going to suck the life out of the would-be
Think of housing as a ladder where everybody simultaneously moves up a rung. But it’s not possible if you don’t have that first-time buyer getting on that first rung of the ladder.
So that’s our thesis – that all these new rules going into effect, and confluent with Chinese demand beginning to wane, are really going to impact the low end of the Canadian market. And that’s going to disrupt the whole property ecosystem across Canada.
Still, there are many distinctions between the US housing market crash of 2007 and what’s unfolding today in Canada and Australia. One of the most critical differences is the paucity of institutional investment products tied to housing. Canadian and Australian banks haven’t been as eager to securitize their mortgages; their banks instead act as portfolio lenders. Therefore there are no exotic products – no synthetic CDOs, no “bespoke” tranches – to bamboozle investors into being ignorant of just how risky the purportedly AAA-rated products they bought actually were.
Instead, the risk in Canada and Australia is more concentrated within the balance sheets of the largest banks. In Canada, Steiner says, the concentration of first and second lien mortgages – loans that are already closing in on default – held by the country’s “Big Six” banks is particularly troubling.
Once these loans start threatening profits, Steiner believes there could be a massive correction with potential downside up to 60%, as investors shift to valuation banks based solely on tangibles to reflect the more pessimistic earnings outlook.
I think the reality here is a little bit different. I don’t think you have this ticking time bomb in the form of exotic CDOs, CDO-squared products, lacing the balance sheet across the entire banking system.
But what I do think you have is an enormous amount of concentration risk on the part of first and second lien mortgages across the “Big Six”. Like I said earlier, I think the Canadian economy has really become very much a one-cylinder economy that’s driven by this property bubble.
And then from a valuations standpoint, you have a lot of the large banks – you mentioned Royal Bank as being one – where valuations are north of two times tangible book value.
So think about what I said earlier, which is that when home prices are appreciating rapidly you have all-time lows in delinquencies. That’s an absolute function. It’s like the economic equivalent of a physical law, like gravity. When prices are appreciating rapidly and an asset class is inflating, naturally you’re going to have very low delinquency rates. And that’s exactly what the rear view of the last 12–18–24 months looks like across the big Canadian banks.
Our point is that when prices start to slow down – God forbid they should actually start to go negative – those delinquency rates are going to rise. And as they rise, the banks will have to provision for those loan losses. And that’s going to erode earnings power.
Until this point, the interview had focused on Steiner’s Canada thesis. Townsend suggested moving on to Australia, which, as Steiner explained, has a similar risk profile to Canada: If anything, Australia’s economy is even more dependent on FIRE.
There are also some idiosyncratic factors like the construction boom.
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.
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
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.
Another risk factor in Australia are IO – investor owner – loans, that are enabling buyers to “reach” for more expensive homes by taking out loans with higher rates, but without putting down the principal. These loans could trigger a “reset shock” similar to what triggered the housing collapse in the US.
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.
To their credit, Australian regulators have begun cracking down on these risky loans, imposing limits around the allowable growth rates for the big four Australian banks around IO lending. But at this point in the cycle, these restrictions could ironically become the catalyst that destabilizes the market.
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.
Instead of creating a “soft” landing, regulators could pull the string that causes the whole tapestry to unravel.
Listen to the whole interview below: