One of the benefits of the DFA channel, as it develops, is the discussion and questions raised in the community. I have already been able to create content to meet specific requests and issues and will do more as we progress. For example, I am working on a series relating to crypto currencies, and another on property ownership (or not) across various household segments. Then there is more to say about The Chicago Plan, and how it might be practically be implemented.
But one of the most common threads is this. Ok, so I understand the risks in the property and finance sectors are increasing, but what should I do, how should I plan, and react. In fact, that often translates to two subsequent questions. First is, where should I put my savings in this high risk environment and second, I have been hearing about the risks in the systems for years, and so did not buy property then and consequently have missed out on significant capital gains. My friends thought I was nuts. So what’s different this time? Why should I stay away from property now?
So I want today to begin explore these questions further. And I need to say upfront, this is not financial advice. I am neither qualified to provide such advice and in any case, in this piece I could not take individual needs or financial situations into account. But, you might want to refer to my earlier programme – “Should I Buy Now”? which I published on 27th January this year.
But what I can do is to go beyond the often cartoonish statements being made at the moment. My favourite silly remark this past week was “the fall in property value offers the change for great buying, now”. I won’t embarrass the person who said this, other than to say they represent, no surprise, perhaps, the real estate industry. The RBA’s recent assertion that most households will cope with a rise in interest rates, and the switch from interest only to principle and interest loans would be another.
So let’s start with where should I put my savings in this high risk environment. As context, let’s look at what happened to UK bank Northern Rock.
Northern Rock, one of Britain’s Biggest Bank, began as a mutual in the North East, but then in 1997 it converted to a bank, offering members “free shares”. Later it became home to the 125% mortgage, and made the error of borrowing very short term, on the bond markets, whilst lending to customers for 25 years or more. Worse they then packaged those mortgages up and sold them on mainly to US banks. Whilst property prices were rising, and credit was free and easy all was well. Savers also put their money with the bank and got above average returns. The bankers looked like magicians and investors piled in. But then came the crash. House prices fell. The value of the mortgages fell too and the Bond markets then stopped lending to the Rock. So the cash flow stopped, but the bank needed billions of pounds just to keep the bank running. They were forced to seek assistance from the Government. No reason for depositors to panic, said the commentators at the time. Well that set the cat among the pigeons. Banks did not trust each other enough to lend to each other in the money markets and customers found their money in the bank was not as safe as people thought. And that was around 18 billion pounds.
The bank was nationalised in 2008, but this was just the start, and the UK Government was forced to spend $1 trillion pounds, yes, $1 trillion pounds on rescuing banks. In a subsequent review, the banking regulators were accused of applying light tough approaches to regulation. The assumption was that the financial system was full of such clever people, that self-regulation was sufficient – something with FED Chair Greenspan later came to recognise was a fallacy.
Five years later, on the other side of the crisis, when debt had been reduced, the full impact on the economy was clearer to see.
So, back to the present. We know that household debt is very high in Australia, the banks have made massive volumes of “liar loans” and global interest rates are rising. In addition, we are already seeing credit being tightened, and home prices are sliding. There is more to come, as discussed in our four scenarios video, which you might want to watch.
If you hold property, as an owner occupier, chances are the value of your property will fall, and the paper profits you think you have may be illusory. But the mortgage won’t be, and we know that many are struggling with big debts and poor cash flow. The good news, is that provided you can continue to make repayments, slipping into negative equity is not an immediate problem, but of course it may mean people are locked into the current properties. In Ireland and the UK, 10 years later, values have recovered, but it was a slow recovery. But if jobs dry up, default becomes more likely.
If you are an investor in property, and given many are not seeing any growth in rental receipts, you may find things more problematic – especially if you have several properties, on interest only loans. Repayments on these loans are likely to increase, as the RBA said the other day. In fact, some of the smartest money in the investment sector has already sold to realise their capital gains – but as values slide, this becomes a less attractive option. Research shows that investors are four time more likely to default on their mortgages, and so will be forced to sell in a downturn. Less experienced investors will likely be left holding the baby.
If you have savings in deposits, chances are the interest rates on those balances have already been cut, as banks try to protect their margins. Whilst mortgage interest rates are often discussed, the poor old saver continues to get a bad deal, yet this does not get much attention. I have always been surprised more is not made of this.
This takes us to the Bail-In question. I won’t go over the arguments again, you can watch my separate video on this.
But two points. First, there is a theoretical government backed deposit guarantee up to $250,000 (as we record this), but it needs to be activated by the Government, on an individual bank basis, so it is not in force today. Second, APRA says deposits will not be bailed-in, despite the fact the APRA now has the power to grab “other instruments” to assist in a bank restructure, and in New Zealand, deposits are definitely up for grabs. The situation in Australia, in my view is deliberately vague. Deposit bail-in could have been expressly excluded, but were not. The $250k guarantee is per financial entity, so you may be able to spread your risks by sharing deposits across multiple separate Australian based banks. Local subsidiaries of international banks are also included provided they are licenced locally. The $250,000 would cover all deposits, including term accounts, so it is not a limit by account, but by banking relationship. Also check if you are using an overseas bank, as they may not be guaranteed. It is worth asking now. Get it in writing.
Money held in superannuation funds will probably be placed with various market investments such as shares and bonds and some cash. But unless your funds are held in a separate self-managed superannuation account, the $250,000 deposit account guarantee would not apply. And it is worth checking with your bank if you have a self-managed deposit account to ensure it is.
Obviously market investments like shares and bonds will react to poor market conditions. We have seen market crashes of 25% or more in the past, and investments may well fall. There are no guarantees. Superfund balances can and will fall, but they will still take their management fees.
Some advocate placing money in Bitcoin or other cyber currencies, because they have decentralised block-chain records which mean Governments cannot get their hands on the funds placed there. While that may be true, values are very volatile, and I regard such Cyber investments as purely speculative and risky. Not really a core or secure option in my view.
What about gold or silver? Well, at least you hold something physical and in the past in crisis, these commodities have retained more value. But then you have the storage risk, and the liquidity risk. If you wanted to realise value later you need to find a buyer, and pricing is not certain. This is also true of ETF’s, and prices may fall.
So, should you hold cash, in notes? Surprisingly, it appears more funds are indeed being held in this form (for example in the UK, never has so much been held in notes – so the Bank of England is looking at removing the fifty-pound note. This is partly to reduce the size of the black economy, and partly to reduce the floats people hold. One point to bear in mind is that there is physical risk – notes burn for example, and you get no interest on notes held, but at least there is less chance of losing more value if the notes are safe.
And that’s the point, there are no easy answer to the question what should I do. It really does depend on your risk appetite, and whether you are most concerned about safeguarding the current value of what you have, or whether you are looking for future capital growth. Generally, I think it is true that risks are reduced by spreading savings and investments across multiple options, but then there is a trade off as complexity costs.
Now, turning to the question of what is different this time, with regards to property prices. In a word availability of credit. In the last decade or so, property prices have moved up and down, but the banks have been willing – very willing – to lend. This has driven prices higher and so many who bought a few years back are sitting on paper profits.
But the tightening of credit which we are seeing now will force prices lower, turn investors away, and as some are also forced to sell, this additional feedback loop will also force prices lower again. If you add in the lower number of foreign buyers, I cannot see a scenario where prices take off again anytime soon. My base case is a drop of 15-20% over the next couple of years. But I could be wrong.
A final point. Many households do not have a handle on their household budgets, so as I keep saying, it is worth drawing up a budget so you can see where the money is coming and going. You may be surprised. Then you can actively manage and prioritise your spending. This is the first critical step to getting to grips with your finances.
Also banks have a legal responsibility to assist in cases of hardship, so if you are in financial difficulty, it is worth talking to them.
So in conclusion, there are no easy answers to this conundrum. Which is why the level of uncertainly is currently so high, and I cannot see this settling down anytime soon.