Now, today I am not going to discuss the mechanics of the digital currency, there are plenty of others who have done that; nor am I going to discuss the limited supply, which is mirroring gold, other than to note this one of the fundamental design criteria of the crypto currency.
But institutional investors are getting more interested.
For example, Goldman Sachs announced it will be opening a crypto derivatives trading desk “within weeks,” as well as recently hiring a cryptocurrency trader as vice president of their digital asset markets. It will trade Bitcoin futures in a principal, market-making capacity and will also create non-deliverable forward products.
Then last week there was some more potentially important news out of the USA. There are rumours that the New York Stock Exchange may be planning to offer ‘Physical Delivery’ of Bitcoin. If this is true, it could mark a significant transformation in the role of digital currencies like Bitcoin.
The suggestion from unnamed “multiple sources” is that NYSE’s parent company Intercontinental Exchange or ICE is planning to offer Bitcoin (BTC) swap contracts but these contracts would be settled with the delivery of Bitcoin itself. Think about that, a mechanism to allow the physical delivery of a digital currency. If this IS true, this would have significant consequence for the future of crypto.
While there are Bitcoin futures contracts currently being offered on Chicago based CME Group derivatives marketplace or CME (since December 2017) and Chicago Board Options Exchange CBOE, these are ultimately settled in dollars.
The suggested crypto swap contracts would be settled in Bitcoin, and this would be a significant milestone which may signal a major Wall Street adoption of crypto.
Significantly it could mean that the ICE has a custody solution. As Bitcoin are generally bearer instruments it means you have to have a third-party custody option if institutional investors are going to get seriously involved.
There are so called “Cold storage custodian solutions” offered by small operators.
It’s not clear whether ICE is likely to build an in-house cold storage solution or to outsource it. In fact, ICE has made no comment at all on this, so it might be just speculation.
But here’s the thing, if ICE can offer a custodian solution that meets SEC rules and compliance requirements, this could “open the floodgates” to institutional capital, resulting in some “big price moves” in the crypto markets.
A custody solution would also open the door for pensions and endowments and so become an emergent asset class…most obviously at the expense of gold.
The Bitcoin price is still sitting well below the previous highs and the markets did not really respond to the rumours. But if this is true, then it may mark a significant inflection point in evolution of crypto. It might go mainstream.
Aussie trade financing deep technology startup, Trade Ledger, has finished ahead of nine other VC-backed companies from across the world to be named the winner of the Barclays UK Ventures “Open Innovation Challenge 2018” in London this week.
The ten finalists were hand-picked by Barclays due to their potential to offer game-changing business solutions across a variety of industries, however Trade Ledger came out on top because of the way it completely transforms processes in business lending, through its world-first technology platform.
“Within Barclays UK Ventures, we’re looking for companies we can partner with to develop and deliver transformational products and services,” said Ben Davey, CEO of Barclays UK Ventures.
“We chose Trade Ledger as they have re-imagined the lending process by improving the processes through automation and opening up lending opportunities to a larger client base, which fully aligns to our Shared Growth ambition.”
The competition involved a face-to-face pitch by each of the ten finalists to Barclays’ technology leadership team. Other finalists hailed from high-tech industries such as AI security, recruitment CRM and marketing automation, process mining software, application performance management, IoT, chatbots, and robotic process automation platform creation.
The event served as a means for Barclays to gain access to some of the most advanced technologies being developed from across the globe.
“These events are a great way for us to uncover solutions that will materially improve our business and the solutions we offer to customers and clients,” said Sean Duffy, Managing Director of Technology Media and Telecoms in Barclays Corporate Banking Division.
“This is the first time we’ve hosted this event in the UK, which is a testament to the growing strength and depth of VC-backed companies in our home market.”
Gaining international exposure through competitions such as this one is an important aspect of Trade Ledger’s “born global” strategy, designed to tackle the £1.2 trillion under-supply of business credit globally.
“We are delighted that Barclays has chosen the Trade Ledger business lending platform as the winner of this global challenge,” Martin McCann, CEO and founder of Trade Ledger.
“It was an incredible opportunity to be able to present our tech and strategy for helping banks address the massive under-supply of business credit, to such a large and diverse group of the bank’s technology leaders.
“We believe the platform will help Barclays accelerate their transformation into data-driven lending, and that our selection proves the unique value of the Trade Ledger platform to support the bank’s innovation and growth ambitions.”
Further discussions on a partnership with Barclays are ongoing, and will help Trade Ledger prove product marlet fit within tier 1 banks globally.
The latest and updated edition of our flagship report “The Property Imperative” is now available on request with data to April 2018.
This Property Imperative Report is a distillation of our research in the finance and property market, using data from our household surveys and other public data. We provide weekly updates via our blog – the Property Imperative Weekly, but twice a year publish this report. This is volume 10.
Residential property, and the mortgage industry is currently under the microscope, as never before. The currently running Royal Commission has laid bare a range of worrying and significant issues, and recent reviews by the Productivity Commission and ACCC point to weaknesses in both the regulation of the banks and weak competition in the sector. We believe we are at a significant inflection point and the market risks are rising fast. Portfolio risks are being underestimated. Many recent studies appear to support this view. There are a number of concerning trends.
Around two thirds of all households have interests in residential property, and about half of these have mortgages. More households are excluded completely and are forced to rent, or live with family or friends.
We have formed the view that credit growth will slow significantly in the months ahead, as lending standards tighten. As a result, home prices will fall. We note that household incomes remain flat in real terms, the size of the average mortgage has grown significantly in the past few years, thanks to rising home prices (in some states), changed lending standards, and consumer appetite for debt. In fact, consumer debt has never been higher in Australia. Household finances are being severely impacted, and more recent changes in underwriting standards are making finance less available for many. But the risk is in those loans made in recent years under looser standards, including interest only loans.
Property Investors still make up a significant share of total borrowing, and experience around the world shows it is these households who are more fickle in a downturn. Many use interest only loans, which create risks downstream, and regulators have recently been applying pressure to lenders to curtail their growth. Already we are seeing a drop in investor loans, and a reduction in interest only loans. A significant proportion will be up for review within tighter lending rules. This may lift servicing costs, at very least and potentially cause some to sell.
We hold the view that home prices are set to ease in coming months, as already foreshadowed in Sydney. We think mortgage rates are more likely to rise than fall as we move on into 2019.
We will continue to track market developments in our Property Imperative weekly video blogs, and publish a further update in about six months’ time.
If you are seeking specific market data from our Core Market Model, reach out, and we will endeavour to assist.
Here is the table of contents.
1 EXECUTIVE SUMMARY
2 TABLE OF CONTENTS
3. OUR RESEARCH APPROACH
4. THE DFA SEGMENTATION MODEL
5 PROFILING THE PROPERTY MARKET
5.1 Current Property Prices
5.2 Property Transfer Volumes Are Down
5.3 Clearance Rates Are Easing
5.4 But Can We Believe the Auction Statistics Anyway?
6 MORTGAGE LENDING TRENDS
6.1 Total Housing Credit Is Up
6.2 ADI Lending Trends
6.3 Housing Finance Flows – Bye-Bye Property Investors
6.4 The Rise of the Bank of Mum and Dad
6.5 Lending Standards Are Tightening
6.6 How Low Will Borrowing Power Go?
6.7 The Portfolio Mix Is Changing
6.8 Funding Costs Are Higher
6.9 The Interest Only Loan Problem
7 HOUSEHOLD FINANCES AND RISKS
7.1 Households’ Demand for Property
7.2 Property Active and Inactive Households
7.3 Cross Segment Comparisons
7.4 Property Investors
7.5 How Many Properties Do Investors Have?
7.6 SMSF Property Investors
7.7 First Time Buyers.
7.8 Want to Buys
7.9 Up Traders and Down Traders
7.10 Household Financial Confidence Continues to Fall
7.11 Mortgage Stress Is Still Rising
7.12 But The RBA Is Unperturbed
7.13 Latest Household Debt Figures a Worry
8 THE CURRENT INQUIRIES
8.1 Productivity Commission
8.2 The ACCC Mortgage Pricing Review
8.3 The Royal Commission into Misconduct in Finance Services
8.4 Merge Financial Advice and Mortgage Brokering Regulation
9 AN ALTERNATIVE FINANCIAL NARRATIVE
9.1 Popping The Housing Affordability Myth
9.2 The Chicago Plan
10 FOUR SCENARIOS
11 FINAL OBSERVATIONS
12 ABOUT DFA
13 COPYRIGHT AND TERMS OF USE
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But in its 53 pages of “dry banker speak” there are some important facts which shows just how much of the global financial system is now interconnected.
They start by making the point that over the past three decades, and despite a slowdown coinciding with the global financial crisis (GFC) of 2007–09, the degree of international financial integration has increased relentlessly.
In fact the rapid pace of financial globalisation over the past decades has also been reflected in an over sixfold increase in the external assets and liabilities of nations as a share of GDP – despite a marked slowdown in the growth of cross-border positions in the immediate aftermath of the GFC.
This chart shows the evolution of advanced economies’ financial exposures to a group of large middle-income countries, split into portfolio exposures and bank exposures. It shows that both types of exposures have increased substantially since the late 1990s.
Here is another chart which again the linkages, looking at cross-border liabilities by counterparty. The chart shows the classification of cross-border debt liabilities by type of counterparty. It shows that cross-border liabilities where both creditor and debtor are banks are the largest of the four possible categories, and increased rapidly in the run-up to the GFC. It also shows a rapid increase in credit flows relative to foreign direct investments (FDI) and portfolio equity flows.
They explain that cross-border bank-to-bank funding (liabilities) can be decomposed into two distinctive forms: (a) arm’s length (interbank) funding that takes place between unrelated banks; and (b) related (intragroup) funding that takes place in an internal capital market between global parent banks and their foreign affiliates. They note that cross-border bank-to-bank liabilities have also played a major role in the expansion of domestic lending, at their peak in 2007 these flows accounted for more than 25% of total private credit of the recipient economy.
This also opens the door to potential arbitrage, for example “rebooking” of loans, whereby loans are originated by subsidiaries but then booked on the balance sheet of the parent institution. Indeed, the presence of foreign branches of financial institutions that are not subject to host country regulation may undermine domestic macroprudential policies.
This degree of global linkage raises significant issues, despite the argument trotted about by economists that there are benefits from the improved efficiency of resource allocation.
First, the increased global interconnectedness has led to new risks, associated with the amplification of shocks during turbulent times and the transmission of excess financial volatility through international capital flows. They suggest there is robust evidence that private capital flows have been a major conduit of global financial shocks across countries and have helped fuel domestic credit booms that have often ended in financial crises, especially in developing economies.
Second, international capital flows have created macroeconomic policy challenges for advanced economies as well. For example, the rest of the world’s appetite for US safe assets was an important factor behind the credit and asset price booms in the United States that fuelled the subsequent financial crisis and created turmoil around the world. It is also well documented that since the GFC, the various forms of accommodative monetary policy pursued in the United States and the euro area have exerted significant spillover effects on other countries by influencing interest rates and credit conditions around the world – irrespective, at first sight, of the nature of the exchange rate regime.
Finally, there is evidence to suggest that in recent years financial market volatility in some large middle-income countries has been transmitted back, and to a greater extent, to asset prices in advanced economies and other countries. For instance, the suspension of trading after the Chinese stock market drop on 6 January 2016 affected major asset markets all over the world. Thus, international spillovers have become a two-way street – with the potential to create financial instability in both directions.
This means that macroeconomic settings in the USA – and especially the progressive rise in their benchmark rate, and reversal of QE, will have flow-on effects which will resonate around the global financial system. In a way, no country is an island.
The paper does also make the point that there may be some benefits – for example, if the global economy is experiencing a recession for instance, the coordinated adoption of an expansionary fiscal policy stance by a group of large countries may, through trade and financial spillovers, benefit all countries. The magnitude of this gain may actually increase with the degree to which countries are interconnected, the degree of business cycle synchronisation, and the very magnitude of spillovers.
But, if maintaining financial stability is a key policy objective, the propagation of financial risks through volatile short-term capital flows also becomes a source of concern.
After detailed analysis the paper reaches the following conclusions.
First, with the advance in global financial integration over the last three decades, the transmission of shocks has become a two-way street – from advanced economies to the rest of the world, but also and increasingly from a group of large middle-income countries, which we refer to as SMICs, to the rest of the world, including major advanced economies. These increased spillbacks have strengthened incentives for advanced economies to internalise the impact of their policies on these countries, and the rest of the world in general. Although stronger spillovers and spillbacks are not in and of themselves an argument for greater policy coordination between these economies, the fact that they may exacerbate financial risks – especially when countries are in different phases of their economic and financial cycles – and threaten global financial stability is.
Second, the disconnect between the global scope of financial markets and the national scope of financial regulation has become increasingly apparent, through leakages and cross-border arbitrage – especially through global banks. In fact, what we have learned from the financial trilemma is that it has become increasingly difficult to maintain domestic financial stability without enhancing cross-border macroprudential policy coordination, at least in its structural dimension. Avoiding the leakages stemming from international regulatory arbitrage and open capital markets requires cooperation, but addressing cyclical risks requires coordination.
Third, divergent policies and policy preferences contribute additional dimensions to global financial risks. In the absence of a centralised macroprudential authority, coordination needs to rely on an international macroprudential regime that promotes global welfare. Yet, divergence in national interests can make coordination unfeasible. Fourth, significant gaps remain in the evidence on regulatory spillovers and arbitrage, and the role of the macroprudential regime in the cross-border transmission of shocks. In addition, research on the potential gains associated with multilateral coordination of macroprudential policies remains limited. This may be due in part to the natural or instinctive focus of national authorities on their own country’s objectives, or to greater priority on policy coordination within countries – an important ongoing debate in the context of monetary and macroprudential policies. This “inward” focus may itself be due to the lack of perception of the benefits of multilateralism with respect to achieving national objectives – which therefore makes further research on these benefits all the more important.
This assessment suggests that, in a financially integrated world, international coordination of macroprudential policies may not only be valuable, but also essential, for macroprudential instruments to be effective at the national level. A first step towards coordination has been taken with Basel III’s principle of jurisdictional reciprocity for countercyclical capital buffers, but this principle needs to be extended to a larger array of macroprudential instruments. Further empirical and analytical work (including by the BIS, FSB and IMF) on the benefits of international
macroprudential policy coordination could play a significant role in promoting more awareness of the potential gains associated with global financial stability. This work agenda should involve a research component focused on measuring the gains from coordination and improving data on cross-border financial flows intermediated by various entities (banks, investment funds and large institutional investors), as well as improving capacity for systemic risk monitoring.
My own take is that we have been sleepwalking into a scenario where large capital flows and international financial players operating cross borders, negating the effectiveness of local macroeconomic measures, to their own ends. This new world is one where large global players end up with more power to influence outcomes than governments. No wonder that they often march in step, in terms of seeking outcomes which benefit the financial system machine.
Somewhere along the road, we have lost the plot, but unless radical changes are made, the Genie cannot be put back into the bottle. This should concern us all.
A timely warning from the IMF about the rapid growth in credit, especially to risky areas, just before a financial crisis. I suspect this is just where Australia is currently!
Supervisors who monitor the health of the financial system know that a rapid buildup of debt during an economic boom can spell trouble down the road. That is why they keep a close eye on the overall volume of credit in the economy. When companies go on a borrowing spree, supervisors and regulators may decide to put the brakes on credit growth.
Trouble is, measuring credit volume overlooks an important question: how much of that additional money flows to riskier companies – which are more likely to default in times of trouble—compared with more creditworthy firms? The IMF’s latest Global Financial Stability Report seeks to fill that gap by constructing measures of the riskiness of credit allocation, which should help policy makers spot clouds on the economic horizon.
Our researchers crunched 25 years of data for nonfinancial companies in 55 emerging and advanced economies. They found that when credit grows rapidly, the firms where debt expands faster become increasingly risky in relation to those with the slowest debt expansions. Such an increase in the riskiness of credit allocation, in turn, points to greater odds of a severe economic downturn or a banking crisis as many as three years into the future.
Extra dose
This buildup of lending to relatively less creditworthy companies adds an extra dose of risk – on top of the dangers that may come with the rapid growth of credit overall. Of course, lending to risky firms may be perfectly rational and profitable. But it can also spell trouble if it reflects poorer screening of borrowers or excessive risk-taking.
Fortunately, regulators can take steps to protect the financial system, if necessary. They can require banks to hold more capital or impose limits on bank loan growth, restraining their risk-bearing capacity and increasing their buffers. Ensuring the independence of bank supervisors, enforcing lending standards, and strengthening corporate governance by protecting minority shareholders can also help keep risks in check.
Why does more credit flow to risker firms in good times? It’s possible that investors are unduly optimistic about future economic prospects, leading them to extend credit to more vulnerable firms. If interest rates are unusually low, banks and investors may be tempted to lend money – in the form of loans or bonds – to riskier companies that pay relatively higher rates of interest. We have seen this “search for yield” in advanced economies in recent years because of the prolonged period of ultra-low interest rates. The riskiness of credit allocation may thus be a good barometer of risk appetite.
Global pattern
Our study found a clear global pattern in the evolution of this new measure of financial vulnerability. Starting at elevated levels in the late 1990s, the riskiness of credit allocation fell from 2000 to 2004, in the aftermath of financial crises in Asia and Russia and the dot-com equity bubble. From a historic low in 2004, riskiness rose to a peak in 2008, when the global financial crisis erupted. It then declined sharply before rising again to a level near its historical average at the end of 2016, the last available data point. Riskiness may have continued to rise in 2017 as market volatility and interest rates remained very low in the global economy.
The Global Financial Stability Report holds a clear lesson for policy makers and regulators: both the total volume of credit and the riskiness of its allocation are important. A period of rapid growth is more likely to be followed by a severe economic downturn if more of that credit is flowing to riskier firms. Policy makers should pay close attention to both measures – and take the appropriate steps when warning signals flash.
The latest BBSW data shows the trajectory in recent weeks. This will add more pressure to bank funding costs.
The question to consider is whether these moves are reflective of changes in global rates – LIBOR for example is higher (see below) – or whether this reflects the perceived risks in the local bank market in the light of the first rounds from the Royal Commission, which has generally underscored potential risks in their lending books. Or both.
The international rates are probably more the cause of the move of 25 basis points or more, which is significant because it suggests more upward pressure ahead, irrespective of what the RBA may choose to do.
We think mortgage rates will likely (and quietly) go higher in the months ahead.
Welcome to the Property Imperative Weekly to 07 April 2018.
Watch the video, or read the transcript.
In this week’s digest of finance and property news, we start with Paul Keating’s (he of the recession we had to have fame), comment that the housing boom is really over at the recent AFR conference.
He said that the banks were facing tighter controls as a result of the Basel rules on capital adequacy, while financial regulators had had a “gutful” of them. This was likely to lead to changes that would restrict the banks’ ability to lend. He cited APRA’s recent interventions in interest only loans as one example, as they restrict their growth. Keating also said the royal commission into misconduct in the banking and financial services sector would also “make life harder” for the banks and pointed out that banks did not really want to lend to business these days and would “rather just do housing loans”. Finally, he spoke of the “misincentives” within the big banks to grow their business by writing new mortgages, including having a high proportion of interest-only lending.
Anna Bligh speaking at the AFR event, marked last Tuesday her first year as CEO of the Australian Banking Association (ABA) – but said she feels “like 500 years” have already passed. Commenting on the Royal Commission she warned that credit could become tighter ahead. The was she said an opportunity for a major reset, not only in how we do banking but how we think about it, its place in our lives, its role in our economy and, most of all, it’s trustworthiness”.
At the same conference, Rod Simms the Chair of the ACCC speech “Synchronised swimming versus competition in banking” He discussed the results of their recent investigation into mortgage pricing, and also discussed the broader issues of competition versus financial stability in banking. He warned that the industry should be aware of, and respond to, the fact that the drive for consumers to get a better deal out of banking is shared by many beyond the ACCC. Every household in Australia is watching. You can watch our video blog on this for more details.
He specifically called out a lack of vigorous mortgage price competition between the five big Banks, hence “synchronised swimming”. Indeed, he says discounting is not synonymous with vigorous price competition. They saw evidence of communications “referring to the need to avoid disrupting mutually beneficial pricing outcomes”.
He also said residential mortgages and personal banking more generally make one of the strongest cases for data portability and data access by customers to overcome the inertia of changing lenders.
Finally, on competition. he says if we continue to insulate our major banks from the consequences of their poor decisions, we risk stifling the cultural change many say is needed within our major banks to put the needs of their customers first. Vigorous competition is a powerful mechanism for driving improved efficiency, and also for driving improved price and service offerings to customers. It can in fact lead to better stability outcomes.
This puts the ACCC at odds with APRA who recent again stated their preference for financial stability over competition – yet in fact these two elements are not necessarily polar opposites!
Then there was the report from the good people at UBS has published further analysis of the mortgage market, arguing that the Royal Commission outcomes are likely to drive a further material tightening in mortgage underwriting. As a result, they think households “borrowing power” could drop by ~35%, mainly thanks to changes to analysis of expenses, as the HEM benchmark, so much critised in the Inquiry, is revised. Their starting point assumes a family of four has living expenses equal to the HEM ‘Basic’ benchmark of $32,400 p.a. (ie less than the Old Age Pension). This is broadly consistent with the Major banks’ lending practices through 2017. As a result, the borrowing limits provided by the banks’ home loan calculators fell by ~35% (Loan-to-Income ratio fell from ~5-6x to ~3-4x). This leads to a reduction in housing credit and a further potential fall in home prices.
Our latest mortgage stress data, which was picked by Channel Nine and 2GB, thanks to Ross Greenwood, Across Australia, more than 956,000 households are estimated to be now in mortgage stress (last month 924,500). This equates to 30.0% of households. In addition, more than 21,000 of these are in severe stress, no change from last month. We estimate that more than 55,000 households risk 30-day default in the next 12 months. We expect bank portfolio losses to be around 2.8 basis points, though with losses in WA are higher at 4.9 basis points. Flat wages growth, rising living costs and higher real mortgage rates are all adding to the burden. This is not sustainable and we are expecting lending growth to continue to moderate in the months ahead as underwriting standards are tightened and home prices fall further”. The latest household debt to income ratio is now at a record 188.6. You can watch our separate video blog on this important topic.
ABS data this week showed The number of dwellings approved in Australia fell for the fifth straight month in February 2018 in trend terms with a 0.1 per cent decline. Approvals for private sector houses have remained stable at around 10,000 for a number of months. But unit approvals have fallen for five months. Overall, building activity continues to slow from its record high in 2016. And the sizeable fall in the number of apartments and high density dwellings being approved comes at a time when a near record volume are currently under construction. If you assume 18-24 months between approval and completion, then we still have 150,000 or more units, mainly in the eastern urban centres to come on stream. More downward pressure on home prices. This helps to explain the rise in 100% loans on offer via some developers plus additional incentives to try to shift already built, or under construction property.
CoreLogic reported last week’s Easter period slowdown saw 670 homes taken to auction across the combined capital cities, down significantly on the week prior when a record number of auctions were held (3,990). The lower volumes last week returned a higher final clearance rate, with 64.8 per cent of homes selling, increasing on the 62.7 per cent the previous week. Both clearance rate and auctions volumes fell across Melbourne last week, with only 152 held and 65.5 per cent clearing, down on the week prior when 2,071 auctions were held across the city returning a slightly higher 65.8 per cent success rate.
Sydney had the highest volume of auctions of all the capital city auction markets last week, with 394 held and a clearance rate of 67.9 per cent, increasing on the previous week’s 61.1 per cent across a higher 1,383 auctions.
Across the smaller capital cities, clearance rates improved week-on-week in Canberra, Perth and Tasmania; however, volumes were significantly lower across each market last week compared to the week prior.
Across the non-capital city auction markets, the Geelong region recorded the strongest clearance rate last week with 100 per cent of the 20 auction results reporting as successful.
The number of homes scheduled to go to auction this week will increase across the combined capital cities with 1,679 currently being tracked by CoreLogic, up from last week when only 670 auctions were held over the Easter period slowdown.
Melbourne is expected to see the most significant increase in volumes this, with 669 properties scheduled for auction, up from 152 auctions held last week. In Sydney, 725 homes are set to go to auction this week, increasing on the 394 held last week.
Outside of Sydney and Melbourne, each of the remaining capital cities will see a higher number of auctions this week compared to last week.
Overall auction activity is set to be lower than one year ago, when 3,517 were held over what was the pre-Easter week last year.
Finally, with local news all looking quite negative, let’s look across to the USA as the most powerful banker in the world, JPMorgan Chase CEO Jamie Dimon, just released his annual letter to shareholders. Given his bank’s massive size (it earned $24.4 billion on $103.6 billion in revenue last year) and reach (it’s a giant in consumer/commercial banking, investment banking and wealth management), Dimon has his figure on the financial pulse.
He says that’s while the US economy seems healthy today and he’s bullish for the “next year or so” he admits that the US is facing some serious economic headwinds.
For one, he’s concerned the unwinding of quantitative easing (QE) could have unintended consequences. Remember- QE is just a fancy name for the trillions of dollars that the Federal Reserve conjured out of thin air.
He said – Since QE has never been done on this scale and we don’t completely know the myriad effects it has had on asset prices, confidence, capital expenditures and other factors, we cannot possibly know all of the effects of its reversal.
We have to deal with the possibility that at one point, the Federal Reserve and other central banks may have to take more drastic action than they currently anticipate – reacting to the markets, not guiding the markets.
And of course the DOW finished the week on a down trend, down 2.34%, and wiping out all the value gained this year, and volatility is way up. Here is a plot of the DOW.
This extreme volatility does suggest the bull market is nearing its end… if it hasn’t ended already. Dimon seems pretty sure we’re in for more volatility and higher interest rates. One scenario that would require higher rates from the Fed is higher inflation:
If growth in America is accelerating, which it seems to be, and any remaining slack in the labor markets is disappearing – and wages start going up, as do commodity prices – then it is not an unreasonable possibility that inflation could go higher than people might expect.
As a result, the Federal Reserve will also need to raise rates faster and higher than people might expect. In this case, markets will get more volatile as all asset prices adjust to a new and maybe not-so-positive environment.
Now– here’s the important part. For the past ten years, the largest buyer of US government debt was the Federal Reserve. But now that QE has ended, the US government just lost its biggest lender.
Dimon thinks other major buyers, including foreign central banks, the Chinese, etc. could also reduce their purchases of US government debt. That, coupled with the US government’s ongoing trade deficits (which will be funded by issuing debt), could also lead to higher rates…
So we could be going into a situation where the Fed will have to raise rates faster and/ or sell more securities, which certainly could lead to more uncertainty and market volatility. Whether this would lead to a recession or not, we don’t know.
We’ll leave you with one final point from Jamie Dimon. He acknowledges markets have a mind of their own, regardless of what the fundamentals say. And he sees a real risk “that volatile and declining markets can lead to a market panic.”
Financial markets have a life of their own and are sometimes barely connected to the real economy (most people don’t pay much attention to the financial markets nor do the markets affect them very much). Volatile markets and/or declining markets generally have been a reaction to the economic environment. Most of the major downturns in the market since the Great Depression reflect negative future expectations due to a potential or real recession. In almost all of these cases, stock markets fell, credit losses increased and credit spreads rose, among other disruptions. The biggest negative effect of volatile markets is that it can create market panic, which could start to slow the growth of the real economy. Because the experience of 2009 is so recent, there is always a chance that people may overreact.
Dimon cautioned investors that interest rates could rise much sooner than they expect. If inflation suddenly comes roaring back. Indeed, it’s entirely possible the 10-year could break above 4% in the near future as inflation returns to 2% and the Fed shrinks its balance sheet.
Dimon also cast a wary eye toward exchange-traded funds, which have seen their popularity multiply since the financial crisis. There are now many ETF products that are considerably more liquid than their underlying assets. In fact far more money than before (about $9 trillion of assets, which represents about 30% of total mutual fund long-term assets) is managed passively in index funds or ETFs (both of which are very easy to get out of). Some of these funds provide far more liquidity to the customer than the underlying assets in the fund, and it is reasonable to worry about what would happen if these funds went into large liquidation.
And Finally America’s net debt currently stands at 77% of GDP (this is already historically high but not unprecedented). The chart below also shows the Congressional Budget Office’s estimate of the total U.S. debt to GDP, assuming a 2% real GDP growth rate. Hopefully, with the right policies they can grow faster than 2%. But more debt does seem on the cards.
And to add to that perspective, we spoke about the recent Brookings report which highlighted the rise in non conforming housing debt in the USA. debt as lending standards are once again being loosened, and risks to mortgage services are rising.
The authors quote former Ginnie Mae president Ted Tozer concerning the stress between Ginnie Mae and their nonbank counterparties.
… Today almost two thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights and all of these things have created a new and challenging environment for Ginnie Mae. . . . In other words, the risk is a lot higher and business models of our issuers are a lot more complex. Add in sharply higher annual volumes, and these risks are amplified many times over. . . . Also, we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks…
They say that goldfish have the shortest memory in the Animal Kingdom… something like 3-seconds. But not even a decade after these loans nearly brought down the entire global economy, SUBPRIME IS BACK. In fact it’s one of the fastest growing investments among banks in the United States. Over the last twelve months the subprime volume among US banks doubled, and it’s already on pace to double again this year.
The stock market is at record highs and people with FICO scores as low as 500 are once again happily obtaining mortgages. Not only that, but these mortgages are once again being securitized and are in demand by yield chasers.
All of the elements that are necessary for the 2008 subprime crisis to repeat itself are starting to fall back into place. Aside from the fact that we have inflated bubbles across basically all asset classes for the most part, not the least of which is evident in the stock market, the Financial Times reported today that not only are subprime mortgage backed securities becoming prominent again, but that the chase for yield was what fueling demand:
Issuance of securities backed by riskier US mortgages roughly doubled in the first quarter from a year earlier, as investors lapped up assets blamed for bringing the global financial system to the brink of collapse a decade ago. Home loans to people with scratches and dents in their credit histories dwindled to almost nothing in the aftermath of the crisis, as litigation-weary lenders retreated to patch up their balance sheets.
But over the past couple of years a group of specialist firms has begun to bring the loans back, navigating a dense web of new rules drawn up to protect borrowers and investors in the $9.3tn US home-loan market. Last year saw issuance of $4.1bn of securities backed by loans that would have been called “subprime” before the last financial crisis, according to figures from Inside Mortgage Finance, with the pace picking up in the latter half of the year. The momentum has continued into 2018, with deals worth $1.3bn in the first quarter — twice the $666m issued in the same period a year earlier.
Our central banks have done such a great job of getting us out of our last crisis that the recovery has prompted a mortgage originators and real estate investors to basically do the same exact thing that they were doing 2006 to 2007. After all, mortgage levels are already almost back to 2008 levels.
If that wasn’t disturbing enough, the hedge fund partner that FT quotes in the article says that the subprime market has “a lot of room to grow“ as if it were some type of new emerging market generating productivity, and not just a carbon copy repeat of exactly what happen nearly 10 years ago.
“The market is . . . starting from such a small base that it has a lot of room to grow,” said Jamshed Engineer, a partner at Axonic Capital, a New York hedge fund with more than $2bn in assets under management.
“[Investors] are definitely chasing yields. Whenever these deals come out, for the most part, they are oversubscribed.”
Relaxes a host of reporting requirements for small – medium banks, and to a smaller extent, large banks
Eliminates a reporting requirement introduced by Dodd-Frank designed to avoid discriminatory lending
Relaxes stress testing requirements intended to show how banks would survive another financial crisis
Raises the threshold for banks which are not subject to enhanced liquidity requirements, stress tests, and enhanced risk management, from $50 billion to $250 billion – exempting several institutions which could pose systemic risks down the road.
Allows megabanks such as Citi to count municipal bonds as “highly liquid assets” that could be used towards the “liquidity coverage ratio,” – assets which can be quickly liquidated during a crisis.
Calls for a report on the risks and benefits of algorithmic trading within 18 months
Despite the fact that the FT states that 500 FICO scores are getting approved for mortgages, S&P, one of the willfully ignorant and blind rating agencies that missed the subprime crisis thinks that everything is going to be fine:
“The risk is contained, in our view,” said Mr Saha.
For the way that our Federal Reserve has addressed the problems of 2007 or 2008, these are the end results that they deserve, but the American people ultimately do not.
Today we examine the recent Financial Market Earthquakes and ask, are these indicators of more trouble ahead?
Welcome to the Property Imperative Weekly to 24th March 2018. Watch the video or read the transcript.
In this week’s review of property and finance news we start with the recent market movements and consider the impact locally.
The Dow 30 has come back, slumping more than 1,100 points between Thursday and Friday, and ending the week in correction territory – meaning down more than 10% from its recent high.
The volatility index – the VIX which shows the perceived risks in the financial markets also rose, up 6.5% just yesterday to 24.8, not yet at the giddy heights it hit in February, but way higher than we have seen for a long time – so perceived risks are higher.
And the Aussie Dollar slipped against the US$ to below 77 cents from above 80, and it is likely to drift lower ahead, which may help our export trade, but will likely lead to higher costs for imports, which in turn will put pressure on inflation and the RBA to lift the cash rate. The local stock market was also down, significantly. Here is a plot of the S&P ASX 100 for the past year or so. We are back to levels last seen in October 2017. Expect more uncertainty ahead.
So, let’s look at the factors driving these market gyrations. First of course U.S. President Donald Trump’s signed an executive memorandum, imposing tariffs on up to $50 billion in Chinese imports and in response the Dow slumped more than 700 points on Thursday. There was a swift response from Beijing, who released a dossier of potential retaliation targets on 128 U.S. products. Targets include wine, fresh fruit, dried fruit and nuts, steel pipes, modified ethanol, and ginseng, all of which could see a 15% duty, while a 25% tariff could be imposed on U.S. pork and recycled aluminium goods. We also heard Australia’s exemptions from tariffs may only be temporary.
Some other factors also weighed on the market. Crude oil prices rose more than 5.5% this week as following an unexpected draw in U.S. crude supplies and rising geopolitical tensions in the middle east. Crude settled 2.5% higher on Friday after the Saudi Energy Minister said OPEC and non-OPEC members could extend production cuts into 2019 to reduce global oil inventories. Here is the plot of Brent Oil futures which tells the story.
Bitcoins promising rally faded again. Earlier Bitcoin rallied from a low of $7,240 to a high of $9175.20 thanks to easing fears that the G20 meeting Monday would encourage a crackdown on cryptocurrencies. Finance ministers and central bankers from the world’s 20 largest economies only called on regulators to “continue their monitoring of crypto-assets” and stopped short of any specific action to regulate cryptocurrencies. So Bitcoin rose 2% over the past seven days, Ripple XRP fell 8.93%and Ethereum fell 14.20%. Crypto currencies remain highly speculative. I am still working on my more detailed post, as the ground keeps shifting.
Gold prices enjoyed one of their best weeks in more than a month buoyed by a flight-to-safety as investors opted for a safe-haven thanks to the events we have discussed. However, the futures data shows many traders continued to slash their bullish bets on gold. So it may not go much higher. So there may be no relief here.
Then there was the Federal Reserve statement, which despite hiking rates by 0.25%, failed to add a fourth rate hike to its monetary policy projections and also scaled back its labour market expectations. Some argued that the Fed’s decision to raise its growth rate but keep its outlook on inflation relatively unchanged was dovish. Growth is expected to run at 3%, but core inflation is forecast for 2019 and 2020 at 2.10%. They did, however, signal a faster pace of monetary policy tightening, upping its outlook on rates for both 2019 and 2020. You can watch our separate video blog on this. The “dots” chart also shows more to come, up to 8 lifts over two years, which would take the Fed rate to above 3%. The supporting data shows the economy is running “hot” and inflation is expected to rise further. This will have global impact. The era of low interest rates in ending. The QE experiment is also over, but the debt legacy will last a generation.
All this will have a significant impact on rates in the financial markets, putting more pressure on borrowing companies in the US, and the costs of Government debt. US mortgage interest rates rose again, a precursor to higher rates down the track.
Moodys’ said this week, that the U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a levelling off of global business activity.
The flow on effect of rate rises is already hitting the local banks in Australia. To underscore that here is a plot of the A$ Bill/OIS Swap rate, a critical benchmark for bank funding. In fact, looking over the past month, the difference, or spread has grown by around 20 basis points, and is independent from any expectation of an RBA rate change. The BBSW is the reference point used to set interest rates on most business loans, and also flows through to personal lending rates and mortgages.
As a result, there is increasing margin pressure on the banks. In the round, you can assume a 10 basis point rise in the spread will translate to a one basis point loss of margin, unless banks reduce yields on deposit accounts, or lift mortgage rates. Individual banks ae placed differently, with ANZ most insulated, thanks to their recent capital initiatives, and Suncorp the most exposed.
In fact, Suncorp already announced that Variable Owner Occupier Principal and Interest rates will rise by 5 basis points. Variable Investor Principal and Interest rates will increase by 8 basis points, and Variable Interest Only rates increase go up by 12 basis points. In addition, their variable Small Business rates will increase by 15 basis points and their business Line of Credit rates will increase by 25 basis points. Expect more ahead from other lenders. The key takeaway is that funding costs in Australia are going up at a time when the RBA is stuck in neutral. It highlights how what happens with rates and in money markets overseas, and particularly in the US, can have repercussions here – repercussions that many are possibly unprepared for.
Locally, the latest Australian Bureau of Statistics showed that home prices to December 2017 fell in Sydney over the past quarter, along with Darwin. Other centres saw a rise, but the rotation is in hand. Overall, the price index for residential properties for the weighted average of the eight capital cities rose 1.0% in the December quarter 2017. The index rose 5.0% through the year to the December quarter 2017.
The capital city residential property price indexes rose in Melbourne (+2.6%), Perth (+1.1%), Brisbane (+0.9%), Hobart (+3.9%), Canberra (+1.7%) and Adelaide (+0.6%) and fell in Sydney (-0.1%) and Darwin (-1.5%). You can watch our separate video on this, where we also covered in more detail the January 2018 mortgage default data from Standard & Poor’s. It increased to 1.30% from 1.07% in December. No area was exempt from the increase with loans in arrears by more than 30 days increasing in January in every state and territory. Western Australia remains the home of the nation’s highest arrears, where loans in arrears more than 30 days rose to 2.44% in January from 2.08% in December, reaching a new record high. Conversely, New South Wales continues to have the lowest arrears among the more populous states at 0.98% in January. Moody’s is now expecting a 10% correction in some home prices this year.
According to latest figures released by the Australian Bureau of Statistics (ABS), the seasonally adjusted unemployment rate increased to 5.6 per cent and the labour force participation rate increased by less than 0.1 percentage points to 65.7 per cent. The number of persons employed increased by 18,000 in February 2018. So no hints of any wage rises soon, as it is generally held that 5% unemployment would lead to higher wages – though even then, I am less convinced.
The latest final auction clearance results from CoreLogic, published last Thursday showed the final auction clearance rate across the combined capital cities rose to 66 per cent across a total of 3,136 auctions last week; making it the second busiest week for auctions this year, compared with 63.3 per cent the previous week, and still well down from 74.1 per cent a year ago. Although Melbourne recorded its busiest week for auctions so far this year with a total of 1,653 homes taken to auction, the final auction clearance rate across the city fell to 68.7 per cent, down from the 70.8 per cent over the week prior. In Sydney, the final auction clearance rate increased to 64.8 per cent last week, from 62.2 per cent the week prior. Across the smaller auction markets, clearance rates improved in Brisbane, Perth and Tasmania, while Adelaide and Canberra both returned a lower success rate over the week. They say Geelong was the best performing non-capital city region last week, with 86.1 per cent of the 56 auctions successful. However, the Gold Coast region was host to the highest number of auctions (60). This week they are expecting a high 3,689 planned auctions today, so we will see where the numbers end up. I am still digging into the clearance rate question, and should be able to post on this soon. But remember that number, 3,689, because the baseline seems to shift when the results arrive.
As interest rates rise, in a flat income environment, we expect the problems in the property and mortgage sector to show, which is why our forward default projections are higher ahead. We will update that data again at the end of the month. Household Financial Confidence also drifted lower again as we reported. It fell to 94.6 in February, down from 95.1 the previous month. This is in stark contrast to improved levels of business confidence as some have reported. Our latest video blog covered the results.
Finally, The Royal Commission of course took a lot of air time this week, and I did a separate piece on the outcomes yesterday, so I won’t repeat myself. But suffice it to say, we think the volume of unsuitable mortgage loans out there is clearly higher than the lenders want to admit. Mortgage Broking will also get a shake out as we discussed on the ABC this week. And that’s before they touch on the wealth management sector!
We think there are a broader range of challenges for bankers, and their customers, as I discussed at the Customer Owned Banking Association conference this week. There is a separate video available, in which you can hear about what the future of banking will look like and the importance of customer centricity. In short, more disruption ahead, but also significant opportunity, if you know where to look. I also make the point that ever more regulation is a poor substitute for the right cultural values. At the end of the day, a CEO’s overriding responsibility is to define the right cultural values for the organisation, and the major banks have been found wanting. A quest for profit at any cost will ultimately destroy a business if in the process it harms customers, and encourages fraud and deceit. You simply cannot assume banks will do the right thing, unless the underlying corporate values are set right. Remember Greenspans testimony after the GFC, when he said “I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.”
Markets are beginning to ask whether companies will be capable of passing on higher costs to the U.S.’ less than financially robust middle class, according to Moodys.
The U.S.’ still relatively low personal savings rate questions how easily consumers will absorb recent and any forthcoming price hikes. Moreover, the recent slide by Moody’s industrial metals price index amid dollar exchange rate weakness hints of a leveling off of global business activity.
Missing from last week’s discussion of a record ratio of U.S. nonfinancial-corporate debt to GDP was any mention of 2017’s near-record high ratio of total U.S. private and public nonfinancial-sector debt relative to GDP. The yearlong averages of 2017 showed $49.05 trillion of total nonfinancial-sector debt and $19.74 trillion of nominal GDP that put nonfinancial-sector debt at 249% of GDP—or just a tad under 2016’s record 250%.
The leveraging up of the U.S. economy has coincided with a downshifting of U.S. economic growth. From 1961 through 1979, U.S. real GDP expanded by an astounding 3.9% annually, on average, while total nonfinancial-sector debt approximated 133% of nominal GDP. When real GDP’s average annual rate of growth eased to the 3.2% of 1979-2000, the ratio of nonfinancial-sector debt to GDP rose to 176%. Since the end of 2000, U.S. economic growth has averaged only 1.8% annually and, in a possible response to subpar growth, nonfinancial-sector debt has soared to 232% of GDP
High Systemic Leverage Reins in Benchmark Yields
Over time, the record shows that the climb by the moving 10-year ratio of nonfinancial-sector debt to GDP has been accompanied by a declining 10-year moving average for the 10-year Treasury yield. For example, as the moving 10-year ratio of debt to GDP rose from 1997’s 183% to 2017’s 245%, the 10-year Treasury yield’s moving 10-year average fell from 7.31% to 2.59%.
Two factors may be at work. First, lower interest rates encourage an increase in balance-sheet leverage. Second, to the degree an elevated ratio of debt to GDP heightens the economy’s sensitivity to an increase in interest rates, lofty readings for leverage limit the upside for interest rates. Moreover, as shown by the historical record, if higher leverage tends to occur amid a slower underlying pace of economic growth, then the case favoring relatively low interest rates amid high leverage is strengthened.
None of this dismisses the possibility of an extended stay above 3% by the 10-year Treasury yield. Instead, today’s record ratio of debt to GDP warns of greater downside risk for business activity whenever interest rates enter into a protracted climb.
Now, today I am not going to discuss the mechanics of the digital currency, there are plenty of others who have done that; nor am I going to discuss the limited supply, which is mirroring gold, other than to note this one of the fundamental design criteria of the crypto currency.
