Pandora's Box: The Cyprus Story

Pandora’s Box: The Cyprus Story

Well here we are again, with yet another European country in financial distress and the ‘troika’ (European Commission, ECB, and the IMF) riding to the rescue. After a brief hiatus the ‘bailout bandwagon’ gets back on the road, and this time it’s Cyprus’s turn to go cap in hand to prevent it defaulting.

So how did Cyprus, a tiny country best known as a fantastic holiday destination, become the centre of a financial firestorm with far-reaching implications?

Its fate was effectively sealed when it joined the euro in 2008. Although it wasn’t in great financial shape at the time of joining, the imbalances in its financial system ballooned once it was effectively backed by the Euro rather than the Cypriot pound.

Over the five year period since joining, its bank assets have doubled, reaching an incredible eight times GDP and completely skewing the risk profile of the country. Money flooded in (much of it from the Russian mafia) attracted by low taxes, a relaxed attitude to banking regulations and the implied guarantee of euro membership. As a result of this flood of money, Cyprus became a major centre for tax evasion and money laundering. Awash in money, much of it ended up invested in Greek corporate and government debt, and when the Greeks effectively defaulted, this money went up in smoke and a Cypriot default became inevitable.

Now we know how the situation developed, let’s look at how the rescue deal was struck and why its ripples will spread much further than the Mediterranean.

 The original deal from the troika was to lend 10bn euros on the proviso that the Cypriots find the remaining 5.8bn euros by imposing a levy on bank deposits, part of which entailed depositors with 100,000 euros or less taking a 6.75% haircut.

Seeing that this would affect almost every voter in the country, create a huge political storm, and probably result in them being thrown out of office, the politicians did exactly what we would expect them to do, voted in their own self-interest and refused the deal.

After much wailing and gnashing of teeth a new proposal was made, ring-fencing those deposits below 100,000 euros, but placing a higher burden on wealthier depositors, and being the only politically tenable solution, was accepted.

Over this period the entire banking system was shutdown to prevent a mass flight of capital, although it is now becoming clear that certain overseas branches of the Cypriot banks remained open for withdrawals and that large sums were indeed spirited out of reach of the Cypriot authorities.

 It would be very interesting to discover who those people were that made these withdrawals, I would place a small wager that it includes politicians and high ranking government officials but I’m just an old cynic.

The net result of this is that it is still unclear as to the amount of haircut these large depositors will have to take, with some of the latest estimates as high as 80%.

So with peoples’ assets being taken, businesses going bust (1 in 3 has already gone bust) and an inability to get your assets out of the country due to capital controls, it is not hard to see the potential for civil unrest.

It is clear to see from all this that life for Cypriots is tough and will get a whole lot tougher in the months ahead. But however tragic for those caught up in the mess why does it have wider implications? 

The answer to that lies in the initial plan proposed by the troika.

The big question every depositor must ask themselves is ‘How safe is my money?’ and the answer (for deposits within the euro zone) was pretty safe, because the Eurozone Banking Deposit Guarantee Scheme provided protection up to a value of 100,000 euros.

However, the initial scheme proposed by the troika included a levy on all depositors irrespective of the amount deposited. The fact it was rejected is irrelevant, it still shows that the troika think that when needs must, peoples bank deposits are fair game. This undermines the very basis of confidence in the euro-zone banking system and changes the dynamic of where to hold your investments.

The significance of the troika’s initial proposal was reinforced by the comments from the man that brokered the deal, Eurogroup chief Jeroen Dijsselbloem who said that the Cypriot package is a template for future EMU rescues, with further haircuts for “uninsured deposit holders”. Once the effects of his comments sunk in, financial markets started to react, and in spite of a later ‘clarification’ of its meaning, the damage had been done.

The bottom line in all this is that the Euro project was flawed from the start. It was sold to the citizens of Europe as a financial amalgamation that would enable all the countries that participated to grow their economies and flourish, and although that certainly was a positive by-product, the main reason was to cement relationships between the major European countries (both financially and politically) so completely, that there would never again be another European war.

Unfortunately, because it was driven by politicians with an agenda rather than people that understand financial markets, major mistakes were made, including the decision not to amalgamate all the countries debts into one, creating a single Eurobond market.

These mistakes sowed the seed for the disaster that we now face.

Because it is still politically motivated, European authorities will continue on the same course, stating categorically that something won’t happen, until of course it does, forced to make harder and more unpalatable choices, as the process grinds on to its inevitable conclusion.

It is for this reason that we are seeing currency flows out of the euro and into the US dollar, a trickle that will become a flood as the euro crisis intensifies and big money starts looking for a safe haven.

 Small money can find a home in ‘tangibles’ like housing, land, antiques or gold, outside the financial system. But big money doesn’t have that luxury, and can only be parked within the system, making the ‘least worst’ the best option, and for the foreseeable future that will be US dollars.

However, in a few years time, when the US becomes the ‘last man standing’ it will face its own financial Armageddon.

The real tragedy in all this is that as a result of the design flaws in the original concept, and the troika’s rigid adherence to a political ideology, it will likely foster the exact sentiments that the entire Euro project was designed to eradicate, with harmonious relationships and a sense of unity, replaced by distrust, anger and a move towards nationalism.

I think this is a seminal moment in the history of the Euro zone.

GOLD REVISITED

GOLD REVISITED

In my first ever posting on this blog ‘To Buy or Not To Buy’, I said that gold and silver were undergoing a major correction in an ongoing bull market, and that although they were extremely oversold and a rally was imminent, once it had run its course we were likely to see even lower prices.

That was back in May 2012, and in the following few months we did indeed see rallies of 15% in gold and 20% in silver, however since those highs in September last year both metals have resumed their declines and are once again oversold and near some important levels of support.

So let’s have another look and see whether the time is right to dip our toes back into the water. 

If we start with a current chart of the gold price we can see the rally that developed from the May low and the subsequent decline. It is also clear to see the zone of support that has developed around the 1530 area, this area has provided a buying opportunity on three occasions and as a result has now become critically important.

It is a similar story with silver.

 

It is easy to see why some investors are starting to get exited, feeling that the correction has gone on for long enough, that sentiment in the sector is abysmal, that we are near to an area of major support and that therefore from a contrarian investing perspective the time is right. 

Normally I would be amongst them, however there are a couple of things nagging at me and one of them is the zone of support.

 As I mentioned earlier, this price zone has been reached three times, and each time there has been enough buying support to drive the gold price back up. The more the level works as support, the more confident investors get that it will continue to act as support, and as a consequence more of them buy gold when it gets around these levels. This works fine until the support fails, at that point many investors try to sell but because of the number of investors that are 'long gold' the price collapses leading to a stampede for the exit.

This can and does happen naturally, when normal sellers just overwhelm the number of buyers at a particular price. However it can also be engineered by some big players in the market that drive the price down through the support zone with heavy selling, creating a panic and a price collapse through the forced selling of investors long positions. 

Once the price collapses and volumes rise, these same players that triggered the collapse go onto the bid side and buy back their positions (going long), knowing that once the dust has settled, the price will go back up because all of the potential sellers have now been forced out.

This may come as a shock to many of you but it happens on a regular basis in financial markets all over the world, and is a tried and trusted technique. Many years ago in my days working for an Investment Bank I even used it myself, so can vouch for its effectiveness. ( It can be argued that these practises, along with many others should be made illegal and you'll hear no argument from me. But until they are, if you intend to play with the big boys it helps to understand how they operate!)

With this in mind let us now take a look at the latest Committment of Traders (COT) data for gold. You may recall I have used this predictive tool in previous posts as it gives some perspective on what positions both the commercials (professionals) and speculators ('Joe Blow' investor) currently holds.

On this chart we can see the build up of 'short' positions by the professionals around the price high in September last year and the buying back of these shorts as the gold price has fallen. However, whilst their short positions have come back to a more normal level there is still plenty of room for them to engineer a further price fall and buy back more. It is important to understand that even though they have reduced their positions, they are still short gold.

Lets also have a look at silver to see if it corroborates what we have seen in gold.

With silver we can also see the extreme short position held by the commercials, and that they have also reduced their positions as the price has fallen. However it is also clear that they still have some way to go and that further price falls would benefit them greatly.

Lastly I want to look at a seldom used type of chart called a Point & Figure chart. These are different from ordinary charts in that they do not measure price against time. Price rises are marked with Xs and price falls are marked with Os, and if the price is unchanged nothing happens to the chart irrespective of whether the price is the same for a day, a week or a month.

They are interesting because the nature of the chart allows forecasts to be made as to future price movements. I don't intend to go into a detailed expanation of P&F charting here, but from looking at the chart below we can see that there is already a downside target in gold of 1365 and that should the price close below the 1533 level, another downside count will be activated around the 1100 level.

Lets have a quick look at a P&F chart of GDX which is an index of a number of gold and silver producing companies. For the gold price targets to have validity they should be matched by similar targets in the mining companies themselves as its hard to envisage a much lower gold price without a corresponding fall in mining shares.

And indeed we can see there is a downside target already triggered of 23.49 which would be a fall of over 30%.

It is very important to understand that these targets aren't set in stone, they can be reversed by price movements, and price can often fall short of the target. They are though an important tool in trying to fathom what a market will do and it is uncanny how accurate they can be.

So let's try to pull this all together.

 On the upside gold and silver are both very oversold, under-loved and near to important areas of support, and the COT figures in both have moderated considerably from their highs allowing a possible rally to form. The danger however is that the support gives way, and there certainly are signs that were that to occur it could turn very ugly for a period of time.

I think the downside risks are too great at the moment and would rather wait until the picture is clearer, either by the price once again bouncing off support and the COT picture continuing to improve, or by the price crashing through the support level and seeing massive selling. 

Either way I don't think we will have long to wait.

But be in no doubt,whenever it occurs the end of this correction will provide a great buying opportunity for the rally that will follow in the years ahead as the sovereign debt crisis explodes.

A New Year, a New Bull Market?

A New Year, a New Bull Market?

Many stock markets have started the year on a tear, with impressive gains seen in many indices, including the S&P 500 and the FTSE 100 both of which are already up over 4%.

There are a number of reasons for this enthusiasm including, a generally rosier view of the global economy, an increasing belief that global quantitative easing (QE) will float asset prices higher (triggered by the Bank of Japan’s [BOJ] recent statement that they intend to print money till their ears bleed, in a final attempt to kick-start their economy from its 20 year slump), and a continuing hiatus in the bad news flow emanating from the euro zone. But probably the most important reason

is the sense of relief triggered by the ‘resolution’ of the Fiscal Cliff issue.

Heading into the close of 2012 global investors were concerned about the rumbling Fiscal Cliff issue, and as a consequence went into ‘risk-off’ mode, meaning stocks and commodities were sold and the funds reinvested into safe havens like US Treasury bonds. Compounding this trend were the many pension funds, investment funds and hedge funds that have the 31^st December as their financial year-end. 

Because the ‘bottom line’ of financial institutions dictates the level of bonus payments that will be made, these institutions tend to become more risk averse the nearer they get to their end of year date. The last thing they want is to ‘take a bath’ on the markets when there is little or no time to make the money back, so they become ‘gun shy’, hanging on to what they have already made rather than look for more opportunities.

This has two effects; firstly in periods when there is already a bigger issue undermining investors’ confidence and the markets are under selling pressure, this trend is accentuated. And secondly, as soon as the new financial year begins these same institutions look to redeploy these same funds back into the market as quickly as possible, leading to a flood of buying and higher prices.

Indeed, over the last few weeks we have seen some of the biggest flows in to equity funds since the 2007 peak.

It is the combination of this rush back into the markets by the financial institutions, and the sense of relief and optimism and return to ‘risk on’ triggered by the fiscal cliff deal that is fuelling the current rally.

So will it continue? Can we look forward to a positive year for stock markets, with an improving economy and an increased appetite for risk? Or is it just a short term fillip, soon to wear off?

Lipstick on a Pig

Although the last gasp fiscal cliff resolution inspired the confidence of investors, it was anything but a true resolution. In my last post http://kiwiblackers.blogspot.co.nz/2012/12/the-fiscal-cliff.html I explained what the fiscal cliff actually was and what I anticipated would happen, thinking that the most probable outcome would be some partial solution with the problem being shunted further into the future.

 

Unsurprisingly that is pretty much what happened, so in spite of the markets’ vote of confidence, the problems have not been dealt with or gone away, and have actually been made worse. But that is a problem for another day it would seem. 

 We will be hearing much more about both the fiscal cliff and the debt ceiling in the months ahead.

Back in the euro zone all has been quiet since the ECB’s announcement back in September 2012 that it would support struggling European countries by unlimited buying of their short term bonds (in order to keep interest rates down and allow them to service their debt) via its Outright Monetary Transactions (OMT), leading to a recovery in many European financial markets.

In the months following, attention focused on the US as it struggled with its own debt and solvency issues. However silence does not equal solution, and although the relative calm may lead us to believe that blue skies lay ahead for Europe, it is far more likely that they are actually in the eye of the hurricane.

 

The systemic and deep-rooted issues in Europe remain, and the OMT’s have done nothing to solve the issues, and indeed are not intended to. But these problems will force themselves to the forefront again once the ‘juice’ from the OMT’s starts to wear off.

So in spite of the increased confidence the background picture continues to decay, with nothing being done to actually resolve the underlying issues, but efforts focused instead on preventing the system imploding. 

Unfortunately all the makeup in the world can’t hide that unpleasant truth.

Priced to Perfection

As we have discussed in previous posts, markets oscillate around a mean, moving from overbought to oversold and back again, with extremes of sentiment taking place at both the major highs and the lows. 

At bottoms investors are very bearish, sick of falling prices and desperate to cut their losses. As they panic out of their positions, prices collapse leading to more panic until the market bottoms with a crescendo of selling, and at that point once everyone that wants to sell has sold and the worst that can happen has been discounted, only buyers remain and the next rally begins.

At tops it is the reverse, as prices move up investors become more bullish so more buying develops pushing prices even higher, this sucks in even more buyers, then as complacency rules, thoughts of a correction are far from investors minds and everyone that wants to buy has already bought, at this point all the good news is discounted, the market is ‘priced to perfection’ and the correction starts.

The difference is that a bottom is often an event, a few days when sellers collectively ‘throw in the towel’, and the rally that follows can be fast and hard creating a ‘V shaped’ bounce. Whereas a top is a process, a series of rallies and corrections sucking in ever more money and investors often taking weeks or months and having more of a ‘dome shaped’ appearance.

We can see this in the chart of the S&P 500 index below

It is the manner of this topping process that makes them much harder to identify than bottoms. However there is one useful tool that helps us to track investor sentiment, giving us a way to measure the level of complacency or fear that exists in the stock market.

The Fear Index

When funds and large investors want to lower their risk exposure to the stock market they can of course just sell some of their holdings, however this isn’t always possible and can sometimes be prohibitively expensive. Another cheaper solution is to ‘hedge’ your exposure, so that any money you lose on your underlying position is offset by the money made on your hedge position, giving the same net result as if you had just sold your underlying.
 

To achieve this hedge, investors will often buy ‘put options’ on the S&P 500 index. These options are derivative contracts that give the buyer the right (but not the obligation) to sell the index at an agreed price at some point in the future, they therefore go up in value when the index falls and decrease in price when the index rallies. 

Because you only buy the right to sell not the obligation, these options are cheap in relation to the level of protection they offer, so like an insurance policy they protect you when you need it and when you don’t they are just the price you pay for peace of mind.

It is therefore easy to see that during periods when investors are bullish and can see no risk to their portfolios, they do not feel the need to buy put options as a hedge and as a result these options trade quite cheaply. The converse is true when investors are bearish, fear is rife, and markets are falling. At these times the demand for put options explodes, as does the price.

Fortunately for us, there is an index that tracks this relative pricing of put options known as the CBOE S&P 100 Volatility Index. It is important to note that there is more than one volatility index, and that the methodology used to calculate it is far more complex than I have described, but for our purposes if we visualise high readings as meaning fear and low readings as complacency, it will suffice.

On the chart below I have added the price of the S&P 500 index to the volatility chart. We can see that volatility is currently very low, and that on previous occasions when it was around this level a stock market correction wasn’t far away.

Conclusion

January is often a positive month for equities as money is ‘put to work’ in the markets, but this year that trend is being magnified by the fiscal cliff debacle. We know that the money flows into equities are the biggest they have been for many years, a sure sign that ‘Joe Blow’ investor is bullish, and this high level of complacency is substantiated by the very low levels of fear shown in the Volatility Index.

When we add this to the deteriorating background picture and the fact that many equity markets are close to heavy overhead resistance (as shown in the chart of the S&P500 Index below), it is hard to see a positive long term outlook, this is just not the recipe for a new bull market.

Having said all this, it is crucial to understand that in spite of the overextended state of the markets, there is nothing to stop them rallying a little further before the correction begins, as we have already seen these tops can take a frustratingly long time to complete, but this should be the last gasp of the cyclical bounce from the 2009 lows. 

We just need to be patient and wait for the markets themselves to tell us when the time is right, rather than trying to ‘jump the gun’; because as John Maynard Keynes famously said ‘The market can stay irrational longer than you can stay solvent’.

The Fiscal Cliff

The Fiscal Cliff 

It’s hard to turn on the news at the moment without someone discussing the U.S Fiscal Cliff and the dire consequences of plunging over it. Will a solution be found in time? Will the Democrats and Republicans continue to lock horns or will sense prevail?

 Much of the coverage is the usual ill informed jawboning by the media looking to fill airtime at a traditionally quiet time of year, however this is an important issue and it is already having an impact on financial markets, so let’s take a closer look.

So what is the Fiscal Cliff?

The history of the Fiscal Cliff goes way back to President Reagan’s time in office. Together with the Congress, his administration and the many since have periodically imposed a time limit on themselves to force them to agree to unpalatable tax increases and spending cuts in order to reduce the country’s Federal Deficit.

 In a nutshell, the current inability to solve the issue is because the Republicans want additional cuts in spending rather than higher taxes for the ‘rich’, whilst President Obama and the Democrats want to cut spending less severely but recoup more in taxes from those earning over US$250000 a year. This is as much an ideological debate as anything else, which explains why they are having such a hard time finding a solution.

The last time this came to a head was in August of 2011 during the Debt Ceiling discussions , and in the best traditions of politicians never to solve anything today that can be put off till tomorrow, they kicked the can down the road until Dec 31^st 2012. After which time, unless an agreement is found, automatic spending cuts and tax increases will be triggered to the tune of US$560 billion, reducing the deficit by roughly half.

 This would have a huge impact with estimates suggesting a loss of 2 million jobs and a 4% fall in GDP in 2013, leading to a severe recession.

Unfortunately there are now a couple of other complicating issues that were not anticipated when the date was set.

Firstly there is the expiration of the Bush tax cuts (tax cuts implemented by President Bush to boost the economy at the time, and subsequently continued by the Obama administration). The expiration of these cuts will act the same as a tax hike, and the fact that they are also scheduled at the same time will only compound the problem.

Secondly, at some point in the first quarter the U.S will once again run up against its Debt Ceiling.

 This is the maximum amount that the government can borrow at any given time, and was set back in August 2011 when both a backstop date of 31^st Dec 2012 was agreed for the triggering of the ‘fiscal cliff’, and an increase of US$2.4 trillion was authorised for the debt ceiling bringing it up to the current level ofUS$16.4 trillion.

This 2011 debate brought the issue into the public eye for the first time, and was a bruising political slugfest, with a deal only being reached at the 11^th hour, and now only sixteen months and US$2.4 trillion later here we are again.

Certainly the repercussions of not getting a deal done are extremely unpleasant. With one of the implications being that the U.S govt would no longer be able to issue more debt to raise funds, it would be unable to meet its financial obligations and the risk of default would increase dramatically.

 We can now see that whilst most people are simply focussed on a resolution to the fiscal cliff, there are a number of issues intertwined, making it a very complex high stakes game indeed. There is a lot to play for and a heck of a lot to lose.

So what do I think will happen?

Well I think there are three potential outcomes:

1.     The politicians on both sides could finally grasp the enormity of what the country faces and putting their ideological dogma to one side agree to a long term plan of eradicating the financial deficit and paying down the country’s debt.

I give this plan about the same chance as Santa coming down my chimney and leaving me the keys to a brand new Ferrari on Christmas Day.

2.     Either the Republicans or the Democrats can see some political advantage in driving the country over the cliff and potentially gaining a better deal once the tax hikes and spending cuts start to bite.

This is a hard one to read but I have absolutely no doubt that either side would do it if they felt they could obtain a clear advantage.

3.     Politicians do what they do best. Grandstand and talk tough long enough to gain approval with their own electorate, and then strike some half-baked deal that solves nothing, kicks the can even further down the road but allows both sides to walk away claiming victory.

Now, call me old fashioned but I know what my money is on.

Of course there is one way they could thrash out a deal very quickly. All they need do is cancel the Christmas holiday for congress, mandate 100% attendance and maintain the session until an agreement is reached. I am sure this would inspire a plague-like outbreak of commonsense and accord.

Unfortunately the likelihood is that politicians will do nothing meaningful until the crisis becomes so severe that the general populace rise up and demand change. At that point they will listen or be voted out, but the chance to solve the problems will have already been lost.

The problems the U.S faces are mammoth, but fortunately for it, there are other regions with more pressing problems. Having been an oasis of calm for a few months now, the Euro zone will burst back onto the scene in 2013 (followed closely by Japan) as the sovereign debt crisis really bites, leading to the U.S temporarily regaining its flight to quality ‘safe haven’ status until it is the last man standing.

It might help to visualise a fleet of ships all sinking at different rates, and as one slips below the waves the crew clamber in hope onto the next one, until that too slips below the waves so they clamber onto the next, and so on until they are on the final ship, and when that finally sinks there is nowhere to go.

That is the global economy, and that’s what awaits us unless we do something now.

I will try to do another post before year end and give an update on how the financial markets are faring, but just in case the call of the beach is too strong I wish you all a fantastic festive season wherever you may be and see you in 2013.

N.Z Banks: How Safe is your Money?

N.Z Banks: How Safe is your Money?

Most of the developed countries of the world operate some form of retail deposit guarantee scheme designed to protect deposits in the event of a bank collapse. Many had been in existence for some years prior to the 2008 GFC and those countries that didn’t have them quickly implemented them as the crisis developed.

I briefly mentioned the N.Z Retail Deposit Guarantee Scheme back in June, in my post ‘Don’t be a Rabbit in the Headlights’ http://kiwiblackers.blogspot.co.nz/2012/06/dontbe-rabbit-in-headlights-as-we.html

 Here’s a quick reminder-

In New Zealand, the Retail Deposit Guarantee Scheme that was introduced during the depths of the 2008 crisis has now been wound down. It was brought in out of necessity because Australia had already done the same thing and if NZ had not followed suit there would have been a mass exodus of funds across the ditch.

The sole reason the schemes were rushed into being around the globe was to restore investor confidence and prevent a ‘bank run’. Were a serious bank run to occur and the banking system collapse, neither the NZ Government nor many other Governments have the necessary financial muscle to actually guarantee the deposits in their banking systems, it would effectively bankrupt the country. The banking sector is simply too large.

The fact that the guarantee has lapsed has not been an issue over the last few years. During this period N.Z has experienced relative calm after the shock felt during the initial stage of the GFC, so the fact that savings could be lost in the event of a bank collapse has not been a matter for concern in the minds of depositors.

Meanwhile the Government and the Reserve Bank have been working to improve New Zealand’s ability to withstand another shock to the financial system and their solution is the Reserve Bank’s Open Bank Resolution (OBR) policy.

This policy was flagged some months back and is designed to act as a new tool in the case of a bank failure.

In general terms the process works like this –

•      A statutory manager is appointed 

• All means of depositing or withdrawing money are frozen, as are all of the bank’s liabilities.

•      A portion of customer accounts are frozen and all other creditor’s claims are frozen in full (the amount frozen will be determined by the size of the bank’s losses plus a certain degree of slack).

These processes occur immediately, and are completed on the day the bank folds, then the following morning,

•        Bank reopens for core transaction business and to allow depositors to access all bar the frozen portion of their funds.

After that, once the final assessment of losses is known, additional funds will be distributed if available.

There are undoubtedly some good aspects to this policy, especially the quick ring-fencing of liabilities, allowing people swift access to the majority of their funds, but the inclusion of customer deposits in the assets that could be frozen will come as a shock to most people.

Many New Zealanders wrongly think that their savings are still guaranteed should a big bank go under, in spite of the expiry of the N.Z Government’s scheme, and as a consequence are more trusting of the banking system than they probably should be.

Even with the addition of the OBR policy, should a bank get into trouble I believe things will play out in a very similar fashion to previous ‘bank runs’.  

•       Once the OBR policy is triggered, depositors will become aware for the first time that some of their funds are at risk

•        As awareness of the implications of OBR policy become known, depositors will immediately start withdrawing their funds from banking entities with the same risk.

•      This will in turn create a problem for these institutions likely resulting in another OBR event with another bank, and so on.

•        Depositors will be desperately searching for a safe home for their funds and at this point, the Government will have no choice but to once again underwrite the entire banking system or face a massive exodus of funds from N.Z to the many jurisdictions that do have a retail deposit guarantee, creating a system wide banking collapse.

I fail to see what good the OBR policy will do as we will inevitably get the same end result. It seems more of a crisis management tool, designed in part to move some of the risk onto depositors, and little to do with making the banking system more robust and less likely to fail.

Rather than playing  ‘pass the buck’ and just focusing on the management of the next crisis, why don’t they instead look to ways of making the system more balanced, less exposed to risk and therefore less prone to a crisis in the first place?

Let’s have a look at some of the more obvious things that Government and the Reserve Bank could do:

•      Work to decrease our massive reliance upon Australian owned banks.

They currently account for around 90% of New Zealand’s banking sector, a situation that is virtually unprecedented anywhere else in the world. Aside from the fact that our balance of payments problems are exacerbated because so much of their profit is generated in N.Z but returned to Australia , the very fact that so much of our banking is foreign owned and therefore subject to problems within the Australian banking system, increases the risk within our own.

•       Legislate to prevent banks from offering mortgages on ridiculously high Loan to Value ratios (LVR’s).

Banks have repeatedly shown themselves unable to self regulate when it comes to mortgage lending. When the housing market is running hot they chase the perceived ‘easy money’ by offering higher and higher leverage until the obvious happens and the bubble bursts, disrupting the entire banking system. If these LVR’s were capped it would both deprive the housing boom of the fuel it needs to flourish, and stop the imbalances developing in the system in the first place.

•        Raise the risk profile of mortgage lending on the banks books. This will stop them pumping money into the over-inflated and under-productive housing sector

By making mortgage lending ‘riskier’ to the banks, it restricts the volume of mortgage lending they can undertake, and increases the relative attraction of other forms of lending. Over time this will result in a rebalancing of the banks’ lending profile which decreases their overall lending risk, and drives more capital into the business sector where jobs and profits are ultimately generated.

•         Curtail the banks ability to access the wholesale funding markets, forcing them to pay more for domestic savers funds.

Currently the banks are sourcing approximately 30% of their funding from the overseas wholesale market at cheap interest rates. This allows them to offer lower rates to domestic depositors because they are not so dependent upon these funds. This high dependency on overseas money dramatically increases the systemic risk, as should this money flow suddenly dry up things would get very ugly, very quickly!

 This is particularly pertinent as the overwhelming majority of money in the wholesale markets originates from the euro-zone, and when the next leg of the GFC hits, it is there that the impacts will be most felt, with wholesale markets freezing up and likely remaining so for some time.

By restricting their access to overseas funds, you force the banks to chase domestic savings. This will drive up the rates offered on domestic deposits, benefiting savers, and decrease our reliance upon this riskier overseas money. It will also benefit our balance of payments as the interest payments will be staying in the country rather than going overseas.

None of these solutions are in themselves a silver bullet, but implemented as part of a broader strategy might help to make our system more robust, less prone to external shock and with a better lending balance.

It is possible to have a banking system we can rely upon in times of global strife rather than one with obvious weaknesses that will more likely be an ‘Achilles heel’.

Unfortunately the chances of any meaningful change are remote. In his inaugural speech, the new Governor of the Reserve Bank Mr Graeme Wheeler seemed to agree with the pre-existing orthodox approach of his predecessor Mr Bollard, and suggested that although new measures might be introduced they would be more tinkering around the edges than a fundamental overhaul of the system.

It would appear therefore that the fallout from the 2008 GFC didn’t frighten the powers that be sufficiently to undertake any meaningful change. They seem content to tweak the system rather than undertake the required action (like rearranging the deckchairs on the Titanic), and as a result the safety of deposits during a serious banking event will remain questionable.

I would be very careful where you hold your savings, and be ready and able to move them should the storm clouds start to gather.

The Government and Reserve Bank may be quite sanguine about the risks, believing that the prospects for the global economy are improving and that another risk event like 2008 is quite a remote possibility.

 I don’t share their enthusiasm.

The New Zealand Property Market - The Bubble that Never Bursts

The New Zealand Property Market - The Bubble that Never Bursts

Originating from the UK, I knew that the Brits had an unhealthy fascination with home ownership and property investment. However, their enthusiasm is positively muted by comparison to the zeal with which New Zealanders embrace property ownership, it really is the only game in town. 
So rather than just relying upon the often heard refrain of 'you can't go wrong with property', lets try and delve a little deeper, starting with some of the factors that have influenced this rush to own property, including:

•     The desire to own something tangible

Many people feel much more comfortable owning something they can touch, rather than a stock or bond etc, giving them an added sense of security.

•      The ease of obtaining cheap credit

It is much easier for ‘Joe Blow’ to obtain finance for a house purchase, commercial property or ‘Buy to Let’ than any other investment. Also, with the credit explosion and the relaxation in lending criteria we witnessed throughout most of the last decade, almost anyone with a pulse could obtain a mortgage.

•       The almost complete lack of pension plans in NZ

This lack of pension offering means that most people see property investment as their one and only retirement plan.

•         A tax policy that encourages property investment

For many years the NZ tax regime has favoured property investment with a number of tax breaks, not the least of which being a complete lack of any capital gains tax, making property investment more attractive than other asset classes.

•     A relatively unsophisticated and under-regulated financial services industry

There is still a feel of the ‘wild west’ when it comes to regulation of financial service providers and the services they offer. The Reserve Bank of NZ (RBNZ) has consistently chosen a light approach and this, allied to incompetence and some good old fashioned corruption has undermined investors’ confidence in the sector, leading to a lack of viable and trustworthy alternatives to the old chestnut of property investment.

Of course, many of these factors exist in other parts of the world and it is for precisely this reason that we witnessed a property price boom not only in NZ but globally, in the years running up to the 2008 global financial crisis (GFC).

In the aftermath of the GFC, many of these countries suffered a property price collapse, bringing them down to more ‘normal’ levels. However, Australia and New Zealand suffered less than most, with rather modest falls and quicker recoveries, indeed by some measures NZ prices are almost back to their 2007 highs, especially around the Auckland area.

So what does the future hold? Are prices still overvalued or can we expect to see another price boom? If they are going to fall, how far should we expect them to go? What can history teach us about property boom and busts?

Firstly, lets take a look at the market currently and try to see how it looks in terms of value.

There are three main measurements that are used both locally and internationally as a means of assessing whether a countrys’ housing stock is over or undervalued.

•         The house price to income ratio

When this ratio is at 3 or below, it signifies a market that is affordable. The current figure for national house prices is 4.74 (seriously unaffordable) and for Auckland it is a vertigo inducing 6.18 (severely unaffordable). 

The chart below gives us some historical perspective.

 We can see that although the ratio is below the 2007 peak, it is still nowhere near the long term average.

•        The house price to rent ratio     

      The historical International long term average is 15, and currently this multiple is  at 21.11 having only fallen 6% from its peak, so we still have some way to go. 

•       The trend in ‘real’ (inflation adjusted) house prices.

As I have mentioned in previous posts, all asset prices are 'mean reverting' meaning that they oscillate around a long term average, swinging from under to overvalued and back again. These cycles can happen over many different timeframes, sometimes taking decades to complete a full cycle. However, no matter how long it takes, once the asset has reached its point of maximum overvaluation, the long term average will start to act  like gravity, pulling it back to earth.

The chart below shows real or 'inflation adjusted' house prices in the U.K from 1975 to the present day.

It is easy to see this oscillation around the mean, but one very important point to note is that prices do not just correct back to the mean or 'fair value', they only reach bottom when they are once again undervalued, with the extent of the undervaluation often proportional to the size of the preceeding overvaluation.
Whilst this is a chart of U.K house prices, the same principles hold true the world over.

Here is a chart of the current N.Z situation

Lastly I want to show you what happened when the greatest property price bubble the world has ever seen finally burst. During the 1980's asset bubble, real estate prices in Japan rose by as much as 6 to 7 times. At its peak in 1991 all the land in Japan (a country the size of California) was worth approximately US$ 18 trillion, about 4 times the value of all the property in the US at the time.

Here is the chart of Tokyo land prices.

Look familiar?

Now I am not trying to suggest that N.Z property prices are anywhere near as overvalued as Japans were at its peak. But it should now be reasonably clear that prices are still seriously overvalued and that the correction still has a long way to go.

 But prices are going up again I hear you cry, and indeed they are. So lets look at some of the reasons why, and whether they are sustainable.

• Shortage of new housing stock

Since the GFC there has been a considerable contraction in the number of new homes being built due to excessive costs of both the raw materials and the local government permitting process

• Low interest rates

The RBNZ has kept interest rates at historic lows to try and revive the economy. This has been a boon for both new home buyers making homes more affordable, and existing house owners allowing them to remortgage at cheaper rates.

• Banks once again offering high LVR mortgages

For the banks, the fear from the effects of the GFC has dissipated, to be replaced with their more usual emotion, greed. Having lowered their Loan to Value ratios on their mortgages to much more conservative levels in the aftermath of the economic turmoil, they are now once again chasing business and offering LVR's up around where they were before the crisis. They truly are nothing if not predictable!

• The effects of the Christchurch Earthquake

The loss of thousands of homes has had a profound effect on the property market, and cannot be remedied in the short term.

• Consumer confidence

The memories of the 2008 GFC are fading, to be replaced with confidence that the worst is behind us and it is only a matter of time before we get back to 'normal'.

All of these factors are supportive of the property market, and particularly regarding  the supply side of the equation, will continue to be for some time. But it is the demand side of things where life should get interesting over the next few years.

If we think back to the immediate aftermath of the 2008 credit crisis, there was a sudden and severe drop in consumer confidence leading to a sharp fall in spending, especially in big ticket items, and the tickets don't get much bigger than a house! Also, the overseas funding that the banks use for much of our mortgage lending shut down, due to the freeze in the European credit markets. This lead to a sharp fall in mortgage lending and tightening of mortgage lending criteria (including the LVRs) as the banks became less concerned with making money and more concerned with survival.
So we have already had a taste of what a financial market collapse can do to property values, and unfortunately the next crisis is just around the corner. However the bad news does not end there, as there are a couple of reasons why this time will be worse.

 When the GFC hit in 2008, governments, corporates and individuals alike had all enjoyed a few good years, so the financial books were in decent shape and there was 'fat' in the system. This allowed govenments the world over to trigger massive stimulus packages in an attempt to stimulate global growth. 
 Fast forwarding to today, we see a very different picture. Government finances around the globe look horrible, and after repeated stimulus packages are getting worse every year. Corporates have downsized and cut costs to the bone in order to maintain profitability, and individuals have dipped into savings, remortgaged their homes and used their credit cards in order to pay the bills. In short, over the last 4 years, all the 'fat' has been used up, meaning that when the next crisis hits we will have nothing left to soften the blow.

Secondly, to try to combat the ongoing effects of the GFC, central banks all over the globe have kept interest rates at historically low levels. This has kept the mortgage burden affordable and resulted in floating mortgage rates being consistently lower than fixed, leading to a huge number of householders in N.Z moving their mortgage from fixed to floating.  
The extent of this swing can be seen in the chart below.

  This is all fine until we have a rise in interest rates , and then because so many householders feel its effects at the same time, its negative impact is magnified, (I outlined why I think interest rates will rise sharply in my post Interest Rates: Where are they Heading?).
Also because of the way that the yield curve moves when interest rates rise, mortgagees are often caught out  when they finally try to fix.
 Let us take a  look at the chart below.

In a 'normalised' yield curve (A), floating rates are cheaper than fixed and the   householder therefore has a floating rate mortgage,the world is a happy place! As the situation starts to change, the first thing to happen is that the 'curve' steepens meaning that the fixed rates go up whilst the floating stays the same (B), the world is still a happy place. Lastly, the entire yield curve moves up as floating rates are finally raised (C), and it is only at this point that the majority of householders decide to fix. Unfortunately now the differential between floating and fixed can be quite large, and the lower that rates are to start with, the more this is accentuated with householders often having to find an extra 10 to 25% just to service their debt.

 We can see that there are some important differences between now and 2008, and although there are some supporting factors for the housing market, I expect them to be overwhelmed by the negatives that will arrive with the next crisis.

So, having established that prices are still overvalued, that they always revert to the mean over time, and that many of the current positives for the housing market will not last, should we expect to see a house price collapse? Well the answer is possibly, but probably not.
There are three ways that overvaluations can correct: the price can fall, inflation can erode it over time, or some combination of the two. In the majority of cases it is the third option that is the most frequent as house prices can often be slow to correct. This is because when people are in financial distress they will only consider selling their property once they have exhausted all other means of servicing their debt. Also, people are incredibly reluctant to sell a property for less than their perceived value, irrespective of the fact that prices have dropped and will continue to do so, they will only except the loss when they have no other option.


 It is because inflation often does most of the damage rather than price that leads to the myth that property never goes down. Many people wrongly believe that if their asset is the same price 10 years after they bought it, they are still breaking even. The reality is that with only a  3% inflation rate they will have lost 25% of its value after 10 years as surely as if the price had dropped  by 25%.
We will likely therefore see a correction lasting many years with prices slow to react at first then falling faster as the economy bites, confidence falls and all other options are exhausted. Meanwhile inflation will just keep chipping away in the background, doing what it always does, costing us money.

To conclude, prices may continue to rise in the short term. But once we roll over into the next stage of the financial crisis I expect the correction to begin in earnest. As we saw in the chart of 'real' house prices above, property is currently 25% overvalued. But as I mentioned earlier, the size of the correction is normally proportional to the size of the preceeding boom, meaning that prices will likely correct even further.

 I expect 'real' house prices to have dropped by 40% from their peak by the time the correction is finished, and if the entire financial crisis pans out as I fear it will the figure will be much higher. If you think that is impossible take another look at that chart of Tokyo land prices and also consider that after the Great Depression of the 1930's a number of areas on the US experienced falls of over 90%!


The point to take from all this is that property is just the same as any other asset,it reacts the same all over the world and it does not have some special immunity making it the perfect asset in all places and at all times, in spite of what many people think.
 There are times when it is right to own and there are times when it isn't. 

 The skill is in knowing the difference.