The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Is it Time to Start Worrying about the Australian Banks?

Pop Quiz. Which of the following countries had the largest increase in housing prices (as measured by countrywideindexes) from March of 2002 to the peak?A)AustraliaB)United StatesC)New ZealandIf you guessed the US based on the dramatic fall in prices since the Case-Schiller reported peak in August of 2006you would be wrong. In fact, in this dubious race to the top the US would actually come in third as measured by theComposite 20 Case-Schiller Index.

Australian House PricesPeak:Weighted Average 8 CapitalCitiesMar-02Mar-05Mar-08Mar-0902-09Increase02-Peak IncreasePeak to March 09Decline

House Price Index74.3101.3131122.264.47%76.31%-6.72%

Peak:US Home PricesMar-02Aug-06Mar-08Mar-0902-09Increase02-Peak IncreasePeak to March 09Decline

Case-Schiller Composite 20122.3206.2172.2139.9914.46%68.60%-32.11%

YearEndYearEndYearEndPeak:New Zealand House Prices199920022008Q1 200802-08Increase02-Peak IncreasePeak to Q4 2008 Decline

House Price Index227282568616101.42%118.44%-7.79%AU data source: http://www.ahuri.edu.au/ NZ data from Reserve Bank of NZ (latest data available)US data from S&P

As the above data indicates, from 1999 New Zealand had by far the largest increase in housing prices, followed byAustralia. However, as shown by the peak to decline data, the global recession and worldwide real estate bubble hasnot had anywhere near the impact on housing prices in these two countries as they have had on US prices. Theinevitable question that results from this observation has to do with whether or not New Zealand (hereinafter NZ)and Australia (hereinafter AU) are in for a similar decline in prices but are just a few years behind the US in the process. If that is the case then the resulting shock to the local banks that serve this region could be just as dramaticas the impact that the ongoing housing price spiral has had on the US banking system. Specifically, the reason it isespecially important to focus on housing in these countries is that, on average, among the seven banks I analyzed,60% of their loan books consist of residential mortgages (and securitizations). Also, the primarily focus should be onAU, as 85%+ of the banks’ loan portfolios are made up of AU-located loans. Accordingly, this is the first of twoseparate pieces on the AU-NZ banks. The first of which will examine the economic trends facing the regionaleconomies and housing markets and the second will delve more deeply into the individual attributes of the banks.The answer to the above question regarding the fate of house prices has a lot to do with the state of the localeconomies in the AU-NZ region. As we continue to see in the US, unemployment leads to foreclosures that thencause housing prices to fall further or stagnate and ultimately wreak havoc on the balance sheets of the exposed banks. In addition, the amount of leverage in the US system, especially when it comes to banks and home lending,has had a monumental influence on the extent of the real estate bust. In retrospect it is blatantly obvious that cheapcredit and lax lending standards in the US led to a lending boom that inflated house prices well above the historicaltrend line. Also, reduced consumer savings rates resulted in homeowners having a much smaller savings cushionthan was required to protect against unexpected events such as job losses. Therefore, in an attempt to assess theinherent risk of further declines, it is important to determine if the housing price boom in the AU-NZ footprint wasfueled and perpetuated by similar use of leverage.

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At first glance the data suggests the answer could be yes. I have accumulated a ton of data on the current states of these countries, so much so that it can be a bit overwhelming. Consequently, I am going to focus on what I feel arethe most relevant and revealing facts. Let’s first take a look at Australia, the country that the banks in the region have by far the most exposure to:

AustraliaMar-99Mar-03Mar-08Mar-0999-09 Average

Personal Savings % of Disposable Income0.80%-2.30%0.70%1.60%0.36%

Mar-99Mar-03Mar-08Dec-0899-08 Increase

Household Debt/GDP35.27%37.93%63.84%67.67%91.88%

Mar-99Mar-08Mar-0999-09 Increase

Housing Debt/Disposable Income66.50%137.70%136.50%105.26%Data from Reserve Bank of Australia

Low consumer savings rate? Check. Increasing household debt as a percentage of GDP? Yup. Skyrocketing housingdebt as a percentage of disposable income? For sure. How about New Zealand?

New ZealandQ1 1991Q1 1999Q1 200999-09 Increase

Household Debt/GDP59%98%156%59%

19841999200899-08 Increase

Household Liabilities/Disposable Income48%103%155%50.49%Housing Value/Disposable Income248%335%498%48.66%Data from Reserve Bank of NZ

Although I can’t find data on NZ’s personal savings rate, the trend in this country seems to be similar to the oneillustrated in the above AU table: increasing household debt and liabilities as a percentage of GDP and disposableincome. However, in terms of NZ, the most interesting component of the chart is the dramatic increase in housingvalue as a percentage of disposable income. What this indicates to me is that housing prices were rising significantlyfaster than incomes, a fact that could mean those prices are not sustainable.Finally, it is important to look at the US data and compare it to that of AU and NZ. If consumer leverage has beenone of the most prevalent causes of the housing bust in the US then it is imperative to have an understanding of howlevered AU and NZ households are in comparison.

USApr-99Apr-08Apr-0999-09 AverageMay-09

Personal Savings Rate2.50%0.00%5.70%1.70%6.90%

Jan-99Jan-08Jan-0999-09 Increase

Household Debt/GDP66.80%98.09%98.56%47.55%Household Debt/Disposable Income92.17%133.48%128.89%39.85%Data from the St. Louis Fed and my calculations

In relation to the increase in personal leverage in AU and NZ, the amount of debt taken on by US consumers over the past decade or so actually looks sort of moderate. Household debt to GDP increased only 47.6% from 1999 incomparison to 59% for NZ and an incredible 91.9% in AU. But, despite the increase in leverage in AU the personalsavings rate has remained low, although it has crept up over the last year. The savings rate of 1.6% as of Marchcompares to the 6.90% rate (announced today based on May data) for the US. The concern for any investors lookingto gain some exposure to the Australian banks is that the global recession combined with a highly levered consumer and potentially unsustainable housing values causes consumers to start saving more. While the AU banks haverelatively minimal exposure to commercial real estate and C&I loans, the effect on the economy of a significant boost in consumer savings would likely lead first to lower consumption (which makes up about 60% of theeconomies of AU and NZ) and then to higher unemployment and eventually more foreclosures.Another leverage metric that has been important to monitor during the financial crisis is the ratio of bank assets toGDP. The case of Iceland has provided a cautionary tale about the disastrous implications of having a levered banking system whose level of assets dwarf GDP.

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AustraliaMar-99Mar-08Mar-0999-09 Increase

Bank Assets/GDP0.79x2.08x2.41x205.34%

New ZealandApr-99Apr-0999-09 Increase

Bank Assets/GDP1.34x2.13x58.42%

USDec-99Mar-08Mar-0999-09 Increase

FDIC Bank Assets/GDP0.76x0.94x0.96x26.52%AU data from Reserve Bank of AU NZ data from Reserve Bank of NZUS data from FDIC.gov

Again, this table shows that AU has had the most significant increase over the past 10 years and now has bank assetsat over 2.4x GDP. I am not suggesting that AU and NZ are at risk of turning into the next Iceland. However, thisratio provides a barometer of how important banking is to the economy. We have seen in the US what a bankingcrisis can do to the broader economy and as a consequence investors need to be cognizant of the potential impact of a retrenchment in credit on consumers and businesses. This is especially true when the banking assets represent anoutsized portion of domestic production. Now that I have established that both AU and NZ have seen significant appreciation in housing values along with anincreasingly debt-burdened consumer, the next step is to try to evaluate what the ultimate impact of this will be onthe banks. In the US, the surge in unemployment has only exacerbated the housing price decline and has forced the banks to recognize large losses on real estate loans. So far, Australia has avoided going into a recession. This isclearly one reason why bank charge offs and non-performing loans have remained relatively contained to date.Referencing first quarter GDP data from anarticlein the newspaper The Age:“Australia has dodged a recession, with data out today showing the economy expanded in the first threemonths of the year.Gross domestic product for the March quarter grew a seasonally adjusted 0.4 per cent from the previousthree months, the Australian Bureau of Statistics said, bouncing back from a revised 0.6 per cent decline inthe final three months of last year.The relief, though, may be temporary as the main contribution to growth was from shrinking imports(adding 1.6 percentage points), not typically a sign of a robust economy. The main drag was businessinvestment (shaving 1.1 points), a signal that the outlook for jobs is likely to darken further.''We've dodged the recession bullet for the time being, but in reality we've had five quarters of sub-trendgrowth and unemployment has gone up in that period,'' Commonwealth Bank chief economist MichaelBlythe said.”Additionally, AU unemployment at 5.7% (according to May data) pales in comparison to the 9.4% (and rising) ratein the US. However, AU unemployment is up substantially from the May 2008 rate of 4.3%. Plus, as there weresome major (and for the most part unheeded) economic and housing bears in the US in 2006 and 2007, it appearsthat there are also some concerned parties emerging in AU as well. Quoting another piece in The Age: “Home prices will fall by double digits by the end of next year, denying Australians a key source householdwealth, according to a JPMorgan analysis.The value of Australian homes will drop 14 per cent by the end of 2010, pushed down by a fallingemployment levels, JPMorgan said. The bank expects the jobless rate, currently at 5.4 per cent, to hit 9 per cent in that time.”Interestingly enough, the JP Morgan forecast is not even as bearish as the prognostications of this AU NationalUniversity professor (via The Age):