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THE BROYHILL LETTER


“House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national
level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady
rates of household formation, and factors that limit the expansion of housing supply in some areas.”

– Current Chairman of the Federal Reserve, Ben Bernanke, 2005


Executive Summary

While most investors today probably understand that Europe isn’t exactly a poster-child for prudent government spend-
ing or budget planning, we’re not sure that the consensus is bearish enough on the spillover effects from a prolonged
European Debt Deflation. Exports are still the foundation of the China story, but with their largest customers still lying
in intensive care, we doubt appetites for cheap Chinese goods will be quite the same. At the same time, strategists today
are still debating whether or not the massive, credit-induced spike in Chinese real estate prices is in fact, a bubble. We’ll let
investors answer that one for themselves, but consider that the ratio of residential real estate to GDP in China looks a lot
like California in 2006, while levels in Beijing and Shanghai match the Japanese peak in 1990.

Market participants around the world have obsessed over every blip in Chinese economic data for the better part of the
last decade; and rightly so, as China has been a rare source of strength in a fragile global economy. This year, the Shanghai
Composite is among the world’s worst performing equity markets, as the government’s visible hand has taken measures to
curb speculation, dampen money growth, slow loan growth, and launch an aggressive attack on housing prices. Leading
indicators of Chinese growth have responded accordingly, and have been slowing along with the stock market since last
fall. We view this speed bump in the high-growth China story as an important leading indicator for global markets and
explore one such consequence Down Under, in this letter.

Who Can It Be Now


Source: Steven Keen’s Debtwatch
Leading up to Japan’s bursting real estate
bubble in 1990, we were told that this time
was different – house prices simply reflected
the growing economic power of Japan Inc.
and there was a land shortage in overcrowded
Tokyo. Today, Japanese real estate prices are
still less than 50% of that peak value reached
more than two decades ago. During the UK
bubble, Brits blamed zoning requirements for
creating land shortages until prices crashed to
the lowest multiple of income on record in
1997. Similarly, builders in Northern Ireland
predicted severe housing shortages if plan-
ners did not release more land in 2003. And
before America’s bubble burst, there were
land shortages across the country, from Florida’s undeveloped west coast to the deserts of Nevada. While prices at home
have already fallen 30% from their peak, they’d have to fall another 45% just to reach the long term trend, which according
to Robert Shiller, has been flat in real terms for three and a half centuries!!

The recurring theme in every case is that housing bubbles are almost always justified by “new era” thinking, land shortages,
and are considered unique right up until the moment they pop. Most bubbles around the world have at least partially de-
flated in the wake of the Great Contraction, yet the property market Down Under continues to chug along ignoring the
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gravitational forces of mean reversion as Aussie consumers continue their American-inspired credit binge. US housing
prices nearly doubled in the decade leading to their ultimate peak as shown in the above chart. Australian real estate kept
pace with these gains until US home prices lost nearly a third of their value as US home owners deleveraged their balance
sheets. Since then, Australian households have watched their home prices appreciate by at least that much, while they con-
tinue to feast at the trough of easy credit.

Here We Go Again

Financial deregulation in Australia began slowly in the


1970s before accelerating more quickly in the 1980s. A
number of factors contributed to a shifting focus within
the banking system from business towards housing in the
1990s, resulting in a doubling of the share of housing
loans to banks’ total lending in the past two decades. In
other words, Australia’s banks are very exposed to the
bubble in household real estate. Deregulation predictably
led to considerable “product innovation” in the Austra-
lian mortgage market. Homeowners in the US under-
stand that “product innovation” is a nice way of saying
weaker lending standards. Wholesale lenders competed
aggressively for market share by undercutting the banks
and creating sexy new mortgage products like home-eq-
uity, interest-only and low-documentation loans. Sound
familiar? These lenders, with no balance sheet and little
capital, quickly garnered 15% of housing loan approv-
als (see chart below). Low-doc loans accounted for 10
percent of new housing loans in 2006, compared with
less than one half percent in 2000. This trend continued
unabated until the Credit Crisis sparked a near closure
of the RMBS market, and several large wholesale lenders
were acquired by major banks. As a result, the market
share of Australia’s major banks rose from 60 percent to
over 80 percent of the entire housing market!!

Granted, lending standards in Australia did not loosen as


much as some other markets. There was little sub-prime
lending of the kind we grew to love here in the states,
and non-performing housing loans have remained low,
for now. Yet, according to Guy Debelle, Assistant Gov-
ernor of the RBA, low-doc loans still account for almost
10 percent of new loans and almost half of all new home
owners are opting to not make any principal repayments.
We also find it curious that “investor’s” (i.e. speculator’s)
share of new home loans has risen almost uncontrolla-
bly, while first time buyers disappear from the market – a
clear indication that affordability is declining, and a big
red flag, as first time buyers represent an important link
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in the residential food chain. Standard & Poor’s recently


warned that Australia’s record mortgage debt could expose
some borrowers to ‘’financial shock’’ should interest rates or
joblessness rise, while flagging the danger associated with the
high levels of debt held by Australians.

Australian households currently hold more than $1 trillion in


debt, a record level. The ratio of household debt to dispos-
able income in Australia was 158 percent, at the end of the
first quarter. About one in seven Australian tax-payers has
an investment property other than the family home. Despite
all the talk about Australian lenders being more responsible
than those in the USA, mortgage debt in Australia rose three
times faster since 1990, according to Steven Keen. Having
started with a mortgage debt to GDP ratio that was just 40%
of America’s, Australia’s ratio is now higher than ours and still increasing (see chart). No deleveraging here. More punch
please.

Whack A Banker

A survey by Australia’s Finance Sector Union shows that nearly one


third of Australian bank employees are worried about their customers’
ability to repay loans, while nearly half say they are under pressure to
push more credit on customers even if customers don’t ask and may
not be able to afford it. In the survey, nearly 60 percent of bank work-
ers said selling debt to customers had ‘’become a much higher priority
and sales targets always go up’’. Acting FSU National Secretary, Wendy
Streets, said that bank workers uniformly reported being under con-
stant pressure to sell more products to customers and have concerns
about customers’ capacity to manage their debt. The survey found that
79% say Australia needs tougher regulations to stop personal debt get-
ting out of control.

Australian Bankers’ Association chief executive Steven Münchenberg


claims, “Banks undertake a detailed assessment of a customer’s ca-
pacity to pay before providing a home loan. Banks’ conservative risk
profiles and the rigorous assessment of the customer’s capacity to pay
are reflected in the low level of banks’ loan delinquencies.” We thought
this was particularly interesting in light of comments by a lender in the
industry that explained, “They cannot write the stuff quick enough,”
and despite stories of prudent lending practices down under, “Some-
times the bank just asks for a few bank or recent credit card statements
before approving multi-million dollar loans.” Another customer wrote,
“I maxed my $10,500 credit card limit during my travels offshore and upon my card’s expiration I decided not to reactive
the new card so that I could easily repay this huge debt. When later talking with a call centre representative not only did she
offer to increase the limit on my maxed out card but also pressured me into reactivating the new card and creating further
debt.” Wow. Conservative risk profiles indeed.
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Another Land Shortage

New homes starts hit a six-year high last quarter thanks


to stimulus spending on public housing. In all, home
starts were almost 35 percent higher than in the first
quarter of 2009, the fastest annual pace in eight years.
Approvals to build new homes surged 43 percent be-
tween May and December last year, leaving a big pipe-
line of construction still to come. Growth in approvals
has leveled off in the past few months but they still re-
main 37 percent above last year’s low. Yet analysts still
allege that far fewer homes are being built than needed
to meet demand. We shall see.

Demand for new home loans fell to a nine-year low in April as rising interest rates dampen enthusiasm for housing. The
number of new home loans has fallen 26 percent since its recent peak in June 2009, a leading indicator for housing. With
a lag, you would expect these numbers to flow through to building approvals, housing starts and ultimately prices. Higher
interest rates are starting to bite with new home sales dropping by more than 6 percent in May 2010 and average loan prices
declining, according to Australia’s Housing Industry Association (HIA). Sydney’s most recent auction clearance rate fell
below 50 percent and remained flat in Melbourne, with both posting their lowest rates since December 2008.

House prices in the major cities climbed 20 percent in the 12


months to March. But activity has cooled since the First Home
Owners Grant expired last year and interest rates began to rise.
Since last October, new home loans have fallen for seven months
straight. Pockets of stress have emerged in Western Sydney fol-
lowing a sharp run up in house prices. More recently there are
signs of increased housing stress in southeast Queensland and
Western Australia, again following sharp rises in house prices in
these areas.

Australia has gone two decades without a serious downturn,


leading most to believe that house prices move only in one di-
rection, despite historical data which clearly indicates that the
ratio of home prices to income has always fluctuated around a
stagnant long term average. The reason is that income acts as an
anchor limiting the price homeowners are able to pay, and has
always pulled prices back to earth in every instance. It is only a
matter of time. In a recent speech, GMO’s Jeremy Grantham
explained that the average family can afford a home about 3.5
times their income. In 2005-2006, new homes in the U.S. were
Source: The Economist selling for well over 5 times median income while other real
estate bubbles have grown to 6 or 7.5 times. Australian real estate is at 7.5 times family income today - twice the price it
should be according to GMO data, and needs to decline by over 40 percent to return to trend. A more dire analysis by The
Economist estimates Australian property is more than 60% overvalued based on the ratio of house prices to rents, more
than any of the 20 countries the publication tracks. Six of the 10 most unaffordable cities are in Australia according to the
annual Demographia International Housing Affordability Survey. It’s no wonder that many first-time buyers are already
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struggling to meet payments, with 40 percent of those who took advantage of government subsidies reporting some de-
gree of financial stress. Initial mortgage payments for a home in Sydney or Melbourne absorb more than half of the aver-
age family’s disposable income. Yet, the potential for even a pause in ascending real estate prices is seldom considered as
the local media often maintains that Australia completely dodged the Great Contraction. It appears that the great majority
of home owners in major cities discount the possibility of a bubble in their own backyard, despite warnings from Jeremy
Grantham, speaking in Sydney and Melbourne last month, that the housing market is a “ticking time bomb.”

Investment Implications

Despite the growing and increasingly obvious risks cited


above, Australian banks are still trading at extremely rich
multiples, particularly when compared to their US coun-
terparts. The average price-to-tangible-book values of two
major lenders on our radar is roughly 3 times, double that
of their American peers. It would appear that the banks
are enjoying an undeserved premium, as investors are led
to believe that lower charge-off rates and delinquencies are
the result of more prudent management teams and more
conservative lending standards. More likely, it is simply an
issue of timing. Take a moment to review the chart below,
from the FDIC’s March 2008 Quarterly Banking Profile.
At the time, the report warned of high and increasing non-
current loan growth. The main point being that the growth
in reserves, while increasing, was not keeping up with the
Source: Hussman Funds
rise in noncurrent loans, so the industry’s coverage ratio
was deteriorating. We all know how this story ended.

Now tell me if you see any similarities between this chart,


from the FDIC in early 2008, and this chart, which is the
latest data from one of Australia’s largest home lenders.
From our perspective, it is increasingly likely that the
rate of loan-loss reserves is forced sharply higher just to
prevent further erosion in the coverage ratio. In order to
actually raise the coverage ratio, far more massive write-
downs would be required, as we have learned the hard
way in the states. While NPLs have inched higher Down
Under, any increase has largely been driven by commercial
loans . . . so far. Not surprisingly, residential delinquencies
have remained subdued as home prices have continued
their ascent. But what happens if home prices don’t go
up forever? The two banks with the largest exposure to Source: Company Presentation, Broyhill Asset Management estimates

Australia’s housing market have aggressively increased housing loans in recent years, such that residential real estate expo-
sure now represents more than 11 times tangible equity. Not exactly what we’d call a Margin of Safety.

Stress tests are all the rage in the wake of the Great Financial Crisis as central banks around the globe rush to assure inves-
tors that the balance sheets of their nation’s banks are sound. In early 2009 results in the U.S. sparked a monster rally in

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risk assets as market participants blindly accepted the promise of regulators. By the end of this month, we should also hear
similar promises out of Europe, although we would encourage prudent investors to view said “strength” with a healthy
dose of skepticism. This is simply a public relations program. Similarly, we find it a tad suspect that the industry-wide tests
conducted by the Australian Prudential Regulation Authority concluded that not a single bank would have breached their
minimum capital requirements under their “severe but plausible” scenario. Upon closer inspection, perhaps this shouldn’t
come as a surprise considering the very banks that are being “stress” tested, applied their own models to the tests. One
particular management team even assured investors on a recent conference call that, “Nothing is likely to have an impact
that would cause us to have to raise any capital.” We are not as confident. Our analysis indicates the potential for severe
stress should housing prices revert to normal, let alone overshoot. We wonder how the currency would react should Aussie
officials be forced to recapitalize the banking system, given investors’ current optimism on the AUD as reflected by this
CSFB survey.

Bottom Line

A disorderly unwinding of China’s credit and property bubble may well be the principal global macro risk today. While
all eyes are on Europe, it would certainly have the potential to catch investors by surprise. But such an unwinding is not
necessary to have a noticeable impact on its largest supplier. In macro, what happens at the margin matters most. Many
argue that a slowing of Chinese GDP growth from 12% toward 8% still represents an exceptional growth rate for the
world’s second largest economy. We suggest that investors focus instead on the 33% decline in the rate of growth, which
will have a comparable effect on China’s demand for (Australian) commodities. Any significant reduction in said demand
could easily provide Australia’s property bubble with a Chinese Pin. Then again, bubbles of this magnitude often collapse
under their own weight as gravity pulls valuations back to earth over time.

One of the ways we seek to earn superior returns on our capital is by developing thoroughly researched macro themes that
are different than the market’s general perception. We are often looking at the same information, but different conclusions
provide us with an opportunity to position accordingly - and wait for the market to play catch up. Mean reversion is always
a good bet, although timing is always uncertain. Today, the consensus remains whole-heartedly in the bullish commodity
camp based primarily on China’s insatiable and uninterrupted appetite for resources. We have invested considerable time
exploring cheap hedges to profit from a speed bump in Chinese demand and another deflating property bubble (or two).

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While we remain constructive on the long term prospects for commodities and other real assets, buying a little insurance
in the face of near term cyclical risks seems like the prudent thing to do, particularly since market participants have again
forgotten that prices are capable of moving in a direction other then up. Since last October, the Reserve Bank has raised
interest rates 6 times. JPMorgan and others are forecasting Australian cash rates to move from the current level of 4.5%
to 6% by next year. We think this is highly unlikely in light of the risks noted above and especially while the rest of the
developed world hurdles towards deflation. The odds of at least one of these bubbles bursting increase with every central
bank tightening. This sequence of events would have interesting consequences for Australian interest rates, currency and
highly leveraged home lenders.

- Christopher R. Pavese, CFA

The views expressed here are the current opinions of the author but not necessarily those of Broyhill Asset Management. The author’s opinions
are subject to change without notice. This letter is distributed for informational purposes only and should not be considered as investment advice
or a recommendation of any particular security, strategy or investment product. This is not an offer or solicitation for the purchase or sale of
any security and should not be construed as such. Information contained herein has been obtained from sources believed to be reliable, but not
guaranteed.

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