High debt, house price risk and income inequality

Over at Capital Ideas, published by Chicago Booth School of Business, there is an excerpt from Amir Sufi & Atif Mian’s book “House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again“.

Debt plays such a common role in the economy that we often forget how harsh it is. The fundamental feature of debt is that the borrower must bear the first losses associated with a decline in asset prices. For example, if a homeowner buys a home worth $100,000 using an $80,000 mortgage, then the homeowner’s equity in the home is $20,000. If house prices drop 20%, the homeowner loses $20,000—his full investment—while the mortgage lender escapes unscathed. If the homeowner sells the home for the new price of $80,000, he must use the full proceeds to pay off the mortgage. He walks away with nothing. In the jargon of finance, the mortgage lender has the senior claim on the home and is therefore protected if house prices decline. The homeowner has the junior claim and experiences huge losses if house prices decline. 

I recommend reading the full article if you have time. The reason why this makes sense is that one household’s debt is another household’s asset. A key risk to the New Zealand economy is the outsized proportion of household assets made up by home equity. A way to reduce that risk is to build up the financial assets of households. This is the real benefit of Kiwisaver and state wealth funds like ACC and the NZ Super Fund. They’re reducing the severity of any house price collapse induced recession in the future. If your household has a diversified portfolio of assets – including across asset classes – then house prices dropping 20% won’t have as much of an impact than if your household has almost 100% of its assets in home equity.

Ex-Billionaire Eike Batista Says He’ll Bounce Back

The Wall Street Journal have an article on Brazilian ex-billionaire Eike Batista who has seen his wealth plummet from tens of billions of dollars to an undetermined amount following the collapse of his empire’s share prices against which substantial loans were raised.

Starting in 2006, Mr. Batista sold shares in a string of interlinking commodities companies he had set up to profit from Brazil’s promise. His OGX oil firm would help find Brazil’s new oil bounty. And it would buy its oil rigs from OSX, a ship builder he took public in 2010. OSX would build its ships at a port facility bigger than Manhattan to be built by LLX. And mining-company MMX would ship raw materials from the port.

Brazil had one of the best performing stock markets in the aftermath of the global financial crisis. Eike Batista was selling a fantastic Brazilian growth story and was able to get a substantial amount – over US$10 billion – of loans and equity investments into his group.

Unfortunately, it hasn’t worked out as well as he planned. The Financial Times have had some good coverage of his OGX group’s struggles over the past year and he even appeared on 60 Minutes last year touting Brazil as a new economic success story.

Brazil is a very interesting country. There are definitely a lot of opportunities there for New Zealand firms. But getting on a plane to Rio or Sao Paulo is hard – I hope either of those two cities are a long haul 787-900 Air New Zealand destination sometime in the next decade!

There Is No Broad Austerity In Europe

The wailing and gnashing of teeth over austerity being the end of the world does not hold up to an examination of the facts. Austerity, as trumpeted by inept journalists who couldn’t tell the difference between Minsky (the economist) and Minsk (capital city, Belarus), means a reduction in government spending.

Courtesy of tooth enamel protectors ZeroHedge, we are pointed to a beautiful chart that highlights the truth of austerity in Europe. Only two countries – Iceland and Hungary have reduced public spending. Ireland has kept spending largely flat because of massive bailout costs and rising social welfare expenditures.

faux 1_0

This is why the kneejerk criticism of Reinhart & Rogoff was so irrelevant to the grand scheme of things. There is no way of figuring out whether high debt causes slow growth or slow growth causes high debt. But the reverse causality seems more reasonable. When you make hiring and firing very difficult and starting a business almost impossible, of course you get slow growth and record unemployment figures.

The big concern over government debt is also another inept journalist meme. This chart from Morgan Stanley shows clearly how the United Kingdom is essentially insolvent and depend on interest rates sticking close to zero in perpetuity. It also shows that in New Zealand, household debt is a massive chunk of our debt problem but government debt is growing rapidly.

World debt to GDP_0

If there was actually broad austerity in Europe, we would see even higher levels of unemployment and even lower levels of GDP growth. Don’t forget – the cost of bailouts and cheap finance made available to insolvent banks is still government spending. Someone, at some point in the future, has to earn a profit and pay taxes on it in order to repay the debt or provide the cashflow to justify the bond market “rolling over” the debt.

One of the reasons why public debt has grown rapidly during Great Depression 2.0 is that automatic stabilisers in the form of welfare spending has increased substantially. Tax expenditures in the form of Working for Families tax credits and the Independent Earner Tax Credit have increased as well, reducing net tax revenue. This means that on top of slow growth, you have massive changes in cash flow even before the impact of the Christchurch earthquakes is taken into account.

The question simply has to be asked – given that there is no broad austerity in Europe – and unemployment is at record highs – what does that imply about the multiplier, if it indeed exists? It implies that the multiplier is far, far lower than the 1.5 trumpeted by Obama’s economic advisors during the rollout of the stimulus. It might even be less than 0 because of a “crowding out” effect.

All of this stuff matters, but no one cares. Some people reading this will experience a kneejerk emotional response that makes them want to post links to articles about public servants losing their jobs while missing the point that cutting wages and salaries does not offset the effect of automatic stabilisers.

Fairfax Selling TradeMe Is No Surprise

The news that Fairfax are selling their stake in TradeMe is no surprise. This is because Fairfax has made a string of poor decisions over the past decade.

They failed to aggressively expand in online media, benefiting primarily through the acquisition of TradeMe. They loaded up on debt and TradeMe was a key contributor to maintaining Fairfax’s debt servicing ability over the past few years.

The reduction in Fairfax’s debt will give them a lot of breathing room. But it will basically take them back to the position they were in pre-TradeMe. That’s a poor online strategy.

It is a fascinating insight into how executives are not very good stewards of shareholder wealth, if you subscribe to that theory. It’s also an interesting insight into how supposedly smart people can make really dumb decisions.

If we look at Fairfax’s most recent investor presentation, we see Fairfax are trading away a business with a margin of 75% (TradeMe) and EBITDA growth of 11.2% for a core group of businesses with margins between 5% and 28%.

The Fairfax executives are basically betting that their transformation strategy will deliver more cost reductions and revenue growth than using TradeMe as a cash cow to pay down their other groups debt.

Their arrogance is amazing. From their own financials, only their internal whole of group restructuring (HR, IT, operations) is delivering higher returns than TradeMe!

One of the biggest contributors to their cash flow – enabling them to stay alive – was the proceeds from the TradeMe IPO!

But we have to remember that the major Fairfax loss is a non-cash impairment as a result of their ~$2.8 billion writedown in masthead value and goodwill.

They have to write down the value of their print assets, yet somehow think selling off TradeMe is a good strategy.

This action reminds me of something Bob Jones wrote in one of his books – whatever AMP is doing, do the opposite.

Corporate executives have a track record of poor decisions. Fairfax loaded up on debt during the boom and delayed aggressive cost reduction until it was too late.

Now they’re letting go of a franchise business with massive margins that can fend off any competition for the foreseeable future.

This whole debacle is another reason why excessive executive compensation is so wrong.

You can make completely stupid decisions that put a company on a trajectory to insolvency but there is no likelihood of Fairfax executives having to repay their “make hay while the sun shines” compensation.

If I was a major institutional investor in Fairfax I’d be extremely annoyed to the point of spending the rest of my career aggressively shorting companies with executives responsible for this at the helm.

“Go short the idiots who think selling TradeMe is a good idea” could be a rewarding hedge fund strategy over the next decade or so!