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.

Micro Managing Credit Allocation Is A Horrible Idea

Funding for Lending in the UK and loan-to-value restrictions in New Zealand are examples of central bank micro-management of credit allocation decisions.

They are both horrible ideas because they fail to consider unintended consequences and ignore economic history. Despite having a mandate for financial stability, what on earth does that actually mean? Does it mean that credit should stagnate? What does a “stable financial system” look like in an environment of dynamic economic growth?

The failure to think about moral hazard is negligent in the extreme. It is essentially shifting the blame for poor risk management from “the bank stuffed up” to “the central bank didn’t intervene in time”. Ridiculous!

I am skeptical of the idea that a central bank can accurately identify appropriate intervention points in the business cycle and deploy whatever tool they’ve chosen without enormous effects on behaviour in the economy they’re trying to “stabilise”.

Where Will Property Developers Obtain Capital From?

The news that the directors of Lombard Finance received from the Court of Appeal home detention sentences substituted for the community work and reparation sentences they received in the High Court was greeted with much whinging about finance companies in general.

But with the collapse of the finance company sector, and of lending to risky property development projects in general, where will property developers obtain capital from? It sure won’t come from the big banks and it is ridiculous to expect NZ private investors to organise funding schemes organically.

In his weekly overviews, Tony Alexander has pointed out that some developers are raising finance in China for projects in Auckland. This is an interesting development, particularly when it is harder for regulators to keep track of overseas promotion of New Zealand investment schemes than if they stick to our shores.

While foreign capital is obviously essential to any supply side response to a housing shortage in Auckland, we cannot ignore the role that altered bank preferences because of Basel III have on the risk takers in property development.

Many property developers have left the industry with their tail between their legs because their last big project – which funnily enough would generally have contributed somewhat to an increased supply of housing in Auckland – failed at the peak of the global financial crisis for reasons more to do with banks reducing their risk profile as opposed to holding out for the rebound that has occurred since.

Finance companies filled an important role by taking on a lot of high risk projects that banks could easily finance – except for the fact that a new property development, because of past oversight mistakes and wet behind the ears lending managers, is unlikely to pass a credit risk committee with new capital and liquidity requirements imposed by fiat around the globe.

I disagree with Shamubeel Eaqub that we can’t build far more houses than we currently do. Much of the blame for the “shortage” of skilled construction labour is that those who used to employ them had the plug pulled by risk averse bankers right when continued work through the global financial crisis would have seen an additional 50,000 or more housing units constructed from 2008 to 2013.

Developers with strong balance sheets (read: a handful) will be able to complete projects and will earn reasonable margins if they can avoid delays and lock in labour on medium term contracts.

They are ably assisted in their profit maximisation by the demise of the second tier lending sector because their traditional competition – those oft criticised property developers – have more chance of an Official Assignee court case than a resource consent hearing on a new subdivision.

There is a market opportunity, already realised by the Manson family of Auckland with their New Zealand Mortgage & Securities, for mezzanine finance in New Zealand that is more in tune with the reality of construction sector projects. It’s risky business – but it’s risk taking that will drive the economic recovery and lead construction back to where it needs to be to match domestic migration to Auckland and population growth in general.

The Risk Free Rate Of Return

The risk free rate of return is the rate of return an investor could earn with “zero risk”. Since the global financial crisis and Asian financial crisis, we’ve been reminded constantly that there is no such thing as “zero risk”.

But the risk free rate of return is useful for comparing the rate of return other assets earn in relation to it. There is no point taking enormous risk to earn a slightly higher return than you could get from government bonds.

The standard global “risk free” rate of return is the 3 month US Treasury bill rate. For New Zealand investors, we could use the 90 Day Bank Bill Rate. As of writing that’s 2.71% on an annualised basis.

That means that if we wanted to lower our private sector risk and rely on the government, and had access to the institutional money markets, we could make 2.71% a year with low “risk”.

The problem with this sort of thinking is that it uses one metric – the “risk free rate of return” – as a decision making tool. The other risks your investment will be exposed to can be ignored.

For example, during the Asian Financial Crisis, many governments defaulted on their sovereign debt. This was in 1997. Attracted by high yields and assuming that governments would always pay their bondholders back, investors piled into markets in Thailand, Malaysia, Indonesia, Korea, Russia, Argentina and Brazil.

Many were heavily burned by forgetting that some countries have completely different attitudes towards debt repayment. Look at Greece – it has survived in the euro zone so far only because hundreds of billions of Euros has been transferred to it by other member countries.

It would have been cheaper for the Eurozone to underwrite Greece’s structural deficits since it entered the Eurozone fraudulently. At least then the true picture of the Eurozone’s complete failure to pursue balanced budgets would have been there for the world to see.

Because the common currency established a central “risk free rate of return” available from the European Central Bank, it effectively subsidised the interest rates payable by poor governments in Greece, Portugal and Spain.

Ratings agencies and investment banks papered over the enormous problems in the European economies to enable continued debt issuance and debt rollovers that failed to address the sick problems in their economies.

Even Germany has enormous external debt to GDP because it has pursued expensive social policies while reforming its economy and lowering labour costs. France has failed to lower labour costs and improve competitiveness, making it an economic zombie doomed to default at some point in the future.

The problem with financial theory is that its proponents will argue that concepts like “risk free rate of return” don’t lead to bigger problems when applied on a global scale. That’s patently false.

If financial theorists didn’t pollute the world with their fake models and theories better suited for the complexity of a village cattle market, groupthink – an entire industry thinking that government debt has little to no risk – would not have occurred on a scale this bad.

Coming back to the risk free rate of return in New Zealand, it is unlikely that New Zealand would default on its debt. But we have no idea about what could happen to New Zealand’s economy over the next decade.

Treasury and Reserve Bank predictions are relied on by the government to conduct “long term budgeting”. All of the predictions are wrong. All of the predictions are arrogant. We would be better off if they came clean and admitted – we can’t predict the state of government finances and when we’ll return to surplus.

As an example of the poor thinking behind these forecasts, cast your mind back to 2008. The National government engaged in “fiscally neutral tax cuts” that cut personal income tax and raised GST simultaneously.

Funnily enough, all that happened was the loss of billions of dollars in tax revenue over the past couple of years. When you add in the cost of the Christchurch earthquake, that’s billions of dollars in extra borrowing the government has taken on.

Forecasts for tax revenue have consistently been revised downwards. That’s because we’re in the stage of a multi-year recession where companies who have been trucking along suddenly default on all of their tax obligations. Even though IRD can be secured creditors, if there’s nothing in the entity they don’t get a dollar.

We need to move away from messy thinking about risk and reward. Using the risk free rate of return is insane in an era where we really have no ability to predict which government will be at risk of default next. The past few years have surely shown us that what finance academics think is clearly not in touch with this thing called “the real world”.

I’d appreciate your comments on this. Do you think that economists and financial “experts” are living in a fantasy world?

What Mum And Dad Investors Will Never Get

Mum and Dad investors getting ripped off is a recurring theme in New Zealand’s investment industry.

I used to have sympathy for these people. Now I wonder how they possibly accumulated enough money to invest while simultaneously being so ignorant of how the real world works.

You can only trust yourself with your money. Just because you have a financial advisor who came highly recommended or they work for a well known investment company, doesn’t mean you can back off 1 inch on the level of due diligence necessary on anyone who comes into contact with your hard-earned cash. Relying on credit ratings, fancy pants directors or “believable” returns is a shortcut to disappointment.

You can’t rely on anyone else to look after your money. Everyone needs to take responsibility for their money. You can’t outsource this stuff to someone whose incentives are not aligned with yours. If you can’t spend the time to read extensively about finance and economics, you have no business going outside of a savings account. There is so much cheap or free content on the internet about these topics you have no excuse not to be able to explain the trade-off between risk and reward or understand intuitively how fees impact compounding growth rates. No excuse whatsoever.

You can’t blame the government or regulators. It never ceases to amaze me that investors who stuffed up want the government to fix things for them. They want their money back, they want a government guarantee or they want justice. Newsflash : regulators don’t have much power, they rely on disclosure initiated by the people they’re regulating and don’t actively go out hunting for people breaking the rules. They’re only human and it’s plain silly to think they can do anything in the face of the incentives faced by investment industry operators.

What “mum and dad” investors will never get is that no one will help them but themselves. They can’t rely on anyone else and need to wake up to how the real world works.

Because of asset-price inflation, a lot of these “mum and dad” investors have suddenly found themselves with a spare $250,000 or more. This means that they could get wholesale investor accreditation if they ask their accountant nicely.

It also means they are ripe for the plucking when it comes to the shadier side of the investment industry. Lower regulation for “rich” or “experienced” investors is an invitation to the slaughterhouse for “mum and dad” types who could no sooner dissect a product disclosure statement than build a model to recreate the likely investment returns of the product they’re thinking of investing in.

You are living in a fantasy world if you think professionals can do anything more than inform your own thinking about investment opportunities. Even then, you still have to spend the time.

If you don’t want to spend the time necessary to educate yourself, don’t participate in the investment industry by purchasing products you can’t understand and writing cheques to people because they’re “good blokes”.

You can start by having a look at Khan Academy or Investopedia.