Time to short Australian residential property?

A close relative of mine returned recently from New York, where he worked on mergers and acquisitions for a major international commerical law firm located within a stone's throw of the New York Stock Exchange. As an official member of the New York Bar, he was fully qualified to work on some of history's biggest deals -- exactly which ones he wasn't permitted to disclose. On his return to Australia, he did announce one thing -- that he, along with just about every institutional investor in the US, believes Australian residential property is 50% overvalued. he said he wouldn't be buying a residence until property prices are a lot lower.

Just how justifed is this? Michael Lewis in his best seller "The Big Short" (Penguin, 2010) shows how the lunatics took over the Wall Street asylum. What we in Australia call the global financial crisis (GFC) was due to financial engineers manufacturing products no-one understood which were then forced down the throats of borrowers who didn't understand them either. The infamous NINJA loans (no income, no job, no assets) were a one way bet that house prices would keep rising -- and not just rise, but rise consistentally and substantially. Of course, that bet didn't pay off but the feeding frenzy that accompanied the massive profits generated by mortgage backed securities  blinded all but a prescient few that America's banking system was headed towards disaster and would likely drag the rest of the world with it.

Australia's RMBS (residential mortgage backed securirties) market was a cheap source of wholesale funds before the GFC.  Now few foreigners will touch the RMBS market. Australian boss of the bond Goliath Pimco "speaking personally" says most instituional investors believe Australian residential real estate is the world's biggest property bubble. One might say, however, if it is a bubble, it has remained inflated for a very long time without deflating. In addition, major lenders are said to evaluate low doc/no doc loans very carefully, although evidence exists that mortgage originators do turn a blind eye to applicants  who do not meet the required criteria. The major banks are still trying to sort out the mess they were landed in through their association with  Queensland-based Storm Financial, which will cost them hundreds of millions of dollars. On the whole, the banks' loan standards are high and they are under no pressure to  shower the indigent with a gushing fountain of money.

One, then, should look at the macro factors driving rhe Australian economy. No prizes will be awarded to those who nominate China. The "China put" is looking very shaky. Shipments of one of Australia's main export, iron ore, have fallen 16% this year, the first reversal in almost two decades. Increasingly, it is looking like China's "borrow to export" model has hit the wall, with the currrent slowdown heralding a new phase of China's development rather than a cyclical downturn. The much-discussed shift to a consumer-based economy doesn't seem to be happening. Most people are too busy staying alive and saving for education, medical treatment and their old age to be too worried ablout consumer goods. And by the way, Shanghai has one of the world's lowest birth rates -- no new consumers.

Another factor is US shale gas coming on line. The first gas exports from the US to Asia set to begin in 2015. The US can supply Asia at 20% of rhe current price The current price is set by reference to the crude oil price. Some elements of Australia's so-called "investment pipeline" are beginning to look even more marginal, such as the coal seam gas projects, which are already marginal.  Within 15 years, the US will be a net energy exporter. They have so much shale gas they literally don't know what to do with it all.

In the event of a real crash in the Australian residential market, what would happen? According to a recent IMF "stress test", in an "Ireland scenario", where house prices halve and unemployment rises to 16% , the Big Four would have to raise capital, but they would survive.

Moody's, the most respected of the three major international ratings agencies, has recently re-risked Australian RMBS. This has not been favourably received. Moody's has factored in the China slowdown but not a "black swan" event such as hostilities between China and Japan in the East China Sea  over rhe Senkaku islands disrupting two-way trade.

National Australia Bank's June 2012 property survey shows a generalised weakening of residential property, with ongoing weakness in New South Wales and Victoria, the two most populous states. Wesstern Australia and Queensland, the two resource-rich states, are showing modest growth. NAB does not expect sustained growth across the nation for at least two years. NAB's next survey will be released in mid October.
In all, Australian property does seem overvalued from an international perspetive but Australia has been enjoying the best terms of trade for a century. Australia is by any measure a remarkably propserous nation. But now it's when the merry-go-round stops, rather than if. As Warren Buffett, the Sage of Omaha said, it's only when the tide goes out you see who's been swimming naked. As far as I can see, we'll all be observing a gentleman called Tony Abbott to see if he's got his budgie smugglers on.   Julia Gillard will be by that time, we can only hope, back in the changing rooms.

In the meantime, there's an old market adage to keep in mind:

He who sells what isn't his'n
Must pay the price or go to prison