U.S. Hedge Funds And The Big, Bad Aussie Short That Could Render Them Broke

by: Caiman Valores

U.S. Hedge Funds are locked in their worst crisis since the Global Financial Crisis.

They believe that the Australian housing and banking markets resemble those seen in the U.S. in the run up to the U.S. housing meltdown.

Many missed out on shorting the U.S. housing bubble, and they are now making a massive $6.5 billion bet shorting Australia’s banks. It could bankrupt them if it doesn’t pan out.

The Australian banks are far healthier than their U.S. counterparts were in 2006, and far more resilient to market disruptions.

There are simply no signs Australia’s housing market will suffer from a catastrophic meltdown that could bring down Australia’s banks.

Now facing the biggest washout since the global financial crisis ("GFC") and with many missing out on picking the 'big short' of movie and book fame, U.S. hedge funds have hit on the next big trade.

They have made an audacious bet collectively shorting Australian banks to the tune of $6.5 billion, in the belief that Australia's housing market is caught in a monumental bubble that is on the cusp of bursting in an apocalyptic fashion.

If this so-called epic housing bubble bursts then Australia's banks will be forced to the brink of collapse, delivering a multi-billion pay day that will allow the U.S. hedge funds to rejuvenate their fortunes. With Australian housing prices continuing to rise just as they did in the U.S. in the lead up to the GFC, along with a range of external economic shocks taking their toll on Australia's economy, it is only a matter of time before the housing market implodes.

Even respected ratings agencies and economic think-tanks globally have weighed in on the action with the Economist claiming that Australian housing is 40% overvalued and international ratings agency Fitch stating that Aussie banks face profit risks from a housing correction and China's transition.

So what could go wrong?

Well, if you base your sentiments solely on the distorted views of U.S. hedge funds and their shallow research, not much at all. But and this is a big but, what if U.S. hedge funds have failed to understand the Australian financial system and housing market along with the fundamental differences that exist between how it operates in Australia and the U.S. in the lead up to the GFC.

Let's dive into the Australian mortgage and housing markets to see whether any differences really exist.

The Australian banking system is fundamentally different from the U.S.

For all intents and purposes Australia's financial system is markedly different to the U.S. and that which existed in the run-up to the GFC.

You see, not only is the market structured differently, but there a significantly higher degree of regulation than that which existed in the U.S. in the lead up to the global financial crisis.

The primary banking regulator the Australian Prudential Regulatory Authority or APRA has also been proactively introducing measures to rein in the excesses in mortgage lending among Australia's banks. APRA has done this by forcing the banks to increase the amount of capital required for their residential mortgage exposures.

In short it means that they have to retain even more capital, which industry wide comes to billions of dollars, that otherwise would have been used to issue mortgages. This has increased the cost of funding for the banks and reduced mortgage volumes. On top of this Australian banks have taken a far more conservative approach towards credit risk, especially after many of them faced the prospect of collapsing in the early 90s due to incurring a significant amount of bad debts through shoddy lending practices during the heady boom times of the 80s.

One of the key differences in the structure of the Australian banking market compared to the U.S. is that it is dominated by four major banks, National Australia Bank (OTCPK:NABZY), Australia and New Zealand Banking Group (OTCPK:ANZBY), Commonwealth Bank of Australia (OTCPK:CMWAY) and the country's only U.S. listed bank Westpac Banking Corporation (NYSE:WBK). Between them they control over 82% of all loans in Australia and the oligopolistic nature of Australia's banking industry allows them to be price takers rather than price makers.

You only need to look at comments from Australia's competition watchdog the Australian Competition and Consumer Commission or ACCC to see just how much the major banks dominate the local financial services market.

In an article from the Sydney Morning Herald, ACCC chairman Rod Sims stated earlier this year:

This means that if Australia's banks get into trouble - as price markers - they can raise mortgages rates and fees as well as cut deposit rates in order to protect revenues, preserves their balance sheets and cash flows, thereby shoring up their profitability. These are levers that U.S. banks, particularly in the lead up to the U.S. housing meltdown and global financial crisis, were unable to pull because of the highly competitive nature of the U.S. financial services market.

Health of Australian banks is better than many believe.

There are a range of concerns over the health of Australia's banks, with the biggest red-flags relating to their exposure to the commodities sector, a slowing China and its impact on the Australian economy and there reliance upon wholesale funding for lending.

Given the mining dependent nature of the Australian economy - with commodities accounting for 8% of GDP - the major banks are vulnerable to the commodities bust.

Nonetheless, their direct exposure as not as high as many analysts have postulated.

Only the ANZ has lending loan commitments that make up more than 2% of the total value of its total loan portfolio. Then the next highest exposure as the graphic shows is the Commonwealth where loan commitments to commodities make up 1.8% of the value of its total loans.

Source: Bloomberg.

While these billion amounts appear daunting they only amount to very low amounts of the banks' total loan portfolios and balance sheets.

So even in the event of all these borrowers defaulting, the damage to the four major banks at its worst would be minimal.

One of the major triggers of fear about the declining health of Australia's banks because of the protracted slump in commodities has been their moves to boost provisions for bad loans to the sector.

Nonetheless, even after boosting provisions for bad debts each of the banks has a low ratio of provisions to total loans as the chart shows.

Source: company filings.

As the chart shows the value of provisions to total loans is far lower than the closest equivalent U.S. bank Wells Fargo (NYSE:WFC).

This highlights the quality of the loan portfolios of Australia's banks, given they are required to make provisions according to the supervisory regime set out by APRA and this is monitored on a regular basis.

Then when looking at the ratio of gross impaired loans to total loans the quality of the banks' loan portfolio's becomes even clearer with this ratio being at acceptable levels and lower than their U.S. based peers.

Source: company filings.

In fact, the highest ratio belongs to National Australia Bank, which interestingly has the least exposure to the commodities sector of the big four. This can be attributed to it operating Australia's largest business bank which means it is exposed to far riskier commercial loans and cash flow lending.

Then it should be considered that they are all well capitalized with an average tier one capital ratio of 10% for the big four, well above the regulatory minimum and comparable to those banks classified internationally as too big to fail.

Source: company filings.

The banks also have to comply with far stricter capital standards that were introduced by the Australian Prudential Regulatory Authority or APRA last year that will come into effect on 1 July 2016.

These standards are aimed at minimising the risks posed to the banks by a sharp deterioration in housing prices.

Let's not forget that the Australian Financial Stability Review in late 2015 found that bad and doubtful debt charges are at historical lows relative to assets. Further highlighting just how healthy Australia's banks are and how judicious they have been with managing credit risk and the strength of APRA's supervisory regime.

Australia's housing market is not headed for an apocalyptic meltdown.

There is no denying it, Australia's housing market and in particular regional markets such as Sydney and Melbourne are caught in a bubble. But whether that will lead to a "bloodbath" collapse that would pull the major banks down is questionable.

It is this apocalyptic meltdown that the hedge funds are banking on and this just isn't going to occur.

Source: SBS Australia.

On a global comparison Australia's housing remains affordable even in Sydney and Melbourne which have the hottest property markets. Both look tame in comparison to other global gateway cities such as Hong Kong and when compared to the least affordable cities globally with coming in well behind Hong Kong.

What many forget is that both of these cities are global gateway cities, which have limited inventories of land and are experiencing high demand, both from internal and external migration. This sees both experiencing high population growth as immigrants flock to the cities seeking jobs and higher wages.

According to the Australian Government Department of Employment, job growth in Sydney in 2014 was 0.7% point higher than the national average, while for Melbourne it was a full percentage point higher. Whereas, according to the Australian Bureau of Statistics average salaries in Sydney and Melbourne were around 11% and 1% higher respectively, than the national average.

These factors will help to support housing prices in both cities and make it quite feasible that a slow cooling will take place.

Actually, a number of economists and research houses believe that a 10% decline in Australian house prices is reasonable and this will be an orderly softening of prices over a few years rather than a sudden collapse.

Capital Economics one of the most pessimistic on the outlook for the Australian housing market concluded in a recent paper that house prices in Australia will fall by around 10% over the course of 2019 and 2020, but a US-style housing collapse won't happen.

In another article from the Sydney Morning Herald JP Morgan's Australian head of hedge fund sales Sujit Dey stated:

The only way house prices crash is if rates go up suddenly and/or unemployment increases materially. Either of these two scenarios will take years...

Even investment bank and fund manager UBS has taken a muted view of the likelihood of a housing crash stating in a research note:

While we are not bullish on house prices we are in the soft landing camp on housing and the consumer and remain constructive on the NSW economy in particular.

Clearly, the Australian housing market will cool but it won't be a bloodbath or U.S. style apocalyptic meltdown as the hedge funds are predicting, rather it will be a gentle cooling over a protracted period. And even if prices fall by 10% it won't endanger the financial health of Australia's banks.

The mortgage market is structured differently.

An important aspect of the Australian mortgage market is that is vastly different to that which existed in the U.S. in the run up to the housing meltdown which caused its financial system to unravel and brought down the banks.

After all, U.S. hedge funds, analysts and traders are used to the familiar sound of "jingle mail" where borrowers who found themselves underwater on mortgage repayments simply walked away from non-recourse loans.

Whereas, in Australia mortgages are recourse loans that allows the lender to pursue the borrower for financial damages if the value of the home used to secure the loan is insufficient to extinguish the loan.

This reduces the financial risk associated with the loan for the lender and also incentivizes the borrower to be far more diligent with their repayments and if they start to fall behind to renegotiate the terms of the mortgage.

Another fundamental difference is that the quality of mortgages and other housing loans issued in Australia is far higher than it was in the U.S. in the run up to the housing meltdown.

You see, at the peak of the housing boom in the U.S. 29% of all loans issued were done so on a deposit of less than 10%. In many cases borrowers were not required to put anything down at all, with U.S. banks and borrower working on the flawed assumption that prices can only continue upward and they can build equity in their home.

Whereas, in Australia, only 9% of all housing loans issued have a deposit of less than 10% and this provides a greater buffer to absorb falling home prices before there is an impact on the borrower or the lender.

Another fundamental difference is that only 2% of the value of outstanding mortgages in Australia are characterized as subprime, whereas in the U.S. that number is estimated to have peaked at as high as 25%. This meant that as prices fell and borrowers found themselves lacking equity in their home and loans being reset to higher non-honeymoon rates, they were unable to afford the repayments.

Then there was the issue of many of those borrowers not even being able to qualify or afford a normal mortgages.

Let's not forget that unlike U.S. borrowers, Australians have a predilection for paying their mortgage off as quickly as possible and on average hold greater equity in their homes. A recent study found that Australian's on average have 48.4% equity in their homes and that the highest amounts on average were in the two hottest markets of New South Wales and Victoria, with average equity of 56.6% and 49.3% respectively.

Whereas, in the U.S. in the run up to the housing meltdown home owners on average had less than 40% equity in their homes, which is significantly less than what we are seeing in Australia today.

Such a low degree of equity can be attributed to poor homeowners being used to fuel U.S. economic growth during the housing bubble where low income earners actively used or were incentivized to use the collateral in their homes to borrow and spend more money. This phenomenon certainly is not occurring in Australia with far stricter credit and prudential standards preventing banks from engaging in this type of behavior.

Such a high level of equity in conjunction with higher incomes and growing household wealth helps to form a buffer that can absorb any financial stress placed on household by internal or external economic shocks.

Final thoughts

Since the global financial crisis where many U.S. hedge funds got it wrong and suffered calamitous losses they have been on the back-foot. This in conjunction with many having missed out on the 'big short' has left them hunting for investments that will allow them to make up for lost ground, with the 'big Aussie short' emerging as a distinct favorite.

Yet this is looking more and more looking like another calamitous mistake on their part driven by shallow research, hubris and desperate naked greed. Cries of an overheated property bubble that is on the cusp of bursting and a catastrophic housing meltdown have surrounded the Australian property market for decades, yet nothing has happened. And it certainly appears that the bloodbath being predicted by U.S. hedge funds will fail to transpire, costing them millions if not billions of dollars.

To best sum it up in the words of one industry insider; Sujit Dey head of JP Morgan's hedge fund sales:

Shorting the Australian housing market has been a widow-maker trade and I think it will continue to be the case...

Disclosure: I am/we are long WBK, NABZY, ANZBY, CBAUF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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