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Discussing Global Deleveraging


Hugh Pavletich
Performance Urban Planning
New Zealand

December 15, 2008

Open Letter to Bernard Hickey, Managing Editor

Dear Bernard,

I read with interest your article Bernard Hickey : Spiralling into a long, deep slump - Business - NZ Herald News where a – what I would describe as a “valiant attempt’ - is made to explain the deleveraging that’s going on. Good on you for having a go at it Bernard!

I’m a little confused though with the general approach of the article – and some of the numbers. Before commenting though – I’m not competent in commenting on the finance sector deleveraging – but am comfortable commenting in broad terms on the deleveraging going on in the property markets. I use the term “broad terms” because I don’t have the capacity as a “sole operator”, doing this work on a voluntary basis, to refine these numbers.

Dealing with your numbers first. I’m very confused about the “$US3 trillion of borrowed money pumped in to property markets”. Its way above that – as I see It. Then the Credit Default Swaps at $US600 trillion “adjusted’to $US15 trillion – sort of blows the credibility of these numbers out the window. I wouldn’t have much of a clue about Credit Default Swaps – with even less knowledge about how to assess the value of them. Then – based on the higher estimate figure of $US600 trillion - these represent “about 534 times NZs annual GDP” (according to your article) – after adjusting I suppose the net exposure to about the $15 trillion mark. That would be about 120 times NZ GDP ( that’s about $US110 billion).

As a property guy (note my writings at ) I would come at the whole issue this way…….

Number One – for bubbles to form there needs to be scarcity or perceived scarcity. The Demographia Surveys illustrate this. It is clear the middle North American urban markets didn’t bubble. Investors / speculators knew full well they couldn’t pump prices because developers / builders could easily provide more stock within a reasonable time, to stop bubbles getting underway. Developers are after all the greatest adversary of investors / speculators – and this is the major reason why there is tension between the two camps. The investors / speculators are forever groveling to politicians to stop developers supplying housing.

For example – by artificially creating land supply scarcities - they managed to crank California up to in excess of 9 times annual household earnings – while Texas stayed pretty constant through the era of excess liquidity and irresponsible lending at 2.5 times gross annual household earnings.

A very important point that must be realized is that for the finance sector to participate in the bubble markets – such as those of California – they SIMPLY HAD NO OPTION OTHER THAN TO ENGAGE IN DISTORTED LENDING IF THEY WISHED TO MAINTAIN / GROW MARKET SHARE. The “root cause” of the problems is the artificially created regulatory land scarcities and inappropriate infrastructure financing .

In my view – the finance / business sector (and particularly the organizations that represent them) have generally done an absolutely lousy job at pointing the above reality out to policymakers and the wider public (too busy generally peddling welfare schemes for their own benefit - to politicians). Its well known the “commercial nous” within the finance sector is not strong – and their ability to assess risk, could certainly not be described as spectacular. I cover this within a recent article Scoop: Housing Bubbles: Learning To Grow Up, where I draw readers attention to a very perceptive article by Michael Lewis on Portfolio Com The End of Wall Street's Boom - National Business News - – which should be read very closely. Note - it was the guys in the finance sector (and very few of them) who realized that housing markets that exceeded three times household income was THE major problem – and they wisely took steps to protect – and indeed profit – from this. One of the most perceptive writers on these issues, with a solid sense of the significance of deleveraging, is John Plender of the Financial Times. I wrote on these matters last December with Scoop: Housing Affordability – The Shift To Reality. It was slightly before this that Herb Greenberg » Blog Archive » Straight Talk on the Mortgage Mess from an Insider was published by Marketwatch as well.

This “misinformation” by the business / finance sector cannot be allowed to persist – because it has serious policy ramifications. Policymakers need to with urgency, focus on the real structural issues at the local land use regulatory level – and focus on greater disclosure requirements (don’t rely on government employees and kid auditors to assess performance) with respect to the finance sector at the National level. It is interesting Bloomberg is fighting via the Freedom of Information Act – and possibly the Courts too – to force the US Federal Reserve to disclosure information with respect to commercial paper it has become involved with. Honest dealing doesn’t happen in the dark.

We only have to observe the current Madoff fiasco in the United States – as an excellent illustration of the capacity of “regulatory oversight” – an out and out Ponzi scheme that had been going on for years – with red flags everywhere. It certainly won’t be the last of them globally. Those who are advocating “increased regulatory oversight” of the finance sector – need to think this out more carefully. Grossly inadequate disclosure appears to be the key issue here. Better I would think to focus on that – and let the market then assess performance – and as part of this - identify the crooks at the early stages.

I am of the view that if all the States of the United States had land use regulatory structures like Texas (or pragmatically modified to suit local conditions and political cultures) – we would not have had housing bubbles in the United States – and would not have the Global Financial Crisis we are currently experiencing. Indeed the US economy would likely still be growing. When policymakers “wake up” to the destructiveness of these artificial housing bubbles – I am very sure they will put in place “regulatory safeguards”(not allowing artificial scarcities in the main) to ensure they don’t happen again. My “suggested solutions” are outlined within “Getting performance urban planning in place”.

These “constrained markets” had the foundation in place to allow these bubbles to get underway. The leveraging capacity within these constrained markets, based on what they perceive to be an “ever inflating”situation is “truly enormous”. I suspect there is substantially more leveraging goes on within inflating property markets, than there is with stock markets. Banks are more willing to lend excessively on real estate (and particularly inflating real estate) rather than shares. Real estate to them (the finance sector) has a greater “aura of security” about it! Auras are no substitute for competent and rigorous risk analysis (which is not learnt in schools but only by long, tested, practical experience).

And it doesn’t take that much additional debt to pump up constrained property markets. My guess with respect to NZ, is that it only took around $NZ70 billion of additional household debt to pump the housing market up another $NZ350 billion or even more. Overall – around $1 of debt to bubble it up about $5.

The 1.6 mil residential units in NZ hit an average price of around $400,000 – all up $NZ640 billion. NZ Median Multiple overall is about 6.3 – it shouldn’t be any more than 3.0 – so there is at least $NZ350 billion of bubble value there. That’s what’s “evaporating” at the moment. Note our puny little stock market was “worth” about $US50 billion at the peak – and has come back some 37% - near $US20 billion – call that $NZ30 billion. Our housing market has come back about 7% so far (conservative as the bottom end has dried up – understating the actual drop) – so from the $NZ640 billion peak – that’s bye bye to about $NZ45 billion of bubble value. So the deleveraging of the stock and housing markets in New Zealand so far is about $NZ75 billion. Our GDP is about the $US110 or $NZ170 billion mark. That dries up a lot of liquidity –and we are only in the early stages.

In very rough terms (note as I said before – I don’t have the research capacity to thoroughly crunch these numbers) – the US with its 127 million residential units ( 10 mil second / holiday, 70 owner occupied, 47 rented) hit an average price (note not median) of about $US320,000 – all up about $US40 trillion (or at least $35 trillion – being conservative) – and it’s come back about 20% since – suggesting about $US8 trillion so far has “evaporated” out of the United States housing market. Note the Fed Flow of Funds account at $US20 trillion for housing only deals with owner occupied housing – some 70 million res units (even that is understated I think). By my calcs the US residential market is “overcooked” by about $US13 trillion – so there is probably about another $US5 - $US6 trillion to further “evaporate” out of it.

United States household debt peaked at about $US13.5 trillion – with around $US11 trillion of mortgages – with about $US7 trillion of this “securitized” I understand. The mind boggles if the “securitized stiff”is only worth about 10 to 20 cents in the dollar. I can fully understand the finance sector lending out to in excess of 11 times annual household earnings in California – offloading it as fast as they could to Europeans and others!

As another “rough guide” residential stock should not exceed about 1.5 times GDP. Houston for example at a Median Multiple of 2.9 residential stock is worth less than 1.3 times its Gross Area Product.

Interestingly - condo / apartment values in the US overall –according to the US National Association of Realtors – are worth slightly more than stand alone housing.

California with its population of 37 mil people and 13 mil residential units – hit a median price of at least $US550,000 – suggesting an average of close to $US700,000 – so in total bubble value terms it peaked at about the $US9 trillion. It’s come back about 40% so far – so that would suggest that about $US3.6 trillion has evaporated to date. This would suggest that of the bubble value wiped out of the US housing market so far – about 45% of it has occurred in California.

California of course was the “big trigger” for the tanking of the global economy.

I think the US stock market capitalization at its peak was in the order of $US18 trillion – it’s since come back from this by about 40% - some $US7.2 trillion. So in the US – on the housing and stock market fronts about $US8 trillion has evaporated out of the residential stock - some $US7.2 trillion out of the stock markets – a total of about $15.2 trillion so far. The US GDP is about the $US14 trillion mark.

The US is about 25% of the global economy. This suggests to me that globally possibly something around $US60 trillion has evaporated out of stock / housing markets so far. Bear in mind the last Demographia Surveys illustrated that the US residential market overall was by no means the most inflated. This year’s 4th Edition Survey (based on 3rd Quarter 2007 data) found that the average Median Multiple for the countries surveyed (refer Graph Page 11) was Canada 3.1; United States 3.6; Ireland 4.7; United Kingdom 5.5 with Australia and New Zealand both at 6.3 times gross annual household earnings. Understandably – other than in “basket cases” such as Vancouver – Canada is adjusting normally.

The above is without considering other asset classes (the financial ones you discuss – commercial property, shipping, rural property - you name it). These are very big numbers – and I don’t think for a moment Governments / Reserves / Treasuries can do a thing (other than waste money in the main with poorly considered bailouts – prolonging / aggravating the situation). In reading the media – one would think these bailouts are “costless” – it’s incredible. Indeed they could well be worsening the situation by diverting scarce capital resources down big holes – never to be seen again – drying up liquidity even more. To say nothing of the other distortions they are creating – the US stock market seems to be barely holding up – being persistently propped up, as they lurch from one bailout to the next. The “aura of security”again!

So my rough guess is that globally – we are seeing something in the order of $US 100 to $US 200 trillion of bubble asset values evaporate (something like 2 to 4 times Gross World Product at about the $US54 trillion mark) – probably at the higher end.

By the way – your article Real Estate Institute of New Zealand House Prices Report last Thursday on was very good. You will note I made about 7 contributions to this within the ‘comments section” – and that in how easy it is to encourage people to consider the issues we are all dealing with – if they are provided with clear information. You will be aware that I’m rather keen to see the New Zealand Government get itself focused on dealing with these issues.

Note also what’s going on in the State of Victoria with land releases so far this year for about 250,000 additional lots / sections – enough for 650,000 people. Currently starter housing (on a house / land package basis) is being put in on the fringes of Melbourne for in the range of $A230 - $260,000 (I expand on these matters in commenting on your Thursday Interest Co Nz article – hyperlinked above). It’s about time the New Zealand media informed the public of what’s happening in the State of Victoria, Australia. It has enormous consequences for New Zealand.


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