The financial malaise is spreading

In this article I make no claims to any technical or theoretical, economic, fiscal or regulatory insights. It is based on personal experience and empirical and anecdotal information gleaned from a background in investment banking and commercial property fund management in London for the past 25 years.

I believe there that there is a common thread in economic cycles in the UK, the origin and impact of which need to be distinguished from the headline “trigger”. I see certain parallels in this respect between the UK and Australia, which may indicate that Australia’s pain is yet to come.

The first UK recession I saw was the 1974 banking crash. The late 1960s and early 1970s were a period of low real interest rates possibly arising from the “print and spend” policies of the government of the day. Real returns on real estate were very attractive and there was some extravagant lending by poorly regulated quasi-banking institutions.

An oil price crunch stopped the merry-go-round in its tracks. The Bank of England launched a lifeboat to support smaller banks: many were wound up and disappeared. The aftermath, “stagflation”, was horrible and lasted until Margaret Thatcher’s painful reforms bit at the beginning of her second term in the early 1980s.

The UK stock market crash of 1987 that ended a five-year boom didn’t seem to have the same impact on banks initially. Their newly acquired stock broking and marketing arms lost some money and were downsized rapidly: but the collapse of consumer confidence led to a hiccup in the growth of house prices, soon translated into a collapse of same, which in turn led to a collapse in retail demand followed by a collapse in property values. This hit the banks hard.

Again recovery was slow and painful, until technology and dotcom euphoria provided that little extra fillip to get consumer confidence going. The bubble burst quite quickly, a few people lost some money, but pretty soon it was business as usual, namely the tedious business of recovery.

This state of affairs lasted in Britain until 2003-4. House prices, knocked by US economic fears after 9-11, started to pick up. Consumer demand recovered. Commercial property started to recover with an increase in demand. Interest rates were low in historic and absolute terms.

2004-5 saw a major price shift in commercial real estate yields. Assets we had purchased in 2001 at yields of close to 10 per cent we sold at yields of close to 7 per cent. The assets we sold were in better shape than when we bought them, but 2 per cent, or two thirds, of that yield shift was purely and simply a change in the market’s valuation. To put this into perspective, a shift in value from a 9 per cent yield to a 7 per cent yield is an increase in value of nearly 30 per cent. Not only did this of rate of growth continue, the yield gap between prime property and secondary (higher yield) assets narrowed.

It was those assets that required more active and management and a deeper understanding that grew at the highest rate. I’m afraid to say that my colleagues and I lost our nerve in early 2006 and started selling everything we could. The reason was that we could not see a sustained growth in consumer and tenant demand sufficient to maintain valuation levels. Investment supply and demand is a fickle friend.

There has been a huge debate about the impact of the sub prime market crisis on financial institutions in the UK and the US. In the UK the catalyst was the very poor management by an inexperienced regulator - the FSA (Financial Services Authority) - of the problems that affected one bank, Northern Rock.

Only one bank came out of this most recent crisis in good shape, HSBC: all the rest are in the rights issue, or dividend reduction business, to prop up capital in the face of sub prime losses and the collapse in short term inter-bank lending - which has happened because banks no longer trust each other. The Bank of England has instituted short-term liquidity lines that are increasing confidence and bringing back some measure of stability, but capital is still needed.

House prices are falling very rapidly, not just because consumers are nervous, but also because mortgage lenders are cutting back. In some cases they are not only restricting new lending, they are also reducing portfolios. Notwithstanding the reduction in prices and reduced interest rates, residential property is still unaffordable for many new entrants.

Already retailers are feeling the pain. Commercial property tenant enquiries are disappearing, asking rents are dropping, and valuations, which are based on a simple calculation of rent multiplied by the yield, are dropping.

Many observers believe March 2008 quarter valuations will be down by 25 per cent. A huge amount of commercial property that has changed hands in the last three years is leveraged at more than 80 per cent. Those borrowers are now under water. A great many of them have bought high yielding and complex assets that they aren’t resourced to manage. The banks haven’t got the resources to manage them either. I believe the real trouble could be about to start.

There are protracted debates in the UK about whether we are now in 1974, or 1987, or 1999. The events triggering booms were different in nature, commercial property, stock market or dotcom euphoria, but all led to an explosion in consumer confidence, spending, personal debt, a dramatic rise in real asset values, followed by a long and a painful and readjustment of values to affordable values afterwards.

The recent round of results for Australian banks, confirming that they have escaped the worst of the sub-prime crisis is excellent news. However, other indicators are less welcome: rising interest rates have eventually contributed to a collapse in house prices in New South Wales in particular, with signs that the malaise is now spreading to the boom states of Queensland and Western Australia. This will lead to a dramatic reduction in domestic demand, which, anecdotally, is happening already.

Meanwhile, with Australian Dollar interest rates still high, housing remains unaffordable for new entrants, which indicates that resurgence in values isn’t likely in the near future. A cycle of defaults in interest payments and loan to value covenants may yet start to impact the balance sheets as well as the earnings of Australian banks. And so the spiral continues down.

Is it possible that the resources boom and measures being taken to keep its impact in check are disguising the same fundamental problems in the domestic economy that are widely reported in other G10 economies? If so Australia needs to alter its economic policy now.