Hypothetical scenario: Australian GFC/Longterm negative growth across the Australian property market

Maybe have a read of the contract you have,and look up the all monies clause,where sometimes when people use credits cards to keep up the payments,which then give the lender a open door to use your properties as security against other debt's,or you default on that loan..

 

Hey Keith,
I suppose a "hypothetical" question is simplistic in nature, however when something serious comes it will be from left field, potentially a factor no one has seen before. Can you please elaborate on shorting the banks being a partial hedge? Not sure i quite follow that? Cheers

 

That's a grim scenario indeed. I agree it's a lot of IF's happening simultaneously. For example, aren't much higher rates AND a decade or more of no growth contradictory? Last time we had really high rates, it was in response to high inflation. I don't remember high rates and low or no growth. Is it either/or or are there times when there is both?

 

Sure. My view is that you need to look at the cause of something rather than the effects. As I said above there are many possible causes - they all have the same effect (ie falling house prices), but some will give short lived effects and some will be permanent.

As background....

The big 4 Oz banks are heavily exposed to residential mortgages (both IPs & PPORs). They all make roughly the same margin on funds (they borrow at say 4% and charge us 5%) and all make a similar profits. They allow for a statistically predictable small number of defaults/bad debts in that margin.

As their margins are so slim, their profits are heavily impacted by one-offs - the major one being bad debts. And when the scenario you posted above happens - house prices fall, unemployment rises, vacancies rise, people stop paying loans, then repossessions & -ve equity happen. And bad debts skyrocket (see Bank Annual reports for 2008), the bank has to wear the losses and their profit plummets, and so do dividends.

To answer your question...

The smart guys will see this coming (and the bank insiders will see bad & doubtful debts rising), bank share prices will fall - by (maybe) 75%. So the smart guys will sell their shares, knowing that the price will be a LOT lower in 6 months time when the annual report is published (which incidentally shows bad & doubtful debt levels).

But the really smart guys will borrow some shares from unwitting mom&pop shareholders and sell them too. This is what short selling is - selling something you don't actually own (but have borrowed). Of course you have to return the shares to mom&pop eventually, so you'll need to buy them back. But in 6 months time they will be 75% cheaper, so that's a really good time to do it - you may have heard the term short covering. So they sell today at $100, and buy back at $25 in 6 months - that's a big profit for a stock price that has fallen, and there are big risks associated with it - and since you're asking the question you really shouldn't be doing it

An equivalent strategy to short selling is buying puts. Google it - it's easy to do with most Oz brokers.

 

If we see high rates and high unemployment, prices will plunge.

 

My property LVR - the nominal value of the debt - is 25%. There's rather a lot of cash in the offset, bringing the true LVR to 7% or so. I'm cashflow positive on property. there are no other debts. Apart from that, I'm getting about twice what I'm spending from dividends. The offset funds and spending well under post-tax income mean that it should be possible to wait out any crash or the like.

It seems to me the key is to have good cash reserves, minimal or no personal debt, low LVR, and income from multiple sources that exceeds what one spends.

 

The first thing I would do if you think there may be losses on the horizon is make sure your loans aren't cross secured. At least then if things do go down, your whole portfolio isn't tied to the sinking ship.

 

So simplified - hedge falling property vals with shorting bank shares? It makes sense in theory but the timing and research are crucial.. We dont play with the stock market, have seen too many tragedies, as im sure you have, but it is an interesting option. Thanks for your time and response. This forum is a true asset to anyone thats keen. Can you tell me what your role as a staff member is? And do i need to be a subscriber to maximise the benefits of this platform? Cheers...