Description

Long Australian Sovereign CDS (Bloomberg Symbol: AUSTLA CDS USD SR 5Y D14 Corp)

In some respects, this is an unfortunate time to be writing this pitch given the negative (and I thought unfair) comments the US President made about Australia today. Moreover, Australia is a terrific country and I in no way anticipate that it will go bankrupt. As I will discuss below, Australia has been more responsible than many other governments in terms of government borrowing over time. However, the goal for value investors looking to hedge is to find cheap insurance and, at this price, I think Australian sovereign CDS trading at or near their all-time lows represents cheap insurance in a compellingly asymmetric way. This can be used to juice a pre-existing short position or can be more of a 'moonshot' short position in its own right.

Pitch

Long Australian Sovereign CDS (Bloomberg Symbol: AUSTLA CDS USD SR 5Y D14 Corp) as either an addition to a pre-existing short Aussie housing position or as a short position in its own right. As some readers may have guessed, this is an idea primarily stemming from our thoughts around the Australian housing market. We think it is in a bubble and is unfortunately likely to burst with painful repercussions throughout the country. I will attempt to add a bit more color in the appendix but dman976’s 2/19/16 short pitch on CBA (Commonwealth Bank of Australia) gives a decent starting point on the bank short pitch and the build-up of household debt.  

While we like the Aussie bank short, the challenges are two-fold:

• The negative carry is high due to the dividend yields (eg >8% for WBC) and the timing is uncertain

• The downside is a bit hard to bound as it’s unclear exactly how much the banks will be holding the bag when and if the housing market goes down (especially if it does not violently implode)

There are no CDOs to short and Aussie bank CDS is fairly expensive (although admittedly getting cheaper), so where can we find some way to more attractively leverage our view?

We would submit that Australian sovereign CDS, trading at or near its all-time lows, represents an asymmetric way to do this:

To reiterate, we do NOT think that Australia is going bankrupt or anything like that. However, while government debt to GDP is low, it is rising quickly and is forecast to rise even more from here:

This recent rise happened during a period of strong GDP growth! If Australia’s economy was to hit the skids (potentially because of a housing slowdown or worse), this debt is likely to increase even further.

Meanwhile, the ‘Big 4’ Australian banks’ balance sheets are ~2.2x the size of Australia’s GDP. They are the definition of ‘too big to fail’ in the context of Oz:

If there was to be a major collapse in housing, the banks’ assets are 70% mortgages and they only have ~HSD% Equity-to-Assets. The average Aussie household is even more levered (see appendix below). Overall, the debt system-wide is much less comforting than the government’s admirably low debt-to-GDP would suggest.

In fact (as discussed in the appendix) Australian household debt is an outlier around the world. 

So who would take it on the chin if everything went to pot in the Australian housing market? We think the clear answer - in one form or another - is the Australian government. And we don’t think that distinct possibility is priced in to the CDS. Let's revisit what we're saying here. While - again - Australia is a terrific country that we would encourage you to visit (have a meat pie and a halal snack pack!) and that is highly unlikely to go bankrupt, this CDS is a risk-based insurance policy and we think that, during the 5yr duration of the CDS, the perceptions of risk (and the corresponding price of the policy) will go up, possibly dramatically.

We also like that Australian sovereign CDS can serve as general insurance against ructions in global financial markets. Because Australia is so dependent on foreign financial flows, it catches a cold when global money markets sneeze.

Returning to the price graph:

What happened in the circled area was not primarily an Australian issue, it was the Grexit panic and the financial turmoil that surrounded it. That did not affect Australia directly in the slightest but Australia’s capital markets not having access to global funding would have been problematic (eg only 70% deposit funding in Oz among the major banks). Unfortunately, Australia’s oversized financial institutions, isolation and distinct, unpegged currency make this a hard problem to resolve. It looks like an unavoidable systemic vulnerability. To that end: when the RBA most recently cut rates, the Big 4 banks actually RAISED their deposit rates which suggests a hunger for non-overseas short-term funding. Yet, weirdly, Aussie 5yr CDS hit what was, at the time, its post-crisis low of 23.944.

Just as an unconventional way of creating portfolio insurance against systemic instability rearing its head again (as it inevitably will), we think you could do much worse at this price. As it happens, however, we think that is just a bonus you get for expressing a view on Australian housing.

Bottom Line: Bad things happen and, despite Australia’s remoteness and status as 'the Lucky Country', Australia is still vulnerable to bad things. Australia's bubble-ridden housing market is a homegrown and particularly notable Bad Thing. The all-time low pricing of Australian sovereign CDS does not reflect that real risk - both from a foreign crisis or a homegrown housing collapse. This can either be layered into a larger Aussie basket or be a more extreme position in its own right. Buying Australian CDS will provide asymmetric exposure in a bad environment and allows for a position to be taken against the Australian banks with a much less onerous negative carry. For those with taxable US investors, this is also a more tax-efficient option than a more traditional short sale.

There is no question that, if the bubble doesn't collapse (or isn't a bubble!) or if it pops in a well-managed way, holders of CDS likely won't make any money. But our downside is capped, the security gives us a lot of time to have the thesis play out and there is not much precedent for painless housing collapses. The asymmetry seems clear and attractive.

Appendix: The Australian Housing Market - We Think It’s a Bubble

Some pictures give a flavor of the story as we see it.

Australian household debt to GDP is virtually the highest in the world:

It is a true outlier that started levitating in the 90’s:

The situation looks even worse compared to household income:

Meanwhile, housing prices have dramatically exceeded income and GDP per capita growth:

And wage growth is decelerating to new lows, further stretching households’ ability to service mortgages:

Unsurprisingly, a large and growing population of mortgage applicants feel the need to lie on their mortgage applications, often at the suggestion of mortgage brokers(!):

Mortgage loans alone now represent nearly 100% of GDP:

Meanwhile, ‘gross rental yields’ (gross revenue from rental property/purchase price, ie not real income) have gotten to the level in large parts of Oz where borrowers cannot generate positive carry even if they spent zero dollars maintaining the house(!) - a practice known as ‘negative gearing’ which is both widely practiced and politically controversial:

This behavior seems pretty clearly irrational, no? So why do it? Having spent some time in the country we think it is easy to see how property-mad Australia has become over this long property boom. Stories abound of property millionaires (indeed, whole websites are dedicated to them) and property-focused magazines and TV shows abound. We spoke with government officials who fondly recalled flipping their first house. The average federal Australian politician reportedly owns an average of 2.7 homes. But a simple way to express this is to show a Google search result:

Note that the US has ~14x the population of Australia!

The explanation for this strong demand for housing assets is that Australia (esp Sydney) is ‘structurally undersupplied’ but we question how that can be the case when rents have not come at all close to keeping up with house prices and, in fact, have gone negative (see 'Rental Index' above). That suggests landlords cutting prices to attract tenants, not a lack of housing available.

Meanwhile, building approvals are at record levels and plenty of supply is coming online:

This supply burst is imminent and seems likely to cause pain in Australia's core east coast markets (Sydney, Melbourne, Brisbane).

To put the scale of the boom in context, “RLB estimates that there were more cranes in use for apartment construction in Sydney, Melbourne and Brisbane (454) than there were in New York, Boston, Chicago, San Francisco, Los Angeles, Toronto and Calgary combined (419).”

This has a real human cost as borrowers in the hottest areas (Sydney and Melbourne) are trying to buy residences priced at many multiples of the median household income:

Which means they spend enormous amounts of their incomes on mortgages.....:

.....despite the fact that the typical mortgage in Australia is increasingly an IO(!):

Interest rates have also come down enormously, but less than 20% of Australian mortgages are fixed-rate, meaning borrowers are painfully exposed to small interest rate increases:

Rising global rates represent yet another threat to this state of affairs but, in general, housing bubbles like this tend to end poorly:

Catalyst

Domestic housing correction in Australia

Global financial unrest

Continued rise in interest rates