I am short, through options, the AUD and CAD relative to the USD in anticipation of a severe depreciation of the AUD and CAD driven by a desertion of wholesale funding for the Australian and Canadian banks and/or a major currency adjustment in response to a RMB devaluation relative to the USD.
In my view, there are two main ways a substantial depreciation of the AUD and CAD relative to the USD can occur – 1) the bursting of their respective domestic housing bubbles, and/or 2) a China-related crisis.
The bursting of their domestic housing bubbles would result in vastly higher net charge-offs for Australian and Canadian banks which should elevate solvency concerns and thus cause wholesale funding to vanish. While I expect Australian banks to experience a liquidity crisis, I do not expect the same for Canadian banks due to the latter’s relatively lower usage of wholesale funding.
Potential China-related crises include a hard landing and/or recapitalization of its banking system and/or major RMB devaluation leading to a severe decline in demand for commodities and drying up capital flows which would likely result in the adjustment of the AUD and CAD relative to the USD.
There are fairly substantial overlaps between the two outcomes. One example is a major RMB devaluation leading to the drying up or reduction of capital flows to Australia and Canada should effectively lead to a run on wholesale funding for the Australian and Canadian banks, which itself should burst their respective domestic housing bubbles. That being said, a severe depreciation in the AUD and CAD can occur independent of a China-related crisis.
I do not believe the scenarios listed above are likely to be the median outcomes, but I do believe these potential outcomes are far from remote. However, put options on the AUDUSD and CADUSD have extremely low implied volatility suggests the market views these potential outcomes as remote. Therein lies the mispricing.
My position is tiny, which raises the question – why even bother? However, the risk/reward is outrageously asymmetric, which makes insuring against these outcomes very attractive, in my view.
All figures for this section are in USD.
In response to the 2008 financial crisis, China embarked on a $4 trillion stimulus program in order to maintain local employment and thus social stability. The government chose to finance this stimulus through the banking system, effectively expanding credit by ungodly amounts.
For a variety of reasons largely irrelevant to the thesis, China has continued said credit expansion at very fast rates to this day. Continued credit expansion eventually leads to diminishing returns, and returns have diminished dramatically over the past decade.
It is quite impossible to accurately measure the “return on investment” on this credit expansion as there is always noise with any metric. One example is to look at absolute credit (defined as total social financing because bank loans understate actual credit outstanding as it excludes large credit sources such as entrusted/trust loans, financing through corporate bond issuance, bankers’ acceptances, etc) growth relative to absolute GDP growth.
On this metric, the absolute credit:GDP ratio (or credit productivity) was 1:1 from 2003-2008, 2:1 from 2009-2010, and has rapidly increased in recent years to 4:1 in 2015, 6:1 in 2016. The figure is closer to 2.2:1 in 2017 as TSF growth slowed considerably.
However, these are likely conservative estimates of “credit productivity” for three main reasons – 1) TSF is understated as it excludes local government debt swaps, peer-to-peer lending, asset-backed securities, etc, 2) GDP is likely overstated by an indeterminate amount (e.g. Liaoning) and 3) the metric GDP itself is an imperfect measurement of productivity as it is indifferent to projects with varying ROIs; projects with negative ROI would still be considered productive using this metric despite the fact they are economically non-productive.
Because much of the country’s GDP growth has been driven by fixed asset investment, the incremental capital output ratio (“ICOR”) is probably a more accurate (but still imperfect) metric to consider. ICOR hovered between 2-4 in the 2000s but has skyrocketed to >15 in the past decade, declining to ~12 in 2017 as fixed asset investment slowed considerably. Most countries have ICORs in the low-single digits.
Likewise, ICOR is also imperfect as it is plagued by similar issues as credit productivity – particularly issues related to GDP. Regardless, it seems reasonable to conclude the ROI on credit expansion has been atrocious over the past decade, based on the above metrics. Atrocious ROI on massive credit expansion has fueled potentially the largest amount of unrecognized non-performing loans globally and historically.
The market appears to severely underestimate the actual level of non-performing loans in the Chinese banking system. According to Natixis, the percentage of non-performing loans for listed banks has increased to ~1.30% from around 1% from 2014 to 2017 while the percentage of loan write-offs has grown from ~40bps to ~60bps over the same period – which vastly understates actual NPLs, in my opinion.
Even if we include special mention loans, the percentage of “adjusted NPLs” would increase to ~5.3% in 2017, implying ~$966b in adjusted NPLs (Natixis estimates 48% of the ~$38tr in on-balance sheet Chinese banking system assets are loans) as compared to ~$237b in non-adjusted NPLs.
The adjusted NPL figure is significantly below my expectations due to two main reasons – 1) there are substantial loan-like assets on the balance sheet of the Chinese banking system which are not captured by the loan figures, and 2) it does not take in account the off-balance sheet (i.e. shadow banking) assets of the system.
Natixis estimates that ~9% of on-balance sheet banking system assets, or ~$3.4tr are “investment receivables” as of 2017. A large part of these investment receivables comprise of structured loans and trust beneficiary rights (“TBRs”). TBRs are essentially non-consolidated loans sold to trust companies, sometimes financed through the issuance of wealth management products, where the bank retains credit risk but is required to set aside significantly lower amounts of capital vs a normal loan – hence getting around loan/deposit limits.
There are many estimates for the amount of shadow banking assets in China ranging from $9tr (PBoC) to $37tr (Daily Telegraph). An apparent leak of the PBoC annual financial stability report in 2017 ballparks the figure at roughly $30tr to $40tr. Thus the lower bound would be $9tr and the upper bound would be $40tr.
In sum, total banking system assets (on- and off-balance sheet) are roughly $50.4tr to $81.4tr.
A 2006 BIS paper assessing China’s banking system reform estimates NPL percentages of 20%-30%+ over the 1997-2003 period following the Asian Financial Crisis and estimates 20.5% cash recovery rates on NPLs disposed off by China’s state-backed AMCs.
Using these figures, actual NPLs in the Chinese banking system could amount to roughly ~$10.1tr to ~$24.4tr with cash recoveries of ~$2.07tr to ~$5tr, implying ~$8.03tr to ~$19.4tr in NPLs net of recoveries.
Natixis forecasts a 0.91% ROA for the on-balance sheet Chinese banking system in 2017, which represents a decline from 0.98% in 2016, and 1.10% from 2015. Natixis also estimates non-adjusted NPL provision coverage of 180%, implying ~$889b in loan loss provisions.
Conservatively assuming similar ROA on total (both on- and off-balance sheet) banking system assets suggests ~$459b to ~$741b in net income, or ~$581b to ~$938b in pre-tax income, using Natixis’ 21% tax rate estimate for Chinese banks.
As a result, total pre-tax, pre-provision income for the Chinese banking system is roughly ~$1.47tr to ~$1.83tr. Natixis estimates 13.2% assets/equity on on-balance sheet banking assets for FY17 implying ~7.57% equity/assets or roughly ~$2.88tr of Chinese banking system equity.
Assuming the Chinese banking system requires a 8% equity/assets to be considered adequately capitalized and that total banking system assets are treated as risk-weighted assets, the system would need to recapitalize to ~$4.03tr to ~$6.5tr of equity after adjusting for NPLs net of recoveries.
With a starting point of ~$2.88tr of equity, the equity “shortfall” would be roughly ~$9.18tr to ~$23.02tr after NPLs net of recoveries, suggesting at current pre-tax, pre-provision profitability, the Chinese banking system would take ~6.2 years to ~12.6 years to recapitalize.
Suffice to say, these are extremely rough numbers given these metrics are not perfect and do not represent the only way for the Chinese banking system to recapitalize.
For example, while system pre-tax, pre-provision profitability might decline as underwriting standards tighten, it could also improve as competition (especially from the shadow banking system) is wiped out.
In addition, the system could rebuild equity through other means – following the AFC of ’97, the system was recapitalized through a combination of 1) government liquidity injections, 2) NPLs transfers to state-backed AMCs, 3) PBoC injections through FX reserves, 4) equity injections from Singapore’s state-controlled investment fund, Temasek Holdings, and of course, 5) pre-tax, pre-provision profitability. With relatively more open financial markets as compared to the 1997-2003 period, other potential sources include raising equity from the capital markets and debt/equity swaps.
While the market appears to be relying on the PBoC FX reserves as the ultimate backstop for the Chinese banking system, the consensus fails to consider whether the PBoC warchest is “unencumbered” or even sufficient.
According to the IMF, reserves/short-term debt exceeding 100% is adequate, reserves/broad money (typically M2) of 5% is typical whereas 20% is the upper range of prudent. China has roughly $3.1tr of FX reserves as of March 2018, short-term debt of roughly ~$1tr as of Dec 2017, and M2 of ~$27.6tr as of Dec 2017.
If we are conservative and utilize the more flattering metric (in this case, short-term debt) to calculate the reserve “headroom”, China would have “unencumbered” FX reserves of ~$2.1tr.
If we assume a 3-year recapitalization, the Chinese banking system would have generated ~$4.4tr to ~$5.5tr of pre-tax, pre-provision profits, which would reduce the equity “shortfall” figure to ~$4.78tr to ~$17.5tr, with the upper range of the figure being more likely; note the lower bound is underpinned by the assumption that the PBoC’s official report of shadow banking assets being only $9tr is accurate, as opposed to its leaked report of $30tr to $40tr, and other estimates in the mid-$30tr range.
This range would hence represent the amount China has to raise from sources other than pre-tax, pre-provision income and state-backed AMCs. This range also far exceeds China’s “unencumbered” FX reserves, or even its FX reserves, for that matter.
Similarly to the AFC ’97, I expect China to recapitalize its banking system with a combination of money printing, government liquidity injections, and PBoC FX injections. A significant devaluation of the CNY would increase the PBoC’s FX reserves in CNY terms. Regardless of the combination, a severe CNY devaluation appears to be the common outcome.
Australia has substantial exposure to the Chinese economy as China accounts for 1/3 of Australia’s share of trade exports (mainly commodities) and roughly 18% of its services exports. Australia is thus tied to the RMB.
Canada has lesser exposure to the Chinese economy in terms of share of exports, but both Canada and Australia have benefited over the years from Chinese capital flows which have manifested themselves largely in their respective housing bubbles. The reversal or drying up of these capital flows would effectively lead to a run on the Australian and Canadian dollar.
All figures in this section are in AUD.
Australia is an outlier economy in one prominent aspect – the country hasn’t had a recession (as technically defined) in almost 3 decades. Australia is also home to one of the most profitable banking oligopolies in the world. However, Australia is also home to one of the largest housing bubbles in history.
Australian house prices to income has exceeded 6.0x in 2017, as compared to the 4.8x the US peaked at in 2005. According to the RBA, total household debt to income has increased ~30% over the past 5 years to ~190%, after being roughly flat for a decade. As a reference, during the peak of the global financial crisis, US household debt to income was roughly ~130%. While the RBA observes total household debt mortgage repayments have been steady as a share of income for years, this neglects to consider the fact interest rates have declined substantially over the past few years.
Although the RBA has encouraged households to switch over from interest-only loans to amortising loans in an attempt to reduce risk, this will massively increase monthly payments for mortgage holders – the RBA estimates roughly ~30% of all national mortgage debt outstanding will be subject to the reset over the next four years, increasing monthly repayments by 30% to 40% for 1.5m borrowers; ~$120b billion of loans will convert to amortising loans annually from 2018-2021. There has also been a decline of interest-only mortgages from 60% of mortgage issuance four years ago to 30%.
Despite the share of new loan approvals with loan-value ratio >90% declining significantly since 2009, the share of 80 < LVR <= 90 loan approvals has offset this decline, suggesting a material portion of new loans are still being issued at high LVRs.
While the RBA expects this wave of mortgage resets to be manageable, this appears unlikely given the massive growth in household debt to income ratios as noted above. The RBA seems to think that borrowers who cannot meet the increased repayments would be able to refinance their mortgage, a view which is at odds with a scenario where housing prices decline – which is expected to occur due to these mortgage resets. It is somewhat ironic that the RBA’s measures to deflate the housing bubble and avoid a crisis could in fact be the catalyst for the crisis.
Furthermore, there are reports of substantial and growing amounts of liar loans being issued in recent years, which suggests the outstanding mortgage book could be lower quality than perceived.
Because of the extreme concentration of Australian banking, I will focus only on the big four banks (ANZ, CBA, NAB, and WBC), which account for over 80% of Australian banking.
According to KPMG, the big four Australian banks had equity of ~$235.4b as of FY17. Pre-tax profit was ~$43.7b. Provisions to credit risk-weighted assets were 0.79%, 0.73%, 0.86%, and 0.76% while credit RWA were $336.8b, $377.3b, $325.9b, and $349.3b for ANZ, CBA, NAB, and WBC respectively. Thus big four provisions were ~$10.86b and hence total pre-tax, pre-provision profit was ~$54.6b.
Loans make up ~69% of the Australian banking system assets. ~42% of system assets are housing loans and thus housing loans make up ~60% of the system’s loan book. This is similar to the U.S. commercial banks’ ~63% exposure to mortgage-related assets during 2008.
Total net loan charge-offs to total loans held by US banks doubled to 1.32% in 2008 on an annual basis, peaking at 2.70% in 2010 and before declining sharply, suggesting a 3-year recapitalization period. On a cumulative basis, this suggests US banks charged off 6.56% of their 2008 loan book. Assuming ~69% of big four assets are loans, total loans would be ~$2.42tr. 6.56% charge-offs would imply ~$158.7b in charge-offs. With pre-tax, pre-provision profit of ~$54.6b, the Australian banking system would recapitalize in just under 3 years.
While this is a relatively rapid recapitalization period for the Australian banking system relative to my estimates for the Chinese banking system, it is comparable to the roughly 3-year period for the US, suggesting the situation is still very severe in absolute terms.
According to KPMG, the big four Australian banks have deposit to loan ratios ranging from 71%-80% as of FY17, suggesting a significant portion of their funding is wholesale in nature. The RBA estimates that the Australian banking system sources roughly ~20% of its funding from short-term wholesale debt which typically have maturities of 6 months or less.
While this figure is materially lower than the 30%+ during the financial crisis, it remains substantial and presents significant refinancing risks. Funding through securitization has tailed off to a negligible amount.
In my view, the market is vastly underestimating the potential net charge-offs in the Australian banking system and when this is eventually recognized, there will be a run on wholesale funding. Illiquidity concerns due to the run on wholesale funding could also result in a self-reinforcing vicious cycle.
Unlike other countries, Australian banks only offer fixed rate loans up to 5 years, while the majority of loans are variable rate. This also explains why despite dramatic growth in household debt relative to income, mortgage repayments have remained steady. As a result, raising interest rates in order to defend the AUD would likely backfire, as it would exacerbate the mortgage crisis, similar to the situation in Britain prior to exiting the ECU.
In addition, Australia has ~$1.6tr in external debt amounting to ~116% of nominal GDP in 2017 compared to ~$76.5b in FX reserves, which suggests it has limited firepower to defend its currency. Even if the central bank stepped in to intervene, it would be self-defeating as it would worsen the country’s external debt situation, which would result in pressure on the AUD anyway.
All figures in this section are CAD.
Canadian house prices to income is nearing 7x, which also far exceeds the 4.8x peak in the US prior to the bursting of the bubble. According to Statistics Canada, Canadian households are levered ~170% to disposable income, also in excess of the ~130% of US household debt to income during the global financial crisis.
A BoC report found that by 2Q17, the originations of high-ratio (i.e. with LTV > 80%) mortgages had fallen 17% vs the previous year, while the proportion of households with high loan-to-incomes (i.e. LTI >450%) among new borrowers fell from 19% to 7%. However, households with high LTI accounted for 22% of low-ratio (LTV <80%) mortgages in 2016, up from 16% in 2014. These households also tend to have a larger than average mortgage, making up 32% of the value of all low-ratio mortgages in 2016, up from 9% in 2014. Thus, while the quality of new mortgages appears to be improving on the margin, the fact remains that the outstanding mortgage book remains of dubious quality.
The BoC recently raised its benchmark interest rate by 1.25% and suggested further rate hikes over 2018 were likely. It also estimated that 47% of mortgages outstanding will reset within 1 year, and 31% would reset in 1 to 3 years. In addition, the OSFI recently unveiled final changes to the stress test requirements on uninsured mortgages, which would require buyers to prove they can afford payments based on the greater of the BoC’s 5-year benchmark rate or their contract mortgage rate + 200bps. Substantial refinancing risks could cause the housing bubble to unravel.
Similarly to Australia, I will focus only on the big six Canadian banks due to the concentrated nature of the banking industry in Canada. According to PwC, the big six Canadian banks system had ~$324b in equity as of FY17. Pre-tax profits were ~$54.2b. Provisions were ~$7.5b. Hence pre-tax, pre-provision profits were ~$61.7b. Their exposure to housing loans ranges from 30% to 60% of their loan books.
Using the 6.56% cumulative charge-offs on its 2008 loan book the US commercial banks experienced during the crisis on the big six’s roughly $2.5tr loan book would imply ~$164b in net charge-offs. As a result, the Canadian banking system would take under 3 years to recapitalize.
Loan to deposit ratios at the big six Canadian banks are at ~80% as of FY17. As a result, the Canadian banking system should not be vulnerable to a liquidity crisis stemming from a run on wholesale funding.
However, wholesale funding remains substantial at roughly ~$1tr relative to the ~$4.88tr in total assets and ~$4.55tr in total liabilities. Although the big six Canadian banks have materially increased their portion of wholesale funding with maturities exceeding one year, the majority of their wholesale funding is remains short-dated, according to a BoC review.
Similarly to Australia, the market is vastly underestimating the potential net charge-offs. Unlike Australia, when this is eventually recognized, I do not expect the big six Canadian banks to experience turn illiquid as a result of a run on wholesale funding as its loans are more than fully covered by deposits; wholesale funding could disappear and the system would still remain liquid. However, the run on wholesale funding would result in severe downward pressure on the CAD.
As with Australia, most mortgages in Canada are fixed rate for a 5-year tenure. As noted above, significant portions of mortgages are due to reset over the next year and 1 to 3 years, which makes raising interest rates to defend the currency counterproductive.
Further, Canada has external debt amounting to ~114.6% of nominal GDP in 2017 compared to $106.6b of FX reserves, suggesting limited firepower to defend the CAD as utilization of FX reserves to shore up the CAD would further worsen the external debt situation and result in further downward pressure on the CAD.
The US is a country with massive unfunded liabilities. The net present value of its Social Security and Medicare liabilities as of September 2017 is $49tr, according to the US government’s 2017 financial report. However, this figure is based on a 75-year projection period. If one uses infinite horizon accounting, unfunded liabilities swell to ~$210tr.
It is hard to see the US ever fully funding these liabilities without the government resorting to money-printing or the country massively increasing its productivity presumably through some sort of step-change in technology and innovation.
Nevertheless, these unfunded liabilities are long-tailed in nature and hence is unlikely to result in massive money-printing over a short span of time resulting in a sharp devaluation of the USD; the money-printing would likely take place over decades.
In addition, US growth appears satisfactory to the Fed in the near-term, which should enable further rate hikes and progress in unwinding its balance sheet. These actions should result in tightening liquidity conditions for the USD, placing upward pressure on the currency.
In my view, shorting the AUD and CAD relative to USD is an exceedingly cheap insurance policy against outcomes the consensus views as remote whereas analysis suggests these outcomes are far likelier than remote, though they are unlikely to be the median.
While the potential outcomes are disastrous, I do not believe them to be ultimately cataclysmic. If the events discussed materialize, asset prices globally would likely be exceptionally cheap thus presenting the best investment opportunities in a long time if one has the resources to capitalize on such a situation.