Doug Abdiel

Follow-up on the last post

I need to give a short update on what happened with the business that I tried to purchase. Unfortunately, I was outbid.  This is an interesting opportunity for learning and reflection, and taking in some lessons for next time:

First, on the process as a whole. I found out that the other bidder put in his offer, then planned to complete due diligence at a later time, and then complete the purchase.  This seems very strange to me.  I would have thought that you would complete a reasonably large due diligence, then make an offer, but I stand corrected.

Second, I had some regret that I missed out on the business, but it was not overwhelming.  I good friend told me that it was better to be outbid than to overpay, and perhaps he was correct.

Third, I am genuinely happy that this has put into relief the amount of time that I have to dedicate to the causes that I can touch.  My wife and I managed to go together to SSI to help with a couple of their social enterprises.  I have also been able to advise a couple of nonprofits about their applications to the Google Impact Australia Challenge, and kick around a couple of ideas for social enterprises of my own.

This post: The Only thing that Goes Up In a Recession

They say that the only thing that goes up in a recession is correlation.  That we find out that assets which we think hedge against other assets are declining just as precipitously.

Here is my fear, in a nutshell.  Australia has created for itself one of the most correlated economies on the globe.  They were not meaning to do this, but they have done it, nonetheless, and the assets that they hold will be ephemeral.  I would really like to know how this analysis is incorrect.

Here is the correlation that I see, in brief.  It is hard to know where to start because most assets are linked to each other so the causal chain can work in any direction, but I’ll try to start big and work my way down.  Because of a legal change some time ago, the Australian retirement system is larger than most of the developed world. Because there are laws against double-taxation of dividends for domestic companies, much of it is invested in the domestic stock market (60% in domestic assets which represent just 2% of the global total).  The Australian stock market is dominated by a few large banks whose assets portfolios are dominated by domestic mortgages.  Those portfolios are large, in part because Australian consumers have tremendously high mortgage debt (2X of GDP).  In the event of a recession, some people will be fired, and they will see their wage income decline, and they will not be able to refinance their homes or bid up more homes, some may even default.  These defaults or renegotiations will lead banks to write down their assets, and lower their stock market capitalization.  Because the retirement/superannuation portfolio is dominated by domestic banks, the value of people’s retirement will decline. People may attempt to readjust and save more by decreasing spending, this will exacerbate the lack of spending from those who were fired.  Because all debt is personal debt (i.e. there is no way to ‘hand back the keys in Australia’), people without jobs will be unable to move to places where their are jobs because they will be underwater on their mortgages. Those on the edge of negative home equity will likely sell to get what they can, but demand will be weak causing the nominal value of homes to decrease further.  People not in default will see their ‘equity’ evaporate at a fast rate, just as their retirement savings is evaporating, just as they are potentially going to be fired.  This loss of all these at the same time will only deepen the spiral.  Let’s take each of these in turn.

First, the retirement system: Big, Defined Contribution, and Equity Heavy

Australia switched from a pay-as-you-go defined system of retirement like Social Security to a defined contribution scheme in the early 90s, and currently has 120% of its GDP in pension assets of which 86.5% is in Defined Contribution superannuation, the assets of the entire superannuation sector are just about $2T. This is generally fine, and allows people to diversify against the kind of population bottlenecks that the US, Japan, and Europe are now facing as the Baby Boomers retire.  As long as there is no correlation between when you would like to retire and the size of that portfolio, then this does not generally cause a problem. Unfortunately, when people see the value of their retirement portfolio decline, they tend to cut back on spending and save more  [Edited to add, see Karl E. Case, John M. Quigley, Robert J. Shiller for general exposition of the ‘wealth effect’]. This is exactly the opposite of what you want to have happen in a recession.  The ‘Paradox of Thrift’ means that as people save/consume less, that prices and earnings fall, further deepening the spiral.  What you really want, then, in your retirement portfolio, is for it to be uncorrelated to your personal spending/aggregate demand.  The only way to do this is through diversification (i.e. reducing correlation)

Like most other developed economies, Australians generally want to invest in a diversified portfolio of stocks.  They seem to have a particular vigor for this idea as 48% of their pension portfolio is in equities, higher than any developed nation except for the US. There is nothing wrong with the stock market.  Over the long term its returns are quite good.  There are a couple of odd quirks about investing in Australia, and about the market in Australia. Let’s take those in turn.

Second: Home Country Bias in Equities

Australia has its own currency and stock market, and Australians believe that they are diversified if they invest in this stock market (the ASX).  This is doubly incorrect.  First, Australia only constitutes 2.4% of the global equity market, but there is a 66.5% investor holding of domestic equities.  This is a larger gap than nearly any other developed country.

Source

Why does Australia like domestic equities more than any other country in the world?  There is a logic to it, if a short-sighted one.  In much of the rest of the industrialized world, people complain of the double-taxation of dividends.  That is, when a company makes a profit, those are taxed, and then when a shareholder is paid a dividend, the same money is taxed as shareholder income.  This is different than other cash flows which come out of the company.  Interest and wages paid by the company are tax-deductible.  This creates an incentive for companies to increase their debt load as much as possible, and minimize equity.  There were two chaps, Modigliani and Miller, who actually won Nobels in economics for looking at this, and they showed that if it were not for taxes, companies would be effectively indifferent to debt or equity financing.  In addition to being unfair to equity holders vs debt holders, financing through debt makes companies susceptible to downturns because they are unable to make their repayments on time.

Most of the other countries in the world tolerate the double-taxation of dividends, but the Aussies, to their credit, tried to correct it.  They have something called ‘franking credits’ which mean if you receive a dividend payment from a domestic company which paid its taxes, then you can receive a ‘credit’ for the taxes paid by the company, and you don’t have to treat 100% of the dividend as income.

This may seem a ‘win’ for the Aussies, and in some ways it is, but it creates a tax incentive in Australia that does not exist in the rest of the world to buy domestic equities, and reduces their diversification.  The hypothetical Australian investor asks himself ‘why would I invest in international equities when I can invest domestically, and pay less tax for the same amount of dividends?’  The answer, over the long term should, be diversification, and refer to the last half of the paragraph about the ‘Paradox of Thrift’ above, but people do not often seem to think about this second order effect.

[Edited to add, one of the critiques of this article was that I did not address the foreign asset holdings of the superannuation funds.  Numbers on this are not easy to come by (see remarks at the end about the opacity of this sector), but I found this, article. Figure 1.9 shows that the foreign assets of superannuation funds are between 16.4% and 18%.  If true, this is actually a worse home country bias than equities overall]

The result is that Australians have all of their eggs in the domestic-equity basket. Surely the whole Australian stock market can’t go down at once, it’s diversified, right?

Third, the non-diversified local equity market

The second reason that investing the the domestic stock market does not provide diversification is that much of the overall market capitalization of the $1.8T of the ASX is in the ASX 200 (91.37% at the time of writing, see here).  Nearly half of the ASX 200 (43.2%) is in the banking sector (see here).

So what are you investing in when you buy the whole Australian stock market?  Largely the banks.

Fourth, the non-diversified banks

The Australian Prudential Regulation Authority publishes monthly statistics on the holdings of the banks in Australia, the statement for August can be see here.  It shows the loans that Australian Banks are making in Table 2.  Excluding loans to other banks, which are not really countable, of the banking sectors loans, fully 63% are in residential property.  This dwarfs anything else that they hold, see here.

Let’s presume that the market mechanistically moved.  If home mortgages reached half of the delinquency rate as the United States (see here), then this would mechanistically lead to a, 7.85% reduction in bank stocks which would lead to a 3.4% reduction in the local equity market, which would lead to a 1.6% reduction in Superannuation, see here.

People may read this and think that because their super portfolio is only worth $185K, that a 1.6% reduction isn’t bad.  If it were isolated, then they may be right, but that is 1.6% in addition to all of the other losses.

The real effects could be much larger as banks reduce new lending to maintain solvency, meaning ability to purchase a new home will be curtailed.  Most of the money supply is created by the banking sector based on margin lending.  If banks start withholding loans to the one of the 1 in three households with mortgage debt, then this could be disastrous for the other people in the loan pool. The average housing debt burden, amongst those who have one, is nearly $300K (Australia now has the highest household debt in the OECD).  Averages hide a mass of wrongs.  If $300K is the average, then 50% of the debt burden is higher than that.  If you make the reasonable assumption that the 50% who owe more are younger, have less equity, and may owe something like $600k, to net out those on the bottom end, then you realize that there are some households which are truly stretched. If you are one of the many Australians who only put 10% down on their home, and you see the value fall by 10%, then your principle was just wiped out.  You are also probably within two years of your interest ‘bonus’ expiring (these low-interest ‘teaser’ rates as we called them in America before 2007 are still common in Australia).  Given your low equity, you probably can’t refinance. You are probably new in your career, you should be worried. Which takes me to the next part….

Fifth, all debt is personal and the effect on labor mobility

If you see your house fall more than your principle, then you had better have cash stashed somewhere, because lenders in Australia have recourse to more than just your home, they can pursue any assets you may have.

What do you do when you can’t turn back in the keys to your house, and when your creditors can pursue you anywhere in the country?  Well, if you are ‘responsible’ then you hunker down, stop spending any extra, and try to service your mortgage.  Unfortunately, if enough people like you stop buying that $8 coffee, then the proprietor of the local cafe will not be able to cover his mortgage.  So what does he do? Well, he likely defaults, which certainly doesn’t help him invest in his super, which doesn’t help the domestic equity market, and the cycle starts again…[Edited to add, it would be great to move to an area where you can find a job, but you may have a hard time renting out your house in a down market, and you are starved for cash. This slowed internal migration in America after their housing downturn, and they could ‘hand back the keys.’]

This can fall for quite some time. The top 10% aside, according to the Grattan Institute, between ~70-~80% of household wealth is in a combination of home and their superannuation, if you add in other property holdings, then this total increases to ~75%-~85%, for even the richest households. If you look at the table below, you will see that the increase in nominal housing value is paralleled by an increase in housing debt.

from here

What to do about this:

The long term solutions to this may well be quite unpalatable to Australians, but the choice is the bitter pill today of the really bitter pill tomorrow. I am not sure if any of this medicine is really very palatable.  Some of it may well cause the recession that I hope can be dodged.

First double-taxation of dividends.  Australia, you’re right, it doesn’t make sense, and the world should stop doing it.  You know what else, it’s safer for people to drive on the left hand side of the road, because 95% of the globe is right handed, and they keep their dominant hand on the wheel when they look over their shoulders.  You’re right about that too, congratulations.  Here’s the but…just like driving, it is not safer to be the only person who drives on the left hand side of the road when everyone else is driving on the right hand side.  Australia’s economy is not hermetically sealed from the rest of the world any more than a man-in-a-Subaru-barreling-down-an American-interstate-into-headlong-traffic-talking-about-how-safe-he-is-because-he-keeps-his dominant-hand-on-the-wheel is.  In this case, doing the ‘right’ thing by narrow metrics is the wrong thing by global metrics.

Second, by fiat, the government could decide that all collateralized debt contracts are no longer personal.  In the event of a recession, the last thing you want is a bunch of lawyers chasing around people for money and gumming up the judicial system while people are afraid to move to where the jobs are.   This would increase labor mobility in a downturn.

Third, the government could either mandate more diversification, or at least allow individuals to provide their own diversification more easily. The retirement system in Australia, is quite highly regulated, but in ways that don’t, in my opinion, always help people protect themselves.  If people want to break out of the retirement system, then they can, but a very limited number of individuals have ‘Self Managed Superannuation Funds.’  These are effectively like Roth or traditional 401Ks in America, but they have a lot of extra requirements, they need to be established as a trust, have their own independent accountant deal with the books annually. This extra barrier to entry prevents many Australians from using them.  There are nearly 600K of these self-managed retirement fund.  Assuming that each one represents a family, that still represents only about 10% of the Australian population, and only about 30% of the amount invested in superannuation (these obviously skew toward wealthy people, who have figured out that they are getting a raw-deal in the regular super system). Even without increasing the size of the self-managed component of the sector, the government could enforce transparency around fees and basic holdings.  The government did this with mortgage comparison rates several years ago, but no such standard marking scheme exists for retirement products.  One personal anecdote, I even had one superannuation fund tell me that it was their company policy not to disclose what their fees were.  In my mind, this is really amazing.  I can’t think of another industry where the provider of a service says, ‘I will provide you a great service, but I won’t tell you the price.’  If the government were to mandate disclosing the percentage of foreign vs domestic holdings, and the asset manager’s fees, then smaller, less sophisticated investors could more easily protect themselves.

What will spark it?

Perhaps the trigger will be the Chinese backing off of their massive property spree by dealing with their own debt-fueled boom. Perhaps, some debt will go bad in some other part of the banks portfolio, and they will tighten up everything.  Perhaps, perhaps, perhaps.  In short, I have no idea, but by definition, no asset can continue to grow at greater than the rate of inflation indefinitely.  If it did, then it would soon become the entire economy.  Here’s a sheet that shows some of those rapid growth implications. Please, make a copy and test your own assumptions.  I hope it shows that single-asset, or single asset class appreciation over the long run is impossible, and if you depend on those capital gains, especially while levered, then you will be in for pain.

What can you do personally

I generally don’t like telling people this unless they are genuinely interested, and I might actually get myself in trouble as I’m not a certified financial planner, and I don’t intend to become one.  That said.  I do have a few recommendations that I can share with anyone who is interested.  You can see an unpublished version here.

Interesting Things I’ve looked at since the last post

• Giving
  • Live on $2.50 for three days: try to live on what half the world spends on food.
  • A slightly more empirical article about the inability of people to increase their concern for the rest of humanity as the suffering grows.  It is short on solutions.  Despite having gone to Haiti to help with hurricane relief in 2004, I find the disaster to be very distant.
  • Mr Money Mustache on Giving (thanks Nick).  I commented on this guy a few posts ago, and said that I found him to be obsessed with money.  That he may be, but he just gave away 4x his annual income, by any measure, I say, ‘respect’
• Finance/Economics
  • Nassim Taleb would be happy with this forum podcast. Great comments at the end about how economics trims out all of the fat.  While that is desirable in good times, in hard times it spells disaster.  In the financial world it encouraged debt loading, making the system fragile
  • I give you peer-to-peer currency transfer.  I was pleased to find out that while the big banks regulated these guys out of competition in the US under the auspices of anti-money laundering, we can still use this to transfer USD to a foreign currency while overseas.  Saves at least 3% on the transfer, larger for smaller amounts.
  • The Decentralized Autonomous Organization is a potential mode of investing that I have never seen before, really intriguing.
  • Interesting Article from Bob Shiller about the long term price of housing and land in the New York Times
  • Should you choose time or money: great article about how those who choose time after a certain threshold in the US ($75K/year) are likely to be happier.
  • Insurance Bonds seem to be an intelligent way to invest if you are not planning to withdraw them in under 10 years.  You can use my little calculator to find the investment differential based on this tax vehicle.  Could be good for a college fund.
  • People don’t want to insure themselves against loss because it may feel disloyal.  Very interesting especially since loss aversion is felt more acutely.
• MISC
  • I read a bit more of Admiral James Stockdale’s reflections on his time in the Hanoi Hilton.  This phrase, among others, stood out to me: Epictetus said: “Men, the lecture-room of the philosopher is a hospital; students ought not to walk out of it in pleasure, but in pain.”
  • I grew up reading the Boxcar Children.  I did not realize that the version I read was a second, more idyllic version. This interesting article contrasts the two and points to some of the values of society at the same time.
  • Another interesting interview with Kevin Kelly, he has an interesting Venn diagram of sorts about how to prioritize his life: What is want to do, What others want me to do, What I am good at, What no one else wants to do
  • The Origins of Political Order from Francis Fukuyama is quite an interesting romp through world history where he makes the thesis that durable states all have coercive strength, commonly-understood laws, and feedback mechanisms for those in power.  His comments on pre-revolutionary France have echoes in the modern era.
  • Selma: Wow, how did I miss this coming out?
  • Memory consolidation Possibly one of the most interesting articles I have read in a couple of years.
  • I was wondering about the data that we were getting from the hospital about birth by week, so I created this spreadsheet to show the real distribution of births by week in America.
  • I finished an interesting Book American Nations: A History of the Eleven Rival Regional Cultures of North America.  I often viewed America through the lense of the ‘coasts’ and the center, but this view is both intuitive, and an interesting romp through American History.