May 2010

Andrew Pegler – 21 May 2010

Right now Barrack Obama is turning his steely gaze to Wall Street. Specifically how to rein in the use of what are called derivatives and today I want to take a plain English gander at one derivative called a futures contract.

Very simply, a derivative is a financial instrument (not always in tune) designed to reduce risk. The most common types are futures, which are the right to buy or sell something at a future date at a set price; and swaps, which involve a swap of assets or payments. They’re called derivatives because they “derive” their value from stocks, bonds and commodities.

Let’s think of futures contracts in terms of bananas (as you do).

Say Bill the banana grower makes a deal with Fred the fruit buyer. One day Fred says to Bill “Mate, tell ya what, in six months I’ll buy a tonne of your ripe bananas for 100 bucks”. Bill thinks for a sec, swats a fly, tugs at his Akubra and says “Yeah, OK, deal”. Although probably unaware of it, Bill and Ted have just created a futures contract because they have both bet on the future.

Bill’s happy because with a set price now in place he is protected from banana prices going south but he could lose out if prices go up. Fred is happy because not only does he know what he is going to pay in six months, he’s also set to clean up if the price goes up because he’s locked in to pay only $100. Conversely, he’ll take a bath if the price falls to $50.

The point is both parties have used a financial instrument (in this case a futures contract) to reduce risk. Pretty clever stuff eh? But that’s just the half of it because that particular banana futures contract now has a value in and of itself, one that will rise and fall with the price of bananas. When bananas go up so does the value of a contract for bananas at a cheaper price. So Fred could sell it to any Tom, Dick or Harry and make a profit.

Well that’s it. Class dismissed. Time for a banana break.

And in other news… noticed the $AUD getting a hammering? The reason is jitters from the Euro debacle have scared the investors, who have taken their money out of anything that’s not US related, which, despite its problems, is still the safest place to park your hard-earned. This run towards the US is driving up the $US relative to all currencies including ours.

Andrew Pegler – 14 May 2010

The RSPT has split the electorate and there are good arguments on both sides. Read on for the plain English version.

How does it work?

Once the RSPT kicks off on 1 July 2012 mining companies won’t get taxed on the first 6% of their profits and for the first five years will be allowed to depreciate assets a lot faster than normal. The federal government will also refund the royalties miners now pay to states and reduce company tax from 30% to 28%. But here’s the rub. All profit over 6% gets hit by a 40% RSPT and what’s left is taxed again at 28%. That’s a total tax of about 58%.

Nup

The head of Fortescue Metals calls it “nationalisation of the mining industry”. Tony Abbott reckons its economic vandalism and the-man-who-would-be-Malcolm described it as “the slightly better than thoroughly anaemic profits tax”. Here’s a list of grievances:

• The minerals resources industry paid $80 billion in taxes and royalties in the past decade. The resources sector pays Australia’s highest tax rate. That’s a fair share.
• The uncertainty is killin’ us! Banks are telling miners not to bother asking for money until the tax is better understood, which, depending when the election is held, could be another six months. That means delays to over $100 billion worth of projects and an army of engineers and geologists sacked or forced to work part-time.
• Peter Costello has stepped up to the lectern with a withering spray saying the mining sector is a huge tax payer for the Australian economy and that the RSPT sends the wrong signal to international investors. But his most potent point is that many Australians will suffer because mining company shares have taken a hammering and so much super is invested there.
• Starting a mining business from exploration to production is high risk and capital-intensive and takes several years during which commodity prices can fluctuate wildly. If we tax away the rewards for taking big risks it could send investment overseas.

Yep

Right now we are in Resources Boom Mark II so it’s entirely appropriate that the government takes money from the big end of town to pay off the national debt we racked up in the GFC. Plus the big miners are overseas owned so we need to keep more of that money in Oz. Here are some other reasons why we should introduce an RSPT.

• We all deserve a slice of the pie. After all that’s our dirt too ya know!
• It’s set to be very profitable for the Budget’s bottom line. Revenue: $12 billion by 2013-2014. And we need every red cent we can throw at the deficit.
• Unlike the present archaic and unfair royalties regime, the RSPT is profits-based so when companies are more profitable the Australian people get more return. Conversely, when profits are lower companies pay less so it’s fairer on them.
• Over the last 30-odd years we’ve heard mineral companies repeatedly threaten to pack up their bat and ball and go home when things haven’t gone their way from land rights to union rules to environmental legislation. So, while this kind of outrage is expected, all the projections are that profitability of mining, even with a RSPT, will continue.

Well that’s enough from me, what do you lot think?

Andrew Pegler – 30 April 2010

This week I thought we’d check out the latest quarterly NAB Business Confidence Survey to see how the patient is faring.

While business confidence eased a tad over the quarter it remains pretty upbeat. And it should come as no surprise that the happiest campers are our diggers and drillers who look like getting better contract prices for our dirt than they expected. Nice one.

As for state rivalry, well the Melbourne Storm may be up the creek without a paddle but Victoria is paddling with a nice current into the fjords of good times. Queensland, however, remains as sluggish a croc that just lunched on cane toad. The culprit? The high Aussie dollar sucking the life out of tourism. Not so perfect one day?

Plans by business to spend up on capital over the next 12 months shifted up slightly and capacity utilisation (how much companies are using their machines and capital to make things) edged up 0.1% to 81.4%. A capital outcome to be sure!

But it’s not all good news. Since January retailing and wholesaling have gone south and the end of the first home owner’s grant has seen construction do the same. And there’s a few costs pressures re-emerging. Retail price inflation continues to drift down thanks to the muscling AUD and firms reporting labour shortages remains only modestly above the low point in mid-2009. A little wobbly but still shining?

Probably the NAB’s boldest prediction – $AUD parity with the $USD in mid-2010. Good news for exporters, another nail in the coffin for manufacturers and tourism operators. Meanwhile core or “underlying” inflation (the inflation measurement that tries to identify inflation trends by removing volatile things like food, petrol and interest rates) is expected to be 2.5% by end 2010, and 2.75% by end 2011. FYI “headline” inflation, which includes everything, is what the media focuses on.

So overall the patient is recovering well. Now, fetch me my golf clubs please nurse.

And in other news… ANZ has announced a half-year statutory profit of $1.9 billion up 36% on last year. As they say there’s only one thing worse than banks making money hand over fist and that’s them losing it. CEO Mike Smith also took the opportunity to describe Europe as a “mess” claiming contagion is now a very real issue. Personally I’m on Portugal watch.

Andrew Pegler – 23 April 2010

They were pivotal in bringing on the GFC and have surfaced as a powerful, mysterious force behind the European default jitters. But does anyone out there actually know what a credit default swap is? Read on for the plain English version.

Credit default swaps (CDSs) were invented in the late 1990s by Wall Street pointy heads. Since 2000, their market has grown from $900 billion to over $30 trillion. And it’s mostly unregulated. Credit default swaps come under the banner of exotic financial instruments (a great name for a Nick Cave backing band?). A financial instrument is something that has monetary value i.e. currency, shares, bonds etc. CDSs are exotic because they’re “pretty out there man”.

In essence, a credit default swap is an insurance policy you take out to reduce the risk of someone not being able to pay a debt. You swap the responsibility of a credit default to an insurer – hence credit default swap. In other words CDSs reduce the risk to a bank of lending someone money. Think of it in terms of Hollywood. If a movie producer takes out an insurance policy on an unreliable movie star it makes it easier for them to raise money for the star’s picture. So if the star is too stoned to film the backers still get their money back.

Here’s an illustrative story starring Wayne, Dean and Bryce. Wayne (the insured i.e. a bank) pays Dean (the insurer i.e. AIG) to insure him against the risk that Bryce (some bloke) won’t be able to pay his mortgage. Wayne just bought a CDS off Dean. One Friday night Bryce loses real bad on race 6 at the Dapto Dogs so Dean (the insurer i.e. AIG) now has to pay Wayne the money Bryce owes because he said he would because Wayne swapped the default to Dean.

Anyone else noticing this central idea of swapping the responsibility of a credit default away from you and onto the insurer?

Anyway with the GFC the problem was that Dean (the insurer i.e. AIG) was supposed to put aside a certain amount of money in case he had to pay Wayne (the bank). But it was unregulated and in the insane credit environment leading up to the credit crisis, the amount Dean put aside was too small to pay anyone. Hence utter chaos and financial Armageddon as sub-prime mortgages across America began to fall like dominoes taking the US economy with it. And the root of all this was the CDS.

I hope that clears that up your honour!

In other news… while on the subject of credit, credit reporter Dun and Bradstreet has revealed that it has downgraded the rating of 16 countries since the start of this year. However, Australia has been upgraded and is now one of the safest countries in the world to invest. The lucky country trundles on eh?

Andrew Pegler – 16 April 2010

Right now our economy needs antipsychotics. It’s a babbling mess, unsure if it’s Arthur or Martha.

Back in 2006 Secretary Treasury Ken Henry pointed out a rather odd phenomenon: our economy had a split personality. Some parts were rocking along while others were contracting. There was no uniform prosperity – it was all over the shop. Manufacturing and consumption were down, employment was wobbly but GDP was stable and growing thanks to busy Aussie diggers and drillers piling up tankers bound for Asian nation building projects. He called this a dual-speed economy. I call it a two-speed economy. He says potato I say potarto etc.

Economic history has a way of repeating itself (they’re not called economic cycles for nought). Again resource exports are hitting new highs and tankering in tonnes of money while tourism, education, primary produce and manufacturing are actually pretty limp, even contracting. Yep that’s right folks, we’ve moved forward to the past.

Pourquoi?

The resources boom is pumping the dollar big time and at last check it was racing towards US 94c. This makes the globally exposed, non-resources bits of our economy like tourism, manufacturing, primary production and education more expensive to overseas markets and therefore less attractive. Think high-class mutton in Prada dressed as lamb. (There’s a gag there about the Aussie economy founded on the sheep’s back but I’ll leave it.) Then there’s the cash splash and three million plasma TVs later household disposable income is now back to where it should be, hence weak consumption more aligned to the post-GFC world. And finally a lingering credit crunch continues to put the squeeze on small business and property development. As if driving home the two-speed thesis, a report by BIS Shrapnel claims the number of large-scale property construction developments that have driven growth over the past decade will slow by six per cent over the next few years leaving mostly minerals or commodities-related major developments to carry the can.

This yin and yang economics means a few things for you. For starters resource companies will become the fastest growing employer and manufacturing states like Victoria will lose out to resource-rich states like WA and Queensland. But the good news is this pull in opposite directions is taking the heat out of the economy and will give the RBA board good cause to pause.

And in other news… further to the two-speed theme of this blog, as reported on PM the other day, despite houses being auctioned at record levels every weekend there’s been a dramatic slump in the number of home loan approvals. The culprit? A two-tiered housing market. On one level we have cashed-up investors buying established homes. On the other are first homebuyers who are being priced out the market. As pointed out in last week’s blog the solution is more supply. Bring it on!

Andrew Pegler – 09 April 2010

What’s the best way to deal with the current house price surge? Frankly I dunno but here are some cave drawings I prepared earlier.

When homo erectus moved out of Africa during the Early Pleistocene, he probably never imagined having to fork out $1mill for a three-bedroom unit in inner western Sydney or $1.3mil for a wrecking ball candidate in inner Melbourne. After all caves were cheap and the only problem was evicting sabre tooth tigers with contrary ideas.

We all know this housing boom is basically nuts (and berries) and that, despite last week’s rate rise, it won’t be coming off the boil any time soon. So short of taking a Cro-Magnon club to the whole problem I’ve scribbled up a few primitive drawings for your grunting pleasure. So drape yourself in Mammoth pelt, invent the wheel and roll over here as I attempt to illuminate our shared problem with this new thing I call fire.

Increase supply?

Is the problem a simple matter of supply and demand? Should we increase supply and thereby slow the price rise? Well derrr. Yes we should and must. The National Housing Council last year estimated Australia was 85,000 houses short of what we needed. The Council is about to release its second report and according to rumours I heard on a recent Mammoth hunt with economist Saul Eastlake this year’s figure will top 100,000. But while opening up the urban fringe is great on paper the problem is a serious lack of suitable land.

Remove subsidies

The government continues to pump up demand with subsidies like first home buyers and negative gearing. Rather than put more cash into the hands of first home buyers, most of which goes to the sellers’ pockets, a lot of people reckon we should cut the first home buyers grant altogether. However, this is another “fine on paper” idea and doesn’t account for the swathes of young folk counting on that leg-up. Then there’s negative gearing i.e. borrowing money to invest in property and claiming a tax deduction on the difference between the rent you get and the interest you pay. Removing this is very hot politically but as pressure develops the government may grow the kahunas to take this Triceratops by the horns.

Cut immigration?

Does the answer lie in curbing population growth and cutting back on immigration? Unfortunately it’s not that simple. With a resources boom in full swing we need all the people we can get. If we don’t get them, the resulting labour scarcity will drive up wages, inflation and interest rates. A disastrous troika indeed!

Until next week, home sapiens, keep bidding and remember location, location, location.