Chris Joye responds to Jeremy Grantham


Given yesterday’s post on the ongoing stoush between Chris Joye and Jeremy Grantham I thought it only fair that Mr Joye be given the opportunity to respond so here it is: “The $100 million challenge”.

Today I want to talk about our $100 million housing challenge to the US fund manager, Jeremy Grantham, and a new revolution in trading and risk management that is about to hit our financial markets. But first some background.

Regular readers will know that after years of research and development, Rismark designed the intellectual property that allowed it to introduce Australia’s first “hedonic”—or “quality-controlled”—house price indices with its strategic partner, RP Data, which is the nation’s largest real estate data company.

We also broke new territory by producing dependable “monthly” measures of house price movements (APM and the ABS report quarterly), and by publishing “seasonally-adjusted” index numbers for the first time.

Finally, we extended our house price index coverage to include non-capital city, or “regional” markets, which while accounting for 40% of all dwellings by number, had historically been neglected by major index suppliers.

On every step of this complex journey we have consulted closely with, and often been guided by, academic, government and industry authorities, such as the RBA.

Today it is safe to say that despite a number of competitive alternatives, RP Data-Rismark’s index suite is recognized as the market leader.

There were two key reasons why we spent so much time and effort transforming Australia’s house price technology. And the first motivation led to us inevitably addressing the second.

Approximately 11 years ago I was in between jobs at Goldman Sachs and the RBA. At that time, most Australian house price indices were based on notoriously unreliable “medians”, and therefore problematically poor.

This would emerge several years later as a serious policy issue targeted by the RBA and Treasury for analytical remedy. That is, government economists pro-actively called for the development of new house price measurement tools.

Financial contracts tied to house price indices, otherwise known as derivatives, also did not exist. It was not until mid 2006 that the Chicago Mercantile Exchange would launch the world’s first house price index “futures” market based on the popular Case-Shiller indices.

This was also several years before I started working on my 380 page paper on housing policy for the then Prime Minister, John Howard. In that study, I noted, “while there are exceedingly sophisticated capital markets for corporate debt, equity, and exotic derivatives therein the same cannot be said for what is, in fact, a much larger asset category: owner-occupied housing.”

While wandering along the beach on a break one day in 2001 I asked myself why people couldn’t hedge the biggest financial risk they faced (aside from a loss of labour income)—that is, the risk of a decline in the value of their largest asset holding, which was typically housing.

Having worked over 2000 and 2001 with Goldman Sachs, and studied economics and finance at university, I was familiar with the functions of financial markets. But actively traded financial contracts tied to the $3 trillion housing asset-class were not available. So I asked myself, Why not simply create futures (or derivatives) tied to a house price index to enable people to cost-effectively hedge the risk of house price rises or falls?

As I started looking into this, I discovered that the principal problem was with the prevailing house price proxies. They were far too infrequently reported, and far too inaccurate, to hope to convince investors to commit billions of dollars to exchange contracts valued, or “marked-to-market”, against them. The project would thus be put on hold until I helped found Rismark, with funding from Macquarie Bank.

A number of years later the RBA and Treasury would independently arrive at the same conclusion, but from the vantage of policymakers wanting superior information on housing risks (recall that Australia had experienced a stunning house price boom in the early 2000s that exercised the minds of regulators).

By combining a team of world-class PhDs with hundreds of millions of dollars of valuable housing data, RP Data and Rismark were able to ultimately solve the analytical problem. Using regression-based “hedonic” methods that carefully control for each property’s unique attributes—such as its location and land size, and its number of bedrooms, bathrooms, car spaces, and so on—we’ve been able to radically enhance the quality of estimates of monthly changes in capital values and rents.

It’s also well documented in the media that we’ve been actively working with regulators and exchanges to develop liquid financial markets based on our patented index technology. Due to various embargoes that will be shortly relaxed, I cannot say much more on this front other than to recommend you keep an eye out for the launch of several “global firsts” in the housing analytics space.

This brings me to GMO’s founder Jeremy Granthan, who has argued that Australia suffers from the mother-of-all housing bubbles. When he first aired these remarks in 2010, we at Rismark challenged him to put his money where his mouth was. Specifically, we offered to work with Mr Grantham to help him to “short”—or bet against a fall in the value of—one of our national indices over the ensuing three year period.

In order to do so, we would have to find a counterparty to take the other side of this transaction: ie, some individual or institution that wanted to effectively go “long”, or lock in the future returns associated with our index.

One blogger recently claimed, incorrectly, that we intended to take the other side ourselves. Our original article demonstrates that this was not, in fact, the case:

“To be clear, Rismark would need to work pro-actively with Mr Grantham to construct this transaction. We believe we have counterparties that would likely be prepared to contract with him. But it may take several months to facilitate (and cannot be guaranteed).

Before we can proceed, we require a firm, contractually-binding commitment from Mr Grantham that should we be able to facilitate this transaction, he will indeed act on the advice that he’s offered to the rest of the world by committing a tiny fraction—less than 1 per cent—of his capital to his predictions.”

How would Mr Grantham have fared had he backed his own rhetoric? The indices that RP Data and Rismark produce for trading purposes are “total return” benchmarks, much like the ASX All Ordinaries Accumulation index, which tracks changes in capital values and dividends.

Since the end of October 2010, when we first outlined this idea, RP Data-Rismark’s capital city accumulation index has risen by about 0.2%.

So using this benchmark, which is the most likely index that a counterparty would wish to trade against (given they’d be expecting the capital gains and rental income realized from Aussie housing), Mr Grantham would be down around $200,000. Call it evens.

If, on the other hand, he wanted to use the RP Data-Rismark index that follows changes in capital values, Mr Grantham would be up about 5% assuming we could have found a counterparty willing to ignore incomes (or rents).

Of course, the proposed transaction was over a three year horizon, so we are only 40% of the way through it. And given that a national house price index has annual volatility of 5-6%, we are still within the realms of what one might expect to see. Much like those analysts who predicted six RBA rate cuts to a 3.5% cash rate by June this year, it would be highly imprudent to bank profits that have yet to be crystallised.

It is certainly true that we devised this bet at a deliberately attractive juncture for the bearish Mr Grantham. It followed the RBA slamming the housing market with a surprise double interest rate hike in November 2010, which we forecast could put downward pressure on house prices over 2011. And that is indeed what transpired with the help of some additional RBA jaw-boning.

The good news for Mr Grantham is that this opportunity still exists. So while he did not have the courage of his convictions when we first proposed it in late 2010, he can still put the trade on today.

Following media coverage of our idea, Mr Grantham did personally contact my brother-in-law about it, and GMO officials requested a meeting in Sydney. Independently, I also received some email enquiries from GMO’s head office in Boston. Curiously, when I actually met with GMO’s executives face-to-face they made it clear they did not personally subscribe to Mr Grantham’s relatively extreme positions.

Nevertheless, in the event that Mr Grantham still believes shorting Aussie housing is one of the best investments of all time, we would love to hear from him…

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.