Monday, September 27, 2010

Is Aussie Mac real?


Robert Gottliebsen today takes on government guarantees of Australian banks. It is more than welcome that this topic gets greater public scrutiny. It is nothing short of bizarre that the very foundation upon which Australian banks operate has shifted and yet we carry on as if nothing has changed. Nonetheless, there are a series of questions that this blog needs to raise about the Gottliebsen angle. The great story teller reckons that:
Australian banks did not make the lending mistakes of their overseas counterparts, but they are hooked on overseas borrowings which are so great that in times of strife the implicit government guarantee of the deposits must be converted to an actual guarantee.

Our government charged a small fee for that actual guarantee but the implicit guarantee that Australian depositors will rely on next year comes free of charge. Theoretically, if the government declared that it would not stand behind the banks but subsidised specific lending, then banks would have to raise vast amounts of additional capital to lower the risks to depositors and shareholder returns would be slashed.

Let's leave aside the question of whether Australian banks' wading into very high LVRs in the early 2000s and their enormous reliance on mortgage insurance are lending mistakes. Instead we'll focus on Gottliebsen's second point, which seems confused. Australian bank borrowing from overseas is in wholesale markets, not retail deposits. The government therefore had to make two guarantees during the GFC to prevent bank runs. One to local retail deposits. The second was to the bonds that the banks sell into global wholesale markets.

The fee that banks paid was for the guarantee on large deposit and wholesale debts and the latter was used with abandon in global markets, racking up $157 billion in contingent liabilities for the Budget before its withdrawal. Here is the website where you can track it.

Gottliebsen makes a good point that without the guarantees (assuming he means both), that the Australian banks would face significantly higher capital requirements, but it is the implied wholesale guarantee that is most destructive to market dynamics. Moral hazard here continues the practice of banks' borrowing offshore that keeps the Australian housing ponzi inflated.

This blogger has argued consistently for a year that the banks are now operating much like Fannie Mae and Freddie Mac used to, with an implied guarantee for bond investors. However, the Gottliebsen story, as confused as it is, has got it wondering if the implied guarantee thesis is legitimate.

To open this question, let's run a hypothetical. In the event of another freeze up in global funding, would the application of another guarantee save the banks and Australian housing?

The year is 2012. Australian pubic debt has peaked at $220 billion, 20 per cent of GDP. We don't know the maturity duration of the guaranteed debt but its likely to be as long as possible, so much of it remains intact, say $130 billion. Going into the shock, brought on by a sovereign default in Europe, commodities collapse 50%. A combination of falling revenues, automatic stabilisers and stimulus send us into a far from outlandish projected deficit of say 7% of GDP for the year ahead and 5% the year after on some rebound in commodities.

So, before we guarantee any more bank debt, we are facing a debt stock at roughly a third of GDP and contingent liabilities that push the total up the 40% of GDP, higher than it has been since WWII. And that assumes that the Budget is not in structural deficit on the back of lower commodity price revenues. We would also likely face pressure on the sovereign rating, making all debt servicing more expensive.

This is back of the envelope stuff, but one has to wonder how effective a guarantee would be in these circumstances. If the conclusion is it would not work, then Australian banks are not trading on the public purse. On the other hand, if the banks faced refinance disaster in this scenario, we'd have no choice, and they do have an implied guarantee.

5 comments:

Anonymous said...

Well done David. I am glad someone is thinking about these things. I am just amazed that we are walking into a situation almost identical to the 1890s.
Its very scary, I think the shock to the Aussie mindset when it comes will be the biggest hit.
I think the trigger is very acurate to Calculated Risk had a excellent blog recently on the probability of a major sovereign default. The upshot was probabilities are easy to gather when we have hundreds of years of default data to work with. ( A major one is about due)I dont like our chances of getting through it with anything less then 15% unemployment.

Cheers

Steve

Leith van Onselen said...

Thanks for the website to track the guaranteed debt, David. Very useful.

It's nice also to see the mainstream media finally acknowledging the banks' offshore funding risks that you have been warning about for years.

Chris said...

Great article - when I talk to my friends, the 'housing always goes up' mentality seems so firmly lodged in people's minds, its hard to imagine the impact on Australian society when this little bubble is popped.

Anonymous said...

You often hear Investors say "INTEREST RATES WENT TO 17% IN 1990 & PRICES DID NOT CRASH PEOPLE STILL COPED". The inference they draw is that rates can rise again & people will cope? Interestingly a 7% home loan interest rates in 2010 is equal to over 22.5% interest rate in 1990 (when Comparative Incomes / Loan Size / ...Percentage of Income to loan payments etc are applied). Just imaging people thought it was tough back in 1990 when rates got up to 17% but at a 7% rate in 2010 is equal to a 22.5% rate in 1990. FYI in 2008 interest rates were 9.5% . A 9.5% interest rate would be the equivalent of a 30.5% rate in 1990 terms. Affordability will inhibit the capital gains that INVESTORS need to make Negative Geared Rentals work. Without large Capital Gains Investors will start flooding the market. Now travel back to 1990 & ask yourself would you enter the market at a rate comparable to 22.5% with forecasts saying it will go to 8.5% which is a 27.29% 1990 rate..Food For Thought?

In Jan 1990 interest rates hit a record high of 17% & people managed to keep their homes then so how would this compare in todays housing market?...The 1990 Median house price was $100K with a 20% deposit & a loan of $80K payments @17% interest over 30 yrs would be $1140 pm or 32% of wages with average family wage of $42K pa...so in 1990 @ 17% the worst interest rates in Aust history payments only ever got to 32% of average family income...Fast Fwd to 2010 Median price is $500K less 20% deposit & a loan of $400K payments @ 7% interest over 30 years are $2661 pm or 43% of wages with average family wage of $75K...in 2008 interest rates were 9.5% this would work out to payments of $3365 or 54% of current wages .... Now historically for the last 30 years interest rates have averaged 10.11% this would works out to payments of $3545 pm or 57% of wages going to mortgage payments ....So summing up current housing mortgage payments @ 7% is still worse than when rates were at 17% but just imagine what will happen when rates rise? AFFORDABILITY will not allow future CAPITAL GROWTH & investors will D*U*M*P __ P*R*O*P*E*R*T*Y because without MASSIVE CAPITAL GAINS Property investment WONT WORK!

Steven Shaw said...

Anonymous, keep in mind that real house prices did decline in 1989-1990 (and were quite flat until 1997).

Take a look at the chart from http://www.unconventionaleconomist.com/2010/09/australian-housing-bubble-in-search-of.html (search for "real house prices")

Here a more official reference for the same data http://www.aph.gov.au/library/pubs/rn/2006-07/07rn07.htm