Tuesday, November 30, 2010

Atlas shrugged

Reader Atlas has down the heavy lifting and answered this blogger's challenge in fine style by explaining Michael Stutchbury clearly for us all:

...isn't Stuchbury simply saying:
a) much of the media has missed the point in that the RBA is saying we need to allow big banks fail without it killing the economy;
b) this flies in the face of much of the bank-bashing that is going on because it says that - far from expanding the overnment support from some players, we should remove it for all (over time); and finally
c) this is all really just a desperate plan to lower mortgage rates a little to help keep the final dying days of the housing bubble alive a little longer

Excellent and thank you Atlas.

The reason for this blogger's confusion is simple. Stuchbury has consistently and universally denied the banks were bailed out during the GFC. If that's the case, how can there be a moral hazard problem to address?

Glenn Stevens has smoked him out.

Lost marbles?

Here's a reader's challenge. If anyone of you can make head or tail of Michael Stutchbury today, I'll guest post you with full attribution.

The RBA's RMBS anxiety

The RBA appears to be running interference against interests in favour of a Budget guarantee for securitisers.

From a speech today by deputy governor Guy Debelle:
In thinking about the AOFM support for the RMBS market, I believe the AOFM program has a number of advantages relative to alternative means of support: it can be easily tailored to help specific types of institutions; it can be phased out easily; the likelihood that the Government loses money on its investment is very small; and there is no ongoing contingent liability to the Government from providing the support. If instead a government guarantee of RMBS were provided, it would be difficult to phase out, creating a commitment that could generate a large contingent liability for the Government.

As well, the entire tenor of Debelle's speech was aimed at reassuring investors that Australian securitisation doesn't need extra support.

Last Friday we had Glenn Stevens tell us that:
In many areas it is probably the case that more competition is always better for consumers, but in banking more competition is good to apoint but beyond a point more competition is not good, because the bankers can be led to do things that ultimately cause a lot of subsequent damage. I think we have to understand that. That is not to say that the current amount of competition we see in any particular market is necessarily enough, but there is a point beyond which extreme competition in lending money leads to problems.

Whilst this blogger is far less sanguine about the stability of market-mediated credit than either of these statements, it is clear that the RBA is pretty uncomfortable with the idea that we return to the wild days of non-bank credit cowboys, especially, it would appear, wielding the badge of the sovereign.

That anxiety is well-founded and should be congratulated.

Credit aggregates unchanged

The RBA released the October credit aggregates this morning and what the RBA itself defines as 'modest' credit growth continues.

Owner-occupier mortgage debt was up 7.1% annualised and investor mortgages 6.9%. Other personal loans clocked up 5%.

Business credit is still in serious decline, down at a 9.3% annualised rate.

No sign here of any dislocation in housing-related debt, however the Minsky-like moment arrived in early November.

As this blogger has argued before, these levels are consistent with flat and falling house prices.

Reflation toast

The SMH reports this morning that:
Europe's credit crisis could help with Australia's borrowing efforts by alerting investors to the economy's strength, says the departing head of the government's debt management agency.

Neil Hyden, who retired last week as the chief executive of the Australian Office of Finance Management, said Europe's woes had not tainted investors' views of Australian government debt.

While the need to rescue Ireland had put global markets on edge, Mr Hyden said Australia's low public debt and Asia's growth prospects were more important to Australia's

creditors. ''In a sense it makes the strength of our economy and financial system and of our securities stand out even more,'' Mr Hyden told the Herald. ''If it had any effect I would see it as positive, or certainly not negative.''

The ex-head of the AOFM has nicely captured the spirit of exceptionalism we currently regard ourselves with. There are no lessons for us in Europe, nor Ireland. The crisis can only be of benefit.

The press hardly has a mention of Europe this morning.

So is this confidence well placed? China is growing fine (indeed, combating overheating) and commodities are holding up through the crisis.

Well, no, frankly, it isn't. The reason is the euro.

First, the principle reflation mechanism for the global economy in this cycle is a falling $US. It is this that boosts the world's biggest economy through rising exports. This stabilsiing effect reassures markets that US imports will remain strong, thus keeping China strong through its currency peg. Commodity exporters benefit as Chinese strength continues its internal investment. And then there is the double benefit of the falling $US adding monetary fire to commodity prices. It's a virtuous cycle driven by the mass liquidity of low US interest rates.

A falling euro upsets this applecart. The $US rises. It's export-led recovery narrative falters. Chinese exports stall. Commodities come under the double pump of weak demand growth and rising relative pricing to the dollar.

All of these dynamics are amplified through the gigantic bets made by global finance along the reflation chain known as the 'risk trade'. If there is a shock, like a partial disintegration of the euro, this reversal will become a panic, liquidity everywhere will evaporate, and we will stand at the verge of another GFC.

The European crisis has nowhere to go for months as far as this blogger can see. Markets can see the Irish bailout is in trouble at the level of the polity and know it may fail at the New Year election. Europe is struggling to find other mechanisms to bailout the other PIGS but markets are moving too fast for them. So the euro keeps falling. And as it does, so too will equities and ultimately commodities too.

Links November 30: Worse than May

World bank: No double-dip. Sell now. Reuters
Contagion rampant: Ireland, Portugal, Spain, Italy, Belgium
CDA carnage hitting core. Zero Hedge
Bailout fail. Guardian
Four scenarios for Europe. Simon Jonson
Not waving, drowning. Paul Krugman
EQE. Zero Hedge
Euro growth to be hit. Bloomberg
Improved US indicators. Calculated Risk
Orderly transition vs markets. El-Erian
Depression back on. Megan McCardle. The Atlantic
$US just begun to rise. Money Game
Money market reform. EOC
Corporate courage in China. John Garnaut
The China bubble. Telelgraph
Super-cycle rolls on. FT
Ho hum, ore up. Bloomberg

Monday, November 29, 2010

Aussie toppy?

An extraordinary article at Seeking Alpha caught this blogger's eye today. In it, one Ananthan Thangavel argues that the Aussie dollar is better than gold.

There can be no surer signal that you are close to a top than when boffin traders announce your currency is more valuable than the yellow metal.

And sure enough, the argument suffers some serious flaws.
Markets are worried about the threat of default by these debt-ridden European countries. While this is a possible outcome, it is a highly improbable one. Throughout the history of time, governments who have faced huge debt problems inflate their way out of the debt. In such a manner, governments print money to pay down their debt, thereby reducing the nominal value of the debt. Since the debt is measured in nominal terms (i.e. $10,000) and not the value of what that debt could purchase, governments often resort to money printing in order to ease the burden of debt repayment.

This outcome has been largely accepted in the US by commodity markets, evidenced by huge advances in the price of agricultural commodities and precious metals. The Eurozone presents a different challenge, as it is an economic alliance without a single government controlling it. This means that ECB President Jean-Claude Trichet must determine what is best for the entire Eurozone simultaneously, even as countries like Germany face no real debt problem while countries such as Greece are on the precipice of default.

It is our belief that the IMF/ECB-dictated austerity measures will ultimately prove to be unsuccessful. In exchange for the bailout funds, Ireland, Greece and the other weaker European countries must agree to strict austerity measures that will raise taxes and cut jobs and expenses for the government. However, as these governments cut back their spending, their GDPs will be adversely affected, causing tax receipts to decline even more and continuing the debt contagion spiral.

Instead of relying on austerity measures to right the balance sheets of the weak Eurozone countries, the ECB will eventually succumb to pressure to enact US-style quantitative easing and monetary base expansion. Until May, the ECB had remained steadfast in protecting the Euro and not enacting potentially inflationary policies. However, Trichet gave way and started purchasing weak Eurozone countries' bonds in order to cap their yields, a move very similar to the US Fed's quantitative easing, and also a policy he had sworn he would not undertake. As Trichet and the ECB realize that traditional policies will not be enough to ensure even modest growth in the Eurozone, Trichet will further relax his stance on inflationary policies. Simply put, the weak Eurozone countries have no choice but to inflate their way out of the debt, and Trichet will realize that the only choice he has is to either allow inflation to reduce the nominal amount of the debt, or risk the dissolution of the Euro entirely.

For these reasons, precious metals and commodities remain in a structural bull market (click on chart to enlarge). While gold and silver have already logged impressive performances for the year, they are in the beginning of a multi-year bull market. As extraordinary policies such as quantitative easing and government repurchases become commonplace among the US, Japan, and eventually Europe, investors will lose confidence in developed market currencies and increasingly turn to developing market currencies and precious metals as stores of value.

This blogger will observe that whether the ECB engages in EQE (European Quantitative Easing) or it doesn't, the Aussie isn't, thankfully, going to rise much further. If we get EQE, the global reflation trade is toast. The euro will replace the $US as the global whipping boy currency. By default that means a rising $US, falling commodity prices and reversed risk trades.

Unless you think US domestic demand can carry the global business cycle with a rising dollar, which is a highly questionable proposition, then EQE spells the end of global reflation and the end of the rise of the Aussie. Precious metals will also take heat but will be stronger because of the implications for competitive devaluation and trade war.

The Six Million Dollar Central Bank

This blog delivered the RBA a bit a of a serve for inconsistency late last week after the boffins' appearance in Parliament.

Having read the hansard, however, what is also obvious is just how much the RBA is rebuilding itself from the ruins of the crashed debt pilots of yesteryear.

Let's take a look.

Gone is the Pitchford Thesis and the free and easy love of private sector debt: Glenn Stevens
Private debt, on the otherhand, is considerably higher than in some countries. It is probably in the pack for English-speaking countries with which we would compare ourselves, but some of those have had a prettybad time lately, so we would not necessarily want to stand out too much more on that score. Thatis why I think that the more modest growth of housing credit that we see now is probablysufficient for the economy’s needs, but we do not want to see that ratio of debt to income keepgoing up the way it was. So that is a thing to watch.

Gone is faith in asset-based wealth: Glenn Stevens
We have looked at households in other countries getting into serious trouble. I think we have all thought, ‘We ought to be a bit carefulabout rate of borrowing and maybe we should be saving more of our current income as opposedto allowing an assumed rise in asset values to, in effect, do our saving for us.’ I think that is atendency that was there a few years back in many countries. My guess is that there has been akind of sea change in people’s attitudes that we would expect to persist for a while.

Gone is faith in private bank prudence: Glenn Stevens
Pretty much every supervisor in the world is telling their banks to rely less onwholesale funding because it is risky. The rating agencies say it. My suspicion would be that, if the financial institutions could have got away with continuing the old pattern, they would have because they found it attractive and profitable, but they did not have that choice. They certainly took decisions to try to raise more deposit funding but it was a decision on which I am not sure they had a great deal of choice in taking.

Gone is the efficient market hypothesis: Glenn Stevens
In many areas it is probably the case thatmore competition is always better for consumers, but in banking more competition is good to apoint but beyond a point more competition is not good, because the bankers can be led to dothings that ultimately cause a lot of subsequent damage. I think we have to understand that. Thatis not to say that the current amount of competition we see in any particular market is necessarilyenough, but there is a point beyond which extreme competition in lending money leads to problems.

There is inquiry about how to manage guarantees: Glenn Stevens
I think you would also, to be honest, have to in the back of your mind pose the question: in the previous world, without this guarantee, would a government stand by to let the system collapse and do nothing? I cannot think that they would. There was always some unspoken, unquantified support. But it is a very interesting question: should that be made explicit and priced or shouldn’t it? That is one of the issues that I think would probably have to have a discussion about, but today is probably not quite the moment.

There is realism about the banks and moral hazard: Glenn Stevens
My very firm view is that we ought to try to get to a position where at that time, whenever that day comes—hopefully not soon—our government will be in a position to say, ‘No, we are not going to give a guarantee and the system can cope with that.’ I think we are much closer to being ableto say that than most countries, but we still have some work to do to get a permanent set of arrangements, particularly for deposits, which can stand the test of time.

Gone is the comfort with wholesale funding: Glenn Stevens
They [the banks] have sought to do that to increase the share of their book funded fromdomestic deposits and to lessen the share funded through wholesale sources. It is pretty obviouswhy that happens and I think it is prudent of them to do it. What we have seen in the past severalyears is that those wholesale funding sources, which for some years up to the middle of 2007 were very available, very inexpensive and, apparently, quite reliable and quite stable, changeddramatically after the problems began in 2007 and especially after the Lehman failure in September 2008.

Gone is the reticence to 'lean against the wind early in the cycle': Glenn Stevens
I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier. I think that if we are doing it right the decisions will be finely balanced most of the time—that is where we should be—and we will probably move a little bit earlier than the moment when it is clear that you have to. That is if we are doing it well. There is some risk that you do things you do not need to do—I agree with that. We have to balance that risk, obviously, against the risk of getting behind the game. Historically, for many central banks, including us, that has tended to be the mistake that we made.

Gone is an easy comfort with trend line growth: Glenn Stevens
So we will see, I think, continued uncertainty about how all this will play out. My guess, as Isay, is that we will see repeat episodes of anxiety every so often for a few years. What thatmeans is that, for us, we balance the possibility that things could go pear-shaped in Europe—they may or may not; we will not know for sure for quite some time.

There is some skepticism about commodities and vision beyond: Phil Lowe
If you look forward, we cannot expect the terms of trade to keep rising and we will inevitably go back to a period where growth in our living standards is going to be determined by productivity growth, or, to put it another way, expansion of the supply side. We are not the experts on how to do that. There are obviously areas, in transport, in education, in health, where things can be done to improve the ability of the economy to produce goods and services efficiently. It is not our core area of competency but it isan area that needs to be looked at very carefully.

Compared with the profligacy of former governors, this is impressive stuff.


Late last week, the blog Data Diary posted on the dynamics of how a Chinese slowdown would trigger an Australian bust. According to the capital market community that is 'short' the banks and commodity giants:
1) Australia has had a massive terms of trade boost as a result of the Chinese property building boom. This has principally flowed through to the domestic economy through taxes on these commodity exports.
2) The domestic economy has taken these tax receipts (distributed via tax cuts or government handouts) and leveraged them, via low interest rates, into the housing sector.
3) Australian household leverage has pushed to very high levels by most sensible measures. This leaves the economy vulnerable to a terms of trade shock – principally a downturn in Chinese property construction.
4) The transmission mechanisms?
A wealth effect from lower share market prices – whatever the failings in logic, commodity companies trade in line with movements in spot prices.

An income effect from declining GDP – if you accept that debt accumulation has peaked, then following the logic that our housing construction sector is built around continued debt driven demand, it is very exposed to stagnation in debt or worse still deleveraging. While housing construction only directly employs 10% of the workforce and comprises 7% of GDP, the multiplier effects through the economy would be significant. This is why governments of all persuasions are so willing to throw taxpayer subsidies towards keeping the sector growing.

And the most scary – and by no means certain – is that we then enter a house price correction – with the attendant wealth effects that are currently haunting the US.

Regular readers will recognise this blog's most feared risk scenario. It is the reason why it is named Houses and Holes.

These are not the rantings of a lunatic pessimist. A 2005 RBA report showed how the income from high terms of trade is channeled into the real economy via two roughly equal courses:
A substantial part of the increase in profits accrues to state and federal governments. Royalties, which are a pre-tax item, are payable to state governments on mineral and onshore petroleum production.4 These are mostly at ad-valorem rates, and although there is substantial variation in rates and defi nitions, they probably imply that around 5 per cent of additional revenues from higher commodity prices typically accrue to state governments. More signifi cantly, based on the statutory corporate tax rate, up to 30 per cent of the increase in profi ts would be payable in corporate income tax to the Australian government. The higher level of profi ts would also result in some additional tax revenue from personal income taxes paid by shareholders on dividends or – in the longer run – on capital gains. Although the payment of these royalties and taxes may initially reduce the stimulus from higher commodity prices, there will still be an expansionary impact to the extent that higher government revenues allow higher government spending or a reduction in tax rates. Over a period of time, assuming government net fi scal positions are held roughly constant, the increase in revenues fl owing from higher export revenues to domestic governments would thus represent a corresponding stimulus to the economy.

The remainder of the initial boost to revenues (roughly two-thirds of the total) accrues to shareholders of the companies. This occurs either in the form of higher dividends, or if earnings are retained, in the form of capital gains. Domestic shareholders include both households and institutional investors such as superannuation funds. However, to the extent that there is foreign ownership of the Australian resources sector, part of the addition to incomes will accrue to foreigners. Although there are no precise figures on aggregate foreign ownership, some ABS data for 2000/01 suggest that foreign ownership in the resources sector is around 50 per cent.

In short, two thirds of the income gain remains in Australia, split evenly between government and shareholders. Data Diary is simply hypothesising a reversal of these two income effects in the event of a China accident. A far from crazy supposition.

However (and at this point you'd better sit down), in this blogger's view, the Data Diary story of commodity bust > sharemarket bust > housing bust > bank bust leaves out one crucial dimension. That is, that our banks already owe $500 billion to offshore creditors.

In the event of a China bust and the attendant likelihood of a structural slowdown, the interest rates on this money is going to rise, perhaps quickly. Just how far will depend upon how well we rebalance our spending against the lower income.

This rising cost of funds will hit the banks just as the negative income effects outlined by Data Diary are crunching their assets. And because the Budget is facing a simultaneous structural deficit on falling commodity-related tax receipts, and declining real economic activity, plus the need for stimulus and the rising costs of automatic stabilisers like unemployment benefits, its effectiveness as a backstop guarantor will be impaired.

The result is a negative feedback loop of credit rationing as the banks' falling assets prices and rising liability costs feed on one another.

The RBA would shred interest rates. But in large part, the banks would be unable to pass on the cuts as they attempt to absorb the pincer squeeze on their balance sheets by expanding interest margins.

As the recent Goldman Sachs report into Australian housing put it:
House price bubbles that are augmented by reversals in the terms of trade can be far more painful events than an independent house price bust pricked via monetary policy. A house price bust consuming somewhere between 5% and 10% of GDP in fiscal resources of other countries would quickly exhaust Australia's fiscal capacity and the patience of foreign and domestic investors if replicated in Australia.

In the terms of Data Diary, the bust mechanisms shift to commodity & sharemarket bust > financial crisis & housing bust > bank bust. This blogger is unable to say what the next step is. Perhaps the superannuation pool is big enough to buy the banks. Perhaps China buys them. Perhaps the Abbott government does (with the ultimate help of the IMF).

A collapsed dollar would help stabilise us eventually but this is still a nasty fate and goes a long way towards explaining why this blogger keeps bleating about wholesale funding, as well as trying to push the bank debate towards finding a way out while the high income is still flowing.

The scenario may be a Black Swan but it's plausible enough to take very seriously.

Links November 29: Better than gold

Aussie dollar better than gold. Seeking Alpha
Ireland should default. Mish
Irish on the streets. NYT
Week ahead for the DOW. Calculated Risk
European crisis cheat sheet. Zero Hedge
Italy next? Vox
CDS to blame. WSJ
All boom ahead. Barf. Gittins.
Suncorp calls for Wallis. The Oz
Rio: pedal to the metal. The Oz

Sunday, November 28, 2010

Not all populism

This blogger has just finished reading the hansard of Glenn Stevens' parliamentary appearance on Friday. Although completely unreported, there was this excellent exchange between Kelly O'Dwyer and the Gov:
—Our task is to draw you out!

Mr Stevens
—Indeed it is—and my task is to try not to be drawn too much!

—Indeed. I will change tack to give you some respite. Australian taxpayershave furnished private banks with $850 billion worth of guarantees, and the RBA has providedthem with unprecedented liquidity facilities. Can you tell us whether this raises the risk of moralhazard in Australia, and can you explain for the benefit of the committee your understanding of ‘moral hazard’.

Mr Stevens
—It is a good question because it goes to the future as well as the past and thepresent. Let me see if I can set out a few facts. The $850 billion you refer to, I take it that isdeposits. The government made available a guarantee for wholesale funding, which was of course priced. The government took some risk here, but it was very well paid to take that risk. Itis earning about $1 billion a year in fees. Sometimes we hear people say, ‘The government didn’tgive it. It sold a guarantee, and at quite a nice price.’ That is closed and the stock of guaranteedliabilities which got to around $170 billion or $180 billion is actually starting to come down nowvery slowly. It will come down more quickly as the guaranteed debt matures over the nextseveral years. It is the same for the state governments. That is about to close, if it has not already.I do not think that will be disruptive.The remaining part, as you say, is the guarantee on deposits of over $1 million. One of thethings that does have to be done in the next six months or so is for officials—and we areworking with the Treasury and the Council of Financial Regulators and others—to try to figureout what the world should look like after that guarantee finishes, which is at the end of Octobernext year. It would be improper to speculate too much, but the size of the cap is obviously anissue that has to be considered carefully.On ‘moral hazard’, there is a moral hazard everywhere in the world because governments andcentral banks did extraordinary things. Some of the things we did were unprecedented for us butby the standards of what some other countries did were pretty mild. So there is a huge moralhazard because governments and central banks did these things. They had to be done, becausethe system faced a catastrophe in the absence of these measures. But them having been done, andeven though we are withdrawing them, the issue we will face—and this is what you were gettingat, I guess—next time there is some pressure is whether there will be another guarantee. My veryfirm view is that we ought to try to get to a position where at that time, whenever that daycomes—hopefully not soon—our government will be in a position to say, ‘No, we are not goingto give a guarantee and the system can cope with that.’ I think we are much closer to being ableto say that than most countries, but we still have some work to do to get a permanent set of arrangements, particularly for deposits, which can stand the test of time. That is on our agenda atthe moment and for the early part of next year. I expect that at future meetings we will probablycome back to that. It is a very important question.This is why, to hark back to the questions Ms Owens asked about the global regulatory work that is being done, people are very conscious of this, very conscious of the need to try to lessen the moral hazards surrounding some of these very big global banks by making them safer, lesslikely to fail and easier to resolve if they do fail and so on. It is very much, though, still a work in progress. That is the best I can tell you at this point.

—Governor, would you consider that these guarantees are contingentliabilities—that they increase the risk profile of the Commonwealth prior to its position pre thecrisis?

Mr Stevens
—We are getting into areas where it is very difficult to talk about this publicly, soI will be a little bit guarded. But, from a strictly accounting point of view, they have taken on acontingent liability that they did not have before. What is the probability that you would actuallyhave to make good on the entire deposit base of the banking system? It is extremely low. So, if you were trying to measure this obligation, it would be the size of that times some probability of having to make good on that, and that is very low number. I think you would also, to be honest,have to in the back of your mind pose the question: in the previous world, without thisguarantee, would a government stand by to let the system collapse and do nothing? I cannotthink that they would. There was always some unspoken, unquantified support. But it is a veryinteresting question: should that be made explicit and priced or shouldn’t it? That is one of theissues that I think would probably have to have a discussion about, but today is probably notquite the moment.

—That leads pretty nicely into my next question, which is: can you tell uswhether there is a risk in the fact that Australia has four ‘too big to fail’ banks that effectivelybenefit from implicit taxpayer guarantees.

Mr Stevens
—We have four large institutions, but the number in a crisis is not necessarilylimited to four because in crisis conditions, if people are panicked enough, even a smaller entitycan end up being quite disruptive if it is in distress. The other side of that, of course, is that thoseinstitutions are supervised very intensively by the supervisor, who is quite prepared onoccasion—and has done so—to require banks to do this or that additional thing over theminimum, if they think that is appropriate from an individual risk or even a systemic risk pointof view. But this is the nature of banks. It is a tricky area because banking just is not like anyother business. A bank failure, even for a not-so-big bank, is not like the failure of any otherbusiness, where someone else comes in, buys the assets, employs the people and everythingkeeps going. It is not that simple in banking, which is why we have regulation that is much moreintrusive on a bank than it is on your average industrial company. It is for that reason. It is whythere is this very difficult, delicate balance with the problem of moral hazard. To make moral hazard go away entirely is probably impossible. It is a tricky area.

—I want to refer to the new statement on the conduct of monetary policy thatwas signed in September 2010. As I understand it, the RBA added the following new text, which has not appeared in previous statements since the first one was signed by the former Treasurer.That statement is:

The Reserve Bank’s mandate to uphold financial stability does not equate to a guarantee of solvency for financialinstitutions, and the Bank does not see its balance sheet as being available to support insolvent institutions.

As you of course know, the RBA has a responsibility to serve as a lender of last resort to deposit-taking institutions that are adversely affected by these liquidity shocks, as it did during the globalfinancial crisis. If a bank can no longer fund itself because of an external shock and the RBA isthe only counterpart in the world willing to lend to it, how can this not represent the RBA usingits balance sheet to support insolvent institutions?

Mr Stevens
—The distinction, though, is between illiquid and insolvent, so, in the classiccentral banking setting, if an institution is illiquid but it does have assets it can pledge ascollateral the central bank, on the assumption that it has some reasonable look at the quality of those assets, can lend against them at an appropriate rate of interest. This is Bagehot’s classic—in a liquidity crunch, lend freely at a high rate to sound banks. We would do that. Nothing in thisstatement on the conduct of monetary policy changes that fact. The Reserve Bank will alwaysplay the role of provider of liquidity against collateral at an appropriate interest rate.The statement about not seeing the balance sheet as being available to support an insolventinstitution is making a different point. It is saying that we do not regard it as proper, and nocentral bank would, for a bank which is actually insolvent to be bailed out by the taxpayerthrough us. If it is going to be bailed out by the taxpayer, the government should make thatdecision and should fund it itself. We would probably have some role in facilitating that in theevent it occurred, but the government would have the credit risk, not the central bank. I think that would be, in central banking circles around the world, the way all central banks would think about it. So our role is in liquidity and we will always be prepared to do the right thing there bythe system and by participants in the system in a crisis, and we have done that and we basicallydoubled our balance sheet in 2008-09, for a brief period, for that very purpose. As to thefinancial rescue of an institution which is not solvent, there may or may not be a public policycase to do that but that is a government call. We would obviously give them our views if theyasked, but that would be their call, I think quite properly.

The full hansard has been Scribd by Peter Martin.

Saturday, November 27, 2010

Last week's hero, this week's villain

Some weeks ago BIS Shrapnel forecast 20% growth for house prices over the next 3 years. The research, sponsored by the mortgage insurer LMI, is looking pretty ridiculous. Indeed, there is a marked splintering in the bulls, with noted spruikers joining the bearish camp over the past month.

However, the bulls turned bears, the unbulls we'll call them, have for the most part stopped at the halfway house of a soft-landing scenario for housing.

Regular readers will know that that is the position occupied by this blogger based upon the hypothesis that we will replay on a national basis the 2003 post-FHBG Sydney process of falling prices in fringe suburbs stalling the move-up ladder and plateauing inner-city prices.

To say that this blogger finds it uncomfortable sharing his turf with a stampede of unbulls hardly sums up its chagrin.

The Australian's Michael Stutchbury is the latest to muscle in on the territory. Stutuchbury's piece runs through the now regularly rehearsed rubbish that there is no bubble, quoting the usual unbulls to prove it. To his credit he at least references some prominent bears too, including Jeremy Grantham.

But the sting in the tale is how Stutchbury concludes we'll engineer a soft-landing:
...the Reserve Bank now suggests that households remain "sensitive to possible future negative shocks to incomes, interest rates and housing prices". While there may be no bubble, that's code for saying that Australians have both borrowed too much and pushed housing prices too high for comfort.

The problem is that the Reserve Bank's interest rate hikes initially make things worse. The rate-sensitive house building sector is being crunched as the central bank pushes up the price of money.

Goldman Sachs' Toohey tips a further 15 per cent fall in house building approvals as the Reserve Bank lifts interest rates higher next year to keep inflation tamed amid the mining boom. Yet worsening housing shortages will push up rents, which in turn will feed into the consumer price index.

But the Reserve Bank documents suggest this is part of correcting the problem that "purchasing a house" has become "more expensive than renting a house".

That is, soaring house prices have way outpaced rents. That's depressed the yields on investing in housing; you can get more by just putting your money in the bank or even into Telstra shares.

That didn't matter when investors could confidently punt on getting a capital gain. But now houses cost too much for buyers and rents are too low for investors, even with strong population demand.

"It doesn't matter if two million people turn up next year," Toohey says. " If they can't afford it, they won't buy it. If an investor can't make a dollar, he won't build it."

With excess housing demand worsening, rising rents and softening prices will allow the housing investment yield to recover. That eventually will encourage builders and investors to construct more dwellings, zoning and planning restrictions permitting.

That's the theory. Treasury's Garton reckons high immigration means Australia's housing price correction is "more likely to occur through higher rents rather than lower prices", which would probably be the least painful option.

But it still means Australians should shelve their favoured investment strategy of negatively gearing into residential property in expectation of a big capital gain. It won't be there.

Although this blogger agrees with the final statement, it finds the reasoning quite bizarre.

On its own terms, the Garton theory is perverse. If falling prices and rising yields stimulate building investment then both prices and yields keep falling as supply caches up to demand.

Of course, it's wrong because of one further factual error.

Since when did an improvement in rental yield lead to increased investment in new dwellings? As the spectacular chart from The Unconventional Economist above shows, that nexus broke in 1987.

Investors have put nearly all of their money into existing dwellings ever since for the simple reason that they know that's where the capital growth is.

Factoring that in, the Garton theory is actually an argument for further house price growth. If investors/speculators hold onto their properties through the correction because rental yields rise (or there is enough talk of it happening) then confidence will rise that the shakeout is shallow and new investors will enter the existing dwelling market chasing the next growth cycle.

It will do nothing for supply.

It's a government supported bubble. If the speculators capitulate, it's gonna bust. If they don't, we'll have to wait for the government to bust for sanity to return.

Weekend reading

Contagion slowing. Ireland, Spain, Portugal, Greece.
European polity turning nasty. Bloomberg
And the global systemic risks of Ireland. Naked Capitalism, Alphaville, Zero Hedge, Baseline Scenario
Iceland vs Ireland. Paul Krugman
Why equities are falling. Bloomberg
Someone else is breathing. DataDiary
No oversupply coming here. FT
No housing bubble, banks strong, no issues with deficits. Gittins is asleep.
The soft landing for housing. Michael Stutchbury
Bank barf. Matthew Stevens
Capesize down 10% in two days. Dry Ships
Speculation Q1 ore contracts to rise 7%. Different to this blogger's guess. BusinessWeek

Weekend special: Financialisation of commodities (h/t Bear Feller for help)
ETFs are the new CDOs. MoneyHQ
Speculation and food prices. TWN
Controlling speculation. IDEAS, IDN
Energy market manipulation. Foreign Policy
China hikes commodity trading margins. Zero Hedge
The copper shortage lie. Mineweb

Friday, November 26, 2010

Glenn Stevens condemns bubble, banks, self

From the Glenn Stevens Senate testimony today, the SMH reports the following:
The boss of the Reserve Bank has stood by the actions of the major banks during this month’s latest round of mortgage rate hikes, saying banking is not like a normal business.

RBA governor Glenn Stevens was peppered with questions on the banks during his three-hour interrogation by federal parliamentarians today - aside from their usual quizzing on the economy, the international climate and interest rates.

The major political parties want to encourage banking competition in an attempt to guard against excessive interest rate rises by lenders in the future, but Mr Stevens said this was only good for customers to a point.

"Beyond that point, more competition isn’t good, because bankers get left to do things which ultimately do a lot of damage," he said. "Competition that pushes down lending standards, ends up lending money to people who really shouldn’t get it, that’s not a good thing."

This blogger agrees with the theme but not the method. Competitive private banks balanced with very strong regulatory constraints is what we need. Governor Stevens is defending private profits with public risk.

Moreover, It can't help noting, that some months ago our illustrious Gov argued in another speech that:
The big rise in debt in the past couple of decades has been in the household sector. There have been many reasons for that and, overwhelmingly, households have serviced the higher debt levels very well. The arrears rates on mortgages, for example, remain very low by global standards. As a result the asset quality of financial institutions has remained very good. So, to be clear, my message is not that this has been a terrible thing.

Fair enough this blogger supposes. Except for one thing. The principal cause of the debt explosion was rampant competition between many more banks and unregulated non-banks.

So what are we to conclude? What was good then is bad now. Or, what is good now was bad then? Or, that our regulators are using arguments of convenience to hide the banks' real vulnerability?

The gold bubble meme

Leon Gettler has a simple and neat summation of global macro today:
The global financial crisis has created two worlds.

First there is the real world of increased job insecurity, growing numbers of long-term unemployed, muted consumer demand and drip-fed credit

And then there is the magical world of bubbles. They seem to be everywhere, from Australian property to Chinese internet, from gold to notes for commercial real estate in the US. A tiny Chinese stock listed on the Nasdaq, China Media Express Holdings, which places TV screens on buses in China and bombards captive passengers with advertisements, has soared since mid-September.

The price of commodities like cotton, corn and soybeans and copper is going through the roof. And the high-risk junk-bond market has returned with a vengeance in the US. Wall Street, always big on grandiloquent verbal evasion, doesn't call them junk bonds: they're "high yield securities".

Bubbles lurking out in the economy are dangerous because they deny reality and suspend laws of supply and demand. When the price goes up, potential buyers pour in, expecting further increases. The combination of greed and leverage leaves markets chronically vulnerable.

Bubbles are created by a herd mentality and all bubbles in history are the same because regression to the magical thinking of childhood does not change. It underpins the belief that markets and those assets will keep rising. The financial meltdown has encouraged this because people are prone to slip into magical thinking in times of crisis.

The only way to make money from bubbles is predicting when they will burst. Their positive feedback systems make that impossible for most of us. I know the balloon I am blowing up or the popcorn I am cooking will burst, but exactly when?

We are now seeing several bubbles that could burst any time soon.

One of the most obvious is gold, which crossed the $1400 mark in recent weeks. The gold price recently slipped with the rally of the US dollar but the Irish bailout this week and the likelihood of the eurozone crisis spreading will keep it high.

Gold is the worst bubble of all. It has no real value. For almost every other asset in the world, the value comes from the cash flow it generates like, for example, the dividend of a stock or the rent from a house, flat or office building. But gold does not generate cash flows. The only thing driving it is fear and greed, the same stuff that drove internet stocks in the late '90s, and left them overpriced. Billionaire George Soros has called gold the ultimate bubble that will burst.

Other bubbles include Chinese real estate, with developers building more apartments than there are buyers.

Another is alternative energy. Think of all the venture capital-backed companies pushing solar and wind power when the economics of alternative energy are still problematic. Few wind and solar energy installations, if any, would make money without government subsidies.

Another potential bubble lies with the emerging markets that are growing wildly even though there's no growth in the world economy. Much of their gains are backed by commodity prices that are also in a bubble.

Probably one of the most alarming bubbles is US treasuries and bond funds. US national debt is now close to $US14 trillion. Treasury bills, basically the IOUs to pay off the money the US government keeps borrowing, are rising because the debt keeps building.

This blogger agrees with the general thrust of the piece, however, it sees things a little differently, basically because its definition of a bubble is also different.

Underpinning Gettler's analysis is the idea that a bubble is any asset the value of which departs from "the cash flow it generates". Ipso facto gold and Treasuries are a bubble.

This blogger defines a bubble a little differently. It is any asset that has departed from fundamental value, not cash flow value.

Fundamental value is a calculation based on a balance between return on capital and return of capital.

In a time of flailing fiat currency, grand monetary experiment in both markets and reserve banks, inflated and unstable paper assets, and global shifts in power, the weighting for 'security' grows against 'return'.

It's the same reason that US Treasuries aren't necessarily a bubble either, though more so than gold. The jury is out because ultimately, the answer to this question depends upon geopolitics not markets.

Don't get this blogger wrong, the gold market is very volatile and could sell off dramatically any time, but the revaluation of gold is cyclical only in the sense that history itself is so. If the you think the US is about to enter a new age of fiscal and monetary discipline, stable prices and unchallenged power then you agree with Mr Gettler.

If not, then you agree with this blogger, gold is undergoing a structural revaluation.

Links November 26: Gold bubble?

This does not look good. Ireland, Portugal, Greece, Spain
Irish nationalisation. Alphaville
China bearishness. M. Pettis, Un. Economist, Bear Feller
Australia's agricultural protectionism. Calyton Utz (h/t nakedcapitalism)
Recession quarter. Peter Martin
Cameron Clyne wants banks to listen. SMH
Should the RBA regulate the banks? Glenda Korporaal
Bubbles everywhere. Leon Gettler.
Gold sentiment. Mark Hulbert
WA property bust. Delusional Economics
NBN pricing under fire. SMH

Thursday, November 25, 2010

RBNZ calls a spade a ponzi

One of the advantages of having a small neighbour that shares the same banking system is that we can glance over and see what kind of shadow we cast. And it is daaaark indeed. From Banking Day today:
New Zealand is in a highly vulnerable macroeconomic position and may require a difficult transition, the Reserve Bank of New Zealand warns in a submission to the Government’s Savings Working Group.

“No-one is quite sure how much vulnerability a net international investment position of around 90 per cent of GDP implies,” the RBNZ says.

“But we are not aware of any other advanced country having had an NIIP position that high in modern times without some fairly difficult subsequent transitions,” the RBNZ said, referring to countries such as Portugal, Iceland, Spain, Greece and Hungary, many of which are currently making such difficult transitions.

New Zealand’s net international investment position was at 86.5 per cent of GDP at the end of the June quarter, up from 85.9 per cent in March.

The RBNZ notes that the main adjustment risk for New Zealand comes from the fact that the economy has gone through a debt-fuelled asset price boom and a period of strong consumption. A further challenge is the result of the government moving from a surplus to significant structural deficit. What makes this worse is the fact that this was financed by foreign capital in relatively short-term debt.

New Zealand’s saving grace, however, is its floating exchange rate and well-hedged debt, the RBNZ said.

But more than macroeconomic vulnerability, it is the country’s financial vulnerability that could have a serious impact, the RBNZ believes.

While the RBNZ judges that New Zealand banks and their Australian parents are well-capitalised so can cope with economic shocks, it can’t ignore the fact that both are heavily dependent on foreign wholesale funding.

However, if confidence in these banks were to be materially undermined, or if global markets were to seize up again because of wider concerns about adjustment pressures in Western countries, this could result in a substantial disruption to the flow of credit and risk. This would be a rather nastier real economic adjustment, the RBNZ said.

New Zealand continues to debate what we won't.

Pricing the miracle commodity

This blogger has attempted to reverse-engineer the major miners' quarterly ore pricing formula before.

It is not an exact science, but it has concluded that prices tend to rise in line with the average spot price of the trailing quarter, whereas when the price falls, they seem to lag the average.

In the same post, this blogger revealed from industry sources that the contract price for Rio is currently hovering in the high $150s per tonne and BHP slightly below that.

Looking at the current quarter (Q4) for clues to contract pricing for next (Q1), to date the average price in the quarter is around $153.4.

Therefore, with a month to go in the quarter, we're looking at a 2-3% correction in ore prices for Q1.

A key pillar of the terms of trade is looking strong another 4 months out.

Links November 25: Rally my butt

Extend and pretend in Irish mortgages. Alphaville
More contagion. Spain, Portugal, Greece, Ireland
Portugal and Spain. Eurointelligence
Spain. WSJ
Why austerity is wrong. Martin Wolf
Signs of life for US employment. Calculated Risk
Now its peak coal. Bloomberg
Offshore refinancing costs to worsen in 2012. SMH
Ore still ripping. Bloomberg
Weather the cause?!? Metal Miner

Wednesday, November 24, 2010

Who's to blame for bank populism?

Stephen Bartholomeusz writes:
The anti-bank sentiment unleashed by Joe Hockey and the weak response to it by Wayne Swan has now resulted in a coalition of re-regulationists, with the six cross-benchers pledging their support for the Greens’ dangerous proposals for "reform".

Now is the time for Swan and Hockey to renounce populism and make the case for a banking system that has served the economy well during a stressful and threatening period. It might also be useful if the bank regulator, the Australian Prudential Regulation Authority, defended the system it is responsible for.

The Greens have introduced a bill into parliament that seeks to re-regulate interest rates, abolish foreign ATM fees, mandate basic transaction accounts and mortgage products and limit fees. Today they were backed by all the cross-benchers.

The anti-bank sentiment whipped up by Joe Hockey is creating a political issue of such magnitude and momentum that it threatens to destabilise a sound but quite delicate system. Wayne Swan hasn’t helped defuse the risk that the government will be forced by the political pressures into doing something that could be damaging to the banking system, the economy and bank customers’ interests by referring to the "bad behaviour" of the banks and promising his own range of reforms.

All the banks have done is to (belatedly) pass on their higher funding costs and help the Reserve Bank tighten monetary policy, which is the RBA’s stated policy intention.

And fair enough too. This column does not agree with regulating interest rates or fees. Until we stabilise the system vis-a-vis its dependence upon wholesale funding, we remain at the beck and call of the banks foreign creditors. If funding costs were to rise suddenly for whatever reason capping bank revenue streams could result in dire outcomes, hastening government intervention.

However, it seems to this blogger shallow to blame this upon Joe Hockey. Although the shadow treasurer has been a bit inconsistent, he has by and large framed his statements as the need to reconstitute the deal between Australian society and its banks. He has not simple bashed the big four willy nilly.

The blame for the populism goes to Labour, the bureaucracy, the regulators, the banks and fawning media for hopeless governance. Since the GFC, all have endeavoured tirelessly to convince us that the banks are invincible and that there is nothing that needs investigating in the system. They did this even as the banks themselves demonstrated its falsehood in their radical new interest rate movements.

By basing post-GFC bank policy on such an obvious lie, the authorities, banks and media opened a vast credibility gap around themselves that was begging for someone with enough brains and gumption to drive through ot.

That Hockey has done so with a trailing of the uninformed is only an indication of how wide is the gap.

A transparent policy process rationally examining the issue arising from the GFC would have prevented all of this.

Son of Wallis Challenge

The bank debate is not going well.

Following the lead of our populist political class, the discussion has bogged down in the relative irrelevance of interest rate rises and whether or not banks should be allowed to move their mortgage rates more or less than the Reserve Bank.

The obsession with lowest-common denominator politics means the country is overlooking what it needs to discuss most: why the banks are in this position in the first place.

Since the global financial crisis (GFC), it has become increasingly obvious that the private financial services regime envisioned by the Wallis Inquiry has failed.

Wallis divided regulation of private credit provision into halves. On one hand, deposit-taking banks were regulated by the Australian Prudential Regulation Authority (APRA). On the other, market-mediated credit providers, like non-banks, werent subject to any particular rules at all.

During the meltdown, however, neither the deposit-taking institutions nor the market-based credit intermediators were able to sustain their independence as private firms.

Mid-tier banks and non-banks either collapsed or were eaten by the big banks. The remnants have been supported by government purchases of their securities via the Australian Office of Financial Management, to the tune of almost $16 billion.

The big banks required several Federal government guarantees across their liability portfolios. For both local deposits and wholesale funds.

As Shadow Treasurer Joe Hockey wrote in The Australian Financial Review yesterday, all of these supports were explicitly rejected by the findings of the Wallis Inquiry.

However, that is not the worst omission from the debate.

Since the GFC, the big banks have continued to expand their exposure to global capital markets - with ADIs now owing over $500 billion to offshore creditors.

As Westpac recently confessed and commentators are more frequently accepting, the banks are doing so in the confident knowledge that in the event of another global, regional or local freeze in their funding markets, that they will again be bailed out by a return of the wholesale guarantee.

Yet the banks use the excuse of these same offshore borrowings as rationale for unilateral interest rate hikes.

Now, as the frenzied but limited bank debate turns the populist heat upon the government, it is preparing a new set of measures to boost competition in the hope that that will prevent the banks abuse their new market power.

This has suddenly unleashed a stream of analysts, economists and vested interests who are campaigning for a Wallis architecture patch-up job by boosting government guarantees for securitisers.

This despite securitisation itself being central to the GFC collapse.

In short, the debate has so far failed to ask any of the most important questions posed by the GFC about our financial system, including:

1. What are the risks and benefits of large bank wholesale debt and how should each be addressed?

2. What,precisely, is the ongoing status of the Federal government guarantee to the large banks wholesale debts and what are the implications for the Budget?

3. Given securitisation was at the centre of the GFC, what role should it play in renewed competition?

4. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?

In the Australian Parliament there has been some encouraging movement toward discussion of these topics in the form of a Senate Inquiry.

However, the terms of reference of the Inquiry are as narrow and disappointing as the debate itself, focussed exclusively on the question of competition rather than larger questions such as how to address too-big-to-fail or the pitfalls of securitisation.

And trapped between a rampant Opposition and a lack of gumption, the government appears determined to ignore calls for a new Son-of-Wallis Inquiry, including in the well known 'six economists' letter.

There is, however, a place where the more important questions pertaining to our banks are being mooted and discussed: an emerging Australian markets and economics blogosphere.

This includes but is certainly not limited to the blogs Delusional Economics, The Unconventional Economist and this author's own blog, Houses and Holes.

That this is transpiring is encouraging but it is certainly not sufficient to carry the load of questions so central to the national interest.

Therefore, the three bloggers mentioned have combined with David Richardson of The Australia Institute to launch a private Son-of-Wallis challenge.

Each of us has contributed personal funds to a $1,000 prize for the best submission to the challenge. The terms of reference are as wide as you like but must address the four unanswered questions above in 1,500 words or less.

The judges of the prize will be the four financiers of the project plus Deep T., a senior financial services insider who is fed-up with his colleague's reliance on public support.

Enter your submission at sonofwallis@gmail.com or visit www.sonofwallis.com for more information.

Deadline for submissions is December 13th. The winner will be announced shortly afterwards, as well as published at BusinessDay.

Tap of the mernin' to ye

This blogger has a couple of thoughts on the Irish crisis.

Fact is, as hinted at recently, prima facie, it's much more attractive for Ireland to default. It's write-down now or zombify yourself through more debt and internal deflation.

This is pretty obvious and the Irish people may therefore be in a position to force their government to do it.

If the Irish default, expect carnage in the euro, a rocketing $US and the reversal of the global reflation trade around emerging markets and commodities. There'll be so much uncertainty about the other European nations' debt, as well as which banks are in the firing line along the daisy chain of derivative losses, that we'll be in a full-blown global panic before you can yell craic!

This is why in actuality, Irish default may prove a bad idea, even for the Irish.

And that's before we even contemplate the political fallout around Irish membership of the euro. They are going to need some kind of mechanism to boot the unworthy from the currency, either temporarily or permanently. This blogger finds it difficult to believe the Irish would dump it themselves.

The other possibility is that the ECB steps in and monetises Irish debt. EuroQE. That may stabilise things for a while but it is a precedent that would then be deployed in other fringe states as markets move on Portugal and Spain. In that event, however, the euro has joined the global currency war and will still destabilise the reflation trade because the $US rises, choking off its export recovery and dampening demand for emerging market goods, as well as reversing the monetary rocket under commodities.

Bailout is the only benign outcome for global growth and rising markets.

(Except iron ore of course which only ever goes up)

Links November 24: Contagion!

Yields up in Spain, Portugal, Greece, Ireland
Euro and risk currencies smashed. $US up. Barchart
Metals trimmed. Barchart
The Irish rebellion. FT
Ireland's TARP. Money Game
Ireland's mistakes. FT
IMF: Ireland must deflate internally. IT
What Ireland should do instead: default. Guardian, Bloomberg, NYT, WSJ
yuan trades against ruble. China Daily
US housing still stuffed. Calculated Risk
Block busted. SMH
Miracle commodity up again. Bloomberg
Indian ore exports collapse. Steel Orbis

Tuesday, November 23, 2010

Future shock

Bloomberg reported yesterday that:
New Zealand’s credit-rating outlook was lowered to negative by Standard & Poor’s, spurring traders to buy protection on the nation’s debt and snapping a three-day rally in its currency.

“The main risk to the ratings would be a significant weakening in the credit quality of New Zealand’s banking sector,” S&P said in a statement today. The South Pacific nation’s AA+ rating, the second-highest grade, is the same level as Hong Kong’s in the Asia-Pacific region.

New Zealand is in danger of a “prolonged” struggle to recover from the global recession due to diminished demand for its goods and services in the U.S., U.K. and Japan, central bank Governor Alan Bollard said last week. S&P highlighted the danger of a widening current-account deficit that leaves the country increasingly dependent on foreign capital.

“It’s a very slow, fragile recovery,” said Jarrod Kerr, director of rates strategy at Credit Suisse AG in Singapore. “It’s just another warning shot for the government.”

For the rest of the article go here. For something a little different, let's travel down the wormhole to the year 2013 and a destination that this blogger fears could await us. (It only took replacing a few names and numbers, in bold):

Australia's credit-rating outlook was lowered to negative by Standard & Poor’s, spurring traders to buy protection on the nation’s debt and snapping a three-day rally in its currency.

“The main risk to the ratings would be a significant weakening in the credit quality of Australia’s banking sector,” S&P said in a statement today. The South Pacific nation’s AA+ rating, the second-highest grade, is the same level as Hong Kong’s in the Asia-Pacific region.

Australia is in danger of a “prolonged” struggle to recover from the global recession due to diminished prices for its commodities, central bank Governor Guy Debelle said last week. S&P highlighted the danger of a widening current-account deficit that leaves the country increasingly dependent on foreign capital.

“It’s a very slow, fragile recovery,” said Credit Suisse AG in Singapore. “It’s just another warning shot for the government."

Australia’s currency fell to 44 U.S. cents as of 5:07 p.m. in Sydney, having reached as high as 44.2 cents earlier today. Credit-default swaps on the nation’s debt jumped 8 basis points to 150 basis points as of 4:23 p.m. in Wellington, according to National Australia Bank Ltd.

Australia’s 10-year-bond yield rose 8 basis points to 7.75 percent as of 5:06 p.m. in Sydney, the highest level in six months, according to data compiled by Bloomberg. Longer-dated Australian bonds are likely to underperform shorter-dated debt “as the market builds more risk premium” into securities with longer maturities, said CSA.

Debelle said in a twice-yearly report this month that the recovery has been “tepid” and household spending remains constrained. In September, he lowered his 2013 growth forecast to 1.6 percent from 2.1 percent and said the expansion will probably be slower in 2014. Last month Debelle kept the benchmark interest rate unchanged at 1.5 percent.

S&P said Australia’s current-account gap is forecast to widen, and average 6.2 percent of gross domestic product over the next three years, from 3.9 percent in the 12 months to June, as the economy recovers.

“This implies further rises in Australia's external financing needs that are already among the highest of any Standard & Poor’s-rated sovereign,” the company said today.

Finance Minister Andrew Robb said S&P’s move highlights the need to reduce the nation’s reliance on foreign debt.

“This is a long-standing problem for Australia and has left us vulnerable as a country,” he said in a statement. “The government is taking steps to reduce this external vulnerability and to move the economy towards savings and exports.”

Australian policy makers are looking to exports, which make up 15 percent of the country’s $1.5 trillion economy, to boost growth as domestic spending and housing remain sluggish.

The Reserve Bank of Australia said this month that the reliance of the nation’s banking sector on short-term wholesale funding from international markets was exposed as a ”key vulnerability” amid the global credit freeze.

“A further weakening in the recovery has the potential to generate further loan losses in the banking system,” the RBA said. “House sales have stalled for the past six months, and there are signs of prices falling again. Were this to be accompanied by renewed weakness in the labor market, some mortgage borrowers would find themselves in a position of financial stress.”

Just sayin...

The death of Invisopower!

In today's AFR, Joe Hockey makes a simple and elegant argument for Wallis:
The Wallis Inquiry formally rejected government guarantees of private companies (including deposit guarantees) for fear of inducing irreversible "moral hazards". These risks found in all insurance markets where the availability of such protection has the perverse effect of encouraging beneficiaries to assume abnormally high risks by playing the "heads we win, tails the taxpayers lose" game.

Yet during the global financial crisis, Australian taxpayers were compelled to deploy more than $850 billion worth of guarantees of the liabilities of private financial institutions. About $690 billion worth of guarantees of bank deposits were put in place because of concerns depositors were rapidly withdrawing savings from smaller banks, potentially precipitating a run on the wider system.

This insurance was provided to the banks for free - no premium was paid to taxpayers. A further $163 billion worth of taxpayer guarantees of the banks' wholesale debts was furnished to allow them to leverage off the commonwealth AAA credit rating. The Reserve Bank of Australia also supplied the banks with $43 billion worth of finance on advantageous terms via its "repo" facilities, which used the banks' home loans as collateral for the first time. Finally, taxpayers committed to inject $16 billion to support the private residential mortgage-backed securities market.

At its most basic level, our financial system was not designed with taxpayer guarantees in mind. So it needs to evolve so that it can appropriately respond to, and manage, these new risks. The time has therefore arrived for a root-and-branch review of Australia's financial system.

Any regular reader of this writer will understand the deep sense of satisfaction it feels that a political leader has offered this pellucid reasoning for a new Wallis Inquiry. It has made the case for new scrutiny of the not-that-well-hidden regulatory fallout from the GFC in these terms for two years in different fora, with almost no support.

It co-wrote the book on the bank's role in the GFC. It beavered away at the topic at its original blog which became The Distillery column at Business Spectator.

At The Distillery, it fearlessly pursued Australian commentator's universal espousal of triumphal bank rhetoric. And it was the first to declare that the Australian banks were the new GSE's, a point of view now shared by all serious analysts.

Then, of course, it donned this current helmet and enslaved itself to the Sith Lord that is blogging.

Forgive it for this huge trumpet blast of self-congratulation but taking this stand was not always easy and today the truth does out.

RSPT anyone?

Via Peter Martin, here's an outline of Joe Hockey' terms of reference for a real Wallis Inquiry. They're a bit tilted towards how do we keep the 'whole ponzi going' and the greatest omission is any mention of mortgages but actually they are pretty good. And wide enough that anything missed will get in anyway.

The government is on a real loser here. The longer they delay, the stronger Joe gets. And he has the people on side.

The vested interests, however, are already well into their campaign against scrutiny and expect it to ramp up as the Wallis chant grows louder.

Just as they did in the case of the RSPT, Business Spectator and The Australian will lead it. Already both have done their level best to silence the debate, with Stutchbury, Hewitt, Albrechtsen, Stevens, Kohler, Bartholomeusz and Gottleibsen all arguing or fear-mongering against change. They really should get on with the mooted merger, those two. Today's strategy is clearly to ignore Hockey, presumably because he's making so much sense.

The Australian has begun trotting out quotes from fund managers threatening doom if we dare inspect our own financial services system.

Since when did transparency and disclosure harm markets?

In a bizarre parallel, however, the bank troglodytes have one advantage. It looks like we're about to run headlong into another global equities rout based around European contagion.

That is not going to support the political environment for change.

Links November 23: I said, SHUT IT DOWN!

Joe's terms for Wallis. Peter Martin
Fear and loathing of Joe. The Australian
Joe the idiot. Hewitt, Bartholomeusz
Ken Henry embraces Dutch Disease. Peter Martin
US austerity drive. Bloomberg, Krugman
US bank face $100 billion BaselIII shortfall. FT
US housing shadow inventory. Calculated Risk
How Ireland's bailout works. Reuters
Europe in real trouble now. Bloomberg
The greatest central banker of our time. RCM
The coming coal crash. John Garnaut
Versus this. NYT
Copper bubble farce. Businessweek
Versus the supply argument, which doesn't canvass speculation. Metal Miner
Gold ETFs bulging. Bloomberg
Deep T's attack on ratings. Delusional Economics

Monday, November 22, 2010

The Claytons Inquiry

It's the Wallis Inquiry you're having when you're not having a Wallis Inquiry.

And Stephen Bartholomeusz outlines it today:
Earlier today Suncorp’s chief executive, Patrick Snowball, made a considered contribution to the debate, noting that since the crisis all the banks had diversified their funding and reduced their dependence on offshore wholesale funding markets.

"This change in the funding mix is important for Australia and a step in the right direction. It does not change the facts that the costs of this funding mix are higher; international debt and equity markets remain stressed; local supplies are not unlimited and funding is the key structural issue for Australia’s financial system," he said.

"This funding issue cannot be addressed quickly or without a comprehensive and non-partisan review. Broadening the range of competitively priced funding options would be the most effective way for the government and regulators to increase bank competition."

Snowball said that funding reforms lacked the immediate political appeal of regulating rate rises and bank fees but were vital rather than optional and would improve competitiveness.

Snowball is right. The crisis exposed the vulnerability of our system to the closure of offshore wholesale markets and it shut down our securitised debt markets.

Responding to that revealed vulnerability ought to be the priority and the primary focus of policymaking – and the probable need for greater government intervention in domestic capital markets tends to suggest a formal inquiry is required.

Hockey’s suggested terms of reference are broader than they need to be, but it would also be worth asking an expert committee to consider the implications of the explicit government guarantees provided during the crisis and the implicit guarantees that continue.

There isn’t a need for another big Wallis-style inquiry into every aspect of the system including its regulatory architecture but a focused investigation of the funding risks for the majors and the lack of access to funding of their competitors and the distortive and potentially dangerous longer term effects of the guarantees might produce some valuable insights and reforms.

Whether it did or didn’t, it would produce the major benefit of shutting the populist politicians up and preventing them from continuing their dangerous meddling in affairs they generally know little about but whose functioning and stability – and profitability – is vital to the economy.

Any regular reader of this blog will know that it is in complete agreement with Bartho's focus. He's one of the only other analysts out there that has consistently given thought to liabilities.

However, one has to ask, how exactly can you isolate an expert examination of financial system funding issues without fundamentally addressing Australian financial services architecture?

The Wallis structure of securitisation-funded entities competing with deposit and wholesale funded entities is the fundamental design created by Wallis. A Claytons Inquiry is a great way to pretend to address the many funding issues like excessive offshore borrowing, unstable marketable securities, moral hazard etc. before just reshuffling government guarantees.

But if you really want to get to the bottom of the risk and give it back to the banks, then you may well need new architecture. You certainly don't want to rule out the possibility before you've started.

We need a full-flavoured, overproof Wallis Inquiry.