Friday, November 19, 2010

Reviving the dodo

Yesterday Ian Harper, one of the minds behind our failed Wallis Inquiry financial services architecture, wrote in the AFR that "More needs to be done to redress the current imbalance between stability and competition in the Australian banking system. Effective stability has returned, however competition has not revived, in part due to the lingering side effects of measures taken during the global financial crisis to secure stability".

This follows on from recent comments by Nicholas Gruen in a similar vein.

Let's get one thing straight. Securitisation is not some innocent victim of the GFC. It was the GFC.

Securitisation - the bundling of loans and shifting of risk - was the single greatest cause and defining feature of the crisis.

The other causes, global imbalances, greed, asset manias are old stories of capitalism.

But never before have we had a global swath of derivatives of sufficient magnitude to wipe out private competition permanently.

To help understand this, we need a brief history of securitisation in Australia. Some of it is drawn from The Great Crash of 2008, this blogger's co-authored book with Ross Garnaut.

It took government intervention to get the non-bank lenders into business. In 1987, the New South Wales Government sponsored the formation of the First Australian National Mortgage Acceptance Corporation. At the same time, the Victorian Government established the National Mortgage Market Corporation. Both operations were subject to 26 per cent government ownership, with the remainder spread among a range of shadow bank players, including investment banks, building societies and unit trust managers. Not to be outdone, the Queensland Government legislated the Secondary Mortgage Market Act to support a program for ‘originators’ in that state. One private provider was also founded to compete with the new government lending shops: MGICA Securities, a subsidiary of AMP Ltd.

These early initiatives came to grief in the bond market meltdown in the lead up to the recession of 1990–91. The government operations in particular were hit hard because they had exposed themselves to a huge refinancing risk. The NSW and Victorian operations were ultimately sold to the private sector; the Queensland market was stillborn. The shadow banking phoenix rose from these ashes in 1992 when John Symond founded Aussie Home Loans with the backing of Macquarie Bank, and John Kinghorn launched RAMS with the support of Citibank.

As with non-bank lenders in the United States, Aussie Home Loans and RAMS relied on investment banks to manage the securitisation process. From the mid 1990s they generated securities similar to the Wall Street MBS, called residential mortgage-backed securities (RMBS). The securities were generally bought by a mix of local and foreign investors. They were extraordinarily successful, seizing 7 per cent of the outstanding mortgage market by 2006.

The non-bank lenders had no regulator and no rules outside of regular trade practices and corporate law. And with investors globally becoming more accustomed to shadow banking, the standards that determined which Australians were creditworthy began to erode. The shadow bank lenders first introduced low-documentation or ‘low-doc’ loans in 1997, then ‘no-doc’ loans by 1999. Subprime or ‘non-conforming’ loans, given to people with bad or impaired credit histories, also proliferated in the late 1990s. Subprime specialist non-bank lenders like Liberty Financial and Bluestone grew swiftly and issued subprime RMBS. These securities first appeared in 2000 and by the end of 2006 some A$6.8 billion had been sold. The market was growing at 150 per cent per annum and looked set to burgeon.

The growing network of mortgage brokers held no deposits, had no reputational risk and was paid by fees for mortgage volume. Amidst the rising arrears rates for Australian RMBS, the highest levels of default were apparent within broker-originated loans. Endemic malpractices included getting clients to sign blank declarations of affordability (and income if relevant) and then working back to how much the client needed to earn to afford the loan.

When the market was in its mania, there was little subtlety in this practice. Audits of the files would readily demonstrate differences in handwriting. Some remarkable outcomes eventuated. Elderly applicants, either retired or in blue-collar occupations, were claiming to have extraordinarily high incomes. GE Money introduced what it called a ‘sanity test’ to forestall these types of occurrences in 2005. Another trick in the fraudster’s handbook was to put up the application as an investment loan (therefore getting the benefit of the potential rental income to augment serviceability) when it was clear that the application was actually for owner occupation. This went hand in hand with the practice of ‘necking kids’; that is, not declaring dependents to increase the applicants’ available income.

In 2007, the Federal Court ordered one mortgage broker to pay a former client A$32 000 in compensation after the broker falsified documents to ensure a A$365000 mortgage for the 20-year-old, unemployed, dyslexic and homeless man. The same broker was in court for similar abuses in 2009.

And the above is not even the worst of it. The mortgage frenzy created by the non-banks drew in the banks, who borrowed enormous sums of money offshore to compete and laid waste to their own credit standards. This is the core of the Great Australian Housing Bubble.

What we need now is an inquiry and new regulation for those banks that mitigates the risk in the offshore borrowing. Authorities should allow mortgage securitisation to die, as the market clearly wants it to. If we want more competition, then create new banks and deposit incentives. At least that way we also get more business lending.

Ian Harper concluded yesterday's treatise by arguing that "A clear signal must be sent that the banks are not he only game in town and that government will support securities markets to a measured extent as well."

It is astounding that some of our economic leaders want to just do it all again, this time risking the national Budget.


The Lorax said...

I really should buy your book.

Torchwood1979 said...

I just got my hands around a copy, looking forward to some good reading material on the train.

Amongst all the economic arguments the problem with securitisation is primarily a moral one. Namely, that the people issuing the loans don't have to wear the consequences. The mortgage broker still gets their commission and the bankers get fat bonuses, but when reality catches up it's the taxpayers who are left with a massive clean up bill.

The following gem makes the point quite succinctly.

Richard F said...

Chris Joye actually covered Harper's article nicely sometime before you did:

Bear Feller said...

@Richard F, Chris Joye is also set to "nicely" benefit from any RMBS guarantee.

Septimus said...

Great post - vital info - thanks.