Thursday, December 23, 2010

Son of Wallis Challenge (SOW) Winner - Kaon Li

A long time ago, there was a farmer who broke his hoe while farming. He took his tool to the blacksmith but he did not have the one gold coin for the repair. The farmer promised the blacksmith to pay double after the harvest, but the blacksmith was a cautious man and refused the offer.

Facing total ruin, the farmer attempted to drown himself by walking into a lake. As the water reached his neck, an apparition appeared in front of him.

“I am the fairy of the lake. Why do you seek death?”

Overcoming his initial shock, the farmer told the fairy his sorry tale. The fairy considered the situation and told the farmer: “I shall give you a gold coin tomorrow, if you promise you’ll give me two gold coins after the harvest. Be warned!! If you fail to provide the coins as pomised, you will be cursed!!”

Elated at his salvation, the farmer gave up all thought of suicide and returned home.

That same night, the fairy appeared in the blacksmith’s dream. “Blacksmith”, said the fairy, “throw a gold coin into the lake tomorrow, and you’ll receive two gold coins after the harvest”.

The blacksmith woke up next morning and threw a gold coin into the lake as urged, which the fairy in turn handed to the farmer. The gold coin allowed the farmer to repair his hoe to grow his crops. At harvest time, the farmer sold his produce and returned the two gold coins to the fairy. The blacksmith was visited in another dream from the fairy to collect his two gold coins, and everyone was happy.

The fairy’s name is banking. When people don’t believe in fairies, the banking system collapses, and we have a financial crisis.

The wholesale funding guarantee offered by the Australian government was the ‘least worse’ option during the GFC. The Irish government started off a global bank run when they guaranteed the liabilities of the Irish banks. After that, only government guaranteed banks could borrow.

While giving certainty to foreign investors during a crisis is critical, the current government guarantee is a lousy way of doing it. It is crony capitalism: profit is privatized, risk is socialized. Although the risk does not show up on the balance sheet of the Government, it is there nevertheless and, as Ireland has shown, it can cripple a country.

The guarantee saved the Australian financial system, however it cemented the ‘too big to fail’ status of the Australian banks. The cost paid by the banks to the Australian government for the guarantee did not and does not address ‘moral hazard’. The banks simply pass the cost along to Australian borrowers.

We need a better deterrent mechanism.

With the global economy stablizing, it is time to ask why the Australian government guaranteed wholesale debt at 100% anyway? If the investor wants 100% security, they should be buying Australian Government bonds. We need a scheme that can impose a ‘haircut’ on the bond holders. My proposal is for the Australian government to support the bank wholesale fundings with a variable 3 month bond swap option. Let me explain how it works.

All wholesale funding of Australian financial institutions will now receive a partial government guarantee. The value of the guarantee with depend on the maturity and credit rating of the institution, and it’ll change every day. For example, a ‘AAA’ bond from one of the big 4 will be guaranteed up to 97c, but Bendigo Bank will only be 95c to the dollar.

The guarantee takes the form of a swap option with a Government bond in 3 month’s time. If the bond holder chooses to exercise the option, the interest rate for the previous 3 months will be forfeited, and the bonds will be exchanged. The bondholder can also hold onto the bond instead, costing them nothing. In effect, it’s a free insurance policy for the bondholder with an excess of 3 month bond revenue.

However, the guarantee is not costless. If the bond is swapped, the financial institution will automatically issue a preference share to the Government of the same value. If the total value of the preference share exceeds the market capitalization of the bank, it’ll become Government owned.

Loss of ownership is a powerful antidote to moral hazard.

Furthermore, a number of ‘phantom board members’, in proportion to the total amount of government guaranteed funds, will be added to the financial institution at their AGM. The phantom position will be filled by a selection of members from the Federal parliament. The spectacle of Bob Katter speaking his mind to the CBA board at the AGM should make the bank very, very reluctant to abuse the facility.

It’ll also make great television.

Beyond the ability to enforce haircuts, the swap option also allows the Australian government to signal the market by adjusting the option swap. By decreasing the guarantee amount, the market will buy less wholesale bonds, and vice versa. Ater all, the market loves complicated yield curves. Unlike CDS, the option swap is also impossible to turn into another ‘financial derivative’ because there is no revenue stream!!

After tackling the issue of wholesale funding, let’s move on to mortgage securitisation.

Securitisation worked in the US for over 70 years prior to the GFC. Originally it served an important role of spreading geographic risk due to the fractured nature of the US banking system. The system failed when the rating agencies start giving fraudulent mortgages a ‘AAA’ rating. They forgot what a mortgage is. A mortgage is a contract based on a person’s ability to pay, backed up by the house. The financial institutions got it backwards, and treated mortgages as loans on the value of the house, backed up by the mortgage holder.

Mortgages for people with no income, no assets, or job should not exist. It is fraud. To prevent a recurrence, we need much stricter criteria on which mortgages can be securitised. This can be done by requiring the mortgages to be at least 3 years old, and with 25% paid off.

As more of a mortgage is paid off, the risk of the mortgage defaulting decreases, so the interest rate should decrease as well. Currently the interest rate charges remains the same throughout the loan, which is a loophole. The proposed system uses lower interest rates as a reward for those who qualify for securitisation. This will encourage the mortgage holder to obtain a mortgage they can afford, and discourage equity loans. To further balance the risk, those with a larger market share must keep their loans longer before they can be securitised. This will prevent the banks from hogging the housing market, and they might even start lending to business again.

It will also means Australians will live in smaller houses. With our population increase, that is what we must do. The current lifestyle is unsustainable.

Now some notes on Wayne Swan’s proposal.

The elimination of exit fees discourages competition. The banks are winning market share because they can get their money cheaper. This in itself is not a bad thing, except the big 4 are pushing a housing bubble instead of lending to businesses. APRA should impose a higher capital ratio on banks who lend too much to a particular sector, but that is totally missing in the plans.

The GFC was caused by a lack of regulation, and the Australian Government want to solve the problem by LESS regulation? The ‘covered bond’ idea is stupid and dangerous. ‘A’ rated financial institutions cannot create a ‘AAA’ security except through a flawed mathematic model: the kind of model which lead to the GFC. Also, deposits are government guaranteed, so creating this ‘ultra special’ class of creditor means taxpayer ends up the loser.

Securitisation removes the risk from the financial institution. With a covered bond, the risk remains while the asset is reduced. It’s a con job.

Finally, when you lower the interest rate, the Reserve Bank simply have to raise the interest rate more to get the same effect on the economy. What is the logic of that? It is not the job of the Australian government to encourage people into buying a bigger house that they cannot afford. What Australia needs is a mining tax to slow down the mining sector, and lock up all the tax proceeds so it does not overheat the economy.

What Wayne Swan and Hockey offer is nothing but crass economic populism.


Anonymous said...

Great work Kaon

Joe M. said...

Brilliant! The bonded guarantee is one of a kind and would instantly focus the minds of our banking Dear Leaders on their own survival. Presto! The return of accountability.

But even without that, any one of your suggestions by itself would be a huge step forward. Bravo.

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