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.