Cash explosion

Reuters reports today that:

Mining giant BHP Billiton Ltd has begun auctions for spot iron ore shipments to Chinese steel mills, local media reported on Friday, marking the latest shift in its pricing strategy to cash in on rocketing prices.

BHP, the world's third largest iron ore producer, has started to auction a 170,000-tonne spot iron ore shipment every fortnight to Chinese customers, the China Securities Journal reported, citing a procurement manager at an unidentified steel mill in southern China.

A tight supply market, combined with fast-rising spot prices, meant that BHP was unwilling to extend even quarterly prices to new customers, the paper reported, forcing many steel producers to buy iron ore either priced on a monthly basis or to take extra spot market shipments.

Spot iron ore prices were on course to hit an eight-month high on Thursday, after all major price indexes rose to trade as high as $US184 per tonne, powered by sustained Chinese buying and supply concerns as a tropical cyclone threatens to interrupt production and shipments in Australia.

Last March, all three major iron ore producers, including Vale SA and Rio Tinto Ltd, agreed with Asian customers to shift pricing for the majority of its iron ore to shorter term contracts based on market-cleared prices and on a landed basis.

According to this blogger's calculations, the Dec10 contract price was around $142. The average for the quarter was in the mid $150s. A 8-9% rise was looking a fair bet for Q1 2011.

However, the current spot price is headed inexorably through $180 per tonnes. if BHP can force through these monthly contracts, presumably based on the trailing average of prices for the previous month, then the price is going to rise into uncharted territory very quickly.

In the 09/10 year, we exported 266 million tonnes plus of iron ore to China and another 124 million or so elsewhere. Rising prices go straight to the bottom line so we're talking roughly an extra $390 million income for every $1 rise.

According to a 2005 RBA study that money is distributed thus:

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.

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. These are mostly at ad-valorem rates, and although there is substantial variation in rates and dei nitions, they probably imply that around 5 per cent of additional revenues from higher commodity prices typically accrue to state governments. More signii cantly, based on the statutory corporate tax rate, up to 30 per cent of the increase in proi ts would be payable in corporate income tax to the Australian government. The higher level of proi 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 fiscal positions are held roughly constant, the increase in revenues 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. This is probably somewhat higher than at the time of earlier resource booms.

The expansionary effect of these income flows on the Australian economy can be expected to operate through a number of channels. Higher dividends and capital gains accruing to domestic shareholders will feed into household income and wealth and, over time, into household spending. More importantly, higher commodity prices are likely to have substantial effects on the behaviour of resource producers, assuming that the price increases are not viewed as completely temporary.

Australia may be taking a hit from the dropping coal volumes and flood damage, but as reconstruction stimulus begins, and coal shipments resume, these incredible terms of trade developments are going to pour cash over everything.

The RBA may want to look through short term inflation spikes but it will do so at its peril. La Nina is setting the stage for a giant Australian blowoff.

Guest post: La Niña, the black swan

This week’s disastrous floods in Queensland have tragically claimed many lives in addition to leaving thousands homeless and without businesses to return to, but the biggest cost economically may be felt abroad. I’m not talking about reinsurance here – though that is indeed an issue considering the estimated $5 billion damages bill – but about the disaster’s ramifications for the price of food and the price of energy: two issues that I see as defining for 2011.

Queensland’s floods may also be just the tip of the iceberg, so to speak, of a much larger weather phenomena that could in turn further exacerbate food and fuel inflation: a ‘super La Niña’ of a size and scope which, according to US meteorologist Art Horn, rivals the La Niña pattern of 1973-4, when Queensland and its capital city Brisbane last sank under a flood of today’s magnitude.

Horn's arguments on the current La Niña bear careful consideration not just because of the potential ramifications for global markets, but because they are being echoed by others from Neville Nicholls of the Australian Meteorological and Oceanographic Society to the always thought provoking John Clemmow of UBS, who discusses the Australian Bureau of Meteorology’s latest ENSO (El Nino Southern Oscillation) report. And, as Adam Mann discusses in Nature, conditions are likely to remain abnormally cool and wet in Australia, while windy and dangerous in North America’s hurricane belt for some months yet.

That doesn’t bode well for coal, of which Australia is the top global exporter, or for oil, of which a significant share comes from the hurricane-prone Gulf of Mexico and Caribbean.

When we consider the impact of other previous super La Niñas, whether in 1955, when epic floods stormed the Pacific North West and New South Wales, 1917, when the Ohio River froze over and the seeds of the 1918 pandemic were arguably sown, or as recently as 2007-8, when food prices reached previous records, the situation bodes even less well.

Simply put, a glance at La Niña’s previous appearances shows up a pattern of dramatic climactic risk, especially at a time when food and fuel are already commanding high prices. Figures from the UN’s Food and Agriculture Organisation, for instance, show that prices of staples are already higher than the peak in 2008, while both Nicolas Sarkozy as chair of the G-20, and World Bank president Robert Zoellick have put food prices at the top of the agenda.

Brent crude, meanwhile, is nearing $US100 a barrel on lower US stockpiles, a leaking Trans-Alaskan pipeline and unsure political situations in Sudan, Belarus and Lebanon.

And these are merely the supply-side issues of a weather phenomenon that cuts both ways. In terms of example, Bloomberg reports that heating oil futures are at a 27-month high on snowstorms in the US, while in China what Xinhua describes as the most extreme weather in ten years is adding impetus for further food price controls.

In India, meanwhile, there’s an onion crisis, Indonesia’s government is encouraging citizens to grow their own food, South Korea has released emergency supplies and deadly riots have broken out across the Maghreb.

But the issues, as it were, keep rolling in. The US Department of Agriculture has just released data reducing soybean and corn estimates, sending futures in those products to 30-month highs.

No doubt the Ponzi scheme of derivative trading, much of it cornered, is adding to the volatility of these commodities.

Yet you cannot argue that we’re seeing a bubble. On the back of Queensland’s floods, analysts from National Australia Bank are now expecting an increase in Australian fruit and vegetable prices of 30%, adding 75 basis points to the March CPI. This, alongside the blockage of Queensland grain ports – which comes in turn after estimates that half of Australia’s wheat harvest could be downgraded to fodder or milling grain – spells further chaos.

Amid dangerously accommodative monetary policy in the US and China, where the latter's M2 money supply has surged by some 20% in the past year, inflation matters dearly. As Patrick Chovanec from Beijing’s Tsinghua University's School of Economics points out, the recent fall in China’s CPI from 5.1% in November to 4.3% in December is a misleading indicator, due to the ultimately unsustainable retail food price crackdown and tepid cash rate measures. And as fellow expat academic, now securities strategist, Michael Pettis, writes this week, no lending quota – China’s de rigueur disinflationary measure – has yet to be set, much to everyone’s surprise.

China is caught between fuelling an economy based on cheap exports and fixed investment with arguable social returns, and the commodity inflation that this development model drives.

These concerns have been noticed by John Berthelsen and Benjamin Shobert, who respectively write that China faces grave social risks from food price inflation and food insecurity as a result of imbalanced economic policy, poor agricultural practices and the effects of climate change and deforestation. Shobert furthermore notes: “of the 13 major famines China has endured, six have been inexorably inter-related to political upheaval and conflict. China’s current leaders are aware of this part of their history,” he writes, “which is why the government’s stated goal of ‘95% self-sufficiency’ [in food supply] is deemed so critical.”

As much as the mainstream press likes to focus on China’s stranglehold of rare earth materials, the real danger in an era of trade wars and rising commodity prices is China’s dearth of food and fuel supply. China’s policy reaction to these challenges will be the ultimate determinant of whether the New Year ends in growth or ends in recession.

It is in this context, perhaps, that China has been spending so much money on its new J-20 stealth fighter plane, tested by the People’s Liberation Army as US Defence Secretary Robert Gates was meeting China’s civilian leaders in Beijing, and on its naval ‘string of pearls’ strategy. Both as a potent symbol, and as a latent weapon, China is acquiring the means to ensure commodity supply well into the future. Suddenly America’s foreign policy in the Middle East doesn’t look so unique.

Of course the only thing that China cannot defend itself against is the whims of the planet and it seems ironic indeed that the place from where climate changing coal was mined has now been inundated by epic flood. Following a Malthusian act of nature, highly combustible coal has been tossed onto the blaze of the world's growing commodity inflation.

And with La Nina still skipping coolly across the Pacific, more may be yet to come.

It would indeed be the ultimate black swan if La Niña pushed Chinese inflation into a cycle-busting inflation spike.

Flashman is a galavanting Australian poltroon working in the funds management sector.

Links January 14: Food crisis

US crop downgrade. WSJ
Looming food price shock. FT
US PPI goes bananas. Econompic
Agencies warn on US debt. WSJ
$US smashed. Bloomberg
Boooooring. France, Germany veto EFSF extension. Ambrose
All PIIGS bonds rally.
US trade deficit shrinks. Calculated Risk
Oil shocks. Econbrowser
Australia's employment flood. Peter Martin, The Oz
Chinese auto bubble. CNN
Ore soaring on cyclone, supply. Reuters
This bastard's headed for records. Bloomberg

Inundated houses

In the year following Hurricane Katrina, something unexpected happened to New Orleans house prices. They rocketed 27% over a period of months. According to USA Today "displaced residents bid up median prices".

This blogger thinks it unlikely that we will see such a dramatic price escalation in Brisbane. The floods are not as serious nor as persistent as those that afflicted New Orleans. The clean up will be more swift too. Another major difference is that this event is associated with a 20-30 year major La Nina. It is a climate system that is well understood and not indicative of a frequent danger. New Orleans, on the other hand, had been dodging hurricanes for years and there remains a very real prospect of another any given year.

So we can expect less damage and less displacement.

Nonetheless, in the short term, we might still expect flood inspired sales and movement. And in that sense there may be a pick-up in housing turnover and perhaps price shifts accordingly.

Following the Brisbane floods of 1974/5, the median price in the city did jump 19% (according to this Macquarie Univerity paper). This was well ahead of Sydney at 8%, Melbourne at 12.5%. But not far ahead of Adelaide at 18%, and behind Hobart at 26% (Perth figures are similar but appear unreliable).

This blogger is hesitant to conclude anything from these figures beyond the fact that the nation was caught up in a housing boom.

Following it's sudden 05/06 house price surge, however, New Orleans has faced sequential years of declining prices. Needless to say, this deflation mirrored broader falls in US housing. A condition playing out on a longer time frame here in Australia as well, with a particular concentration in and around Brisbane.

But there has been one factor in New Orleans that has effected greater falls at the top-end of the market that may play out in Brisbane as well. That is the cost of insurance.

Yesterday Business Spectator has a decent take on the likely economic fallout from the floods. But the one paragraph stuck this blogger as unrealistic was the insurance fallout:

To date the floods are located in more sparsely populated regions minimising the economic impact. Approximately 800,000 people live in the broad region affected by the flooding.

Robert Whelan, chief executive office of the Insurance Council of Australia estimates that while this is a major weather event, due to low population densities in the region, it is a moderate insurance event. Preliminary estimates suggest insurers will receive about 4,300 claims and pay out about $150 million. By comparison, the industry received about 161,000 claims and paid out about $1 billion dollars after a 20 minute Perth hail storm early last year.

The operative quote being "to date". According to the ABC, 3,000 homes were inundated in Ipswich alone yesterday and "already thousands of homes in some Brisbane suburbs have waters past the second-storey after Wednesday's peak". AP reported that in Brisbane, "a total of 14,600 homes and 2,800 businesses are expected to be flooded and at least 50 suburbs affected."

Thankfully, reports this morning suggest the flood is below 1974 peaks but the preliminary insurance estimate is still very optimistic. Insurance costs in flood-effected districts are going to rise.

The question is, will the inflation be so onerous as to accelerate price falls in top-end realty, as in the case of New Orleans?

Many of the flood effected areas of Brisbane are prime realty so it meets that criterion but the conditions of the flood explored above suggest that even though premiums will rise, the irregularity of the incidents should contain the inflation.

Again, some reassurance is to be found in the 1974 experience, in which there is no evidence of Brisbane median prices departing from national averages in the years after the flood.

This blogger will admit, though, this is speculation. The best it can offer at this stage is the observation that insurance premiums are worth watching. Any rise cannot help an already struggling market.

Links January 13: 11th hour euro

Portugal sells bonds. Rehn indicates expanding EFSF. Reuters
In a lot: Ireland, Portugal, Greece, Belgium
In a little: Spain, Italy
Italy in the gun. Zero Hedge
Euro to fall most. Ken Rogoff
Perhaps. US debt spike. Econompic.
Geithner ramps China rhetoric as Hu approaches. FT
So does China. IMarketNews
My former baby making waves on China's J20. The Diplomat (h/t nakedcapitalism)
US begins rifle-shot protectionsim. FT
US will go broader. Michael Pettis
Gail Kelly getting the boot. Banking Day
Or is she? SMH, SMH, The Oz
Flood impacts. BS
Another Indian state banning ore exports. Reuters
Iron ore contracts going monthly. The Oz
Oil rocket. Bloomberg
And Hizbollah isn't helping. FT
India's record gold imports. Zero Hedge

Not posting today

Hi Everyone,

Out of respect for those that have perished and those that are grieving, I won't post today. My sympathies go out to all who are suffering.

David

Links January 12: Random walk

Mish calls Australian bubble bust. Mish
US foreclosure pipeline. Alphaville
US housing headed for new low. Calculated Risk
Macroprudential goes global. FT, Stephen Bartholomeusz
McKibbin demands flood stimulus. The Age
More capesize carnage. Dry Ships
Contagion today: Belgium out. All else in.
Gold not a bubble till $2k. BusinessWeek
Alcoa sees China slowing. Bloomberg
China rampaging credit growth. Reuters
China's great pile of paper. Econompic

Uh oh, euro

Yes, that pattern could be seen as a nice head and shoulders top for the euro. No surprise, really, with Europe's bail-ins rolling inexorably toward Portugal. As FT Alphaville illustrated so nicely overnight:

...it took Greece and Ireland less than a month to request EU/IMF aid after their 10-year bond yields breached that all-important 7 per cent level (as indicated in the charts above). Though it’s worth noting that Portugal has been through the 7 per cent barrier a couple of times before and saw yields decline after. Nevertheless, all eyes are on the Club Med member this week.

The crisis has no end in sight. Also in the FT, one of the clearest thinkers on the rolling debacle, Wolfgang Munchau, explains why:

The most glaring manifestation of this lack of leadership is the EU policy consensus that this crisis will eventually be self-correcting, and that a robust liquidity backstop is all that is needed. This is a tragic error. What makes this crisis self-sustaining is the presence of two interacting components: a combined private and public sector solvency crisis, and a competitiveness crisis. To address a lack of competitiveness, southern Europe, including Italy, would need outright deflation. In some cases wages and prices would need to drop by 30 per cent to fall in line with northern eurozone levels. Yet deflation would increase the real value of debt. It may just be conceivable that the periphery will get on top of their competitiveness problem, or on top of the debt problem, but surely not on top of both at the same time, without devaluation or default.

And indeed, that's what David Rosenberg sees coming sooner rather than later. His proximate cause is one of this blogger's favourite themes, that the Irish body politic may flip the bird at the European bail-in in its March/April election.

This blogger has been relatively confident that European fiscal authorities will see reason in time to avert catastrophes. But there is a rather uncomfortable convergence ahead that will put a great deal of pressure on this thesis. As we know, following Portugal is Spain. The Source offers this asessment of the extent of that bail-in:

A rough calculation by Barclays Capital suggests that after paying for Ireland and Portugal, the EFSF would have about €235 billion left, not enough to cover the €290 billion that a Spanish bailout would likely entail.

The yield on the Spanish 10 year is currently 5.5%. Last November, it took just three weeks for Portugal's 10 year bond to rise from the same level to above 7%. It seems to this blogger that it is quite possible that Spanish bonds could trace the same path even as we approach the Irish elections.

The spectacle of the European Financial Stability Facility (EFSF) concurrently attempting to bail-in Spain whilst Ireland defaults out is so Kafkaesque that the credibility of European authorities may suffer an altogether larger run, with all too predictable outcomes.

But let's take a breather for a moment and back away from this precipice. Let's assume instead that some form of eleventh hour fiscal integration solves these problems (which is this blogger's central case). The pressure needed to bring that about is still going to be very large. The euro is going to fall and the US dollar rise on the flight to safety.

This will set up a self-fulfilling sell cycle for global equities. As this blogger has noted many times before, contemporary capital markets are not based upon discipline and fundamentals but sentiment and liquidity. As such, behavioural economics is king and the narrative that underpins recovery is just as important as the recovery itself. Without a weakening $US, the recovery narrative of correcting global imbalances that supports internal Chinese growth, US exports and rising commodity prices ceases to make sense.

As this blogger described late last year, it's central case is that European convulsions are buying opportunities because the growth in emerging markets is so impressive and the larger global cycle will grind higher. If you ignore the danger of a critical crisis in European fiscal credibility, this is still the case.

But this is no time to be toying with markets.

Disclaimer: The content on this blog is the opinion of the author only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation, no matter how much it seems to make sense, to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author has no position in any company or advertiser reference unless explicitly specified. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult someone who claims to have a qualification before making any investment decisions.

Links January 11: Next wave

Out: Spain, Italy, Belgium
In: Ireland, Greece, Portugal,
Timeline Portugal. Alphaville
Europe's combined solvency & competitiveness crisis. Wolfgang Munchau
Rosenberg sticks with bonds, buys dollar. Globe and Mail
Dollar bull. The Source
Will oil stuff the recovery? Tim Duy
Era of cheap capital over. The Source
Brazil embraces trade war. FT
Capesize hammered again. Dry Ships
China December ore imports up. Bloomberg
OMG, that's another cup and handle on the ore chart. Bloomberg
Coal rocket. The Oz

What's up (or down) with the BDI? (updated)

Coal, iron ore and grain prices are all headed one way - up.

Yet the Baltic Dry Index, the generally reliable gauge of demand for bulk commodities is collapsing.

Last year the BDI correctly foreshadowed and tracked the mid-year slowdown in the global economy, despite being given short shrift by many bullish commentators seeking to rationalise an upward bias in markets. So what's going on now?

The answer appears to be the QLD floods. As Reuters reports:

Australia's key coal port of Gladstone said on Sunday devastating floods have left it so short of coal that a queue of ships waiting to load would likely be diverted elsewhere.

A deluge in Queensland state has flooded mines and damaged roads and railways, cutting the major Blackwater rail line that goes from the coal centre of Emerald through the flooded town of Rockhampton and south to Gladstone.

Queensland is a major world supplier of coking coal for use in steel-making, and the floods have pushed global prices up.

Although Gladstone itself was not flooded, a Gladstone Ports Corporation spokeswoman told Reuters only two trainloads of coal arrived last week, only two ships loaded and the coal arriving was only for domestic use.

"We have got about 18 ships sitting out waiting," spokeswoman Lee McIvor told Reuters on Sunday. "We are expecting the coal companies to reallocate and reschedule these ships elsewhere."

On a normal day, Gladstone would receive around 24 trainloads of coal, McIvor said.

A glance at the index's internals offers further evidence that the floods are playing a role in the drop. According to Wikiinvest, 25% of the BDI is made up of capesize ships. Capesize vessels dominate trade in iron ore and coal. And it is in the capesize component of the index that we find by far the highest carnage.

Further confirmation comes from Lloyd's List which notes that owing to the knock-on effect of QLD floods and the lack of demand for capesize vessels:

...Rates for West Australia to China iron ore trips are so low that owners are considering withdrawing tonnage from the spot market as daily returns from such voyages barely cover operating costs.

Finally, for future reference, the below video is an excellent exposition of the value of the index:



Update
Bloomberg has another good piece today on imminent increases in capesize supply.

S&P spoils the party

It's an 'happy new year' all around this morning. Except, apparently, from Standard and Poors who, according to Banking Day are about to downgrade our financial system:

Persistently high rates of credit growth relative to GDP and seemingly high property prices could filter into lower credit ratings for banks as Standard & Poor’s revises its approach to credit analysis.

Amid numerous recent reviews of methods applied by the ratings agencies, in light of the credit shock, one S&P review is producing results that will demand attention by investors in bank debt and other securities.

On Friday, S&P published a series of papers on its revised criteria for rating banks, and on which it seeks comment by early March.

While S&P noted, in its media release, that the proposals “would have a modest impact” on banks, changes in ratings of one notch or more (and both up and down) are in prospect.

In the case of Australian banks the risk of a ratings change appears to be a downside one.

One of the papers summarises S&P’s latest work on its “Banking Industry Country Risk Assessment” or BICRA score. These scores range from one, the safest, to 10, the riskiest.

At present, S&P includes Australia’s banking industry as one of six banking markets scored as a “one”.

Under the new approach, the S&P BICRA score for Australia’s banking industry is, tentatively, a “two”.

Banking Day is unsure how this national financial system downgrade will affect individual bank ratings but it doesn't make a lot of sense to downgrade a system then endorse its main parts. Looks like funding costs are going up again with all that that entails.

This blogger has obtained the preliminary assessment as well as the new methodolgy (find them below). See page 4 of the first document for the pending BICRA scores.

S&P Preliminary BICRA in 23 Countries Jan 6 2011 (1)

S&P FI RfC Methodology for Determining BICRA May 13 2010 (1)

Links January 10: The more things change...

US law versus the banks. nakedcapitalism
Recent US data. Calculated Risk
Jobs and the Fed. Tim Duy
Strong Dec ISM. Econompic
Week ahead for the DOW. Calculated Risk
How the copper bubble will bust. Zero Hedge
J.P. Morgan shifts into the White House. Baseline Scenario
And Volcker jumps ship. Dealbook
Is the Loonie priced in? Forex Blog
70's bogue here again. FT
Full blown contagion today: Ireland, Portugal, Greece, Spain, Italy, Belgium
Baltic Dry collapse. Dry Ships
Ore price to be volatile. Reed
Expect 2011 ore record. BusinessWeek
Why we need an SWF. Jessica Irvine
Capital shortage for non-resource business. SMH
Retailers should blame rent. Blair Speedy
Animated global imbalances:

Holiday Reading

Dear Readers,

I will be away until January 10th, 2011. Hopefully the world will not implode in that time.

For your reading pleasure over Christmas, following this post are the nine leading entries to the Son of Wallis Challenge. The winner, Kaon Li, is first but the others are not presented in any particular order. Thanks to all who contributed.

Au revoir and enjoy your break. I encourage you to return next year, there are some very exciting plans afoot for this humble blog...

Thanks for reading.

David

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.

SOW - Rory McKeown

Individuals and companies have been incentivised perversely across the banking industry, and being led by a corrupt banking ideology, Australia has paid a price for this. It could should shape itself as a role model for banking leadership by implementing the following proposals, and creating incentives for small banks, and securitized bonuses. Until these factors are dealt with the banking industry will always claim more free market economic is a good thing. Unfortunately when it goes wrong, free market economics is the last thing they are prepared to confront. Their logic went something like this:

• we have assets on our books that are not what we thought they are, we are now undercapitalised.
• If people know this, they will remove their money from our bank, this will cause a bank run. 

• If we collapse, banks X and Y will collapse as well because they have assets we sold to them.

(IV) If we all collapse, your banking system will collapse.

(V) If the banking system collapses, your country will collapse. Therefore, you must help us.

Any cohesive solution to preventing this occurring again must deal with preventing this logic to ever hold true.

• How did the banks end up with these “faulty” assets?

A big topic, but lets consider a simple process. A retail bank lends to customers to purchase a house. The securitizers at an investment bank then buy these loans and package them into an issue, create the securizitaion vehicle and sell tranches to other institutions. Based on a rating given by an “authorised” entity banks and other institutions then pay an appropriate risk premium for the bundle of coupons all the individual retail borrowers pay. The advantage of this is that pension funds and insurance companies can invest in these assets which claim to be as secure as corporate bonds. At every point in this process, an individual is basing his expected year-end bonus on these deals going through: the retail bank adviser, the securitiser. the ratings agency advisor,the fund manager. However the security is expected to last on average 20 years.

Hence there is a duration mismatch in the risk profile of the individual and the institution. Any solution to the current banking crisis must minimize this risk.

The retail bank and the securitising institution should be forced to take a substantial piece of any “synthetic” product (e.g. 20% each). These “mirco-issues” should contain a piece of each tranche, in effect replicating exactly the payoffs for each institution. Bonuses for their employees should be paid annually from the coupons of these micro-issues. If the bank wishes to pay them more, then let them take a bigger share of the coupon, however they should be very aware that their own personal wealth is intimately linked to the product that they are creating.


(II) How can a retail bank end up with assets of ambiguous quality on it's books?

Were a retail bank to package and hold it's own debt, the loan quality of the book should be clear. They verified and created the mortgages. Instead were third parties are used to sell mortgages the quality is likely to decrease: the downside incentives for third party individuals are massively outweighed by volume related pay incentives. Hence a loan book of false creditworthiness and overestimated earnings claims.

The other side of this is large retail banks wanting to play in the interbank markets, buying and selling securities in a hope to create “alpha”. This has been sanctioned by executives at the top level who see peers performances and bonuses and hope to create the same for themselves. Buy buying poor quality opaque products with artificially secure ratings and apparently high yields, these executives encouraged their own staff to take bigger risks.

All of this was implicitly made possible by banks trusting ratings that proved to be in the short term “cheap”, but in the long run very expensive.

The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products. The increased competition and reputational damage of poor analysis would likely cause margins to drop, and prosecutions for misratings are much more likely to happen in the free market. Suing the government is generally an exercise in futility, as each department displays no fault with bureaucratic aplomb.

(III) & (IV) Why are the banks so interconnected, and how can this be prevented?

The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threating collapse.

The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.

Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.

A tax such as this on profits before wages that is relative to the proportion of risk that the institution poses to the system, not to itself. Given the current scale of the banks, this taxation would effectively be extremely punitive on bank earnings, however as executives realize a small institution is more profitable to them as an individual, they would be incentivised to start their own small banks.
The overall effect should be to force bankers into competition rather than into collaboration by preventing large institutions from making huge profits.

Trading with institutions in a jurisdiction which does not manage risk in the same way should be allowed, but have an extremely high risk profile to reflect the risk of the unknown.

Without uniformity in global systemic risk management, a crisis in one area can cause a crisis in another. It could be argued that America exported toxic debt and fetid banking. If a jurisdiction (aka fiscal area) is not prepared to impose risk curbs on its bank, local banks should be incentivised to avoid trading within the region.


• How can any country become so dependent on one industry?

Money has been the lifeblood of economies across the world for centuries. However if the control of money is centralized, the greater the risk a failure at this control point will effectively destroy the system. As discussed above the scale of large banks is now an implicit threat to any country that allows them to grow out of proportion to the economy that they exist in. And it must be asked how much do the executives know about their business? How can they continue to work in the financial services industry while overseeing a period that has effectively jeopardized the whole system? The claim is that who else can understand the complexities of modern finance? It's obvious that these people cant.

Bankers must face serious financial and personal losses in the face of failure.

The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.

To conclude:
Measure and tax systemic risk
Align incentives to financial products sold and created across their lifetime
Ensure that bankers know their business, and are barred from the industry on failure.

In any other business, most notably the current wave of environmentalism, taxation and responsibility are seen as good things. Why not banking?