Deep T – The Capital Rort

It really is an extraordinary situation Australia finds itself in right now. Whilst we can learn much from history, don’t look there for the answer on this one as the financial position of the country is unprecedented. Although this is par for the course for just about the entire globe, ours seems to be a different different.

Arguments abound across the web and mainstream media about whether all’s good or the holocaust awaits. Did we survive the GFC better than any western country or did we prime the bubble for a much larger fallout? My school of logic says that the mere fact that so much debate exists means there is a problem. If we accept that there is a problem to be managed then the more the real facts are explained, perhaps the more manageable the problem and the less the fallout. Hysterical bubble talk and delusional denial is not constructive but a “let’s understand what’s going on” may produce some positive results. Unfortunately, both bank and Government spokespeople have far too much vested interest to speak the plain truth.

As far as mainstream media is concerned, do any of you media hacks out there have the figures on how much revenue is generated for Fairfax and News by real property advertising in Australia? Unfortunately, everyone the public relies on has a massive thumb in the 4 and 20.

Now that I’ve got that piece of self justification off my chest, let’s have a look at some truth in how the banks calculate capital for residential mortgages.

There are two ways an Australian Deposit taking Institution (“ADI”) calculates capital to be allocated against a residential mortgage. Either in accordance with APRA’s APS 112 Attachment C or under Advanced Basel II methodology. Let’s address the rather simple APRA methodology first and then look at the implications of the advanced method.

My critics may be saying that I oversimplify. If it’s the simple truth then they’re correct but you can’t understand the bigger position without knowledge of the basic fundamentals. That’s where it starts.

My simple question is, how much capital does an ADI need to allocate to a mortgage over time? Let’s start with a $100 mortgage and the table below from APS 112 for standard mortgages.

The way ADI capital calculations are articulated, a 100% weighting on a $100 loan asset translates into $8 of capital but APRA weights standard residential mortgages as per Table 4 which shows a lower weight for lower LVR’s.

Therefore if a mortgage is standard and written at 95% LVR then the capital allocated is $100 *75%*8% = $6. On the basis that an ADI wants a 20% return on capital then a borrower pays $6*20%=$1.20 pa to the bank as a return on capital. We’ll not complicate matters by doing the calculation for mortgage insurance as this also involves calculating the capital required for the LMIs.

However, I will make the unsubstantiated statement that the total capital now in the system needed by both the ADI and LMI is at least equal to the amount required for an uninsured mortgage. However, for a very long time it was not and a significant arbitrage was in the system between ADI’s and LMI”s until 2008.

The definition of standard loan is as follows as referenced in APS112.

6. A standard eligible mortgage is defined as a residential mortgage where the ADI has:

(a) prior to loan approval and as part of the loan origination and approval process, documented, assessed and verified the ability of the borrowers to meet their repayment obligation;
(b) valued any residential property offered as security; and
(c) established that any property offered as security for the loan is readily marketable.

The ADI must also revalue any property offered as security for such loans when it becomes aware of a material change in the market value of property in an area or region.

Sounds reasonable enough, even the last sentence. But here lies the “arbitrage the system” opportunity that every banker dreams of. APRA in APS-112 have insisted that property is revalued by an ADI if “it becomes aware of a material change in the market value of property in an area or region”. I will express an opinion here that I’m sure APRA was trying to protect against properties falling in value but have left open the biggest game in town for all our banks.

Currently the major and regional banks use the services of the new technology of automated valuation models (AVMs) to revalue their mortgage books upwards to decrease their capital requirements. Has a light switched on yet as to why there has been such a dramatic rise in the use and media coverage of those property valuation spruikers. If anyone knows of one of those banks who do not use AVMs can you please let us all know.

So what is the effect of continually revaluing the properties upwards? Using our standard 95% LVR mortgage above, let’s assume a revaluation so that the LVR is now 85%. The capital required is now $100*50%*8%= $4 with a return on capital requirement of $4*20%= $0.80 pa. Quite a difference, and if we go one step further, then the result and achieve a 75% LVR then the capital is now $2.80 with a return requirement of $0.56.

So with roughly a revaluation of the property of 20% (ask any property spruiker, “That’s nothin’ mate!”) a bank can save itself $3.20 of capital per $100 of mortgage which can be recycled as capital to support another mortgage. Think about how that increase in both return on capital and funds allocated to another mortgagor slave is an absolute incentive for bankers to perpetuate the cycle up of house price valuations. Their reward? Huge bonuses based on what is in essence a positive reinforcement spiral where everyone pats each other on the back for what a great job they’re doing. Well at least, that is, until the money runs out.

What was that? Did you hear anything? Maybe the sound of a slow burning fuse? But I digress.

Under advanced Basel II methodology, banks are able to have their own approved internal models which replace the APS112 requirements. These models only make it much less transparent as to what the capital calculations are based on. Please see the CBA’s statement and make note of the amount of residential mortgages used to calculate capital adequacy on APS 330 Table 16a to 16d – Capital adequacy (risk weighted assets) ie $ 56,753M and the actual credit exposure on table APS 330 Table 17a – Total credit exposure excluding equities and securitization ie $326,384M to understand the extent of the difference between what is actually lent and the exposure used to calculate capital.

In this case for CBA it’s $269Bn. I cannot explain how the numbers have been calculated other than to point them out and that some internal model which updates valuations has been used. The benefits on the way up in house prices would seem to be huge. What would the effect be if house prices dropped 20%?, 30%?, 40%?

If you have followed all of this then you have my utmost compliments, but also, maybe your heart should also be jumping a beat or two. The emu in the kitchen is not what losses the banks will have to suffer if house prices reduce and borrowers default in large numbers, it is where do they find the capital to support all those loans now on increased LVRs that have not defaulted? As APRA have required, The ADI must also revalue any property offered as security for such loans when it becomes aware of a material change in the market value of property in an area or region. A positive reinforcement spiral on the way up and a negative one on the way down.

Maybe that’s not a fuse I hear, but a gurgle….gurgle…..blup!

As all 4 major banks have the same issue to varying degrees, this is a huge systemic risk. It also means for this writer anyway, that it’s not difficult to predict what will happen. The current Government will, in cahoots with the banks, do all in its power to prop up the mortgage and housing markets to the misery and detriment of all new borrowers and many existing ones. Like the bank CEO’s, the PM and her ministers, ie when the truth is finally drummed into their incompetent heads, will just be praying that they’ve collected their loot and past the parcel before it all collapses.

Maybe, Matilda, the gangs will take over the highways!

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.

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  1. David Llewellyn-Smith

    The same thing that happened in the US will happen here. Mark-to-market will be throttled in the deep night and it'll be extend and pretend all the way…

  2. Time for diversification in asset classes, regions and a bit more to physical gold…errr you can't own a gun legally in OZ, right ?

    I agree with DT that those stupid MPs in Canberra would do their best to pump the residential property market and mortgage growth at the expense of ALL taxpayers, old and young, gents and ladies, no one spared. The more prudent you are in your financial affair, the more you will be punished. Raise the Tea Party banner here also (or prob Lamington Party to adjust to local OZ taste).

  3. It's highly bloody embarrassing but I can't even get through the fundamentals:

    1.) The author says "The way ADI capital calculations are articulated, a 100% weighting on a $100 loan asset translates into $8 of capital…."

    Q: Why does this translate into "$8 in capital"? What exceedingly simple thing am I missing?

    2.) The author says " On the basis that an ADI wants a 20% return on capital…."

    Q: Is that an assumption or a reasonable benchmark based on prior knowledge?

    Please help the simpleton out. I'm doing my best to understand.

  4. "1.) The author says "The way ADI capital calculations are articulated, a 100% weighting on a $100 loan asset translates into $8 of capital…."

    Q: Why does this translate into "$8 in capital"? What exceedingly simple thing am I missing?"

    I think it is because the prudential standards require minimum capital of 8% of an ADI's risk-weighted assets to be held by the ADI.

  5. Economic Delusion

    Peachy is correct, an ADI under APRA requires base of a minimum capital level of 8% of risk weighted assets at any given time. Securitised mortgages are adusted on the sliding scale table in the post.

    However the 8%/20% aren't really the point. The point is that beause APRA uses a sliding scale of Captial requirements for secured mortgages then the higher the value of secured property ( and therefore the lower the LVR of their existing loans ) the less capital banks need to backup those loans. This means that banks can stretch there existing capital further and further to take on new loans. However as prices fall the reverse is true, and all of a sudden banks require large injections of new capital.

    When home prices are falling and therefore investors are aware that banks wil be less profitable, exactly where are they going to get all this new capital from ??

    See the problem..

  6. ED,
    Yes, I see the overall problem but I want to work through everything so I can understand the nuts and bolts, almost like a new education. Aside, I'm digging the blog and find it the perfect antidote to the slop served up everyday by the mainstream.

  7. Great post! The use of AVMs will come under serious scrutiny in Australia, as it has in the US. What has been interesting (scary?) in the US is that – while the average prices still come out fairly close to the AVM estiamtes, houses that are sold in floreclosure recieve MUCH less. This is partly because of the forced seller issue, but mostly because of adverse selection (i.e. if the average price has remained flat, there are still plenty of houses that fall 10%+, and those houses are more likely to have defaulted mortgages on them).

    Original LVR is just as important, if not more important, than Current LVR, because it provides information about the borrower's credit worthiness and propensity to default. Updating values in this way is very similar to what happened in Subprime mortgages in the US – 'asset based' lending that ignores borrower credit quality.

  8. Capital adequacy quantitative disclosed
    1:Capital requirements for credit risk is subject to the foundation IRB approach and the advanced IRB approach for each portfolio
    2:Capital Requirements for equity exposure are subject to market based approaches, simple risk weight method; and equities in the banking book under the internal models approach (for banks using IMA for banking book equity exposures) and equity portfolios subject to EAD PD LGD. By the way stands EAD PD LGD for Exposure at Default, Probability of Default and Loss Given Default.
    Capital requirements for market risk (and they have to disclose the approaches used) Standardised approach and internal models approach- trading book. Again with operational risk approach disclosed; basic approach; standardised approach and advanced measurement approach AMA. Don;t for Tier 1 capital Ratio.

    Just a thought maybe you should work out how Capital Adequacy is calculated before you comment.

  9. Economic Delusion

    From Deep T just to clear it up:

    8% is the default capital level for all assets on a bank’s balance sheet. For standard mortgages you do not hit this level until the LVR is greater than 100%. That is what table 4 was outlining, the % of capital required for mortgages dependent on LVR, standard or non-standard and whether it was mortgage insured. However, the biggest determinate is LVR.

    The 20% used is simply an estimate of the gross ROC that a bank would want to achieve. At the moment the net ROC of banks is about 15%

  10. The banks have been allowing people to withdraw equity from their properties to fund consumption (4WDs, food) or investment (rental properties). The evidence is all around us that this has been happening on a large scale.

    On those mortgages where equity has been withdrawn, the LVR will not have fallen that much, and in some cases may have increased, even with prices increasing. Under the Standard Basel II Approach the banks would not be able to reduce their capital held against these loans. Things may well be different under the IRB approach (but we cannot access data about the banks' internal assumptions about defaults etc because those models are – ahem – 'proprietary').

    Any comments? Is there any data on how much equity withdrawal has happened over recent years? And have the banks made it easy for people to withdraw equity without formally remortgaging (eg by allowing them a kind of current account mortgage with an overdraft)?

  11. Economic Delusion

    You bring up a fine point damnpascoe, however I do not have access to any of this data. I would love to find someone who does.

    Although my initital thoughts are that this may have some effect on slowing the fall of LVRs but given the rapid rise in property valuations in the last 24 months I am not sure just how much. I may be wrong, as I have no data to back this up.

    This does however highlight why speculative credit bubbles give a false sense of the how well an economy is doing, all that "equity, mate" getting pumped into the system buying goods and keeping businesses running. But it is unsustainable capital growth backed debt growth.

    Once the speculative growth stops, so does that additional funding source for the economy, and the lights slowly start dimming.

    Oh, and all that extra debt still needs to be paid off and/or inflated away :)))

  12. @damnpascoe, it's that kind of data many would love to see too. I do know in the U.K. many mortgage holders had their ATM taps turned off when they hit 20% equity in their homes. Again, and like you've pointed out, no specific numbers nor broad percentages. That was an article in the the UK Telegraph a while ago, this year though.

    Despite the banks being allowed to do this, the owner didn't have to take the offer. Once in Australia many people didn't spend on other properties, cars, holidays, new TVs, furniture, private schools, until their mortgage was well under control. Some did though. Ahhh the good ol' days…

  13. So….I wonder what the author’s view of the actual RMBS securities would be. I’m an overseas investor and looking at potentially investing in Aussie RMBS. Essentially, I’ve been very impressed with the underwriting standards, the way informal and institutional controls align incentives between originator, investor, and borrower, and the historical collateral performance–especially in the case of the downturn of 2004.

    My view is that I don’t want to make a housing “bet” per se. What I’m personally going to do is stress the Aussie housing market by 40% and if these things are still holding up, then I’ll buy.

    Now tell me I’m wrong ;-).

  14. Hey there, You have done a fantastic job. I will definitely digg it and personally recommend to my friends. I’m sure they’ll be benefited from this website.