Australian banks paint themselves into a corner

The Australian Financial Review’s (AFR) Due Diligence section today ran a superb article on the challenges facing the Australian banking sector. Below is an extract of the best parts (“Banks feel chill wind of housing slump”, 30 May 2011):

For all their mind-boggling complexity, banks are largely a play on house prices. During tha past two decades, house prices have risen and so has the size of mortgages. As people get more equity in their homes they feel richer and spend more on their credit cards…

[But] house prices are now either falling or going nowhere. The effect on Australia’s banks will be profound.

As one senior banker explains, when mortgage credit growth was running at 15%, a bank could get 10% revenue growth “even if you weren’t any good. You just had to be in the market”.

Suddenly we hit a wall about two years ago. You’re not getting the earnings growth any more…Housing credit is growing at its slowest pace in 30 years…

More than any other factor, a series of housing booms is what has fuelled the growth in banks’ profits. Mortgages are banks’ single biggest asset class… they make up 65% of total assets at the CBA and Westpac, 55% at ANZ and 50% at NAB. They are also more profitable than any other type of loan…

Some simple numbers illustrate the pickle the banks are in. According to the Australian Prudential Regulatory Authority, there was just over $1 trillion of mortgages sitting in the banking sector in March. Growth at 6.6% [the rate of mortgage growth in the 12 month’s to March] means $66 billion of mortgages in 12 months.

Applying a 1% net interest margin – the difference between the rate at which a bank borrows money and lends it – means the entire banking sector can expect $660 million in additional revenue in the next 12 months from mortgages.

If housing credit growth was running at 15%, as it did for most of the last two decades, the additional revenue would be $1.5 billion. That’s just under $900 million that is no longer trickling into the banks, and most of it would have gone straight to the bottom line.

There is no way an increase in business lending will plug the gap…

The key challenge facing the Australian banking sector is that it has become too heavily exposed to the Australian housing market.

Following the implementation of the Basel Capital Adequacy Accord in 1988 (“Basel I”) and the updated Basel II Capital Adequacy Framework in 2008, Australian banks have been permitted to hold far lower levels of capital against mortgages relative to business loans, which has encouraged the banks to lend large sums to housing in order to earn significantly higher profits.

According to the above AFR article, despite lower margins on mortgage lending (1% against 2.15% on business loans), the Australian banks have typically delivered a return on equity on mortgages of around 25% versus 18% for business lending.

Little wonder then that Australia’s banks have, over the past two decades, so heavily shifted their focus from business lending to housing. As shown below, business lending comprised nearly two-thirds of total lending in 1990, with housing lending and personal lending making up the difference. However, in 2011, business’ share of total lending has fallen to around one-third, swallowed up by housing lending.

The growth in mortgage lending has been staggering, rising almost exponentially since 1990.

To illustrate, first consider the growth of mortgage lending expressed as an index:

Second, the growth of mortgage lending expressed in nominal dollar terms:

And finally, the growth of Australia’s mortgage debt relative to other advanced economies (chart from the IMF):

The problem for the banks is that mortgage growth has dropped to its lowest level in two decades – from between 10% and 20% per annum in the decade and a half prior to the global financial crisis to only 6.6% in the 12 months to March 2011 (see below chart).

And with mortgage credit growth constrained, the prospect of continued house price growth is diminished as is the banks’ ability to continue growing their profits.

In many ways, the banks are caught in a pincer in that they must continue lending liberally to housing or risk a house price correction and a significant increase in non-performing loans.

This reality has recently been articulated by Robert Gottliebsen in Business Spectator. In April, Gotti described the banks’ predicament as follows:

As long as banks keep restricting the supply of dwellings and fostering the demand by generous consumer loans, dwelling prices will not slump.

But if Australian banks restrict consumer housing credit in the same way as the US banks and the banks involved in the Gold and Sunshine coasts market did we will see a big fall in property asset prices, which, in turn, will lead to a rise in bank bad debts.

In many ways the Australian banks are trapped. They must keep up consumer housing funding to avoid a fall.

And today, Gotti followed-up with another article demonstrating the catch-22 position that the banks are in:

Australian banks were the major cause of the housing boom and if they make a false move they risk bringing on a crisis in which they will be the major losers.

The most publicised reasons for the fall in the dwelling market have been the rise in interest rates, fewer overseas buyers, the increase in power, petrol and other costs. But ranking with those forces has been a rapid and severe tightening of bank credit. Whereas before banks would lend up 105 per cent on an investment dwelling, now those loans are not available and banks are being much more careful who they lend to and how they apply lending criteria. Accordingly, it can take borrowers weeks to get a decision that would once be made in hours.

If the banks were to continue the current tightening then it is highly likely that the market would fall between another 5 per cent and 10 per cent, given that is bank credit plays such a big role in determining the level of dwelling prices…

The banks, having pushed the market up, cannot afford to let it fall too far or they will suffer very large losses, particularly if the current decline in non-mining economic activity in the major capitals causes unemployment to rise.

Nevertheless, although they are trapped, it takes great courage for the banks to lower lending standards and cut prices on a falling market because if there is a further economic downturn then your losses may compound. In addition there is a prospect of an overseas crisis that leads to much higher costs of overseas wholesale funding of our banks.

Clearly, Australia’s banks have painted themselves into a corner. If they attempt to belatedly limit their exposure to housing by reducing the availability of mortgage credit, then they risk causing a slump in housing demand and falling prices.

However, if the banks relax lending standards, they may succeed in keeping Australia’s housing bubble inflated for a while longer. But in doing so, they would increase their exposure to future shocks and potentially larger loan losses down the track.

They say the best way to cure a hang over is to keep drinking…

Cheers Leith

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Unconventional Economist
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  1. Alex Heyworth

    From an investor’s standpoint, the question is to what extent this outlook for the banks is already factored in to their share prices. Given how far they are off their highs, and the current high yields, there may not be too much more downside.

    Maybe banks will reconfigure themselves to become more like they used to be – good yield, solid, but not much in the way of growth (in real terms).

  2. This concentration of home lending started before 1990. In the bull market of the 1980s a number of building societies incorporated and listed.

    Building societies had an old fashioned concept of borrowing from the community and lending $ for $ back to the community. As I recalled, a number of societies became Bank of Melbourne, which was acquired by St George which was acquired by Westpac. Concurrently, Aussie Home Loans & others developed a parallel market. Post GFC we are left with the filthy four.

    Somewhere along this path the ACCC and its predecessors have failed society generally & home owners specifically.

    Escalating house prices create only an illusion of wealth. The SME sector has been progressively denied funding since 1990 yet it is that sector that creates jobs and wealth for everyone. Overall, a complete stuff up that is near impossible to now unravel.

    Does anyone really believe that four providers constitutes competition?

    If any of the big 4 get the staggers they’ll be rescued by government which will replicate the American banking scene of privatising banking profits and socialising losses.

    As Gough Whitlam once said about banking, and in reference to the Bank of NSW (Westpac) – “you can bank on the wails”

    It’s about time other sources of capital entered the home loan market. A possible option would be for Australia Post to distribute loans funded by large super funds.

    All this as the US banking system is effectively still insolvent and Europe is on the brink of a potential financial collapse.

  3. HEY what is the bird sitting on that (Bank) branch??……It’s only a chicken coming home to roost.

  4. “However, if the banks relax lending standards”

    I believe they are already doing this with smaller LVRs (95% is back) and this yesterday:

    I am pleased to read this as I came to a similar conclusion about a year ago that the banks were stuffed for this very reason. They have to keep lending, but more lending just makes the problem bigger.

    I have sold out off all my banks holdings over the past 12 months. I actually got CommBank about right. Sold @ $58+, hasn’t been near there for a while.

  5. Recently fitch threatened to downgrade them further if they relaxed lending standards to compensate for loss of business. I wonder if they will now make good on that threat ?

  6. With more than 80% of income earning households already in big debt, usual lowering lending standards will not be enough to keep scheme live. They will have to go to extremes (100 year mortgages, 100% LVR subprime, …)

  7. Hi UC,

    Question for you: “1% net interest margin” – is it really that low?

    Reason I ask is that with fractional reserve banking using say 10:1 ratio a 1% net margin seems way too low. I saw RBA figures of wholesale rates of 4%, but the figures are lagging.

    I meet a WP ex-manager at a recent meeting and he admitted that they are over exposed to housing.

    How long before Shorten/Swan give the banks access to our super funds?

  8. Emergencey meetings here at the bank yesterday and the topic you guessed it the major slump in lending figures. Bank is about to announce a big drop in the rates for new loans to the bank. I also hear on the grape vine (quite a reliable source) more redundancies from the commercial sector. 22 in Feb not sure how many this time. Interesting.

  9. Citizen action is required to hold these Ponzi capitalists responsible. The bankers have convinced us they are doing ” Gods work”, they are doing the devils work. Unless we plug the loop holes that allow them to destroy peoples lives with unsustainable debt they will continue with impunity.

  10. Sandgroper Sceptic

    Banks need to be reformed period. They should be more like utilities and less like giant Ponzi enablers. Personally I would force the banks to hold the mortgages on their books (no securitization) making them liable if things go wrong, get rid of government guarantees and put a limit on the LVR of any loan I would like 50% but few people would be able to afford a house until the price came down, at least 20 or 30% would be prudent. At the moment the banking system is an explosive device waiting to go off that could wreck the economy and for what – expensive houses and high bank profits. Socialise losses and privatise profits is not the way ahead.

  11. Excellent work continues to be done by Leith Van Onselen. I don’t know of any more thoroughly done blogging on the subject of house price bubbles, Australia’s being the central issue here, but utilising data from further afield to shed light on the subject.

    I have referred before to the LACK of a role for “easy credit” in South Korea’s famous property cycles. Here is an absolute gem of RECENT analysis:

    The government tweaks mortgage loan-to-value requirement ratios from 50% to 60% and back, according to boom/bust conditions, and they STILL have volatile property price trends………”easy credit” is the cause, is it…..?????

    Leith being Leith, I know he will take this seriously. Unlike the many fixed-agenda types who infest the blogosphere. The big problem in South Korea is of course, their “green belts” and their easily-captured urban planning processes.

    • Yes Prince. High-inflation alone would be a good reason for the average person to speculate in housing.
      In fact Australia’s inflation is one of the main causes of our housing speculation. Do you know the others?

      • “In fact Australia’s inflation is one of the main causes of our housing speculation. Do you know the others?”

        (i) Pending retirement of a significant part of the population.

        A population that has a sense of entitlement of their quality of life in retirement because “they’ve paid taxes their whole life” and this quality has a great deal of longetivity risk due to the forecast number of years retired. They need leverage (i.e financial risk) to make greater returns.

        • Good points there Rusty.
          Old Germans in 1935 had paid taxes all of their lives too. They got an awful retirement though. Problem was what the taxes been spent on. (War Machines and nasty Hitler government).

      • Thanks, Prince, isn’t that incredible? Even when young people have to put down 40% or 50% on their home, they still end up with property bubbles and huge debt – and reverse equity when a crash comes. By the way, the mortgage finance requirements were even steeper in their circa 1990 bubble.

        Guess what brought this volatility about? Green belts and easily hijacked planning processes.

        Regarding the incentive for speculation, Claw, supply-side restrictions is one thing that many mainstream economists do not bother to mention. Those that do, usually purport to show that land use controls were “responsible for X percent of price inflation”, and “easy credit” (or some such) was responsible for a large proportion, and speculation was responsible for the rest. This fails to explain why so many markets did NOT have “100 minus X” percent price inflation (i.e. they had NO inflation at all) when they had the easy credit but not the land use controls. These theoretical difficulties have been surmounted in an unfortunately little-known paper by Stephen Malpezzi and Susan Wachter, where they show that a high proportion of “demand” is speculative, and ENDOGENOUS to the supply inelasticity that results from land use controls. That is, it is triggered BY the supply constraints; it would not have had any impact otherwise.

        Seeing this paper, “The Role of Speculation in Real Estate Cycles”, was published in 2002, I am sure that their findings would be even more dramatic if California’s more recent experiences were analysed.

  12. Doubting Thomas

    The Banks will struggle on.

    If US cannot get QE3 (or some version of it) up, and if China – for any reason – pulls backs on commodities; we are toast.

    We will follow the Irish into oblivion, Won’t happen here? Not for eighteen months anyway, maybe twenty-four.

    We’ll also imitate the Japanese; a nightmare will unfold and the zombie banks will rule the Earth.

  13. nearly every person i speak to re: the “potential” property market downturn in Aust. is under the impression (and not entirely wrong) that the US crash was all a result of sub-prime defaults. rather than get into a lengthy discussion my refined response to them nowadays, is to think about why the banks etc were making NINJA loans in the first place. the same is true here.

    an issue i didn’t see raised that adds to the self cornering of the banks is the wholesale funding issue. the only way for them to realistically up their lending is to borrow more offshore, which will lead to further downgrades, limiting ability to borrow offshore.

  14. the banks are screwed and they know it. the rba knows it and the gov knows it. how else do you account for the FHOG boost and the RBA’s redaction of its advice to the treasury regarding potential economic shocks to the country. they know they need to keep asset prices inflated (read housing) so they will keep on lending until they cannot, ie until there is some externally forced shock that curtails the availability of wholesale funding.

    I have yet to read any article or blog on the net relating to the fact that the big 4 banks are nothing more than emnations of the state. yes the level of federal debt is low but can you really regard the banks liabilities as anything other than a future burden on the taxpayer? It happened in every other advanced anglo economy and I for one most definitely do not think the outcome will be different here.

    same old same old. It is astounding that people seem to have learnt nothing from history. “oh today isnt 1930, we are much more developed and smarter than back then. there wont be another great depression”. yeah of course we are. its totally different this time….