I wasn’t at my desk when I heard the news that Moody’s had downgraded Australia’s major banks. At the time I didn’t feel the need to look too deeply as I was feeling a little smug. I have been posting for quite some time that these banks are undercapitalized and therefore, by extension, over rated.
However, once I had time to view the detail of what the Moody’s analyst was saying, the gravity of the rating downgrade sunk in. This is certainly the biggest system changer since September 2008.
Whilst a Moody’s rating is only a credit analysts opinion, an opinion based on the facts as we know them can be reliable and in this case game changing.
Although Moody’s only downgraded by one notch, the downgrading was much more important because of the reasons why. Here’s my summary of the important points in the announcement, and apologises for ground already covered in this blog.
The real rating of the banks without the implied government guarantee is A1. In the financial world, that maybe only one step down from AA3, but to lose the AA handle is significant. It’s also significant that Moody’s two notch rating uplift due to the implied government guarantee covers a jump from an A category to a AA category. There is also:
- Too much reliance on wholesale funding
- Too much reliance on offshore borrowings
- Australia must sustain the current account deficit
- Systemically retail deposits will not be able to meet banks borrowing needs
In short, by relying far too heavily on houses and holes Australia has significantly increased the banks systemic risk.
Moody’s is not dog whistling. It’s sending a very direct and clear message to wholesale funders of Australia’s banks. Do your homework. There are very real risks with the credit of these banks and the system which supports them.
However, what Moody’s doesn’t tell us and what you won’t hear either from the MSM or the banks themselves is what will be the real effect of Moody’s actions.
To state the almost obvious, the Moody’s change will affect four things for the banks in the absence of balance sheet strengthening:
- What the banks will pay for their debt in the future
- How much debt the banks can raise over the next few years
- The form that the debt raisings will take
- Where the debt raisings will occur
Firstly, and despite the cries to the contrary from the banks, the interest rate paid by banks especially on term funding will certainly be more expensive. This may occur by margins rising immediately, margins not decreasing as much as they would have or margins increasing more than they would have. Its very hard for me to believe that wholesale investors will not use the Moody’s downgrade as ammunition for higher margins, especially offshore investors.
But if you want an estimate to work with, I’d say it will increase margins over time by up to 25bps for 5 year debt with the forecast credit growth. Shorter term will be much less and even zero effect for the very short end but that’s not where the risk is or the need. Whilst we’ve always been able to calculate the cost, because of Moody’s stark focus on the measurement, we can accurately calculate the cost of the implied government guarantee. I’ll give my views on this at the end.
Wholesale investors everywhere are reliant on their risk management structures which impose limits on names and ratings to name two parameters. The system works on the basis that the lower the rating the higher the risk so the lower the limit. There will be some investors which may have a AA limit on their investment criteria who will not take into account the two notch uplift from the government guarantee. For them, the big Australian banks are on AA3 with no cushion, meaning they may no longer invest. So undoubtedly, the universe of money and investors has decreased for the Australian banks which will also affect margins. Therefore the banks will have to resort to structured arrangements to meet the amount and cost of funding targets.
Banks will therefore resort to more structured deals to raise debt, more of that quality Australian RMBS and covered bonds. It is no coincidence of course that Australia has draft covered bond legislation with a number of issues likely to occur before the end of the year. So what’s the problem here? Offshore investors will be targeted to sell covered bonds. There is a whole new class of real money investors who are unlikely to have invested in Australian bonds of any sort before. These investors will be molly coddled because we need the funds. One way of ensuring that these investors part with the cash is to ensure that the mortgages that go into covered bond structures are of a very high quality. The issue here is that there’ll be a higher concentration of higher risk loans on the balance sheet which will be supported by a taxpayer guarantee. APRA will try to prevent this to a degree but they’ve not been successful in enforcing their rules for RMBS. So it’s hard to see how this will change with covered bonds.
Of a less controversial nature is that banks will also be forced to significantly lengthen the average term of their liabilities. If they don’t, be sure that further downgrades are on the way. This will increase funding costs which ultimately will be passed on to borrowers which in turn increases the risk of balance sheet assets because of over leveraged borrowers. A positive feedback loop of negative information.
Moody’s also forecasts that offshore borrowings will decrease in the next 12-18months before increasing thereafter. I don’t agree unless there are significant further reductions in business lending. I have previously posted that there are significant amounts of offshore borrowings on the banks balance sheets that are classified as by the banks as deposits which seems to distort some analysis. The information is contained in RBA Table B12.2 where it shows that as at Dec 2010 some $171bn of offshore borrowings are classified as deposits.
Nevertheless, Moody’s makes it clear that the banks undoubtedly need offshore money to survive and that’s where they’ll continue their efforts. Covered bonds as I stated above will be aimed squarely at offshore investors and not just for price but as a brand new source of funds to prop up our banks and therefore our housing markets.
Beyond the obvious, I did think there was one audible dog whistle in Moody’s announcement. With this.
The fundamental funding structure of the major Australian banks remains in place. Australia’s mandatory superannuation scheme will continue to capture retail savings, of which only a low proportion are available to fund the banks. This situation is due in turn to the low allocation– by international comparison — of superannuation savings to fixed-income investments and deposits.
Moody’s may be suggesting that if all else fails then legislation should be brought in to force much more of our super into the banks. The corollary of that is not pleasant. however. More money into the housing market. Frightening to say the least.
Lastly let’s revisit the ability to accurately calculate the value of an implied guarantee. I certainly don’t agree we make it explicit and in effect nationalize the banks. These banks are TBTF but we as taxpayers can’t have the banksters rorting this for the benefit of their wallets. My solution is simple and something in great discussion around the world. Whilst these banks are TBTF, they must carry enough capital to have them rated AAA (or equivalent) without the implied guarantee. I feel and every Australian should feel secure with that structure, even if the rating bit grates. It would sure make it hard for bankers to pay themselves huge bonuses from achieving high returns on capital.