Moody’s is serious

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.

Comments

  1. Thanks for that….I’m no expert in this area but to me any downgrade by a ratings agency should be construed as a ‘warning sign’….otherwise why have ratings agencies at all? While the MSM has blithely ignored it….the people who make decisions about lending our banks money cannot (will not) ignore it.

    What will the RBA’s take on this be…..will it increase the pressure for a rate rise here?

  2. If anything, I’d say the opposite. At least, it will shift RBA perceptions of the schedule for rises. If bank funding costs rise, the RBA will have to factor in the increasing possibility of the banks passing on extra rises to preserve margins…

  3. Thank you Deep T, this is a wonderfully informative analysis, especially for those (such as I) who don’t have the insider industry knowledge.

    “Whilst these banks are TBTF, they must carry enough capital to have them rated AAA (or equivalent) without the implied guarantee.”

    Q. HOW could that be achieved … realistically?

    Q. How much do you think is “enough capital”?

    Note also the comment from reader Nod yesterday, regarding the banks’ collective exposure to $15 Trillion in Off-Balance Sheet derivatives –

    http://barnabyisright.com/resources-articles/tick-tick-tick-aussie-banks-15-trillion-time-bomb/

    What do you think is the likelihood of a failure on some/all of that little pile, and resultant impact on capitalisation needs, viz that desirable AAA? I see its mostly in FX and Interest Rate derivatives – would not a wildly swinging AUD FX rate (ie, outside the bounds of their models/algorithms/guesses) pose a risk of big losses there?

    Many thanks in advance.

    • Sorry for the delay

      Q. HOW could that be achieved … realistically?

      APRA regulates how much capital and liquidity the banks must carry which is generally in accordance with International Basel standards. APRA could rgulate that banks over a certain size, say, relative to total banking assets,must carry extra capital.

      Q. How much do you think is “enough capital”?

      I am no fan of the credit rating agencies but they are still embedded in the system and regulation and so must be relied upon to a degree. I can’t give an opinion on exactly how much capital to achieve AAA status without an implied guarantee but it would likely be well over twice

      I’ll get back to you on the derivatives issue

      • Thanks Deep T. Very helpful and appreciated.

        So the capitalisation req’s for local banks, upon whom citizens of this country depend, are not really set here at all, via our own elected representatives or APRA, but by international central banksters’ conferring in Basel.

        Nice.

    • David, this derivatives market is a complex and highly entangled area. I just simply view them as highly complicated instruments designed to siphon money out of the market and concentrate it into the hands of the very wealthy – wealth is never destroyed, it is transferred. 101 kleptocracy.

      From my understanding, after the crash of ‘29 safeguards such as the Glass-Steagall Act was introduced to separate Investment banking from Commercial banking and a ban was also placed on speculative instruments called derivatives. This ban was incrementally removed and derivatives began to grow in significance in the 1970s and 1980s and played a significant role in creating the greatest bull market in financial history from 1982 to 2007.

      How do we fix this? I don’t know, but one suggestion put forward by Dr Webster Tarpley (historian and economist) was to completely wipe them out – reset.

    • I dont trust super. Never have, never will. How can one trust a series of governments over 40 years to never steal from this kitty? I know we are not Argentina, but that is now. How do i know what Australia will look like in 30 years time? We are only 100 years old as a national government. When i saw one of my mates put in extra (over the 9%) i thought he was crazy.

      • Agreed. I’ve discussed this prev. with Prince – I reckon there’s no chance I’ll ever see a penny of mine unless a way can be found to grab it myself .. and soon.

      • Agreed MM – that’s part of the reason we run our own SMSF. The wife and I have both agreed if the government gets to grabby as we approach retirement, we’ll transfer all our super assets to some foreign bank acocunt the same day we take a one-way trip to a nice country with no extradition treaties. Legilsative risks is the biggest for super as far as I can see.

        • Food for thought QC – I need to look at that. When does a SMSF make sense? I have 60k ATM, think thats too small isnt it?
          Is it possible to buy an overseas investment property with it? I have always thought it would be nice to consume my super somehow and if you had a ski cabin somewhere you could visit it?
          As an aside, back in the day i used to work as a debt collector in a call centre. We used to convince people in debt trouble to liquidate their super (there are special rules to pull it out).

    • I agree David Super will be semi nationalised to put into whatever dud idea the Feds come up with. Swan is talking about making us put money into Infrastructure investments. What a great idea MAP MIG Rivery City motorway Babcock Power, Alinta yeah thats what I want for my retirement.

      Financial Collapse always brings massive political change and from where I sit the Government is getting into every industry and peoples lives Set top Boxes Pink bats Super. We are moving slowly toward a command economy the banking collapse will be the final excuse to go that one step further and take peoples savings. The Financial review has a story today about the banks $6 Trillion in Derivative exposure ! WTF ! When the collapse comes and Stevens signs a $100 Billion cheque like Beranke did Julia & Wayne will just come out with a massive Supernauation levy/tax. Argentina is a good example for a country with all natures gifts they seem to blow themselves up frequently with this sort financial destruction.

      Steve

  4. We need a preview function!

    Clarification of above: what I meant to get across is that since our govt must underpin the TBTF banks, then either (a) the govt will go into the hole bailing them a la Ireland, then turn to confiscating super to cover their own funding needs, or (b) force super into banks first.

    Either way, the evidence is clear that this is a growing trend worldwide … stealing the citizens’ retirement savings.

  5. I cant beleive anyone listens to rating agency’s personally. I think the GFC proved how hopelessly conflicted they are.

    I agree with what you are saying in your article however as I know investors DO listen to them. They prefer that to doing their own work.

    • As I posited yesterday MM – whilst this is 100% true, that the ratings agencies (and regulators) were “captured” by the businesses they oversaw, it doesn’t necessarily mean that they will repeat their mistakes.

      In fact, it is likely (like banks do in recessions, as proved by Minsky), they will overshoot on their conservatism to show they have learnt their lesson.

      This coupled with the “ratings agencies are useless” meme, means that most if not all investors in banks will shrug off this as meaningless.

      Hence bank share prices are going up, and the MSM has called this downgrade “nothing” “yawn” “whatever”.

      • Interesting perspective Prince. On one hand it makes sense to me.

        But there does seem one flaw in the argument – if ratings agencies were (as you point out) “captured”, then *why* would they now suddenly *not* be, and thus free to call the truth on the same industry that is (presumably) still their breadwinner?

        It doesn’t smell right to me.

        Agree your rationale as to likely market response – (ie) “we’re no longer listening”. Question is whether this outcome is by accident, or design.

      • Prince

        Debt markets rule and lead the equity markets. Debt markets were reacting very strongly to the GFC in mid 2007. Wasn’t the equity market peak November 2007?

  6. What to do if you are in Debt, fix your loan? go variable? given that when SHTF occurs the RBA will drop rates, or will they given cost inflation ?
    Perhaps an each way bet. Certainly either way disposable income is going to fall further.

  7. Maybe (well past) time for a (super?)profits tax on banks, with a % of profits to be channeled into an independantly managed bailout fund.

    Funds could be invested in treasury securities, or even overseas govt securities, and interest get paid back to the banks.

    In case one or more need a bailout, then these funds are made available, on the proviso that future profits of the bank(s) bailed out repay the fund first before dividends or bonuses get paid.

    Just an idea..

    • Isn’t this just another version on the theme that the major banks should be required to carry a lot more capital?

      • Yes, with the difference that instead of each bank self-insuring the big 4 all contribute to a fund that insures then all.

        Although now that i write that it does seem open to keeping your wins and sharing your losses.

  8. That is why I refuse to put extra money in Super because the govt can do whatever it desires with it.

  9. It seems to me that once again the ratings agencies are a little late to the table with their info.

    I think that there has been plenty of independant commentators saying for some time that the Australian banks have a number of issues with funding moving forward.

    The only difference now is that a ratings agency has come out and said it in the public arena rather than on online blogs, etc where the independants publish.

    I think that this can only be a good thing in the long term for the Australian economy. Although we will have to go through some serious pain (likely through the deleveraging process) in the shorter term.

    I should also mention that most Australians have far more exposure to the banks than they realise. They are exposed to a dowturn in banks if the banks start calling in loans due to funding pressures. They are exposed to via their independant investment portfolios (even worse so if they have margin loans over these investemnts) and finally most people don’t realise how much exposure they have to the banks in their Superfunds. Its quite a bit more than most people would be aware of.

    Writing this makes me think that in the short term, maybe we are going to see more pain than I thought.

    • The other less well understood exposure that most don’t think about is that going into “cash” through bank deposits is actually putting at least 50% of your money into housing. So we’re all up to our eyeballs in bank and housing almost regardless of what we do

      • You can see why many investors are going down the hard asset (i.e. gold & silver) path.

        Its risky to deposit in a bank, invest in a bank, by any form of property or share and finally who would seriously lend money to any government in this day and age (oh thats right the fed, by printing and then lending the newly printed money to the US Government).

        • Good points Adrian and Deep T. I am finding it so frustrating that it doesnt look like there is anywhere you can trust to put your money into. My perception is that counterparty risk in all financial transactions is a lot higher than it has been earlier in my life. I say perception, becuase maybe the GFC has just educated me on risk. A good thing at my young age.

  10. Given the likes of the uber wealthy like Gina reinhart, and Clive Palmer are dependant on a sound banking system etc. Maybe a 10% levee on the assets of all their entities( excluding super of course) with assets over 50 million. The government matches as a dollar for dollar amount and we have a new SWF to assist in stabilising the Australian Banking system. Although 15 trillion in deriviative exposure is a pretty large sum to swallow

    • I think that is called Theft Jack. Today its Palmer & Co tomorrow you and me.

      Steve

  11. Its called an ugly new tax (which I suppose is theft by another name)on the Uber rich and we are probably going to cop one on all of us tomorrow anyway.

    • I think thats the problem with this Country we all want to steal from eachother. Negative geared investors, banks, RBA distributing inflation on the public ( a form of theft) all want to steal from taxpayers/public.
      No one wants to get by on the fruits of their own efforts there is always someone else who can pay.
      Eventualy there is no-one left to steal from. I suspect that is where Greece/Argentia is now.

      • You say “fruits of their own efforts” but what is that anyway? All the money you get paid came from someone else.

        • I mean being involved in an enterpirse that does not rely on a subsidy from the taxpayer. Think the Car Industry and now thanks to the AOFM the Mortgage market.

  12. Alex Heyworth

    Maybe once the banks have got the market established with bonds covered by high quality mortgages, they will start bundling the lower quality stuff as well and start flogging it off to foreigners as high quality debt. 🙂 Given the ratings agencies track record, they’ll probably be fooled again.

  13. Set your SMSF up so it can invest in PMs. When you’re over 55 you can pay the extra tax and withdraw from the Super system and do something safe with your monay. Check out the Perth Mint website for yourself and read up on gold.

    • …true, but keep in mind that precious metals, too, are likely to bubble and pop at some point, once they’ve served their function as an alternative currency….

  14. Hi Deep T.

    On the one hand, I have enjoyed the evolution of your posts (more now about how it affects the punters), and there is now some confirmation of your analysis (yes, as you told us months ago, banks are undercapitalised and over-rated). Well done.

    On the other hand, holy [email protected]