Lending standards and the CAD curse

Australian banks’ reliance on foreign funding has lead to the alarming situation whereby we (as a nation of households) have borrowed from the rest of the world to buy existing houses from each other at inflated prices.   As I once said it makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses.  Delusional Economics has explored this idea in more detail here.

Admittedly I made that claim without evidence – it was an intuitive interpretation of the data in the balance of payments and in particular, the interest payments heading abroad in the primary income account. But, in the interests of an informed debate, I have digested some of the literature on this matter and found that the intuitive principle is well supported.

In February this year, Andrea Ferrero, of the Federal Reserve Bank of New York, published this paper arguing that a progressive relaxation of borrowing constraints can generate a strong negative correlation between house prices and the current account. Households increase their leverage borrowing from the rest of the world so that the current account turns negative. The following plot is from the paper (p2).

The model demonstrates the mechanism by which relaxed lending standards decreases domestic saving, increase foreign bowings and decrease the current account. The model also shows that prices vastly overshoot the new equilibrium point. The quote below is from page 14 (my emphasis).

The key shock that generates a house price boom and a contemporaneous current account deficit in the model below is a reduction in the parameter that measures the loan-to-value requirement. At a broad level, lower collateral requirements capture easier access to credit for housing finance.

The main experiment consists of shocking the collateral constraint parameter. In particular, financial innovation corresponds to a higher loan-to-value ratio.

At a very basic level, the model captures the negative correlation between house prices and current account balance. In response to the shock [relaxation of collateral criteria], house prices persistently increase while the current account worsens, at least for a couple of periods, before slightly overshooting its long run average of zero. A more realistic sequence of shocks approximating a progressive relaxation of collateral constraints (the process of financial liberalization) is likely to generate a run-up of house prices and a deterioration of the external balance more in line with what observed in the data.

This appears to support the idea that simply constraining lending criteria would have been an effective measure to contain house prices, and reduce the current account deficit.

Indeed, the evidence of this relationship appears quite strong, and it is easy enough to find other articles supporting this argument empirically.

My main criticism of the paper is the timing of the house price growth measure. China for example appears to have flat real price growth in the above graph for the period 2001-2006. That would seem consistent with the arguments surrounding the relationship between the current account and house prices.

However, since that time credit standards in China were lowered, prices shot up (around 2007), then access to credit was subsequently tightened, and prices flattened (around 2008). To me, a good experiment to demonstrate this relationship, although hampered by global conditions at the time. The below graph from The Economist house price comparison tool shows China’s house price growth in this period was far below that of the US, UK and Australia. More recent data shows strong house price growth since 2009.

Out of interest, here is a list of countries according to their current account balance. Eyeballing this list it is pretty easy to find the prominent housing bubble markets near the bottom.

To be clear, access to credit is the key (and this may provide the explaination of the Japanese experience in the 1980s). Tighter standards on loan-to-value ratios force domestic saving and limit the need for foreign borrowing, meaning asset prices can reflect the economic reality of that country alone, and not the savings decisions of other nations.

One example of where the relationship  between house prices and the current account appears to fail is Japan in the 1980s.  A housing bubble coupled with a growing current account surplus (at 2.1% of GDP on average over the decade) is not what these models predict. One might argue that Japanese saving was high enough that the current account was simply lower than it would have otherwise been, but not negative.

I will present one final conclusion from here, with my emphasis.

We find robust and strong positive association between current account deficits and the appreciation of the real estate prices/(GDP deflator).

Our results are consistent with the notion that for all countries, current account deficits are associated with sizeable appreciation of the real estate. This effect holds controlling for the real interest rate, GDP growth, inflation, and other conditioning variables. We also find evidence consistent with the growing globalization of national real estate markets. These findings are consistent with various scenarios explaining patterns of capital flows across countries, including differential productivity trends and varying saving patterns. In the absence of pre-existing distortions, financial inflows are unambiguously welfare improving. Yet, in a second-best environment, public finance considerations imply that inflows of capital may magnify distorted activities, increasing thereby the ultimate costs of these distortions.

Arguably, the experience of emerging markets in the aftermath of financial liberalization during the 1990s illustrated these concerns. Needless to say, this second-best assertion is not as argument against financial integration, but a cautionary tale – greater financial globalization implies the need to be more asserting in dealing with moral hazard and other pre-existing domestic conditions.

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  1. Nice data. Does this support the Bullhawks who suggest rate cuts will have an immediate stimulatory impact on the housing market?

    On the topic of access to credit, a local agent believes some lenders have applied a max 70% LVR to borrowers. Sounds ridiculous to me. Of course she went on to say prices were about to start rising again…….

    • Deus Forex Machina

      Actually many lenders, big guys, are in the process of relaxing or have relaxed standards once again.

      things like 97% with capitalised LMI and certainly 95% plus capitalised LMI.

  2. Deus Forex Machina

    It’s always about lending standards isn’t it…

    Bigger LVR’s mean more leverage mean more borrowing potential for mortgagors means more to be funded by the banks….means higher prices.

    The way the system is funded however is changing and has changed over the past 4 years. Thankfully

  3. “,i>This appears to support the idea that simply constraining lending criteria would have been an effective measure to contain house prices, and reduce the current account deficit.”

    Would this dampen the expansion of the CAD via increased interest payments abroad, rather than reduce it? i.e. even if there is no expansion of credit interest still has to be paid on existing loans — and the magnitude is huge, much more than you’d get from a mining tax or a carbon tax etc.

    Out of interest, here is a list of countries according to their current account balance.

    How about the charts next to the table. The per capita balance chart shows us as world champion sovereign debtors. That chart, more than anything else, should illustrate to people that despite one sector of the economy going well at the moment, we aren’t accumulating sovereign wealth.

  4. Seems like a pretty straightforward argument to me. If you are a deficit country the the only access to credit is from the foreign. sector of the economy on the capital side. So the negative correlation holds. If your a surplus country you can still have a housing bubble. Basically bubbles require a source of funding and if you have no income you have to borrow to make it a reality.

    Would be interested in the proof though that we have been using foreign money to bid up the prices of houses against one another and not instead to build more?

  5. Nice article.

    I think another aspect related to this is the effect of leapfrogging (buying 1 property, let it rise, draw down on equity mate to buy another… Wash, rinse, repeat).

    Had speculators not been able to refinance every 12 months at ridiculous lvr’s and buy as many properties as they could afford (rather than what they need – 1 or 2 max) i doubt the massive have/have not distortions we have today would have occurred.

    I really like what the article was saying about the impact of reduced lvr’s as prices rise. It should be the opposite to keep a stable housing market out of booming!

  6. Credit standards is a descritption of lending policies based around LVRs, and servicing ratios plus many other factors. I find it difficult to talk in terms of tightening or relaxing lending standards when theoretically it should be self adjusting by adjusting the required capital for increases or decreases in risl.
    APRA consistently expouse the view that our banking system is fine and well capitalised. However, this cannot possibly be the case with an ever increasing risk profile on reseidantial mortgages and no incresae in capital requirements.
    Expansion of credit by the banks fromn offshore which now totals $700bn would not be possible without regulatory complicity in under providing the amount of capital against the assets the bowrrowing was used to fund.
    Exactly the same is now true for deposits enticed into banks as “safe” when used for dubious residential mortgagees when the funds could be used for more constructuve purposes

    • “Expansion of credit by the banks from offshore which now totals $700bn would not be possible without regulatory complicity…”

      Very true. But making a change from an ‘easy-money environment’ to ‘tough-money environment’ is extremely politically challenging (given that the regulators themselves are simply a political tool).

      For me the question is – how do we adjust given our current starting point?

      • Very good question. Where do you start?

        Clearly the politico-housing complex, soon to market to the world for more funds, will just deny there is an issue. To many that is a solution, because its possible the fall out will be another generations problem.

        We cannot have a solution with undercapitalised TBTF banks. That blood sucking from the taxpayer must be addressed even if slowly. Without moving to a long term solution, the PHC will ensure systemic bank failure.

        To address the redistribution of wealth that the housing bubble has created, we need to have -tve real interest rates for quite some time. I realise that this will cause many problems for some of the innocent as well.

        Too little space here to explain myself fully, perhaps I’ll post in more detail soon.

        • Diogenes the Cynic

          Solving the problem with negative real interest rates sticks in my gullet. If real interest rates had been higher in the past then the problem would be now be smaller.

          To prevent the tax payer footing the bill during the next stage of this depression I think radical surgery is required – strict LVRs now for all future loans, 97% is ridiculous the regulatory agencies should be prosecuting management.
          Require an immediate capital buffer from the banks that they cannot touch – force them to raise equity now whilst there are still buyers of bank stock.
          Bring into the open all the gaming going on about capital ratios. It should be fully published on a website accessible to the public.
          Limit banks in terms of size – if they were smaller then they would not threaten the system. Think 50 small columns not 4 massive pillars.
          Prosecute any breaches of the rules by banking senior management with teeth, they should go to jail if they break the rules.

          The era of TBTF banks will be over at the end of this crisis the question is how will we get there? By nationalising them and forcing taxpayers and savers to suffer or by making changes now while there is still time?

          • Diogenes the Cynic, I think you have outlined the reforms that Deep T. and myself would love to see.

            How can it be made a political priority? How to stay in government long enough to make such reforms, when the demographics and homeownership rates are against you?

            Any ideas there?

            My only thought is that it needs to be done by stealth, or with bipartisan agreement. You can’t have an opposition party winning elections by promising to undo your tough reforms.

        • You and others have mentioned that the big 4 are allowed to use a different method than the smaller banks for their asset accounting so a start would be to stop that.

          • Diogenes the Cynic

            Rumplestatskin those questions are extremely pertinent and are Work-In_Progress. Banks are not exactly popular and this could be an area where bipartisan support is possible. The ALP has been making much of its financial reform programme but seems to have missed the boat on TBTF banks, focusing on consumer initiatives like account portability, fees, and the various super reforms that will impact financial advisors.

            I expect grandfather provisions would have to be in place for existing loans but new loans and redraws (no more Equity mate! to 97%) could have a new phase in period where caps on LVRs are progressively lowered, 90,then 80 then 70 etc. If this occurred whilst the property market was falling slowly then affordability arguments would actually not make any sense, properties would be becoming more affordable all the time to new buyers.

            The capital buffer issue should be done by the regulatory authorities leaning hard on the banks now to raise extra capital. The transparency issue of gaming capital ratios requires a directive from a Treasurer who knows what he is doing, it would be easy to achieve if it was made a priority, I doubt new legislation would be required here. Transparency would get a tick from quite a few crossbenchers as long as it was not called “Bank Watch.” As I see it this is a nonpolitical item.

            Limiting the size of banks should have been done with the deposit guarantee legislation, essentially they have to be shrunk which would definitely arouse PR campaigns by TBTF Banks incorporated. This is the hardest objective to achieve, effectively we let the opposite happen during 2008/9 with Bankwest and St George being absorbed by the Big 4. I doubt we have enough time to do it, maybe when we do nationalise one of the Big 4 banks then we can push hard for the kind of radical emergency surgery that is needed to prevent further bouts of this cancer occurring in our financial system

    • Deep T I thought the foreign wholesale funding had gone down, but at $700B that $100B more than when I was told, on this blog, that I was wrong. Maybe I’m still wrong, but the figure I found was $600B.

      • I use the RBA staistics tables. In table B3 it shows that the wholesale borrowings of the banks in total is nearly $500bn gross. However, in that table some offshore borrowings are “hidden” in deposits. So if you look at table B12.2 which shows in more detail the offshore borrowings, it shows that there are about $190bn of offshore deposits. The total is nearly $700bn of offshore wholesale borrowings plus offshore deposits

  7. Dr Nick
    Dr Nick Riviera
    September 19, 2011 at 7:58 am

    Would this dampen the expansion of the CAD via increased interest payments abroad, rather than reduce it? i.e. even if there is no expansion of credit interest still has to be paid on existing loans — and the magnitude is huge, much more than you’d get from a mining tax or a carbon tax

  8. Sorry Dr Nick Question
    I didn’t understand what you wrote here
    Did you mean INCREASE the CAD via increased interest rates abroad?

    • flawse I was commenting about the statement in the article that I reproduced in my comment and questioning whether it would reduce the CAD. i.e. if you don;t borrow any more you still have to service what you got.

      The first word should have been “Wouldn’t” rather than “Would “

  9. Deep T
    _ve real interest rates create less saving, more spending and a higher CAD, more foreign borrowings, more sales of our industries and resources.
    I don’t see how this solves anything?

    Also I refer to Rumples conclusion on Moral hazard. If we reward those who practise excess, then we are magnifying what I’d consider to the the REAL problems.

      • Flawse, you misunderstand. First fix the banks so there is no ability to grow credit at taxpayer expense. I’m very sorry for the reality check but the debt must be significantly reduced. Perhaps we’ll all be happy to give up 30% of our super as a once off????

  10. Indo…we either borrow to fund the CAD or, as we have been doing, we combine both. The only reason the A$ is of any value at all after 50 years of CAD’s is that people are able to exchange it for real assets.
    Our whole political and financial system is based on it.

    • Are you saying that if we dont sell away our exchange rate would fall , by how much , how drastically does this reduce our standard of living?

  11. Deep T I’m thinking about your response…but just upfront I KNOW the debt has to be reduced. It’s the question of how.
    It’s sure that Bank’s ability to load the taxpayer with the risk would be reduced but that only fixes part of the problem.

    ON these economic questions we go round in circles or feed=back loops if you prefer.
    However, looking in the long term, as well as the problems you outline, negative real after-tax returns are a (the?) major factor. People, over decades, have received NATRI. So they have done the logical thing through not saving and and spending the money. After-all, in general, why save?

    So, logically, they will continue to spend. In future it may not be on houses but it will be on something else…LONG term. My current perspective is that we will get inflation for a variety of reason including prosperity and demographics in China.
    I think that short term, as you and others have concluded, the destruction of the auto rise in house prices every year will have a very sobering effect.
    In the long term it will not be enough.

    In essence I am saying that the political problem is bigger even than you think.

  12. Indo
    Don’t get me wrong. I DO read, and like to read, those who disagree with me.
    Note I don’t disagree with anything in Rumples post. I Don’t disagree with Deep T. I just think is is a bigger problem than we are thinking.

    In answer to your question
    Yes the exchange rate would fall and drastically. All other things remaining more or less the same.
    I don’t know how far the exchange rate would fall and against what?
    I used think we ought be about A$=$0.40 US. That’s now a pretty outdated notion especially in the light of the terms of trade.
    Given that what we should be running, as we dig up our resources, is a substantial Current Account Surplus I’m guessing still we are looking at USD 0.6 or some such…just a GUESS!!!!!!TOTAL GUESS. Others here would be more qualified and have more the time to calculate that than I.

    Now as I’ve alluded to elsewhere my take is we are in serious trouble. Instead of importing deflation out of China, even if the A$/USD rate remains stable, we are looking at importing serious inflation. This will add to domestic inflation of around 6%.
    If anyone can see a painless way out i’m all ears.

    • Given our position as a small open economy, we are not going to get much choice in the way out. The US is trying inflation (as are others, just on the quiet), and we can’t act independently of that. I suspect we will get inflation whether we like it or not (perhaps not in asset prices until the value of money has dropped quite a way).

          • 🙂 true I guess.
            I’d only dispute the degree (for my own purposes) I’m pretty sure no one is factoring the watershed that is now happening in China.
            As an example, I include, without arguing anything, an email we received from a factory in China this morning. Every factory we deal with is experiencing production problems based around staff.

            “In the last couple days, we were going thru the whole case and identified the cause of these issue and added preventive actions. The main cause, is due to the difficulty of recruiting, we are experiencing a high turn over rate on staff, that some of the production management control staffs were fresh new to their positions. “

          • An alternative to buying gold (which I feel the price has already factored in inflation) is to take what works for you out of the Alpha Strategy by John Pugsly. Available as a PDF via google search. The basic thrust of the strategy is to buy everything you need now with todays dollars thereby beating inflation. Sure the plan is far from perfect but stocking up on stuff you will use in the future whilst the AUD is stupidly high makes sense to me. Maybe not a lifetimes supply though 😉

  13. Deep T
    Connect some dots for me here if you have the time and inclination please. I know you are not proposing a 30% donation of all our super. Just for the theory, even if we have a one-off 30% slice taken, how does that fix the problem.
    I own up to sometimes getting so deep in this I get lost as everything goes back on itself.

    • I may address in more detail in the future but if we dont want massive pain and defaults as house prices fall to reasonable affordable levels, the banks need to reduce mortgage balances by about $300bn and the reliance on offshore borrowing by the same amount. Our super funds contribute the $300bn to the banks through some non recourse instrument as assets are liquidated and funds become available.

      It may seem like taking from one hand for the other but its not. Those with large super balances are not likely to have large mortgages.

      Its a very left field suggestion which may be able to be made more equitable in the detail but will never be implemented anyway.

      Its also a pretty dumb suggestion without reform of the banks as per Diogenes the Cynic

      • I can see that if the assets liberated also generate some foreign currency holdings then I can see it. Suppose they are shares held in the US or Treasuries etc.However we would have only traded a foreign asset, of which we have a limited amount, for a reduction in the Bank loans.

        Otherwise i’m a bit stuck thinking the one hand to the other as in it’s just a domestic transaction.
        On the other hand the purchase of the assets of the Super fund would certainly take some liquidity out of the system which would in turn have ramifications for the CAD and foreign account. However that would also have interest rate ramifications. On the other hand if the funds to buy the Super fund assets were borrowed from overseas so that it wouldn’t affect domestic interest rates then we haven’t gained anything. As nation everything is back where it was.
        I’ll think some more if it doesn’t hurt to much.
        There’s an old joke “I get lost in thought because it is unfamiliar territory”

  14. Rumples i first saw that correlation re CAD’s and house prices in a speech Bernanke gave in evidence to Congress (I think) or perhaps the Senate. I forget now which he was telling them causes the other. I do have the speech stored somewhere. In any case he was passing the correlation off as a causation. Now I know Bernanke knows the difference. What bothered me was that he wasn’t pulled up by any of the legislators.

    • I argue that they are both the result of relaxed lending – the easy money economy. Lending comes first, this bids up home prices, and when banks seek out reserves the need to go offshore (since we are all borrowing domestically and not saving), and this capital account surplus necessarily requires interest payments which come out of the current account (specifically in the sub account of primary income).

      • Rumples i agree almost completely.
        I do think that Banks themselves probably don’t head offshore immediately for reserves. As per Keen I’m thinking they only need to go overseas for that part of the credit that doesn’t come back to them as deposits…i.e. the CAD in essence.
        I realise that this is all circular and feedback but that IMO is economics.
        Certainly we are on the same page. It’s just detail

  15. One of the best reads on CAD, foreign debt and bank credit (think Oz housing Ponzi finance scheme) I have run across is by Leigh Harkness (ex Aus Treasury and Tonga Min of Finance).

    Senate Economics Committtee – ‘Competition within the Australian banking sector’ http://www.aph.gov.au/senate/committee/economics_ctte/banking_comp_2010/submissions.htm
    See sub 33 Mr Leigh Harkness (PDF 182KB)

    The author noted that Tonga’s “falling foreign reserves” could eventually be traced back “to a rise in bank credit” and that “when bank credit increased, foreign reserves declined and when bank credit declined, foreign reserves increased.” and that “current account deficit is funded by raising foreign debt or selling off the farm.”

    APRA has failed to rein in wreckless bank lending and the AOFM thinks it is sport to engage RMBS with the likes of RAMS (its 120% LVR Equity Loans make a mockery of regulation).