Casualties of the externality

Now that all the hype over the RBA’s rate cut and Mega Bank’s reduction in mortgage rates has died down. Its time to recap on the only campaign in Australian media focused on Mega Bank’s balance sheet and urging bankers to follow regulatory rules and responsibilities. Whatever situation Mega Bank may be faced with politically it has a responsibility and is liable to follow the rules of the regulators who represent all Australians.

Unfortunately, added to the mix are certain regulatory shortcomings which need addressing but these shortcomings are not there to be exploited by Mega Bank in order to transfer risk to the Australian taxpayer.

My purpose of outlining a number of very technical regulatory requirements and the position of Mega Bank’s balance sheet, is to be able to establish the facts and where the Bank may be failing in its duties, responsibilities and liabilities and therefore misrepresenting the real risk position. The reader can make up their own mind on culpability. So what have we established?

Mega Bank uses a methodology based on the internal risk based approach of Basel II and III to calculate risk weighted assets and therefore minimum capital requirements. The methodology results in Mega Bank only having 1.6% capital on total residential mortgages or around 2% if mortgage insurance is included. In the face of Australia having the least affordable housing in the world and a weakening housing market, this does seem an extraordinarily low capital requirement compared to other asset classes.

Nevertheless under Basel Pillar 3 disclosure requirements, Mega Bank should “make high quality and timely disclosures of information on its risk profile, risk management and capital adequacy to contribute to the transparency of financial markets and to enhance market discipline “ I am quoting APS 330 which also includes the detailed disclosure requirements for the IRB methodologies on page 13 Table 6. No analyst, except perhaps those working for Mega Bank or APRA, would say that the Pillar 3 disclosures of all arms of Mega Bank as released to the ASX and on their websites satisfies the general and detailed requirements of APS 330. This is a wholesale failing of the system that significantly affects, shareholders, wholesale lenders, depositors and the tax payer from understanding what risks they carry.

I’ve also outlined how the recent structure of Australian covered bond issuance is deeply flawed with the shape of Mega Bank’s balance sheet put squarely into the hands of the credit rating agencies with little thought to unsecured lenders or depositors. The importance of this regulatory lapse is highlighted by the fact that whilst the APRA approved IRB methodologies only require 1.6% minimum capital the CRAs requires more than 20% overcollateralization of residential mortgages to achieve AAA ratings. Covered bond issuance by Mega Bank continues to significantly weaken the already thin capitalization levels that support unsecured lenders.

Its at this point in my discussions with those with vested interests that I get the so what look, “but Mega Bank has an implied government guarantee”. Or as one commentator, Smokester, put it, “the externality”. An expression I’ve now heard and read several times with the meaning that although such an implied guarantee exists it’s outside the bank’s control and therefore can be taken advantage of but carries no responsibility. Just another form of, losses are for the taxpayer and gains for the banks, but in a jargon which makes it acceptable. With no apologies to those who disagree, it is not acceptable.

I also have praised APRA in a previous post on the new APS 110, where it is proposed that directors and senior management are more responsible for ensuring that an ADI has adequate capital. Adequate capital must also be determined by forward looking possible risk scenarios which after stress testing should leave an ADI in a position to be able to continue to operate. This is a very significant change for Mega Bank’s directors and senior management. I’d be concerned that although the IRB methodologies produced very low minimum capital requirement for residential mortgages. Australia is looking down the barrel of falling credit demand and availability, and declining house prices. Are those directors meeting their capital responsibilities in these circumstances?

Maybe the “externality” is the get out card. The directors and management of Mega Bank know it’s a fact, although its never mentioned. APRA and the Government know it’s a fact and is relied upon heavily by lenders and other stakeholders, although it’s never mentioned. Just because it’s not mentioned does not mean a judge may not decide that directors should not take it into account in their capital decisions. After all, look at the benefits to the politico-housing complex.

The problem with this defence of course is that not all Australians are members of the politico-housing complex or are heavily invested in housing. In fact every day less and less Australians are joining the circus. Unfortunately as the system stands the non members are meant to pay for the sins of the members

There is, however, a much greater distortion in Australia’s banking system which, whilst the opposite of ”the externality” argument, actually allows it to play out. The credit rating agencies do not consider the implied government guarantee of Mega Bank to be an externality not to be mentioned. Rather, it’s a factor front and centre in their credit opinions which allows Mega Bank to receive a rating which is at least 2 notches above where it should be. The CRA’s direct acceptance of the implied guarantee gives legitimacy to the externality that neither Mega Bank, APRA  or the Government will directly admit.

Whilst a CRA can give any credit opinion it want, I’d argue that giving direct credit to the “externality” is in the interests of Mega Bank but not its lenders which rely on the credit rating. Firstly, where did the 2 notches up come from? If there is a guarantee then why not assign a AAA rating as per the Australian government? If it can’t be relied upon, then how can it be taken into account? What is the probability of the government ensuring that unsecured lenders will be paid if insolvency occurs? These are questions to which the CRAs should provide answers, otherwise I see the same type of conflicts of interest that the CRAs have been accused of during the US sub-prime debacle. A less conflicted approach would be to have a headline credit rating without the implied guarantee with a rating supplement for those investors willing to believe the rating upgrade for the guarantee.

The fundamental problem with “the externality” effect is that it allows Mega Bank to hold low capital levels whilst at the same time raising debt at low levels relative to where the cost should be without its effect. This allows a large expansion of mortgage credit without the need to raise extra capital. Mortgage growth could generate its own minimum capital requirements each year in the recent boom years. A classic requirement in generating asset bubbles with little to no impairment to credit growth. At the very least, “the externality” should have been paid for even if in the form of capital to protect the taxpayer.

Whilst I make all these points, establish the facts and at least question the system, there are many who believe that “so what, the system has worked well for Australia and many have benefitted. That’s life”. “There are winners and losers, isn’t that normal business?”

There is nothing normal about the situation we find ourselves in. This is about a generation building a life style on the proceeds of debt and the valuations of assets based on air to support it. The only thing that sustains the pseudo wealth creation is the slow and steady transference of that debt to younger generations assisted by our government through “the externality”. The debt must also increase to create the same lifestyle for and to attract those younger generations. Shear weight of the numbers required, means that at some point there are not enough entrants in the game to sustain it. This is a generational battle  that can only end sadly for most.  It cannot be termed as the luck of the draw or accident of birth benefit for the select ones.

One of the largest problems we are faced with is that the majority of Australians currently believe they are the beneficiaries of the system called the politico-housing complex. Whilst I’ve pointed out how failures in our financial system and “the externality” have allowed this complex to thrive, why care when you think it works for you?  As taxpayers and beneficiaries of the politico-housing complex, support is given to” the externality” because it delivers in spades in driving up wealth through increased house prices.

At least it has until recently, but if you know what’s good for you, Ms Taxpayer, you will take notice as there will be very few winners when the game ends.

Every day now and I’d say for at least the last year the ranks of those doing well out of the politico housing complex are reducing with those carrying the burden increasing. This weight of numbers, as mentioned above, will gradually shift not just the debate and the political will but must see a rebalancing of housing wealth whether fast or slow.

I’ll take the liberty and use some very rounded numbers to make my point. Everyone who bought a house in the last year is well behind in cashflow compared to renting and likely to be well behind in the value of equity they have in their house. That’s about 0.5M borrowers out of around 5M borrowers who are not benefitting from the politico-housing complex or from supporting “the externality”. Let’s assume that the slow melt continues, or indeed that there is simply no real increase in house prices over the next 5 years. During that time with absolute certainty the balance between those benefitting and those supporting shifts dramatically. However, at that point the beneficiaries become targets as no generation with the balance of power will wear the burden.

It is inevitable that the balance must shift. By deduction, flat house prices or a slow melt over 5 years cannot be a viable outcome. Half a million borrowers bearing the burden now will not turn into 2.5 million carrying the burden and allowing the Boomers to cash out. The majority of Gen X, Gen Y and immigrants are not that stupid. Are they?


  1. “The majority of Gen X, Gen Y and immigrants are not that stupid. Are they?”

    DeepT I don’t think they are, but the power of MSM and the politico-housing complex who push the line will go down fighting (we never saw it happening). I wonder if anyone in MSM will pick this SocGen assessment.

    Great post. Thanks.

    • dumb_non_economist

      I don’t agree, they are! Why do the over whelming majority still believe in housing. A slow melt is the equivalent of the frog in the slowly warming water, doesn’t realise the danger until it’s too late.

      Unless the MB “side” of the housing argument gets msm attention attitudes won’t change.

      By the time “we” wake up to the danger we’ll be toast.

      • DNE the average Joe who is busting his/her gut to make a living, and live, generally does not have time to research to get a good view, and you have MSM telling them to buy housing, but worse IMO is that our governments now and in the past have promoted this housing only investment story. I’ll be amazed if we don’t see a large price fall in the next few years.

        I don’t like to call anyone stupid, just missing the truth.

        No side of politics is anywhere near making a difference on this either, and you can see why given the leverage in housing.

  2. If the bank’s debt is effectively nationalised (“externalities”), why not just re-nationalise all the banks, or re-introduce a new government bank. That way at least the taxpayer benefits from the profits, and this would implicitly lead to better banking responsibility. I am old enough to remember government-owned Commonwealth Bank and State Bank of Victoria. Bank lending was so much more responsible back then.

    • “Bank lending was so much more responsible back then.”


      The bank collapsed due to the weight of the bad loans made in the 1980s, in particular by its merchant banking arm Tricontinental, after deregulation of the banking industry in the mid-1980s by the Hawke ALP government. Tricontinental eventually collapsed, which threatened the existence of the State Bank and forced its sale to the Commonwealth Bank.

  3. rob barrattMEMBER

    Deep T
    I blogged the other day that I spent nearly 7 years with negative equity after I bought a house in Cambridge in the UK in 89. Luckily I never had to sell. Despite this, inflation gradually did it’s thing and eventually prices became inflated again. Schiller & co pointed out that long term prices of housing always follow inflation, and unless someone brings in the 60 year mortgage, I would assume that nothing else is possible. Debt reaches a celing & then it subsides again. Australia is just learning what I did back then (to my cost, I wish to God I’d just left the money in a term deposit..) when my mindset was “it’s different here”. Plus que ca change…

    • My dad’s advice “Never buy property expecting to profit immediately, it is usually passed onto next generation so that it can be profitable, so a “holding-period” of at least 40+ years is a must!”

      although i must admit, both me and my dad both like to “land-bank”! 🙂

  4. I also have praised APRA in a previous post on the new APS 110, where it is proposed that directors and senior management are more responsible for ensuring that an ADI has adequate capital.

    +10. After the James Hardie ruling yesterday, that provision gets more teeth. I wish the renumerations were also tied to capital provisions.

  5. The majority of Gen X, Gen Y and immigrants are not that stupid. Are they?

    Well, I myself am Gen X immigrant and do not plan to bail-out Baby Boomers’ plan to wealthy retirement by taking huge mortgage anytime soon. But, unfortunately this is not common idea amongst the Gen X/Y and recent immigrants.

    I’ve come to conclusion that Federal Govt from both sides of politics have taken some conspiracy method to select new immigrants that have “cultures” to worship real-property to perpetuate the bubble.

    • being an immigrant, I have realised one thing, people are same every where, they might have differing accents/languages/up-bringing, skin-color and eating habits.

      However, ignorance, stupidity and greediness are common traits that doesn’t discriminate between sex, race or creed!

    • russellsmith55

      As a proud member of Gen Y, I can say with certainty that we are in fact that stupid as I have already watched many of my friends do it. And many are excitedly waiting for their change to do it too. Most people I tell of Melbourne’s 7% average year-on-year fall are shocked, like how could it ever possibly happen?!!

      The whole ‘housing downturn’ information hasn’t been disseminated as far as us blog readers would like to hope, and probably won’t ever reach deep enough penetration.

  6. Great post Deep T. All of it, but I especially wish your closing paragraphs could be widely distributed and read, beginning with “There is nothing normal about the situation we find ourselves in.”

  7. Sebastionbear

    Thanks Deep T – great post illuminating the misinformation and deceit of Megabank quadropoly.

    I’m just so happy that my last mortgage payment is coming up next month, and then all I’ll have to worry about is the best returns for investment – I’m thinking it may not be property..:)

  8. Banks are leveraged to the limit but they simply can’t say it publicly because so much of the financial system is a Con-trick. CRA reports are simply part of the Con!

    The big 4 all run capital ratios around 4% and reducing. With that much leverage any significant increase in defaults (which are up 25%) increases their capital requirements exponentially.

    In a world were several markets offer zero interest rates it is telling that all 4 major local banks claim an increase in funding costs. Presumably the lending sources ignore CRA reports and are charging higher rates due to the actual local business environment of 35 yr low in credit growth coupled with an accelerating slide in local property prices and increasing defaults.

    The correction is happening, all we can do is be patient and encourage Boomers to “get out at the top’ and start selling!

  9. House prices may melt or crash (there is no magical 3rd way except rampant inflation), but DEEP T, what about the unsecured depositors to the Banks? You note a potential risk but don’t define its magnitude. Just how much is at risk and how close are we to the ledge that depositors get pushed off?

    If the idea that bank deposits were really at risk then the capital adequacy balloon could pop faster than you could say “run to the bank”. I see a Humpty Dumpty jigsaw at the bottom of the wall then…