Recently I’ve read and heard opinions expressed that securitisation, particularly residential mortgage backed securities (“RMBS”), are no longer relevant to the Australian financial system. Nothing could be further from the truth. RMBS is central to maintaining the solvency and liquidity of all banks/ADIs in Australia and cometh the offshore credit squeeze are likely to be acknowledged as the means for stability and not the reciprocal.
The majority of assets on Australian bank balance sheets are residential mortgages or Australian RMBS, 85% of which belong to Mega Bank. Therefore as resi mortgages are collateralised by Australian houses, the devaluing of this house is commonly thought as representing the largest threat to financial stability, but this may not necessarily be the case.
House prices, affordability and debt volumes continue to polarise Australian society whilst distorting the allocation of capital and debt towards non-productive pursuits. A commonly held view that significant falls in house prices will devastate Australia and its financial system fail to account for both who really should bare the cost and how the system has and could have the tools to manage such an event.
On the face of it significant falls in house prices and even the sale of houses at deflated prices does not have any great direct detrimental effect on an economy. To the contrary, I’d argue at another time, that decreases in house prices in Australia from current values are likely to stimulate home building and investment in productive pursuits. Nevertheless, decreases in house prices that result in significant losses on mortgage loans or an inability of a borrower to refinance creates positive loss feedback increasing systemic financial risk and mass deleveraging, and a loss of the ability for Mega Bank to maintain lending levels. All of which can create hardship for many Australians including innocents.
Our government and regulators should not prioritise the effect on the current majority of current home owners of house price decreases, rather, the priority should be protecting those who have been duped into massive mortgages, the new generation of home owners and the potential unemployed resulting from a systemic failure of Mega Bank. The fate of land bankers, subsidised housing investors, depositors with unearned gains and bankers with implicit public support should be of little consideration.
Although it would appear not the intention of the RBA, decreasing interest rates as we head to our own form of ZIRP, helps mortgagors to the detriment of depositors. While there are other effects of “towards ZIRP” policies, the relationship between depositors and borrowers is worth exploring a little. Firstly, depositing funds in an Australian ADI is most often referred to as a “cash” holding. It is, of course, not cash as notes and coins, but rather an exposure to the ADI’s assets, which are mostly residential mortgages. “Cash” as an investment would be better understood if it was more correctly referred to as a “mortgagee deposit”.
In a more commercially independent financial system, matching mortgagee depositors with the risk of mortgagor borrowers even partially, would be normal, but that’s not what we have in Australia. In the wake of Lehman’s collapse in September 2008 and the ill fated decision by Ireland to guarantee the debts of its banks, the Australian government guaranteed Australian ADI retail deposits. Over the past 2 years while wholesale borrowing has been wound out of government support, retail deposits below $250,000 continue to receive government support with no current cost to the ADI or the depositor.
As with the “cash” moniker, the government support of retail deposits is not actually a “guarantee” as is most often referred to. It’s more the equivalent of a “back stop loss”. For those who believe that if you have a deposit in an ADI, especially Mega Bank, and that bank could not meet its obligations when a depositor wanted to make a withdrawal that the depositor, or the bank, could waltz down to the federal government and get their money should read the Banking Act in detail. The government “guarantee” of deposits is not an actual guarantee at all and falls into the same descriptive category as “cash”. Maybe, these definitions do not mean much to many but when looking at how the system operates, the incentives and risks, the detail is very important.
In Australia today, decreasing interest rates cost mortgagee depositors (cash) to the benefit of mortgagors (borrowers), does create a little rebalancing of cost and benefit within society. On the other hand those depositors now enjoy a backstop loss from our government at no current cost. This arrangement, although distorting investment decisions, is providing a level of stability to the financial system and therefore house prices, but is nowhere near enough to counter the head winds of decreasing bank lending from offshore.
To understand systemic risk in Australia, we need to analyse the capital and liquidity positions of Mega Bank and other ADIs. I’ve written at length about the capital position of Mega Bank so for this post I’ll address the liquidity position and although linked can be analysed separately.
Changes to the liquidity regime of banks were strengthened by the Basel Committee rules in the aftermath of the financial crisis so that banks globally were better able to meet short-term obligations (“liquidity”) when issues arise within the system or bank so that money is withdrawn well above normal requirements. In Australia, our circumstances meant that regulators have come up with our own form of liquidity support.
In summary, due to a shortage of government debt in Australia our regulators have come up with unique arrangement to provide liquidity to ADIs. Under Basel III, government debt formed the basis of qualifying assets to determine a bank’s liquidity. Government is not the only qualifying asset with other assets including RMBS qualifying, nevertheless, it was felt that Australia needed something different. The basis of the liquidity to be provided to the Australian financial system is through repo facilities and a conditional liquidity facility (“CLF”) with the Reserve bank of Australia.
These facilities allow any bank to provide certain securities to the RBA as security collateral for both short and long-term borrowing. After predetermined haircuts the RBA is required to lend on these eligible securities when they’re presented to the RBA. So if any ADI in Australia is faced with a situation where there is a run on deposits or wholesale offshore investors wanting debts repaid and having exhausted other avenues, can borrow from the RBA to meet those obligations using the eligible securities. A simple an effective provision of liquidity and the transfer of debt to the government’s balance sheet. A conservative estimate for the size of ADI CLF and repo with the RBA by 2015 is $350BN.
So what are the twists to this system that are worth understanding?
The first twist concerns price and timing. APRA and the RBA announced the CLF when government debt levels were very low. They also announced that the CLF does not have to be fully in place until January 2015 and that from that time each ADI would pay 0.15% pa for the CLF. This suited the ADIs very well because they did not have to build portfolios of low yielding government debt and could continue accumulating much higher yielding residential mortgages. At a low cost of only 15 bps pa, this was hardly a cost to even think about. Without irony I point out that since then and even though still relatively low, government debt has risen significantly (circa $200Bn) but the majority of bonds are owned by offshore investors. Without bids from Mega Bank and other ADIs that’s hardly surprising. Undoubtedly this offshore purchase of Aussie government bonds has had a significant effect on the value of the currency.
Secondly, with residential mortgages making up the majority of ADI balance sheets then the large majority of eligible securities under the RBA repo and CLF requirements will be securitised residential mortgage backed securities. That’s right RMBS. Admittedly RMBS with AAA opinions attached but RMBS nevertheless.
Regulators globally and APRA in particular have denounced the use of RMBS and have made issuance particularly difficult and unattractive. Yet Australia’s whole financial system revolves around just those securities. Actually, how could it be any other way with the majority of bank assets being resi mortgages, in a crisis those are the assets that will need to be used to support any liquidity funding. Fortunately there are some wise people at the RBA, so that rules are now being formulated for loan level information on mortgages supporting the RMBS to be made available by the ADIs so that the RBA and others can assess the risk underlying the RBA’s liquidity support. The RBA has also announced that this information will be “publicly” available.
Australia’s financial system has developed since 2008 to be supported by government backstop loss for retail deposits at zero current cost, and the RBA’s repo and CLF lending programmes that are primarily designed for RMBS but at a distorted low cost. The implied guarantees referred to by the credit rating agencies are not just opinions, its played out in both these mechanisms.
Bagehot said that a Central Bank should lend liberally but at high cost to banks suffering a temporary liquidity crisis with good collateral. In only focusing on the collateral and not the cost our regulators continue to send the wrong signals to banks.
Whilst it may be comforting to believe that a mechanism has been or is being set up to provide liquidity to ADIs, without a further mechanism to recapitalise the banks if necessary, taxpayers will end up with the cost of the responsible losses on bank balance sheets. Ireland is an example of this process, but it can be avoided.
Lenders and large depositors in banks must be at risk for bank losses in some manner, whether slowly through low or negative yield mechanisms or quickly by turning a part of debt into equity in the bank in a crisis. It’s a necessary completion of the back-up support mechanism for Australia’s financial system to make lenders and shareholders liable for losses
With the back-up mechanisms in place, Australia can easily manage large decreases in housing prices without a collapse of the financial system. Such a collapse is really what the hysteria surrounding a dramatic drop in house prices is all about.
Lastly, but not least, now that we understand that our banking system is largely supported by the taxpayer at an insignificant cost to all ADIs we should focus on reward for effort and innovation. Our banking leaders especially Mega Bank continue to both not acknowledge the taxpayer support but also continue to pay themselves userous salaries on the back of this support. It’s a national disgrace and it’s about time we all nailed our colours to the mast on this issue.