We must bail-in the creditors

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.


  1. As usual, and excellent read. But where’s the mast to do the nailing to?! MB is about the only one I know of……

    • Yeah thats part of the problem isnt it. This is a good post pointing out what many of us are perfectly aware of but reality is off and running elsewhere.

      So people like DeepT and MB can raise this issue but it will simply be ignored as long as possible.

      At the moment we have a government backstopping megabank, the megabank focused on mortgages, loaded to the gunnels with an asset base largely comprised of overvalued mortgages, and a public which thinks this is ultimately in their interest.

      • I couldn’t agree more, what a scandal born of ignorance and venality.

        I couldn’t agree more with DeepT:

        “….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…..”

  2. Excellent work.

    Our hands are not tied by the existing level of household debt – only if we do nothing.

  3. A great piece, thank you.

    0.15% p.a. for a liquidity facility is unbelievable. Government sponsored protectionism of monopolies/oligopolies in this place is out of control.

    To think that spivvy outfits such as those with yellow shopfronts popping up all around us benefit from such a subsidy angers me.

    • ” Government sponsored protectionism of monopolies/oligopolies in this place is out of control.”

      That it is.

  4. “The fate of land bankers, subsidised housing investors, depositors with unearned gains and bankers with implicit public support should be of little consideration”

    agree with all except maybe depositors – they are the victims here, where else do you park your money whle waiting for house prices to drop so you can buy and get established? I think the key is to get banks to the point where implicit guarantees are not required. My suggestion last week of 80% tax rates to all banks who do not sign up to a total “opt out” of the gurantee would make sense here. FORCE them to have higher capital ratios etc. Its that simple.

    • Extending the current 70bp “govt guarantee” charge, that is currently only collected on a few large guaranteed bank deposits and Term funding issuances during the GFC, to all retail deposits beneath $250k would be an even better start… it would also be a nice revenue raiser.

  5. I agree with your sentiments but:
    i) the simple fact is that an uncontrolled case of systemic risk is going to cost you 25% of GDP and harm everybody, not just the odd property developer or 95% lvr borrower
    ii) the only way to kill systemic risk when it threatens to occur is by government support of the system (this is clearly an externality which benefits banks in particular(produing agency problems) and the community in general). No amount of liquidity or equity will cover the demands of depositors scrambling to get their money (note the way the FDIC treats the 1000s of banks which default in the US each decade, or the Dutch authorities with SNS) and in Australia whenever you have a non systemic bank failure it has to be minute or it will mestatise to the big 4.
    iii) So because of the size of the big 4 banks, you are stuck with government support or you have a great depression.Whichever is the case the public pays
    iv) So what you need to do, and write about, is how you ex ante regulate and ex ante charge so as you reduce your agency problems (you will never eliminate them.)
    Not sure that bailing in bond holders and not depositors is a smart thing to
    Nor am I sure about supply restrictions that you all bang on about in your macroprudential ruminations as being the answer. The price mechanism is the only thing that ulitmately works, but we have a oligpopoly that tends to be a natural monopoly , so even if you increase capital levels, it will simply be passed onto users of banks.
    The only effective solution I can think of is to split the banks and reduce their ratings, so that all banks compete on an even footing, but that is macro level stupid, as it means that the total cost of the system is increased.
    Having said that, the big 4 and the ABA continually sucker punch the authorities about any competition or survival issue. The most effective interest group in the country

    • Smokester

      My post wasn’t offering detailed solutions to the problem that already exists but again pointing the non experts to how the system is set up. My only suggestion is that lenders and shareholders must know they are at risk.

      I question the exaggerated cost to GDP of 25% in house prices reverting to long term affordability and price levels but any exaggerated increases in GDP in the past caused by excessive debt which cannot be repaid must ultimately be exposed.

      Lastly, the real point of my post was the last para with which you seem to agree. Just nail those colours.

      If our banks are public utilities then the bankers should be paid as such. That’s a start to addressing the problem

      • I say, on good authority, that in the long run there is a “cost to GDP” of urban land value being inflated.

        Ludwig Von Mises’ most famous quote (I think) is the following:

        “….The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved….”

        I would like to add, as a corollary to that, that there is no means of avoiding a final and catastrophic failure in urban economies when policies are pursued, of forever forcing up and keeping propped up, the prices of urban land. The high prices are a cost to every part of the economy that actually produces any real wealth, and hence the high prices are the means of the destruction of the system in which they are embedded.

        Consider this: how well would we expect our rural sector to do if we forced up the price of their land tenfold and more? Why are we so blase about doing this to our urban economies?

  6. I’m with you Squirell. No sympathy for the Megamortgage folks who are overstretched, out on a limb, home equity to be rubbed out, underwater. Did someone hold a gun to their head?
    Duped by who? Couldn’t see this coming? Personal indebtedness at historic highs, yet still signing up for the McMansion, and the jetski, three holidays a year in Asia etc. on the cc.
    And it’s the thrifty depositor, prudently saving for a rainy day with an approved and regulated bank who should take the hit? I don’t think so, DeepT. First up it should be the banks’ shareholders, you know the ones who laugh at the depositors as they collect their ever increasing fully franked dividends, who should get creamed. No dividends for a while. Then it’s the investors in the bank’s securities who should be next. You remember, potentially higher reward for the higher risk? Well, risk just walked in.

      • I don’t give a stuff for bondholders either. They lent the banks money that was loaned out again to house buyers; they knew the risk they were taking, and have made a drastic mistake about the level of it, just like the famous buyers of MBS’s (and even worse, derivatives based on MBS’s) in the USA. I see no difference.

        It is quite enough moral hazard in the modern economy, that so many ordinary people are shielded from the consequences of bad decisions that make them less capable of earning a reasonable income and/or providing for dependents; it is far worse moral hazard to shelter the voluntary investors of surplus wealth from THEIR mistakes.

        We badly need to get this surplus wealth going into productive investments; letting the investors in non-productive Ponzi schemes get stiffed as they deserve, has to be part of that process.