444 Heading for Housing crash: Australia's banks are borrowing from abroard - in foreign currency -

Heading for Housing crash: Australia's banks are borrowing from abroard - in foreign currency - to fuel our housing bubble

(1) Beware the housing bubble
(2) Australia's housing is 63% overvalued - The Economist; bubble is funded by foreign borrowing
(3) Foreign Investors Shun Australian Bank Debt
(4) Deep T - The Capital Rort
(5) ANZ offers to buy back foreign debt raised under federal government's guarantee
(6) Jeremy Grantham on Australian housing bubble (again)
(7) Don't assume that China will save us; it will buy from Africa & Latin America

(1) Beware the housing bubble
by Paul Syvret
Courier-Mail
February 12, 2011

http://www.couriermail.com.au/news/opinion/beware-the-housing-bubble/story-e6frerg6-1226004877143

MACBETH, of course, all ended in tears and the question now being asked by many investors is whether the Australian property market will suffer a similarly bloody demise.

And it is not just Australians. Increasingly, foreign investors are looking at our real estate market and asking how on earth the seemingly sky-high prices and low affordability ratios can be sustained and if, in fact, the country is near the top of a housing bubble.

One such group arrives next week, when the Motley Fool's international investment team begins a study tour.

Don't be fooled by the name, as Motley Fool is a financial services group that has been around for nearly two decades and reaches millions of small investors.

When it comes to the Australian property sector, they have three questions:

1: Is Australia's housing bubble bigger than the one in the US?

2: What would trigger a correction?

3: Who would get hurt the worst?

One of the men they are going to for answers is possibly Australia's most renowned housing bear, University of Western Sydney Associate Professor Steve Keen, an economist who eschews most of the neo-classical economic doctrines in favour of a credit-oriented analysis of demand.

Keen has been calling a top (and predicting a long and painful fall) for the housing market for some time and indeed famously lost a bet with Macquarie Bank's Rory Robertson some time back which saw him walk from Canberra to the top of Mt Kosciusko.

His answer to their first question pulls no punches: "The Australian housing bubble is categorically larger than the US." If Keen is right, then we are in more trouble than the early settlers, given the collapse of the US mortgage market in 2008 triggered the biggest global financial crisis since the Great Depression.

At the core of our housing bubble, Keen argues, is an explosion in debt combined with a market further distorted and overheated by government incentive payments (which were turbocharged by the Rudd government's doubling of grants during the global financial crisis).

Keen says that, in nominal terms, Australian house prices have increased 600 per cent since 1986.

In the US, they peaked at about a 350 per cent increase in 2006 before the music stopped.

They are now at about 2? times above 1986 levels.

The same story applies to real house prices (which adjusts the figures for inflation). In the wake of the US mortgage crash, the index is about 160 per cent above its 1986 level.

In Australia, we're sitting at about a 260 per cent gain in real terms.

"Though I apportion most blame for the Australian house price bubble to the finance sector, there's little doubt that the fuse itself was lit by the government's intervention via the First Home Owners Scheme, which began in 1983," Keen says.

"This scheme has always been used as a means to stimulate the economy and it's worked, but in much the same way an anabolic steroid will help an athlete win a medal: it pumps up the performance at the event, only to leave the athlete with long-term health problems in the future."

Keen says that on all measures Australian house prices are insanely overvalued, particularly when judged on such measures as price-to-income ratios or price-to-per capita GDP.

"Spruikers claim that there have been significant demographic shifts, that houses now are bigger and better than those in 1970 and so on. However, all of the increase in the house price to GDP per capita index above its average has occurred since 2001 when (former prime minister John) Howard doubled the First Home Owners Grant because of a fear of recession and there has been no real change in Australian demographics since then," he says.

Keen also dismisses claims that demand and population growth are pushing price inflation, arguing the ratio of population to dwellings has been steadily falling.

Indeed, he says, the brief period when population was rising faster than housing stock between 2006 and 2010 actually saw prices weaken.

"Population dynamics gave spruikers a good story, but it wasn't what drove prices up. We've had a debt-driven housing bubble, just as has the US, and it's the dynamics of debt that will determine when and how it bursts, not demographics," he says.

And here is where the numbers get frightening.

Since the 1970s, the ratio of debt per dwelling to price has increased 400 per cent, and the ratio of debt to disposable income has increased by 800 per cent.

"Ponzi schemes ultimately fail under their own weight because they involve paying early entrants more than they put in, while producing no profits with high running expenses," Keen says.

"A debt-financed Ponzi scheme can, however, appear to work for a long time because the price of the object of the scheme in this case house prices can rise so long as debt levels per house rise faster still.

"That was the case in Australia. Property spruikers focus on the price increases and ignore the debt, but the latter has risen far more than the former. Nominal house prices are up by a factor of 15 over 1976, but debt per house has risen by a factor of 55."

Keen contends that, while Australia doesn't have the same "sub-prime" problems that brought the house of cards crashing down in the US, "the level of mortgage debt actually rose faster and higher here".

His hypothesis received some indirect backing from Reserve Bank governor Glenn Stevens yesterday, when he told a parliamentary committee Australia's household debt levels are high by world standards.

"The debt-to-income ratio here back 20 years ago was low by the standards of developed countries, now it's certainly up there with the ones that are high," Stevens said. "This is why we shouldn't always assume really low rates are good because that's one of the things that can prompt people to build up more debt than they should.

"That's how, some people would argue, American households got into trouble after a long period of cheap money."

According to Keen, easy debt lots of it is your basic ingredient in a bubble.

"What will bring this bubble undone is its very success. Having successfully driven house prices skywards, the cost of entry into the market is now prohibitive so that the flow of new entrants is drying up. Since the scheme depends on a constant flow of new entrants, this alone will bring it unstuck," he says.

Keen's critics argue there hasn't been the same sort of speculative housing construction boom here that the US experienced.

He says that's true, but adds: "In the aggregate now, less than 10¢ in every borrowed dollar builds a new home. This does mean that there isn't an overhang of newly completed properties on the Australian market.

"But conversely, the huge proportion of investors who have bought in solely to achieve capital gains means that the investor side of the market is very fragile. Any sustained pause in price increases means these investors face mounting losses."

What of all the property analysts who may agree Australian house prices are overheated, but say we are in for a soft landing, with falls largely limited to a decline in real prices (and affordability improving as incomes rise) over the period of a few years?

"There has simply never been an asset bubble that has burst and gone sideways. Never," Keen says.

syvretp@qnp.news ltd.com.au

(2) Australia's housing is 63% overvalued - The Economist; bubble is funded by foreign borrowing
http://www.unconventionaleconomist.com/2010/11/australian-banks-delusion-meets.html

MONDAY, NOVEMBER 8, 2010

Australian Banks: Delusion Meets Desperation

The following article was posted on Seeking Alpha - a leading North American investment blog that provides free investment market analysis primarily from money managers, investment newsletter writers, and the general public.

The great Australian housing bubble debate is gathering momentum. In recent weeks, several international observers have released warnings that Australia's housing market is severely overvalued. For instance, in its latest survey of global house prices, the Economist estimates that Australia's housing market is 63% overvalued based on its analysis of “fair value” in housing, which is based on comparing the current ratio of house prices to rents with its long-run average (see below table).

Meanwhile, in his latest quarterly newsletter to GMO investors, Jeremy Grantham again warns that the Australian housing market is an unmistakable bubble waiting to burst, although the speed of the decline is very uncertain.

Outside of a handful of bloggers (including yours truly), the claims that Australia's housing market is a bubble has received strong objections from the mainstream media, banks, and economists who claim that Australia's housing market is underpinned by solid fundamentals, including a strong economy, high immigration and chronic housing shortages.

One well known perma-bull, who has staked his reputation on the robustness of Australia's housing market, has even labelled Grantham's claims "sensationalist and spurious" and has asked "Mr Grantham to cease and desist from his hyperbolic jawboning", and offered him a $100m bet on the direction of house prices.

For their part, Australia's two largest banks - the Commonwealth Bank of Australia (CBA) and Westpac - both of whom are very large issuers of debt in global capital markets and have the most to lose from a housing bust, have recently released reports on why Australia's housing market is sound. The CBA's presentation, prepared as part of a global investor roadshow, received widespread condemnation for using dodgy data and self-serving rhetoric. Likewise, Westpac's report has been attacked in the blogosphere for down-playing the risks inherent in Australia's housing market (see here and here).

The stakes were raised last week when the Reserve Bank of Australia (RBA) raised interest rates by 0.25%, which was quickly followed by a further 0.20% increase (0.45% in total) by Australia's largest lender, the CBA (the other banks are expected to follow shortly). The Opposition Treasury Spokesman, Joe Hockey, had earlier made the case that the government needs to act to rein in unilateral interest rate rises and called for "...a mature debate about the future of banking here in Australia and the challenges around the world", as well as the establishment of another Financial System Inquiry to examine these issues (the previous 'Wallis Inquiry' was completed in 1997). With pressure building following the CBA's unilateral interest rate increase, the Government has now committed to release measures aimed at improving competition in the banking sector.

Adding to the hysteria, these interest rate rises have come at a time when Australia's capital city house prices are starting to fall (see below table), whilst auction clearance rates are at two-year lows.

The banks are vigorously defending their position arguing that their costs of wholesale funding are rising as cheap borrowings undertaken prior to the global recession need to be rolled-over at a higher rate.

The chief lobby group for the banks, the Australian Bankers Association (ABA), argues that bumper profits are needed to allay concerns of international investors about a potential housing bubble, and attributes worries about Australian house prices on overseas markets as part of the reason for any extra rate hikes by its members.

According to the ABA's chief, Steven Munchenberg:
“Over the last few weeks, we've had a lot of international investors asking very detailed and probing questions about why it is Australia thinks it doesn't have a housing bubble... Bankers were grilled at length as to why investors should not be worried Australia has a housing bubble... [The Australian banks remain] very conscious of the risks of international investors becoming nervous about investing in Australia".

Then in another article, the ABA chief elaborated further on the risks the banks face:
"The danger ultimately is that if we can't raise that money offshore, we can't lend it in Australia. And then what you get is credit rationing...You get people running businesses who can't get loans or renew their loans. You get people who can't raise money to buy their house, and that's a far worse situation...I can't honestly tell you that we need exactly 'this much' profit to keep those international investors happy so they keep putting money into Australia. But I can tell you that they want to see solid profits to do that."

In a similar vein, the CBA Chief Executive, Ralph Norris, has defended his bank's actions whilst warning that political action against the banking sector could hurt their ability to raise funds offshore:
The Commonwealth Bank chief executive, Ralph Norris, says the prized AA credit ratings of the big four banks could come under pressure from Canberra increasing regulation or pushing through controls on mortgage pricing.

Speaking publicly for the first time on the interest rate furore engulfing his bank, Mr Norris said political fire directed at the industry was creating uncertainty among overseas investors.

In the end, jawboning on interest rates and by us not moving on interest rates creates uncertainty in offshore markets, Mr Norris told Weekend Business.

I've had a lot of negative comments from investors internationally in recent weeks that Australia does not look like a particularly business-friendly environment from the point of its politicians.

Curiously, at the same time as denying the existence of a housing bubble, the CBA appears to be trying to escape the market they were part of creating, by reducing its exposure to mortgage lending:
The Commonwealth Bank has been building up its domestic mortgage book at an anaemic rate while mounting a fierce argument that the nation has not suffered a housing bubble.

Data from the banking regulator [APRA] suggests that Australia's biggest mortgage lender is increasingly averse to new lending, growing its home loan book at the slowest rate among the major banks.

CBA's total mortgage lending grew by just 0.36 per cent in September -- the same month that chief executive Ralph Norris travelled abroad to assure investors there was no property bubble in Australia.
The heart of the issue:

As discussed in my earlier article, The Great Australian Housing Bubble, the Australian banks have been willing enablers of Australia's housing bubble via their increased emphasis on housing lending relative to other forms of lending (such as lending to businesses); which has been funded to a large extent by heavy offshore (foreign) borrowings.

This structural shift toward housing lending is clearly evident by the below chart, which shows the dramatic rise in mortgage lending as a percentage of total credit.

Regarding the banks' heavy offshore borrowing, consider first the below chart, which I have produced from Australian Bureau of Statistics (ABS) data, showing the breakdown of offshore borrowings by Australian depository corporations, split-out between short-term debt (maturing in less than 12 months) and long-term debt (maturing in more than 12 months). Depository corporations comprise banks (accounting for the overwhelming majority of foreign funding), building societies, credit unions and registered financial corporations.

As you can see, offshore borrowings by depository corporations has exploded over the past 20 years, from around $50 billion in 1988 to nearly $700 billion currently.

Currently, depository corporations have around $300 billion of short-term foreign borrowings maturing within 12 months, in addition to another $380 billion of longer-term foreign borrowings outstanding. Other things equal, this $300 billion of short-term foreign borrowings must be refinanced within 12 months just to maintain the current level of credit within the Australian economy (let alone increase it).

Now consider the total value of Australia's residential housing stock split-out by equity and debt (see below). There is currently around $1.1 trillion of housing debt supporting $4 trillion of housing assets.

Finally, consider the below chart, which shows three indexes starting at January 2000 representing the growth in residential loan assets, bank deposits and offshore borrowings. It also includes a ratio to compare residential housing loans and deposits.

What should become increasingly clear is that the growth in Australian housing values has been funded, to a large extent, by foreign borrowings, much of it short-term.

The key risk is that the banks ability to refinance their borrowings rests with the willingness of foreign investors to continue to lend them money. When times are rosy, perceived risks are low, and credit is freely available - such as prior to the onset of the global recession - the banks are able to refinance their foreign borrowings easily and cheaply. But in times of heightened risk-aversion - such as when Lehman Brothers collapsed in the dark days of the global recession - foreign investors are less inclined to continue extending credit, leaving Australia's banks, house prices, and broader economy exposed to a sudden liquidity shock. This is the pro-cyclical nature of modern, risky finance. During good times, asset prices become inflated by easy credit. But when circumstances sour, credit is pulled-back, causing debt-deflation.

It is matter of historical record that Australia's banks were saved during the global recession by the extraordinary measures undertaken by the Australian Government. The banks inability to raise funds offshore at reasonable cost meant that, without the Government's support, their cost of capital would have risen dramatically, they would have had to immediately withdraw credit from the Australian economy, and might eventually have faced insolvency.

Fortunately for the banks, the Australian Government and Reserve Bank responded swiftly by unleashing a raft of measures aimed at supporting both their ability to borrow funds as well as their asset base (i.e. home values).

Measures undertaken to underwrite the banks' borrowings (liabilities) included:
The Government's Guarantee Scheme for Large Deposits (>$1 million) and Wholesale Funding, which functioned from 28 November 2008 until 14 March 2010;
The Government's Guarantee of Deposits <$1 million, which will remain in place until 12 October 2011; and
The RBA permanently relaxed the requirements on the assets that it accepts as collateral in exchange for loans provided to financial institutions (called 'repurchase agreements') [see here for a detailed examination of this measure].

On the asset-side, the Government successfully re-inflated the housing bubble through a temporary doubling of the First Home Buyers Grant to $14,000 for existing dwellings and $21,000 for new dwellings, as well as temporarily relaxing the restrictions on Australian home ownership by foreign citizens.

These measures were not costless to the Australian taxpayer. The wholesale funding guarantee has racked-up $154 billion of contingent liabilities for the Australian Government, whereas the deposit guarantee has accumulated around $600 billion of contingent liabilities. For its part, the temporary boost to the First Home Buyers Grant cost taxpayers in excess of $1 billion.

Of greater concern is that, although the Guarantee Scheme for wholesale debt and large deposits has expired, there is now the expectation that the authorities will support the banks when required going forward. Our too-big-to-fail banks are continuing to borrow heavily offshore under the cover of an implied government (taxpayer) guarantee that they expect will become explicit should foreign investor appetite for the banks' debt again fade.

The banks know they have Australian taxpayers over a barrel. They might as well be saying: "provide us with your backing or we will restrict credit, crashing both the housing market and economy and, in the process, destroying middle Australia's main source of wealth".

Where to from here?

With deposit growth flattening, business lending already cut-back, and offshore borrowing becoming more difficult in spite of implicit government support, where will future house price growth come from if credit is constrained? One industry insider believes he has the answer:

The big four [banks] are just starting to struggle to fund asset growth which has only been in residential mortgages. It all demonstrates that the fate of the housing market without further government intervention is way out of the hands of the RBA or any other regulator...

However, vested interests are working on the solutions to make it much much worse. The scenario is that the Government will be lobbied to bring back the guarantee on wholesale debt. However, so that this is directed straight at the housing market, the government will extend the guarantee only to residential mortgage backed securities (RMBS). The Government will charge all issuers the same fee for the guarantee, a gesture at encouraging competition by allowing small and non ADIs access to funds. In return the Government will get some form of commitments to keep mortgage rates low or at least in line with the RBA rates. The gesture to appease the borrowers.

Of course these actions will result in nothing more than a further inject of air into the balloon. We’ll all enjoy the temporary boost until the offshore investors realise that this is just another way of increasing Aussie Govt debt which is also increasing way beyond forecasts due to massive misallocation of resources and then suddenly... Bang!

Interesting times down here in the land of Oz. ...

(3) Foreign Investors Shun Australian Bank Debt
http://www.unconventionaleconomist.com/2010/12/foreign-investors-shun-australian-bank.html

MONDAY, DECEMBER 27, 2010

The Australian banks' excessive borrowing from foreigners, which has been used to fund the Great Australian Housing Bubble, is something that I have warned about since starting this blog. This issue first entered my consciousness in 2009 when reading fellow blogger, David Llewellyn-Smith's brilliant book, The Great Crash of 2008.

Amazingly, this issue has received little attention from mainstream Australian commentators and economists who have continually espoused Australia's 'strong', 'conservative' and 'well-regulated' banking system, despite these very same banks requiring considerable taxpayer support during the Global FinancialCrisis.

So it had been left largely to a hand full of bloggers, including Houses and Holes, Delusional Economics, Money Morning, and me to sound the alarm...That was, until now. On Christmas Day, the Herald-Sun and Perth Now published identical articles warning that the foreign investors whom funded the Great Australian Housing Bubble are growing cautious:

AUSSIE banks, once held up as the envy of the world, are now at the mercy of foreign lenders.

Despite the Federal Government's measures to boost competition in the banking market, little has been done to address the huge reliance on overseas lenders to fund our mortgage market.

Official figures show our banks now owe overseas investors a record $352.7 billion, equivalent to 27 per cent of the country's entire economic output.

The extraordinary figure, contained in data from the Australian Bureau of Statistics, is fuelling concerns Australia's financial system is becoming over-stretched...

Global fund managers are already getting nervous about Australia's overheating property market - a fact that could lead them to charge a higher interest rate for money they lend to our banks - or withdraw funding all together.

"If the global economy recovers strongly that could push interest rates up a lot, and that's a real risk for Australia's because rates are already high and house prices are becoming an issue," said Trevor Greetham, asset allocation director at Fidelity Investments in the UK, which has $3.4 trillion under management.

Analysts said if Mr Greetham and others like him withdraw funding, then our banking system will be plunged into a catastrophic credit crunch. Mortgages will be rationed, minimum deposit sizes will be forced up and property prices are likely to collapse...

"Everybody is looking for the first signs that overseas investors have had enough," one banking analyst said.

Gerard Fitzpatrick, global fixed income portfolio manager for Russell Investments, said he was increasingly cautious about lending to Australian banks.

Speaking from London last week, he cited the recent catastrophe in Ireland, where the house price bubble effectively broke the banks.

"I'm not saying Australia is the same as Ireland, but there are definitely similarities," Mr Fitzpatrick said.

"You've had a booming housing sector and rapidly increased lending by banks.

"The two situations have enough in common for bond investors to consider the consequences for the Australian housing market - and the banks that are supporting it."

Wow. It's no big deal when a handful of contrarian bloggers sound the alarm over our banks' heavy offshore borrowings and the risks of a sudden liquidity crisis. But when two of the nation's main tabloid newspapers warn of a possible credit crunch and property market crash, then its time to take this issue seriously.

Even if foreign investors continue to provide funding to Australia's banks, the cost is likely to rise significantly. A recent article published in New Zealand's Business Day explained this situation:

Banks posted record profits in 2010 but earnings growth in the coming year may be difficult as the big four Australian banks behind New Zealand's trading banks prepare to compete for funds with heavily indebted foreign governments...

On top of the competition from foreign governments in the coming years, the banks are having to refinance their debt at higher post-GFC rates and will pay a premium for longer-term debt as they seek to lock in funding.

"There's going to be a lot of demand for longer duration bank debt than what we've seen in the past," CLSA Asia Pacific analyst Brian Johnson said.

Credit Suisse's Jarrod Martin and James Ellis warned local banks could be crowded out.

This is at a time when the local banks have a huge funding requirement, with CBA and Westpac the fourth and fifth biggest borrowers in global debt markets, UBS analyst Jonathan Mott said.

The past decade saw banks lend more money to home buyers and businesses in Australia without matching the lending with savings. The funding gap was filled by a growing reliance on offshore debt markets...

Now a greater challenge lies ahead: having to compete harder in offshore credit markets against global banks and heavily indebted northern hemisphere governments expected to issue debt aggressively from 2012.

"Banks could find their access to flows of wholesale funding diminishes below critical minimum requirements (their annual re-financing tasks) which cannot easily be replaced by other funding sources," Messrs Martin and Ellis said.

"Ultimately that cost would be passed through to borrowers...
So it looks like one of the key pillars supporting the Great Australian Housing Bubble - easy credit - is showing signs that it might collapse. No wonder then that the Australian Government recently announced that it will permit Australia's banks to issue covered bonds to open up a new source of relatively low cost funding, even though they could put depositor and taxpayer funds at risk.

But even if covered bonds can successfully increase the flow of credit to the Australian economy, you have got to wonder whether tapped-out households will accept the offer of more debt. The fact is, the hubris and exceptionalism previously displayed by the Australian populace regarding Australia's banking system and housing market appears to be evaporating and confidence waning. And as with all assets fuelled by debt, confidence is everything. Once the masses stop believing that borrowing heavily to buy housing is a sure bet, then the Australian housing ponzi will collapse on itself. Home buyers will delay purchasing just as sellers rush for the exits. I described the psychology of the housing market in an earlier post:

Property market observers should also be careful to not get too carried away in applying conventional demand-supply dynamics to the housing market.

Ongoing price increases within the housing market often stimulate demand as opposed to the conventional assumption that price increases suppress demand. This is because as prices rise the 'got to get in now' mentality intensifies. So as prices rise, more and more people are attracted to purchasing (investing in) houses, pushing prices up further and attracting even more people into the market.

Eventually, however, excessive leverage sees the hysteria unravel. People start selling and as the number of properties on the market begins to increase and prices begin to fall, the 'got to get out now' mentality begins to develop. Eventually, the number of people exiting the market develops into a stampede despite prices falling (which 'should' stimulate demand), and the bubble pops. Only time will tell whether this dynamic has been the real driver of house price growth over the last decade.

With credit in Australia likely to contract, cracks appearing in the China growth story, and poor demographics, it looks like the Australian housing market and economy might be in serious trouble. ...

(4) Deep T - The Capital Rort

http://macrobusiness.com.au/2010/11/deep-t-the-capital-rort/

Posted by Delusional Economics in Uncategorized on Nov 16th, 2010

{LVR = Loan to Valuation Ratio; LMI = Lenders Mortgage Insurance}

It really is an extraordinary situation Australia finds itself in right now. Whilst we can learn much from history, don’t look there for the answer on this one as the financial position of the country is unprecedented. Although this is par for the course for just about the entire globe, ours seems to be a different different.

Arguments abound across the web and mainstream media about whether all’s good or the holocaust awaits. Did we survive the GFC better than any western country or did we prime the bubble for a much larger fallout? My school of logic says that the mere fact that so much debate exists means there is a problem. If we accept that there is a problem to be managed then the more the real facts are explained, perhaps the more manageable the problem and the less the fallout. Hysterical bubble talk and delusional denial is not constructive but a “let’s understand what’s going on” may produce some positive results. Unfortunately, both bank and Government spokespeople have far too much vested interest to speak the plain truth.

As far as mainstream media is concerned, do any of you media hacks out there have the figures on how much revenue is generated for Fairfax and News by real property advertising in Australia? Unfortunately, everyone the public relies on has a massive thumb in the 4 and 20.

Now that I’ve got that piece of self justification off my chest, let’s have a look at some truth in how the banks calculate capital for residential mortgages.

There are two ways an Australian Deposit taking Institution (“ADI”) calculates capital to be allocated against a residential mortgage. Either in accordance with APRA’s APS 112 Attachment C or under Advanced Basel II methodology. Let’s address the rather simple APRA methodology first and then look at the implications of the advanced method.

My critics may be saying that I oversimplify. If it’s the simple truth then they’re correct but you can’t understand the bigger position without knowledge of the basic fundamentals. That’s where it starts.

My simple question is, how much capital does an ADI need to allocate to a mortgage over time? Let’s start with a $100 mortgage and the table below from APS 112 for standard mortgages.

The way ADI capital calculations are articulated, a 100% weighting on a $100 loan asset translates into $8 of capital but APRA weights standard residential mortgages as per Table 4 which shows a lower weight for lower LVR’s.

Therefore if a mortgage is standard and written at 95% LVR then the capital allocated is $100 *75%*8% = $6. On the basis that an ADI wants a 20% return on capital then a borrower pays $6*20%=$1.20 pa to the bank as a return on capital. We’ll not complicate matters by doing the calculation for mortgage insurance as this also involves calculating the capital required for the LMIs.

However, I will make the unsubstantiated statement that the total capital now in the system needed by both the ADI and LMI is at least equal to the amount required for an uninsured mortgage. However, for a very long time it was not and a significant arbitrage was in the system between ADI’s and LMI”s until 2008.

The definition of standard loan is as follows as referenced in APS112.

6. A standard eligible mortgage is defined as a residential mortgage where the ADI has:

(a) prior to loan approval and as part of the loan origination and approval process, documented, assessed and verified the ability of the borrowers to meet their repayment obligation;
(b) valued any residential property offered as security; and
(c) established that any property offered as security for the loan is readily marketable.


The ADI must also revalue any property offered as security for such loans when it becomes aware of a material change in the market value of property in an area or region.

Sounds reasonable enough, even the last sentence. But here lies the “arbitrage the system” opportunity that every banker dreams of. APRA in APS-112 have insisted that property is revalued by an ADI if “it becomes aware of a material change in the market value of property in an area or region”. I will express an opinion here that I’m sure APRA was trying to protect against properties falling in value but have left open the biggest game in town for all our banks.

Currently the major and regional banks use the services of the new technology of automated valuation models (AVMs) to revalue their mortgage books upwards to decrease their capital requirements. Has a light switched on yet as to why there has been such a dramatic rise in the use and media coverage of those property valuation spruikers. If anyone knows of one of those banks who do not use AVMs can you please let us all know.

So what is the effect of continually revaluing the properties upwards? Using our standard 95% LVR mortgage above, let’s assume a revaluation so that the LVR is now 85%. The capital required is now $100*50%*8%= $4 with a return on capital requirement of $4*20%= $0.80 pa. Quite a difference, and if we go one step further, then the result and achieve a 75% LVR then the capital is now $2.80 with a return requirement of $0.56.

So with roughly a revaluation of the property of 20% (ask any property spruiker, “That’s nothin’ mate!”) a bank can save itself $3.20 of capital per $100 of mortgage which can be recycled as capital to support another mortgage. Think about how that increase in both return on capital and funds allocated to another mortgagor slave is an absolute incentive for bankers to perpetuate the cycle up of house price valuations. Their reward? Huge bonuses based on what is in essence a positive reinforcement spiral where everyone pats each other on the back for what a great job they’re doing. Well at least, that is, until the money runs out.

What was that? Did you hear anything? Maybe the sound of a slow burning fuse? But I digress.

Under advanced Basel II methodology, banks are able to have their own approved internal models which replace the APS112 requirements. These models only make it much less transparent as to what the capital calculations are based on. Please see the CBA’s statement and make note of the amount of residential mortgages used to calculate capital adequacy on APS 330 Table 16a to 16d – Capital adequacy (risk weighted assets) ie $ 56,753M and the actual credit exposure on table APS 330 Table 17a – Total credit exposure excluding equities and securitization ie $326,384M to understand the extent of the difference between what is actually lent and the exposure used to calculate capital.

In this case for CBA it’s $269Bn. I cannot explain how the numbers have been calculated other than to point them out and that some internal model which updates valuations has been used. The benefits on the way up in house prices would seem to be huge. What would the effect be if house prices dropped 20%?, 30%?, 40%?

If you have followed all of this then you have my utmost compliments, but also, maybe your heart should also be jumping a beat or two. The emu in the kitchen is not what losses the banks will have to suffer if house prices reduce and borrowers default in large numbers, it is where do they find the capital to support all those loans now on increased LVRs that have not defaulted? As APRA have required, The ADI must also revalue any property offered as security for such loans when it becomes aware of a material change in the market value of property in an area or region. A positive reinforcement spiral on the way up and a negative one on the way down.

Maybe that’s not a fuse I hear, but a gurgle….gurgle…..blup!

As all 4 major banks have the same issue to varying degrees, this is a huge systemic risk. It also means for this writer anyway, that it’s not difficult to predict what will happen. The current Government will, in cahoots with the banks, do all in its power to prop up the mortgage and housing markets to the misery and detriment of all new borrowers and many existing ones. Like the bank CEO’s, the PM and her ministers, ie when the truth is finally drummed into their incompetent heads, will just be praying that they’ve collected their loot and past the parcel before it all collapses.

Maybe, Matilda, the gangs will take over the highways!

(5) ANZ offers to buy back foreign debt raised under federal government's guarantee

http://www.smh.com.au/business/anz-offers-to-buy-back-some-foreign-debt-early-20101231-19bwz.html

ANZ offers to buy back some foreign debt early
Danny John
January 1, 2011
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ANZ has become the first of the big banks to buy back a tranche of foreign debt raised under the federal government's triple-A credit rating before the bonds were due to mature.

In a move that reflects the improving health of international credit markets, the country's third-largest bank has opened a fortnight-long window for investors to cash in $1.9 billion of notes a year earlier than planned.

The bonds were issued just over two years ago, after the government offered to guarantee the banking industry's funding requirements because debt markets had frozen in the global financial crisis.

Despite being some of the strongest financial institutions in the world, Australia's big four banks - along with the second-tier operators, such as Bank of Queensland and Suncorp - were unable to raise money for the best part of a year without the backing of the wholesale funding guarantee.

In all, the banking sector raised $160 billion in debt in tranches ranging from three years to five years, with the earliest sums due to mature at the end of this year.

As well as paying much higher interest rates to investors because of the perceived risks caused by the crisis, the banks are charged an annual fee by the government for using its credit rating, which makes that debt more expensive to maintain than that raised under their own ratings.

The big four banks, with their double-A ratings, pay a fee equivalent to 0.7 per cent on the total amount; the lower-rated smaller banks are charged as much as 1.5 per cent.

The recovery in credit markets over the past year means that non-guaranteed debt is now cheaper to raise than that with the guarantee. As a result, the banks have not felt the need to use the guarantee since the last quarter of 2009. The government withdrew its support for new raisings at the end of last March.

ANZ, which raised about $20 billion under the guarantee, has offered to buy back 10 per cent of its outstanding foreign debt between now and January 13 at a market-set rate of interest.

Its offer was announced a month after National Australia Bank offered to buy back $2950 million of guaranteed debt that had been raised from domestic credit markets at the height of the financial crisis. The NAB bonds were due to mature in March next year.

(6) Jeremy Grantham on Australian housing bubble (again)

By Gareth Brown

http://blog.intelligentinvestor.com.au/doddsville/jeremy-grantham-on-australian-housing-bubble-again/

OCT 28,2010

Below I’ve republished a postscript from Jeremy Grantham’s latest quarterly letter to GMO investors, titled Night of the living Fed. The information is free to registered users, so I hope he won’t mind. For those who are interested in reading Grantham’s reports on a more regular basis, head to www.gmo.com and register for free. Grantham is one of the best thinkers in the investment world.

The topic of Australian house prices generates loads of argument from both sides of the debate, even in our own little office. I’m hoping to avoid a brawl here, though, and merely wish to pass on a piece of writing I found useful and funny. I’m with Grantham, you can make up your own mind.

GMO quarterly 26/10/10 – page 15-16

Postscript: Australian and U.K. Housing

I happily concede that the U.K. and Australian housing events are not your usual bubbles. Australia, though, does pass one bubble test spectacularly: we have always found that pointing out a bubble – particularly a housing bubble – is very upsetting. After all, almost everyone has a house and, not surprisingly, likes the idea that its recent doubling in value accurately reflects its doubling in service provided, e.g., it keeps the rain out better than it used to, etc. Just kidding. So, the house is the same. Perhaps the quality of the land has changed? In any case, Australians violently object to the idea that their houses, which have doubled in value in 8 years and quadrupled in 21, are in a bubble.

The U.K. and Australia are different partly because neither had a big increase in house construction. That is to say that the normal capitalist response of supply to higher prices failed. Such failure usually represents some form of government intervention. In Australia, for example, the national government sets the immigration policy, which has encouraged boatloads of immigration, while the local governments refuse to encourage offsetting home construction. There has also been an unprecedentedly long period of economic boom in Australia, and the terms of trade have moved in its favor. And, let’s not forget the $22,000 subsidy for new buyers. But does anyone think that bubbles occur without a cause? They always need two catalysts: a near-perfect economic situation and accommodating monetary conditions. The problem is that we live in a mean-reverting world where all of these things eventually change. The key question to ask is: Can a new cohort of young buyers afford to buy starter houses in your city at normal mortgage rates and normal down payment conditions? If not, the game is over and we are just waiting for the ref to blow the whistle. In Australia’s case, the timing and speed of the decline is very uncertain, but the outcome is inevitable. For example, the average buyer in Sydney has to pay at least 7.5 times income for the average house, and estimates range as high as 9 times.

With current mortgage rates at 7.5%, this means that the average buyer would have to chew up 56% of total income (7.5 x 7.5), and the new buyer even more. Good luck to them! In the U.K., which also has floating rate mortgages and, in this case, artificially low ones, the crunch for new buyers will come when mortgage rates rise to normal. But even now, with desperately low rates, the percentage of new buyers is down. Several of these factors, which do not apply to equities, make for aberrant bubbles, and clearly the Australian and U.K. housing markets fit the bill. In comparison, the U.S. and Irish housing bubbles behaved themselves. So let’s see what happens and not get too excited. After all, these may be the first of 34 bubbles not to break back to long-term trend. There may be paradigm shifts. Oil looks like one, but oil is a depleting resource. If we could just start depleting Australian land, all might work out well.

(7) Don't assume that China will save us; it will buy from Africa & Latin America

Slugging it out over our future direction

Sydney Morning Herald
December 27, 2010

http://www.smh.com.au/business/slugging-it-out-over-our-future-direction-20101226-197w7.html

Maris Beck asks investment experts to make their predictions for 2011.

In his classic Australian history The Tyranny of Distance, Geoffrey Blainey wrote: "So far as we know, Australia had only one commodity which was valued beyond its shores towards the end of the 18th century - the trepang or sea slug …"

A few centuries later the country is in the throes of a commodities boom - and sea slugs have sunk from export prominence.

Times have changed, and they will change again. The question is how.

As investors position themselves for the year ahead, the mining sector and Australia's largest trading partner, China, are central to their considerations. Many believe the commodity bonanza and sustained Chinese growth saved Australia from the worst of the 2008 crash.

But as the stalled engines of global growth sputter back to life, the global head of economics at Macquarie, Richard Gibbs, has warned that the mining bonanza is a fool's paradise.

Gibbs believes China will increasingly look to Africa and Latin America as alternative sources of crucial commodities.

"As each year goes by, we get closer to the year when the Chinese are going to bring to the table significant new competing supply," he says.

Australia's two-speed economy, in which mining services growth outstrips other sectors, is a liability, Gibbs says. "In the same way the gains in China were magnified in the Australian economy, any losses in China will be magnified. It is a double-edged sword." ...